[...]... fanciful hypothetical or an abstract theoretical discussion It is the reality of our times, and has happened over and over again In the past 10 years there have been more than half a dozen spectacular blowups And it will happen again and again We’ve had billion dollar debacles at Barings Bank, Metalgesellschaft, Orange County, Sumitomo Trading, and Long Term Capital Management (LTCM); the latter required... see they are the key to learning swaps as well A FUZZY AREA: WHAT IS AND ISN’T A DERIVATIVE? What is and isn’t a derivative is more a matter of convention and definition than you might at first imagine Some things that are considered basic, primary assets are actually less basic and primary than common knowledge would lead you to believe Corporate America is ruled by two predominant financial market sectors:... ways and actions can be understood, predicted, and controlled Many firms do it very nicely every day Financial derivatives such as options, futures, forwards, and swaps inherit their value directly from their parents In fact, a financial derivative would not have a price at all if the parent ceased to exist (stopped trading) The parents are the three basic financial groups that we are already quite familiar... carriers of cash are at risk) Instead of traders worrying about dragging away their purchases and validating authenticity, they could hand it to their traffic departments to arrange preparations for taking physical delivery Today, typical cash or spot deliveries take place 2 to 3 days after the trade date Some professionals have recently begun to use more technical phrases such as ‘‘T ϩ 2’’ and ‘‘T ϩ 3’’... trading assets We define them to be basic trading assets and not derivatives These three assets underlie all derivatives and are thus called the underlying assets What we are investigating in this book, and what most people are uncomfortable with, are the slightly more arcane derivatives called options, forwards, and futures These derivatives use stocks, bonds, and commodities as their underlying parent... convention, that is, general agreement, than by strict rule that certain assets are called derivatives Many assets that should technically be called derivatives are not It’s important to discuss what does and does not make the cut as a derivative if we want to understand the big picture about markets more clearly We start off gently by describing a derivative relationship that isn’t financial at all, but... money at the bank And in order to decide on which new crops to plant at season’s end it was critical to get a handle on what the market would pay for next year’s crops of wheat, corn, and soybeans The only prices available, however, were for same-day delivery of wheat and corn Unless you had already shipped and placed your crop into a warehouse you wouldn’t have the warehouse receipts needed for same-day... swapped These are called the cash or spot markets, in reference to the delivery date The term cash comes from the phrase ‘‘cash on the barrelhead,’’ meaning immediate payment And spot comes from ‘‘on the spot’’ deliveries and payments Over the years the terms cash and spot became almost equal in meaning, and traders began to allow a few days of delay for purposes of convenience and safety (known carriers... familiar CHAPTER 1 What a Derivative Is and What It Isn’t 9 GETTING COMFORTABLE WITH DERIVATIVES Every day we see and easily understand real-life derivative relationships all around us, yet many of us are confused by the derivative relationships in financial markets Once you get the hang of it you will see that most financial derivatives are not so difficult to grasp While the mathematics might be daunting... options, forwards, and futures It is our task here to come to grips with what they are and what they can do for us Our primary focus is options, but as you will see, we need a nodding acquaintance with forwards and futures to get the whole picture And that is a good thing, for it makes the financial world a whole lot clearer after a bit Options, forwards, and futures are the building blocks and backbone . again. In the past 10 years there have been more than half a dozen spectacular blowups. And it will happen again and again. We’ve had billion dollar debacles at Barings Bank, Metalgesellschaft, Orange. learning the ins and outs of deriv- atives was more a matter of time and application than of mathe- matical wizardry. Mathematical theory has its place, but it often seems wide of the mark and. exaggeration, options are the backbone of today’s enormous financial deriva- tives markets. But finance is a very broad and diverse area of study. And options are certainly not the only financial