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An Intuitive Introduction to Finance and Derivatives pp 51–61 Cite as

Introduction to Derivatives

  • Alex Backwell 2  
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Financial derivatives are introduced, in terms of both broad concepts and specific examples. Option payoff functions are constructed, interpreted, and combined into more complicated strategies.

  • Financial derivatives
  • Forward contracts
  • Option contracts
  • Payoff functions

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A derivative is only one type of claim, though. A share is also a claim, a legal entitlement to a stake in a company. Another term you may hear is contingent claim , emphasising that derivatives are contingent on (dependent on) their underlying asset.

In practice, it may not be perfectly free. Fees would often be incurred, credit risk measures may require an initial deposit to secure the transaction, etc. Although these effects are not covered in our idealised theory, many have been studied in considerable detail.

Although a cash-settled derivative is often convenient, this is a case where a physical settlement might be the easier option.

Often this fee is fully or partially in the form of a spread : a difference between the bank’s long and short offerings, so that the bank positions do not exactly cancel, but leave them with a profit.

Note that relative pricing (or relative valuation) can also, but not here, refer to a pricing approach that compares similar assets to each other (rather than comparing/relating a derivative to its underlying asset). For instance, to price the share of a medium-sized mining company, one can look at the price-to-earnings ratios of other medium-sized mining companies trading on the market and use these to estimate a price based on the company’s earnings.

The 1973 paper of Black and Scholes gets a tremendous amount of credit, as it should, but the understanding added by Merton (in his paper later that year) was utterly essentially. Although the phrase Black–Scholes model is common (introduced, in fact, by Merton), the Black–Scholes–Merton model is a more appropriate designation.

Black, F., & Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81 (3), 637–654.

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Hull, J. C. (2015). Options, futures, and other derivatives (9th ed.). Pearson.

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Lewis, M. (1989). Liar’s Poker . W.W. Norton & Company.

Merton, R. C. (1973). Theory of rational option pricing. The Bell Journal of Economics and Management Science, 4 , 141–183.

Wilmott, P. (2013). Paul Wilmott on quantitative finance . Wiley.

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Backwell, A. (2023). Introduction to Derivatives. In: An Intuitive Introduction to Finance and Derivatives. Springer Texts in Business and Economics. Springer, Cham. https://doi.org/10.1007/978-3-031-23453-8_6

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This paper examines nonfinancial corporate risk management by studying how the outcomes of previous derivatives positions predict future hedging behavior. For their analysis, the authors focus on nonfinancial firms in Mexico. They construct a novel data set that combines the universe of derivatives transactions in Mexico with international trade transactions and foreign currency borrowing.

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