Page 34 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 3: Forward Contracts

or the market, or in anticipation of earnings disappointments often due to accounting Notes
irregularities, new competition, change of management, etc. Often used as a hedge to
offset long-only portfolios and by those who feel the market is approaching a bearish
cycle. High risk. Expected Volatility: Very High.
13. Special Situations: Invests in event-driven situations such as mergers, hostile takeovers,
reorganizations, or leveraged buy-outs. Investors May involve simultaneous purchase of
stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit
from the spread between the current market price and the ultimate purchase price of the
company. May also utilize derivatives to leverage returns and to hedge out interest rate
and/or market risk. Results generally are not dependent on direction of market. Expected
Volatility: Moderate.

14. Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or
potential worth. Such securities may be out of favour or underfollowed by analysts. Long-
term holding, patience, and strong discipline are often required until the market recognizes
the ultimate value. Expected Volatility: Low - Moderate.

Self Assessment

Fill in the blanks:
1. …………… risks reflect the pejorative impact of fluctuations in financial prices on the cash
flows that come from purchases or sales.
2. ………….refers to the impact of fluctuations in financial prices on the core business of the
firm.
3. …………..risks describe the changes in the value of a foreign asset due to changes in
financial prices, such as the foreign exchange rate.
4. Investors buy equity, debt, or trade claims at …………..of companies in or facing
bankruptcy or reorganization.

5. Future performance of strategies with …………..volatility is far less predictable than
future performance from strategies experiencing ………….volatility.

3.2 Basics of Forward Contracts

A forward contract is an agreement between two parties to buy or sell underlying assets at a pre
determined future date at a price agreed when the contract is entered into. Forward contracts are
not standardized products. They are over-the-counter (not traded in recognized stock exchanges)
derivatives that are tailored to meet specific user needs. The underlying assets of this contract
include:

1. Traditional agricultural or physical commodities
2. Currencies (foreign exchange forwards)
3. Interest rates (forward rate agreements or FRAs)

Example: Suppose you decide to subscribe to cable TV. As the buyer, you enter into an
agreement with the cable company to receive a specific number of cable channels at a certain
price every month for the next year. This contract made with the cable company is similar to a
futures contract, in that you have agreed to receive a product at a future date, with the price and
terms for delivery already set. You have secured your price for now and the next year-even if the

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