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Risk Management Using Derivatives: Forwards and Futures

This document provides an overview of forward contracts and how they are used to manage risk. It defines a forward contract as an agreement between two parties to buy or sell an asset at a predetermined price on a future date. Forward contracts allow parties to mitigate price risk but do not protect against other risks like counterparty default. The key differences between forwards and futures are also outlined, with futures being standardized exchange-traded contracts that have greater liquidity and no counterparty risk. The document discusses pricing models for forwards and how their value is determined based on factors like the spot price, interest rates, and cash flows. Hedging strategies using long and short forward positions to offset risks from holding, buying, or selling underlying assets are also described

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36 views

Risk Management Using Derivatives: Forwards and Futures

This document provides an overview of forward contracts and how they are used to manage risk. It defines a forward contract as an agreement between two parties to buy or sell an asset at a predetermined price on a future date. Forward contracts allow parties to mitigate price risk but do not protect against other risks like counterparty default. The key differences between forwards and futures are also outlined, with futures being standardized exchange-traded contracts that have greater liquidity and no counterparty risk. The document discusses pricing models for forwards and how their value is determined based on factors like the spot price, interest rates, and cash flows. Hedging strategies using long and short forward positions to offset risks from holding, buying, or selling underlying assets are also described

Uploaded by

reshma
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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MODULE II

RISK MANAGEMENT USING


DERIVATIVES
Forwards and Futures

FORWARD CONTRACTS
A promise to deliver a good at the terms agreed upon
today
There are two parties. One party agrees to buy the
underlying asset and the other party agrees to sell the
same
The remaining terms of the contract like the price,
date, quality, quantity, location of delivery etc. are
negotiated and agreed upon at the time of entering
into the agreement
The party that agrees to buy the asset forward is said
to be long and the counter party is said to be short

FORWARD CONTRACTS
A agrees to pay B Rs. 75 in a months time in
return for delivery of a specified quantity of
coffee.
On the delivery day, the transaction will be
settled by B delivering the agreed upon amount
of coffee in return for the assured payment of
Rs.75.

SPOT VS FORWARDS
Exchange of security and cash happens immediately
in a spot transaction, while in forwards this happens
on a later date, terms and conditions in both are laid
down at the time of entering into the contract
Spot transation time line

0
1
2
PRICE AGREED
AND PAID +
SECURITY DELIVERED

SPOT VS FORWARDS

Forward transaction time line

0
1
Price agreed
received +

3
cash paid/
Security delivered

EXAMPLE
A refiner enters into an agreement with a crude
oil supplier to buy 1 million barrels in three
months time @$50/barrel. If the spot rate of
crude oil on the delivery date is (a) $55 and(b)
$45 per barrel, what are the cash flow
consequences?
(a) Gain for the refiner/loss for the supplier - $5
million
(b) loss for the refiner/gain for the supplier - $5
million

PAY-OFF DIAGRAM

Buyers Gain =Sellers Loss

50

Price ($per barrel)

Sellers Gain = Buyers Loss

FORWARDS
Forward contracts only help to mitigate the price risk
the risk that the asset or security price will change
in the intervening period between decision making
and delivery of the asset
It will not help to mitigate performance risk or credit
risk the risk that one of the parties to the
agreement fail to uphold his side of agreement when
the contract matures
Forwards are highly customised contracts terms
and conditions are tailor made to meet the
requirements of the counterparties, so highly illiquid
also

FORWARDS VS FUTURES
Forwards

Futures

1. Private contract between two parties


2. Not standardised
3. Usually one specified delivery date
4. Settled at the end of the contract
5. Delivery or final cash settlement
usually takes place
6. Some credit risk is present
7.Deals are done on OTC market

1. Traded on an exchange
2. Standardised contract
3. Range of delivery dates
4. Settled daily
5. Contract is usually closed out
prior to maturity
6. Virtually no credit risk
7. Deals are done on organised
exchanges
8.Price risk is eliminated
9.Liquidity is high

8.Price risk is eliminated


9.Liquidity is low

PRICING OF FORWARDS
The principle of arbitrage links the relationship
between spot and forward prices
It is also called law of one price investment
strategies that have the same pay-offs must have
the same current value
Arbitrage involves:
Simultaneous buying and selling
No initial investment
Making risk less profits net of transaction cost

PRICING OF FORWARDS

Arbitrage free price

F0 = P0ert

Where
F0 = forward price of the asset on day 0
P0 = spot price of the asset on day 0

r = carrying cost(risk free interest rate)


t = life of the forward contract

PRICING OF FORWARDS

Cash and carry(cost of carry) Model


F0 > P0ert
Reverse cash and carry model
F0 < P0ert

PRICING OF FORWARDS

When the asset pays continuous income


F0 = P0e(r-i)t

Where
F0 = forward price of the asset on day 0
P0 = spot price of the asset on day 0

r = carrying cost(risk free interest rate)


i = asset income expressed in % p.a
t = life of the forward contract

PRICING OF FORWARDS

When the asset pays income at discrete points


F0 = (P0 I)ert

Where
F0 = forward price of the asset on day 0
P0 = spot price of the asset on day 0

r = carrying cost(risk free interest rate)


I = discounted PV of asset income
t = life of the forward contract

VALUE OF A FORWARD CONTRACT


Forward value (FV)
PV of (Current Forward Price Old Forward Price)
Present value of the forward contract
(Fold - F new) x e-rt
Where
r = interest rate applicable for the residual maturity and
t = time left to maturity

USES OF FORWARD CONTRACTS


Speculation traders who have good knowledge
of the market
Hedging protection against adverse price
movements

HEDGING WITH FORWARDS

Hedging strategies for different spot market


position

Current status

Concerned about

hedge

Holding the asset


About to buy the asset
Sold short the asset
About to issue a liability

Asset price may fall


Asset price may rise
Asset price may rise
Asset price(interest rate) may
fall(rise)
Asset price(interest rate) may
fall(rise)
Asset price(interest rate) may
rise(fall)

Short
Long
Long
Short

Have a floating rate liability


Have a floating rate asset

Short
Long

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