Page 39 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 3.4 Summary

 A cash market transaction is one in which a seller agrees to deliver a specific cash commodity
to a buyer at some point in the future.

 Unlike futures contracts (which occur through a clearing firm), forward contracts are
privately negotiated and are not standardized.

 Further, the two parties must bear each other's credit risk, which is not the case with a
futures contract.
 Also, since the contracts are not exchange-traded, there is no marking to market
requirement, which allows a buyer to avoid almost all capital outflows initially (though
some counterparties might set collateral requirements).

 Given the lack of standardization in these contracts, there is very little scope for a secondary
market in forwards.
 The price specified in a forward contract for a specific commodity.

 The forward price makes the forward contract have no value when the contract is written.
 The forward market is like a real estate market in that any two consenting adults can form
contracts against each other.

 This often makes them design terms of the deal which are very convenient in that specific
situation, but makes the contracts non-tradable.

3.5 Keywords

Delivery Price: The pre-specified price of the underlying assets at which the forward contract is
settled on expiration is said to be delivery price.
Economic exposure: Economic exposure refers to the impact of fluctuations in financial prices on
the core business of the firm.

Future Spot Price: This is the spot price of the underlying asset on the date the forward contract
expires and it depends on the market condition prevailing at the expiration date.
Long Position: The party that agrees to buy an underlying asset (e.g. stock, commodity, stock
index, etc.) in a future date is said to have a long position.
Short Position: The party that agrees to sell an underlying asset (e.g. stock, commodity, indices,
etc.) in future date is said to have a short position.
Transactional risks: Transactional risks reflect the pejorative impact of fluctuations in financial
prices on the cash flows that come from purchases or sales.
Translation risks: Translation risks describe the changes in the value of a foreign asset due to
changes in financial prices, such as the foreign exchange rate.

3.6 Review Questions

1. We noted that a hedge is a financial instrument whose sensitivity to a particular financial
price offsets the sensitivity of the firm's core business to that price. Discuss.
2. Future performance of strategies with high volatility is far less predictable than future
performance from strategies experiencing low or moderate volatility. Explain.

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