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Week2_Equity_Stock Index Futures - Derivatives and Risk...

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Derivatives and Risk Weeks 2-4 Futures and Forwards (Week 2- Equity/Stock Index Futures)
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Learning Outcomes By the end of this part of the module, you should be able to: Understand the basic concepts of futures and forwards Be able to explain the sources of financial markets risk. Be able to use forwards/futures in taking risk or managing risk.
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Hedging Hedging is the tai chi of trading Jim Kharouf Futures, October, 1996 Hedging is a type of transaction designed to reduce or eliminate risk.
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Why Hedge Firms hedge to save taxes, reduce bankruptcy costs and in some cases, because managers want to reduce the risk of their own wealth, which is tied to their firm’s performance Hedging is also done in the course of offering risk management services for clients and possibly because shareholders cannot hedge as effectively as firms
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Difference between Hedge and Speculation Hedge: a position in the futures market is accompanied by an opposite position in the spot market The hedger does not necessarily have to have a long or short position in the spot market. A hedge can be established if the hedger is reasonably certain of taking a future position in the spot market. The hedge protects against price changes in the interim period until the spot transaction is made. A speculative strategy is not normally accompanied by a transaction or contemplated transaction in the spot market.
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Short Hedge and Long Hedge Distinguish hedges that involve short and long positions in the derivative contracts. A hedger who holds an asset and is concerned about a decrease in its price Short hedge: Long Spot + Short Futures A hedger who plans to buy an asset and is concern about an increase in its price Long hedge: Short Spot + Long Futures
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Convergence of Convergence of Forwards/Futures to Spot Forwards/Futures to Spot Time Time (a) (b) Forward/Futures Price Forward/Futures Price Spot Price Spot Price
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The Basis Hedging entails the assumption of basis risk The uncertainty of the basis over the hedge period Basis is defined as the spot price minus the future price Basis= Spot Price-Future Price
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Hedging and The Basis T=Time point of expiration (say a particular month, day, and year) t = time point prior to expiration (t=0 implies “today”) S 0 = spot price today f0=future price today S T =spot price at expiration f T =future price at expiration Profit (short hedge)= Spot market profit + future market profit =(S T - S 0 ) + (f 0 – f T ) =(S T - f T ) – (S 0 - f 0 ) =Basis at the T - Initial basis Profit (long hedge)= Spot market profit + future market profit =(S 0 - S T ) + (f T - f 0 ) =(S 0 - f 0 ) – (S T - f T ) = Initial basis – Basis at the T Perfect hedging means there is no basis risk, i.e. hedging profit is zero
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Hedging Contract Choice The future contract used for hedging should be liquid and should be on an asset that is highly correlated with the asset being hedged.
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