Intro to Finance
Learn online
>Basic concepts
>Corporate finance
>Other materials
Financial careers
>Banking
>Management
>Real estate
>Insurance
Goodies!
Ask Financious
Useful links
About us
Definition
Derivatives are financial instruments whose values depend on the performance of an underlying security or asset like stocks, bonds, or market index prices.
They are used to hedge financial positions, and reduce risks, but sometimes, they can be very dangerous if manipulated unwisely.
Futures contracts, forward contracts, options, and swaps are different types of derivatives
It is the most common derivative. Options give the bearer the �option�, not the obligation, to buy or sell a security. Basically there are two main types of options:
The call options and the put options.
- A call option gives the bearer the right to buy an asset for a specified price (the exercise price or strike price) until a specified expiration date (which is included). For example, a February 1 call option on Yahoo stock has a strike price of 80$. The holder of the option can choose to buy Yahoo stock at 80$ anytime before February 1 (February 1 included).
If in January the price of a Yahoo share increases to 95$, the owner of the option can exercise the option and buy stock from the option seller at 80$ per share, then sell the stock at the market price of 95$ and make a net profit of 15$ per share minus the price of the option that he originally bought. In this case, the option is called an �in the money� call since the strike price is less than the current stock price. However, if the current Yahoo stock price is less than the strike price of 80$, then the option is an �out of the money� call and the bearer choose naturally not to buy stock at a higher price than the market. If the strike price equals the current market price, the option is �at the money�.
-A put option gives its owner the right to sell a security for a specified strike price on or before a specified expiration date. With the same example as before, let�s consider a February 1 put option on Yahoo stock, with a strike price of 80$. This option entitles its bearer to sell Yahoo stock at 80$ until February 1 included. If the market price is 65$, the option holder would buy stock at this price then sell it at 80$ per share by exercising his put option. His net profit would be 15$ per share minus the price of the option. Naturally, if the current market price is greater than 80$, he won�t exercise his put option.
Finally, the pricing of options is determined by many factors: the price of the underlying security and its volatility, the strike price, the time to expiration, the dividends of the underlying asset�etc
Next section: Derivatives (2) Go back