lecture11 - Lecture X Economics of Derivatives and...

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Economics of Derivatives and Derivatives Markets – Regulatory Framework for Stable and Efficient Growth Lecture X
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- OVERVIEW - Economics of derivatives and derivatives markets Definition (very brief) History of derivatives (brief) Purpose – positive economic functions Price discovery Risk shifting Hedging Speculation Unbundle and repackage risks Public Interest Concerns (brief) Why derivatives? Comparison to banking, securities, and insurance. Market structures – not merely a black-box Market makers and end-users Hedgers and speculators Market balance or completeness Exchange traded OTC Electronic platforms: bulletin boards and automated order matching Lecture X
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- Definition - Definition of derivatives (simple but consistent with regulation) A derivative is a transaction that is designed to create price exposure, and thereby transfer risk, by having its value determined – or derived – from the value of an underlying commodity, security, index, rate or event. Unlike stocks, bonds and bank loans, derivatives generally do not involve the transfer of a title or principal, and thus can be thought of as creating pure price exposure, by linking their value to a notional amount or principal of the underlying item. Types derivatives products include - Forward - Futures - Options (American, European, barrier, path dependent) - Swaps (FX, interest rate, CCS, swaptions) - Hybrid securities (security with derivative attached, a.k.a. structured note) Lecture X
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- Definition - Definition of a forward contract as a simple example The simplest and perhaps oldest form of a derivative is the forward contract. It is the obligation to buy or borrow (sell or lend) a specified quantity of a specified item at a specified price or rate at a specified time in the future. A forward contract on foreign currency might involve party A buying forward at t 1 (and party B selling) US$1,000,000 for Euros at $1.3405 on t 91 . A forward rate agreement on interest rates might involve party A contracting on t1 to borrow (party B lending) $1,000,000 for three months (91 days) at a 2.85% annual rate beginning t 91 . What does this achieve economically? Buying forward creates a long position in the underlying item (e.g. foreign currency). If the future market price (exchange rate) in the spot market appreciates in value, then the long position will gain in value much like that from owning the item outright. This creation of price exposure then facilitate hedging and speculation. Lecture X
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- History - Evidence of derivatives trading as early as 1750 B.C. in Mesopotamia Holland in 1595 – creation of Amsterdam laws to facilitate transfer of title Chicago Board of Trade, 1848 – trading in central market with standardized contracts End of Bretton Woods monetary system – foreign exchange futures – 1971- lead to the creation of financial futures on foreign exchange rates in 1972 on CME and NYMEX Black-Scholes-Merton Options Pricing Formula – 1973 – boosted the trading of options CBOT Futures on Treasury securities in 1977
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This note was uploaded on 02/09/2012 for the course COMPUTER S a303 taught by Professor None during the Spring '11 term at BEM Bordeaux Management School.

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lecture11 - Lecture X Economics of Derivatives and...

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