Lecture_11_-_Arbitrage-_Forwards_Futures_and_Options_Contracts_as_Tools_for_Risk_Management

Lecture_11_-_Arbitrage-_Forwards_Futures_and_Options_Contracts_as_Tools_for_Risk_Management

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Money Markets and Finance Lecture 11 Arbitrage: Options, Forwards and Futures Contracts as Tools for Risk Management 1. Lecture Overview Today, we will focus on how we can use derivatives to minimise exposure to the following risks: – Price risk; – Foreign exchange risk; and, – Interest rate risk. Specifically, during the course of the lecture, we will consider how we can use forwards, futures and options contracts to hedge the above three risks. 2. What is Risk Management? We will begin with a simple example. Suppose it is September and your company has just agreed to make a sale of machines to a Japanese customer in December. Further: The sale price is 80 million Japanese Yen payable at the end of the December, with the cost of making and marketing the product equal to 750,000 Australian dollars; The forward exchange rate for December is 80 (meaning that you can enter into a contract to receive 1 Australian Dollar for each 80 Japanese Yen in December); and, Based on the forward rate of 80, the sale is worth 80 million Yen / 80 = 1 million Australian dollars giving a profit of 250,000 Australian dollars. 2. What is Risk Management? However, if by December the exchange rate has moved to 160 (meaning one Australian dollar is worth 160 Japanese Yen), and you did not lock in the forward rate of 80 in September, the 80 million Yen we receive will be worth 80 million / 160 = 500,000 Australian dollars. Since the cost of making and selling the product is 750,000 Australian dollars, the company will make a loss of 250,000 Australian dollars. The problem here is that the company’s profit or loss depends upon : It’s core business (making and marketing its products); and It’s foreign exchange speculation business. 2. What is Risk Management? Most companies are good at their core business but no good at all at secondary business such as foreign exchange speculation: Risk management is a way of minimising exposure to non- core activities such as price fluctuations, foreign exchange fluctuations and interest rate fluctuations; and, A company engaged in an appropriate risk management program can be assured that a profitable transaction will not be made unprofitable solely by the above fluctuations. We will now consider managing each of the risks by way of detailed examples. 3. Price Risk Consider the following scenario: – You are a fund manager holding a portfolio that mimics the ASX 200 index; – The ASX 200 Index started the year at 4,000 and is currently at 4,800; – The manager’s fund was valued at $80 million at the beginning of the year; and, – Since the fund has already generated a handsome return for the year, the manager wishes to lock in a value for the portfolio today.
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3. Price Risk Given the preceding information, you can lock in the current value of the fund using either forwards / futures or option contracts.
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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.

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Lecture_11_-_Arbitrage-_Forwards_Futures_and_Options_Contracts_as_Tools_for_Risk_Management

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