two parties
a. one agrees to buy
b. one agrees to sell
2.
2.
3.
speculate
2.
hedge
a. eliminate uncertainty of future price
physical assets
a. e.g., commodities
2.
financial assets
a. T-bills
b. bonds
c. equities
d. foreign currencies
1
A. Long Position
1.
2.
has removed the uncertainty about price he can pay for asset in future
3.
B. Short Position
1.
2.
has removed the uncertainty about price which he can sell asset for in future
3.
2.
cash settlement
a. calculate who won and who lost and transfer cash
(i) if price > agreed upon (forward) price, short party pays long
(ii) if price < agreed upon (forward) price, long party pays short
2.
be careful: if the second contract is with a different party (than the first contract)
a. you have credit risk (counterparty) risk
(i) the party that has to pay you may default
2
A. End User
1.
B. Dealers
1.
Slide 1
1.
2.
example
a. you want to sell 100,000 shares of X in 90 days
(i) don't want price risk
b. you take short position
(i) locks in sales price
c. contract can be:
(i) physical delivery
(ii) cash settlement
3.
Slide 2
1.
2.
3.
C. Coupon Bonds
1.
2.
3.
4.
A. Eurodollar Deposit
1.
2.
3.
an add-on rate
a. similar to a CD
b. not a discount rate (like T-bill)
4.
5.
6.
Slide 3
2.
3.
parties:
a. long position
(i) party that would borrow the money
(A) long the loan
(i) contract price is the interest rate on loan
(ii) wins if interest rates increase
(A) contract to borrow at below mkt rate
(B) receive payment
b. short position
(i) party that would lend the money
(A) short the loan
(ii) wins if interest rates decrease
(A) right to lend at above market rates
Slide 4
1.
2.
the interest difference would come at the end of the loan period
a. b/c we think of interest as add-on
b. so we calculate PV of interest "savings" (or "excess interest")
3.
2.
3.
4.
Slide 5
2.1567%
$ 215,671.64
Slide 1
0.004555556
$ 99,544,444.44
Slide 2
$ 16,666.67
Slide 3
Assume that the actual 90 day LIBOR (60 days from now -- at expiration) is 4.5%.
Compute the cash settlement payment at expiration and identify which party
makes the payment.
$ 6,250.00
$ 6,180.47
$ 6,180.47
Slide 4
STEP 1: calculate how much the company will receive under the contract.
20MM EUR x 1.25 = 25MM USD
STEP 2: calculate how much the company would have received WITHOUT
the forward contract.
20MM EUR x 1.27 = 25.4MM USD
STEP 3: determine who makes payment.
Your company makes a payment of $400K.
You agreed to receive 1.25 USD (per Euro) when rate turned
out to be 1.27USD.
NOTE: remember that Steps 1 and 2 didn't actually happen.
In other words, we didn't exchange money based on those
steps. These steps were simply the calcuation used to exchange
money in step 3.
Slide 5