24-0 Forward Contracts 24.3 A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date Forward contracts are legally binding on both parties They can be tailored to meet the needs of both parties and can be quite large in size Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations LO4

24-1 Positions Long – agrees to buy the asset at the future date (buyer) Short – agrees to sell the asset at the future date (seller) LO4

24-2 Figure 24.3 – Payoff profiles for a forward contract LO4

24-3 Hedging with Forwards Entering into a forward contract can virtually eliminate the price risk a firm faces It does not completely eliminate risk because both parties still face credit risk Since it eliminates the price risk, it prevents the firm from benefiting if prices move in the company’s favor The firm also has to spend some time and/or money evaluating the credit risk of the counterparty Forward contracts are primarily used to hedge exchange rate risk LO4

24-4 Figure 24.5 – Hedging with forward contracts LO4

24-5 Futures Contracts 24.4 Same profile as the forward contract Futures contracts trade publicly on organized securities exchange Require an upfront cash payment called margin Small relative to the value of the contract “Marked-to-market” on a daily basis Clearinghouse guarantees performance on all contracts The clearinghouse and margin requirements virtually eliminate credit risk LO4

24-6 Futures Quotes See Figure 24.6 Underlying asset, exchange, contract size, quote The contract size is important when determining the daily gains and losses for marking-to-market Delivery month Open price, daily high, daily low, settlement price, change from previous settlement price, open interest LO4

24-7 Futures Quotes continued The change in settlement price times the contract size determines the gain or loss for the day Long – an increase in the settlement price leads to a gain Short – an increase in the settlement price leads to a loss Open interest is how many contracts are currently outstanding LO4

24-8 Hedging with Futures The risk reduction capabilities of futures is similar to that of forwards The margin requirements and marking-to- market require an upfront cash outflow and liquidity to meet any margin calls that may occur Futures contracts are standardized, so the firm may not be able to hedge the exact quantity, quality, and/or delivery date it desires LO4

24-9 Hedging with Futures – continued Credit risk is virtually nonexistent Futures contracts are available on a wide range of physical assets, debt contracts, currencies and equities Cross-Hedging – Hedging an asset with contracts written on a closely related, but not identical, asset Basis Risk – When cross-hedging, the risk that the futures prices does not move directly with the cash price of the hedged asset LO4