BA 4825/5825 IAM 520 Financial Derivatives

Spring 2005 Dept. of BA- IAM METU

Dr. Adil Oran Dr. Z. Nuray Gner

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 1

Class Web Page

http://www.ba.metu.edu.tr/~adil/ba4825/ syllabus: can be found at the web site

my page: http://ba.metu.edu.tr/~adil/

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 2

General Information

BA 4825-5825 and IAM520

Financial Derivatives

Class Schedule: M&W 11:45-13:00 G208 Dr. Z. Nuray Gner Communication: Office hrs: (H113) T&Th 16:15-17:30 Phone: (312)210-2041 e-mail: nguner@ba.metu.edu.tr
Ch. 1: 3

Dr. Adil ORAN Communication: Office hrs: (H114) M&T 14:45-16:00 Phone: (312)210-2041 e-mail: adil@ba.metu.edu.tr
D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Textbook

An Introduction to Derivatives, Chance, D.M. 6th Edition, Thomson/South Western, USA, 2004. http://www.swlearning.com/finance/chance/ http://www.harcourtcollege.com/finance/chance/

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

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Course Objectives

provide a solid foundation in the principles of derivatives strike a balance between institutional details theoretical foundations practical applications expose students to a rather comprehensive coverage of theory and application in the derivatives area

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 5

Course Description

Hybrid Finance area course Basic knowledge of Mathematics, Accounting, Finance, and Economics is assumed

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

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Class Preparation

Prior to Class: Read relevant material prepare any assignments given Come to class ready to take part in discussions Ask questions whenever you need to!

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 7

E-Mail list

ba4825@yahoogroups.com The course will have an email list for updates to web content changes in times announcements also good for asking questions subscribe from class web page

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 8

Grading
Midterm Midterm Final Assignments Total 20 20 50 10 100

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

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Chapter 1: Introduction

The speed of money is faster than its ever been. Loleen Doerrer Time, April 11, 1994, p. 33

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 10

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

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 11

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

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 12

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

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 13

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

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

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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

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 15

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

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 16

Derivative Markets and Instruments (continued)

Swaps and Other Derivatives Definition of a swap: a contract in which two parties agree to exchange a series of cash flows Exclusively over-the-counter Other types of derivatives include swaptions and hybrids. Their creation is a process called financial engineering. The Underlying Asset Called the underlying A derivative derives its value from the underlying.
An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 17

D. M. Chance

Some Important Concepts in Financial and Derivative Markets

Risk Preference Risk aversion vs. risk neutrality Risk premium Short Selling Return and Risk Risk defined The Risk-Return tradeoff (see Figure 1.1, p. 7)

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 18

Some Important Concepts in Financial and Derivative Markets (continued)

Market Efficiency and Theoretical Fair Value Definition of an efficient market The concept of theoretical fair value

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

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Fundamental Linkages Between Spot and Derivative Markets

Arbitrage and the Law of One Price Arbitrage defined Example: See Figure 1.2, p. 10 The concept of states of the world The Law of One Price The Storage Mechanism: Spreading Consumption across Time Delivery and Settlement

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

Ch. 1: 20

The Role of Derivative Markets

Risk Management Hedging vs. speculation Setting risk to an acceptable level Price Discovery Operational Advantages Transaction costs Liquidity Ease of short selling Market efficiency

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

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Criticisms of Derivative Markets

Speculation Comparison to gambling

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

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Misuses of Derivatives

High leverage Inappropriate use

D. M. Chance

An Introduction to Derivatives and Risk Management, 6th ed.

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Derivatives and Your Career

Financial management in a business Small businesses ownership Investment management Public service

Source of Information on Derivatives

http://chance.swlearning.com

Summary
D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 24

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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 25

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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 26