RSM333 lecture8 - Forwards Futures and Swaps Outline I Derivative securities II Forward contracts III Pay-off and pricing of forward contracts IV

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Forwards, Futures and Swaps 8 Outline I. Derivative securities II. Forward contracts III. Pay-off and pricing of forward contracts IV.Future contracts V. Swaps: structure and valuation
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1 Sabrina Buti, Rotman School of Management, RSM 333 Derivative Securities s A derivative is a financial instrument whose payoffs and values derive from, or depend on, some other underlying asset. s There are two basic types of derivative securities: 1. Forwards, futures, and swaps 2. Options
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2 Sabrina Buti, Rotman School of Management, RSM 333 Why do we use derivatives? s To speculate – that is, to make bets on the future direction of some underlying asset. s To reduce your risk profile . Risks that can be mitigated through derivatives are: 1. Exchange risk 2. Credit risk 3. Interest rate risk When a firm reduces its risk profile using these tools, it is said to be hedging .
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3 Sabrina Buti, Rotman School of Management, RSM 333 s A wheat farmer is worried that the current price for wheat, $3/bushel, may drop to $1/bushel, by the time the farmer is able to harvest it. s The flour mill operator is happy to purchase wheat at $3/bushel, but is worried that the price may increase to $5/bushel in a few months. s The wheat farmer and the flour mill operator may make a deal that the farmer will sell his wheat to the flour mill operator in 3 months time for $3/bushel, regardless of the price of wheat at that time. s If wheat prices rise, the wheat farmer will regret the deal, but the flour mill operator will be thankful, and vice versa if the price falls. These are forward/future contracts. They are not options . They are firm commitments to make a transaction in the future, at a price agreed to at the present. Example: Forward contracts (1)
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4 Sabrina Buti, Rotman School of Management, RSM 333 s On April 1 st , the farmer and the flour mill operator agree to exchange 1,000 bushels of wheat at $3 per bushel in four months – Underlying asset: wheat – Flour mill operator: long position – Farmer: short position – Maturity, T: August 1 st – Forward price, F T (0) = $3 s What will happen in four months? Example: Forward contracts (2)
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5 Sabrina Buti, Rotman School of Management, RSM 333 Forward contracts - Payoffs -1 10 9 8 7 6 0 1 2 3 4 5 -2 1 0 -3 2 3 Payoffs per bushel ($) Wheat price S T ($) Long position (flour mill) Short position (farmer) Forward price F T (0)
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6 Sabrina Buti, Rotman School of Management, RSM 333 Forward/spot contracts s A forward contract is an agreement to buy or sell an asset at a certain future time for a certain price that is established today. DIFFERENT FROM s A spot contract is an agreement to buy or sell an asset today.
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7 Sabrina Buti, Rotman School of Management, RSM 333 Long/short position s The party that agrees to buy the underlying asset on a specified future date is said to assume a long position . s
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This note was uploaded on 04/23/2011 for the course RSM 333 taught by Professor Sabrinabutti during the Spring '11 term at University of Toronto- Toronto.

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RSM333 lecture8 - Forwards Futures and Swaps Outline I Derivative securities II Forward contracts III Pay-off and pricing of forward contracts IV

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