Ch_09_Hedging

Ch_09_Hedging - Using Derivatives to Manage Interest Rate...

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Using Derivatives to Manage Interest Rate Risk 11
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Using Derivatives to Manage n Derivative n Any instrument or contract that derives its value from another underlying asset, instrument, or contract 22
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Using Derivatives to Manage n Derivatives Used to Manage Interest Rate Risk n Financial Futures Contracts n Forward Rate Agreements n Interest Rate Swaps n Options on Interest Rates n Interest Rate Caps n Interest Rate Floors 33
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Characteristics of Financial n Financial Futures Contracts n A commitment, between a buyer and a seller, on the quantity of a standardized financial asset or index n Futures Markets n The organized exchanges where futures contracts are traded n Interest Rate Futures n When the underlying asset is an interest-bearing security 44
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Characteristics of Financial n Buyers n A buyer of a futures contract is said to be long futures n Agrees to pay the underlying futures price or take delivery of the underlying asset n Buyers gain when futures prices rise and lose when futures prices fall 55
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Characteristics of Financial n Sellers n A seller of a futures contract is said to be short futures n Agrees to receive the underlying futures price or to deliver the underlying asset n Sellers gain when futures prices fall and lose when futures prices rise 66
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Characteristics of Financial n Cash or Spot Market n Market for any asset where the buyer tenders payment and takes possession of the asset when the price is set n Forward Contract n Contract for any asset where the buyer and seller agree on the asset’s price but defer the actual exchange until a specified future date 77
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Characteristics of Financial n Forward versus Futures Contracts n Futures Contracts n Traded on formal exchanges § Examples: Chicago Board of Trade and the Chicago Mercantile Exchange n Involve standardized instruments n Positions require a daily marking to market n Positions require a deposit equivalent to a performance bond 88
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Characteristics of Financial n Forward versus Futures Contracts n Forward contracts n Terms are negotiated between parties n Do not necessarily involve standardized assets n Require no cash exchange until expiration n No marking to market 99
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Characteristics of Financial n A Brief Example n Assume you want to invest $1 million in 10-year T-bonds in six months and believe that rates will fall n You would like to “lock in” the 4.5% 10- year yield prevailing today n If such a contract existed, you would buy a futures contract on 10-year T- bonds with an expiration date just after the six-month period n Assume that such a contract is priced 1010
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Characteristics of Financial n A Brief Example n If 10-year Treasury rates actually fall sharply during the six months, the futures rate will similarly fall such that the futures price rises n An increase in the futures price generates a profit on the futures trade n You will eventually sell the futures contract to exit the trade 1111
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Characteristics of Financial n A Brief Example n You will eventually sell the futures
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Ch_09_Hedging - Using Derivatives to Manage Interest Rate...

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