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2Financial_forwards_futures

2Financial_forwards_futures - Financial Forwards and...

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Financial Forwards and Futures Financial Forwards and Futures Chapter 5 Chapter 5 Today’s agenda Financial futures and forwards Stocks, indices, currencies Interest rate derivatives will be covered separately Pricing forwards on non-dividend paying assets Pricing forwards on dividend paying assets (stock) Detecting arbitrage opportunities; arbitrage strategies Limits of arbitrage Futures contracts Index futures Currency forwards and futures Covered interest arbitrage Limits of arbitrage
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Review: forward contracts Section 2.1 Forward contracts are binding agreements to buy/sell assets at a prespectified future date T and a pre-determined price. Payoff of: Long forward = Spot price at expiration - forward price Short forward = Forward price - spot price at expiration To close out a long forward contract you need to enter into a short forward contract with the same maturity as the initial contract. Cash flow at T: (S T -F t,T )+(F t’,T -S T )=F t’,T -F t,T Alternative ways to buy an asset Section 5.1 Four payment/delivery combinations 1. Outright purchase: ordinary transaction 2. Fully leveraged purchase: investor borrows the full amount 3. Prepaid forward contract: pay today, receive the asset later 4. Forward contract: agree on price now, pay/receive later
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Prepaid forward contracts Supplemental material In July 1999, the Company entered into a prepaid forward gold sales contract (the “Prepaid Forward”) […]. Under the Prepaid Forward, the Company agreed to sell 483,333 ounces of gold, to be delivered in June of each of 2005, 2006 and 2007 in annual installments of 161,111 ounces (the “Annual Delivery Requirements”). The Company also agreed under the Prepaid Forward to deliver semi-annually 17,951 ounces of gold, from June 2000 through June 2007 (the “Semi-Annual Delivery Requirements”) for a total gold delivery obligation over the life of the Prepaid Forward of 752,598 ounces. At the time the Prepaid Forward was entered into, the Company received net proceeds of $137.2 million ($145.0 million of gross proceeds before transaction costs of $653,000 and the purchase of a $7.1 million surety bond to guarantee delivery of the Annual Delivery Requirements). Newmont Mining, 2004 Annual Report Pricing prepaid forwards Section 5.2 Prepaying for future delivery of a commodity is known as a 'gold trade,' because it is the way gold bullion has been trading for centuries. If we can price the prepaid forward ( F P ), then we can calculate the price for a forward contract: F = Future value of F P Three possible methods to price prepaid forwards Pricing by no arbitrage Pricing by discounted present value Pricing using logic For now, assume that there are no dividends.
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Pricing prepaid forwards by (no) arbitrage Arbitrage: A situation in which one can generate positive cash flow with no net investment and no risk.
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