1. Lecture # 02 1.1 Introduction

2. The Nature of Derivatives 1.2 A derivative is an instrument whose value depends on the values of other more basic underlying variables

3. Examples of Derivatives 1.3 Futures Contracts Forward Contracts Swaps Options

4. Derivatives Markets 1.4 Exchange traded Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading Contracts are standard there is virtually no credit risk Over-the-counter (OTC) A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers Contracts can be non-standard and there is some small amount of credit risk

5. Size of OTC and Exchange Markets (Figure 1.1, Page 3) 1.5 Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

6. Ways Derivatives are Used 1.6 To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another

7. Forward Contracts 1.7 Forward contracts are similar to futures except that they trade in the over-the-counter market Forward contracts are particularly popular on currencies and interest rates

8. Foreign Exchange Quotes for GBP June 3, 2003 (See page 4) 1.8 BidOffer Spot1.62811.6285 1-month forward1.62481.6253 3-month forward1.61871.6192 6-month forward1.60941.6100

9. References 1.9 Adopted from Options, Futures, and Other Derivatives, 6 th Edition, Copyright © John C. Hull 2005