Essay about forward and future

Essay about forward and future Essay about forward and future Futures and Forward: Basics ïÆ' ¼ ïÆ' ¼ ïÆ' ¼ ïÆ' ¼ Payoff Market Mechanics What drives the gains from trade? Reading: Ch. 2 What is a Derivative? Definition: A derivative is a financial instrument (contracts) whose value is based on the value of other underlying assets Type of Contract Underlying Assets Forward/ Future Investment Asset Options Commodity Swap Stock Price Interest Rate Exchange Rate †¦.. Energy: gas, Oil Corn Weather derivatives †¦. Road Map Payoff Type of Contract Underlying Assets Forward / Future Investment Asset Options Commodity Strategy Swap Pricing Fin330_Chang 3 Plans for Forwards/Futures ï  ¬ Basics ï  ¬ ï  ¬ ï  ¬ ï  ¬ Hedging Strategies (Ch.3) ï  ¬ ï  ¬ ï  ¬ Payoff and mechanics of Forward and Futures (Ch.2) What drives the gains from trade? Presentation 1: OTC vs. Centralized market How to hedge properly as a firm/trader? Presentation 2 : the use of derivatives Pricing ï  ¬ ï  ¬ Interest rates basics (Ch. 4) Arbitrage pricing (Ch. 5) Fin330_Chang 4 How Big Is the Derivative Market? Source: Bank of International Settlements (www.bis.org) Fin330_Chang 5 Forward Contracts ï  ¬ Definition: a binding agreement (obligation) to buy/sell an underlying asset at a predetermined date in the future, at a price set today ï  ¬ A forward contract specifies ï  ¬ ï  ¬ ï  ¬ The features and quantity of the asset to be delivered The â€Å"expiration date† The price the buyer will pay at the time of delivery: â€Å"the forward price† Agreement 0 Fin330_Chang Settlement/Delivery T time 6 Features of Forward Contracts ï  ¬ Features of Forward Contracts ï  ¬ ï  ¬ ï  ¬ ï  ¬ ï  ¬ Customized Non-standard and traded over the counter (not on exchanges) No money changes hands until maturity Non-trivial counterparty risk Futures contracts are the same as forwards in principle except for some institutional and pricing differences. Fin330_Chang 7 Notation ï  ¬ ï  ¬ ï  ¬ ï  ¬ S0: Spot price at time 0 ST: Spot price at time T F0: Forward/Futures price at time 0 T: Time until delivery date (in years) Fin330_Chang 8 Payoff on Forward Contracts ï  ¬ The payoff on a forward contract is its value at expiration. ï  ¬ Payoff on a long position = Spot price at expiration – Forward price = ST – F0 ï  ¬ Payoff on a short position = Forward price – Spot price at expiration = F 0– S T Fin330_Chang 9 Payoff on Forward Contracts ï  ¬ The payoff on a forward contract is its value at expiration. ï  ¬ ï  ¬ Fin330_Chang Agrees to buy the asset at time T Payoff on a long position = Spot price at expiration – Forward price = ST – F0 (Pay F0 and get something worth ST) Agrees to sell the asset at time T Payoff on a short position = Forward price – Spot price at expiration = F 0 – ST (Get F0 for something worth ST) 10 At expiration Payoff Diagrams Long Position: Payoff = Spot – Original Futures Price = ST – F0 (at expiration) ST Fin330_Chang Short Position: Payoff = Original Futures Price - Spot = F0 – ST (at expiration) ST 11 Cash Settlement ï  ¬ ï  ¬ An alternative settlement procedure Instead of requiring delivery of the asset, two parties make a net cash payment, which yields the same cash flow as if delivery had occurred ï  ¬ Why? ï  ¬ ï  ¬ A physical transaction likely have transaction costs Example: The stock index ST=$1040 ; F0 =$1020 ï  ¬ Fin330_Chang Net payment $20 from the short position to the long 12 Example: Gold-diggers A gold-mining firm enters a short forward contract, agreeing to sell gold at a price of $850/oz. in 1 year ï  ¬ What is the payoff on this short forward position? ï  ¬ Fin330_Chang ST 13 Questions ï  ¬ Why entering this contract? ï  ¬ Who might want to take the long position of this contract? Fin330_Chang 14 Why entering this contract?