Chapter 1: Introduction

1. Chapter 1: Introduction The speed of money is faster than it’s ever been. Loleen Doerrer Time, April 11, 1994, p. 33 An Introduction to Derivatives and Risk Management, 6th ed.

2. Important Concepts in Chapter 1 • Different types of derivatives • Risk preferences, risk-return tradeoff, and market efficiency • Theoretical fair value • Arbitrage, storage, and delivery • The role of derivative markets • Criticisms of derivatives An Introduction to Derivatives and Risk Management, 6th ed.

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 derivatives market at year-end 2001 • $111 trillion notional principal • $3.8 trillion market value • Real vs. financial assets An Introduction to Derivatives and Risk Management, 6th ed.

4. 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, 6th ed.

5. 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, 6th ed.

6. 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, 6th ed.

7. 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, 6th ed.

8. 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, 6th ed.

9. Some Important Concepts in Financial and Derivative Markets • Risk Preference • Risk aversion vs. risk neutrality • Risk premium • Short Selling • Return and Risk • Risk defined • The Risk-Return tradeoff (see Figure 1.1, p. 7) An Introduction to Derivatives and Risk Management, 6th ed.

10. Some Important Concepts in Financial and Derivative Markets (continued) • Market Efficiency and Theoretical Fair Value • Definition of an efficient market • The concept of theoretical fair value An Introduction to Derivatives and Risk Management, 6th ed.

11. Fundamental Linkages Between Spot and Derivative Markets • Arbitrage and the Law of One Price • Arbitrage defined • Example: See Figure 1.2, p. 10 • 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, 6th ed.

12. 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 An Introduction to Derivatives and Risk Management, 6th ed.

13. Criticisms of Derivative Markets • Speculation • Comparison to gambling An Introduction to Derivatives and Risk Management, 6th ed.

14. Misuses of Derivatives • High leverage • Inappropriate use An Introduction to Derivatives and Risk Management, 6th ed.

15. Derivatives and Your Career • Financial management in a business • Small businesses ownership • Investment management • Public service Source of Information on Derivatives http://chance.swlearning.com Summary An Introduction to Derivatives and Risk Management, 6th ed.

16. (Return to text slide) An Introduction to Derivatives and Risk Management, 6th ed.

17. (Return to text slide) An Introduction to Derivatives and Risk Management, 6th ed.