ABSTRACT
This chapter considers two main derivative contracts, namely, forwards and options. The holder of a forward contract is obliged to trade at the maturity of the contract. Unless the position is closed before the delivery date, the holder of a long forward must take possession of the asset regardless of whether the asset has risen or fallen (or pay the difference in prices). An investor with specific views on the future behavior of stock prices may be interested in derivatives with payoff profiles that are different from those of the standard European call and put options. In principle, any continuous piecewise payoff function can be manufactured from European call and put payoffs with different strikes. So being given a specific payoff, one can design a portfolio of securities with the same payoff function. The log-normal pricing model is obtained as a limiting case of binomial tree models when the number of periods approaches infinity.
