A derivative is a financial instrument that's value, as its name suggests, is derived from the value of an underlying asset or security. There are many different derivative securities available, including: forwards, futures, options, rights, warrants, convertibles and swaps. This note introduces some of the key concepts, terminology and strategies associated with these derivatives.
When valuing the premium to be paid for put or call options, the underlying security is only one of several factors that can determine the option's value. By calculating the impact and value of all the determinants, an option's price more accurately reflects its value. This note examines the effects of various determinants on the price of an option and introduces two models that use options equivalents: the Black-Scholes Option Pricing Model and the Binomial Option Pricing Model.
The real options approach to capital budgeting uses an options-based analysis to evaluate the real (as opposed to the financial) potential of projects. By charting the options as a series of decision points and events, managers can understand the risks and rewards of the projects, and more fully assess their opportunities. This note introduces the real options approach and describes the four main categories: expansion and follow-on options, timing and delay options, abandonment options and options that introduce flexibility into production. The expansion option is discussed in detail, including sample calculations and decision trees.