1、Introduction,Derivatives,Derivatives are financial instruments whose returns are derived from those of other (financial) instruments. By using derivatives, one can transfer undesired risk to other parties.,Content,An introductory treatment of financial derivatives. Characteristics of the institution

2、 and markets The strategies used How derivatives are used in managing the risk,Derivative markets and instruments,Options Forward contracts Futures contracts Options on futures Swaps and other derivatives,Options,An option is a contract between two parties-a buyer and a seller-that gives the buyer t

3、he right, but not the obligation, to purchase or sell something at a later date at a price agreed upon today.,Call vs put,An option to buy something is referred to as a call; an option to sell something is called a put.,OTC market vs options exchange,Over-the-counter market is a market where option

4、trading is conducted privately between two parties. Options exchange is a place where options are publicly traded.,Forward contracts,A forward contract is a contract between two parties to purchase or sell something at a later date at a price agreed upon today. Forward contracts are traded strictly

5、in an OTC market consisting of direct communications among major financial institutions.,Futures contracts,Futures contracts evolved out of forward contracts and possess many of the same characteristics. Futures contracts differ from forward contracts in that they trade on organized exchange and the

6、y are subject to a daily settlement procedure.,Options on futures,Options on futures, sometimes called commodity options or futures options, gives the buyer the right to buy or sell a futures contract at a later date at a price agreed upon today.,Swaps and other derivatives,A swap is a contract in w

7、hich two parties agree to exchange cash flows. Some of these types of contracts are referred to as hybrids because they combine the elements of several other types of contracts.,Some important concepts,Risk preference Short selling Return and risk Market efficiency and the theoretical fair value,Ris

8、k preference,Risk aversion: individuals expect to get risk premium to justify taking the risk. Risk neutral: investors are indifferent to risk, they require no compensation for risk and the expected return on all securities is the risk-free interest rate.,Short selling,Short selling, sometimes calle

9、d short, means that investors sell an asset that is not owned by them but borrowed from a broker.,Return and risk,Return is the numerical measure of investment performance. Risk is the uncertainty of future returns. High return is always accompanied by greater risk, which results in the positive rel

10、ationship between risk and return, known as the risk-return trade-off relationship. Investors have to balance between risk and return in financial markets.,Market efficiency and theoretical fair value,Market efficiency: In an efficient market, investors cant consistently earn returns above that woul

11、d compensate them for the level of risk they assume. Theoretical fair value: true economic value of the asset.,Fundamental linkages between spot and derivative markets,Arbitrage and law of one price The storage mechanism Delivery and settlement,Arbitrage,Arbitrage is a type of transaction in which a

12、n investor seeks to profit when the same good sells for two different prices.,Law of one price,Investors always prefer more wealth to less Given two investment opportunities, investors will always prefer one that performs at least as well as the other in all states and better in at least one state I

13、f two investment opportunities offer equivalent outcomes, they must have equivalent prices An investment opportunity that produces the same return in all states is risk-free and must earn the risk-free rate,The storage mechanism,Storage is a form of investment in which one defers selling the item to

14、day in anticipation of selling it at a later date. The price of the storable item, the derivative contract and the risk-free rate will all be related.,Delivery and settlement,At expiration: immediate delivery of the item or a cash payment of the same value. Before expiration: enter into offsetting t

15、ransaction.,The role of derivative markets,Risk management Price discovery Operational advantages Market efficiency,Risk management,Derivative markets are used to reduce or increase the risk of owning the spot items. These markets are so effective at reallocating risk among investors, on one need as

16、sume an uncomfortable level of risk.,Price discovery,Spot market is large and fragmented and there are many varieties and grades. So there are many candidates for the spot price. The futures market is more active and information taken from it is often considered more reliable.,Operational advantages,Lower transaction costs Greater liquidity than the spot markets Selling short is much easier,Market efficiency,Derivative markets facilitate the a