Accounting Response
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davenport_week_1_pp3.pptxChapter 1 Web Extension 1A
An Overview of Derivatives
Topics in Web Extension
Overview of derivatives
Forward contracts
Futures contracts
Options
Swaps
Forward Contracts
2 parties to contract, each with a basic position:
One party is “long” (buy). Obligates party to buy the underlying asset at some fixed price at a specified date in the future.
One party is “short” (sell). Obligates party to sell the underlying asset at some fixed price at a specified date in the future.
Terms
Forward price
Delivery date (expiration date)
Forward contracts are common for currencies.
Hedging Risk with Forward Contracts
US wine importer might plan on purchasing French wine with euros in the fall. Could lock in the currency exchange rate for the fall by taking a long position in a euro currency forward contract.
US computer manufacturer might plan on selling computers to German company in fall, with the payment in euros. Could lock in exchange rate by taking a short position in euro forward contract.
Both parties have reduced risk by locking in the exchange rate.
Problems with Forward Contracts
Forward contracts are made directly between two parties, so there is the possibility of default (although banks often are one of the parties in each transaction, in effect acting as “middlemen”).
Forward contracts are often designed for a specific need, so there is not a standardized contract, which makes it difficult to have a secondary market.
Futures contract solve these problems.
Futures Contracts
Similar to forwards, except:
Marking-to-market
Many more assets- agriculture, livestock, metals, indexes, currencies, interest rates, energy
Standardized contracts that trade on exchanges, such as CBOT
Options
Basic Positions
Call / Put
Long / Short (writer)
Terms
Exercise Price
Expiration Date (can let expire unexercised)
Assets- Stocks, indexes, currency, and futures
CBOE
Swaps
Two parties agree to “swap” some particular obligation (usually associated with debt)
Swap payments in one currency for payments in another currency
Swap floating-rate payments for fixed-rate payments
