Study on the Different Types of Forward Contracts Finance Essay

FORWARD CONTRACTS: A forward contract agreement is effective under the consistent critical terms method if all the following criteria are met: 1. The forward contract is for the purchase or sale of the same quantity or notional amount and at the same time as the hedge able item. 2. Upon association with the hedge able item, the forward contract has a zero fair value. 3. The references rate of the forward contract is consistent with the reference rate of the hedge able item. Example: While entering into agreement of forward contracts which involve buying an equity forward, that is purchasing the equity at a specific date in the future, for the price which has been agreed at the time of forward contract is made or entered in it. (Tomas Bjork) INTEREST-RATE FORWARD CONTRACTS: It involves interest rates on agreement; the seller has the opportunity of hedging against a futures fall in interest rates. As wall as the buyer has the security from a future rise in interest rates. Interest rate forward contract, more normally called a forward rate agreement or FRA. The FRA has instruments on which they are based; there is a worldwide market for time deposition in various currencies issued by large responsible banks. (Financial News, journal ) LONG POSITION: The purchase or buying of securities such as commodity, stock or currency, with the intention that the assets value will rise in coming future. The long position is far used by banks and bay window to manage foreign exchange risk. In context of options, the buying of an options contract. It’s like opposite to Short position. Example: The shareholder in KFC’s corp. is said to be “long KFC’s” or “has the long position in KFC’s”. Buying a put option contract from a writer entitle you the right, not the obligation to buy (or sell) a specific asset for a specified amount at a specified time or date. (Fischer Black) SHORT POSITION, HEDGE: The sale of borrowed shares or securities, commodity with an expectation that the price of the asset might fall in value. In the context of option, it is the sale of an options contract.

Opposite of “long position”. Example: The classic economic rationale for future markets is, of course, that they facilitate hedging-that they allow those who deal in a commodity to transfer the risk of price change in that commodity to speculators more willing to bear such risk. An investor who borrows shares of from a broker and sells them in open market is said to have a short position in the stock. The investor must eventually return the borrowed stock by buying it back from the open market. And if the price of stock falls in the market, the investor buys it for less than the price from he or she sold it, thus making a profit. Selling a put options contract to buyer entitles the buyer the right, not the obligation to buy from or sell to you a specific asset or commodity for a specified amount at a specified time or date. (Louis H. Ederington) FINANCIAL FUTURE CONTRACT: A similar, moveable, exchange-traded contract that delivery of trade good, securities, currency, or stock market index, at a specified price, on a specified time to come. Unlike options, futures convey an indebtedness to buy.

The risk to the holder is unlimited, and because the yield pattern is proportionate, the risk to the seller is unlimited as well. Dollars lost and increase gain by each party on a futures contract is equivalent and opposite. In other words, future trading is a zero-sum game.

The exchange of assets occurs on the date specified in the declaration. An exchange traded contract, for settlement at a date beyond the normal spot settlement data, for the purchase and sale of a standardized quantity of a financial instrument. The futures contract locks in the future rate of return on a notional investment by the buyer, the seller lock in the cost of borrowing. (Investor word, journal) ARBITRAGE: Attempting to profit by overwork price differences of indistinguishable or similar financial instruments, on different markets or in different forms. The ideal version capture slight difference in price is riskless arbitrage. A risk-free transaction of securities industry, the purchasing of under value share and the simultaneously resale of these shares for a higher price, generating a profit on the difference. (Tomas Bjork) MICRO HEDGE: Hedge is designed to reduce or eliminate risk resulting from a particular asset or liability, as opposed to the risk arising from an entire list of the financial assets held by an individual or a bank. If the asset or liability is part of a large portfolio with a number of correlate risks, then micro-hedge is less likely to be an effective technique. Opposite of macro-hedge. (Stephen G. Cecchetti) MACRO HEDGE: Hedge designed to reduce or eliminate risk for an entity.

Opposite of micro-hedge. An investment technique used to reduce the risk of portfolio of commodity. In most cases, this would mean taking a position that offsets the whole portfolio. But it is difficult proficiency in exercise because there is seldom one commodity that offset the risk of a broader portfolio, so applying for a macro-hedge is most likely requires taking an outset position in each single commodity. An index fund manager believes that there will be a loss in the index in the upcoming future. To reduce the risk of a downward turn in the index, the manager can take a short position in the index fund’s future market that might lock in a price for the index. (Carl Ackermann) CROSS HEDGE: Hedging one instrument’s risk with a different by taking a particular portion is a related financial instrument. This is frequently done when there is no financial instrument being hedged, or a suitable financial instrument exists but the marketplace is extremely illiquid. The cross hedging counts completely on how strongly correlate the instrumental being hedged is with the semantic role or tool which underlies the financial instrument or derivative contract. Furthermore; the recognition quality of the derivation and the instrument being hedged need to be of similar liquid, so that price changes are resemblance.

Lastly, the due date of the financial instrument must be at least as long as the due date of the craved hedged; otherwise investor will be left with an un-hedged exposure for a point of time. (Ronald W. Anderson, Columbia University) HEDGE RATIO: The change in price of a call option for every one-point move in the price of the rudimentary security. The hedge ratio is also called delta. The ratio of volatility of the portfolio to be hedged and of the volatility of the hedging instrument. Example: the price of a commodity future with a hedge ratio of 40 will rise 40% (of the security-price move) if the price of the rudimentary stock increases. Typically, options with lofty level hedge ratio are usually more fruitful to buy rather than pen since the degree the portion movement-relative to the rudimentary price and the comparable little time-value wearing-the greater the leverage.

The opposite is true for alternative with a low hedge ratio. (Financial Institution & Market Madura International Edition 9th Edition 2010) BASIC RISK: An applied to interest rate swap, risk that the index used for an interest rate swap doesn’t move perfectly in tandem with floating-rate instrument specified in a swap agreement. As applied to financial futures, risk that the future prices do not move perfectly to in tandem with the assets that are hedged. (Financial Institution & Market Madura International Edition 9th Edition 2010) STOCK MARKET RISK: The variability in returns on stock that is due to basic swapping changes in investor expectations is referred to as market risk. It is part of systematic risk. They are caused by “tangible” events like political, social, or economical and “intangible” events like market psychology. Other factors playing a major role in market risk are interest rate and inflation. (Financial Institution & Market Madura International Edition 9th Edition 2010) PORTFOLIO INSURANCE: A strategy of hedging a stock portfolio against market risk by selling stock index futures short or buying stock index put options. Program trading combined with the trading of index futures to hedge against market movements. The hedging technique is frequently used by institutional investors when the market direction is uncertain or volatile.

Short selling index futures can offset any downturns, but it also hinders any gains. (Financial Institution & Market Madura International Edition 9th Edition 2010) REQUIREMENTS: If you expect interest rates to increase, what type of hedge should you set up, long or short? And why? Sol: Long hedge requires taking a long position in future contract, it is appropriate when a certain asset or commodity would be purchased in the future and one is interested in locking in the price now. For example, the textile company would use a long hedge.

And short hedge involves a short position in the future contract, it can be applicable when a hedger already owns asset and expect to sell it in the future. For example, the aluminium producer would use a short hedge. If 1% increases in the interest rate results in a decline in the value for treasury bonds of par. So, I would like to set up short hedge or short position because the interest rate is going to increase in the future period.

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