1 Introductory Concepts

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1 Introductory Concepts
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2Derivative Concept

• Defn A derivative is an asset whose value
  depends upon the future value of one or more
  underlying assets.
• In some ways, a derivative is a bet e.g., point
  spread on the SuperBowl.

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3Derivative Concept, Contd

• It might be best not to push the analogy with
  gambling too far. Unlike recreational gambling,
  we will show later that derivatives can play
  important roles in promoting optimal production
  choices and optimum welfare in society.

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4Markets

• Defn Markets are places where things (assets) of
  value are traded.
• Defn A trade is an exchange of one asset for
  another.
• The trade usually involves the exchange of one
  asset for money, but that is not always the case.
• The place of trade may be virtual or concrete.
  Nowadays, many markets are electronic (e.g.,
  NASDAQ and some German Bond markets).

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5Market Intermediation

• Suppose agent A wishes to sell an asset, while
  agent B wishes to buy the same asset. Market
  intermediation occurs when an institution (for
  profit or non-profit) facilitates the agents in
  locating one-another. The agents need never know
  each other. The intermediation is beneficial if
  the cost of sustaining it exceeds the cost of
  private searches. Intermediation is studied in
  Transactions costs economics.

Agent A
Market
Agent B
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6Market Intermediation, Contd

• Sometimes intermediation takes the form of a
  middleman, a broker, who intervene between the
  agents and the market. Perhaps the market
  institutions are too difficult for private
  individuals to deal with given limited time
  resources, or middlemen provide services that are
  difficult to automate, or pro-monopoly
  regulations entrench brokers

Agent A
Broker
Market
Broker
Agent B
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7Asset Types

• There are non-financial assets such as
  commodities, real estate, baseball cards, etc.
  These are claims on physical assets.
• There are also financial assets such as common
  stock, preferred stock (which pay interest as
  well as dividends), corporate bonds (e.g.,
  McDonalds 7 p.a.coupons, paid semi-annually,
  redeemed in 2,000 and not callable), Treasury
  bonds, State bonds, Municipal bonds, and
  currencies.

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8Asset Types, Contd

• Derivatives are a third type of asset. They are
  contingent claims on underlying assets. Thus,
  there can be derivatives on commodities, bonds,
  or any other of the above mentioned asset types.
  Derivatives might also be written on combinations
  of asset types. For example, a derivative may be
  written on the interaction between oil prices and
  the / exchange rate by a firm in the United
  Kingdom.
• There can also be higher-order derivatives
  whereby a derivative is taken as the asset upon
  which a second derivative is written. An example
  is an option on a futures contract. An option on
  an option is also a common type of traded asset
  (bankruptcy example).

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9Asset Types, Contd

• For legal and regulatory purposes, financial
  assets and commodities are treated differently.
• The reasons for the legal distinction are mainly
  historic, but there are genuine economic reasons
  for treating the two asset classes separately.

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10Securities vs. Commodities

• Commodities are tangible and can be
  non-homogeneous. Wheat can have 10 or 14
  protein, low or high moisture, 2 or 3 damaged
  kernels. Wheat location is important. But
  different units of a security, such as IBM stock,
  are generally indistinguishable. There may be a
  need to standardize commodities for the purpose
  of writing derivatives.

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11Derivatives in their Most General Form

• Derivatives may be viewed as functions (in what
  sense?). or contracts (in what sense?), or
  computer programs (no bugs). Just as there are
  an infinity of functions that may be written on
  an underlying variable, there are an infinity of
  derivatives that one may trade that are based on
  that underlying variable.
• Effectively, the only limit is ones imagination.
  However, many derivatives that one could dream
  up might be of no practical interest to anyone,
  and so a market may not exist in such derivative
  assets because there is no demand.
• The most common types of derivatives are
  forwards, futures, SWAPs and options.