ABSTRACT
Chapter overview: This book centers on derivatives-not those you have studied in your calculus class, but those instruments whose values (or, in financial parlance, payoffs) depend on or are “derived” from other more basic underlying variables, such as the price of a stock or a commodity, an interest rate, a currency exchange rate, or even non-financial variables like the temperature of a city on a particular day or your semester GPA in college, so long as they can be quantified. These underlying driving variables are called the underlying asset , or in short, the underlying. To begin our systematic study of derivatives, this preparatory chapter provides a conceptual introduction to the two predominant types of derivatives, namely, forwards and options, and sets up the basic derivatives terminology that will be intensively used throughout this book. These primitive derivatives are basic building blocks of more sophisticated financial instruments that will be examined in later chapters. For each of forwards and options, we analyze its mechanics, typical use, and, most importantly, the structure and derivation of its payoff.
