ABSTRACT
Chapter 1 introduces foundational concepts in financial markets and provides an introduction to derivative analysis. The chapter starts with the roles of real assets, financial assets, financial mathematics, and financial derivatives, as well as arbitragers, hedgers, and speculators. It then discusses principles of asset valuation including the use of expected values of future cashflows discounted for the time value of money and for risk. Chapter 1 introduces basic financial derivatives (forward contracts, call options and put options) and the intuition and application of put-call parity, basic derivative trading strategies and arbitrage. A simplified model demonstrates that the value of an option depends on the underlying stock value but does not otherwise depend on the market’s aversion to the risk. Therefore, an option’s value relative to the value of the stock is the same in a world with risk-neutral investors as it is in the real world of risk-averse investor. This concept, the risk-neutral principle, is stressed in this chapter and in derivative valuation models throughout the book. The ease and precision of risk-neutral financial derivative valuation is central to the crucial role that financial derivatives serve as effective risk management tools in an increasingly complex (and productive) economy.
