CHAPTER 14
DERIVATIVES: ANALYSIS AND VALUATION
I. An Overview of Forward and Futures Trading
Forward and futures contracts are the most straightforward form of derivative
instruments because they allow an investor to lock in the purchase or sales price of a
transaction that will not be completed until a later date
Global Exchange Traded Derivatives Volume by Category (Exhibit 14.1)
II. Hedging with Forwards and Futures
A. Hedging and the Basis
1. Short vs. long hedge
2. Defining the Basis
III. Valuation of Forward and Futures Contracts
A. The Cost to Carry Model
IV. Financial Futures
A. Interest Rate Futures
A T-Bond/T-Note (NOB) Futures Spread
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V. An Overview of Option Markets and Contracts
A. Option Market Conventions
1. Option contracts have been traded for centuries
B. Price Quotations for Exchange-Traded Options
1. Equity Options
a. Other option markets include: American (AMEX), and Philadelphia
VI. The Fundamentals of Option Valuation
A. The Basic Binomial Approach – Three Step Process
1. Design riskless hedge with one share of stock held long and some number (h)
of call options
VII. The Black-Scholes Valuation Model
A. Properties of the Model (Exhibit 14.14)
Function of five variables
1. Current security price
B. Estimating Volatility
1. Historical: price movements (Exhibit 14.17)
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C. Valuing European-Style Put Options (Exhibit 14.19)
D. Problems with Black-Scholes Valuation
1. Empirical studies showed that the Black-Scholes model overvalued out-of-the-
VIII. Swaps
A. Forward Rate Contracts
B. Extensions of Swaps
1. Equity Index-Linked Swaps
2. Credit-Related Swaps
IX Option-Like Securities
A. Warrants
Equity call options issued directly by the company whose stock serves as
the underlying asset
C. Callable Bonds