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chap009 - Chapter 9 Derivatives Futures Options and Swaps...

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Chapter 9 Derivatives: Futures, Options, and Swaps Chapter Overview This chapter provides an introduction to derivatives, and examines both their uses and abuses. Reading this chapter will prepare students to: explain derivatives; understand how derivatives can be used to transfer risk; and analyze the pricing of derivatives. Important Points of the Chapter Recent history has shown that derivatives are open to abuse; they were at the bottom of the scandal that engulfed Enron and were also linked to the collapse of Long Term Capital Management (the hedge fund). But when used properly, derivatives are extremely helpful instruments that can be used to reduce risk, or as a form of insurance. Application of Core Principles Principle #2: Risk (page 203) Derivatives allow people to transfer risk, and this encourages them to do things they would not otherwise do because in effect they provide a kind of insurance. Principle #1: Time (page 209) The longer the time to expiration the more valuable an option. Principle #2: Risk (page 209) The option premium increases with the volatility of the price of the underlying asset. Principle #2: Risk (page 213) The difference between the benchmark rate for a swap (the market interest rate on a U.S. Treasury bond of the same maturity as the swap) and the swap rate (the rate to be paid) is called the swap spread, and is a measure of risk. In recent years it has attracted substantial attention as a measure of the overall risk in the economy (systematic risk). Teaching Tips/Student Stumbling Blocks Derivatives were first introduced back in Chapter 3; you may wish to review that material. Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 119
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Chapter 9 Derivatives: Futures, Options, and Swaps The material on hedging and speculation was introduced in Chapter 5; you may wish to review that material before beginning section II. Give students a brief look at the action at the Chicago Board of Trade; part of the movie Ferris Bueller’s Day Off (1986) was filmed there and showing that very brief clip of the movie (it’s probably less than a minute) can really give them a feel for the action in the pits. Features in this Chapter Applying the Concept : Who Can Use Commodity Futures Markets? (page 201) Farmers use futures contracts to hedge against the risk of price fluctuations. It is a kind of insurance against price drops; without it, decreases in prices could force farmers to go bankrupt. Without the guarantee of the selling price farmers would plant less to reduce their risk. The ability of people to buy insurance increases their willingness to take risks. Futures markets, and derivatives in general, allow people to transfer risk to those who are equipped to handle it. In parts of the world where people do not have access to futures markets (as in poorer countries) the economy suffers.
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