Overview

There are a multitude of different derivaitve contracts. However, they can usually be classified under a set of broad criteria.

Plain Vanilla Derivatives

The plain vanialla derivatives are fairly simple and common contracts, which are also fairly easy to value.

• Futures and Forwards :
• Call and Put Options :

Maturity Types

Most derivatives have a maturity date. The specifics of what the maturity date means for a given derivative is dependent on its maturity type, which generally falls within three categories.

• European : a plain vanilla derivative, that expires on a prescribed date, and for with the holder cannot exercise the option prior to the maturity.
• American : allows the holder of the option to exercise it at any point up to the maturity.
• Bermudan : allows the holder to exercise the option on a given set of pre-defined dates.

Exotic Derivatives

Exotic derivatives are derivatives that include clauses that increase the complexity of the derivative beyond the standard maturity types. A typical example of an exotic derivative is a call option with a knock out clause. A knock out clause is a price for which if the underlying ever closed at a price at or above the knock out price, the option will expire worthless.

For example, you may have call option with a strike price of 100 dollars but with a knock out price of 130 dollars, that is, if the underlying ever achieved a closing price at or above 130 dollars prior to the maturity, the option becomes worthless.

Exotic derivatives typically are created in order to reduce the cost of the option,

Some common exotic derivative clauses:

• Knock Out
• Knock In

Interest Rate Derivatives

Fixed income brings a whole new set of challenges to modeling derivatives. The complexity largely comes from two factors. First, the quantity that usually forms the basis of an analysis is not traded. That is, the yield (or discount) curve is the entity that forms the core of most fixed income models, but is itself not a traded instrument.

The second complexity comes from the fact that the curve itself is complex, and can be decomposed into any number of stochastic factors (in theory, even infinite number of factors.)

For more information, see fixed income derivatives