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Introduction to derivatives products intial
1.
Chapter 1 Introduction to Derivatives
2.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-2 What Is a Derivative? • Definition An agreement between two parties which has a value determined by the price of something else • Types Options, futures and swaps • Uses Risk management Speculation Reduce transaction costs Regulatory arbitrage
3.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-3 Observers End user End user Intermediary • Economic Observers Regulators Researchers Three Different Perspectives • End users Corporations Investment managers Investors • Intermediaries Market-makers Traders
4.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-4 Financial Engineering • The construction of a financial product from other products • New securities can be designed by using existing securities • Financial engineering principles Facilitate hedging of existing positions Enable understanding of complex positions Allow for creation of customized products Render regulation less effective
5.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-5 The Role of Financial Markets • Insurance companies and individual communities/families have traditionally helped each other to share risks • Markets make risk-sharing more efficient Diversifiable risks vanish Non-diversifiable risks are reallocated • Recent example: earthquake bonds by Walt Disney in Japan
6.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-6 Exchange Traded Contracts • Contracts proliferated in the last three decades • What were the drivers behind this proliferation?
7.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-7 Increased Volatility… • Oil prices: 1951–1999 • DM/$ rate: 1951–1999
8.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-8 …Led to New and Big Markets • Exchange-traded derivatives • Over-the-counter traded derivatives: even more!
9.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-9 Basic Transactions • Buying and selling a financial asset Brokers: commissions Market-makers: bid-ask (offer) spread • Example: Buy and sell 100 shares of XYZ XYZ: bid = $49.75, offer = $50, commission = $15 Buy: (100 x $50) + $15 = $5,015 Sell: (100 x $49.75) – $15 = $4,960 Transaction cost: $5015 – $4,960 = $55
10.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-10 Bid-Ask Spread • Viewpoint of Market Maker Price Magnitude For Market Maker For Investor Bid Lower Buy Price Sell Price Ask Higher Sell Price Buy Price
11.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-11 Short-Selling • Long Position or “Go Long” You pay money up front. • Short Sale or Short or Go Short or Short Position You collect money up front
12.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-12 Short-Selling • When price of an asset is expected to fall First: borrow and sell an asset (get $$) Then: buy back and return the asset (pay $) If price fell in the mean time: Profit $ = $$ – $ The lender must be compensated for dividends received (lease-rate) • Example: short-sell IBM stock for 90 days
13.
Copyright © 2006
Pearson Addison-Wesley. All rights reserved. 1-13 Short-Selling (cont’d) • Why short-sell? Speculation Financing Hedging • Credit risk in short-selling Collateral and “haircut” • Interest received from lender on collateral Spread is additional cost Scarcity decreases the interest rate Repo rate in bond markets Short rebate in the stock market
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