Overview

The four lessons build a foundation in this order. First, the market architecture: exchange-traded versus OTC markets, the roles of hedgers, speculators, and arbitrageurs, and the mechanics of going long or short. Second, the time value of money — not as an abstract concept but as the compounding engine that converts all future cash flows into present values, and as the source of forward rates and FRA mechanics. Third, the law of one price and replication: the idea that two portfolios with identical payoffs must have the same price, and how that forces the forward price of a stock to equal $S_0 e^{rT}$ without any assumption about how prices move. Fourth, a first look at the taxonomy of instruments that organises the rest of the unit: linear (delta-one) payoffs versus convex option payoffs, and why the two classes require different pricing machinery.

By the end of this topic you should be able to:

• classify any derivative market venue as exchange-traded or OTC, and explain why each venue exists;
• distinguish the objectives of a hedger, a speculator, and an arbitrageur, and describe how each generates market liquidity;
• convert rates between continuous, annual, and semi-annual compounding and compute present values, forward rates, and FRA payoffs;
• derive the no-arbitrage forward price of an investment asset and price an existing forward contract;
• classify an instrument as delta-one or non-linear, and explain why that distinction determines the pricing method.

1. Contents
2. The big picture