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Managerial Finance Topic 11 2017
Managerial Finance Topic 11 2017
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Topic Outline
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What is a derivative?
A derivative is a financial instrument whose
payoffs and values are derived from, or depend
on, something else:
Examples:
Forward agreement
Futures
Swaps
Options
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Forward Contracts
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Futures Contracts
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Futures Contracts some Language
Going short
delivering the commodity / currency
Going long
receiving the commodity / currency
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Futures Contracts
Standardizing Features
Contract Size
Delivery Month
Daily resettlement
Minimizes the chance of default
Initial Margin
About 4-10%of contract value
Cash or T-bills held in a street name at your
brokerage
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Daily Resettlement: An Example
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Daily Resettlement: An Example
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Daily Resettlement: An Example
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Daily Resettlement: An Example
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Selected Futures Contracts
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Basic Futures Relationships
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What is hedging?
Making an investment to reduce the risk of
adverse price movements in an asset.
When a firm uses derivatives to reduce its risk
exposure, it is hedging:
e.g. an orchard business enters into a futures
contract for its citrus crop
e.g. an importer of machinery from Germany
uses a forward rate agreement for the Euro and
the Australian dollar
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Hedging vs. Speculation
Hedging involves taking an offsetting position in a
derivative in order to balance any gains and
losses to the underlying asset
e.g. an importer arranging a forward rate
agreement for the currency of payment.
The main purpose of speculation is to profit from
betting in the direction in which an asset will be
moving.
e.g. a firm with no exposure to a particular
currency taking out a forward rate agreement
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Hedging
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Hedging some Language
short hedge
a transaction that secures protection
against a possible decline in price of an
item to be traded at a later time
long hedge
a transaction that secures protection
against a possible increase in price of an
item to be traded at a later time
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Hedging and Speculating: Example
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Hedging: How many contracts?
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Interest Rate Futures Contracts
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Pricing of Treasury Bonds
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Pricing of Treasury Bonds
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Pricing of Forward Contracts
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Pricing of Futures Contracts
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Hedging in Interest Rate Futures
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Duration Hedging
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Duration Hedging
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Duration Formula
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Calculating Duration: Example
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Calculating Duration: Example
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Duration
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Swaps Contracts
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The Swap Bank
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An Example of an Interest Rate Swap
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An Example of an Interest Rate Swap
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An Example of an Interest Rate Swap
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An Example of an Interest Rate Swap
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An Example of an Interest Rate Swap
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An Example of an Interest Rate Swap
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An Example of an Interest Rate Swap
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An Example of an Interest Rate Swap
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An Example of an Interest Rate Swap
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An Example of a Currency Swap
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An Example of a Currency Swap
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An Example of a Currency Swap
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An Example of a Currency Swap
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An Example of a Currency Swap
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An Example of a Currency Swap
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An Example of a Currency Swap
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Credit Default Swaps
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Variations of Basic Swaps
Currency Swaps
fixed for fixed
fixed for floating
floating for floating
amortizing
Interest Rate Swaps
zero-for floating
floating for floating
Exotics
For a swap to be possible, two humans must like the idea.
Beyond that, creativity is the only limit.
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Risks of Interest Rate and Currency Swaps
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Risks of Interest Rate and Currency Swaps
Credit Risk
This is the major risk faced by a swap dealerthe risk
that a counterparty will default on its end of the swap.
Mismatch Risk
It is hard to find a counterparty that wants to borrow
the right amount of money for the right amount of
time.
Sovereign Risk
The risk that a country will impose exchange rate
restrictions that will interfere with performance on the
swap.
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Pricing a Swap
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Actual Use of Derivatives
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End of Topic 11
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