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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Chapter 1: Introduction The speed of money is faster than it’s ever been. Loleen Doerrer Time, April 11, 1994, p. 33 Important Concepts in Chapter 1 Different types of derivatives Risk preferences, risk-return tradeoff, and market efficiency Theoretical fair value Arbitrage, storage, and delivery The role of derivative markets Criticisms of derivatives Business risk vs. financial risk Derivatives A derivative is a financial instrument whose return is derived from the return on another instrument. Size of the derivatives market at year-end 2001 $111 trillion notional principal $3.8 trillion market value Real vs. financial assets Derivative Markets and Instruments Options Definition: a contract between two parties that gives one party, the buyer, the right to buy or sell something from or to the other party, the seller, at a later date at a price agreed upon today Option terminology price/premium call/put exchange-listed vs. over-the-counter options Derivative Markets and Instruments (continued) Forward Contracts Definition: a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today Exclusively over-the-counter Derivative Markets and Instruments (continued) Futures Contracts Definition: a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today; subject to a daily settlement of gains and losses and guaranteed against the risk that either party might default Exclusively traded on a futures exchange Derivative Markets and Instruments (continued) Options on Futures (also known as commodity options or futures options) Definition: a contract between two parties giving one party the right to buy or sell a futures contract from the other at a later date at a price agreed upon today Exclusively traded on a futures exchange Derivative Markets and Instruments (continued) Swaps