Lecture 18 & 19,20

Hedgers:

•Seek protection from price movements

•Long hedge–protection against a price rise

•Short hedge–protection against a price fall

•Example: an oil producer will enter into a futures contract to ensure that they cansell their oil production in a few months at a fixed price

•Speculators:•

Seek to profit from price movements

•Long–bets on price rises

•Short–bets on price declines

•Example: you bet that oil price will rise, you may use a long futures contract. Why not buy some physical crude oil?

fair delivery price

the agreed-upon price that equalizes the value of buying the underlying asset in the spot market and holding it until the contract's maturity with the cost of entering the futures contract.

Arbitrage

the practice of taking advantage of price differences between markets to earn a risk-free profit. This typically involves buying an asset in one market at a lower price and simultaneously selling it in another market at a higher price.

Futures Parity Theorem

ays that the futures price should equal the current price of the asset plus any costs of holding it until the contract ends.

Special Case 1: Dividend Payments•If the stock pays a dividend, futures owners are NOT entitled to receive thedividend before the delivery date

Special Case 2: Storage Costs•Some underlying assets have a significant costs for storage•Consider the costs of storing a precious metal (hire a guard!)•Consider the costs of storing crude oil (Need large oil containers!)•Storing electricity (Need to buy huge batteries!)•Futures owner do not need to pay for these costs

Convienence Yield

the benefit or value that holders of a physical commodity (such as oil, wheat, or metals) receive from owning the commodity itself rather than holding a futures contract on it. This concept is unique to commodities and arises when there is high demand for immediate availability, which can make physically holding the commodity more valuable than merely having a contract to buy it in the future.

Swaps

an exchange of periodic cash flows between two parties. The cash flowsmay vary in terms of currency denomination, interest rate basis and/or other financialfeatures

Interest Rate Swap

exchange of fixed-rate interest payments for floating-rate interest payments

The notional principal(fv0 does not change hand.

The cash flows are in the same currencies.

•It involves two companies that have different comparative advantages in the debt market: one company may be relatively more competitive in the fixed-rate market, whilethe other may be relatively more competitive in the floating-rate markets

Currency Swap

exchange of one stream of cash flows denominated in one currency for anotherstream of cash flows denominated in another currency

Esxxample swaps Ib and Bud

• IBM's Perspective: IBM will only agree to the swap if the fixed rate they are paid is at least as good as what they could get in the market (their benchmark).

• Bud's Perspective: Bud will only agree to the swap if the floating rate they receive (based on LIBOR) is at least as good as what they could earn by borrowing at LIBOR.

intrinsic value of stocks should be the “present values” of all future dividend

To conduct this analysis, we need two pieces of information•Future dividends (cash flows)•Appropriate discount rates for future cash flows

If market is efficient, present value of future cashflows

should equal to today’s price

Constant Dividend

Preferred stocks promise to pay a fixed dividend

Gordon Growth Model

Common stocks will distribute parts of net income to shareholders as dividends•If the business keeps growing, the dividends should also increase

Multi-Stage Growth Model

EAarly-stage firms may experience rapid growth initially, but as they mature, theirgrowth rate may decline