Chapter 13 Financial Derivatives. Copyright © 2002 Pearson Education Canada Inc. 13- 2 Spot, Forward, and Futures Contracts A spot contract is an agreement.

chapter 13

Financial Derivatives

Copyright © 2002 Pearson Education Canada Inc. 13- 2

Spot, Forward, and Futures Contracts

• A spot contract is an agreement (at time 0) when the seller agrees to deliver an asset and the buyer agrees to pay for the asset immediately (now)

• A forward contract is an agreement (at time 0) between a buyer and a seller that an asset will be exchanged for cash at some later date at a price agreed upon now

• A futures contract is similar to a forward contract and is normally arranged through an organized exchange

The main difference between a futures and a forward contract is that the price of a forward contract is fixed over the life of the contract, whereas futures contracts are marked-to-market daily


Interest-Rate Forward Markets

Long position = agree to buy securities at future date

Hedges by locking in future interest rate if funds coming in future

Short position = agree to sell securities at future date

Hedges by reducing price risk from change in interest rates if holding bonds

Pros

1. Flexible

Cons

1. Lack of liquidity: hard to find counterparty

2. Subject to default risk: requires information to screen good from bad risk


Financial Futures Markets

Financial futures are classified as • Interest-rate futures • Stock index futures, and • Currency futures

In Canada, financial futures are traded in • Montreal Exchange (which maintains active markets

in short-term and long-term Canadian government bond futures), and

• Toronto Futures Exchange (which maintains active markets in the Toronto 35 and Toronto 100 stock indexes futures)


Widely Traded Interest-RateFutures Contracts


Interest Rate Futures Markets

Interest Rate Futures Contract1. Specifies delivery of type of security at future date2. Arbitrage at expiration date, price of contract = price of the

underlying asset delivered3. i , long contract has loss, short contract has profit4. Hedging similar to forwards

Micro vs. macro hedge

Traded on Exchanges: Global competition

Success of Futures Over Forwards1. Futures more liquid: standardized, can be traded again, delivery of

range of securities2. Delivery of range of securities prevents corner3. Mark to market: avoids default risk4. Don’t have to deliver: netting


Widely Traded Stock Index Futures Contracts


Currency FuturesHedging FX Risk

Example: Customer due 20 million DM in two months, current DM = $0.50

1. Forward agreeing to sell DM 20 million for $10 million, two months in future

2. Sell DM 20 million of futures


Widely Traded Currency Futures


Options

Options Contract

Right to buy (call option) or sell (put option) instrument at exercise (strike) price up until expiration date (American) or on expiration date (European)

Hedging with Options

Buy same # of put option contracts as would sell of futures

Disadvantage: pay premium

Advantage: protected if i , gain if i Additional advantage if macro hedge: avoids accounting

problems, no losses on option when i


Profits and Losses: Options vs. Futures$100,000 T-bond contract,

1. Exercise price of 115, $115,000.

2. Premium = $2,000

Figure 13-1


Factors Affecting Premium

1. Higher strike price lower premium on call options and higher premium on put options

2. Greater term to expiration higher premiums for both call and put options

3. Greater price volatility of underlying instrument higher premiums for both call and put options


Interest-Rate Swap Contract


Hedging with Interest Rate Swaps

Reduce interest-rate risk for both parties1. Midwest converts $1m of fixed rate assets to rate-sensitive

assets, RSA , lowers GAP2. Friendly Finance RSA , lowers GAP

Advantages of swaps1. Reduce risk, no change in balance-sheet2. Longer term than futures or options

Disadvantages of swaps1. Lack of liquidity2. Subject to default risk

Financial intermediaries help reduce disadvantages of swaps

Chapter 13 Financial Derivatives. Copyright © 2002 Pearson Education Canada Inc. 13- 2 Spot, Forward, and Futures Contracts A spot contract is an agreement.

Documents

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