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Corporate Finance 2 - Lesson 7
CHAPTER 11
DERIVATIVES MARKETS
2Corporate Finance 2 - Lesson 7
The Purpose of Futures andForward Markets
The purpose is to eliminate the price riskinherent in transactions that call for futuredelivery– of money,– a security,– or a commodity.
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Forward Exchange Markets
• Buying/selling of a specified amount, price,and future delivery date of foreigncurrency.
• Direct relationship between buyer andseller.
• Foreign exchange dealers earn revenues onthe spread between buying and selling.
• Seller delivers at the specified date.
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Futures Markets
• Buying/selling of standardized contractsspecifying the amount, price, and future deliverydate of a currency, security, or commodity.
• Buyers/sellers deal with the futures exchange, notwith each other.
• A specific trade (buy/sell) involves a hedger and aspeculator.
• Delivery seldom made -- buyer/seller offsetsprevious position before maturity.
• Futures contracts expire on specific dates.
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Spot versus Futures Market
• Trading for immediate or very-near-termdelivery is called the spot market.
• Trading for future delivery -- futuresmarket.
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A Position in the Futures Market
• Long -- an agreement to buy (purchase) inthe future.
• Short -- an agreement to sell (deliver) inthe future.
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Margin Requirements
• Initial margin -- small percentage depositrequired to trade a futures contract.
• Daily settlements -- reflect gains/lossesdaily and cash payments.
• Maintenance margin -- minimum depositrequirements on futures contracts.
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Futures Exchanges
• Competition between exchanges is keen.• Contract innovation is common.• Exchanges advertise and promote heavily.• Exchange specifies terms of a contract.
– Dates.– Denomination.– Specific items that can be delivered.– Method of delivery.– Minimum daily price variance.– Rules for trading.
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Futures Markets Participants
• Hedgers attempt to reduce or eliminateprice risk.
• Speculators accept the price risk in turn forexpected return.
• Traders speculate on very-short-termchanges in future contract prices.
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Risks in the Futures Markets
• Basis risk -- risk of an imperfect hedge becausethe value of item being hedged may not alwayskeep the same price relationship to the futurescontracts.
• Cross-hedges -- using the futures market tohedge a dissimilar commodity or security.
• Related-contract risk -- risk of failure due to aunanticipated change in the business activitybeing hedged, such as a loan default orprepayment.
11Corporate Finance 2 - Lesson 7
Risks in the Futures Markets(concluded)
• Manipulation risk -- risk of price lossesdue to a person or group trading (buying orselling) to affect price.
• Margin risk -- the liquidity risk that addedmaintenance margin calls will be made bythe exchange.
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Swaps Compared to Forwards andFutures
• Swaps are like forward contracts in that theyguarantee the exchange of two items in thefuture, but a swap only transfers the net amount.
• Swaps do not pre-specify the terms of trade as doforward contracts. Prices are conditional onchanges in a indexed interest rate such as T-bills.
• Swaps are used to hedge interest rate risk as arefinancial futures. Credit risk differences betweenthe parties provide the economic incentive toswap future interest flows.
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Swaps Compared to Forwards andFutures, cont.
• Swaps are used to hedge interest rate riskas are financial futures.
• Credit risk differences between the partiesprovide the economic incentive to swapfuture interest flows.
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Swap Dealers
• Serve as Counter-parties to both Sides ofSwap Transactions
• Dealers negotiate a deal with one party,then seek out other parties with oppositeinterests and write a separate contract withthem.
• The two contracts hedge each other andthe dealer earns a fee for serving bothparties.
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Swaps Have Limited Regulation
• Bank regulators require risk-based capitalsupport for swap-risk exposure.
• Other swap competitors, investment banksand life insurance companies have noregulatory capital costs.
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Example of a Swap
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Options
• Right to buy or sell
– an item
– at a predetermined price (strike price)
– until some future date.
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Options versus Futures Contracts
• The option at the strike price exists overthe period of time, not at a given date.
• The buyer of an option pays the seller(writer) a premium which the writer keepsregardless of whether or not the option isever exercised.
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Options versus Futures Contracts,cont.• The option does not have to be exercised
by the buyer;• The option can be sold if it has a market
value, before the expiration date.• Gains and losses are unlimited with futures
contracts; with options the buyer can loseonly the premium and the commission paid.
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Calls and Puts
• Call option -- buyer has the option to buyan item at the strike price.
• Put option -- buyer has the option to sellan item at the strike price.
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Covered and Naked Options
• Covered option -- writer either owns thesecurity involved in the contract or haslimited his or her risk with other contracts.
• Naked option -- writer does not have orhas not made provision to limit the extentof risk.
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Gains and Losses on Options andFutures Contracts