1. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 1 Chapter 1: Introduction What’s good about finance is that it lubricates the machinery of capitalism. John Bogle, Journal of Indexes, Fourth Quarter, 2003, p. 41 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 2 Important Concepts in Chapter 1 n Different types of derivatives n Presuppositions for financial markets, risk preferences, risk-return tradeoff, and market efficiency n Theoretical fair value n Arbitrage, storage, and delivery n The role of derivative markets n Criticisms of derivatives n Ethics © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 3 n Business risk vs. financial risk n Derivatives u A derivative is a financial contract whose returns are derived from those of an underlying factor. n Size of the derivatives market at year-end 2013 u $710 trillion notional principal u U.S. Fourth Quarter GDP was only $17 trillion u See Figure 1.1 for OTC notional Figure 1.1Figure 1.1 u See Figure 1.2 for exchange-traded volume Figure 1.2Figure 1.2 n Real vs. financial assets © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 4 Derivative Markets and Instruments n Derivative Markets u Instrument – generic term describing either asset or liability upon which the derivative contract is based u Contract – an enforceable legal agreement u Security – a tradable instrument representing a claim on a group of assets u Cash market (or spot market) – market where underlying is delivered immediately or shortly thereafter © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 5 Derivative Markets and Instruments n Options u 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 u Option terminology F price/premium F call/put F right, not an obligation © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 6 n Forward Contracts u 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 u Exclusively over-the-counter Derivative Markets and Instruments (continued) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 7 n Futures Contracts u 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 u Exclusively traded on a derivatives exchanges u Subject to daily settlement Derivative Markets and Instruments (continued) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 8 n Swaps and Other Derivatives u Definition of a swap: a contract in which two parties agree to exchange a series of cash flows u Exclusively over-the-counter u Viewed as a combination of forward contracts u Swaptions are special type of option on a swap Derivative Markets and Instruments (continued) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. Underlying Asset n The Underlying Asset u Called the underlying u A derivative derives its value from the underlying u Can be almost anything, such as weather measurements Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 9 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 10 Important Concepts in Financial and Derivative Markets n Presuppositions – rule of law, property rights, culture of trust n Risk Preference u Risk aversion vs. risk neutrality u Risk premium n Short Selling n Repurchase agreements (repos) n Return and Risk u Risk defined u The risk-return tradeoff (see Figure 1.3) Figure 1.3Figure 1.3 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 11 n Market Efficiency and Theoretical Fair Value u Efficient market defined: A market in which the price of an asset equals its true economic value. u An efficient market is a consequence of rational and knowledgeable investor behavior u The concept of theoretical fair value F The true economic value Important Concepts in Financial and Derivative Markets (continued) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 12 Fundamental Linkages Between Spot and Derivative Markets n Arbitrage and the Law of One Price u Arbitrage defined: A type of profit-seeking transaction where the same good trades at two prices. u Example: See Figure 1.4 Figure 1.4Figure 1.4 F The concept of states of the world u The Law of One Price n The Storage Mechanism: Spreading Consumption across Time n Delivery and Settlement © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 13 The Role of Derivative Markets n Risk Management u Hedging vs. speculation u Setting risk to an acceptable level u Example: Southwest Airlines n Price Discovery n Operational Advantages u Transaction costs u Liquidity u Ease of short selling n Market Efficiency © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 14 Criticisms of Derivative Markets n Speculation n Comparison to gambling © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 15 Misuses of Derivatives n High leverage n Inappropriate use © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16. Derivatives and Ethics n Codes of ethics and standards of professional conduct are vital components of the derivatives profession n Examples u CFA Institute u Professional Risk Managers International Association u Global Association of Risk Professionals Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 16 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 17 Derivatives and Your Career n Financial management in a business n Small businesses ownership n Investment management n Public service Summary Source of Information on Derivatives http://www.cengagebrain.com Use: ISBN 9781305104969 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 18 (Return to text slide) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 19 (Return to text slide) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 20 (Return to text slide) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 1: 21 (Return to text slide) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.