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Chap1 Introduction To Forward Contracts (Derivatives)

1. Chapter 1 introduces forward contracts, which are agreements to buy or sell an asset at a predetermined price on a future date. The party agreeing to sell is taking a short position while the party agreeing to buy is taking a long position. 2. Forward contracts allow parties to hedge against future price risk. Speculators use them to profit from anticipated price movements. 3. Key terms are defined, including the forward price, spot price, basis (the difference between forward and spot prices), and long/short positions.

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134 views

Chap1 Introduction To Forward Contracts (Derivatives)

1. Chapter 1 introduces forward contracts, which are agreements to buy or sell an asset at a predetermined price on a future date. The party agreeing to sell is taking a short position while the party agreeing to buy is taking a long position. 2. Forward contracts allow parties to hedge against future price risk. Speculators use them to profit from anticipated price movements. 3. Key terms are defined, including the forward price, spot price, basis (the difference between forward and spot prices), and long/short positions.

Uploaded by

Sandra Hbaieb
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Derivative

Derivative Securities
Securities

Tunis Business School


Program
Program
Chapter 1: Introduction to Forward contracts.
Chapter 2: The Spot-Forward Parity
Chapter 3: Introduction to Options
Chapter 4: Valuation of Options
CHAPTER 1

Introduction
Introduction to
to Forward
Forward contracts
contracts

Derivative Securities
Tunis Business School
Study
Study Objectives
Objectives
1. Define Forward contracts.
2. Define the Basis.
3. Define Long and Short positions.
4. Present some examples of hedging through Forward contracts.
Introductory example
Forward Contract

• A forward contract is an agreement to buy or sell an


asset on a fixed date in the future, called the delivery
time, for a price specified in advance, called the
forward price.
• The party to the contract who agrees to sell the asset
is said to be taking a short forward position. The
other party, obliged to buy the asset at delivery, is
said to have a long forward position.
Forward Contract

• The principal reason for entering into a forward


contract is to become independent of the unknown
future price of a risky asset.
• There are a variety of examples: a farmer wishing to
fix the sale price of his crops in advance, an importer
arranging to buy foreign currency at a fixed rate in
the future, a fund manager who wants to sell stock
for a price known in advance.
Trading Strategies

• Speculation -
– short - believe price will fall
– long - believe price will rise
• Hedging -
– long hedge - protecting against a rise in price
– short hedge - protecting against a fall in price
Notations

• St: the Spot price at time t


• S0: the Spot price at time 0
• ST: the Spot price at time T (maturity, expiry date)
• Ft: the Forward price at time t
• F0: the Forward price at time 0
• FT: the Forward price at time T (maturity, expiry
date)
Notations
(continued)

• Bt: the basis at time t


• B0: the basis at time 0
• BT: the basis at time T (maturity, expiry date)

• Bt = Ft – St
• B0 = F0 – S0
• BT= FT – ST = 0 FT = ST
• Why BT = 0?
The basis
The Basis is the difference between the futures
price and the spot price
Basis = F - S

The
TheBasis
Basisisisnot
notconstant:
constant:
••convergence
convergence
••two
twomarkets
markets

the
thecorrelation
correlationbetween
between spot
spot
and
andfuture
futureprices
pricesisis<<1.0
1.0
The basis

Basis Risk: the variability in the


basis that will affect profits and/or
hedging performance

basis
F
S
Long and Short positions

• Purchase, ownership, detention, possession, …


Long positions

• Sale, commitments to honor … Short


positions
Long and Short positions

Graphical representation:
Long and Short positions

• Profit on a long position = ST – S0


• Profit on a long Forward position = FT – F0

• Profit on a short position = S0 – ST


• Profit on a short Forward position = F0 - FT

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