My Course Essay

1437 WordsMay 25, 20146 Pages
Topic 1 Introduction to Derivatives (Chapter 1&2) What Is a Derivative? • Definition – An agreement between two parties which has a value determined by the price of something else • Types – Forward, futures, option, and swap • Uses – – – – Risk management Speculation Arbitrage Reduce transaction costs 1 Three Different Perspectives • End users – Corporations – Investment managers – Investors • Intermediaries – Market-makers – Traders • Economic Observers – Regulators – Researchers Observers End user Intermediary End user 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 2 The Role of Financial Markets • Insurance companies have traditionally helped each other to share risks • Markets make risk-sharing more efficient – Diversifiable risks vanish – Non-diversifiable risks are reallocated • Recent example: earthquake bonds by Walt Disney in Japan Exchange Traded Contracts • Contracts proliferated in the last three decades • What were the drivers behind this proliferation? 3 Increased Volatility… • Oil prices: 1947–2004 • $/£ rate: 1947–2004 …Led to New and Big Markets • Exchange-traded derivatives • Over-the-counter traded derivatives: even more! 4 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, 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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