Finance: Capital Markets, Financial Management, and Investment Management

CHAPTER 6

Basics of Derivatives

Derivative instruments play an important role in financial markets as well as commodity markets by allowing market participants to control their exposure to different types of risk. In this chapter, we describe the various types of derivative contracts. The two basic derivative contracts are futures and forward contracts and options contracts. There are other types of derivative contracts that are economically equivalent to a package of these two basic contracts: swaps and caps and floors. We explain the investment characteristics of all of these contracts and the basic principle of pricing futures and forward contracts. In Chapters 20 and 21, we explain how derivative instruments are used in investment management and how the pricing of the derivatives may deviate from the pricing model explained in this chapter.

FUTURES AND FORWARD CONTRACTS

Basic Features of Futures Contracts

A futures contract is a legal agreement between a buyer and a seller in which:

1. The buyer agrees to take delivery of something at a specified price at the end of a designated period of time.

2. The seller agrees to make delivery of something at a specified price at the end of a designated period of time.

Of course, no one buys or sells anything when entering into a futures contract. Rather, those who enter into a contract agree to buy or sell a specific amount of a specific item at a specified future date. When we speak of the “buyer” or the “seller” of a contract, ...