Derivatives are financial products which value depends on another variable. This can for example be a stock price, an interest rate, a foreign exchange rate, commodity prices but also depend on the temperature, defaults and other variables. Derivatives can be used to hedge, speculate, increase or decrease leverage, locking in profits or losses and changing the nature of assets and liabilities.
In order to assess whether it is opportune to include derivatives and how this affects the total portfolio profile it is required getting insight in how these derivatives are valued. In derivative valuation, a key ingredient are so-called no-arbitrage conditions. These conditions imply that market forces ensure that there is no free lunch present in the financial market under consideration. As such, all derivatives can be valued through discounting them using the risk free rate.
In what follows, we discuss forward contract valuation and swap valuation. Then we move on explaining the different option types in the market followed. Valuation of options can be done through the binomial model and, or Black Scholes option pricing model. As a special case, we conclude with warrant valuation.