Introduction to Financial Derivatives with Python by Elisa Alos

Introduction to Financial Derivatives with Python by Elisa Alos

C H A P T E R 1

Introduction

1.1 FINANCIAL MARKETS
Finances are a natural element for people. We met together and exchanged

resources since the beginning of time. In a financial market,
people trade securities at a low transaction cost. The listed price reflects
the asset’s supply and demand. But the purpose is to transfer risks in
exchange for investment opportunities.
We may trade financial instruments at central locations, such as organized

exchanges. But they can also be negotiated in a private contract between two

parties in an Over-The-Counter (OTC) contract. This makes
it possible to design tailor-made agreements even when counterparty risk
exposition increases.
We can execute a trade for different reasons, such as investing, hedging, or speculating.
• Investing is the act of distributing financial resources into assets
to generate financial returns. It’s a long-term initiative.
• Hedging is the use of financial instruments to mitigate or eliminate certain

types of risks. Hedge strategies are designed to reduce
risks, rather than to generate returns.
• Speculating is based on trading in the financial markets to generate short-term

gains. The trader assumes the risk of losing money
but holds the expectation of obtaining a significant profit.
1.2 DERIVATIVES
Financial market instruments can be divided into two different categories. On

the one hand, we have the ‘prime source’ assets, which we will

refer to as ‘underlyings’, and which can be stocks, bonds, commodities,
foreign currencies, etc. On the other hand, their ‘derivative’ contracts,
financial claims that promise some payment or delivery in the future,
depending on the behavior of the underlying.
The most typical financial derivatives are futures (or forwards) and
options. A future (or forward) is a legal agreement to buy or sell a particular

asset at a predetermined price and at a specified time in the future.
Meanwhile, an option contract gives the right but not the obligation to
buy (or sell) a particular asset at a predetermined price and at a specified
time in the future.
Many people think that derivative contracts, such as futures and
options, are inventions of the modern economy. However, derivative

contracts emerged as soon as humans could make credible promises. They
were the first instruments to guarantee the supply of basic products,

facilitate trade and insure farmers against the loss of crops. The first

written evidence of a derivative contract was in law 48 of the Hammurabi
code, roughly between 1782 to 1750 BCE.
One of the first stories related to the speculation of derivatives is due
to Thales of Mileto. Thales made a deposit at the local olive presses. As
nobody knew for sure whether the harvest would be good or bad, Thales
purchased the rights to the presses at a relatively low rate. When the
harvest proved to be abundant, the demand for the presses was high,
Thales charged a high price for their use and reaped a considerable
profit.
The earliest evidence of organized exchange was in the 1730s, when
the Tokugawa shogunate authorized rice futures trading. After that,
the Dojima Rice Exchange opened. Nearly a century later, in 1848, the
Chicago Board Of Trade (CBOT) was founded as an association of grain
merchants, see (Algieri, 2018). The first applications of derivatives were
related to the use of commodities.
In 1973, the world’s first listed options exchange, the Chicago Board
of Options Exchange (CBOE), opened in Chicago. The same year that
the Black-Scholes-Merton formula was published. Since then, the trading
volume of derivatives has increased largely.
1.3 TIME HAS A VALUE
A natural process in finance is to lend and borrow money. The question
arises of how much we should ask in exchange for lending money for a
fixed term. Although the borrower returns the same amount to us, it

Introduction to Financial Derivatives with Python by Elisa Alos