1. Introduction to Derivatives
Chapter 1
Introduction to Derivatives

2. What Is a Derivative? Definition Types Uses
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
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3. Three Different Perspectives
End users
Corporations
Investment managers
Investors
Intermediaries
Market-makers
Traders
Economic Observers
Regulators
Researchers
Observers
End
user
Intermediary
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4. 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
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5. 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
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6. Exchange Traded Contracts
Contracts proliferated in the last three decades
What were the drivers behind this proliferation?
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7. Increased Volatility…
Oil prices: 1951–1999
DM/$ rate: –1999
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8. …Led to New and Big Markets
Exchange-traded derivatives
Over-the-counter traded derivatives: even more!
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9. 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
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10. Bid-Ask Spread Viewpoint of Market Maker and Investor Price Magnitude
Lower
Buy Price
Sell Price
Ask
Higher
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11. 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
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12. Short-Selling (cont’d)
Why short-sell?
Speculation
Financing
Hedging
Credit risk in short-selling
Collateral and “haircut”
Interest received from lender on collateral
Scarcity decreases the interest rate
Repo rate in bond markets
Short rebate in the stock market
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