十
六
Asset
Valuation: Derivative Investments
1.A: Introduction
a: Define derivative instrument, arbitrage opportunity, forward contract, futures contract, option
(both a put and a call), option on futures, and swap.
A financial derivative is a financial instrument whose payoffs depend on another financial
instrument or asset. For example, an option on a share of stock depends on the value of the
underlying price of the share. This book discusses four types of derivatives: forwards, futures,
options, and swaps.
An arbitrage opportunity is the chance to make a riskless profit with no investment. In
arbitrage, you observe two identical assets with different prices.
A forward contract is a contract negotiated in the present that gives the contract holder both
the right and full legal obligation to conduct a transaction at a specific future time involving a
specific quantity and type of asset at a predetermined price.
A futures contract is a forward contract that has been highly standardized and closely
specified. As with a forward contract, a futures contract calls for the exchange of some good
at a future date for cash, with the payment for the good to occur at the future delivery date.
An options contract gives its owner the right, but not the legal obligation, to conduct a
transaction involving an underlying asset at a predetermined future date and at a
predetermined price (called the exercise or strike price). Options, however, only give the long
position the right to decide whether or not the trade will eventually take place.
A swap is an agreement between two or more parties to exchange sets of cash flows over a
period in the future. The parties that agree to the swap are known as counterparties. The
cash flows that the counterparties make are generally tied to the value of debt instruments or
the value of foreign currencies. Therefore, the two basic kinds of swaps are interest rate
swaps and currency swaps.
b: Discuss the no-arbitrage principle.
Since any observed pricing errors will be instantaneously corrected by the first person to
observe them, any quoted price must be free of all known errors. This is the basis behind the
text’s no-arbitrage principle, which states that any rational price for a financial instrument
must exclude arbitrage opportunities. The no-arbitrage opportunity assumption is the basic
requirement for rational prices in the financial markets. This means that markets and prices
are efficient. That is, all relevant information is impounded in the asset’s price.
c: Distinguish between a futures contract and a forward contract.
•
Forwards are private contracts and do not trade on an organized exchange. Futures
contracts trade on organized exchanges.
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