Chapter 1: Introduction

1. Chapter 1: Introduction Financial markets teach you humility. Two years ago, I made these related forecasts. First I forecast the euro would strengthen as European economic recovery picked up and the US economy slowed. Second, I forecast euro strength would be augmented over the next five years by a reduction of Europe's $100 billion to $150 billion of excess dollar reserves. Third, I forecast that the authorities would be less concerned over exchange rates, would only intervene after bigger exchange rate moves, and so exchange rate volatility would rise.  Interestingly, people still ask for my opinion. Avinash Persaud, Managing director, Global Markets Analysis, State Street Bank Risk, October, 2000, p. 29 An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2. Important Concepts in Chapter 1 • Different types of derivatives • Presuppositions for financial markets, risk preferences, risk-return tradeoff, and market efficiency • Theoretical fair value • Arbitrage, storage, and delivery • The role of derivative markets • Criticisms of derivatives • Ethics An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3. Business risk vs. financial risk • Derivatives • A derivative is a financial instrument whose return is derived from the return on another instrument. • Size of the OTC derivatives market at year-end 2010 • $601 trillion notional principal • GDP is only $15 trillion • See Figure 1.1 and Figure 1.2 • Real vs. financial assets An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. Derivative Markets and Instruments • Derivative Markets • Over-the-counter and exchange traded • Exchange traded derivatives volume in 2010 was over 22 billion contracts on at least 78 derivatives exchanges, according to Futures Industry magazine (a leading source of derivatives industry information • Derivatives trade all over the world • See Table 1.1 for the top ten derivatives exchanges An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. 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 An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. 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 An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. 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 An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8. 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 An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. 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. An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. Some Important Concepts in Financial and Derivative Markets • Presuppositions – rule of law, property rights, culture of trust • Risk Preference • Risk aversion vs. risk neutrality • Risk premium • Short Selling • Repurchase agreements (repos) • Return and Risk • Risk defined • The risk-return tradeoff (see Figure 1.3) An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. Some Important Concepts in Financial and Derivative Markets (continued) • Market Efficiency and Theoretical Fair Value • Efficient market defined: A market in which the price of an asset equals its true economic value. • An efficient market is a consequence of rational and knowledgeable investor behavior • The concept of theoretical fair value • The true economic value An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. Fundamental Linkages Between Spot and Derivative Markets • Arbitrage and the Law of One Price • Arbitrage defined: A type of profit-seeking transaction where the same good trades at two prices. • Example: See Figure 1.4 • The concept of states of the world • The Law of One Price • The Storage Mechanism: Spreading Consumption across Time • Delivery and Settlement An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. The Role of Derivative Markets • Risk Management • Hedging vs. speculation • Setting risk to an acceptable level • Example: Southwest Airlines • Price Discovery • Operational Advantages • Transaction costs • Liquidity • Ease of short selling • Market Efficiency An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14. Criticisms of Derivative Markets • Speculation • Comparison to gambling An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. Misuses of Derivatives • High leverage • Inappropriate use An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16. Derivatives and Ethics • Codes of ethics and standards of professional conduct are vital components of the derivatives profession • Examples • CFA Institute • Professional Risk Managers International Association • Global Association of Risk Professionals An Introduction to Derivatives and Risk Management, 9th ed.

17. Derivatives and Your Career • Financial management in a business • Small businesses ownership • Investment management • Public service Source of Information on Derivatives http://www.cengage.com/finance/chance Summary An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18. (Return to text slide) An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. (Return to text slide) An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20. (Return to text slide) An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. (Return to text slide) An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

22. (Return to text slide) An Introduction to Derivatives and Risk Management, 9th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.