Lecture 1
Introduction to Financial Derivatives
Yan Ji
Feb 8, 2022
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Course logistics
Instructor: Yan JI
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Assistant Professor of Finance
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Ph.D. in Economics, MIT, 2017
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Office hours
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Right after class or by email appointment, jiy@ust.hk, LSK 5009
In general, I reply your emails within 24 hours.
Teaching assistant: Katy CHOI, katycck@ust.hk
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LSK 5068, by email appointment, katycck@ust.hk
Textbook: Not required (see syllabus).
Requirements and grading:
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2 versions of slides for most lectures (the shorter version is for exam)
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6 problem sets; first 5 will be graded (20%)
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Midterm exam (30%) on 22-Mar, 19:00-21:00 and final exam (50%)
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Attendance is not required, but I highly encourage you to attend lectures.
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Course structure
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Our course contains rich materials to make sure you will feel full:
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Appetizer: lecture 1: introduction.
Main course: lectures 2 – 22: various kinds of derivatives and their applications.
Dessert: Lectures 23 – 24: theory vs. reality; high-level issues.
This course is different from other derivative courses at HKUST
(e.g., MATH 4511, IEDA 3330, IEDA 4331)
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Our course is less technical.
Our course teaches many real-world cases, applications, and stories.
Math is necessary, but economics, intuitions, and reasoning are more important.
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Outline
1. What Is A Financial Derivative?
2. Why Are Derivatives Important?
3. Who Are The Users of Derivatives?
4. How Are Derivatives Traded?
5. The Evolution of Derivatives Markets?
6. How are derivatives created?
7. Summary
8. Goals and Plans
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Outline
1. What Is A Financial Derivative?
2. Why Are Derivatives Important?
3. Who Are The Users of Derivatives?
4. How Are Derivatives Traded?
5. The Evolution of Derivatives Markets?
6. How are derivatives created?
7. Summary
8. Goals and Plans
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What is a financial derivative?
Definition: A derivative is a financial security or contract whose payoff depends on, or is
derived from, the value of the “underlying” asset, index, or goods
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The “underlying” can be
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financial assets (stocks, bonds, exchange rates, interest rates)
commodities (oil, gold, wheat)
intangible goods (CO2 allowance, patent, license)
events (corporate default, sovereign default, natural catastrophe)
natural condition indices (temperature, precipitation, snow)
combined indices (multiple stocks, multiple events)
Examples: forwards, futures, options, ...
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A contract that gives investors the right, but not the obligation, to buy 100 shares of
Apple at $700 per share in exactly 300 days (Option)
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A contract that requires investors to buy 100 shares of Apple at $700 per share in
exactly 300 days (Forward or Futures)
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A contract that pays investors $1 if the democratic party wins the presidential election,
$0 otherwise (Exotic Option)
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Outline
1. What Is A Financial Derivative?
2. Why Are Derivatives Important?
3. Who Are The Users of Derivatives?
4. How Are Derivatives Traded?
5. The Evolution of Derivatives Markets?
6. How are derivatives created?
7. Summary
8. Goals and Plans
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Example I: the Swiss watchmaker
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The business:
A Swiss manufacturer of luxury watches agrees to deliver a shipment to a major U.S.
retailer in December for the upcoming holiday season. The watchmaker and retailer
have negotiated a payment of $10 million to be made to the watchmaker upon
delivery.
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The problem:
What if the U.S. dollar’s value against the Swiss franc deteriorates? ⇒ reduced profit
for Swiss firm.
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Q: Can you find a way to eliminate the risk of exchange rate fluctuations?
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The solution:
Enter into a long position in December Swiss franc futures, which will effectively lock
in the exchange rate now for the US dollar payment due in the future.
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Example II: Alpha asset management
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The business:
Alpha Asset Management has been investing in the stocks of a gold mining company
for the last 5 years, and has an unrealized capital gain of 50 million dollars.
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The problem:
For tax reasons, the fund does not want to sell its shares and realize the profits this
year. However, the portfolio manager is concerned that the stock price might fall in
the future.
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Q: Can you find a way to “lock in” the profit without selling the shares?
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The solution:
Buy at-the-money put option on the stock, which allows the fund to sell the shares at
the current price in case the stock price falls in the future.
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Example III: index fund manager
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The business:
You are the portfolio manager of an S&P500 index fund. You are evaluated based on
the tracking errors — how closely your daily portfolio return tracks that of the index.
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The problem:
When markets become volatile, tracking the index becomes more difficult, and
tracking errors tend to rise, which affects your performance.
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Q: Is there a way to “insure” yourself against the risk of deteriorating tracking
performance at times of high volatility?
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The solution:
Enter into a variance swap on the S&P 500 index, which pays off when market
volatility rises.
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House prices rose and then fell...
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Defaults and delinquencies increased
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Example IV: “The Big Short”
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The business:
It is 2006. You believe that the housing market is overheated, and that a major
correction in house prices will cause large amount of mortgage defaults, leading to big
losses in subprime loans particularly.
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The problem:
You can’t short houses. Housing stocks can be costly to short.
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Q: How can you make a bet against the housing market at a large scale?
The solution:
John Paulson shorted collateralized debt obligations, whose performance depends on
the performance of a pool of mortgage securities; he also bought credit default swaps,
a contract that pays off when mortgage debt goes bad, and sold short the ABX
subprime index.
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Example V: Corporate managerial compensation
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The business:
You are a non-executive board director of a public technology firm. To provide
incentives to the CEO who controls the firm, you and other board members decide to
compensate your CEO with firm shares with selling restrictions. This imposes a
firm-specific performance exposure on the CEO’s compensation. This restricted stock
compensation scheme can exert more efforts from the CEO.
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The problem:
If the CEO dislikes risks, potentially profitable but risky projects will be avoided
intentionally. This can be inefficient for the firm’s shareholders. Sometimes, missing
good opportunities to the competitors may fail the firm.
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Q: How can you enhance the compensation scheme to guarantee CEO’s incentive
while not missing good yet risky opportunities?
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The solution:
On top of stocks, you can also compensate the CEO with call options on the firm’s
stock so that he/she receives more when the project succeeds but is insured when the
project fails.
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Summary of importance
Derivatives play a central role in transferring risks in the economy:
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To hedge risks (Swiss watchmaker, index fund tracking).
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To speculate or make a bet (“the big short”).
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To circumvent market restrictions (“the big short”).
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To lock in a profit (alpha asset management).
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To reduce transaction cost (alpha asset management).
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To design managerial compensation considering incentive-risk tradeoff (managerial
compensation) .
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Many others ...
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Outline
1. What Is A Financial Derivative?
2. Why Are Derivatives Important?
3. Who Are The Users of Derivatives?
4. How Are Derivatives Traded?
5. The Evolution of Derivatives Markets?
6. How are derivatives created?
7. Summary
8. Goals and Plans
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Derivatives users
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End-users
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individuals
non-financial institutions, e.g.
I corporate firms
I governments
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financial institutions, e.g.
I pension funds, insurance companies, commercial banks, regional banks, investment banks
I mortgage providers, building societies
I mutual funds, hedge funds, money-market funds
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Market-makers
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large dealer banks (business units or subsidiaries of commercial banks, investment banks
or investment companies)
I e.g. Bank of America Merrill Lynch, Citigroup, Goldman Sachs, JP Morgan Chase, Morgan
Stanley, ...
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independent dealers (firms solely involved in broker-dealer services)
I e.g. LPL Financial LLC, Lincoln Financial Network, Ameriprise Financial Services Inc., ...
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Corporate firms trade derivatives
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ISDA 2009 survey: over 94% of Fortune 500 firms use derivatives for financial risk
management
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Fortune-500-traded derivatives: by sector and type
Source: ISDA 2009 Survey
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Fortune-500-traded derivatives: by countries
Source: ISDA 2009 Survey
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Outline
1. What Is A Financial Derivative?
2. Why Are Derivatives Important?
3. Who Are The Users of Derivatives?
4. How Are Derivatives Traded?
5. The Evolution of Derivatives Markets?
6. How are derivatives created?
7. Summary
8. Goals and Plans
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Exchange-Traded Derivatives (ETD)
Definition: Derivative products that are traded via specialized and standardized
derivatives exchanges.
Characteristics of exchanges:
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Physical locations
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Central clearing house: an exchange centralizes the communication of bid and offer
prices to all direct market participants
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Little counter-party risk: margin posted from both sides of trades to act as a “good
faith” deposit
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Standardized contracts on underlying assets, contract size, maturity, ...
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Transparent public information on prices and trades
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Liquid and stable for smoothing trading among end-users
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Examples of traded securities: futures, options (on stocks and futures)
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Major derivatives exchanges
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Chicago Mercantile Exchange (CME)
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Over-The-Counter (OTC) derivatives
Definition: Derivative contracts that are traded (and privately negotiated) directly
between two parties (market-makers and end-users), without going through an exchange
Characteristics of OTC markets:
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OTC markets have never been a “place”
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Dealers act as market makers by quoting prices and trading with their customers
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More counter-party risk
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Customized and exotic contracts
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Opaque information on prices and trades
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Systemic risk: less liquid and instable because dealers can withdraw from market
making at any time and the whole market is crashed if a few dealers are distressed
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Examples of traded securities: swaps, forwards, exotic options
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Summary of derivatives market structure
Market Makers:
(broker-dealers)
reporting dealers
Clearing member firms
OTC Markets
Exchanges
No locations
NYMEX, CBOT & CME
Central Clearing
Transparent
Negotiation, Clearing
Opaque
End Users: institutions such as
Dealers, non-dealer financial institutions,
corporates, and governments.
End Users: individuals & institutions
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Example: derivatives markets vs. types
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Outline
1. What Is A Financial Derivative?
2. Why Are Derivatives Important?
3. Who Are The Users of Derivatives?
4. How Are Derivatives Traded?
5. The Evolution of Derivatives Markets?
6. How are derivatives created?
7. Summary
8. Goals and Plans
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Market size: OTC vs. Exchanges
Data sources: BIS on derivatives and IMF on world GDP
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Derivatives markets in 2004 ($258 trillion)
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Derivatives markets in 2010 ($601 trillion)
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Derivatives markets in 2017 ($532 trillion)
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A brief history
Rapidly-growing and tremendously-massive markets (over $500 trillion in notional value)
Not only the size, but also the range of the underlying “assets”
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70’s ⇒ Foreign Exchange (FX) Futures, Equity Options, Treasure Bond (T-bond)
Futures
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80’s ⇒ Foreign Exchange (FX) Swaps, Interest Rate Swaps, Options on Futures,
Swaptions, Asian options
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90’s ⇒ Exotic Options, Catastrophe Options, Mortgage Backed Securities
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00’s ⇒ Credit Derivatives, Energy derivatives, Weather derivatives, Collateralized
Debt Obligations
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Next? ⇒ Liquidity? Political Risk?
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A case study on swaps market development
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1970s: strict regulation on FX transactions
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Consider a US company and a UK company:
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Difficulty for companies to fund investments in foreign subsidiaries
Capital control across borders.
US company wants to fund capital investments in UK
=⇒ transfer dollars into UK and transfer UK profits back to US
UK company wants to fund capital investments in US
=⇒ transfer pounds into US and transfer US profits back to UK
Problem: Regulation prohibits transfer of funds
Solution: Foreign Exchange Swaps
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UK company borrows (dollars) in US
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US company borrows (pounds) in UK
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The two then swap payments to service debt and profits transfers
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Funding the foreign subsidiary
US Bond Market
Issue
Dollar Bond
UK Bond Market
USD Coupon
Issue
Pound Bond
UKP Coupon
US company
(in US)
UK company
(in UK)
Regulation
UK subsidiary
(in US)
Dollar
Investment
Pound
Investment
US subsidiary
(in UK)
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Solution: swap
US Bond Market
UK Bond Market
USD Coupon
UKP Coupon
US company
(in US)
Swap
Agreement
UK company
(in UK)
Issue
Pound Bond
Issue
Dollar Bond
USD Coupon
UK subsidiary
(in US)
UKP Coupon
US subsidiary
(in UK)
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Necessary and even vital, but we face challenges
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1993: Metallgeselschaft. Losses ∼ $1.3 Bil.
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1994: Procter & Gamble. Losses ∼ $ 200 Mil.
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Seller of liquidity
2006: Amaranth. Losses ∼ $3 Bil
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Short straddle on the Nikkei Futures
1998: LTCM. Losses ∼ $3.5 Bil.
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Interest rate derivatives
1995: Barings. Losses ∼ $1.3 Bil.
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Levered swap
1994: Orange County. Losses ∼ $1.5 Bil.
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Oil futures
Gas futures
2007-2009: Credit Crisis
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Credit derivatives and Structured CDOs
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Outline
1. What Is A Financial Derivative?
2. Why Are Derivatives Important?
3. Who Are The Users of Derivatives?
4. How Are Derivatives Traded?
5. The Evolution of Derivatives Markets?
6. How are derivatives created?
7. Summary
8. Goals and Plans
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Financial innovation created new derivatives in recent years
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Derivatives are created by financial engineers to make profits.
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An interesting example is collateralized debt obligations (CDOs).
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Financial system channels resources to uses
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Mortgages: Loans collateralized by houses
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Solution: securitization redistributes mortgage risks
CDOs are constructed in two steps:
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Pool underlying securities (mortgages, but also corporate bonds, loans etc).
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Sell claims to parts of the cash fiows on the pool (“tranches”).
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Outline
1. What Is A Financial Derivative?
2. Why Are Derivatives Important?
3. Who Are The Users of Derivatives?
4. How Are Derivatives Traded?
5. The Evolution of Derivatives Markets?
6. How are derivatives created?
7. Summary
8. Goals and Plans
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Summary
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A derivative is a financial security or contract whose payoff depends on, or is derived
from, the value of the “underlying” asset or index
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It is used for hedging, speculation, profit lock-in, regulatory arbitrage, managerial
compensation, ...
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Over-the-counter and exchange-traded derivatives
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Traded on various types of underlying assets and indices
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Massive and still growing markets
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Challenges
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Outline
1. What Is A Financial Derivative?
2. Why Are Derivatives Important?
3. Who Are The Users of Derivatives?
4. How Are Derivatives Traded?
5. The Evolution of Derivatives Markets?
6. How are derivatives created?
7. Summary
8. Goals and Plans
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Goals and Plans
The main focus of this course includes
(1) Empirical properties and institutional aspects of major derivative products and
markets
(2) Techniques for pricing and hedging of derivative securities
(3) Applications of derivatives in investment and risk management
Our plan (see Syllabus)
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