Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 42. Introduction to the Pricing of Futures/Forwards and Options

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Abstract: There are various models that been proposed to value financial assets in the cash market. Models for valuing derivatives such as futures, forwards, options, swaps, caps, and floors are valued using arbitrage principles. Basically, the price of a derivative is one that does not allow market participants to generate riskless profits without committing any funds. In developing a pricing model for derivatives, the model builder begins with a strategy (or trade) to exploit the difference between the cash price of the underlying asset for a derivative. The market price for the derivative is the cost of the package to replicate the payoff of the derivative.

Keywords: futures contract, forward contract, delivery date, settlement date, initial margin, variation margin, clearinghouse, cash-and-carry trade, reverse cash-and-carry trade, net financing cost, cost of carry (carry), positive carry, negative carry, call option, put option, American option, European option, strike price, expiration date, at-the-money option, in-the-money option, out-of-the-money option, intrinsic value, time premium, put–call parity relationship

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. When using derivatives, ...