LEC5 - 1 ACCG329 Lecture 5: Forwards and Futures 2009,...

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Unformatted text preview: 1 ACCG329 Lecture 5: Forwards and Futures 2009, Semester 1 Egon Kalotay What are Derivatives? A derivative security is a financial asset whose value derives from that of another (underlying) asset Examples: options, futures, swaps, equity, and an infinite variety of variations and possibilities for the payoff structure and the underlying. Derivatives are useful, interesting, challenging and controversial Pricing of derivatives is typically arbitrage based (preference free) 2 Uses of Derivatives Hedging: Derivatives are used to reduce risk through reducing or eliminating exposure to market prices. Speculation: Derivatives can be used to bet on the value or outcome of the underlying. Arbitrage: Derivatives are used to exploit mispricing. In its purest form, an arbitrage strategy is risk free. Valuation and Hedging Based on the idea of replication and the absence of riskless moneymaking opportunities many examples Basis of Risk Neutral Pricing or the idea that, under circumstances, we can price assets as if investors were risk neutral (without believing or assuming that they are). 3 Forwards and Futures: Definitions Forward Contract: is an agreement to trade (one party buys from the other) the underlying asset at a price agreed upon when the contact is originated. Payment occurs at a predetermined maturity. No cash flows prior to maturity. Futures Contract: can be thought of as a standardised, exchange traded contract for one party to buy for future delivery, and the other to sell for future delivery the underlying asset. Gains and losses on futures positions are settled daily. Forward Contract Payoffs K Price of Underlying at Maturity Payoff Long Forward K Payoff Price of Underlying at Maturity Short Forward 4 Forwards: Example Application Suppose a trader wishes to lock in a price at which to close out a short position in 1,000 Art Mart P/L shares in exactly 3 months from April 1, 2006. The current share price is $100, and the risk free interest rate is 12%. He thus negotiates a deal to enter (long) into a forward contract maturing on June 30, 2006 to buy 1,000 Art Mart shares at a forward price of $103.04 per share Forwards: Example Application 1 April 06 1 May 06 1 June 06 30 June 06 5 Replicating a Forward Contract: Simple (No Income) Case To replicate the long position in a forward contract: Borrow the amount required to buy the underlying asset now at the spot price and purchase Repay the borrowing and accrued interest at maturity Limits on the Forward Price?...
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This note was uploaded on 08/13/2011 for the course ACCG 329 taught by Professor Egonkalotay during the Three '09 term at Macquarie.

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LEC5 - 1 ACCG329 Lecture 5: Forwards and Futures 2009,...

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