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    L2 Financial Derivatives MBA

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    David Adeabah Osafo
    This document provides an introduction to financial derivatives. It defines derivatives as financial instruments whose value is based on an underlying asset. Examples of derivatives include futures contracts and options. The document discusses how derivatives markets have grown alongside increases in the volatility of underlying assets like currencies, commodities, and interest rates. It outlines the main uses of derivatives which include risk management, speculation, reducing transaction costs, and regulatory arbitrage. The perspectives of different parties involved in derivatives markets are presented. Financial engineering principles and the concept of transaction costs including bid-ask spreads are also introduced. The document concludes with an overview of the process of short selling financial assets.

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    L2 Financial Derivatives MBA

    Uploaded by

    David Adeabah Osafo
    185 views20 pages
    This document provides an introduction to financial derivatives. It defines derivatives as financial instruments whose value is based on an underlying asset. Examples of derivatives include futures contracts and options. The document discusses how derivatives markets have grown alongside increases in the volatility of underlying assets like currencies, commodities, and interest rates. It outlines the main uses of derivatives which include risk management, speculation, reducing transaction costs, and regulatory arbitrage. The perspectives of different parties involved in derivatives markets are presented. Financial engineering principles and the concept of transaction costs including bid-ask spreads are also introduced. The document concludes with an overview of the process of short selling financial assets.

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    L2 Financial Derivatives MBA

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    This document provides an introduction to financial derivatives. It defines derivatives as financial instruments whose value is based on an underlying asset. Examples of derivatives include futures contracts and options. The document discusses how derivatives markets have grown alongside increases in the volatility of underlying assets like currencies, commodities, and interest rates. It outlines the main uses of derivatives which include risk management, speculation, reducing transaction costs, and regulatory arbitrage. The perspectives of different parties involved in derivatives markets are presented. Financial engineering principles and the concept of transaction costs including bid-ask spreads are also introduced. The document concludes with an overview of the process of short selling financial assets.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    185 views20 pages

    L2 Financial Derivatives MBA

    Uploaded by

    David Adeabah Osafo
    This document provides an introduction to financial derivatives. It defines derivatives as financial instruments whose value is based on an underlying asset. Examples of derivatives include futures contracts and options. The document discusses how derivatives markets have grown alongside increases in the volatility of underlying assets like currencies, commodities, and interest rates. It outlines the main uses of derivatives which include risk management, speculation, reducing transaction costs, and regulatory arbitrage. The perspectives of different parties involved in derivatives markets are presented. Financial engineering principles and the concept of transaction costs including bid-ask spreads are also introduced. The document concludes with an overview of the process of short selling financial assets.

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    FINANCIAL DERIVATIVES FINC 612

    INTRODUCTION TO DERIVATIVES

    Saint Kuttu, PhD

    Saint Kuttu, PhD 1


    What Is a Derivative?
    Definition
    A financial instrument that has a value
    determined by the price of something else
    An agreement where you pay 1 if the
    price of corn is greater than 3 and
    receive 1 if the price of corn is less that
    3 is a derivative
    This contract can be used to speculate on the
    price of corn or it can be used to reduce risk. It
    is not the contract itself, but how it is used,
    and who uses it, that determines whether or
    not it is risk-reducing
    Saint Kuttu, PhD 2
    An Overview of Financial Markets
    The trading of a financial asset involves at least
    four discrete steps
    A buyer and a seller must locate one another
    and agree on a price
    The trade must be cleared (the obligations of
    each party are specified)
    The trade must be settled (the buyer and the
    seller must deliver the cash or securities
    necessary to satisfy their obligations in the
    required period of time)
    Ownership records are updated

    Saint Kuttu, PhD 3


    An Overview of Financial Markets (contd)
    Much trading of financial claims takes place on
    organized exchanges. In the past, the exchange
    was solely a physical location where traders
    would buy and sell. Such in-person venues have
    largely been replaced by electronic networks that
    provide a virtual trading venue

    After a trade has taken place, a clearinghouse


    matches the buyers and sellers, keeping track of
    their obligations and payments. To facilitate these
    payments and to help manage credit risk, a
    derivatives clearinghouse typically imposes itself
    in the transaction, becoming the buyer to all
    sellers and the seller to all buyers.
    Saint Kuttu, PhD 4
    An Overview of Financial Markets (contd)
    It is possible for large traders to trade many
    financial claims directly with a dealer bypassing
    organized exchanges. Such trading is said to occur
    in the over-the-counter (OTC) market
    Exchange activity is public and highly regulated
    Over-the-counter trading is not easy to observe or
    measure and is generally less regulated
    For many categories of financial claims, the value of
    OTC trading is greater than the value traded on
    exchanges

    Saint Kuttu, PhD 5


    An Overview of Financial Markets (contd)
    There are at least four different measures of a market and
    its activity
    Trading volume. This measure counts the number of
    financial claims that change hands
    Market value. The market value is the sum of the
    market value of the claims that could be traded,
    without regard to whether they have traded
    Notional value. Notional value measure the scale of a
    position, usually with reference to some underlying
    asset
    Open Interest. Open interest measures the total
    number of contracts for which counterparties have a
    future obligation to perform.

    Saint Kuttu, PhD 6


    Derivatives Markets
    The introduction of derivatives in a market often coincides
    with an increase in price risk in that market
    Currencies were permitted to float in 1971 when the
    gold standard was officially abandoned. The modern
    market in financial derivatives began in 1972, when the
    Chicago Mercantile Exchange started trading futures
    contracts on seven currencies
    OPECs 1973 reduction in the supply of oil was
    followed by high and variable oil prices
    U.S. interest rates became more volatile following
    inflation and recessions in the 1970s.
    The market for natural gas has been deregulated
    gradually since 1978, resulting in a volatile market in
    recent years
    The deregulation of electricity began during the 1990s
    Saint Kuttu, PhD 7
    Increased Volatility

    Oil prices: $/ rate:


    19472011 19472011

    Saint Kuttu, PhD 8


    Led to New and Big Markets
    Exchange-traded derivatives

    Over-the-counter markets have also grown rapidly


    over this period
    Sources: (a) St. Louis Fed; (b) DRI and St. Louis Fed; (c) St. Louis Fed; (d) CRB
    Yearbook.
    Saint Kuttu, PhD 9
    Exchange Traded Contracts

    Contracts proliferated in the last four decades

    Saint Kuttu, PhD 10


    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 to those
    most willing to hold it

    Saint Kuttu, PhD 11


    The Uses of Derivatives
    Uses
    Risk management. Derivatives are a tool for
    companies and other users to reduce risks
    Speculation. Derivatives can serve as
    investment vehicles
    Reduce transaction costs. Sometimes
    derivatives provide a lower cost way to
    undertake a particular financial transaction
    Regulatory arbitrage. It is sometimes
    possible to circumvent regulatory restrictions,
    taxes, and accounting rules by trading
    derivatives
    Saint Kuttu, PhD 12
    Perspectives on Derivatives

    End users Intermediaries Economic


    Observers
    Corporations Market-makers
    Regulators
    Investment Traders
    managers Researchers
    Investors
    Observers

    End End
    Intermediary
    user user

    Saint Kuttu, PhD 13


    Financial Engineering and Security Design
    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
    Allow for creation of customized products
    Enable understanding of complex positions
    Render regulation less effective

    Saint Kuttu, PhD 14


    Transaction Costs and the Bid-Ask Spread
    Buying and selling a financial asset
    Brokers: commissions
    Market-makers: bid-ask (offer) spread
    Example 1.1: 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

    Saint Kuttu, PhD 15


    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

    Saint Kuttu, PhD 16


    Short-Selling (contd)
    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
    Saint Kuttu, PhD 17
    Saint Kuttu, PhD 18
    Saint Kuttu, PhD 19
    Thank You for Your Attention

    Saint Kuttu, PhD 20

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