Hedging Instruments: Futures, Forwards, Options, and Swaps

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Overview. Derivatives and Shifting RiskHedging vs. SpeculatingForward

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Hedging Instruments: Futures, Forwards, Options, and Swaps

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1. Hedging Instruments: Futures, Forwards, Options, and Swaps Reading: Siklos, Chapter 15

2. Overview Derivatives and Shifting Risk Hedging vs. Speculating Forward & Futures Origins & Workings Options Types & Examples How Important is Hedging?

3. Hedging Hedge: engage in a financial transaction that reduces or eliminates risk Basic hedging principle: Hedging risk involves engaging in a financial transaction that offsets a long position by taking a short position, or offsets a short position by taking a additional long position

4. Taking A Position Taking a position means deciding whether you wish to buy or sell an asset in the future If a financial institution has bought an asset and has therefore taken a long position, it conducts a hedge by contracting to sell the asset at some future date (i.e. taking a short position). If a financial institution has taken a short position by selling a security that it needs to deliver at a future date, then it conducts a hedge by contracting to buy that security (i.e. take a long position) at a future date.

5. Hedging vs. Speculating Hedging involves an attempt to reduce risk in financial market transactions Speculation involves an attempt to profit via the acceptance of greater risk The Key concept is the notion that hedgers and speculators have opposite expectations about future financial asset prices

7. Forward and Futures Markets Futures and Forward contracts are both agreements to buy/sell some (financial) asset at a future date at a price negotiated today Despite their similarities there are subtle but important differences between the two types of contracts

8. Forward vs. Futures Contracts. Forward Contracts Delivery likely Product may or may not be standardized Bilateral transaction Generally over the phone Self-regulated Futures Contracts Offset likely Standardized product Intermediary involved Auction setting Regulated by agencies

9. Pros and Cons of Forward Contracts Pros Can be as flexible as the two parties want them to be. Cons Difficulty in finding a counterparty to make the contract with. Lack of “market liquidity” – ease of carrying out financial transactions Subject to default risk

10. A Transaction in the Forward Market

11. The Workings of Futures Contracts (cont’d) Ft(t) – futures contract price at time t for delivery at time t S(t) – spot price at time t The basis: Ft(t) - S(t) Mark-to-Market: gains and losses are tallied on a daily basis Understanding futures prices

12. Hedging in Interest Rate Futures Long Hedge: investor expects bond prices to rise in the cash market (the yield to fall) and can offset the risk of making the wrong bet via higher futures prices Short Hedge: investor expects bond prices to fall in the cash market (the yield to rise) and can offset the capital loss via a profit from lower futures prices

13. Financial Options The right to buy (a call) or sell (a put) a financial asset at a price negotiated today The buyer of a call is protected against an unexpected price increase in the spot market The buyer of a put is protected against an unexpected fall in the price of an asset in the spot market

22. The Value of an Option

23. Factors Affecting Premium 1. Higher strike price ? lower premium on call options and higher premium on put options Greater term to expiration ? higher premiums for both call and put options 3. Greater price volatility of underlying instrument ? higher premiums for both call and put options

24. Options: A Simple Numerical Example

25. Swaps A SWAP is an agreement to swap interest rates or foreign exchange for a pre-agreed future period Uncertainty about future interest rates and exchange rates and differences in expectations about them creates an opportunity to exchange payment flows Banks act as intermediaries between the parties to a transaction who want to exchange a floating rate for a fixed rate debt, or vice-versa

27. Interest-Rate Swap Contract

28. How Important is Hedging? Since the 1970s, the world has become a riskier place for financial institutions. Volatility in interest rates and the bond and stock markets have increased significantly. Hedging through financial derivatives is extremely useful for risk reduction. Interest rate risk Foreign exchange risk

29. Summary Investors who wish to reduce risk do so via hedging; others are speculators Futures, forwards, and options are the main types of derivative products that reflect the desire to hedge Derivatives have become increasingly important financial instruments in Canada

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