D.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:1Chapter1:IntroductionThespeedofmoneyisfasterthanit’severbeen.LoleenDoerrerTime,April11,1994,p.33D.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:2ImportantConceptsinChapter1DifferenttypesofderivativesRiskpreferences,risk-returntradeoff,andmarketefficiencyTheoreticalfairvalueArbitrage,storage,anddeliveryTheroleofderivativemarketsCriticismsofderivativesD.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:3Businessriskvs.financialriskDerivativesAderivativeisafinancialinstrumentwhosereturnisderivedfromthereturnonanotherinstrument.Sizeofthederivativesmarketatyear-end2001$111trillionnotionalprincipal$3.8trillionmarketvalueRealvs.financialassetsD.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:4DerivativeMarketsandInstrumentsOptionsDefinition:acontractbetweentwopartiesthatgivesoneparty,thebuyer,therighttobuyorsellsomethingfromortotheotherparty,theseller,atalaterdateatapriceagreedupontodayOptionterminologyprice/premiumcall/putexchange-listedvs.over-the-counteroptionsD.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:5ForwardContractsDefinition:acontractbetweentwopartiesforonepartytobuysomethingfromtheotheratalaterdateatapriceagreedupontodayExclusivelyover-the-counterDerivativeMarketsandInstruments(continued)D.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:6FuturesContractsDefinition:acontractbetweentwopartiesforonepartytobuysomethingfromtheotheratalaterdateatapriceagreedupontoday;subjecttoadailysettlementofgainsandlossesandguaranteedagainsttheriskthateitherpartymightdefaultExclusivelytradedonafuturesexchangeDerivativeMarketsandInstruments(continued)D.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:7OptionsonFutures(alsoknownascommodityoptionsorfuturesoptions)Definition:acontractbetweentwopartiesgivingonepartytherighttobuyorsellafuturescontractfromtheotheratalaterdateatapriceagreedupontodayExclusivelytradedonafuturesexchangeDerivativeMarketsandInstruments(continued)D.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:8SwapsandOtherDerivativesDefinitionofaswap:acontractinwhichtwopartiesagreetoexchangeaseriesofcashflowsExclusivelyover-the-counterOthertypesofderivativesincludeswaptionsandhybrids.Theircreationisaprocesscalledfinancialengineering.TheUnderlyingAssetCalledtheunderlyingAderivativederivesitsvaluefromtheunderlying.DerivativeMarketsandInstruments(continued)D.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:9SomeImportantConceptsinFinancialandDerivativeMarketsRiskPreferenceRiskaversionvs.riskneutralityRiskpremiumShortSellingReturnandRiskRiskdefinedTheRisk-Returntradeoff(seeFigure1.1,p.7)D.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:10MarketEfficiencyandTheoreticalFairValueDefinitionofanefficientmarketTheconceptoftheoreticalfairvalueSomeImportantConceptsinFinancialandDerivativeMarkets(continued)D.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:11FundamentalLinkagesBetweenSpotandDerivativeMarketsArbitrageandtheLawofOnePriceArbitragedefinedExample:SeeFigure1.2,p.10TheconceptofstatesoftheworldTheLawofOnePriceTheStorageMechanism:SpreadingConsumptionacrossTimeDeliveryandSettlementD.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:12TheRoleofDerivativeMarketsRiskManagementHedgingvs.speculationSettingrisktoanacceptablelevelPriceDiscoveryOperationalAdvantagesTransactioncostsLiquidityEaseofshortsellingMarketefficiencyD.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:13CriticismsofDerivativeMarketsSpeculationComparisontogamblingD.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:14MisusesofDerivativesHighleverageInappropriateuseD.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:15DerivativesandYourCareerFinancialmanagementinabusinessSmallbusinessesownershipInvestmentmanagementPublicserviceSummarySourceofInformationonDerivatives:16(Returntotextslide)D.M.ChanceAnIntroductiontoDerivativesandRiskManagement,6thed.Ch.1:17(Returntotextslide)