Derivatives +Website. Markets, Valuation, and Risk Management by Robert E. Whaley (Wiley Finance)

Derivatives +Website. Markets, Valuation, and Risk Management by Robert E. Whaley (Wiley Finance)

PART One

Derivative Markets

CHAPTER 1

Derivative Contracts and
Markets

A derivative contract is a contractual agreement to execute an exchange at
some future date. The term “derivative” arises from the fact that the agreement

“derives” its value from the price of an underlying asset such as a stock,
bond, currency, or commodity. A stock index futures derives its value from an
underlying stock index, a foreign currency option derives its value from an
underlying exchange rate, and so on. The key feature of the transaction specified
in a derivative contract is that it will be executed in the future rather than today.
One can easily become overwhelmed by the apparently countless types of
derivative contracts traded in the marketplace. The pages of the Wall Street
Journal (WSJ) list the prices of tens of thousands of standardized, exchangetraded

futures, options, and futures option contracts on hundreds of different
underlying assets. And this only begins to scratch the surface. The WSJ reports
only trading summaries for U.S. derivatives exchanges. Other exchanges worldwide

have derivatives trading volume roughly equal to that in the United States.
Moreover, the notional amount of exchange-traded derivatives worldwide

represents only about 16% of all derivatives outstanding (i.e., USD 233.9 trillion as
of December 2003). About 84% of derivatives are private contracts arranged
with banks and various other financial houses. Many of these contracts are
plain-vanilla forwards, swaps, caps, collars, or floors, but you will also hear of
inverse floaters, protected equity notes, ratio swaps, time swaps, knockout
options, spread locks, wedding-band swaps, and the like.
 Do not be misled, however. Derivatives are not nearly as mystifying as they
may seem. Fundamentally, there are only two different types of contracts—a
forward and an option. A forward is a contract to buy or sell an underlying
asset at some prespecified future date at a price agreed upon today. No money
changes hands until the expiration date, at which time the buyer pays the
amount of cash specified in the contract and the seller delivers the underlying
asset. An option is also a contract to buy or sell an underlying asset at some

prespecified future date at a price agreed upon today. Unlike a forward, however,
the buyer of the option has the right but not the obligation to buy or sell the

Derivatives +Website. Markets, Valuation, and Risk Management by Robert E. Whaley (Wiley Finance)