Introduction to Derivatives and Risk Management: Chapter 1
Transcript of Introduction to Derivatives and Risk Management: Chapter 1
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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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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 1: 2
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'
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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