lecture # 02 1.1 introduction. the nature of derivatives 1.2 a derivative is an instrument whose...

Lecture # 02 1.1 Introduction

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Lecture # 02

1.1

Introduction

The Nature of Derivatives

1.2

A derivative is an instrument whose value depends on the values of other more basic underlying variables

Page 3: Lecture # 02 1.1 Introduction. The Nature of Derivatives 1.2 A derivative is an instrument whose value depends on the values of other more basic underlying

Examples of Derivatives

1.3

•Futures Contracts

•Forward Contracts

•Swaps

•Options

Page 4: Lecture # 02 1.1 Introduction. The Nature of Derivatives 1.2 A derivative is an instrument whose value depends on the values of other more basic underlying

Derivatives Markets

1.4

Exchange tradedTraditionally exchanges have used the

open-outcry system, but increasingly they are switching to electronic trading

Contracts are standard there is virtually no credit risk

Over-the-counter (OTC)A computer- and telephone-linked network

of dealers at financial institutions, corporations, and fund managers

Contracts can be non-standard and there is some small amount of credit risk

Page 5: Lecture # 02 1.1 Introduction. The Nature of Derivatives 1.2 A derivative is an instrument whose value depends on the values of other more basic underlying

Size of OTC and Exchange Markets(Figure 1.1, Page 3)

1.5

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

020406080

100120140160180200220240

Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04

Size of Market ($ trillion)

OTC

Exchange

Page 6: Lecture # 02 1.1 Introduction. The Nature of Derivatives 1.2 A derivative is an instrument whose value depends on the values of other more basic underlying

Ways Derivatives are Used

1.6

To hedge risksTo speculate (take a view on the

future direction of the market)To lock in an arbitrage profitTo change the nature of a liabilityTo change the nature of an

investment without incurring the costs of selling one portfolio and buying another

Page 7: Lecture # 02 1.1 Introduction. The Nature of Derivatives 1.2 A derivative is an instrument whose value depends on the values of other more basic underlying

Forward Contracts

1.7

Forward contracts are similar to futures except that they trade in the over-the-counter market

Forward contracts are particularly popular on currencies and interest rates

Page 8: Lecture # 02 1.1 Introduction. The Nature of Derivatives 1.2 A derivative is an instrument whose value depends on the values of other more basic underlying

Foreign Exchange Quotes for GBP June 3, 2003 (See page 4)

1.8

Bid Offer

Spot 1.6281 1.6285

1-month forward 1.6248 1.6253

3-month forward 1.6187 1.6192

6-month forward 1.6094 1.6100

Page 9: Lecture # 02 1.1 Introduction. The Nature of Derivatives 1.2 A derivative is an instrument whose value depends on the values of other more basic underlying

References

1.9

Using Derivatives to Manage Interest Rate Risk. Derivatives A derivative is any instrument or contract that derives its value from another underlying

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