Chapter 1 Introduction to Derivatives. Copyright © 2006 Pearson Addison-Wesley. All rights...

Chapter 1

Introductionto Derivatives

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


Observers

End user

End user

Intermediary

• EconomicObservers

Regulators Researchers

Three Different Perspectives

• End users Corporations Investment

managers Investors

• Intermediaries Market-makers Traders


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


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


Exchange Traded Contracts

• Contracts proliferated in the last three decades

• What were the drivers behind this proliferation?


Increased Volatility…

• Oil prices: 1951–1999

• DM/$ rate: 1951–1999


…Led to New and Big Markets

• Exchange-traded derivatives

• Over-the-counter traded derivatives: even more!


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


Bid-Ask Spread

• Viewpoint of Market Maker

Price Magnitude For Market Maker

For Investor

Bid Lower Buy Price Sell Price

Ask Higher Sell Price Buy Price


Short-Selling

• Long Position or “Go Long” You pay money up front.

• Short Sale or Short or Go Short or Short Position You collect money up front


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


Short-Selling (cont’d)

• Why short-sell? Speculation Financing Hedging

• Credit risk in short-selling Collateral and “haircut”

• Interest received from lender on collateral Spread is additional cost

Scarcity decreases the interest rate Repo rate in bond markets Short rebate in the stock market

Chapter 1 Introduction to Derivatives. Copyright © 2006 Pearson Addison-Wesley. All rights...

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