Payoffs of forwards, futures, and options are examined. No-arbitrage valuation. Binomial and Black-Scholes pricing models. Uses of derivatives.

In contrast to how we value non-derivative assets, the valuation of derivative assets relies on replicating the security's payoffs using the underlying asset and a riskless bond. The value of the replicating portfolio is the fair value of the derivative. This approach sidesteps the need for forecasting cash flows and determining a risk-adjusted discount rate, as is done when valuing non-derivative assets.

Why do firms and investors use derivatives? They want to manage their risk exposures. We examine how derivatives alter the risk-return profile of the underlying asset. We also discuss the potential reasons stock option prices have historically deviated from the Black-Scholes model.