FIN 620-session 9 lecture

FIN 620-session 9 lecture - FIN 620 Long-Term Financial...

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FIN 620 Long-Term Financial Management Session 9  1. Lecture Notes/Comments In chapter 25, we discuss derivatives and hedging risk. The value of a derivative asset is “derived” from an underlying primary asset. Derivatives can be used to change an individual’s or firm’s risk exposure. Forward Contracts Characteristics: Forward contract – agreement between a buyer (long) and a seller (short) for future delivery of an asset at a price specified today Forward price – price agreed upon today to be paid at a future date when delivery occurs Settlement date – date when delivery occurs and the forward price is paid (received) In a forward contract, both parties are legally bound to execute the transaction in the future at the agreed-upon price, but no money changes hands at the inception of the contract. Here is an example to help explain this concept: Suppose you want to buy a new Ford Mustang convertible as soon as it becomes available. You contract with the dealer to pay a specified price on a specified future date (the delivery date). In essence, a private-market forward contract has been created. You have a long position (buyer) in the underlying asset (Mustang) and the Ford dealer has a short position (seller). Now suppose that after the contract is signed, demand for the car rises so that the market value of the car increases above the agreed-upon price. You have a document that gives you the right to buy the asset at below market prices, and the dealer is obligated to sell at that price. The “long” position wins because prices have increased. Suppose on the other hand, the economy worsens and the demand for cars decreases. This drives the market value of the car lower. The dealer, however, has a contract that forces you to pay the above market price. In this case, the “short” position wins because prices have decreased. What keeps either party from defaulting on the contract? This question is a good lead-in to the discussion of futures, margin and marking-to-market.
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Futures contract – forward contract traded only on an exchange with gains and losses recognized (or marked-to-market) on a daily basis. Typically, futures contracts are divided into two broad categories commodity contracts such as oil, gold, or wheat So what are the major differences between an OTC forward contract and an exchange traded futures contract? Forward Futures Customized Standard features (delivery date, size of contract, quality of asset, etc.) Search cost – use dealers No search cost – contact broker Low liquidity High liquidity Higher default risk – limited to large, creditworthy institutions Virtually no default risk No up-front or intermediate cash flows Initial margin requirements, daily marking- to-market, margin calls No Clearinghouse Clearinghouse that guarantees performance Delivery normally occurs Majority of contracts offset, not delivered How do we ensure that both parties fulfill their end of the contract, particularly if there is
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This note was uploaded on 02/14/2011 for the course FINANCE 620 taught by Professor Halstead during the Fall '09 term at UMBC.

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FIN 620-session 9 lecture - FIN 620 Long-Term Financial...

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