The 1990s were a decade
of revolutionary change in financial markets. Perhaps
the most significant change was the emergence of "derivatives,"
securities whose value is derived from the value of
an underlying asset such as a stock, bond, or commodity.
While some derivatives (like options and forward contracts)
have been around for quite some time, the 1990s brought
a wave of financial innovation and growth in the use
of derivatives. Today, the derivatives markets have
become the largest, financial or otherwise, in the world.
Derivatives are used in one or more of the following
- Hedging--where risks are reduced without as significant
an impact on returns.
- Speculating--where risks are increased in an attempt
to enhance returns.
- Capitalizing on arbitrage opportunities--where an
investor attempts to capture a riskless profit.
Whatever their function, all financial
derivatives share fundamental characteristics.
They are are financial instruments whose value is based
on the market value of an underlying asset such as a
stock, bond, or commodity. Examples include options,
futures contracts, and forward contracts.
This section focuses on options, given their relative
simplicity and importance in a variety of legal contexts.
We first look at the basic terminology and operation
of options. Then we introduced the Black Scholes Option
Pricing Model, a sophisticated and important model for
valuing options. Next we explore some applications of
option valuation and option theory. Finally, we examine
some other derivatives.
- Option fundamentals
Let's play a game. I will give you $5 if you flip
a coin and it comes up heads twice. If not, I pay nothing.
To play my game, you must pay me $1.00 for each flip.
We can play as many times as you'd like. Are you interested?
4.4.2 - Basic option valuation
Surprisingly, but like most of modern financial theory,
the systematic valuation of options is a relatively
new field. In the 1960s, options only existed on a few
of the bigger stocks. Prices were largely set by negotiations,
and rules of thumb prevailed. Meanwhile, the topic of
pricing options was heating up the offices of the country's
leading economic academicians. (More
4.4.3 - Option applications
Perhaps the area where stock options are most pervasive
is executive compensation. Frequently, companies will
award key executives or board members lucrative stock
options in addition to their base compensation. Another
area is the use of options to lock-up the bidding for
a company in a takeover. (More 4.4.3>>)
4.4.4 - Other derivatives
Options are derivatives in the sense that their value
is derived from an underlying security. As the term
is commonly used, derivatives refer to instruments also
include negotiated contracts between two persons called
counterparties. (More 4.4.4>>)