Corporate Finance 2 - Lesson 7

CHAPTER 11

DERIVATIVES MARKETS

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The Purpose of Futures andForward Markets

The purpose is to eliminate the price riskinherent in transactions that call for futuredelivery– of money,– a security,– or a commodity.

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Forward Exchange Markets

• Buying/selling of a specified amount, price,and future delivery date of foreigncurrency.

• Direct relationship between buyer andseller.

• Foreign exchange dealers earn revenues onthe spread between buying and selling.

• Seller delivers at the specified date.

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Futures Markets

• Buying/selling of standardized contractsspecifying the amount, price, and future deliverydate of a currency, security, or commodity.

• Buyers/sellers deal with the futures exchange, notwith each other.

• A specific trade (buy/sell) involves a hedger and aspeculator.

• Delivery seldom made -- buyer/seller offsetsprevious position before maturity.

• Futures contracts expire on specific dates.

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Spot versus Futures Market

• Trading for immediate or very-near-termdelivery is called the spot market.

• Trading for future delivery -- futuresmarket.

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A Position in the Futures Market

• Long -- an agreement to buy (purchase) inthe future.

• Short -- an agreement to sell (deliver) inthe future.

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Margin Requirements

• Initial margin -- small percentage depositrequired to trade a futures contract.

• Daily settlements -- reflect gains/lossesdaily and cash payments.

• Maintenance margin -- minimum depositrequirements on futures contracts.

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Futures Exchanges

• Competition between exchanges is keen.• Contract innovation is common.• Exchanges advertise and promote heavily.• Exchange specifies terms of a contract.

– Dates.– Denomination.– Specific items that can be delivered.– Method of delivery.– Minimum daily price variance.– Rules for trading.

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Futures Markets Participants

• Hedgers attempt to reduce or eliminateprice risk.

• Speculators accept the price risk in turn forexpected return.

• Traders speculate on very-short-termchanges in future contract prices.

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Risks in the Futures Markets

• Basis risk -- risk of an imperfect hedge becausethe value of item being hedged may not alwayskeep the same price relationship to the futurescontracts.

• Cross-hedges -- using the futures market tohedge a dissimilar commodity or security.

• Related-contract risk -- risk of failure due to aunanticipated change in the business activitybeing hedged, such as a loan default orprepayment.

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Risks in the Futures Markets(concluded)

• Manipulation risk -- risk of price lossesdue to a person or group trading (buying orselling) to affect price.

• Margin risk -- the liquidity risk that addedmaintenance margin calls will be made bythe exchange.

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Swaps Compared to Forwards andFutures

• Swaps are like forward contracts in that theyguarantee the exchange of two items in thefuture, but a swap only transfers the net amount.

• Swaps do not pre-specify the terms of trade as doforward contracts. Prices are conditional onchanges in a indexed interest rate such as T-bills.

• Swaps are used to hedge interest rate risk as arefinancial futures. Credit risk differences betweenthe parties provide the economic incentive toswap future interest flows.

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Swaps Compared to Forwards andFutures, cont.

• Swaps are used to hedge interest rate riskas are financial futures.

• Credit risk differences between the partiesprovide the economic incentive to swapfuture interest flows.

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Swap Dealers

• Serve as Counter-parties to both Sides ofSwap Transactions

• Dealers negotiate a deal with one party,then seek out other parties with oppositeinterests and write a separate contract withthem.

• The two contracts hedge each other andthe dealer earns a fee for serving bothparties.

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Swaps Have Limited Regulation

• Bank regulators require risk-based capitalsupport for swap-risk exposure.

• Other swap competitors, investment banksand life insurance companies have noregulatory capital costs.

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Example of a Swap

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Options

• Right to buy or sell

– an item

– at a predetermined price (strike price)

– until some future date.

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Options versus Futures Contracts

• The option at the strike price exists overthe period of time, not at a given date.

• The buyer of an option pays the seller(writer) a premium which the writer keepsregardless of whether or not the option isever exercised.

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Options versus Futures Contracts,cont.• The option does not have to be exercised

by the buyer;• The option can be sold if it has a market

value, before the expiration date.• Gains and losses are unlimited with futures

contracts; with options the buyer can loseonly the premium and the commission paid.

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Calls and Puts

• Call option -- buyer has the option to buyan item at the strike price.

• Put option -- buyer has the option to sellan item at the strike price.

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Covered and Naked Options

• Covered option -- writer either owns thesecurity involved in the contract or haslimited his or her risk with other contracts.

• Naked option -- writer does not have orhas not made provision to limit the extentof risk.

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Gains and Losses on Options andFutures Contracts