Chapter 1

Introduction to Derivatives
What Is a Derivative?

Definition
An agreement (financial instrument) between two parties
which has a value determined by the price of something else
(underlying asset)
Types and Purposes
Options, Forwards/Futures, Swaps
Risk/Asset management, Credit Evaluations, Capital
Budgeting

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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

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Measures of Market Size and
Activity

Four ways to measure the size and activity of a

market
Market value: Market Capitalization
Trading volume: Total # of shares traded
Open interest: Total # of contracts that are open
(position/obligation to pay or deliver a security)
Notional value: Scale of a position
(ex: notional value of the right to buy 100 shares of
IBM stock at $100 = $10,000)

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Example: Measures of Market Size
in the Widget Exchange Market

Three traders (A, B, C) with widget price $100

A buys, B sells, 5 contracts
A buys, C sells, 15 contracts
B buys, C sells, 10 contracts
C buys, A sells, 20 contracts
Trading Volume = _____ , Open Interest = ___
Notional Value of (TV, OI) = ($____, $____)
https://zerodha.com/varsity/chapter/open-interest/
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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).

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The Five Largest Stock Exchanges

The table shows the market capitalization of stocks traded on the

five largest stock exchanges in the world in 2017.

Table + The five largest stock exchanges in the world,

by market capitalization (in billions of U.S. dollars).
Rank Exchange Headquarters Market cap Monthly trade volume
1 New York Stock Exchange New York 19,223 1,520
2 NASDAQ New York 6,831 1,183
3 London Stock Exchange Group London 6,187 165
4 Japan Exchange Group Tokyo Tokyo 4,485 402
5 Shanghai Stock Exchange Shanghai 3,986 1,278

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Increased Volatility

Oil prices:
19472006
Figure Monthly percentage
change in the producer price
index for oil, 19472006.

DM/$ rate:
19472006
Figure Monthly percentage
change in the dollar/pound
($/) exchange rate, 19472006.

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Led to New and Big Markets

Exchange-traded derivatives

Figure Millions of futures contracts

traded annually at the Chicago
Board of Trade (CBT), Chicago
Mercantile Exchange (CME), and
the New York Mercantile Exchange
(NYMEX), 19702006. The CME
and CBT merged in 2007.

Over-the-counter traded derivatives: even more!

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The Role of Financial Markets

Insurance companies and individual

communities/families have traditionally
helped each other to share risks
(Derivatives) Markets make risk-sharing more efficient
Diversifiable risks vanish
Non-diversifiable risks are reallocated

Recent example: earthquake bonds by Walt Disney in

Japan, catastrophe bonds by Mexico

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Uses of Derivatives

Risk management
Speculation
Reduced transaction costs
(Regulatory) arbitrage

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Three Different Perspectives

End users Intermediaries Economic

Corporations Market-makers Observers
Investment Traders Regulators
managers Researchers
Investors

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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

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Short-Selling

Definition: Sale of an asset that you do not already own

Example: short-sell IBM stock for 90 days
First: borrow and sell one share (get $100) today
Then: buy back and return the stock (pay $ X) 90 days later
The lender must be compensated for dividends received (lease-rate)
Profits?

When?
The stock price is expected to increase
The stock price is expected to decrease
Short position vs Long position
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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

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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, Ask (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

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Example: short-selling and bid-ask
spread

You desire to short-sell 100 Shares of XYZ stock

Bid price: $25.18, Ask price: $26.42 (today)
Cover the short position 60 days later
Bid price: $22.89, Ask price: $23.15 (60 days later)

Profit?
100x($_____) - 100x($____) = $____

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