FRM Notes 2011 Unit IIB Forward and Futures Contracting

FRM Notes 2011 Unit IIB Forward and Futures Contracting -...

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Version: January 3, 2011 FIN 7400: Financial Risk Management II. TOOLS AND APPLICATIONS OF MARKET RISK MANAGEMENT B. Forward and Futures Contracting The forward and futures markets are quite large. The Bank for International Settlements reported that in June 2010 interest rate forward market has notional principal of about $56.2 trillion and market value of about $81 billion. The currency forward market has notional principal of about $25.6 trillion and market value of $925 billion. The global futures markets in 2009 had volume of about 8.2 billion contracts. This figure is difficult to truly understand, however, because the contracts of quite diverse sizes and many commodity contracts, which are measured in quantities of a commodity. Forward Contracts A forward contract is a transaction between two parties, a buyer and a seller, for the buyer to purchase an asset from the seller at a fixed price at a future date. The contract is privately negotiated between the parties, is subject to limited regulatory oversight and exposes each party to the possibility of default of the other. The fixed price agreed upon by the parties is called the forward price. Settlement at expiration is either by physical delivery of the asset or an equivalent exchange of cash. That is, suppose party A agrees to buy an asset from party B for €100 in one year. A year later when the contract expires, the asset price in the market is €110. If the contract is by physical delivery, party B delivers the asset (worth €110) to party A, who pays party B €100. If the contract is for cash settlement, party B simply pays party A €10. Other than the logistics and transaction costs, the two procedures have the same value. (Cash-settled forward contracts are often called nondeliverable forwards. ) All forward contracts specify the delivery procedure when the contract is initiated. Forward contracts exist strictly in the over-the-counter market. Each party assumes the risk that the other will default. We shall talk more about the event of default and credit risk in Unit III. Our primary focus in this course is on foreign currency and interest rate forwards. There are forward contracts on commodities and equities, but we will not cover them. At the initiation of a forward contract, the value of the contract is zero. The present value of the commitment is zero for both parties, and neither pays any money to the other. We show later why this is so, but it has nothing to do with the expected price the parties expect to prevail at expiration. The forward contract’s payoff is based on a certain amount of notional principal. The Unit IIB Notes Page 1 of 29 D. M. Chance, LSU
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Version: January 3, 2011 FIN 7400: Financial Risk Management formula is used to determine the payoff reflects the size (notional principal) of the contract.
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FRM Notes 2011 Unit IIB Forward and Futures Contracting -...

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