1.1IntroductionChapter 11.2business risk Risk the uncertainty of futures sales or the cost of inputsfinancial riskinterest rates, exchange rate, stock price, commodity prices1.3The Nature of DerivativesA derivative is an instrument whose value depends on the values of other more basic underlying variables.Its performance depends on how other financial instruments perform. Its a meaning of managing financial risks. To transfer any undesired risk to other parties.1.4Ways Derivatives are UsedlTo hedge riskslTo speculate (take a view on the future direction of the market)lTo lock in an arbitrage profitlTo change the nature of a liabilitylTo change the nature of an investment without incurring the costs of selling one portfolio and buying another1.5Derivatives MarketslExchange tradedlTraditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic tradinglContracts are standard there is virtually no credit risklOver-the-counter (OTC)lA computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managerslContracts can be non-standardized and there is some small amount of credit risk1.6Over-the Counter MarketslThe over-the-counter market is an important alternative to exchangeslIt is a telephone and computer-linked network of dealers who do not physically meetlTrades are usually between financial institutions, corporate treasurers, and fund managers1.7Size of OTC and Exchange MarketsSource: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market1.8Spot market vs. Derivative marketCash market or spot market: delivery is made immediately or shortly thereafter, payment is made immediately.In derivative market, delivery is made at a later date, or the position will be offset.1.9Difference between the OTC market and the exchange The terms of a contract do not have to be specified by an exchange. Free to negotiate any attractive dealA disadvantage is that there is some credit risk in an over-the-counter trade. 1.10Examples of DerivativesFutures Contracts Forward Contracts Swaps Options1.11Futures ContractsA futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time)1.12Futures ContractslAgreement to buy or sell an asset for a certain price at a certain timelSimilar to forward contractlWhereas a forward contract is traded OTC, a futures contract is traded on an exchange1.13Exchanges Trading FutureslChicago Board of TradelChicago Mercantile ExchangelLIFFE (London)lEurex (Europe)lBM the exercise date or the maturity 1.42The holder of option contracts, have long positionsThe writer (seller) of option contracts, have short positions Four types of participants in options marketsBuyers of callsBuyers of putsSellers of callsSellers of puts1.43Optionsthe right Buyer Seller the premium1.44Intel Option Prices (May 29, 2003; Stock Price=20.83); Strike PriceJune CallJuly CallOct CallJune PutJuly PutOct Put20.001.251.602.400.450.851.5022.500.200.451.151.852.202.851.45Exchanges Trading OptionslChicago Board Options ExchangelAmerican Stock ExchangelPhiladelphia Stock ExchangelPacific ExchangelLIFFE (London)lEurex (Europe)land many more1.46Options vs Futures/ForwardslA futures/forward contract gives the holder the obligation to buy or sell at a certain pricelAn option gives the holder the right to buy or sell at a certain price1.47The over-the-counter market for optionsThe over-the-counter market for options has grown fast since the early 1980s and is now bigger than the exchange-traded market.One of its advantages is that they can be tailored to meet the particular needs. 1.48Types of Traders Hedgers Speculators ArbitrageursSome of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculatorsthe successful reason of derivative markets 1.49many different types of traders and a great deal of liquidity (there is no problem in finding someone that is prepare to take the other side)1.50Hedger : reduce the risk that they face from potential future movements in a market variable. Speculator : bet on the future direction of a market variable (and its extent of the change)Arbitrageurs: take offsetting positions in two or more instruments to lock in a profit.1.51Trading Note 1.1 Hedging with forward contractsIt is June 3,2003. ImportCo must pay 10 million on September 3,2003, for goods purchased from Britain. Using the quotes in Table 1.1. it buys 10 million in the three-month forward market to lock in an exchange rate of 1.6l 92 for the sterling it will pay. ExportCo will receive 30 million on Septe