This lesson provides a detailed examination of derivatives, the core instruments used in financial risk management.

5.1 Understanding Derivatives
Derivatives are financial contracts whose value is derived from an underlying asset, index, or reference rate . They are used for hedging risk, for speculation, and for arbitrage .

5.2 Key Derivative Types

  • Forwards: OTC contracts to buy or sell an asset at a set price on a future date .

  • Futures: Standardised, exchange-traded forward contracts .

  • Swaps: OTC contracts to exchange cash flows, often used to swap a fixed rate for a floating rate .

  • Options: Contracts giving the holder the right, but not the obligation, to buy (call) or sell (put) an asset at a specified price .

5.3 Forward vs. Futures
Key differences include:

  • Standardisation: Futures are standardised; forwards are customisable.

  • Trading Venue: Futures are exchange-traded; forwards are OTC.

  • Settlement: Futures are marked-to-market daily; forwards are settled at maturity.

5.4 Options Fundamentals
Options give the holder the right to buy (call) or sell (put) an asset at a specified price (the strike price). Key terms include:

  • Premium: The price paid for the option.

  • Intrinsic Value: The difference between the market price and the strike price.

  • Time Value: The value attributed to the time remaining until expiration.

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