risk management deri 15c.pdf - Risk Management Matti Suominen Aalto 1 Forwards WHAT ARE FORWARDS AND FUTURES Spot Markets In the spot markets is it for

risk management deri 15c.pdf - Risk Management Matti...

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1 Risk Management Matti Suominen, Aalto
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2 Forwards WHAT ARE FORWARDS AND FUTURES? Spot Markets: In the spot markets, is it for currencies, stocks or bonds, the transactions which take place today are actually settled two or three days after the transaction takes place. In this sense, even the spot markets are forward markets, i.e., you fix the price (or exchange rate) today but the delivery and the payment happen only two or three days later. Forward Markets: In a forward contract you make a firm commitment to buy or sell a certain quantity of, say, currency on some future date (3, 6 or 12 months ahead) at a price, the forward price, which is fixed already today. The forward price is set so that it costs nothing to enter a forward contract. There is typically no physical market place for forward markets but banks make these deals over the counter with companies who want to hedge their positions.
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3 Forward Pricing Example: Price of GM share today = $50 Risk-free interest rate = 3% p.a. 12 months forward price of GM share = F 12 (=price such that it costs nothing to enter a forward contract) Expected dividends over the next 12 months = 0. The forward price can be understood by looking at a buyer’s situation: Buying GM today costs: Buying GM using a forward contract costs:
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4 Forward Pricing The cost of these two alternatives must be the same: PV(F 12 )=$50. a F 12 = $50 x (1+0.03) = 51.5. More generally: The ‘fair’ forward price is: F T t = (S t -PV[dividends]) x (1+r A ) (T-t) where r A is the simple risk-free annual interest rate.
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5 Forward prices versus expected future prices Note that all we have to know in order to determine the forward price is: The current price of the underlying. The interest rate. The length of time until delivery. In our example, the forward price is different from the expected stock price in 12 months time (if investors are risk averse) which is: For instance, if: Market risk premium π = 6% β of GM stock = 1 E(S 12 ) = $50 x (1+ 0.03 + 0.06) = 54.5 Does the fact that today’s forward price for GM stock is below the expected future price of GM mean that you should purchase GM forward contracts today? {Note: To get the expected stock price, we use CAPM: E(R GM )=r f + βπ for the expected return and multiply S 0 x (1+E(R GM ))} ) 1 ( ) ( 0 12 βπ + + × = f r S S E
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6 Futures Futures contracts are like forwards: A contract to buy (or sell) a
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