MGT 181 ch. 23 & 24

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

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

As the stock price increases

the call price increases and the put price decrease

as the exercise price increases

the call price decreases and the put price increases

as the time to expiration increases

both the call and the put prices increase (premium increase)

as the risk-free rate increases

the call price increases and the put price decreases