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Unformatted text preview: STAT 2820 Chapter 1 Introduction to Derivatives by K.C. Cheung 1.1 Derivatives A derivative is a financial instrument whose value depends on (or derived from) the values of other more basic underlying variables. • “Financial instrument” or “financial asset” is a contract/agreement between two parties. It is not a real asset, it has no production power. • Examples of “underlying variables”: the price of a stock, price of corn, amount of snow falling at a certain region • Examples of derivatives: futures, forwards, options, swaps, insurance 1.2 Use of Derivatives 1. Risk management • Derivatives can sometimes reduce the overall level of risk-→ hedging • Insurance is an example of derivative used to reduce risk 2. Speculation • Derivatives can be used to make bets on various market quantities such as stock price or oil price. 3. Reduce transaction costs • Sometimes a series of transactions can be replicated by a single transaction of a derivative-→ less transactions using derivatives-→ lower transaction costs 4. Regulatory arbitrage • Derivatives are sometimes used to avoid/bypass regulatory restrictions 1.3 Exchange-Traded Markets vs Over-The-Counter Markets 1.3.1 Exchange Markets • Standardized contracts defined by the exchange STAT2820 Chapter 1 2 • Examples: Eurex, CME Group (merger of Chicago Mercantile Exchange and Chicago...
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- Fall '11