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Week4_Forwards-1 - Derivatives and Risk Week 4 Forwards...

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4/22/11 Derivatives and Risk Week 4_ Forwards
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4/22/11 Forward Contracts Forward contracts are agreements by two parties to engage in a financial transaction at a future point in time. Although the contract can be written however the parties want, the contact usually includes: The exact assets to be delivered by one party, including the location of delivery The price paid for the assets by the other party
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4/22/11 Forward Contracts An Example of an Interest-Rate Forward Contract First National Bank agrees to deliver £5 million in face value of 6% Treasury bonds maturing in 2023 Rock Solid Insurance Company agrees to pay £5 million for the bonds FNB and Rock Solid agree to complete the transaction one year from today at the FNB headquarters in town
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4/22/11 Forward Contracts Long Position Agree to buy securities at future date Hedges by locking in future interest rate of funds coming in future, avoiding rate decreases Short Position Agree to sell securities at future date Hedges by reducing price risk from increases in interest rates if holding
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4/22/11 Forward Contracts Pros 1. Flexible Cons 1. Lack of liquidity: hard to find a counter- party and thin or non-existent secondary market 2. Subject to default risk—requires information to screen good from bad risk
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4/22/11 Forward Contracts VS an Outright Purchase To purchase an asset entails at least three separate steps: 1. setting the price to be paid 2. Transferring cash from the buyer to the seller 3. transferring the asset from the seller to the buyer An outright purchase all three steps occur simultaneously Purchase via a forward contract step 1 occurs first, step 2/3 occurs in the future i.e., set a price today and the transfer of asset and cash occur at a specified data in the future. Uncertainty on the price movement is mitigated
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4/22/11 Forwards Contracts Traded OTC No obligation for forward contracts to be standardised, and the terms are at the discretion of the parties involved (amounts/dates/size). Forwards contract will be held to maturity Is a legally binding agreement between two identified parties This will be the BANK and the COMPANY Exposed to risk of non-performance by the
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4/22/11 Forward Contracts vs. Futures Contracts Contract usually closed out Private contract between 2 parties Exchange traded Non-standard contract Standard contract Usually 1 specified delivery date Range of delivery dates Settled at end of contract Settled daily Delivery or final cash settlement usually occurs prior to maturity FORWARD S FUTURE S Some credit risk Virtually no credit risk
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4/22/11 Transaction costs in Forward and Futures Trading Futures markets have very low trading costs One of their major advantages Forward markets have a relatively higher contracting costs.
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