Chapter 6. Derivatives Pricing

Derivatives are financial instruments which derive their value from (or are dependent on) the value of another product, called the underlying. The three basic types of derivatives are forward and futures contracts, swaps, and options. In this chapter we will focus on this latter class and show how basic option pricing models and some related problems can be handled in R. We will start with overviewing how to use the continuous Black-Scholes model and the binomial Cox-Ross-Rubinstein model in R, and then we will proceed with discussing the connection between these models. Furthermore, with the help of calculating and plotting of the Greeks, we will show how to analyze the most important types of market risks that options involve. Finally, we will discuss what implied volatility means and will illustrate this phenomenon by plotting the volatility smile with the help of real market data.

The most important characteristics of options compared to futures or swaps...