Derivatives: Markets, Valuation, and Risk Management

CHAPTER 22

Key Lessons

The sheer length of this book may give the impression that derivatives are a long and complicated subject. If it were a murder mystery, we might expect hundreds of characters and a complex story line. The irony is that the characters are few—two main characters, a forward and an option, and two supporting characters, a risk-free bond and the underlying asset. And the story line is simple: Two perfect substitutes must have the same price and, therefore, price dynamics. Consequently, the price risk of one instrument can be managed using the other.

This book is about risk management using derivative contracts, that is, how derivatives can be used to effectively manage the different types of risks faced by individuals, corporations, governments, and governmental agencies in their day-to-day operations. For corporate producers such as oil refiners, managing price risk of input costs (i.e., crude oil) as well as output prices (i.e., heating oil and unleaded gasoline) are relevant. For end-users such as airlines, managing its exposure to jet fuel prices is important. Depending upon user, some risks may be acceptable, while others may not. A gold company, for example, may have a thorough understanding of the world's supply and demand for gold production and, consequently, may be better able to predict gold price movements in the short- and long-run. On the other hand, it may have little or no awareness of probable movements in exchange rates. For this company to ...