1. Chapter 1 Introduction to Derivatives

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1-2 What Is a Derivative? Definition  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

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1-3 Observers End user End user Intermediary Economic Observers  Regulators  Researchers Three Different Perspectives End users  Corporations  Investment managers  Investors Intermediaries  Market-makers  Traders

4. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1-4 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

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1-5 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

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1-6 Exchange Traded Contracts Contracts proliferated in the last three decades What were the drivers behind this proliferation?

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1-7 Increased Volatility… Oil prices: 1951–1999 DM/$ rate: 1951–1999

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1-8 …Led to New and Big Markets Exchange-traded derivatives Over-the-counter traded derivatives: even more!

9. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1-9 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

10. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1-10 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

11. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1-11 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