Note1 - FI 478 Investment Strategies and Speculative...

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Unformatted text preview: FI 478 Investment Strategies and Speculative Markets Professor Fan Yu Lecture 1 Introduction to Derivatives Introduction to Forwards and Futures This Version: January 2, 2008 c & 2008 Fan Yu. All Rights Reserved. 1 & What Are Derivatives? & A derivative refers to any of a broad class of &nancial securities whose value is determined by (derivedfrom) the value of more basic underlying variables. Examples of the underlying variables that are easy to think of are the prices of stocks, bonds, commodi- ties and the value of various stock indices. Less obvious examples include the Richter scale, the total dollar damage of hurricanes in the state of Florida, the credit rating (default status) of a company, or the average daily temperature at the Detroit Metropolitan Air- port in January. In other words, the underlying can be almost any well-de&ned quantity. & What Are Derivatives Good For? & The most important property of a derivative instrument is that it makes it possible to manage risk exposure independently from the actual position taken in the underlying asset or variable. & For example, by selling futures contracts one can hold an inventory of oil but hedge away the risk that the price may drop before it is sold. Or one can use a forward rate agreement to lock in the e/ective interest rate to be paid on a loan that will only take place at a future date. Or, one can buy a cap contract to &x the maximum interest rate that will ever have to be paid on a oating rate loan. Or... & Arent Derivatives Risky? & In light of recent &ascoes at Barings, Metallgesellschaft, Proctor and Gamble, Orange County, LTCM, China Aviation Oil, and Ama- ranth, there is a misconception that it is dangerous to deal with derivatives. & Like ordinary securities, derivatives are exposed to a variety of risks, including credit risk, market risk, operational risk, and so on. Deriv- atives viewed in isolation may appear to be very risky, because the potential pro&t or loss can be huge. However, properly designed strategies involving derivatives are normally risk-reducing when all elements of the strategy are considered. & Granted, derivatives are more complex and harder to understand than plain old stocks and bonds. Thats why we are taking a spe- cialized course in derivatives. 2 & Aren&t Derivatives Speculative? & By facilitating active management of risk exposure, derivatives make both risk reduction (hedging) and risk bearing (speculation) eas- ier. A basic position in an underlying asset is frequently inherently risky, as in buying a long-term bond whose price might go down. Proper use of derivatives can greatly increase the ability to manage such risks and reduce the speculative element of normal business activities....
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Note1 - FI 478 Investment Strategies and Speculative...

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