Module 7: Derivative Securities

(BUSFIN 4221 – Investments)

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Instructor:	Andrei S. Gonçalves
E-mail:	Andrei_Goncalves@kenan-flagler.unc.edu
Website:	andreigoncalves.com/BUSFIN4221

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Welcome to Module 7!

Download the class slides here and the “to print” version here.

The previous two modules detailed Debt and Equity markets. These markets expose investors to a lot of risks. One natural question is: how can we get rid of part of this risk?

Derivatives can give us the answer. A derivative security is “a contract in which the payout depends on (or derives from) the value of other underlying asset/variable”. By creating a payout that moves in the opposite direction relative to the price of a given underlying security, a derivative can provide “insurance” for positions on that underlying security.

Obviously, for you to buy insurance, someone needs to sell it. Sometimes the other side of the trade just has different risk exposure in comparison to you and you are both really buying insurance (against opposite risks). However, sometimes the other side of the trade is just willing to bear the risk. As such, derivatives can add risk to a portfolio as much as they can reduce it (it all depends on how you use it).

In this module, we will learn how to use derivatives to add and reduce risk. We will illustrate the point by focusing on the most famous types of derivatives (Futures, Forwards, Swaps, and Options). The focus will be on the “Risk x Insurance” aspect of derivatives as opposed to valuation techniques because pricing derivatives is a long topic that deserves an entire class. However, I will at least introduce the logic of non-arbitrage as a general principle to price derivative contracts.