Chapter 1 Introduction The speed of money is

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

Important Concepts in Chapter 1 n n n 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 D. M. Chance An Introduction to Derivatives and Risk Management, 6 th ed. 2

n n Business risk vs. financial risk Derivatives u 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 u $111 trillion notional principal u $3. 8 trillion market value Real vs. financial assets D. M. Chance An Introduction to Derivatives and Risk Management, 6 th ed. 3

Derivative Markets and Instruments n Options u 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 u Option terminology F price/premium F call/put F exchange-listed vs. over-the-counter options D. M. Chance An Introduction to Derivatives and Risk Management, 6 th ed. 4

Derivative Markets and Instruments (continued) n Forward Contracts u 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 u Exclusively over-the-counter D. M. Chance An Introduction to Derivatives and Risk Management, 6 th ed. 5

Derivative Markets and Instruments (continued) n Futures Contracts u 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 u Exclusively traded on a futures exchange D. M. Chance An Introduction to Derivatives and Risk Management, 6 th ed. 6

Derivative Markets and Instruments (continued) n Options on Futures (also known as commodity options or futures options) u 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 u Exclusively traded on a futures exchange D. M. Chance An Introduction to Derivatives and Risk Management, 6 th ed. 7

Derivative Markets and Instruments (continued) n n Swaps and Other Derivatives u Definition of a swap: a contract in which two parties agree to exchange a series of cash flows u Exclusively over-the-counter u Other types of derivatives include swaptions and hybrids. Their creation is a process called financial engineering. The Underlying Asset u Called the underlying u A derivative derives its value from the underlying. D. M. Chance An Introduction to Derivatives and Risk Management, 6 th ed. 8

Some Important Concepts in Financial and Derivative Markets n n n Risk Preference u Risk aversion vs. risk neutrality u Risk premium Short Selling Return and Risk u Risk defined u The Risk-Return tradeoff (see Figure 1. 1, p. 7) D. M. Chance An Introduction to Derivatives and Risk Management, 6 th ed. 9

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

Fundamental Linkages Between Spot and Derivative Markets n n n Arbitrage and the Law of One Price u Arbitrage defined u Example: See Figure 1. 2, p. 10 F The concept of states of the world u The Law of One Price The Storage Mechanism: Spreading Consumption across Time Delivery and Settlement D. M. Chance An Introduction to Derivatives and Risk Management, 6 th ed. 11

The Role of Derivative Markets n n Risk Management u Hedging vs. speculation u Setting risk to an acceptable level Price Discovery Operational Advantages u Transaction costs u Liquidity u Ease of short selling Market efficiency D. M. Chance An Introduction to Derivatives and Risk Management, 6 th ed. 12

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

Misuses of Derivatives n n High leverage Inappropriate use D. M. Chance An Introduction to Derivatives and Risk Management, 6 th ed. 14

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

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

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