Derivatives and Risk Management

Derivative Markets and

Instruments

An Introduction
Chance/Brooks

An Introduction to Derivatives and Risk Management, 9th ed.

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Important Concepts

Different types of derivatives

Presuppositions for financial markets, risk preferences,
risk-return tradeoff, and market efficiency, short selling
Theoretical fair value
Arbitrage and delivery
The role of derivative markets
Criticisms of derivatives

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Business risk vs. financial risk

Business Risk related to underlying nature of business and deal with

uncertainty of future sales or the cost of input
Financial Risk deals with uncertainties in interest rates, exchange
rates, stock prices and commodity prices

Derivatives

A derivative is a financial instrument whose return is derived from the

return on another instrument.
Derivatives provide a means of managing business as well as financial
risks.
By using derivatives, one party can transfer, for a price (like insurance
premium), any undesired risk to other parties.

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Size of the OTC derivatives market at year-end

2015(approximately

$700 trillion notional principal (all over the world

GDP is only $15 trillion (America)

Real vs. financial assets

Real assets are physical assets including agri.

Commodities, metals and sources od energy
Financial assets are stock and bonds/loans and
currencies

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An Introduction to Derivatives and Risk Management, 9th ed.

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Derivative Markets and Instruments

Derivative Markets

Over-the-counter and exchange traded

Derivatives trade all over the world

Derivative Contract Categories

Exchange Traded contracts (Futures)
Over the counter contracts (Forwards and

Swaps

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Derivative Markets and Instruments

Options
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
Option terminology
price/premium (Paid by Option buyer)
call/put
exchange-listed vs. over-the-counter options

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An Introduction to Derivatives and Risk Management, 9th ed.

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Derivative Markets and Instruments

Forward Contracts
Definition: a contract between two parties for one party to buy
something from the other at a later date at a price agreed upon
today
Exclusively over-the-counter
Obligation not a right
The contract is said to be customized
No physical facilities for trading
No formal corporate body organized as market
Direct communication among financial Institutions
Facilitate understanding future contracts

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Derivative Markets and Instruments

Futures Contracts
Definition: a contract 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
Exclusively traded on an organized futures exchange /
Markets
The buyer/seller of future contract can sell/buy the
contract in future markets relieving obligation to buy/sell

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Derivative Markets and Instruments

Options on Futures (also known as commodity options or

futures options)
Definition: a contract between two parties giving one
party the right to buy or sell a futures contract from the
other at a later date at a price agreed upon today
Exclusively traded on a futures exchange

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An Introduction to Derivatives and Risk Management, 9th ed.

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Comparison of Forward and Future Contracts

Forward
Private contract between
two parties
Not standardized
Usually one specified
delivery date
Settled at end of contract
Delivery or final cash
settlement takes place
Some credit risk
Chance/Brooks

Futures
Traded on an exchange
Standardized Contract
Range of delivery dates
Settled Daily
Contract is usually closed

out prior to maturity

Virtually no credit risk

An Introduction to Derivatives and Risk Management, 9th ed.

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Derivative Markets and Instruments

Swaps
Definition of a swap: a contract in which two parties
agree to exchange a series of cash flows
It is variation of forward contract that essentially
equivalent to a series of forward contracts.
Typically at least one of the two series of cash flows is
determined by a later outcome
Exclusively over-the-counter
Example
Interest rate swap make up more than 60%of $700
trillion notional principal over the counter.

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Derivative Markets and Instruments

Swaption - Special type of option

A firm might buy an option to enter into a swap called swaption
Hybrids
Combine elements of several other types of contracts
Creation of new and useful products to meet diverse needs of
investor
Financial Engineering
The process of creating new financial products.
The Underlying Asset
Called the underlying
A derivative derives its value from the underlying.

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An Introduction to Derivatives and Risk Management, 9th ed.

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Some Important Concepts in Financial and

Derivative Markets

Presuppositions for well functioning Financial Markets

Risk Preference

rule of law
property rights
culture of trust
Risk aversion vs. risk neutrality
Risk premium

Short Selling
Repurchase agreements (repos)
Return and Risk

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Some Important Concepts in Financial and

Derivative Markets (continued)

Market Efficiency and Theoretical Fair Value

Efficient market defined: A market in which the price of an asset

equals its true economic value.
In an efficient capital market, security prices adjust rapidly to the
arrival of new information, therefore the current prices of
securities reflect all information about the security.
Whether markets are efficient has been extensively researched and
remains controversial.
In an efficient market, the price of an asset equals its true
economic value, which is called the theoretical fair value.

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Fundamental Linkages Between Spot and

Derivative Markets

Arbitrage and the Law of One Price

Arbitrage defined: A type of profit-seeking transaction
where the same good trades at two prices.
Arbitrage is an attractive strategy for investors.
The law of one price does not mean that price of one
asset must be equal to price of other asset. But it says
that equivalent combinations of financial instruments
must have a single price

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Fundamental Linkages Between Spot and

Derivative Markets

Markets ruled by Law of one price have four features

Investor always prefer more wealth to less
Given two investment opportunities, investor will
always prefer one that performs at least as well as the
other in all states and better in at least one state
If two investment opportunities offer equivalent
outcomes, they must have equivalent price
An investment opportunity that produces the same
return in all states is a risk free and must earn the risk
free rate.

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An Introduction to Derivatives and Risk Management, 9th ed.

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The Role of Derivative Markets

Risk Management
Hedging vs. speculation
Setting risk to an acceptable level
Price Discovery
Operational Advantages
Transaction costs
Liquidity
Ease of short selling
Market Efficiency

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Criticisms of Derivative Markets

Speculation
Comparison to gambling

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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.