Chapter 16Basics of Financial Derivatives

Derivative instruments, or simply derivatives, are contracts that derive their value from the behavior of cash market instruments such as stocks, stock indexes, bonds, currencies, and commodities that underlie the contract. There are three general categories of derivatives: (1) forwards and futures, (2) options, and (3) swaps. Derivatives are also classified based on the underlying asset or reference for the contract. Commodity derivatives have as their underlying traditional agricultural commodities (such as grain and livestock), imported foodstuffs (such as coffee, cocoa, and sugar), or industrial commodities. Derivatives based on a financial instrument or a financial index are classified as financial derivatives and include equity derivatives, interest rate derivatives, credit derivatives, and currency derivatives.

This chapter is the first of three chapters that cover the first three financial derivatives (equity derivatives, interest rate derivatives, and credit derivatives) and their applications to portfolio management. In this chapter we introduce the different types of financial derivatives, their risk-return characteristics, and the fundamentals of how they are priced. The next two chapters focus on the specific applications. Chapter 17 explains and illustrates the application of equity derivatives to equity portfolio management and Chapter 18 explains and illustrates the application of interest rate and credit default swaps ...

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