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DERIVATIVES: BASIC DEFINITIONS AND PRINCIPLES

A derivative is an asset whose value depends on another asset or a market parameter, called the underlying asset (or the underlying market parameter). A forward contract on interest rates locks in today a rate applicable tomorrow for a preset period of time. When entering into a forward contract, the buyer or seller has the obligation to comply with the terms of the contract at its maturity. A buyer of a put (call) option on stock has the right to sell (buy) a stock at a preset price until a certain horizon. The seller of an option has an obligation to comply with the contractual rights of the option buyer.

Table 6.1 summarizes the definitions of various common derivatives. Swaps are mentioned, and are defined in the chapter on interest and foreign exchange rates, and belong to the broad family of forward contracts. Derivatives can be written on any underlying:

• stocks

• stock index

• interest rates and foreign exchange rates

• bonds

• options on forward contracts

• commodities

• electricity

• weather

• insurance claims.

Traded instruments are grouped according to the nature of the underlying. The three families are equity, fixed income, which groups all instruments which are interest bearing or depend on foreign exchange, and credit, which is the most recent family of derivatives, of which underlying is the credit risk of an asset. Cross-tabulating the two main families of contracts, forward

TABLE 6.1

Instruments

Definition

Forward contracts

Obligation to buy (sell) and asset at a given price and at a given date, specified at the origin of the contract.

Swaps

The obligation to exchange cash flows at periodical intervals or dates

Options

The right, but not the obligation, of buying (selling) a given asset at a given price over a given period, specified at the origin of the contract.

Futures

Listed forward contracts exchanged on an organized market with standard characteristics.

contracts and options, with the three market segments, covers the spectrum of common instruments. Note that some derivatives are hybrid instruments, with components belonging to two families. For example a quanto instrument eliminates foreign exchange risk: a quanto equity index allows taking a position on a foreign currency equity index, with proceeds in the home currency, without any foreign exchange risk.

The replication principle states that any assets can be replicated by a combination of other financial assets, subject to certain conditions[1]. The replication principle allows one to understand how to engineer, or "construct," products, notably forward contracts and swaps, as illustrated later. The implications are far reaching. A major implication is the "law of one price," which states that the asset price should be the same as that of the replicating portfolio. This is a fundamental law in finance. Another implication is that products can be created synthetically by the replicating portfolio. In these chapters on derivatives, we use the replication principle for showing how simple forward contracts can be constructed as portfolios of other assets.

End users of derivatives are investors and lenders, such as corporations, banks, insurance companies, and funds. Derivatives are used for both hedging and speculation. Typical hedging transactions are those that serve for limiting the uncertainty of certain industrial commercial and industrial transactions, for example by setting a buying price for commodities today for tomorrow. However, the border between speculation and hedging is thin. For example setting today a buying price for tomorrow can also be viewed as a bet that wins when the future price will be lower than the buying price set today for tomorrow. The distinction between hedgers and speculators is that hedgers have an initial position whereas speculators have no initial position.

  • [1] See Neftci [55] for a useful source for replication and the "law of one price".
 
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