Scribd
Upload
6 views

UEH AdvancedFM Chapter1

This document provides an introduction to derivatives and financial markets. It defines derivatives as financial instruments whose value is based on an underlying asset. The four main steps of a financial transaction are specified: parties agree on a price, obligations are defined, the transaction is settled, and ownership records are updated. Transactions can occur over-the-counter or on an exchange. Derivatives allow for risk sharing and diversification. They are used for risk management, speculation, and reducing transaction costs. Financial engineering creates new derivative products, while market makers hedge their positions to create markets.

Uploaded by

kalus00123
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
6 views

UEH AdvancedFM Chapter1

This document provides an introduction to derivatives and financial markets. It defines derivatives as financial instruments whose value is based on an underlying asset. The four main steps of a financial transaction are specified: parties agree on a price, obligations are defined, the transaction is settled, and ownership records are updated. Transactions can occur over-the-counter or on an exchange. Derivatives allow for risk sharing and diversification. They are used for risk management, speculation, and reducing transaction costs. Financial engineering creates new derivative products, while market makers hedge their positions to create markets.

Uploaded by

kalus00123
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 23

Advanced Financial Mathematics

Chapter 1
Introduction to derivatives
These notes are greatly inspired from the book Derivatives Markets

Chapter1-Advanced Financial Mathematics-UEH-F2023 2


Definition

• A financial instrument that has a value determined by the price of


something underlying asset.

• It is a contract between two parties that determines future financial


flows.

• An underlying asset can be a commodity or a financial security.

• Example:

Chapter1-Advanced Financial Mathematics-UEH-F2023 3


Overview of financial markets

• Four main steps are highlighted during the transaction of a financial


product:

Chapter1-Advanced Financial Mathematics-UEH-F2023 4


Steps of a transaction
1. A seller and a buyer meet and agree on a price for what is being
traded.

2. The obligations of each party are specified. An intermediary


ensures the smooth execution of the transaction and may require
a deposit from both parties at times.

3. The transaction is settled, and the obligations are fulfilled by


both parties.

4. Ownership records need to be updated.

Chapter1-Advanced Financial Mathematics-UEH-F2023 5


Over-the-counter transactions

In some cases, transactions occur over-the-counter without the


involvement of an intermediary or exchange. These cases
include:
1. To facilitate high-volume transaction without fees.
2. For less standard and less common transactions.
3. To enable the combination of multiple different assets into a
single transaction.

Chapter1-Advanced Financial Mathematics-UEH-F2023 6


The respective sizes of organized markets and over-the-counter (OTC) markets.
(source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying
assets for exchange market.) Chapter1-Advanced Financial Mathematics-UEH-F2023 7
Mesures of market size and activity

• Transaction volume

• Market value:

• Notional value:

• Open interest

Chapter1-Advanced Financial Mathematics-UEH-F2023 8


Chapter1-Advanced Financial Mathematics-UEH-F2023 9
The roles of financial markets
Risk sharing

• The derivative products stemming from these stocks, bonds, or


other underlying assets play similar roles to equities (equity or
shareholders) or bonds (debt).

• The risk-sharing in financial markets is similar to that of insurance.

Chapter1-Advanced Financial Mathematics-UEH-F2023 10


Risk diversification

• Risk sharing is possible when a risk is diversifiable.

• For non-diversifiable risks, derivatives can be used to transfer the


risk to those willing to bear it.

Chapter1-Advanced Financial Mathematics-UEH-F2023 11


The utility of derivative products

• Risk management

• Speculation

• Reduced transaction cost

• Regulayory arbitrage

Chapter1-Advanced Financial Mathematics-UEH-F2023 12


Perspectives on derivative products

• The end-users perspective.

• The market maker persepective.

• The economic observers.

Chapter1-Advanced Financial Mathematics-UEH-F2023 13


Financial engineering
• The main idea behind derivative products is that there are various
ways to create such a product.

• Hedging position: market makers protect their positions (hedging).

• Their reason for existence is to create a market.

Chapter1-Advanced Financial Mathematics-UEH-F2023 14


Buying and short selling financial assets
Transaction cost and bid-ask spread
• bid price:

• ask price :

• bid-ask spread:

Chapter1-Advanced Financial Mathematics-UEH-F2023 15


Bid-Ask spread for options on TESLA stock

Chapter1-Advanced Financial Mathematics-UEH-F2023 16


Example 1 (p.15 DM)

A market maker sets a bid price at $49.75 and an ask price at $50
for a particular asset, with a commission of $15 per transaction.

He finds an individual willing to sell 100 shares of the asset and


another individual willing to buy 100 shares of the asset.

Determine the costs for each party and the market maker's profit
during this transaction!

Chapter1-Advanced Financial Mathematics-UEH-F2023 17


Solution of Example 1

Chapter1-Advanced Financial Mathematics-UEH-F2023 18


Terminologies

We define some terminology related to the buying and selling of


assets.

• Market order:

• Limit order:

Chapter1-Advanced Financial Mathematics-UEH-F2023 19


Terminologies (continued)

• Stop sell order (stop loss) :

• Long position (long) :

• Short position (short) :

Chapter1-Advanced Financial Mathematics-UEH-F2023 20


Short selling

• Selling an asset that one does not own is called "short selling".

Chapter1-Advanced Financial Mathematics-UEH-F2023 21


The main uses of short selling

• Speculation: pour tirer profit d’une baisse de valeur anticipée


d’un actif.

• Financing: to raise a down payment, money right away, like a


loan.

• Hedging: To protect against the decline in the value of an asset


that you own.

• What are possible risks of short selling?

Chapter1-Advanced Financial Mathematics-UEH-F2023 22


Remarks
• In some cases, a lending rate (lease rate) required by the lender is
established as a "lease fee".

• An intermediary will sometimes ensure the proper functioning of


the operation surrounding the short sale

Chapter1-Advanced Financial Mathematics-UEH-F2023 23

You might also like