Financial Derivatives

Financial Derivatives

Various Types and Pricing of Forward Contracts

Contents
1. Introduction.............................................................................................................................3
2.1 Futures...................................................................................................................................4
2.2 Options..................................................................................................................................8
2.3 Swaps...................................................................................................................................10
3. Pricing of Forward Contracts..............................................................................................13
4. References...........................................................................................................................16

1. Introduction
A derivative is a financial instrument with a value dependent on the value of some other, underlying asset.
The distinguishing feature of derivative instruments (or derivative contracts) is that they are legal agreements between two parties to trade an underlying asset at a date in the future. This is in contrast to most investments, which are issued by a borrower to an investor in order to raise money. Derivatives are mainly used to control risk. They can be used to reduce risk (a process known as “hedging”), or to increase risk (known as “speculation”) in order to enhance returns.
Derivatives allow individuals and companies to hedge risks. This means that they make it more likely that risks are borne by those best able to bear them. This makes it possible for individuals and companies to take on more risky projects - with higher promised returns - and hence create more wealth by hedging those risks that can be hedged.
There is also some evidence to suggest that futures (a form of derivative) trading influences current prices,