TABLE OF CONTENTS It is difficult to speak generally about derivative securities. It is possible to observe that a derivative security involves a contingent claim; it is a security that has some essential feature, typically the price, that is derived from some future event. This event is often, though not always, associated with a security or commodity delivery to take place at a future date. The contingent claim can be combined with other security features or traded in isolation. This definition is not too helpful because financial markets are riddled with contingent claims. Sometimes the contingent claim is left bundled with the spot commodity, in which case the derivative security is also the spot commodity (e.g., mortgage-backed securities). Yet, the term "derivative security" is usually restricted further to only include cases where the contingent claim is unbundled and traded as a separate security, effectively forwards, futures, options, and swaps. In what follows, this class of unbundled contingent claims will be referred to as derivatives securities.
Derivative securities trading is definitely not a modern development. The implicit and explicit embedding of derivative features was common in the types of securities traded in early markets. Early examples of securities with derivative features include claims on the 14th century Florentine mons that had a provision for redemption at 28% of par, though that provision was seldom exercised; 16th-century bills of...
