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Chance/Brooks. An Introduction to Derivatives and Risk Management, 7th ed.. Ch. 1: 2. Important Concepts. Different types of derivativesRisk preferences, risk-return tradeoff, and market efficiencyTheoretical fair valueArbitrage, storage, and deliveryThe role of derivative marketsCriticisms of derivatives.
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1. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 1 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
2. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 2 Important Concepts 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
3. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 3 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
4. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 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
5. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 5 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 Derivative Markets and Instruments (continued)
6. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 6 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 Derivative Markets and Instruments (continued)
7. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 7 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 Derivative Markets and Instruments (continued)
8. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 8 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. Derivative Markets and Instruments (continued)
9. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 9 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 don’t 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)
10. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 10 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. Some Important Concepts in Financial and Derivative Markets (continued)
11. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 11 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
12. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 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
13. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 13 Criticisms of Derivative Markets Speculation
Comparison to gambling
14. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 14 Misuses of Derivatives High leverage
Inappropriate use
15. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 15 Derivatives and Your Career Financial management in a business
Small businesses ownership
Investment management
Public service
16. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 16
17. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 1: 17