DRM Chapter 1 - Introduction

Derivatives and Chapter 1 : Introduction
John C Hull
Options, Futures, and Other Derivatives
Risk
Management
ACV Subrahmanyam
Summer Term 2024
Agenda
• Background
• Exchange Traded Markets
• Over the Counter Markets
• Forwards
• Futures
• Options
• Types of Traders
• Hedgers
• Speculators
• Arbitrageurs
• Risks and Risk Management
2
What are derivatives ?
𝑦 =f (x )
• Class of Financial Asset
“ that derives value from some underlying
variable”
• What is the underlying?
• Started with Commodities – Stocks – Indices
• Basically, any financial asset whose value
changes with respect an event / variable
(Differentiable) – weather derivatives / default
swaps
• Popularity depends on use (liquidity and depth)
• Fundamental Characteristic – enables
exposure without ownership
Source: • Derivatives enables transformation of Risk
https://en.wikipedia.org/wiki/Derivative
3 without losing Money Power
Derivatives and Risk Management : ACV Subrahmanyam Wednesday, June 19, 2024
Exchange Traded Vs Over the Counter Markets
• Started with Commodity trading on Chicago Board of Trade in 1848 – Farmers and
Merchants
• Contract “Commitment to perform certain acts/duties by parties for something in return”
• Contracts fix the outcome and reduce uncertainty
•Standardized products
Exchange Traded Markets •Trading floor or computerized trading
(Ready Made Clothes) •Virtually no credit risk
Over the Counter (OTC) •Often non-standard (customized) products

•Telephone (dealer) market
Markets
•Some credit risk
Custom Tailored
https://www.bis.org/publ/otc_hy2405.h
tm OTC markets are much larger and popular than exchanges
4 Derivatives and Risk Management : ACV Subrahmanyam Wednesday, June 19, 2024
TEXT
Three varieties of Derivatives
• Party that intends to buy is called a long party or holding a long
position
• Party that intends to sell is called a short party of holding a short
position
• Current market price as on date is referred as SPOT PRICE (St)
• The Price agreed between parties for a future date is called STRIKE
PRICE (K)
Forwards Futures Options
Contract to trade in future at a Contract to trade in future at a Option is a contract that gives
given price and or quantity of given price and or quantity of “Right” to buy (Call option) or
the underlying the underlying sell(put option) the underlying
at a price in future
OBLIGATION FOR BOTH OBLIGATION FOR BOTH
BUYER AND SELLER BUYER AND SELLER RIGHT For Buyer and
OBLIGATION FOR Seller
Customized OTC type trade EXCHANGE traded (Fixed
structure) Both exchange traded and
Do not require upfront OTC
payment Require margin maintenance
• (conditions apply) and involves daily settlement Require immediate payment of
• Some credit risk • (conditions apply) premium (Fixed Costs)
• No credit risk
TEXT
Types of Traders
Derivatives allow for protecting one’s portfolio from movements in underlying value
Risk avoidance Vs. Risk Taking
Creating Market Depth and Fallout risks (also)
Hedgers Speculators Arbitrageurs

Primary objective to avoid risk Betting for or against the Observe market frictions / gaps
market
Capture the gains (Risk less
Forwards, futures (Neutralize) Maximize gains profit)
and Options (Insurance) Uses Futures and Options Very important to equalizing
prices across markets
Cost of strategy – Margin/ Create market depth and help
Premium - Leverage price discovery Temporary cannot be a
permanent feature
Generally backed by a specific Also increase volatility / Risks
business purpose Transaction costs/ Regulation
Exploits Leverage
TEXT
Summary
• Investors find it more attractive to trade a derivative on an
asset than to trade the asset itself.
• First look at forward, futures, and options contracts
• A call option gives the holder the right to buy an asset by a
certain date for a certain price.
• A put option gives the holder the right to sell an asset by a
certain date for a certain price.
• Derivatives have been very successful innovations in
capital markets
10

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Derivatives and Chapter 1 : Introduction

(Ready Made Clothes) •Virtually no credit risk

Over the Counter (OTC) •Often non-standard (customized) products

Hedgers Speculators Arbitrageurs

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