Part 1 - Definitions & basic info
21 October 2025 14:17
Financial derivatives
A financial derivative is a financial asset whose very existence depends upon some other asset or
measure (‘the underlying’)
- Without the other asset/measure being in existence, the derivative could not exist
- The derivative's value depends to some extent upon the value, price, level or other
measurement of the underlying
○ An underlying may be common stock (equity shares), a market or economic index, a
commodity, an interest rate, an exchange rate, weather situation, etc., etc.
- Classes of financial derivative include options, swaps, forwards and futures
Options
An option is the right, but not the obligation to buy or to sell (but not both) the underlying
- At a pre-determined price (= exercise/strike price)
- And with reference to an expiry date (= expiration/maturity/exercise date)
○ If the right is to buy the underlying, the option is a call option
○ If the right is to sell the underlying, the option is a put option
If the option may only be exercised on the expiry date, it is a European option
If the option may be exercised at any point up to and including the expiry date, is
it an American option
□ An American option always has value greater than or equal to the otherwise
identical European option given the American offers the holder more
freedom
- Parties to an option contract
○ The original seller of the option contract is the writer and must be prepared to honour
the contract if the holder decides to exercise
The writer of an option holds a short position (is short) in the option
○ The purchaser/owner of the option contract is the holder and they alone have the
decision whether or not to exercise
The holder of an option holds a long position (is long) in the option
Obligations
- If the holder of a call option exercises their right to buy, then the writer must be prepared to
sell them the underlying at the contracted volume and price
- If the holder of a put option exercises their right to sell, then the writer must be prepared to
buy the underlying from them at the contracted volume and price
- If the holder does not exercise, the writer has no further obligation
Options can provide both a reduction in risk and an amplification of risk
- Reduction in risk via appropriate and effective use of options in hedging
- Amplification in risk via options trading/speculation, rather than trading/speculating in the
underlying
○ More sensitivity to market volatility and potentially unlimited loss potential for option
writers
Once held, options always have either zero or positive value because the holder does not HAVE to
exercise the option
Additionally, an American option will always have greater value than a European option due to the
flexibility of early exercise (vs constricted exercise date at expiry for European options)
What defines an option (in an option contract)?
Fiance v2 Page 1
,What defines an option (in an option contract)?
- Identity of the underlying
○ Have to be very specific in relation to the details of the underlying
- Number of units covered
○ i.e. 10,000 shares/20 barrels of oil
- Exercise price
- Expiration/exercise date
○ And whether the option is European vs US
- Right to buy or sell
○ Need to specify whether a call or put option
- Market and settlement provisions
Option markets
Exchange-traded options
- Traded on recognised exchange, settled through a clearinghouse, guaranteed
○ Settlements largely guaranteed
○ Mitigation of counterparty risk
○ Listed
○ Secondary market liquidity
○ Market makers on most exchanges
- Standardised
○ e.g. volume, maturity, settlement
○ Reduction in TCs given high volume, knowledgeable players, emerging transactions
○ Well-understood
- Subject to regulatory oversight
Over-the-counter (OTC) options
- Private transaction between the buyer and seller
○ So more flexibility in terms negotiated by buyer and seller
○ Not listed… no established secondary market so more limited liquidity
- Brokers/dealers may (often) be involved
- There may be some regulatory oversight
Fiance v2 Page 2
, Part 2 - Option payoffs and profits
21 October 2025 14:40
Long put payoff d iagram
(European; exercise price = 100)
Long call payoff diagram
If you held the call option, you would only exercise the option where k>100
Short put option
Given what the holder does, the writer feels the opposite consequences
Short call
Fiance v2 Page 3
21 October 2025 14:17
Financial derivatives
A financial derivative is a financial asset whose very existence depends upon some other asset or
measure (‘the underlying’)
- Without the other asset/measure being in existence, the derivative could not exist
- The derivative's value depends to some extent upon the value, price, level or other
measurement of the underlying
○ An underlying may be common stock (equity shares), a market or economic index, a
commodity, an interest rate, an exchange rate, weather situation, etc., etc.
- Classes of financial derivative include options, swaps, forwards and futures
Options
An option is the right, but not the obligation to buy or to sell (but not both) the underlying
- At a pre-determined price (= exercise/strike price)
- And with reference to an expiry date (= expiration/maturity/exercise date)
○ If the right is to buy the underlying, the option is a call option
○ If the right is to sell the underlying, the option is a put option
If the option may only be exercised on the expiry date, it is a European option
If the option may be exercised at any point up to and including the expiry date, is
it an American option
□ An American option always has value greater than or equal to the otherwise
identical European option given the American offers the holder more
freedom
- Parties to an option contract
○ The original seller of the option contract is the writer and must be prepared to honour
the contract if the holder decides to exercise
The writer of an option holds a short position (is short) in the option
○ The purchaser/owner of the option contract is the holder and they alone have the
decision whether or not to exercise
The holder of an option holds a long position (is long) in the option
Obligations
- If the holder of a call option exercises their right to buy, then the writer must be prepared to
sell them the underlying at the contracted volume and price
- If the holder of a put option exercises their right to sell, then the writer must be prepared to
buy the underlying from them at the contracted volume and price
- If the holder does not exercise, the writer has no further obligation
Options can provide both a reduction in risk and an amplification of risk
- Reduction in risk via appropriate and effective use of options in hedging
- Amplification in risk via options trading/speculation, rather than trading/speculating in the
underlying
○ More sensitivity to market volatility and potentially unlimited loss potential for option
writers
Once held, options always have either zero or positive value because the holder does not HAVE to
exercise the option
Additionally, an American option will always have greater value than a European option due to the
flexibility of early exercise (vs constricted exercise date at expiry for European options)
What defines an option (in an option contract)?
Fiance v2 Page 1
,What defines an option (in an option contract)?
- Identity of the underlying
○ Have to be very specific in relation to the details of the underlying
- Number of units covered
○ i.e. 10,000 shares/20 barrels of oil
- Exercise price
- Expiration/exercise date
○ And whether the option is European vs US
- Right to buy or sell
○ Need to specify whether a call or put option
- Market and settlement provisions
Option markets
Exchange-traded options
- Traded on recognised exchange, settled through a clearinghouse, guaranteed
○ Settlements largely guaranteed
○ Mitigation of counterparty risk
○ Listed
○ Secondary market liquidity
○ Market makers on most exchanges
- Standardised
○ e.g. volume, maturity, settlement
○ Reduction in TCs given high volume, knowledgeable players, emerging transactions
○ Well-understood
- Subject to regulatory oversight
Over-the-counter (OTC) options
- Private transaction between the buyer and seller
○ So more flexibility in terms negotiated by buyer and seller
○ Not listed… no established secondary market so more limited liquidity
- Brokers/dealers may (often) be involved
- There may be some regulatory oversight
Fiance v2 Page 2
, Part 2 - Option payoffs and profits
21 October 2025 14:40
Long put payoff d iagram
(European; exercise price = 100)
Long call payoff diagram
If you held the call option, you would only exercise the option where k>100
Short put option
Given what the holder does, the writer feels the opposite consequences
Short call
Fiance v2 Page 3
