What is a Derivative?

Financial instrument (or an agreement b/w two people) that has a value determined by the price of something else

It is not the contract itself, but how it is used, and who uses it that determines whether or not it is risk-reducing

Uses of Derivatives

Risk management – can use derivatives to hedge your loss


– derivatives can serve as investment vehicles

Reduced transaction costs

– sometimes derivatives provide a lower-cost way to effect a particular financial transaction

Regulatory arbitrage

– it is sometimes possible to circumvent regulatory restrictions, taxes, and accounting rules by trading derivatives

Derivatives provide an alternative to a simple sale or purchase, and thus increase the range of possibilities for an investor seeking to accomplish some goal

Perspectives on Derivatives

End-user perspective

– corporations, investment managers, and investors who enter into derivatives contracts

Market-maker perspective-intermediaries who will buy derivatives from customers who wish to sell, and sell derivatives to customers who wish to buy (they, of course, charge a spread)

Economic observer

– for example, regulators often observe behaviour of derivative market participants when trying to decide how to regulate a certain activity or market participant

Financial Engineering and Security Design

It is generally possible to create a given payoff in multiple ways

Financial engineering

– construction of a given financial product from other products

Implications of financial engineering:

1) Market-makers can hedge their position by creating an offsetting position to whatever he product he buys or sells

2) Products can be customized

3) Possible to improve intuition about a given derivative by realizing that is equivalent to something we already understand

4) Regulatory arbitrage is difficult to stop