Why learn Derivatives?

I am studying level 2 now.
I feel like Derivatives is a subject that is far and not related from how I evaluate and invest in stocks. The concept and approaches are very unfamiliar to me making me difficult to learn this.
Why should we learn this subject?
Do you use this knowledge in your area? How?

On the contrary you MUST learn derivatives if you are dealing with cash products and a traditional fundamental analyst. Market don’t move based on any particular style of analysis. You just increase your chances of spotting correct bets if you know your basics of fundamental, technical and the derivatives. Market is a different animal altogether and only fools try to “predict” it.

On another note, derivatives can be real fun. It is pure mathematics and the levels at which they teach you in the CFA are really elementary math if you know how to discount. FRM takes the derivatives portion a level higher perhaps because of the quant focus but nothing at a very high level.

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agreed. In particular, exotic options such as barrier, exchange, shout!, etc can be pretty fun. Problems involving them are akin to a puzzle of sorts. I think Black Scholes PDE is one of the most elegant yet simple and beautiful equations in Finance, at least with my minimal knowledge in the subject.

BSM is theoretically ( and practically to a very high degree of confidence) stable. Students and Candidates make it difficult on themselves once they try to memorise d1 and d2. Of course candidates with prior calculus background will find them easier because BSM is essentially a Binomial distribution in the continuous mode. But that is not to say you have to know Calculus or even binomial to understand the underlying principle. That is very solid and very straight forward.

David Harper has some cool videos on BSM, Merton model and the science behind pricing an option based on default probabilities. What I like about him is that he makes the often intricate mathematical formulas very illustratively simple.

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I was actually referring to Black Scholes PDE, of which BSM is one possible solution. You’re right that one - out of many - way of deriving BSM is through a binomial model. I think the easiest and most intuitive way is through risk-neutral pricing. One could also derive it from the Capital Asset Pricing Model (or so i read), but seems to me that this would require quite a bit of mathematical ingenuity.

d1 and d2 are actually fairly simple and easy to remember imo, and once one practices enough problems, they become almost second nature. It certainly helps that once you know one of them, all you have to do is add or subtract \sigma \sqrt(T) to obtain the other. That means only remembering one is sufficient.

Thanks for your reply.

There was an interesting and impressive quote “only fools try to predict the market”.
I never thought so. The reason why we learn this discounting cash flows, estimating cash flows, fed model, yardeni model etc, we try to know the future direction of the market. in some sense, it could be a “prediction” isn’t it?

Btw, your comment really helped me and I am reading almost the end chapter of Curriculum Book.

Thanks for your reply.

your comment helped me start the subject and I am reading almost the end chapter of Curriculum Book.

Black Sholes and Black model seem to be very beautiful animal as you said so!

Derivatives are cool! And, frankly, they’re pretty easy. What I mean is that once you learn a few basic principles (price so that there is no arbitrage opportunity, value as PV(what you will receive) − PV(what you will pay), and so on), you apply them to all derivatives without passion or prejudice.

Yes: BSM is beautiful. And note that this is a professional opinion: I’m a mathematician by education.

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Yea, definitely! Although, in my opinion, derivatives are far from being ‘easy’. The CFA curriculum barely scratches the surface of derivatives theory. FRM is more thorough in this regard. A more rigorous study on derivatives would require a thorough understanding of applied stochastic calculus, and include things like geometric brownian motion, Ito-doeblin, Brownian Bridge, Multidimensional Feynman-Kac, etc, etc. Complicated, but fascinating stuff. One day I’ll learn about them.

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You are right. But I am inclined to learn Financial Mathematics now. Just don’t know where to start from

Bill, one of my regrets in life is I did not pursue my masters in math. Instead chose a business degree. I would not go so far as saying it haunts me but I do keep on wondering what if I stayed the course.

The passion is rekindled having read the book “The man who solved the market” - by David Zuckermann on Jim Simmons.

If I ever get enough time, I would like to finish a PhD in mathematics: algebraic topology (specifically, knot theory). There are a couple of professors at UC Davis whose area of expertise is knot theory, and I would love to move up that way (for reasons other than merely to go to school there).