20 The Milken Institute Review
The Merriam-Webster dictionary defi nes a derivative
in the fi eld of chemistry as “a substance that can be
made from another substance.” Derivatives in fi nance
work on the same principle.
These fi nancial instruments promise payoffs that are derived from
the value of something else, which is called the “underlying.” The
underlying is often a fi nancial asset or rate, but it does not have to
be. For example, derivatives exist with payments linked to the S&P
500 stock index, the temperature at Kennedy Airport, and the number
of bankruptcies among a group of selected companies. Some estimates
of the size of the market for derivatives ...view middle of the document...
(Futures contracts are similar to
forward contracts, but they are standardized
contracts that trade on exchanges.) At the
mint chocolate-chip end of the spectrum,
however, the sky is the limit.
A forward contract obligates one party to buy
the underlying at a fi xed price at a certain future
date (called the maturity) from a counterparty,
who is obligated to sell the underlying
at that fi xed price. Consider a U.S. exporter
who expects to receive a €100 million payment
for goods in six months. Suppose that
the price of the euro is $1.20 today. If the euro
were to fall by 10 percent over the next six
months, the exporter would lose $12 million.
But by selling euros forward, the exporter
locks in the current forward exchange rate. If
the forward rate is $1.18 (less than $1.20 because
the market apparently expects the euro
to depreciate a bit), the exporter is guaranteed
to receive $118 million at maturity.
Hedging consists of taking a fi nancial position
to reduce exposure to a risk. In this example,
the fi nancial position is a forward contract,
the risk is depreciation of the euro, and
the exposure is €100 million in six months,
which is perfectly hedged with the forward
contract. Since no money changes hands
when the exporter buys euros forward, the
market value of the contract must be zero
when it is initiated, since otherwise the exporter
would get something for nothing.
Although options can be written on any underlying,
let’s use options on common stock
as an example. A call option on a stock gives
its holder the right to buy a fi xed number of
shares at a given price by some future date,
while a put option gives its holder the right to
sell a fi xed number of shares on the same
terms. The specifi ed price is called the exercise
price. When the holder of an option takes
advantage of her right, she is said to exercise
the option. The purchase price of an option –
the money that changes hands on day one – is
called the option premium.
Options enable their holders to lever their
resources, while at the same time limiting
their risk. Suppose Smith believes that the
current price of $50 for Upside Inc. stock is
too low. Let’s assume that the premium on a
call option that confers the right to buy
shares at $50 each for six months is $10 per
share. Smith can buy call options to purchase
100 shares for $1,000. She will gain from
stock price increases as if she had invested in
100 shares, even though she invested an
amount equal to the value of 20 shares.
With only $1,000 to invest, Smith could
have borrowed $4,000 to buy 100 shares. At
maturity, she would then have to repay the
RENÉ M. STULZ is the Reese professor of money and
banking at Ohio State University. A version of this article
appeared in the Summer 2004 issue of the Journal of
Economic Perspectives. It is published here by permission of
the American Economic Association.
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