Introduction to Derivatives: Types, Risks, and Markets

TOPIC 7: INTRODUCTION TO OPTIONS AND FUTURES

1. INTRODUCTION TO DERIVATIVES

Definition: financial instrument whose payoffs and values are derived from / depend on something else. Goals:

• To illustrate the economic function/application of derivatives
• Understand how derivative markets are organized
• Be aware of the main derivative markets

Risk: The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment.

Types:Market risk: Change in the value of an asset due to changes in exchange rates, interest rates, inflation rates, bond prices, equity prices, or commodity pricesCredit risk: The other party fails to meet the agreed conditions (payments and dates). Example: Counterparty risk and country risk.Liquidity risk

• Difficulty to close a position in the market
• Difficult access to financing

Fundamentals: one of the instruments of the financial marketplace.

Derivatives: Security whose value stems or is derived from the value of other assets (underlying asset).Types1) Forwards. The owner has the obligation to sell or buy something in the future at a predetermined price.2) Futures. The owner has the obligation to sell or buy something in the future at a predetermined price. The difference to a future contract is that forwards are not standardized.3) Options. The owner has the option to buy or sell something at a predetermined price and is therefore more costly than a futures contract.4) Swap. A swap is an agreement between two parties to exchange a sequence of cash flows.

Derivatives & Risk: Derivative markets neither create nor destroy wealth - they provide a means to transfer risk. Zero-sum game in that one party’s gains are equal to another party’s losses. Participants can choose the level of risk they wish to take on using derivatives. With this efficient allocation of risk, investors are willing to supply more funds to the financial markets, enables firms to raise capital at reasonable costs.