Derivative Securities

Financial instruments are classified into three categories: derivatives, equity, and debt. The price of and payoff from a Derivative are derived from the value of underlying assets like stocks, commodities, bonds, or market indexes. Thus, as the value of the underlying asset changes, the value of the derivative changes. Derivatives are used to manage risk, speculate, and arbitrage. The most common types of derivatives are options, futures, forwards, and swaps. Here, we focus on options.

Outline

In this section, we focus on options. Like bonds, options are contractual agreements between buyers and sellers for a particular transaction at a later date. However, unlike bonds, options are derivatives, which means that their value is derived from the value of an underlying asset.

• American and European Call and Put Contracts are agreements between a buyer and a seller that use equity (shares of a stock or an exchange-traded fund) as their underlying asset. Call contracts give the holder the right, but not the obligation, to buy an underlying asset at a predetermined price within a specified timeframe, while Put contracts grant the holder the right, but not the obligation, to sell an underlying asset at a predetermined price within a specified timeframe.

• Call and Put contracts can be combined to develop composite trade structures with interesting payoff and profit properties. Here, we initially limit our focus to contracts that have the same underlying asset and the same expiration date.