Chap07 Part I Futures - 01/18/10 Chapter 7 Part I --...

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Unformatted text preview: 01/18/10 Chapter 7 Part I -- Futures 1 Chapter 7 Futures and Options on Foreign Exchange Part I Futures and Futures Markets 01/18/10 Chapter 7 Part I -- Futures 2 Derivative securities A derivative security is a financial instrument whose value depends on the values of other, more basic underlying variables (contingent claims) The variables underlying derivatives are often the prices of traded assets, but do not have to be A stock option is a derivative whose value is dependent on the price of a stock A forward contract is a derivative whose value is dependent on the spot exchange rate Weather derivatives are contracts where the payoff is determined by the average temperature at a particular location Our focus is on currency or foreign exchange derivatives 01/18/10 Chapter 7 Part I -- Futures 3 Derivative securities Derivatives are a very important type of financial instrument Hedging Speculating Arbitrage (recall interest rate parity) Derivatives received a lot of bad publicity in the mid-90smany view derivatives as dangerous and detrimental to the financial system Barings PLC and Nick Leeson Orange County school board Proctor and Gamble 2008 Societe Generale lost $7.2 billion when the stock market turned agains Rogue Traders positions 01/18/10 Chapter 7 Part I -- Futures 4 Forward contracts Our first derivative contract is already under our belts. Recall forward contract is an agreement to buy (long position) or sell (short position) foreign exchange at a certain future time for a certain price (the delivery price). The forward exchange rate is derived from the spot exchange rate, the U.S. interest rate, the foreign interest rate, and the time to maturity. T T T r r S F ] 1 [ ] 1 [ ) / ($ ) / ($ $ + + = 01/18/10 Chapter 7 Part I -- Futures 5 Forward contracts hedging example On March 23, a Canadian corporation knows that it will receive 1,000,000 on June 23 (in 3 months) from a customer in the UK and wants to hedge against exchange rate moves. S($/)=1.6000 today (the receivable would be worth $1,600,000 today), but the spot exchange rate in 3 months is unknown so the value of the receivable is also unknown. 01/18/10 Chapter 7 Part I -- Futures 6 Forward contracts hedging example Choice 1: Do nothing Scenario 1: Convert 1,000,000 at the spot rate in 3 months. Suppose that it is 1.6500 (S T =1.6500). The value of the receivable is $1,650,000 (gains $50,000 due to the depreciation of the dollar) Scenario 2: Convert 1,000,000 at the spot rate in 3 months. Suppose that it is 1.5500 (S T =1.5500). The value of the receivable is $1,550,000 (loses $50,000 due to the appreciation of the dollar) 01/18/10 Chapter 7 Part I -- Futures 7 Forward contracts hedging example Choice 2: Sell pounds forward Scenario 1: The corporation can enter into a forward...
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This note was uploaded on 01/17/2010 for the course FINA 4810 taught by Professor Hamilton during the Spring '08 term at University of Georgia Athens.

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Chap07 Part I Futures - 01/18/10 Chapter 7 Part I --...

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