CHAPTER 1: INTRODUCTION

Chapter 1: Introduction
The speed of money is faster than it’s ever been.
Loleen Doerrer
Time, April 11, 1994, p. 33
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 1
Important Concepts in Chapter 1
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Different types of derivatives
Risk preferences, risk-return tradeoff, and market
efficiency
Theoretical fair value
Arbitrage, storage, and delivery
The role of derivative markets
Criticisms of derivatives
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 2
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Business risk vs. financial risk
Derivatives
 A derivative is a financial instrument whose return is
derived from the return on another instrument.
Size of the derivatives market at year-end 2001
 $111 trillion notional principal
 $3.8 trillion market value
Real vs. financial assets
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 3
Derivative Markets and Instruments
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Options
 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
 Option terminology
 price/premium
 call/put
 exchange-listed vs. over-the-counter options
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 4
Derivative Markets and Instruments
(continued)
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Forward Contracts
 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
 Exclusively over-the-counter
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 5
Derivative Markets and Instruments
(continued)
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Futures Contracts
 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
 Exclusively traded on a futures exchange
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 6
Derivative Markets and Instruments
(continued)
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Options on Futures (also known as commodity options or
futures options)
 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
 Exclusively traded on a futures exchange
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 7
Derivative Markets and Instruments
(continued)
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Swaps and Other Derivatives
 Definition of a swap: a contract in which two parties
agree to exchange a series of cash flows
 Exclusively over-the-counter
 Other types of derivatives include swaptions and
hybrids. Their creation is a process called financial
engineering.
The Underlying Asset
 Called the underlying
 A derivative derives its value from the underlying.
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 8
Some Important Concepts in Financial and
Derivative Markets
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Risk Preference
 Risk aversion vs. risk neutrality
 Risk premium
Short Selling
Return and Risk
 Risk defined
 The Risk-Return tradeoff (see Figure 1.1, p. 7)
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 9
Some Important Concepts in Financial and
Derivative Markets (continued)
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Market Efficiency and Theoretical Fair Value
 Definition of an efficient market
 The concept of theoretical fair value
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 10
Fundamental Linkages Between Spot and
Derivative Markets
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Arbitrage and the Law of One Price
 Arbitrage defined
 Example: See Figure 1.2, p. 10
 The concept of states of the world
 The Law of One Price
The Storage Mechanism: Spreading Consumption across
Time
Delivery and Settlement
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 11
The Role of Derivative Markets
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Risk Management
 Hedging vs. speculation
 Setting risk to an acceptable level
Price Discovery
Operational Advantages
 Transaction costs
 Liquidity
 Ease of short selling
Market efficiency
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 12
Criticisms of Derivative Markets
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Speculation
Comparison to gambling
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 13
Misuses of Derivatives
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High leverage
Inappropriate use
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 14
Derivatives and Your Career
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Financial management in a business
Small businesses ownership
Investment management
Public service
Source of Information on Derivatives
http://chance.swlearning.com
Summary
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 15
(Return to text slide)
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 16
(Return to text slide)
D. M. Chance
An Introduction to Derivatives and Risk Management, 6th ed.
Ch. 1: 17