The Handbook of Financial Instruments

Chapter 28 Equity Derivatives

Bruce M. Collins, Ph.D.

Chief Executive Officer QuantCast

Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor of Finance School of Management Yale University

Derivative instruments, or simply derivatives, are contracts that essentially derive their value from the behavior of cash market instruments such as stocks, stock indexes, bonds, currencies, and commodities that underlie the contract. When the underlying for a derivative is a stock or stock index, the contract is called an equity derivative. The purpose of this chapter is to explain these instruments, their investment characteristics, and to provide an overview as to how they are priced. The basic features described in this chapter for equity derivatives apply to fixed income derivatives, the subject of the next chapter.

THE ROLE OF DERIVATIVES

Equity derivatives have several properties that provide economic benefits that make them excellent candidates for use in equity portfolio management. These properties are derived from the following four roles that derivatives serve in portfolio management: (1) to modify the risk characteristics of a portfolio (risk management); (2) to enhance the expected return of a portfolio (returns management); (3) to reduce transaction costs associated with managing a portfolio (cost management); and, (4) to achieve efficiency in the presence of legal, tax, or regulatory obstacles (regulatory management).

Institutional equity investors have the means to accomplish ...