Derivatives

A derivative is a financial security whose payoffs depend on the prices and cash flows of some primary assets or indexes created from the prices and cash flows of some primary assets. There exist derivatives on derivatives, or compound derivatives as well (by composition of payoffs, the original definition applies here too). Derivatives are a zero supply asset, i.e. for every buyer there is a seller of the derivative. The buyer and seller of a derivative are called the counter parties.For this chapter we only consider derivatives where there is no counter party risk, i.e. the counter parties to the derivatives make the promised payments with probability one. We invoke this assumption to simplify the notation with respect to the payments made to the derivative's counter parties. This is nearly true in practice since both counter parties (in theory) provide sufficient collateral to guarantee the execution of all contracted payments.