Chapter 7

Introduction to Derivatives*

This chapter provides an overview of derivatives markets. Derivatives are financial contracts traded in private over-the-counter (OTC) markets or on organized exchanges. As the term implies, derivatives derive their value from some underlying index, typically the price of an asset. Depending on the type of relationship, they can be broadly classified into two categories: linear and nonlinear instruments.

To the first category belong forward rate agreements (FRAs), futures, and swaps. Their value is a linear function of the underlying index. These are obligations to exchange payments according to a specified schedule. Forward contracts involve one payment and are relatively simple to evaluate. So are futures, which are traded on exchanges. Swaps involve a series of payments and generally can be reduced to portfolios of forward contracts. To the second category belong options, whose value is a nonlinear function of the underlying index. These are much more complex to evaluate and will be covered in the next chapter.

This chapter describes the general characteristics as well as the pricing of linear derivatives. Pricing is the first step toward risk measurement. The second step consists of combining the valuation formula with the distribution of underlying risk factors to derive the distribution of contract values. This will be done later, in the market risk section (Part Five of this book).

Section 7.1 provides an overview of the size of the ...