OPTIONS, FUTURES, AND OTHER DERIVATIVES

Engines of Financial Innovation

Options and futures are examples of derivative securities, that is, securities that derive their value from the value of another security, underlying asset, or benchmark. There are two basic types of options. Call options (calls) are securities that give the holder the right but not the obligation to buy some underlying asset at a predefined price during a specific period of time. Put options (puts) are securities that give their owner the right, but again, not the obligation to sell an underlying asset at a predefined price during a specific period of time. Futures are exchange-traded, standardized contracts for the future delivery either of an actual (physical) commodity or for cash settlement based on future values of some financial security or index. Other examples of derivatives include forward contracts or agreements, and swaps. Forwards are similar to futures, except that they are privately negotiated, over-the-counter transactions, and therefore are not marked to market. Swaps are complex trades between financial institutions or other sophisticated investors. There are many types of swaps, including interest-rate swaps, currency swaps, and equity swaps.

The term derivative came into widespread use in the mid-1980s (previously, financial analysts talked about “synthetics”). The concept of linking the value of a security to an underlying asset, however, is a very old one—you could say that it is the basic idea of securities. In a broad sense, all bonds, stocks, and mutual funds are derivatives. They derive their value from underlying assets: in the case of secured bonds, specific corporate assets such as a building; for unsecured bonds and stocks, a claim on general corporate assets; and for mutual funds, a claim on the securities that make up the funds’ portfolios.

No one uses the word derivative in this way, nor are we suggesting that you should do so. We are merely pointing out that though the term is new, and though a great deal of creativity and ingenuity have gone into creating new derivative securities, these securities are part of a tradition of innovation going back to the beginning of financial markets.

In this section, we will provide an overview of the world of options, futures, and other derivatives. In Chapter Sixteen, we focus on options, describing what they are, who uses them, and why. Chapter Seventeen introduces you to the world of futures, highlighting how they are used and explaining their special risks. Finally, in Chapter Eighteen, we will give a brief introduction to some of the other creative uses of derivative products, which are gradually making their way from the world of institutional high finance and onto a computer screen in your home.