Introduction to Derivatives
Derivative is a financial instrument whose payoff depends on the values of other underlying variables.
Forward Contracts
A forward contract is an agreement to buy or sell asset at a certain future time for a certain price. This is traded privately over the counter (OTC).
\(\underline{\text{Features}}\) positions (long - agree to buy the asset, short - agree to sell the asset), agreed time, maturity time, forward price
Options
An option is a contract which gives the owner the right to buy or sell an asset for at (or before) a certain future time for a certain price. This is traded publicly on exchange market.
\(\underline{\text{Features}}\) positions (long - buy the option, short - sell the option), call (right to buy the asset) / put (right to sell the asset), European (only at maturity date) / American (before maturity date), time to maturity, strike price
Payoffs
Payoff is an intrinsic value of a derivative, i.e., pure profit excluding fees and premiums.
- \(S_t\): price of the underlying asset at time \(t\)
- \(K\): forward price / strike price
- \(T\): time to maturity (years)
- Out of the money (OTM): negative payoff
- At the money (ATM): break even
- In the money (ITM): positive payoff