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C HAPTER 13 - FINANCIAL DERIVATIVES What are the four main financial markets? Derivative 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 insurance markets. 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). Examples: 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. FORWARD CONTRACTS: 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. Example: 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. Advantage: 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 forward contract. Example: 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.
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Advantage of Forward Contracts: they are very flexible can be customized to the needs of the parties. Disadvantages of Forward Contracts:
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