economics 330 money and banking lecture 18 n.
Download
Skip this Video
Loading SlideShow in 5 Seconds..
Economics 330 Money and Banking Lecture 18 PowerPoint Presentation
Download Presentation
Economics 330 Money and Banking Lecture 18

Loading in 2 Seconds...

play fullscreen
1 / 13

Economics 330 Money and Banking Lecture 18 - PowerPoint PPT Presentation


  • 144 Views
  • Uploaded on

Economics 330 Money and Banking Lecture 18. Prof. Menzie Chinn TAs: Chikako Baba, Deokwoo Nam. Chapter 13 (7/e, 8/e Alt.). Financial Derivatives. Hedging. Hedge: engage in a financial transaction that reduces or eliminates risk Basic hedging principle:

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Economics 330 Money and Banking Lecture 18' - kristopher


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
economics 330 money and banking lecture 18

Economics 330Money and BankingLecture 18

Prof. Menzie Chinn

TAs: Chikako Baba,

Deokwoo Nam

chapter 13 7 e 8 e alt

Chapter 13 (7/e, 8/e Alt.)

Financial Derivatives

hedging
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

interest rate forward markets
Interest-Rate Forward Markets

Long position = agree to buy securities at future date

Hedges by locking in future interest rate if funds coming in future

Short position = agree to sell securities at future date

Hedges by reducing price risk from change in interest rates if holding bonds

Pros

1. Flexible

Cons

1. Lack of liquidity: hard to find counterparty

2. Subject to default risk: requires information to screen good from bad risk

financial futures markets
Financial Futures Markets

Financial Futures Contract

1. Specifies delivery of type of security at future date

2. Arbitrage  at expiration date, price of contract = price of the underlying asset delivered

3. i, long contract has loss, short contract has profit

4. Hedging similar to forwards

Micro vs. macro hedge

Traded on Exchanges: Global competition

Regulated by CFTC

Success of Futures Over Forwards

1. Futures more liquid: standardized, can be traded again, delivery of range of securities

2. Delivery of range of securities prevents corner

3. Mark to market and margin requirements: avoids default risk

4. Don’t have to deliver: netting

hedging fx risk
Hedging FX Risk

Example: Customer due 10 million DM in two months, current DM=$1

1. Forward contract to sell 10 million euros for $10 million, two months in future

2. Sell 10 million of euro futures

options
Options

Options Contract

Right to buy (call option) or sell (put option) instrument at exercise (strike) price up until expiration date (American) or on expiration date (European)

Hedging with Options

Buy same # of put option contracts as would sell of futures

Disadvantage: pay premium

Advantage: protected if i, gain if i

Additional advantage if macro hedge: avoids accounting

problems, no losses on option when i

profits and losses options vs futures
$100,000 T-bond contract,

1. Exercise price of 115, $115,000.

2. Premium = $2,000

Profits and Losses: Options vs. Futures
factors affecting premium
Factors Affecting Premium

1. Higher strike price  lower premium on call options and higher premium on put options

2. 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

interest rate swap contract
Interest-Rate Swap Contract

1. Notional principle of $1 million

2. Term of 10 years

3. Midwest SB swaps 7% payment for T-bill + 1% from Friendly Finance Co.

hedging with interest rate swaps
Hedging with Interest-Rate Swaps

Reduce interest-rate risk for both parties

1. Midwest converts $1m of fixed rate assets to rate-sensitive assets, RSA, lowers GAP

2. Friendly Finance RSA, lowers GAP

Advantages of swaps

1. Reduce risk, no change in balance-sheet

2. Longer term than futures or options

Disadvantages of swaps

1. Lack of liquidity

2. Subject to default risk

Financial intermediaries help reduce disadvantages of swaps