Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 1 Chapter 1: Introduction It is only by risking our persons from one hour to another that we live at all. William James The Will to Believe, 1897 © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 2 Important Concepts in Chapter 1 n Different types of derivatives n Risk preferences, risk-return tradeoff, and market efficiency n Theoretical fair value n Arbitrage, storage, and delivery n The role of derivative markets n Criticisms of derivatives © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 3 n Business risk vs. financial risk n Derivatives u A derivative is a financial instrument whose return is derived from the return on another instrument. n Size of the OTC derivatives market at year-end 2007 u $596 trillion notional principal u GDP is only $15 trillion n Real vs. financial assets © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 4 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 © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 5 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 Derivative Markets and Instruments (continued) © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 6 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 Derivative Markets and Instruments (continued) © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 7 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 Derivative Markets and Instruments (continued) © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 8 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. n The Underlying Asset u Called the underlying u A derivative derives its value from the underlying. Derivative Markets and Instruments (continued) © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 9 Some Important Concepts in Financial and Derivative Markets n Risk Preference u Risk aversion vs. risk neutrality u Risk premium n Short Selling n Repurchase agreements (repos) n Return and Risk u Risk defined u The risk-return tradeoff (see Figure 1.1) Figure 1.1Figure 1.1 © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 10 n Market Efficiency and Theoretical Fair Value u Efficient market defined: A market in which the price of an asset equals its true economic value. u An efficient market is a consequence of rational and knowledgeable investor behavior u The concept of theoretical fair value F The true economic value Some Important Concepts in Financial and Derivative Markets (continued) © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 11 Fundamental Linkages Between Spot and Derivative Markets n Arbitrage and the Law of One Price u Arbitrage defined: A type of profit-seeking transaction where the same good trades at two prices. u Example: See Figure 1.2 Figure 1.2Figure 1.2 F The concept of states of the world u The Law of One Price n The Storage Mechanism: Spreading Consumption across Time n Delivery and Settlement © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 12 The Role of Derivative Markets n Risk Management u Hedging vs. speculation u Setting risk to an acceptable level u Example: Southwest Airlines n Price Discovery n Operational Advantages u Transaction costs u Liquidity u Ease of short selling n Market Efficiency © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 13 Criticisms of Derivative Markets n Speculation n Comparison to gambling © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 14 Misuses of Derivatives n High leverage n Inappropriate use © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 15 Derivatives and Your Career n Financial management in a business n Small businesses ownership n Investment management n Public service Summary Source of Information on Derivatives © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 16 (Return to text slide) © 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.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 1: 17 (Return to text slide) © 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.