Derivatives and Alternative Investments
Derivatives Basics
Derivatives derive value from an underlying. Master forwards, futures, options, and swaps. Forwards are customized and carry counterparty risk; futures are standardized, exchange-traded, and marked to market daily. Options confer rights, not obligations: a call gives the right to buy, a put the right to sell, at the strike price. Know the payoff versus profit distinction-profit nets the premium paid.
Pricing Principles
Option value = intrinsic value + time value. Intrinsic value for a call is max(0, S − K); for a put, max(0, K − S). Put–call parity for European options: C + K/(1+r)^T = P + S. The binomial and Black–Scholes models build on no-arbitrage and risk-neutral valuation. Swaps are series of forward contracts; interest rate swaps exchange fixed for floating payments.
Alternative Investments
Hedge funds, private equity, real estate, and commodities offer diversification but carry illiquidity, valuation uncertainty, and higher fees (management plus incentive fees). Understand lockups, redemption gates, and the J-curve in private equity.
Common Traps
- Confusing payoff with profit (ignoring premium).
- Assuming American and European options are always equivalent.
- Forgetting that futures require margin and daily settlement.
- Overlooking illiquidity and stale pricing in alternative return data.
Worked Example
Buy a call with strike 50 for premium 3; underlying at expiration is 60. Payoff = max(0, 60 − 50) = 10. Profit = 10 − 3 = 7. Break-even underlying price = 50 + 3 = 53.