This presentation contains an introduction to derivatives, what they are and their purpose in finance. The main types of derivatives, the value of derivatives and how it is derived, derivative hedging, option pricing, volatility, and much more will be discussed and explained in the simplest terms for readers with any financial background to understand. For further information regarding derivatives, visit www.finpipe.com and learn more!

1. Derivatives Explained
All of your derivative inquires answered

2. Derivatives are financial
securities whose value
is derived from another
"underlying" financial
security

3. Examples of derivatives include:
Options
Futures
Swaps
Swaptions
Structured notes

4. Derivatives can be used for hedging, protecting against
financial risk, or can be used to speculate on the movement
of commodity or security prices, interest rates or the levels
of financial indices

5. Some derivatives are compared to insurance. Just as you
pay an insurance company a premium in order to obtain
some protection against a specific event, there are
derivative products that have a payoff contingent upon the
occurrence of some event for which you must pay a
premium in advance

6. The valuation of
derivatives makes
use of the
statistical
mathematics of
uncertainty, which
is very complex

7. The value of a derivative is never predetermined. It is
derived from the underlying factors such as asset, index, or
interest rate

8. There are two main types of derivatives:
Linear
Non-linear

9. A linear derivative is one whose
payoff is a linear function. For
example, a futures contract has
a linear payoff in that every
one-tick movement translates
directly into a specific dollar value
per contract.
A non-linear derivative is one
whose payoff changes with time
and space.

10. With non-linear derivatives it is possible to capture gains
from volatility by hedging a portion of the option's value.
This is called the "delta" given by a mathematical formula
derived from the formula used to determine price, and
rebalancing the hedge as spot moves around and the delta
changes

11. The more times we can delta-
hedge the option, the more profit
we will realize!

12. Every time you realize a profit, you help to pay for the
option.
If you own an option and you delta hedge it, you will:
• make money if the stock price goes up
• make money if the stock price goes down

13. At the end of the day,
you will only make
money if you have
realized delta-hedging
profits that are greater
than the premium you
paid away for the
option

14. Option Pricing
Buy an option
• arguing that we will make more money dynamically
hedging around it than we will pay in premium
Sell an Option
• arguing that we will make more money in premium than
we will lose in dynamically hedging the option

15. One of the prime
determinants of the
price of an option is
the volatility

16. Volatility
The measure of how much the spot rate is expected to
move around
• high volatility environment: the spot rate will be expected to move
around aggressively and options premiums are very high
• low volatility environment: the spot rate is expected to move around
very little and options premiums are very low

17. Two characteristics of
volatility:
volatility is not constant; it
changes over time
volatility is statistically
persistent; it trends

18. Credit risk is a significant element of the galaxy of
risks facing the derivatives dealer and the
derivatives end-user
Risk of Default
• Most obvious form of risk
• Default means that the counterparty to which one is exposed
will cease to make payments on obligations into which it has
entered because it is unable to make such payments
• This is the worst case credit event that can take place

19. For more financial education
regarding derivatives, visit
www.finpipe.com