Chapter 1
Introduction
to Derivatives

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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

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Observers
End
user
End
user
Intermediary
• Economic
Observers
 Regulators
 Researchers
Three Different Perspectives
• End users
 Corporations
 Investment
managers
 Investors
• Intermediaries
 Market-makers
 Traders

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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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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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Exchange Traded Contracts
• Contracts proliferated in the last three decades
• What were the drivers behind this proliferation?

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Increased Volatility…
• Oil prices:
1951–1999
• DM/$ rate:
1951–1999

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…Led to New and Big Markets
• Exchange-traded derivatives
• Over-the-counter traded derivatives: even more!

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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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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

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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

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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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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