Introduction to Derivatives

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Presentation transcript:

Introduction to Derivatives Chapter 1 Introduction to Derivatives

What Is a Derivative? Definition Types Uses An agreement between two parties which has a value determined by the price of something else Types Options, futures and swaps Uses Risk management Speculation Reduce transaction costs Regulatory arbitrage Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Three Different Perspectives End users Corporations Investment managers Investors Intermediaries Market-makers Traders Economic Observers Regulators Researchers Observers End user Intermediary Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Financial Engineering The construction of a financial product from other products New securities can be designed by using existing securities Financial engineering principles Facilitate hedging of existing positions Enable understanding of complex positions Allow for creation of customized products Render regulation less effective Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Role of Financial Markets Insurance companies and individual communities/families have traditionally helped each other to share risks Markets make risk-sharing more efficient Diversifiable risks vanish Non-diversifiable risks are reallocated Recent example: earthquake bonds by Walt Disney in Japan Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Exchange Traded Contracts Contracts proliferated in the last three decades What were the drivers behind this proliferation? Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Increased Volatility… Oil prices: 1951–1999 DM/$ rate: 1951–1999 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

…Led to New and Big Markets Exchange-traded derivatives Over-the-counter traded derivatives: even more! Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Basic Transactions Buying and selling a financial asset Brokers: commissions Market-makers: bid-ask (offer) spread Example: Buy and sell 100 shares of XYZ XYZ: bid = $49.75, offer = $50, commission = $15 Buy: (100 x $50) + $15 = $5,015 Sell: (100 x $49.75) – $15 = $4,960 Transaction cost: $5015 – $4,960 = $55 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Bid-Ask Spread Viewpoint of Market Maker and Investor Price Magnitude Lower Buy Price Sell Price Ask Higher Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Short-Selling When price of an asset is expected to fall First: borrow and sell an asset (get $$) Then: buy back and return the asset (pay $) If price fell in the mean time: Profit $ = $$ – $ The lender must be compensated for dividends received (lease-rate) Example: short-sell IBM stock for 90 days Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Short-Selling (cont’d) Why short-sell? Speculation Financing Hedging Credit risk in short-selling Collateral and “haircut” Interest received from lender on collateral Scarcity decreases the interest rate Repo rate in bond markets Short rebate in the stock market Copyright © 2006 Pearson Addison-Wesley. All rights reserved.