A derivative (or derivative security) is a financial instrument whose value depends on the values of other, more basic underlying variables. In recent years, derivatives have become increasingly important in the world of finance. Futures and options are traded actively on many exchanges. Forward contracts, swaps, and many different types of options are regularly traded outside exchanges by financial institutions, fund managers, and corporations in what is termed the over-the-counter market. Derivatives also often form part of a bond or stock issue.

Very often the variables underlying derivatives are the prices of traded assets. A stock option, for example, is a derivative whose value is dependent on the price of a stock. However, as we shall see, derivatives can be dependent on almost any variable, from the price of hogs to the amount of snow falling at a certain ski resort.

This book has two objectives. The first is to explore the properties of those derivatives that are commonly encountered in practice; the second is to provide a general framework within which all derivatives can be valued and hedged. In this opening chapter, we take a first look at forward contracts, futures contracts, and options. In later chapters, these instruments and they way they are traded are discussed in more detail.

1.1 FORWARD CONTRACTS

A forward contract is a particularly simple derivative. It is an agreement to buy or sell an asset at a certain future time for certain price. It can be a contrasted with a spot contract, which is an agreement to buy or sell an asset today. A forward contract is traded in the over-the-counter market-usually between two financial institutions or between a financial institution and one of its clients.

One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the the same price. The price in a forward contract is known as the delivery price. At the time the contract is entered into, the delivery price is chose so that the value of the forward contract to both sides is zero. This means that it costs nothing to take either a long or a short position.