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Chance & Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 1: 1
Introduction to Financial Risk
Management
It is only by risking our persons from onehour to another that we live at all
William James
The Will to Believe, 1897
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Chapter Objectives
Provide brief introductions to the different typesof derivatives: options, forward contracts, futurecontracts, swaps
Reacquaint you with the concepts of risk
preference, short-selling, repurchaseagreements, the risk-return relationship, marketefficiency
Define the important concept of theoretical fair
value, which will be used throughout the book
D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 2
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Chapter Objectives (cont)
Explain the relationship between spot andderivative markets through the mechanisms
of arbitrage, storage, and delivery. Identify the role that derivative markets play
through their four main advantages.
Address some criticisms of derivatives.
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 4
Business Risk vs. Financial Risk
Risk : Uncertainty of future returns.
Business Risk : Risk associated with
particular line of business (e.g. futuresales, cost of inputs in future)
Financial Risk : risk associated with stockprices, exchange rates, interest rates &commodity prices
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 5
Derivatives
A derivative is a financial instrument whose
return is derived from the return on anotherinstrument(their performance depends onhow other financial instruments perform)
Derivatives serve as a valuable purpose inproviding a means of managing financialrisk.
By using derivatives, companies and
individuals can transfer, for a price, anyundesired risk to other parties who eitherhave risks that offset or want to assume thatrisk.
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Derivatives can be based on
Real assets; physical assets such asagricultural commodities, metals etc.
Financial assets; stocks, bonds/loans, &
currencies
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 7
Derivative Markets and Instruments
In the markets for assets, purchases & sales requirethat the underlying asset be delivered eitherimmediately or shortly thereafter.
Payment usually is made immediately although creditarrangements are sometimes used.
Because of this characteristics, we refer thesemarkets as cash markets or spot markets.
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 8
Derivative Markets and Instruments
Options
Definition: a contract between two parties thatgives one party, the RIGHT(not obligation) to
buy/sell something from/to the other party, at alater date at a price agreed upon today.
Option terminology
price/premium
Call (buy)/put (sell)exchange-listed vs. over-the-counter options
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 9
Forward Contracts
Definition: a contract between two parties for oneparty (AN OBLIGATION) to buy/sell somethingfrom/to the other at a later date at a price agreedupon today
Exclusively over-the-counter (unorganizedexchanges)
Derivative Markets and Instruments
(continued)
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 10
Futures Contracts
Definition: a contract between two parties for oneparty (AN OBLIGATION) to buy/sell somethingfrom/to the other at a later date at a price agreedupon today; subject to a daily settlement of gainsand losses and guaranteed against the risk thateither party might default
Exclusively traded on a futures markets(organized exchanges)
Derivative Markets and Instruments
(continued)
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 11
Options on Futures (also known as commodityoptions or futures options)
Definition: a contract between two parties givingone party the RIGHT to buy or sell a futurescontract from or to the other at a later date at aprice agreed upon today
MixtureOptions on Futures markets
Exclusively traded on a futures exchange
Derivative Markets and Instruments
(continued)
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 12
Swaps and Other DerivativesDefinition 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 andhybrids. Their creation is a process calledfinancial engineering.
The Underlying Asset
Called the Underlying A derivative derives its value from the underlying.
Derivative Markets and Instruments (continued)
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 13
Some Important Concepts in Financial
and Derivative Markets Risk Preference
Risk aversion vs. risk neutrality
Risk averse-not a risk takerRisk neutral-risk taker
Risk premium
Additional return you expect to earn on average
to justify taking the risk
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 14
Some Important Concepts in Financial
and Derivative Markets (continued) Short Selling
Normally, an investor would buy a stock & latersell it. In short selling, the order is reversed whereyou sell 1st & later buy the stocks (you begin & endup with no stock).
Allow short seller to profit from a decline in stocks
price.
Short seller borrow stock from broker, later hemust purchase a share of a same stock in themarket to replace the stock that was borrowed
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Some Important Concepts in Financial
and Derivative Markets (continued) Repurchase Agreements (Repos)
A legal contract between a seller and a buyer; theseller agrees to sell currently a specified asset tothe buyer-as well as buy it back (usually) at aspecified time in the future at an agreed futureprice.
Repos are useful because they provide a great
deal of flexibility to both the borrower and lender.
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 16
Some Important Concepts in Financial
and Derivative Markets (continued) Return and Risk
Risk : Uncertainty of future returns
The Risk-Return tradeoff (see Figure 1.1, p. 7) Positive relationship between risk and return.
Risk, Return
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 17
Market Efficiency
In Efficient market, price fluctuate randomly &investors cannot consistently earns abnormal
returns.
Some Important Concepts in Financialand Derivative Markets (continued)
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Some Important Concepts in Financialand Derivative Markets (continued)
Theoretical Fair Value
It suggests that somewhere out there is the realvalue of the asset. If we could perhaps make lotsof money buying when the asset is priced too low
& selling when it priced too high.
In order to find that true economy value of theasset, it requires a model of how the asset ispriced. E.g. CAPM & APT Models.
Derivatives emphasis is placed on determining thetheoretical fair value of a derivative contract.
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 19
The Role of Derivative Markets
Risk Management
Hedging-reduces investors risk Setting risk to anacceptable level
Speculation (opposite to hedging)
Price Discovery-an important info. about prices as itsprovide forecast of future spot prices.
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 20
The Role of Derivative Markets
(continued) Operational Advantages
Lower transaction costs compare to spot market.
Provide greater liquidity than the spot markets.Ease of short selling
Market efficiency
Derivative market provide means of managing
risks, discovering prices, reducing costs,improving liquidity, selling short, & making themarket more efficient.
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 21
Criticisms of Derivative Markets
Speculation
Comparison to gambling
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 22
Misuses of Derivatives
High Degree of Leverage - Powerful instruments assmall price changes can lead to large gains andlosses.
To use derivatives without having the requisiteknowledge is dangerous.
Inappropriate use investors tend to use it forspeculation without taking into account market
efficiency. In Efficient market, price fluctuate randomly & investors
cannot consistently earns abnormal returns.
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 23
Derivatives and Your Career
Financial management in a business
Small businesses ownership
Investment management
Public service
Summary
Source of Information on Derivativeshttp://chance.swlearning.com
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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 24
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