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Hedging
The process by which firms reduce exposure to price or rate fluctuations (forwards, futures, swaps, options)
Forward Contracts
A binding agreement between two parties for the sale of an asset in the future (settlement date) at price agreed upon today (forward price). No up front cost, but because a forward contract is a financial obligation, there is a credit risk.
forward contracts can eliminate the price risk a firm faces
Futures contracts
same as forward contracts, but gains and losses are realized daily as opposed to just on the settlement date. Contracts are standardized
Need upfront cash payment called margin
Daily resettlement feature is called marking-to-market, greatly reduces risk of default associated with forward contracts
Clearinghouse
Acts as a middleman between two parties. Guarantees performance on all contracts and eliminates risk
Recap of Forward
customized
search cost - use dealers
low liquidity
higher default risk — limited to large, creditworthy institutions
no up-front or intermediate cash flows
no clearinghouse
delivery normally occurs
Recap of Futures
standard features (delivery date, size of contract, quality of asset, etc)
no search cost — contact broker
high liquidity
virtually no default risk
initial margin requirements, daily marking-to-market, margin calls
clearinghouse that guarantees performance
majority of contracts offset, not delivered
Options contract
contract that gives owner the right to buy or sell some asset at a fixed price before or on a given date
Call option owner
has the right to buy the asset
Put option owner
has right to sell the asset
exercise or strike price
specified contract price
Expiration date
specified contract date
option premium
up front cost for this option benefit
call option writer
is obligated to sell the asset if the option is exercised
put option writer
is obligated to buy the asset if the option is exercised
Call option characteristics
spot > strike: “in the money”
Spot < strike: “out of the money”
Spot = strike: “at the money”
Max gain: (∞ - premium)
Max loss: (premium)
writer call option characteristics
max gain: (premium)
Max loss: (-∞ + premium)
Put option characteristics
Spot < strike: “ in the money”
Spot > strike: “out of the money”
Spot = strike: “at the money”
Profit = sold - bought - premium
max gain: (strike price - premium)
Max loss: (premium)
writer of put characteristics
max loss: (-strike + premium)
Max gain: (premium)
intrinsic value
The value of the call/put at expiration
