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Unformatted text preview: 1 Money Markets and Finance Money Markets and Finance Lecture 9 Lecture 9 Arbitrage: Forwards and Futures Contracts Arbitrage: Forwards and Futures Contracts 1. Lecture Overview 1. Lecture Overview In the course of todays lecture we will discuss forward and futures contracts . These contracts belong to a larger class of instruments called derivatives . Derivatives is the name given to the class of instruments as they derive their value from some underlying asset. Todays lecture will focus on discussing: What forward and futures contracts are; The characteristics of forward and futures contracts; and, How forward and futures contracts are valued. We will consider how derivatives can be used to hedge the risks faced by a firm in Lecture 11. 2. What is a Forward Contract? 2. What is a Forward Contract? A forward contract is a contract made today for delivery of an asset at a pre-specified time in the future at a price agreed upon today: The buyer (the person in the long position) of a forward contract agrees to take delivery of an underlying asset at a future time, T , at a price agreed upon today. No money changes hands until time T ; The seller (the person in the short position) agrees to deliver the underlying asset to the person in the long position at a future time, T , at a price agreed upon today. Again, no money changes hands until time T ; and, A forward contract, therefore, simply amounts to setting a price today for a trade that will occur in the future. Both parties are obliged to fulfill their obligations under a forward contract. 2. What is a Forward Contract? 2. What is a Forward Contract? Forward contracts are traded over the counter rather than on a centralized exchange. The over-the-counter market is an informal market involving trades between a buyer and a seller of a security. Also: One of the parties is often an investment bank; The terms of the contract (size, timing, etc.) are customized for the clients (ie agreed upon by buyer and seller in each contract); and, Performance of the contract is not guaranteed by any third party, so each party bears the credit risk of the other (ie the risk that the other party will default). 2. What is a Forward Contract? 2. What is a Forward Contract? Example: Forward Contract A wool farmer is expecting to yield 2,500 kilograms of greasy wool from his sheep exactly 3 months from today. To eliminate the risk of a decline in the price of greasy wool before the harvest, the farmer can sell the 2,500 kilograms of wool forward. Imagine that a fashion house is willing to take the other side of the contract. Given this: The two parties agree today on a forward price of 800 cents per kilogram ($20,000 in total), for delivery three months from now; No money changes hands now; and, In three months, the farmer delivers the 2,500 kilograms of greasy wool to the fashion house in exchange for $20,000. Note that this price is fixed and does not depend upon the spot price of wool at...
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This note was uploaded on 10/13/2011 for the course FINM 1001 taught by Professor Miss during the Three '10 term at Australian National University.
- Three '10