Derivatives: Markets, Valuation, and Risk Management

CHAPTER 1

Derivative Contracts and Markets

A derivative contract is a contractual agreement to execute an exchange at some future date. The term “derivative” arises from the fact that the agreement “derives” its value from the price of an underlying asset such as a stock, bond, currency, or commodity. A stock index futures derives its value from an underlying stock index, a foreign currency option derives its value from an underlying exchange rate, and so on. The key feature of the transaction specified in a derivative contract is that it will be executed in the future rather than today.

One can easily become overwhelmed by the apparently countless types of derivative contracts traded in the marketplace. The pages of the Wall Street Journal (WSJ) list the prices of tens of thousands of standardized, exchange-traded futures, options, and futures option contracts on hundreds of different underlying assets. And this only begins to scratch the surface. The WSJ reports only trading summaries for U.S. derivatives exchanges. Other exchanges worldwide have derivatives trading volume roughly equal to that in the United States. Moreover, the notional amount of exchange-traded derivatives worldwide represents only about 16% of all derivatives outstanding (i.e., USD 233.9 trillion as of December 2003). About 84% of derivatives are private contracts arranged with banks and various other financial houses. Many of these contracts are plain-vanilla forwards, swaps, caps, collars, or floors, but ...