HAPTER 13 - FINANCIAL DERIVATIVES
What are the four main financial markets?
forward contracts, futures, options, future options, swaps, etc.
Generally, a derivative security "derives" its value from the price movements in some
underlying commodity, currency, common stock, stock index, T-bill, interest rate, etc.
It is like a "side bet."
Why do derivative markets exist? Largely to facilitate hedging, the derivative
markets are largely
We saw in the last few chapters how interest
rate risk played an important role in the S&L crisis. We also studied the potential
adverse effects of currency risk on an international firm's profits. Firms, like
individuals, are "risk averse" and would like to protect themselves against the three
main types of risk that businesses face:
PRICE RISK, CURRENCY RISK and
INTEREST RATE RISK.
In this chapter, we look at futures contracts, and study the important role that they
play in risk management and risk-sharing by allowing firms to hedge risk. The text
focuses specifically on financial derivatives (used to hedge interest rate risk), but we
will consider a broader coverage of futures.
SPOT MARKET vs. FORWARD/FUTURES MARKET:
In the spot (cash)
market, buyers and sellers agree on Price (P) and Quantity (Q) for immediate delivery
(or within a few days).
Ford buys 1m German marks in the spot market
for currency, or it buys 1m pounds of steel in the cash market for steel. Or Mars
Candy Company buys 1m pounds of sugar in the cash market. Northwest Airlines
buys 500,000 gallons of gasoline in the spot market.
private contracts between two parties (buyer and
seller) agreeing to an exchange in the future. Buyer and seller agree on Price and
Quantity today, for delivery sometime in the future (one month, one year, ten years).
Forward contracts are private contracts, and are therefore not marketable securities,
there is no secondary market, e.g. like the difference between a bank loan (not
marketable) and a bond (marketable). We studied forward rates and forward contracts
for foreign exchange in Chapter 7.
Jolly Green Giant Co., or Pepsi Cola, enters into a forward contract in May
to purchase corn at harvest time in October, at a guaranteed price, from various
farmers for their entire crop.
buyer (company) and the seller (farmer)
have a guaranteed price. They are now protected from price swings in corn, they have
eliminated price risk completely by hedging their position, locking in a price with a
GM enters into a forward contract for British pounds with Bank One, to
either buy pounds or sell pounds, in six months at a guaranteed ex-rate. By locking
in, GM has hedged currency risk.