INTERNATIONAL FINANCE LESSON 4

Risk Management and Derivatives Antu Panini Murshid Today’s Agenda      What are derivatives? Futures contracts Swaps futures and options Forward exchange rates Covered interest rate parity What are Derivatives?   Unlike other assets derivatives are not a claim on a commodity or real asset A derivative is an instrument whose value depends on the value of other underlying assets   Pork bellies, oil, other financial instruments An increasing amount of trading takes place in markets where actual commodities and instruments of borrowing and lending are not traded Examples of Derivatives?     Forward contracts Futures contracts Swaps Options Derivatives Risk Sharing or the “11-letter 4-letter-word”  Why use derivatives     To hedge risks To speculate by taking a view on the future direction of the market To lock in the rate of return or interest costs on borrowed funds (decide on terms today) To change the nature of an investment without incurring transaction costs Forward Contracts   A forward contract is an agreement where the terms of a future trade are decided upon today This contrasts with a spot contract where the agreement is to buy or sell the asset immediately Example    Wheat farmer plants crop in January and receives payment after harvest in July Farmer expects to sell wheat to a miller for $10,000 But price of wheat may fluctuate   Price of wheat ↑ farmer gains and miller loses Price of wheat ↓ farmer loses and miller gains Example   Both parties face uncertain prices To minimize these uncertainties they may agree the terms of their trade now By engaging in a forward transaction the farmer reduces the risk of a loss and the miller reduces the risk of a price fluctuation Spot and Forward Exchange Rates   The spot rate is the rate at which one currency can be exchanged for another currency at the present time The forward rate is the rate at which one currency can be exchanged for another at some future delivery date (beyond the spot delivery date), where the terms of the transaction are agreed upon today Exchange Rate Risk   Forward exchange rates are used to hedge against exchange rate risk Exchange rate risk is the effect of unanticipated exchange rate movements on profits Settling Accounts    Although the buyer (seller) of a futures contract has the right to receive (deliver) the underlying instrument, rarely are these assets actually exchanged Instead the “difference” is settled in cash by the exchange on a daily basis in accordance to the current spot price This daily settlements of accounts is called marking to market Futures Pricing    The futures price is not specified in the contract, rather on any given day, it is determined by the market The futures price reflects the market’s expectations regarding the spot price of the underlying asset on the date of delivery Clearly it must be the case then that the futures price and spot price converge as the time to delivery approaches Example: Reducing Interest Rate Risk    A bank makes 1-yr loan at 6% fixed interest 6-month time deposits earn variable int 4% If interest rate ↑ then a loss is incurred Bank sells T-bill future (in March settle price for a September delivery $1million T-bill is 95.16) If interest rate ↑ spot price