Financial Economics

18

PRICING DERIVATIVES BY ARBITRAGE: LINEAR PAYOFF DERIVATIVES

Aderivative instrument is a financial instrument whose value depends on some underlying asset. The term “derivative” is used to describe this product because its value is derived from the value of the underlying asset. The underlying asset, simply referred to as the underlying, can be either a commodity, a financial instrument, or some reference entity such as an interest rate or stock index, leading to the classification of commodity derivatives and financial derivatives. Commodity derivatives have as their underlying traditional agricultural products and are distinguished by hard and soft commodities. Hard commodities are products from the energy (e.g., oil and gasoline), precious metals (e.g., gold, platinum, and silver), and industrial metals (aluminium, copper, and zinc) sectors. Soft commodities are typically weather-dependent, perishable commodities for consumption from the agricultural sector, such as grains, soybeans, or livestock (e.g., cattle or hogs). Financial derivatives are a relatively new entrant into the derivatives market in comparison to commodity derivatives. Included in the realm of financial derivatives are derivatives on individual stocks, stock indexes, interest rates, bonds, and currencies.

Although there are close conceptual relations between derivative instruments and such cash market instruments such as debt and equity, the two classes of instruments are used differently: Debt and equity ...