Futuresforwards_stu - Chapter 19 Futures Contracts and...

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19-2 Chapter 19 Futures Contracts and Forward Rate Agreements Hedging risk
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19-3 Learning Objectives Consider the nature and purpose of derivative products Outline features of a futures transaction Review the types of futures contracts available through a futures exchange Identify why participants use derivative markets and how futures are used to hedge price risk Identify risks associated with using a futures contract hedging strategy Explain and illustrate the use of an FRA for hedging interest rate risk
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19-4 Chapter Organisation 19.1 Hedging Using Futures Contracts 19.2 Main Features of a Futures Transaction 19.3 Futures Market Instruments 19.4 Futures Market Participants 19.5 Hedging: Risk Management Using Futures 19.6 Risks in Using Futures Markets for Hedging 19.7 Forward Rate Agreements (FRAs) 19.8 Summary
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19-5 19.1 Derivative contracts – Futures and FRA volatility Futures contracts and Forward Rate Agreement*** (FRAs) are called derivatives because they derive their price from an underlying physical market product A futures contract is the right to buy or sell a specific item at a specified future date at a price determined today – uncertainty lock the interest rate The risk management function of a derivative-based strategy is to lock-in price today that will apply at a future date. Two main types of derivative contracts 1. Commodity (e.g. gold, wheat and cattle) 2. Financial (e.g. shares, government securities and money market instruments)
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19-6 19.1 Hedging Using Futures Contracts Hedging involves transferring the risk of unanticipated changes in prices, interest rates or exchange rates to another party The change in the market price of a commodity or security is offset by a profit or loss on the futures contract Derivative contracts enable investors and borrowers to protect assets and liabilities against the risk of changes in interest rates, exchange rates and share prices Basic futures strategy rule: conduct a transaction in the futures market today that corresponds with the proposed physical market transaction due at a later date
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19-7 19.1 Hedging Using Futures Contracts (cont.) Example: A farmer wants to sell wheat in a couple of months, but is concerned that the price is going to fall in the mean time. How can the farmer hedge this price risk? Solution Enter into a wheat futures contract to sell If wheat prices fall, the futures contract will rise in value, offsetting the loss in the physical market from the fall in the wheat price If wheat prices rise, the futures contract will fall in value, offsetting the gain in the physical market from a rise in the wheat price
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19-8 Chapter Organisation 19.1 Hedging Using Futures Contracts 19.2 Main Features of Futures Transactions 19.3 Futures Market Instruments 19.4 Futures Market Participants 19.5 Hedging: Risk Management Using Futures 19.6 Risks in Using Futures Markets for Hedging 19.7 Forward Rate Agreements (FRAs) 19.9 Summary
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19-9 19.2 Main Features of Futures Transactions
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