1.1. What is a derivative security? Give an example of a derivative and explain why it is a derivative. ANSWER A derivative security is a fi nancial contract that derives its value from the price of an underlying asset such as a stock or a commodity, or from the value of an underlying notional variable such as a stock index or an interest rate (see Section 1.1). Consider a forward contract to trade 50 ounces of gold three months from today at a forward price of F= $1,500 per ounce. The spot price of the underlying commodity gold determines this derivative’s payoff. For example, if the spot price of gold is S(T) = $1,510 per ounce at time T = 3 months, then the buyer of this forward contract buys gold worth $1,510 for $1,500. Her profi t is [S(T) – F] × Number of units = (1,510 – 1,500) × 50 = $500. This is the seller’s loss because derivative trading is a zero- sum game; that is, for each buyer there is a seller. 1.2. List some major applications of derivatives. ANSWER Some applications of derivatives: • They help generate a variety of future payoffs, which makes the market more “complete.” • They enable trades at lower transactions costs. • Hedgers can use them to cheaply reduce preexisting risk in their economic activities. Speculators can take leveraged positions without tying up too much capital. • They help traders overcome market restrictions. For example, an exchange may restrict traders from short- selling a stock in a falling market, but a trader can adopt a similar position by buying a put option. • They promote a more effi cient allocation of risk by allowing the risk of economic transactions to be shifted to dealers who can better manage these risks.