Introduction to Derivative Instruments
The past few decades have witnessed a revolution in the trading of derivative securities in world financial markets. A financial derivative may be defined as a security whose value depends on the values of more basic underlying variables, like the prices of other traded securities, interest rates, commodity prices or stock indices. The three most basic derivative securities are forwards, options and swaps. A forward contract (called a futures contract if traded on an exchange) is an agreement between two parties that one party will purchase an asset from the counterparty on a certain date in the future for a predetermined price. An option gives the holder the right (but not the obligation) to buy or sell an asset by a certain date for a predetermined price. A swap is a financial contract between two parties to exchange cash flows in the future according to some prearranged format. There has been a great proliferation in the variety of derivative securities traded and new derivative products are being invented continually over the years. The development of pricing methodologies of new derivative securities has been a major challenge in the field of financial engineering. The theoretical studies on the use and risk management of financial derivatives have become commonly known as the Rocket Science on Wall Street.