MGT 181 ch. 23 & 24

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19 Terms

1

Hedging

The process by which firms reduce exposure to price or rate fluctuations (forwards, futures, swaps, options)

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2

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

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3

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

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4

Clearinghouse

Acts as a middleman between two parties. Guarantees performance on all contracts and eliminates risk

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5

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

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6

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

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7

Options contract

  • contract that gives owner the right to buy or sell some asset at a fixed price before or on a given date

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8

Call option owner

has the right to buy the asset

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9

Put option owner

has right to sell the asset

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10

exercise or strike price

specified contract price

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11

Expiration date

specified contract date

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12

option premium

up front cost for this option benefit

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13

call option writer

is obligated to sell the asset if the option is exercised

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14

put option writer

is obligated to buy the asset if the option is exercised

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15

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)

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16

writer call option characteristics

  • max gain: (premium)

  • Max loss: (-∞ + premium)

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17

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)

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18

writer of put characteristics

  • max loss: (-strike + premium)

  • Max gain: (premium)

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19

intrinsic value

The value of the call/put at expiration

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