8
2 Concepts of Finance
depends on correct valuation of the option, i.e. setting the sale price c of the option.
We will return to this topic in Chaps. 5 and 6.
Note how owning an option constitutes a value, because it can be used at a later time
to do something useful, for example, to hedge a risk. Therefore options have a price.
In later chapters we will discuss how this price can be determined. Derivatives, such
as forwards, futures and options all depend on underlying assets, but they constitute
independent values themselves, so they can be traded. In this way derivatives are full
members of the market pool, having the useful property of being highly correlated
with the underlying stocks. And that makes them particularly suitable for hedging
and for balancing risks.
Apart from the options, forwards, and futures there are further derivatives, such
as swaps and other credit derivatives, forward options, and accumulators, but their
discussion is beyond the scope of this book. On the other hand, an asset that is central
in many trades and that we therefore need to discuss, is money.
2.4 Money
Historically, trades were based on bartering, which involves the direct exchange of
goods or services between trading partners. Since this exchange is necessarily based
on a double coincident of wants, where one trading partner desires what another
has to offer, it is often difficult to find such a partner. Moreover, it is often inconvenient, because only entire animals can change hands. Therefore, our predecessors
introduced a medium of exchange—money. Initially silver, gold, or other rare commodities were used and cast into standardized units—coins—which served as a
reference for trades. Note that coins have an intrinsic value, which corresponds to a
number of cows or eggs. As trade expanded, however, the limited supply of the rare
commodities began to limit trade.
This problem can be circumvented, if some authority—historically a king, today
a central bank—guarantees to exchange a piece of paper, having no value in itself,
for something else, for example, gold coins or other currencies. This paper money,
based on a promise from an authority, is called fiat-money, because it is introduced
by decree.
1 Note that the value of the paper money is closely linked to our trust in
the authority to ensure that the money is very difficult to counterfeit and anyone,
who forges the money, is prosecuted and punished. This trust in a central authority
that manages the flow of money is the linchpin on which fiat money hinges.
On a national level, central banks are the authorities that regulate the availability
of money by setting the interest rate at which commercial banks can borrow money
from the central bank, such as the European Central Bank in the Eurozone or the
Federal Reserve Bank in the US. Until August 1971 the US, and many other countries,
linked to the US through the Bretton-Woods agreement, used gold reserves to back
their currencies. Notably, a large fraction of the US reserves was stored in Fort Knox.
1 Such as “fiat lux”—let there be light (Genesis 1:3).
2 Concepts of Finance
depends on correct valuation of the option, i.e. setting the sale price c of the option.
We will return to this topic in Chaps. 5 and 6.
Note how owning an option constitutes a value, because it can be used at a later time
to do something useful, for example, to hedge a risk. Therefore options have a price.
In later chapters we will discuss how this price can be determined. Derivatives, such
as forwards, futures and options all depend on underlying assets, but they constitute
independent values themselves, so they can be traded. In this way derivatives are full
members of the market pool, having the useful property of being highly correlated
with the underlying stocks. And that makes them particularly suitable for hedging
and for balancing risks.
Apart from the options, forwards, and futures there are further derivatives, such
as swaps and other credit derivatives, forward options, and accumulators, but their
discussion is beyond the scope of this book. On the other hand, an asset that is central
in many trades and that we therefore need to discuss, is money.
2.4 Money
Historically, trades were based on bartering, which involves the direct exchange of
goods or services between trading partners. Since this exchange is necessarily based
on a double coincident of wants, where one trading partner desires what another
has to offer, it is often difficult to find such a partner. Moreover, it is often inconvenient, because only entire animals can change hands. Therefore, our predecessors
introduced a medium of exchange—money. Initially silver, gold, or other rare commodities were used and cast into standardized units—coins—which served as a
reference for trades. Note that coins have an intrinsic value, which corresponds to a
number of cows or eggs. As trade expanded, however, the limited supply of the rare
commodities began to limit trade.
This problem can be circumvented, if some authority—historically a king, today
a central bank—guarantees to exchange a piece of paper, having no value in itself,
for something else, for example, gold coins or other currencies. This paper money,
based on a promise from an authority, is called fiat-money, because it is introduced
by decree.
1 Note that the value of the paper money is closely linked to our trust in
the authority to ensure that the money is very difficult to counterfeit and anyone,
who forges the money, is prosecuted and punished. This trust in a central authority
that manages the flow of money is the linchpin on which fiat money hinges.
On a national level, central banks are the authorities that regulate the availability
of money by setting the interest rate at which commercial banks can borrow money
from the central bank, such as the European Central Bank in the Eurozone or the
Federal Reserve Bank in the US. Until August 1971 the US, and many other countries,
linked to the US through the Bretton-Woods agreement, used gold reserves to back
their currencies. Notably, a large fraction of the US reserves was stored in Fort Knox.
1 Such as “fiat lux”—let there be light (Genesis 1:3).