1. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-1 The Uses of Derivatives Uses –Risk management. Derivatives are a tool for companies and other users to reduce risks. –Speculation. Derivatives can serve as investment vehicles. –Reduce transaction costs. Sometimes derivatives provide a lower cost way to undertake a particular financial transaction. –Regulatory arbitrage. It is sometimes possible to circumvent regulatory restrictions, taxes, and accounting rules by trading derivatives.

2. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-2 Perspectives on Derivatives End users –Corporations –Investment managers –Investors Intermediaries –Market-makers –Traders Observers End user End user Intermediary Economic Observers  Regulators  Researchers

3. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-3 Perspectives on Derivatives (cont’d) End users: They enter into derivatives contracts for the reasons listed in P.14.P.14 Market-makers:  They will buy derivatives from customers who wish to sell, and sell derivatives to customers who wish to buy.  They make money by charging a spread (buy at low price and sell at higher price. Economic observers: They look at the use of derivatives, the activities of the market-makers, the organization of the markets and the logic of the pricing models and try to make sense of everything.

4. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-4 Financial Engineering and Security Design 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 –Allow for creation of customized products –Enable understanding of complex positions –Render regulation less effective

5. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-5 Transaction Costs and the Bid- Ask Spread Buying and selling a financial asset –Brokers: commissions. –Market-makers: earn bid-ask (offer) spread ask (offer) price: price that you buy the stock from market makers. bid price: price that you sell the stock to market makers.

6. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-6 Transaction Costs and the Bid- Ask Spread (cont’d) Example 1.1: 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 –Round-trip transaction cost: $5015 – $4,960 = $55

7. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-7 Ways to buy or sell Market order To trade a specific quantity of the asset immediately at the best price that is currently available. Advantage: The trade is executed as soon as possible. Disadvantage: You might have been able to get a better price had you been more patient.

8. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-8 Ways to buy or sell (cont’d) Limit order To trade a specific quantity of the asset at a specified or better price. Advantage: Can trade at a better price. Disadvantage: The possibility that the order is never filled.

9. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-9 Ways to buy or sell (cont’d) Stop-loss order The stop-loss order becomes a market order to sell once the price of an asset hits the prescribed value.

10. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-10 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. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-11 Short-Selling (cont’d) Why short-sell? –Speculation –Financing –Hedging Credit risk in short-selling –Collateral and “haircut” Interest received from lender on collateral –Demand on the collateral drives down the interest rate –Demand on cash drives up the interest rate –Repo rate in bond markets –Short rebate in the stock market

12. Chapter 3 An Introduction to Forwards and Options International Edition

13. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-13 Introduction Basic derivatives contracts –Forward contracts –Call options –Put Options Types of positions –Long position –Short position Graphical representation –Payoff diagrams –Profit diagrams

14. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-14 Forward Contracts Definition: a binding agreement (obligation) to buy/sell an underlying asset in the future, at a price set today. Futures contracts are the same as forwards in principle except for some institutional and pricing differences. A forward contract specifies –The features and quantity of the asset to be delivered. –The delivery logistics, such as time, date, and place. –The price the buyer will pay at the time of delivery. Today Expiration date

15. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-15 Reading Price Quotes Settlement price Daily change Open interest Daily low Daily high The open price Expiration month

16. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-16 Open Interest Number of contracts outstanding. (Since each trade of a contract has both a buyer and seller, a buyer-seller pair counts as one contract). Reading Price Quotes (cont’d)

17. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.2-17