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Financial Derivatives are securities that derive their value from the value of other assets. Thus, before I can tell you the price of the derivative, I need to know the price of the underlying asset.Forwards:The basic categories of Financial Derivatives are
Breaking the option category down further there are two types of options: calls and puts.
- Forwards
- Futures
- Options
Forward contracts are contracts between two parties whereby one party agrees to sell to another party at some point in the future for a price agreed upon now. The amount of the sale as well as when it occurs is customizable to the contract.Futures:Problems with this type of derivative include the difficulty in finding someone to transact with, the contracts are non-transferable, and a high probability of default.
Futures can be thought of a forwards that have are transferable, standardized, and designed to reduce the probability of, and costs of, a default.Options:
Call Options- calls are contracts that allow the call owner to buy the underlying asset at a pre-agreed upon price. The key difference between options and both forwards or futures is that the owner of a call contract does not have an obligation to buy.Hence the most common definition of a call contract:
A call contract gives the owner the right, but not the obligation, to buy at an agreed upon price, at or before an agreed upon time.
This implies that the most a call buyer can ever lose is the initial investment, whereas the downside for both forwards and futures are not capped.
Put Options- a out option is a contract that gives the owner the right, but not the obligation to sell an asset at an agreed upon price at or before an agreed upon time.
For more on derivatives check out the FinanceProfessor.com main derivative page
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