Pricing and Hedging Financial Derivatives: A Guide for Practitioners

2

Derivatives: Forwards, Futures and Swaps

In this chapter, we introduce the standard derivative products of forwards, futures and swaps. We will go through key definitions and the most common jargon and we will subsequently start discussing the pricing and hedging framework for derivatives, with examples taken from a variety of asset classes. In particular, the notion of a forward contract and its pricing is crucial to fully understand the concepts presented in the following chapters of this book. Given its importance, we will discuss it with reference to different asset classes (such as equity, foreign exchange, commodity and fixed income), trying to develop a framework based on intuition rather than a formal proof. The drawback of an approach focused on intuition is that, from time to time, our discussion may not be theoretically rigorous, although we will reach exactly the same conclusions. In particular some of the instruments presented in this chapter (such as futures and swaps) will be discussed only in relatively basic terms and to the extent that they are linked to other sections of the book.

2.1 DERIVATIVES

A derivative is a financial instrument whose value is dependent upon, or derived from, one or more other financial instruments or observable variables; these instruments or observable variables are generally known as underlying assets. Derivatives are financial instruments in their own right with their own price dynamics. Consequently, we can say that the price of ...