Foundations of Computational Finance with MATLAB

CHAPTER 8Equity Derivatives

8.1 Introduction

It's relatively easy to grasp the mechanics of stocks and bonds. Stock ownership in a corporation represents equity even when the number of shares owned is a very small percentage of the total number of outstanding shares. If the company's board of directors voted to sell all the assets, pay off the liabilities, and distribute the remaining funds to shareholders, then each shareholder is entitled to his or her relative ownership percentage. Bonds are debt instruments or loans to organizations. In return for lending funds, investors typically expect periodic repayment of interest and principal repayment at maturity. If the organization goes bankrupt or voluntarily ceases operations, bondholders have a claim on assets in an effort to seek repayment.

In contrast, derivatives don't have direct claims on an organization's cash flows or equity. As their name implies, derivative securities derive their value from other financial instruments, such as stocks, currencies, and future contracts, among others. Although the various derivative markets usually don't make headlines like stocks and bonds, they are a vital part of global finance. They trade on public exchanges like the Chicago Board Options Exchange (CBOE) and in transactions between financial institutions in the over-the-counter (OTC) market. Derivatives can be used for speculation, hedging, or to create unique investment return profiles through financial engineering.

Derivatives ...