ActSc371_Lecture 30_Chapter 26 (Ross)

ActSc371_Lecture 30_Chapter 26 (Ross) - ActSc 371 Corporate...

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Lecture 30 Chapter 26 Derivatives and Hedging Risk (Corporate Finance by Ross et al.) ActSc 371 – Corporate Finance 1 Instructor: Dr. Lysa Porth 1
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Introduction Derivative: financial instrument whose payoffs and values are derived from, or depend on, something else. Derivatives are generally used: as an instrument to hedge risk - tools for changing the firms risk exposure (hedging – risk reducing). speculative purposes - used to change or even increase the firm’s risk exposure (speculating- risk enhancing) Call options are quite complicated examples of derivatives. Most derivatives are forward or future agreements or what are called swaps.
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26.1 Forward Contracts A forward contract specifies that a certain commodity will be exchanged for another at a specified time in the future at prices specified today. A forward contract does the following: Specifies the quantity and exact type of the asset or commodity the seller must deliver. Specifies delivery logistics, such as time, date, and place. Specifies the price the buyer will pay at the time of delivery. Obligates the seller to sell and the buyer to buy, subject to the above specifications.
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26.1 Forward Contracts It’s not an option: both parties are expected to hold up their end of the deal. There is no initial payment or premium required to enter a forward contract (apart from commissions and bid-ask spreads). The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.
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Forward Example Forward contracts are simply tailor made future contracts. If you agree with your friend to buy his text book from him when he is finished with corporate finance, you have agreed to a forward contract. If on September 1st you agreed to pay for the book and pick it up at a later date- you are buying a forward contract on September 1st. Your friend is selling a forward contract on September 1st. Cash changes hands only when the text book changes hands. The only difference between a normal every day cash transaction and a forward contract is the time between agreeing to buy the book and receiving the book. Every time a business orders some materials that can’t be delivered immediately they are entering a forward contract. They are agreeing to pay today’s price for the materials when they arrive. The only difference from a cash transaction is the time in between.
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26.2 Futures Contracts: Preliminaries A futures contract is like a forward contract: It specifies that a certain commodity will be exchanged for another at a specified time in the future at prices specified today. A futures contract is
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This note was uploaded on 12/16/2011 for the course ACSTC 371 taught by Professor Lisaporth during the Fall '11 term at Waterloo.

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ActSc371_Lecture 30_Chapter 26 (Ross) - ActSc 371 Corporate...

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