Week 3: Introduction

In previous weeks, we touched upon different types of financial assets and financial instruments used in financial markets. Those money market instruments or securities, such as the Treasury Bills and commercial papers are highly liquid and they have very short term maturities, normally less than one year. This means that investors see the money market as a safe place. Capital market instruments form another category of financial assets and include bonds and equities. We also learned that financial investors often diversify their investments. They do not put all their money into one basket, but rather the invest in different assets to form a portfolio of investments. Diversification can reduce risk. This week we will be discussing a third category of financial assets - financial derivatives.

Put simply, financial derivatives are financial papers or contracts whose value is derived from the value of an underlying asset. A key difference between financial derivatives and other financial instruments is that derivatives are more complicated investment instruments since they do not have value themselves. However, there is a market for trading them where their value depends on the current market value of the underlying asset. In the following steps, we will look at two representative financial derivatives - futures and options. We will introduce you to the concept of a forward contract and discuss what the differences are between a forward contract and a futures contract.

We will also explain some main features of a futures contract and look at the mechanisms that underpin the futures market. Finally, we will discuss options contracts, how they differ from a futures contract and look at the issues involved in pricing both a futures contract and an option. At the end of this week’s learning you will hopefully be able to understand what financial derivatives are, and why they can be used by investors to hedge or to speculate in financial markets. This will lay a strong foundation for next week’s learning where the focus will shift to the implementation of risk management, including the application of financial derivatives.