M01_MCD_548160_01_PP_C01_

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter 1

Introductionto Derivatives

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-2

What Is a Derivative?

• Definition– An agreement between two parties which has a value

determined by the price of something else

• Types– Options – Futures– Swaps


An Overview of Financial Markets

• Trading of Financial Assets– Stock exchanges, derivatives exchanges, and dealers

facilitate trading – Trading of financial claims can take place on

organized exchanges or through the over-the-counter (OTC) market


Measures of Market Size and Activity

• Four ways to measure the size and activity of a market – Open interest– Trading volume– Market value – Notional value


The Five Largest Stock Exchanges

• The table shows the market capitalization of stocks traded on the five largest stock exchanges in the world in 2006.

Table 1.1 The five largest stock exchanges in the world, by market capitalization (in billions of U.S. dollars).


Increased Volatility…

• Oil prices: 1947–2006

• DM/$ rate: 1947–2006

Figure 1.1 Monthly percentage change in the producer price index for oil, 1947–2006.

Figure 1.2 Monthly percentagechange in the dollar/pound($/£) exchange rate, 1947–2006.


…Led to New and Big Markets

• Exchange-traded derivatives

• Over-the-counter traded derivatives: even more!

Figure 1.4 Millions of futures contracts traded annually at the Chicago Board of Trade (CBT), Chicago Mercantile Exchange (CME), and the New York Mercantile Exchange (NYMEX), 1970–2006. The CME and CBT merged in 2007.


Exchange Traded Contracts

• Contracts proliferated in the last three decades

• What were the drivers behind this proliferation?

Table 1.2 Examples of futures contracts traded on the Chicago Mercantile Exchange (CME)/Chicago Board of Trade (CBT), Eurex, and the New York Mercantile Exchange (NYMEX).


The Role of Financial Markets

• Insurance companies and individual communities/families have traditionally helped each other to share risks

• Markets make risk-sharing more efficient

– Diversifiable risks vanish– Non-diversifiable risks are reallocated

• Recent example: earthquake bonds by Walt Disney in Japan


Uses of Derivatives

• Risk management

• Speculation

• Reduced transaction costs

• Regulatory arbitrage


EconomicObservers

RegulatorsResearchers

Three Different Perspectives

• End users– Corporations

– Investment managers

– Investors

• Intermediaries– Market-makers

– Traders


Financial Engineering

• The construction of a financial product from other products

• New securities can be designed by using existing securities

• Financial engineering principles

– Facilitate hedging of existing positions– Enable understanding of complex positions– Allow for creation of customized products– Render regulation less effective


Short-Selling

• When price of an asset is expected to fall– First: borrow and sell an asset (get $$)– Then: buy back and return the asset (pay $)

– If price fell in the mean time: Profit $ = $$ – $– The lender must be compensated for dividends received (lease-rate)

• Example: short-sell IBM stock for 90 days

Table 1.4 Cash flows associated with short-selling a share of IBM for90 days. S0 and S90 are the share prices on days 0 and 90. Note that the short-seller must pay the dividend, D, to the share lender.


Short-Selling (cont’d)

• Why short-sell?

– Speculation– Financing– Hedging

• Credit risk in short-selling

– Collateral and “haircut”

• Interest received from lender on collateral

– Scarcity decreases the interest rate– Repo rate in bond markets– Short rebate in the stock market


Basic Transactions

• Buying and selling a financial asset

– Brokers: commissions– Market-makers: bid-ask (offer) spread

• Example: Buy and sell 100 shares of XYZ

– XYZ: bid = $49.75, offer = $50, commission = $15– Buy: (100 x $50) + $15 = $5,015– Sell: (100 x $49.75) – $15 = $4,960– Transaction cost: $5015 – $4,960 = $55

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter 1

Additional Art


Table 1.3 Estimated year-end notional value of outstanding derivatives contracts, by category, in billions of dollars.


Figure 1.3 Monthly change in 3-month Treasury bill rate, 1947–2006.

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