Chapter 1: Introduction

The attitude here is that derivatives have, on the whole, been a tremendously positive force around the world. In all these countries they impose market discipline and force supervisors to rethink their rules and regulations. David Folkents-Landau Risk, September, 1997, p. 28

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Important Concepts

Different types of derivatives Risk preferences, risk-return efficiency Theoretical fair value Arbitrage, storage, and delivery The role of derivative markets Criticisms of derivatives

tradeoff,

and

market

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Business risk vs. financial risk Derivatives A derivative is a financial instrument whose return is derived from the return on another instrument. Derivatives provide a means of managing business as well as financial risks. By using derivatives, one party can transfer, for a price (like insurance premium), any undesired risk to other parties. Size of the OTC derivatives market at year-end 2005 $285 trillion notional principal $9.1 trillion market value Real vs. financial assets

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Derivative Markets and Instruments

Options Definition: a contract between two parties that gives one party, the buyer, the right to buy or sell something from or to the other party, the seller, at a later date at a price agreed upon today Option terminology price/premium call/put exchange-listed vs. over-the-counter options

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Derivative Markets and Instruments (continued)

Forward Contracts Definition: a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today Exclusively over-the-counter

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Derivative Markets and Instruments (continued)

Futures Contracts Definition: a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today; subject to a daily settlement of gains and losses and guaranteed against the risk that either party might default Exclusively traded on a futures exchange

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Derivative Markets and Instruments (continued)

Options on Futures (also known as commodity options or futures options) Definition: a contract between two parties giving one party the right to buy or sell a futures contract from the other at a later date at a price agreed upon today Exclusively traded on a futures exchange

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Derivative Markets and Instruments (continued)

Swaps and Other Derivatives Definition of a swap: a contract in which two parties agree to exchange a series of cash flows Exclusively over-the-counter Other types of derivatives include swaptions and hybrids. Their creation is a process called financial engineering. The Underlying Asset Called the underlying A derivative derives its value from the underlying.
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Some Important Concepts in Financial and Derivative Markets

Risk Preference Risk aversion vs. risk neutrality More vs. less risk-averse Risk premium Short Selling Sell overpriced stock that you dont own and purchase it back later (at a lower price) Borrow the stock from another investor (through your broker) Return and Risk Risk is measurable or quantifiable uncertainty of future returns.

The risk-return tradeoff (see Figure 1.1, p. 7)

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Some Important Concepts in Financial and Derivative Markets (continued)

Market Efficiency and Theoretical Fair Value In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices of securities reflect all information about the security. Whether markets are efficient has been extensively researched and remains controversial. In an efficient market, the price of an asset equals its true economic value, which is called the theoretical fair value.
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Fundamental Linkages Between Spot and Derivative Markets

Arbitrage and the Law of One Price The Law of One Price requires that equivalent combinations of assets must sell for a single price. In an efficient market, the Law of One Price must hold. If occasionally prices get out of line, arbitrage mechanism keeps prices in line. Example: See Figure 1.2, p. 10 The concept of states of the world The Storage Mechanism: Spreading Consumption across Time Delivery and Settlement
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The Role of Derivative Markets

Risk Management Hedging vs. speculation Setting risk to an acceptable level Price Discovery Operational Advantages Transaction costs Liquidity Ease of short selling Market Efficiency

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Criticisms of Derivative Markets

Speculation Comparison to gambling

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Misuses of Derivatives

High leverage Inappropriate use

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Derivatives and Your Career

Financial management in a business Small businesses ownership Investment management Public service

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