Financial Trend

FIN 6406 Corporate Finance

Week 1 Part 1B

An Overview of Derivatives

Summary of Topics
• Overview of derivatives – Forward contracts – Futures contracts – Options – Swaps

Forward Contracts
• Two parties to contract, each with a basic position: – One party is “long” (buy). Obligates party to buy the underlying asset at some fixed price at a specified date in the future. – One party is “short” (sell). Obligates party to sell the underlying asset at some fixed price at a specified date in the future. • Terms – Forward price – Delivery date (expiration date) • Forward contracts are common for currencies.

Hedging Risk with Forward Contracts
• A wine importer in the United States might plan on purchasing French wine with Euros in the fall. Could lock in the currency exchange rate for the fall by taking a long position in a euro currency forward contract. • A computer manufacturer in the United States might plan on selling computers to German company in fall, with the payment in Euros. Could lock in exchange rate by taking a short position in euro forward contract. • Both parties have reduced risk by locking in the exchange rate.

Problems with Forward Contracts
• Forward contracts are made directly between two parties, so there is the possibility of default (although banks often are one of the parties in each transaction, in effect acting as “middlemen”). • Forward contracts are often designed for a specific need, so there is not a standardized contract, which makes it difficult to have a secondary market. • Futures contract solve these problems.

Futures Contracts
• Similar to forwards, except: – Marking-to-market – Many more assets- agriculture, livestock, metals, indexes, currencies, interest rates, energy – Standardized contracts that trade on exchanges, such as CBOT

Options7
• Basic Positions – Call / Put – Long / Short (writer) • Terms – Exercise Price – Expiration Date (can let expire unexercised) – Assets- Stocks, indexes,... [continues]

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