LEARNING EXTENSION 11

Introduction to Futures and Options

In addition to stocks and bonds, the financial system has developed other investment vehicles to meet the needs of various market participants. A type of instrument that is gaining widespread use among institutional investors and corporate financial managers is derivative securities. A derivative security has its value determined by, or derived from, the value of another investment vehicle. They go by a variety of names, such as forwards, futures, options, and swaps. In this learning extension, we will focus on two types of derivatives: futures and options.

derivative security

a security whose value is determined by, or derived from, the value of another investment vehicle

WHY DO DERIVATIVES EXIST?

Most assets that you are probably familiar with, such as stocks, bonds, gold, or real estate, are traded in the cash or spot market. The stock exchanges and the primary and secondary markets we examined earlier in the text are examples of spot markets. Trades occur in these markets, and cash, along with ownership of the asset, is transferred from buyer to seller.

spot market

the cash market for trading securities; where securities are bought and sold

At times, however, it may be advantageous to enter into a transaction with the promise that the exchange of asset and money will take place at a future time. Such an exchange allows a transaction price to be determined today for a trade that will not occur until a mutually agreed ...

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