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Derivates Lecture 1

Derivatives are used in many areas of finance including bonds, executive compensation, capital investments, and transferring risks associated with mortgages. During the 2007 credit crisis, risky mortgages were bundled together and securitized to create derivative products that later became worthless when housing prices declined, causing huge losses for financial institutions and investors globally and resulting in a major recession. Derivatives exchanges allow standardized derivative contracts to be traded and have existed for a long time, with one of the earliest being the Chicago Board of Trade established in 1848.

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94 views1 page

Derivates Lecture 1

Derivatives are used in many areas of finance including bonds, executive compensation, capital investments, and transferring risks associated with mortgages. During the 2007 credit crisis, risky mortgages were bundled together and securitized to create derivative products that later became worthless when housing prices declined, causing huge losses for financial institutions and investors globally and resulting in a major recession. Derivatives exchanges allow standardized derivative contracts to be traded and have existed for a long time, with one of the earliest being the Chicago Board of Trade established in 1848.

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 Derivatives are added to bond issues, used in executive compensation plans, embedded in

capital investment opportunities, used to transfer risks in mortgages from the original lenders to
investors, and so on. We have now reached the stage where those who work in finance, and
many who work outside finance, need to understand how derivatives work, how they are used,
and how they are priced
 the credit crisis that started in 2007. Derivative products were created from portfolios of risky
mortgages in the United States using a procedure known as securitization. Many of the products
that were created became worthless when house prices declined. Financial institutions, and
investors throughout the world, lost a huge amount of money and the world was plunged into the
worst recession it had experienced for many generations.

EXCHANGE-TRADED MARKETS
 A derivatives exchange is a market where individual trade standardized contracts that have been
defined by the exchange. Derivatives exchanges have existed for a long time.The Chicago Board
of Trade (CBOT) was established in 1848 to bring farmers and merchants together.

 First futures-type contract was developed. It was known as a to-arrive contract

Electronic market

Open outcry system. This involves traders physically meeting on the floor of the exchange, shouting, and
using a complicated set of hand signals to indicate the trades they would like to carry out.
Exchanges are increasingly replacing the open outcry system by electronic trading.

OPTIONS
Options are traded both on exchanges and in the over-the-counter market
A call option gives the holder the right to buy the underlying assetby a certain date for a certain price
A put option gives the holder the right to sell the underlying asset by a certain date for a certain price
The price in the contract is known as the exercise price or strike price; the date in the contract is known
as the expiration date or maturity.

The price of a call option decreases as the strike price increases, while the price of a put option increases
as the strike price increases. Both types of option tend to become more valuable as their time to maturity
increases. These properties of options will be discussed further in Chapter 10.

The strike price is defined as the price at which the holder of an options can buy (in the case
of a call option) or sell (in the case of a put option) the underlying security when the option is
exercised. Hence, strike price is also known as exercise price.

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