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Lecture 10 Notes MANAGING RISK WITH DERIVATIVE SECURITIES Forwards Futures Microhedge vs Macrohedge Options Swaps Comparisons --Off-balance-sheet instruments. --Interest rate risk, foreign exchange risk, credit risk exposures. FORWARDS Forward Contract: Contractual agreement between a buyer and a seller at time 0 to exchange a prespecified asset for cash at some later date. The price is fixed over the life of the contract. Exmp: A 3-month forward (to deliver 20-year bonds) price at time 0 of $97 per $100 of face value means that in 3 month’s time the seller delivers $100 of 20-year bonds and receives $97 from the buyer. --Participants take a position in forward contracts because the future spot price or interest rate is uncertain. --Once a party has agreed to a forward position, canceling the deal prior to expiration is generally difficult. --Bilateral contracts subject to counterparty default risk. --Participants of the forward markets: Commercial banks, investment banks, broker- dealers. Hedging with Forward Contracts: --Hedging the interest rate risk. Exmp: Suppose a PM holds a 20-year, $1 million face value gov’t bond. At time 0, these bonds are valued at $97 per $100 of face value. Forecast: r to rise by 2% to 10% in next 3 months. (Bond prices will fall!) 20-year maturity bond. Duration: 9 years.
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Capital loss: -$161,667 Percentage loss: 16.67% (from $97 to $80.833) What can be done to offset this loss? Hedge this position by selling $1 million face value of 20-year bonds for forward delivery in 3 month’s time at $97 for every $100 of 20-year bonds. Basis risk: Residual or unhedgeable risk.
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