Wk 3 - Corporate Finance II LECTURE 3: INTRODUCTION:...

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Corporate Finance II LECTURE 3: INTRODUCTION: FORWARDS, FUTURES & OPTIONS
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Part I REVIEW OF PREVIOUS LECTURE
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Part I: Review of Previous Lecture Review of Previous Lecture Part I: Review of Previous Lecture Summary of the Previous Lecture Topics Learning Objectives
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Previous Lecture Topics Last lecture’s topics. Problem context/definition Measuring returns Measuring risk Variance & covariance Securities and Portfolios Portfolios: Risk & return The CAPM
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Previous Lecture Learning Objectives Last lecture’s learning objectives. Returns calculation. Variance and covariance calculation. Systematic risk (Beta) calculation. Capital market line (CML) Security market line (SML) Using the CAPM to: calculate expected returns calculate expected prices evaluate investment advice
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Part II Today: Forwards, Futures & Options
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Lecture Summary: Outline of Today’s Lecture 1 The Objective 2 Forward Contract 3 Futures Contract 4 Option Contract 5 Examples 6 Homework
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The Objective Recall that Price = PV [Expected future cashflows] = Magnitude and timing of cashflows → E (·) calculation. Probabilities of cashflows → E (·) calculation. Risk and timing of cashflows → PV (·) calculation. The risk of cashflows can make prices go down or up
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The Objective How can we alter this risk? 1 Forecast future cashflows More accurate forecasts → lower risk. Forecasting can be “tricky”, it’s not clear that it always works . Forecasting gives the false impression that risk reduction is costless ! 2 Identify the risk. Identify the impact of this risk on price. Try to reduce or eliminate the risk. Try to increase the risk. Manage the Risks
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The Objective We concentrate on (2), a “newer” and more informative/thoughtful approach. Makes the cost of risk reduction explicit. We can make an informed decision when evaluating the costs vs. benefits. Possible applications are limited only by: 1 Your sound understanding of the principles/basics. 2 Your imagination. 3 Your effort.
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The Objective There are 2 ways to reduce or eliminate risk: “On balance sheet” Smithson’s terms: “Off balance sheet” Some caveats: Use of derivatives may not always be “off balance sheet”.
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The Objective A more accurate description might be . . . ways to reduce or eliminate risk: 1 Using transactions involving the firms real assets/operations. 2 Using transactions involving financial contracts. Over time both will tend to be used. 1 can be slower to execute, can involve longer time frames, have high transaction costs. 2 can be quicker to execute, involve short time frames, have lower transaction costs.
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The Objective Example A domestic company faces foreign exchange risk via the presence of a foreign competitor. Assume the competitor has identical cost structures → The
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This note was uploaded on 05/12/2010 for the course COMMERCE finc at University of Sydney.

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Wk 3 - Corporate Finance II LECTURE 3: INTRODUCTION:...

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