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Financial Derivatives 3

Kingdom of Saudi Arabia

Ministry of Education

Saudi Electronic University

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المملكة العربية السعودية

وزارة التعليم

الجامعة السعودية الإلكترونية

College of Administrative and Financial Sciences

Assignment-3

FIN-405-Financial Derivatives

Due Date: 05/05/2022@ 23:59

Course Name: Financial Derivatives

Student’s Name:

Course Code: FIN-405

Student’s ID Number:

Semester: Second

CRN:

Academic Year:2021-22-2nd

For Instructor’s Use only

Instructor’s Name:

Students’ Grade:

Marks Obtained/Out of 10

Level of Marks: High/Middle/Low

General Instructions – PLEASE READ THEM CAREFULLY

· The Assignment must be submitted on Blackboard (WORD format only) via allocated folder.

· Assignments submitted through email will not be accepted.

· Students are advised to make their work clear and well presented, marks may be reduced for poor presentation. This includes filling your information on the cover page.

· Students must mention question number clearly in their answer.

· Late submission will NOT be accepted.

· Avoid plagiarism, the work should be in your own words, copying from students or other resources without proper referencing will result in ZERO marks. No exceptions.

· All answered must be typed using Times New Roman (size 12, double-spaced) font. No pictures containing text will be accepted and will be considered plagiarism).

· Submissions without this cover page will NOT be accepted.


Assignment 3

Submission Date by students: 05 May 2022-11:59 PM(Thursday)

Place of Submission: Students Grade Centre via blackboard.

Marks: 10 Marks

Q1. Explain the classification of Future traders by trading style? ( Marks-3)

Q2. Suppose there is a commodity in which the expected future spot price is $60.To induce investors to buy futures contracts, a risk premium of $4 is required. To store the commodity for the life of the futures contract would cost $5.50.

Find the future s price? (Marks-3)

Q3. Explain the difference between a short hedge and a long hedge. ( Marks-2)

Q4. Briefly explain Interest rate swap and currency swap . (Marks-2)

Financial Derivatives 3

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

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

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Important Concepts in Chapter 1

n Different types of derivatives
n Presuppositions for financial markets, risk preferences,

risk-return tradeoff, and market efficiency
n Theoretical fair value
n Arbitrage, storage, and delivery
n The role of derivative markets
n Criticisms of derivatives
n Ethics

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived from the

return on another instrument.

n Size of the OTC derivatives market at year-end 2010
u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2

n Real vs. financial assets

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Derivative Markets and Instruments

n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22 billion contracts

on at least 78 derivatives exchanges, according to Futures Industry
magazine (a leading source of derivatives industry information

u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Derivative Markets and Instruments

n Options
u 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

u Option terminology
F price/premium
F call/put
F exchange-listed vs. over-the-counter options

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Forward Contracts
u 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
u Exclusively over-the-counter

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Futures Contracts
u 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

u Exclusively traded on a futures exchange

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Options on Futures (also known as commodity options or
futures options)

u 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

u Exclusively traded on a futures exchange

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Swaps and Other Derivatives
u Definition of a swap: a contract in which two parties agree to exchange a

series of cash flows
u Exclusively over-the-counter
u Other types of derivatives include swaptions and hybrids. Their creation

is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Some Important Concepts in Financial and
Derivative Markets

n Presuppositions – rule of law, property rights, culture of
trust

n Risk Preference
u Risk aversion vs. risk neutrality
u Risk premium

n Short Selling
n Repurchase agreements (repos)
n Return and Risk
u Risk defined
u The risk-return tradeoff (see Figure 1.3)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Market Efficiency and Theoretical Fair Value
u Efficient market defined: A market in which the price of an asset equals its

true economic value.
u An efficient market is a consequence of rational and knowledgeable

investor behavior
u The concept of theoretical fair value
F The true economic value

Some Important Concepts in Financial and
Derivative Markets (continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Fundamental Linkages Between Spot and
Derivative Markets

n Arbitrage and the Law of One Price
u Arbitrage defined: A type of profit-seeking transaction where the same

good trades at two prices.
u Example: See Figure 1.4
F The concept of states of the world

u The Law of One Price

n The Storage Mechanism: Spreading Consumption across
Time

n Delivery and Settlement

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

The Role of Derivative Markets
n Risk Management
u Hedging vs. speculation
u Setting risk to an acceptable level
u Example: Southwest Airlines

n Price Discovery
n Operational Advantages
u Transaction costs
u Liquidity
u Ease of short selling

n Market Efficiency

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Criticisms of Derivative Markets

n Speculation
n Comparison to gambling

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Misuses of Derivatives

n High leverage
n Inappropriate use

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Derivatives and Ethics

n Codes of ethics and standards of professional conduct are
vital components of the derivatives profession

n Examples
u CFA Institute
u Professional Risk Managers International Association
u Global Association of Risk Professionals

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

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

Summary

Source of Information on Derivatives
http://www.cengage.com/finance/chance

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

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

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Important Concepts in Chapter 1

n Different types of derivatives
n Presuppositions for financial markets, risk preferences,

risk-return tradeoff, and market efficiency
n Theoretical fair value
n Arbitrage, storage, and delivery
n The role of derivative markets
n Criticisms of derivatives
n Ethics

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived from the

return on another instrument.

n Size of the OTC derivatives market at year-end 2010
u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2

n Real vs. financial assets

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Derivative Markets and Instruments

n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22 billion contracts

on at least 78 derivatives exchanges, according to Futures Industry
magazine (a leading source of derivatives industry information

u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Derivative Markets and Instruments

n Options
u 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

u Option terminology
F price/premium
F call/put
F exchange-listed vs. over-the-counter options

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Forward Contracts
u 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
u Exclusively over-the-counter

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Futures Contracts
u 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

u Exclusively traded on a futures exchange

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Options on Futures (also known as commodity options or
futures options)

u 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

u Exclusively traded on a futures exchange

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Swaps and Other Derivatives
u Definition of a swap: a contract in which two parties agree to exchange a

series of cash flows
u Exclusively over-the-counter
u Other types of derivatives include swaptions and hybrids. Their creation

is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Some Important Concepts in Financial and
Derivative Markets

n Presuppositions – rule of law, property rights, culture of
trust

n Risk Preference
u Risk aversion vs. risk neutrality
u Risk premium

n Short Selling
n Repurchase agreements (repos)
n Return and Risk
u Risk defined
u The risk-return tradeoff (see Figure 1.3)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Market Efficiency and Theoretical Fair Value
u Efficient market defined: A market in which the price of an asset equals its

true economic value.
u An efficient market is a consequence of rational and knowledgeable

investor behavior
u The concept of theoretical fair value
F The true economic value

Some Important Concepts in Financial and
Derivative Markets (continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Fundamental Linkages Between Spot and
Derivative Markets

n Arbitrage and the Law of One Price
u Arbitrage defined: A type of profit-seeking transaction where the same

good trades at two prices.
u Example: See Figure 1.4
F The concept of states of the world

u The Law of One Price

n The Storage Mechanism: Spreading Consumption across
Time

n Delivery and Settlement

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

The Role of Derivative Markets
n Risk Management
u Hedging vs. speculation
u Setting risk to an acceptable level
u Example: Southwest Airlines

n Price Discovery
n Operational Advantages
u Transaction costs
u Liquidity
u Ease of short selling

n Market Efficiency

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Criticisms of Derivative Markets

n Speculation
n Comparison to gambling

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Misuses of Derivatives

n High leverage
n Inappropriate use

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Derivatives and Ethics

n Codes of ethics and standards of professional conduct are
vital components of the derivatives profession

n Examples
u CFA Institute
u Professional Risk Managers International Association
u Global Association of Risk Professionals

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

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

Summary

Source of Information on Derivatives
http://www.cengage.com/finance/chance

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

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

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Important Concepts in Chapter 1

n Different types of derivatives
n Presuppositions for financial markets, risk preferences,

risk-return tradeoff, and market efficiency
n Theoretical fair value
n Arbitrage, storage, and delivery
n The role of derivative markets
n Criticisms of derivatives
n Ethics

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived from the

return on another instrument.

n Size of the OTC derivatives market at year-end 2010
u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2

n Real vs. financial assets

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Derivative Markets and Instruments

n Derivative Markets
u Over-the-counter and exchange traded
u Exchange traded derivatives volume in 2010 was over 22 billion contracts

on at least 78 derivatives exchanges, according to Futures Industry
magazine (a leading source of derivatives industry information

u Derivatives trade all over the world
u See Table 1.1 for the top ten derivatives exchanges

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Derivative Markets and Instruments

n Options
u 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

u Option terminology
F price/premium
F call/put
F exchange-listed vs. over-the-counter options

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Forward Contracts
u 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
u Exclusively over-the-counter

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Futures Contracts
u 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

u Exclusively traded on a futures exchange

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Options on Futures (also known as commodity options or
futures options)

u 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

u Exclusively traded on a futures exchange

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Swaps and Other Derivatives
u Definition of a swap: a contract in which two parties agree to exchange a

series of cash flows
u Exclusively over-the-counter
u Other types of derivatives include swaptions and hybrids. Their creation

is a process called financial engineering.
n The Underlying Asset
u Called the underlying
u A derivative derives its value from the underlying.

Derivative Markets and Instruments
(continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Some Important Concepts in Financial and
Derivative Markets

n Presuppositions – rule of law, property rights, culture of
trust

n Risk Preference
u Risk aversion vs. risk neutrality
u Risk premium

n Short Selling
n Repurchase agreements (repos)
n Return and Risk
u Risk defined
u The risk-return tradeoff (see Figure 1.3)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Market Efficiency and Theoretical Fair Value
u Efficient market defined: A market in which the price of an asset equals its

true economic value.
u An efficient market is a consequence of rational and knowledgeable

investor behavior
u The concept of theoretical fair value
F The true economic value

Some Important Concepts in Financial and
Derivative Markets (continued)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Fundamental Linkages Between Spot and
Derivative Markets

n Arbitrage and the Law of One Price
u Arbitrage defined: A type of profit-seeking transaction where the same

good trades at two prices.
u Example: See Figure 1.4
F The concept of states of the world

u The Law of One Price

n The Storage Mechanism: Spreading Consumption across
Time

n Delivery and Settlement

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

The Role of Derivative Markets
n Risk Management
u Hedging vs. speculation
u Setting risk to an acceptable level
u Example: Southwest Airlines

n Price Discovery
n Operational Advantages
u Transaction costs
u Liquidity
u Ease of short selling

n Market Efficiency

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Criticisms of Derivative Markets

n Speculation
n Comparison to gambling

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Misuses of Derivatives

n High leverage
n Inappropriate use

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Derivatives and Ethics

n Codes of ethics and standards of professional conduct are
vital components of the derivatives profession

n Examples
u CFA Institute
u Professional Risk Managers International Association
u Global Association of Risk Professionals

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

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

Summary

Source of Information on Derivatives
http://www.cengage.com/finance/chance

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

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

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

Important Concepts in Chapter 1

n Different types of derivatives
n Presuppositions for financial markets, risk preferences,

risk-return tradeoff, and market efficiency
n Theoretical fair value
n Arbitrage, storage, and delivery
n The role of derivative markets
n Criticisms of derivatives
n Ethics

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chance/Brooks
An Introduction to Derivatives and Risk

Management, 9th ed.
Ch. 1: 0

n Business risk vs. financial risk
n Derivatives
u A derivative is a financial instrument whose return is derived from the

return on another instrument.

n Size of the OTC derivatives market at year-end 2010
u $601 trillion notional principal
u GDP is only $15 trillion
u See Figure 1.1 and Figure 1.2

n Real vs. financial assets

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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