1sl - THE UNIVERSITY OF HONG KONG FACULTY OF BUSINESS AND...

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1 T HE U NIVERSITY OF H ONG K ONG F ACULTY OF B USINESS AND E CONOMICS FINA0301 CDE - D ERIVATIVES First Semester, 2009-2010 Tutorial 0 Slide Chapter 1 - Introduction to Derivatives checkbld What is a Derivative? A derivative is an agreement between two parties which has a value determined by the price of something else . Options, futures, and swaps are examples of derivatives. Example: Suppose your family grows corn and your friend’s family buys corn to mill into cornmeal. If the price of corn in one year is greater than $3, you will pay the friend $1. If the price of corn is less than $3, the friend will pay you $1. Such bet provides insurance, you earn $1 if your family’s corn sells for a low price; this supplements your income. Your friend earns $1 if the corn his family buys is expensive; this offsets the high cost of corn. The contract has reduced risk for both of you. It is not the contract itself, but how it is used, and who uses it, that determines whether or not it is risk reducing. Context is everything. checkbld Use of Derivatives 1. Risk Management – Derivatives are a tool for companies and other users to reduce risks . The seller of corn enters into a contract which makes a payment when the price of corn is low. This contract reduces the risk of loss for the corn seller, who we therefore say is hedging. 2. Speculation – Derivatives can provide a way to make bets that are highly leveraged (that is, the potential gain or loss on the bet can be large relative to the initial cost of making the bet) and tailored to a specific view. 3. Reduced transaction costs – For example, the manager of a mutual fund may wish to sells stocks and buy bonds. Doing this entails paying fees to brokers and paying other trading costs. It is possible to trade derivatives instead and achieve the same economic effect as if stocks had actually been sold and replaced by bonds. 4. Regulatory arbitrage – Derivatives are often used to achieve the economic sale of stock (receive cash and eliminate the risk of holding the stock) while still maintaining
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FINA0301 – Tutorial 0 Slide______________________________________________________ Mr. Clive Man Chung HO 2 physical possession of the stock. This transaction may allow the owner to defer taxes on the sale of the stock, or retain voting rights, without the risk of holding the stocks. checkbld Perspective on Derivatives 1. End users – End-users are the corporations, investment managers, and investors who enter into derivative contract. End-users have a goal (for example, risk reduction) and care about how a derivative helps to meet that goal.
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