1. Copyright © 2001 by Harcourt, Inc. All rights reserved.1 Chapter 1: Introduction You’re into derivatives whether you like it or not. Your adjustable rate mortgage is a derivative. You got a deal on a loan that was cheaper than a fixed-rate mortgage. In return you’re taking a risk. P. J. O’Rourke Eat the Rich, 1998

2. Copyright © 2001 by Harcourt, Inc. All rights reserved.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

3. Copyright © 2001 by Harcourt, Inc. All rights reserved.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 derivatives market at year-end 1999 u $88 trillion notional principal u $2.8 trillion market value n Real vs. financial assets

4. Copyright © 2001 by Harcourt, Inc. All rights reserved.4 Derivative Markets 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

5. Copyright © 2001 by Harcourt, Inc. All rights reserved.5 n Forward Contracts u Definition: an agreement 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 (continued)

6. Copyright © 2001 by Harcourt, Inc. All rights reserved.6 n Futures Contracts u Definition: an agreement 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 (continued)

7. Copyright © 2001 by Harcourt, Inc. All rights reserved.7 n Options on Futures (also known as commodity options or futures options) u Definition: an agreement between two parties giving one party the right to buy 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 (continued)

8. Copyright © 2001 by Harcourt, Inc. All rights reserved.8 n Swaps and Other Derivatives u Definition of a swap: an agreement 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 Derivative Markets (continued)

9. Copyright © 2001 by Harcourt, Inc. All rights reserved.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 Return and Risk u Risk defined u The Risk-Return tradeoff (see Figure 1.1, p. 12)

10. Copyright © 2001 by Harcourt, Inc. All rights reserved.10 n Market Efficiency and Theoretical Fair Value u Definition of efficient market u The concept of theoretical fair value Some Important Concepts in Financial and Derivative Markets (continued)

11. Copyright © 2001 by Harcourt, Inc. All rights reserved.11 Fundamental Linkages Between Spot and Derivative Markets n Arbitrage and the Law of One Price u Arbitrage defined u Example: See Figure 1.2, p. 14 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

12. Copyright © 2001 by Harcourt, Inc. All rights reserved.12 The Role of Derivative Markets n Risk Management u Hedging vs. speculation u Setting risk to an acceptable level n Price Discovery n Operational Advantages u Transaction costs u Liquidity u Ease of short selling n Market efficiency

13. Copyright © 2001 by Harcourt, Inc. All rights reserved.13 Criticisms of Derivative Markets n Speculation n Comparison to gambling

14. Copyright © 2001 by Harcourt, Inc. All rights reserved.14 Misuses of Derivatives n High leverage n Inappropriate use

15. Copyright © 2001 by Harcourt, Inc. All rights reserved.15 Derivatives and Your Career n Financial management in a business n Small businesses ownership n Investment management n Public service Summary

16. Copyright © 2001 by Harcourt, Inc. All rights reserved.16 Appendix: Sources of Information on Derivatives u Specialized Trade Publications u Specialized Derivatives Journals u Internet Sites u Other Sources