1Introduction to OptionsEcon 422: Investment, Capital & FinanceUniversity of WashingtonSummer 2010E. Zivot 20056R.W. Parks/L.F. Davis 2004August 18, 2010Derivatives•A derivative is a security whose payoff or value depends on (is derived from) the value of another security, the ‘underlying’ security.•Derivatives are referred to as contingent claims, the claim is contingent on the underlying asset.• Examples of derivatives:E. Zivot 20056R.W. Parks/L.F. Davis 2004•Examples of derivatives:– Options– Forward Contracts– Futures– Swaps
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2Financial & Non-Financial Option ExamplesFinancial Examples:–Traded Options (CBOE, NYSE)–Convertible bond (embedded option within debt instrument)–Prepayment option on mortgage–Venture Capital follow-on investment option–Employee stock optionsE. Zivot 20056R.W. Parks/L.F. Davis 2004Non-Financial Examples:–Enrollment in this course— ‘right to attend lectures but not obligated’Financial ‘Option’ Definitions•An optionprovides you the right, without obligation to buy or sell an asset at a preobligation, to buy or sell an asset at a pre-specified price in the future.•An option is a derivativesecurity in that its value is contingent upon the underlying asset.E. Zivot 20056R.W. Parks/L.F. Davis 2004