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

An Introduction to Derivatives and

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 Important Concepts in Chapter 1

 Different types of derivatives

 Presuppositions for financial markets, risk preferences,
risk-return tradeoff, and market efficiency
 Theoretical fair value
 Arbitrage, storage, and delivery
 The role of derivative markets
 Criticisms of derivatives
 Ethics

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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 OTC derivatives market by the end of June 2020
 $607 trillion notional principal
 2019 US GDP is only about $21.4 trillion
 See Figure 1.1 and Figure 1.2
 Real vs. financial assets

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 Derivative Markets and Instruments
 Derivative Markets
 Over-the-counter and exchange traded
 Exchange traded derivatives volume in 2019 was over
34 billion contracts on at least 80 derivatives
exchanges, according to Futures Industry magazine (a
leading source of derivatives industry information
 Derivatives trade all over the world
 See Figure and Table for the top twenty derivatives
exchanges

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 Derivative Markets and Instruments
 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

• What is a call option?

• What is a put option?
 exchange-listed vs. over-the-counter options

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 Derivative Markets and Instruments
(continued)
 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

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Risk Management, 9th ed.
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 Derivative Markets and Instruments
(continued)
 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
 How do forwards/futures work?

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 Derivative Markets and Instruments
(continued)
 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

An Introduction to Derivatives and

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Risk Management, 9th ed.
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 Derivative Markets and Instruments
(continued)
 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.
 What is a swap contract?

An Introduction to Derivatives and

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 Some Important Concepts in Financial and
Derivative Markets
 The Underlying Asset
 Called the underlying
 A derivative derives its value from the underlying.
 Presuppositions for well-functioning financial markets– clear rule
of law, clean property rights, culture of trust
 Risk Preference
 Risk aversion vs. risk neutrality
 Risk premium
 Short Selling
 Repurchase agreements (repos)
 Return and Risk
 Risk defined
 The risk-return tradeoff (see Figure 1.3)
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 Some Important Concepts in Financial and
Derivative Markets (continued)

 Market Efficiency and Theoretical Fair Value

 Efficient market defined: A market in which the price of
an asset equals its true economic value.
 An efficient market is a consequence of rational and
knowledgeable investor behavior
 The concept of theoretical fair value
 The true economic value

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 Fundamental Linkages Between Spot and
Derivative Markets
 Arbitrage and the Law of One Price
 Arbitrage defined: A type of profit-seeking transaction
where the same good trades at two prices.
 Example: See Figure 1.4
 The concept of states of the world

 The Law of One Price

 The Storage Mechanism: Spreading Consumption across
Time
 Delivery and Settlement

An Introduction to Derivatives and

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 The Role of Derivative Markets
 Risk Management
 Hedging vs. speculation
 Setting risk to an acceptable level
 Example: Southwest Airlines
 Price Discovery
 Operational Advantages
 Transaction costs
 Liquidity
 Ease of short selling
 Market Efficiency

An Introduction to Derivatives and

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 Criticisms of Derivative Markets

 Speculation
 Comparison to gambling

An Introduction to Derivatives and

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 Misuses of Derivatives

 High leverage
 Inappropriate use

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Derivatives and Ethics

 Codes of ethics and standards of professional conduct are

vital components of the derivatives profession
 Examples
 CFA Institute
 Professional Risk Managers International Association
 Global Association of Risk Professionals

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 Derivatives and Your Career
 Financial management in a business
 Small businesses ownership
 Investment management
 Public service

Source of Information on Derivatives

http://www.cengage.com/finance/chance

Summary

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 An Introduction to Derivatives and
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Rank Exchange Jan-Dec 2019 Vol
1 National Stock Exchange of India 5,960,653,879
2 CME Group 4,830,045,369
3 B3 3,880,624,283
4 Intercontinental Exchange 2,256,762,531
5 Eurex 1,947,144,196
6 CBOE Holdings 1,912,075,382
7 Nasdaq 1,785,341,204
8 Korea Exchange 1,546,717,194
9 Moscow Exchange 1,455,043,932
10 Shanghai Futures Exchange 1,447,597,054
11 Dalian Commodity Exchange 1,355,584,225
12 Zhengzhou Commodity Exchange 1,092,703,580
13 BSE 1,026,425,811
14 Miami International Holdings 1 440,049,131
15 Hong Kong Exchanges and Clearing 438,690,021
16 Borsa Istanbul 387,996,034
17 Japan Exchange Group 361,063,321
18 Multi Commodity Exchange of India 306,592,744
19 Taiwan Futures Exchange 260,765,482
20 ASX 260,478,736
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