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Chapter 1: Introduction

It is only by risking our persons from one hour to another thatIt is only by risking our persons from one hour to another that

we live at all.we live at all.

i!!iam "amesi!!iam "ames

The Will to BelieveThe Will to Believe, 18#$, 18#$

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Important Concepts in Chapter 1

Di&&erent t'pes o& derivativesDi&&erent t'pes o& derivatives

Risk pre&erences, risk(return tradeo&&, and marketRisk pre&erences, risk(return tradeo&&, and market

e&&icienc'e&&icienc' )heoretica! &air va!ue)heoretica! &air va!ue

Ar*itrage, storage, and de!iver'Ar*itrage, storage, and de!iver'

)he ro!e o& derivative markets)he ro!e o& derivative markets

Criticisms o& derivativesCriticisms o& derivatives

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Business risk vs. &inancia! riskBusiness risk vs. &inancia! risk

DerivativesDerivatives

A derivative is a financial instrument whose return isA derivative is a financial instrument whose return is

derived from the return on another instrumentderived from the return on another instrument..

i-e o& the )C derivatives market at 'ear(end %$i-e o& the )C derivatives market at 'ear(end %$ 0#2 tri!!ion notiona! principa!0#2 tri!!ion notiona! principa!

3D4 is on!' 01 tri!!ion3D4 is on!' 01 tri!!ion

Rea! vs. &inancia! assetsRea! vs. &inancia! assets

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Derivative Markets and Instruments

ptionsptions

De&inition:De&inition: a contract between two parties that givesa contract between two parties that gives

one party, the buyer, the right to buy or sell somethingone party, the buyer, the right to buy or sell something

from or to the other party, the seller, at a later date at afrom or to the other party, the seller, at a later date at aprice agreed upon todayprice agreed upon today

ption termino!og'ption termino!og'

price/premiumprice/premium

ca!!/putca!!/put e6change(!isted vs. over(the(counter optionse6change(!isted vs. over(the(counter options

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7orard Contracts7orard Contracts

De&inition:De&inition: a contract between two parties for onea contract between two parties for one

party to buy something from the other at a later date atparty to buy something from the other at a later date at

a price agreed upon todaya price agreed upon today

96c!usive!' over(the(counter96c!usive!' over(the(counter

Derivative Markets and Instruments

continued;

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7utures Contracts7utures Contracts

De&inition:De&inition: a contract between two parties for onea contract between two parties for one

party to buy something from the other at a later date atparty to buy something from the other at a later date at

a price agreed upon today; subect to a daily settlementa price agreed upon today; subect to a daily settlement

of gains and losses and guaranteed against the risk thatof gains and losses and guaranteed against the risk that

either party might defaulteither party might default

96c!usive!' traded on a &utures e6change96c!usive!' traded on a &utures e6change

Derivative Markets and Instruments

continued;

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ptions on 7utures a!so knon as commodit' options orptions on 7utures a!so knon as commodit' options or

&utures options;&utures options;

De&inition:De&inition:

a contract between two parties giving onea contract between two parties giving one

party the right to buy or sell a futures contract from theparty the right to buy or sell a futures contract from the

other at a later date at a price agreed upon todayother at a later date at a price agreed upon today

96c!usive!' traded on a &utures e6change96c!usive!' traded on a &utures e6change

Derivative Markets and Instruments

continued;

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aps and ther Derivativesaps and ther Derivatives

De&inition o& a sap:De&inition o& a sap: a contract in which two partiesa contract in which two partiesagree to e!change a series of cash flowsagree to e!change a series of cash flows

96c!usive!' over(the(counter96c!usive!' over(the(counter

ther t'pes o& derivatives inc!ude saptions andther t'pes o& derivatives inc!ude saptions andh'*rids. )heir creation is a process ca!!edh'*rids. )heir creation is a process ca!!edfinancialfinancialengineeringengineering..

)he

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ome Important Concepts in 7inancia! and

Derivative Markets Risk 4re&erenceRisk 4re&erence

Risk aversion vs. risk neutra!it'Risk aversion vs. risk neutra!it'

Risk premiumRisk premium hort e!!inghort e!!ing

Repurchase agreements repos;Repurchase agreements repos;

Return and RiskReturn and Risk

Risk de&inedRisk de&ined )he risk(return tradeo&& see)he risk(return tradeo&& see 7igure 1.17igure 1.1;;

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Market 9&&icienc' and )heoretica! 7air =a!ueMarket 9&&icienc' and )heoretica! 7air =a!ue

9&&icient market de&ined:9&&icient market de&ined:A market in which the price ofA market in which the price of

an asset e"uals its true economic value.an asset e"uals its true economic value.

An e&&icient market is a conse>uence o& rationa! andAn e&&icient market is a conse>uence o& rationa! and

kno!edgea*!e investor *ehaviorkno!edgea*!e investor *ehavior

)he concept o& theoretica! &air va!ue)he concept o& theoretica! &air va!ue

)he true economic va!ue)he true economic va!ue

ome Important Concepts in 7inancia! and

Derivative Markets continued;

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7undamenta! ?inkages Beteen pot and

Derivative Markets Ar*itrage and the ?a o& ne 4riceAr*itrage and the ?a o& ne 4rice

Ar*itrage de&ined:Ar*itrage de&ined:A type of profit#seeking transactionA type of profit#seeking transaction

where the same good trades at two prices.where the same good trades at two prices.

96amp!e: ee96amp!e: ee 7igure 1.%7igure 1.%

)he concept o& states o& the or!d)he concept o& states o& the or!d

)he ?a o& ne 4rice)he ?a o& ne 4rice

)he torage Mechanism: preading Consumption across)he torage Mechanism: preading Consumption across)ime)ime

De!iver' and ett!ementDe!iver' and ett!ement

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)he Ro!e o& Derivative Markets

Risk ManagementRisk Management

@edging vs. specu!ation@edging vs. specu!ation

etting risk to an accepta*!e !eve!etting risk to an accepta*!e !eve!

96amp!e: outhest Air!ines96amp!e: outhest Air!ines 4rice Discover'4rice Discover'

perationa! Advantagesperationa! Advantages

)ransaction costs)ransaction costs

?i>uidit'?i>uidit' 9ase o& short se!!ing9ase o& short se!!ing

Market 9&&icienc'Market 9&&icienc'

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.

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Criticisms o& Derivative Markets

pecu!ationpecu!ation

Comparison to gam*!ingComparison to gam*!ing

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Misuses o& Derivatives

@igh !everage@igh !everage

Inappropriate useInappropriate use

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Derivatives and our Career

7inancia! management in a *usiness7inancia! management in a *usiness

ma!! *usinesses onershipma!! *usinesses onership

Investment managementInvestment management

4u*!ic service4u*!ic service

ummar'

ource o& In&ormation on Derivatives

http://.cengage.com/&inance/chance

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Return to te6t s!ide;

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Return to te6t s!ide;

2010 C L i All Ri ht R d M t b d i d d li t d t d t bli l ibl b it i h l i t