Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 1: 0 Chapter 1: Introduction Financial markets teach you humility. Two years ago, I made these related forecasts. First I forecast the euro would strengthen as European economic recovery picked up and the US economy slowed. Second, I forecast euro strength would be augmented over the next five years by a reduction of Europe's $100 billion to $150 billion of excess dollar reserves. Third, I forecast that the authorities would be less concerned over exchange rates, would only intervene after bigger exchange rate moves, and so exchange rate volatility would rise. Interestingly, people still ask for my opinion. Avinash Persaud, Managing director, Global Markets Analysis, State Street Bank Risk, October, 2000, p. 29 © 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. Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 1: 0 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 © 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. Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 1: 0 n Business risk vs. financial risk n Derivatives u A derivative is a financial instrument whose return is derived from the return on another instrument. n Size of the OTC derivatives market at year-end 2010 u $601 trillion notional principal u GDP is only $15 trillion u See Figure 1.1 and Figure 1.2 n Real vs. financial assets © 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. Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 1: 0 Derivative Markets and Instruments n Derivative Markets u Over-the-counter and exchange traded u Exchange traded derivatives volume in 2010 was over 22 billion contracts on at least 78 derivatives exchanges, according to Futures Industry magazine (a leading source of derivatives industry information u Derivatives trade all over the world u See Table 1.1 for the top ten derivatives exchanges © 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. Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 1: 0 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 part ...

1. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chapter 1: Introduction
Financial markets teach you humility. Two years ago, I made
these
related forecasts. First I forecast the euro would strengthen as
European economic recovery picked up and the US economy
slowed. Second, I forecast euro strength would be augmented
over the
next five years by a reduction of Europe's $100 billion to $150
billion
of excess dollar reserves. Third, I forecast that the authorities
would be
less concerned over exchange rates, would only intervene after
bigger
exchange rate moves, and so exchange rate volatility would rise.
Interestingly, people still ask for my opinion.
Avinash Persaud, Managing director,
Global Markets Analysis, State Street Bank
Risk, October, 2000, p. 29
© 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.

2. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived
from the
return on another instrument.
n Size of the OTC derivatives market at year-end 2010

3. u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2
n Real vs. financial assets
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Derivative Markets and Instruments
n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22
billion contracts
on at least 78 derivatives exchanges, according to Futures
Industry
magazine (a leading source of derivatives industry information
u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges
© 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.
Chance/Brooks

4. An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 exchange-listed vs. over-the-counter options
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

5. Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 futures exchange
Derivative Markets and Instruments
(continued)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publ icly accessible
website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk

6. Management, 9th ed.
Ch. 1: 0
n Options on Futures (also known as commodity options or
futures options)
u 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
u Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 Other types of derivatives include swaptions and hybrids.
Their creation

7. is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Some 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)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

8. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
Some Important Concepts in Financial and
Derivative Markets (continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Fundamental Linkages Between Spot and
Derivative Markets

9. 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
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

10. n Market Efficiency
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Criticisms of Derivative Markets
n Speculation
n Comparison to gambling
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Misuses of Derivatives
n High leverage
n Inappropriate use
© 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.

11. 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/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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.cengage.com/finance/chance
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

12. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chapter 1: Introduction
Financial markets teach you humility. Two years ago, I made
these
related forecasts. First I forecast the euro would strengthen as
European economic recovery picked up and the US economy
slowed. Second, I forecast euro strength would be augmented
over the
next five years by a reduction of Europe's $100 billion to $150
billion
of excess dollar reserves. Third, I forecast that the authorities
would be
less concerned over exchange rates, would only intervene after
bigger
exchange rate moves, and so exchange rate volatility would rise.
Interestingly, people still ask for my opinion.
Avinash Persaud, Managing director,
Global Markets Analysis, State Street Bank
Risk, October, 2000, p. 29
© 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.

13. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived
from the
return on another instrument.
n Size of the OTC derivatives market at year-end 2010

14. u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2
n Real vs. financial assets
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Derivative Markets and Instruments
n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22
billion contracts
on at least 78 derivatives exchanges, according to Futures
Industry
magazine (a leading source of derivatives industry information
u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges
© 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.
Chance/Brooks

15. An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 exchange-listed vs. over-the-counter options
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

16. Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk

17. Management, 9th ed.
Ch. 1: 0
n Options on Futures (also known as commodity options or
futures options)
u 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
u Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 Other types of derivatives include swaptions and hybrids.
Their creation

18. is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Some 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)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

19. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
Some Important Concepts in Financial and
Derivative Markets (continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Fundamental Linkages Between Spot and
Derivative Markets

20. 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
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

21. n Market Efficiency
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Criticisms of Derivative Markets
n Speculation
n Comparison to gambling
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Misuses of Derivatives
n High leverage
n Inappropriate use
© 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.

22. 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/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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.cengage.com/finance/chance
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

23. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chapter 1: Introduction
Financial markets teach you humility. Two years ago, I made
these
related forecasts. First I forecast the euro would strengthen as
European economic recovery picked up and the US economy
slowed. Second, I forecast euro strength would be augmented
over the
next five years by a reduction of Europe's $100 billion to $150
billion
of excess dollar reserves. Third, I forecast that the authorities
would be
less concerned over exchange rates, would only intervene after
bigger
exchange rate moves, and so exchange rate volatility would rise.
Interestingly, people still ask for my opinion.
Avinash Persaud, Managing director,
Global Markets Analysis, State Street Bank
Risk, October, 2000, p. 29
© 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.

24. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessib le
website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived
from the
return on another instrument.
n Size of the OTC derivatives market at year-end 2010

25. u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2
n Real vs. financial assets
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Derivative Markets and Instruments
n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22
billion contracts
on at least 78 derivatives exchanges, according to Futures
Industry
magazine (a leading source of derivatives industry information
u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges
© 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.
Chance/Brooks

26. An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 exchange-listed vs. over-the-counter options
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

27. Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk

28. Management, 9th ed.
Ch. 1: 0
n Options on Futures (also known as commodity options or
futures options)
u 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
u Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 Other types of derivatives include swaptions and hybrids.
Their creation

29. is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Some 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)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

30. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
Some Important Concepts in Financial and
Derivative Markets (continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Fundamental Linkages Between Spot and
Derivative Markets

31. 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
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

32. n Market Efficiency
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Criticisms of Derivative Markets
n Speculation
n Comparison to gambling
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Misuses of Derivatives
n High leverage
n Inappropriate use
© 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.

33. Derivatives and Ethics
n Codes of ethics and standards of professional conduct ar e
vital components of the derivatives profession
n Examples
u CFA Institute
u Professional Risk Managers International Association
u Global Association of Risk Professionals
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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.cengage.com/finance/chance
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

34. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chapter 1: Introduction
Financial markets teach you humility. Two years ago, I made
these
related forecasts. First I forecast the euro would strengthen as
European economic recovery picked up and the US economy
slowed. Second, I forecast euro strength would be augmented
over the
next five years by a reduction of Europe's $100 billion to $150
billion
of excess dollar reserves. Third, I forecast that the authorities
would be
less concerned over exchange rates, would only intervene after
bigger
exchange rate moves, and so exchange rate volatility would rise.
Interestingly, people still ask for my opinion.
Avinash Persaud, Managing director,
Global Markets Analysis, State Street Bank
Risk, October, 2000, p. 29
© 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.

35. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived
from the
return on another instrument.
n Size of the OTC derivatives market at year-end 2010

36. u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2
n Real vs. financial assets
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Derivative Markets and Instruments
n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22
billion contracts
on at least 78 derivatives exchanges, according to Futures
Industry
magazine (a leading source of derivatives industry information
u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges
© 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.
Chance/Brooks

37. An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 exchange-listed vs. over-the-counter options
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

38. Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk

39. Management, 9th ed.
Ch. 1: 0
n Options on Futures (also known as commodity options or
futures options)
u 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
u Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 Other types of derivatives include swaptions and hybrids.
Their creation

40. is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Some 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)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

41. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
Some Important Concepts in Financial and
Derivative Markets (continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Fundamental Linkages Between Spot and
Derivative Markets

42. 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
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

43. n Market Efficiency
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Criticisms of Derivative Markets
n Speculation
n Comparison to gambling
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Misuses of Derivatives
n High leverage
n Inappropriate use
© 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.

44. 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/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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.cengage.com/finance/chance
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

45. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chapter 1: Introduction
Financial markets teach you humility. Two years ago, I made
these
related forecasts. First I forecast the euro would strengthen as
European economic recovery picked up and the US economy
slowed. Second, I forecast euro strength would be augmented
over the
next five years by a reduction of Europe's $100 billion to $150
billion
of excess dollar reserves. Third, I forecast that the authorities
would be
less concerned over exchange rates, would only intervene after
bigger
exchange rate moves, and so exchange rate volatility would rise.
Interestingly, people still ask for my opinion.
Avinash Persaud, Managing director,
Global Markets Analysis, State Street Bank
Risk, October, 2000, p. 29
© 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.

46. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived
from the
return on another instrument.
n Size of the OTC derivatives market at year-end 2010

47. u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2
n Real vs. financial assets
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Derivative Markets and Instruments
n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22
billion contracts
on at least 78 derivatives exchanges, according to Futures
Industry
magazine (a leading source of derivatives industry information
u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges
© 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.
Chance/Brooks

48. An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 exchange-listed vs. over-the-counter options
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

49. Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk

50. Management, 9th ed.
Ch. 1: 0
n Options on Futures (also known as commodity options or
futures options)
u 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
u Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 Other types of derivatives include swaptions and hybrids.
Their creation

51. is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Some 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)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

52. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
Some Important Concepts in Financial and
Derivative Markets (continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Fundamental Linkages Between Spot and
Derivative Markets

53. 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
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

54. n Market Efficiency
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Criticisms of Derivative Markets
n Speculation
n Comparison to gambling
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Misuses of Derivatives
n High leverage
n Inappropriate use
© 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.

55. 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/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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.cengage.com/finance/chance
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

56. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chapter 1: Introduction
Financial markets teach you humility. Two years ago, I made
these
related forecasts. First I forecast the euro would strengthen as
European economic recovery picked up and the US economy
slowed. Second, I forecast euro strength would be augmented
over the
next five years by a reduction of Europe's $100 billion to $150
billion
of excess dollar reserves. Third, I forecast that the authorities
would be
less concerned over exchange rates, would only intervene after
bigger
exchange rate moves, and so exchange rate volatility would rise.
Interestingly, people still ask for my opinion.
Avinash Persaud, Managing director,
Global Markets Analysis, State Street Bank
Risk, October, 2000, p. 29
© 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.

57. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived
from the
return on another instrument.
n Size of the OTC derivatives market at year-end 2010

58. u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2
n Real vs. financial assets
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Derivative Markets and Instruments
n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22
billion contracts
on at least 78 derivatives exchanges, according to Futures
Industry
magazine (a leading source of derivatives industry information
u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges
© 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.
Chance/Brooks

59. An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 exchange-listed vs. over-the-counter options
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

60. Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk

61. Management, 9th ed.
Ch. 1: 0
n Options on Futures (also known as commodity options or
futures options)
u 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
u Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 Other types of derivatives include swaptions and hybrids.
Their creation

62. is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Some 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)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

63. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
Some Important Concepts in Financial and
Derivative Markets (continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Fundamental Linkages Between Spot and
Derivative Markets

64. 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
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

65. n Market Efficiency
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Criticisms of Derivative Markets
n Speculation
n Comparison to gambling
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Misuses of Derivatives
n High leverage
n Inappropriate use
© 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.

66. 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/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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.cengage.com/finance/chance
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

67. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chapter 1: Introduction
Financial markets teach you humility. Two years ago, I made
these
related forecasts. First I forecast the euro would strengthen as
European economic recovery picked up and the US economy
slowed. Second, I forecast euro strength would be augmented
over the
next five years by a reduction of Europe's $100 billion to $150
billion
of excess dollar reserves. Third, I forecast that the authorities
would be
less concerned over exchange rates, would only intervene after
bigger
exchange rate moves, and so exchange rate volatility would rise.
Interestingly, people still ask for my opinion.
Avinash Persaud, Managing director,
Global Markets Analysis, State Street Bank
Risk, October, 2000, p. 29
© 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.

68. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived
from the
return on another instrument.
n Size of the OTC derivatives market at year-end 2010

69. u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2
n Real vs. financial assets
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Derivative Markets and Instruments
n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22
billion contracts
on at least 78 derivatives exchanges, according to Futures
Industry
magazine (a leading source of derivatives industry information
u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges
© 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.
Chance/Brooks

70. An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 exchange-listed vs. over-the-counter options
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

71. Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk

72. Management, 9th ed.
Ch. 1: 0
n Options on Futures (also known as commodity options or
futures options)
u 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
u Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 Other types of derivatives include swaptions and hybrids.
Their creation

73. is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Some 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)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

74. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
Some Important Concepts in Financial and
Derivative Markets (continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Fundamental Linkages Between Spot and
Derivative Markets

75. 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
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

76. n Market Efficiency
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Criticisms of Derivative Markets
n Speculation
n Comparison to gambling
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Misuses of Derivatives
n High leverage
n Inappropriate use
© 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.

77. 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/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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.cengage.com/finance/chance
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

78. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chapter 1: Introduction
Financial markets teach you humility. Two years ago, I made
these
related forecasts. First I forecast the euro would strengthen as
European economic recovery picked up and the US economy
slowed. Second, I forecast euro strength would be augmented
over the
next five years by a reduction of Europe's $100 billion to $150
billion
of excess dollar reserves. Third, I forecast that the authorities
would be
less concerned over exchange rates, would only intervene after
bigger
exchange rate moves, and so exchange rate volatility would rise.
Interestingly, people still ask for my opinion.
Avinash Persaud, Managing director,
Global Markets Analysis, State Street Bank
Risk, October, 2000, p. 29
© 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.

79. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publi cly accessible
website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived
from the
return on another instrument.
n Size of the OTC derivatives market at year-end 2010

80. u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2
n Real vs. financial assets
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Derivative Markets and Instruments
n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22
billion contracts
on at least 78 derivatives exchanges, according to Futures
Industry
magazine (a leading source of derivatives industry information
u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges
© 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.
Chance/Brooks

81. An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 exchange-listed vs. over-the-counter options
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

82. Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk

83. Management, 9th ed.
Ch. 1: 0
n Options on Futures (also known as commodity options or
futures options)
u 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
u Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 Other types of derivatives include swaptions and hybrids.
Their creation

84. is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Some 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)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

85. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
Some Important Concepts in Financial and
Derivative Markets (continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Fundamental Linkages Between Spot and
Derivative Markets

86. 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
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

87. n Market Efficiency
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Criticisms of Derivative Markets
n Speculation
n Comparison to gambling
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Misuses of Derivatives
n High leverage
n Inappropriate use
© 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.

88. 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/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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.cengage.com/finance/chance
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

89. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chapter 1: Introduction
Financial markets teach you humility. Two years ago, I made
these
related forecasts. First I forecast the euro would strengthen as
European economic recovery picked up and the US economy
slowed. Second, I forecast euro strength would be augmented
over the
next five years by a reduction of Europe's $100 billion to $150
billion
of excess dollar reserves. Third, I forecast that the authorities
would be
less concerned over exchange rates, would only intervene after
bigger
exchange rate moves, and so exchange rate volatility would rise.
Interestingly, people still ask for my opinion.
Avinash Persaud, Managing director,
Global Markets Analysis, State Street Bank
Risk, October, 2000, p. 29
© 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.

90. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived
from the
return on another instrument.
n Size of the OTC derivatives market at year-end 2010

91. u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2
n Real vs. financial assets
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Derivative Markets and Instruments
n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22
billion contracts
on at least 78 derivatives exchanges, according to Futures
Industry
magazine (a leading source of derivatives industry information
u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges
© 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.
Chance/Brooks

92. An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 exchange-listed vs. over-the-counter options
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

93. Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk

94. Management, 9th ed.
Ch. 1: 0
n Options on Futures (also known as commodity options or
futures options)
u 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
u Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 Other types of derivatives include swaptions and hybrids.
Their creation

95. is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Some 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)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly access ible

96. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
Some Important Concepts in Financial and
Derivative Markets (continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Fundamental Linkages Between Spot and
Derivative Markets

97. 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
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

98. n Market Efficiency
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Criticisms of Derivative Markets
n Speculation
n Comparison to gambling
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Misuses of Derivatives
n High leverage
n Inappropriate use
© 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.

99. 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/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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.cengage.com/finance/chance
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

100. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chapter 1: Introduction
Financial markets teach you humility. Two years ago, I made
these
related forecasts. First I forecast the euro would strengthen as
European economic recovery picked up and the US economy
slowed. Second, I forecast euro strength would be augmented
over the
next five years by a reduction of Europe's $100 billion to $150
billion
of excess dollar reserves. Third, I forecast that the authorities
would be
less concerned over exchange rates, would only intervene after
bigger
exchange rate moves, and so exchange rate volatility w ould rise.
Interestingly, people still ask for my opinion.
Avinash Persaud, Managing director,
Global Markets Analysis, State Street Bank
Risk, October, 2000, p. 29
© 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.

101. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived
from the
return on another instrument.
n Size of the OTC derivatives market at year-end 2010

102. u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2
n Real vs. financial assets
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Derivative Markets and Instruments
n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22
billion contracts
on at least 78 derivatives exchanges, according to Futures
Industry
magazine (a leading source of derivatives industry information
u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly acces sible
website, in whole or in part.
Chance/Brooks

103. An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 exchange-listed vs. over-the-counter options
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

104. Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk

105. Management, 9th ed.
Ch. 1: 0
n Options on Futures (also known as commodity options or
futures options)
u 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
u Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 Other types of derivatives include swaptions and hybrids.
Their creation

106. is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Some 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)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

107. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
Some Important Concepts in Financial and
Derivative Markets (continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Fundamental Linkages Between Spot and
Derivative Markets

108. 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
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

109. n Market Efficiency
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Criticisms of Derivative Markets
n Speculation
n Comparison to gambling
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Misuses of Derivatives
n High leverage
n Inappropriate use
© 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.

110. 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/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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.cengage.com/finance/chance
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

111. website, in whole or in part.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Chapter 1: Introduction
Financial markets teach you humility. Two years ago, I made
these
related forecasts. First I forecast the euro would strengthen as
European economic recovery picked up and the US economy
slowed. Second, I forecast euro strength would be augmented
over the
next five years by a reduction of Europe's $100 billion to $150
billion
of excess dollar reserves. Third, I forecast that the authorities
would be
less concerned over exchange rates, would only intervene after
bigger
exchange rate moves, and so exchange rate volatility would rise.
Interestingly, people still ask for my opinion.
Avinash Persaud, Managing director,
Global Markets Analysis, State Street Bank
Risk, October, 2000, p. 29
© 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.

112. Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived
from the
return on another instrument.
n Size of the OTC derivatives market at year-end 2010

113. u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2
n Real vs. financial assets
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Derivative Markets and Instruments
n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22
billion contracts
on at least 78 derivatives exchanges, according to Futures
Industry
magazine (a leading source of derivatives industry information
u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges
© 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.
Chance/Brooks

114. An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 exchange-listed vs. over-the-counter options
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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

115. Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk

116. Management, 9th ed.
Ch. 1: 0
n Options on Futures (also known as commodity options or
futures options)
u 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
u Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
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 Other types of derivatives include swaptions and hybrids.
Their creation

117. is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.
Derivative Markets and Instruments
(continued)
© 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.
Chance/Brooks
An Introduction to Derivatives and Risk
Management, 9th ed.
Ch. 1: 0
Some 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)
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible