CHAPTER 1.

INTRODUCTION
 1. Definitions and Uses

A derivative is a financial instrument that derives its

performance from the performance of an underlying asset.

A derivative is a financial instrument that derives its

performance from the performance of an underlying asset.

Derivatives are associated with an underlying asset (the

underlying), whose value is the source of risk
 1. Definitions and Uses

common derivatives underlyings: equities, fixed-income

securities, currencies, and commodities

other derivatives underlyings: interest rates, credit,

energy, weather
 1. Definitions and Uses

Derivatives - legal contracts with two parties—the

buyer and the seller (the writer). Each agrees to do
something for the other, either now or later.
• The buyer, who purchases the derivative, is
referred to as the long or the holder because he
owns (holds) the derivative and holds a long
position.
• The seller is referred to as the short because he
holds a short position
 1. Definitions and Uses

• Create strategies that cannot be implemented with the

underlyings alone. For example, derivatives make it
easier to go short.

• A relatively high degree of leverage: invest only a small

amount of their own capital relative to the value of the
underlying.
 1. Definitions and Uses

• Small movements in the underlying can lead to fairly

large movements in the amount of money made or lost
on the derivative
• Trade at lower transaction costs than comparable spot
market transactions
• Often more liquid than their underlyings
• Offer a simple, effective, and low-cost way to transfer
risk.
 1. Definitions and Uses

1. Which of the following is the best example of a

derivative?
A. A global equity mutual fund
B. A non-callable government bond
C. A contract to purchase Apple Computer at a fixed price
 1. Definitions and Uses

2. Which of the following is not a characteristic of a

derivative?
A. An underlying
B. A low degree of leverage
C. Two parties—a buyer and a seller
 1. Definitions and Uses

3. Which of the following statements about derivatives is

not true?
A. They are created in the spot market. either now or future (can forward market)

B. They are used in the practice of risk management.

C. They take their values from the value of something else.
money from derivatives
underlying assets
 2. The Structure of Derivative Markets
Both have market to trade: local market

Exchange Traded OTC

Standardized Customized
Less flexible More flexible
Margin money is needed No margin money is required
More regulations Fewer regulations
Market Risk Market Risk + Counterparty Risk
 2. The Structure of Derivative Markets

1. Which of the following characteristics is not associated

with exchange-traded derivatives?
A. Margin or performance bonds are required.
B. The exchange guarantees all payments in the event of
default.
C. All terms except the price are customized to the parties’
individual needs.
 2. The Structure of Derivative Markets

2. Which of the following characteristics is associated with

over-the-counter derivatives?
A. Trading occurs in a central location.
B. They are more regulated than exchange-listed
derivatives.
C. They are less transparent than exchange-listed
derivatives. minh bach, ro rang = less regulations
 2. The Structure of Derivative Markets

2. Which of the following characteristics is associated with

over-the-counter derivatives?
A. Trading occurs in a central location.
B. They are more regulated than exchange-listed
derivatives.
C. They are less transparent than exchange-listed
derivatives.
 2. The Structure of Derivative Markets

3. Market makers earn a profit in both exchange and over-

the-counter derivatives markets by:
A. charging a commission on each trade.
B. a combination of commissions and markups.
C. buying at one price, selling at a higher price, and hedging
any risk. speculations
 2. The Structure of Derivative Markets

4. Which of the following statements most accurately

describes exchange-traded derivatives relative to over-the-
counter derivatives? Exchange-traded derivatives are
more likely to have:
A. greater credit risk.
B. standardized contract terms.
C. greater risk management uses.
 3. Types of Derivatives

forward commitments vs contingent claims:

forward commitments: obligate the parties to engage in a

transaction at a future date on terms agreed upon in advance

contingent claims: provide one party the right but not the
obligation to engage in a future transaction on terms agreed
upon in advance
 3. Types of Derivatives

3.1 Forward commitments:

3.1.1 Forward Contracts
A forward contract is an over-the-counter derivative
contract in which two parties agree that one party, the
buyer, will purchase an underlying asset from the other
party, the seller, at a later date at a fixed price they agree
on when the contract is signed.
 3. Types of Derivatives

3.1 Forward commitments:

3.1.2 Futures
A futures contract is a standardized derivative contract created and
traded on a futures exchange in which two parties agree that one
party, the buyer, will purchase an underlying asset from the other
party, the seller, at a later date and at a price agreed on by the two
parties when the contract is initiated and in which there is a daily
settling of gains and losses and a credit guarantee by the futures
exchange through its clearinghouse.
 3. Types of Derivatives

Futures Forwards
Traded on exchange Privately negotiated
Standardized Customized
No counterparty risk, since payment is Credit default risk, since it is privately
guaranteed by the exchange clearing house negotiated, and fully dependent on the
counterparty for payment

Actively traded Non-transferrable

Regulated Not regulated
Settled Daily Settled at Maturity
 3. Types of Derivatives

3.1 Forward commitments:

3.1.3 SWAPS
A swap is an over-the-counter derivative contract in which
two parties agree to exchange a series of cash flows
whereby one party pays a variable series that will be
determined by an underlying asset or rate and the other
party pays either (1) a variable series determined by a
different underlying asset or rate or (2) a fixed series.
 3. Types of Derivatives

3.2 Contingent Claims :

3.2.2 Credit Derivatives
A credit derivative is a class of derivative contracts between
two parties, a credit protection buyer and a credit
protection seller, in which the latter provides protection to
the former against a specific credit loss.
 3. Types of Derivatives

3.2 Contingent Claims :

3.2.1 Options
An option is a derivative contract in which one party, the
buyer, pays a sum of money to the other party, the seller or
writer, and receives the right to either buy or sell an
underlying asset at a fixed price either on a specific
expiration date or at any time prior to the expiration date.