L22_CIRF - Today(read Ch 11 of Levich Currency and interest...

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1 Lecture 22 Currency and interest rate futures 1 Today (read Ch 11 of Levich) Currency and interest rate futures Distinctions between forward and futures Description of future contracts Margin requirement of future contracts Pricing future contracts Lecture 22 Currency and interest rate futures 2 Futures Market A financial contract in which settlement of the transaction happens at a future date while all other financial aspects of the transaction are fixed today. Example: A future contract to purchase 1oz gold at $35 in 3 months Actual settlement: transaction actually occurs Cash settlement: gain or loss 3 month later: market price of gold is $40 for 1 oz gold Receive $5 Dominant: cash settlement
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2 Lecture 22 Currency and interest rate futures 3 Forwards v.s. Futures A binding contract executed today for settlement at a future specified date Problem: possibility of default when market price differs from contracted price, one of the two parties will have an incentive to get out of the deal Forward contracts: only with people of high character, reputation, and credit quality Futures contracts: both counterparties post a “good- faith bond” held by a third party Lecture 22 Currency and interest rate futures 4 Forwards v.s. Futures If forwards and futures essentially do the same thing (allow one to buy the right to transact at a given price) why do both kinds of contracts exist? Hint: Note that the forward is itself a derivative security – one could use interest bearing securities to obtain forward delivery of a currency. Answer:
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3 Lecture 22 Currency and interest rate futures 5 Distinctions: Operation Forwards Futures Traded in the dispersed interbank market 24h. Lacks price discovery. Traded in centralized exchanges during specified trading hours. Exhibits price discovery. Transactions are customized and flexible to meet customer preferences. Transactions are highly standardized to promote trading and liquidity. Lecture 22 Currency and interest rate futures 6 Distinctions: delivery and settlement Forwards Futures delivered on the date of maturity which is set between the provider and the customer Delivered on specific dates in the year Settled on the date of maturity Settled daily on the exchange’s clearing house
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4 Lecture 22 Currency and interest rate futures 7 Distinctions: margins and credit risk Forwards Futures Counterparty risk is variable . The clearinghouse standardizes the counterparty risk. No cash flows take place until the final maturity of the contract. Daily cash may flow in or out of the margin account, which is marked to market . Risk borne by each party Little credit risk Lecture 22 Currency and interest rate futures 8 Forwards Futures Self-regulating Regulated by commissions or agencies Presented by bid-ask spread Commissions paid to brokers
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5 Lecture 22 Currency and interest rate futures 9 Development of Futures Contracts
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This note was uploaded on 04/12/2008 for the course ECON 442 taught by Professor Chari during the Winter '08 term at University of Michigan.

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L22_CIRF - Today(read Ch 11 of Levich Currency and interest...

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