Chapter 1: Introduction
The attitude here is that derivatives have, on the whole, been a
tremendously positive force around the world. In all these
countries they impose market discipline and force supervisors
to rethink their rules and regulations.
David Folkents-Landau
Risk, September, 1997, p. 28
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Important Concepts in Chapter 1
Defintion of derivatives
Risk preferences, risk-return tradeoff, and market
efficiency
The role of derivative markets
Criticisms of derivatives
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Derivatives
A derivative is a financial instrument whose return is
derived from the return on another instrument.
Size of the OTC derivatives market at year-end 2018
$544 trillion notional principal
$9.7 trillion market value
Real vs. financial assets
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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
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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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
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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
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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.
The Underlying Asset
Called the underlying
A derivative derives its value from the underlying.
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Some Important Concepts in Financial and
Derivative Markets
Risk Preference
Risk aversion vs. risk neutrality
Risk premium
Return and Risk
Risk defined
The risk-return tradeoff (see Figure 1.1, p. 7)
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The Role of Derivative Markets
Risk Management
Hedging
Setting risk to an acceptable level
Price Discovery
Operational Advantages
Transaction costs
Liquidity
Market Efficiency
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Criticisms of Derivative Markets
Speculation
Comparison to gambling
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Misuses of Derivatives
High leverage
Inappropriate use
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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
[Link]
Summary
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