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Derivatives
Defined
Basic Derivatives
Derivative Markets
Exchange-traded futures and options
standardized products trading floor or computerized trading
Use of Derivatiwve
Relevance to Corporate Finance
Hedging: Hedgers use derivatives to reduce the risk that they from potential future movements in the price of an asset related to their business operations. Speculating: Speculators used derivatives to anticipate and attempt to profit by trading on expectations about future direction in the price of an asset. Arbitrage: Arbitrageurs take offsetting positions in the same asset to lock in a profits To change the nature of an asset or liability. To change the nature of an investment without incurring the costs of selling one portfolio and buying another.
Forward Contracts
A forward contract gives the owner the right and obligation to buy an asset on a specified future date at a future price agreed today. The seller of the forward contract has the right and obligation to sell the asset on a specified future date at a future price agreed today. At the end of the forward contract, at delivery, ownership of the good is transferred and payment is made from the purchaser to the seller.
Forward Contracts
Generally, no money changes hands on the origination date of the forward contract. But, collateral may be demanded.
Forward Contracts
Basic Characteristics
Table 11-1 Foreign Exchange Quotes
Foreign Exchange Rates (Canadian dollars per foreign currency) US ($)
Spot 1 month 3 month 6 month 1 year 3 year 5 year 10 year 1.107 1.1063 1.1044 1.1017 1.0971 1.0697 1.0622 1.0312
GB ()
2.040 2.0393 2.0383 2.0368 2.0340 n/a n/a n/a
JAP ()
0.009721 0.009754 0.009821 0.009920 0.010116 n/a n/a n/a
Euro ()
1.3991 1.4007 1.4039 1.4082 1.4159 n/a n/a n/a
Reflects the time value of money and expected exchange rate changes. Forward rates the price TODAY for future delivery, so the further away, the lower the present value.
Source: Data from Bank of Montreal (BMO) Nesbitt Burns, Globe and Mail , June 10, 2006.
Hedging using a forward contract requires that the investor have an opposite exposure to the contract.
This is a covered position.
Speculation on a forward contract requires that the investor NOT own the underlying asset.
This is a naked position a position that leaves the investor exposed to changes in the value of the underlying asset.
The date on which the currency is actually exchanged, the settlement date, is generally two days after the value date of the contract.
Advantages of Hedge: Company knows its costs and can plan its finances accordingly Cost of the hedge is zero - No money is exchanged at inception of the forward FX agreement
Disadvantage of Hedge: Company is still exposed to FX risk if the HRK/EUR spot rate is less than 7.3750 in 3 months
Note: Effect of hedge is same as buying EUR today and holding in an interest-bearing account (Forward FX agreement is NOT a simple speculation)
Unhedged Company must pay: 7.45 x 1,000,000 = HRK 7,450,000 Money saved by hedging: 7,450,000 7,375,000 = HRK 75,000
3% on the kuna
A company with EUR 1 million and a need for HRK in three months should be indifferent ( because of arbitrage opportunities related to Internationa l Rate Parity), as to whether it: Invests the EUR 1 million for 3 months at 1% and converts the euros (plus interest) into HRK at the end of this time, OR Sells the EUR 1 million spot for HRK, and invests the HRK at 3% for 3 months
profit
S <F
S >F
The payoff is linear with 45 degree angle and passes through the forward rate F.
loss
profit
The short profits if the spot price at delivery, S, is below the original forward price, F.
S<F
loss
F=S
S>F
Example: You sell 20 million forward at a forward price of $0.0090/ . At expiration, the spot price is $0.0083/ . Did you profit or did you lose? How much?
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8-35
Exchange
Chicago Board of Trade (CBOT) Chicago Mercantile Exch. (CME) New York Merchantile Exchange NY Cotton Exchange The Commodity Exchange (Comex) London Metal Exchange (LME) Winnipeg Commodity Exchange CBOT CME Montreal Exchange Euronext/Liffe CME
Forward and Future Contracts serve the same purpose. Forward contracts offer more flexibility because they are customized OTC contracts. Forward contracts, however, face additional risks:
Not actively traded (created by a bank for customers) Possess credit risk
Differences are listed in Table 11 3 on the following slide.
Forwards
Contracts Trading Default (credit risk) Initial deposit Settlement Customized Dealer or OTC markets Important Not required On maturity date Standardized Exchanges
Futures
Unimportant - guaranteed by clearinghouse Initial margin and maintenance margin required Marked to market daily
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8-40
8-45
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Forward market when the speculator believes the spot price at some future date will differ from todays forward price for the same date
Options markets extensive differences in risk patterns produced depending on purchase or sale of put and/or call
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An option that would not be profitable, excluding the cost of the premium, if exercised immediately is referred to as outof-the money (OTM)