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