Modern Financial Systems: Theory and Applications

CHAPTER 9

Pricing Derivatives by Arbitrage

Chapter 9 analyzes how derivative securities are priced in the absence of arbitrage opportunities. It examines and values forward contracts, options, and futures contracts. The chapter emphasizes how the different instruments represent different ways of dividing and trading underlying asset risk. Relations among debt, equity, and options are also reviewed in order both to emphasize the risk management implications of using different instruments and to relate the risk in debt and equity to the risks in options.

This chapter continues Chapter 8’s development of securities pricing in the absence of arbitrage. Here, we see how forwards, options, and futures can be used for dividing up and pricing risks. While the discussion does not intend to make you an expert in using or valuing derivative securities, it will show you how the different instruments are composed of the same building blocks. The chapter also shows how different contracts can be valued using the principles of pricing by arbitrage. The chapter begins by examining forward contracts. It next examines options, and then follows with a discussion of relations between debt, equity, and options. The nature and uses of futures contracts are outlined. Finally, the chapter values two futures contracts and a credit default swap.

This chapter also reviews how different contracts can be used in practice. This part will help you understand subsequent chapters that discuss the instruments’ ...