- A derivative is a financial product with its value directly dependent on its underlying variables. The most common forms of derivatives are futures, options and swaps. Other tradeable assets such as commodities or stocks can possess underlying derivatives.
- Basically a derivative is a contract, its payoff being dependent on the behavior of the underlying good or asset. Derivatives are extensively categorized by their relationship between the underlying good or security/asset, their pay-off profile, the type of derivative attached (such as forward, options, swap etc.) and the market in which they trade.
- Derivatives can be applied for speculation or for protecting an already positioned investment, such as an investor selling naked calls on a stock will expect the stock price to plummet; however, while in such doing, he/she will also expose himself/herself to unlimited risk. A common tactic would be buying currency forwards to limit losses on account of fluctuations in the exchange rate, thus mitigating the risk exposure to the naked call.
• Derivatives are widely applied by investors for following reasons:
- A derivative can be applied for speculation; an investor can make a profit by using a derivative if he or she accurately predicts the price movement of a stock or asset.
- A derivative will provide leverage therefore a minor movement in the underlying asset can build up a large difference in the value of the attached derivative.
- Derivatives are commonly applied for hedging purposes; as a hedge, the derivative will mitigate the risk associated with the underlying variable.
- A derivative can assist an investor to procure exposure to the attached product when it is otherwise not possible to trade
On account of derivatives are mathematically-based and exceedingly complicated it is effective to integrate a derivative calculator into investment strategy. A derivative calculator will graph the derivative (meaning the slop of the function at all points) of the underlying investment and plot the expected course of action.
1. Black–Scholes model
The Black–Scholes or Black–Scholes–Merton model is a mathematical model of a financial market containing derivative investment instruments. From the model, one can deduce the Black–Scholes formula, which gives a theoretical estimate of the price of European-style options…..