The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CHAPTER 14

Fundamentals of Equity Derivatives

Bruce M. Collins, Ph.D. Professor of Finance Western Connecticut State University

 

Frank J. Fabozzi, Ph.D., CFA, CPA Professor in the Practice of Finance Yale School of Management

 

 

 

 

 

Derivative securities, or simply derivatives, are financial agreements or contracts between two parties that “derive” their value from an underlying asset. The contract specifies the terms of a payout from one party to another. The underlying asset is typically a cash market instrument such as a stock, a bond or a commodity. When the underlying instrument is an equity security, the contract is called an equity derivative. The equity security can be a stock, a basket of stocks, an index or a group of indexes.

The purpose of this chapter is to explain these instruments, their investment characteristics, and to provide an overview as to how they are priced. In the next chapter, we look at how equity derivatives can be used in the management of equity portfolios.