Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 1 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter 18 Futures Contracts and Forward Rate Agreements Website:

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 2 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Learning Objectives Outline features of futures contracts Identify futures market instruments and participants Understand the different types of risks that can be hedged using futures Overview of forward rate agreements

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 3 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 18.1 Introduction 18.2 General Principles of Hedging Using Futures 18.3 Main Features of Futures Transactions 18.4 Futures Market Instruments 18.5 Futures Market Participants

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 4 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 18.6 Hedging: Risk Management Using Futures 18.7 Risks in Using Futures Markets for Hedging 18.8 Forward Rate Agreements (FRAs) 18.9 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 5 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.1 Introduction Futures contracts and FRAs are called derivatives because they derive their price from an underlying physical market product Two main types of derivative contracts – Commodity (e.g. gold, wheat and cattle) – Financial (e.g. shares, government securities and money market instruments)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 6 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.1 Introduction (cont.) Derivative contracts enable investors and borrowers to protect assets and liabilities against the risk of changes in interest rates, exchange rates and share prices

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 7 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 18.1 Introduction 18.2 General Principles of Hedging Using Futures 18.3 Main Features of Futures Transactions 18.4 Futures Market Instruments 18.5 Futures Market Participants

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 8 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.2 General Principles of Hedging Using Futures Hedging involves transferring the risk of unanticipated changes in prices, interest rates or exchange rates to another party A futures contract is the right to buy or sell a specific item at a specified future date at a price determined today

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 9 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.2 General Principles of Hedging Using Futures (cont.) The change in the market price of a commodity or security is offset by a profit or loss on the futures contract Example: a farmer wants to sell wheat in a couple of months. He is concerned that the price is going to fall in the meantime. How can he hedge this price risk?

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 10 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.2 General Principles of Hedging Using Futures (cont.) – Solution  Enter into a wheat futures contract to sell If wheat prices fall, the futures contract will rise in value, offsetting the loss in the physical market from the fall in the wheat price If wheat prices rise, the futures contract will fall in value, offsetting the gain in the physical market from a rise in the wheat price

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 11 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 18.1 Introduction 18.2 General Principles of Hedging Using Futures 18.3 Main Features of Futures Transactions 18.4 Futures Market Instruments 18.5 Futures Market Participants

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 12 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.3 Main Features of Futures Transactions Orders and agreement to trade – Futures contracts are highly standardised and an order normally specifies  Whether it is a buy or sell order  The type of contract (varies between exchanges)  Delivery month (expiration)  Price restrictions (if any) e.g. limit order  Time limits on the order (if any)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 13 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.3 Main Features of Futures Transactions (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 14 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.3 Main Features of Futures Transactions (cont.) Margin requirements – Both the buyer (long position) and the seller (short position) pay an initial margin, held by the clearing house, rather than the full price of the contract – Margins are imposed to ensure traders are able to pay for any losses they incur due to unfavourable price movements in the contract

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 15 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.3 Main Features of Futures Transactions (cont.) Margin requirements (cont.) – A contract is marked-to-market on a daily basis by the clearing house  I.e. repricing of the contract daily to reflect current market valuations – Subsequent margin calls may be made, requiring a contract holder to pay a maintenance margin to top-up the initial margin to cover adverse price movements

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 16 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.3 Main Features of Futures Transactions (cont.) Closing out of a contract – Involves entering into an opposite position – Example: if company S initially entered into a ‘sell one ten-year treasury bond contract’, it would close out the position by entering into a ‘buy one ten-year treasury bond contract’ as illustrated in Table 18.2

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 17 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.3 Main Features of Futures Transactions (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 18 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.3 Main Features of Futures Transactions (cont.) Contract delivery – Most parties to a futures contract  Manage a risk exposure or speculate  Do not wish to actually deliver or receive the underlying commodity/instrument and close out of the contract prior to delivery date

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 19 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.3 Main Features of Futures Transactions (cont.) Contract delivery (cont.) – SFE (Sydney Futures Exchange) requires financial futures in existence at the close of trading in the contract month to be settled with the clearing house by standard delivery or cash settlement

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 20 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 18.1 Introduction 18.2 General Principles of Hedging Using Futures 18.3 Main Features of Futures Transactions 18.4 Futures Market Instruments 18.5 Futures Market Participants

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 21 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.4 Futures Market Instruments Futures markets can be established for any commodity or instrument that – Is freely traded – Experiences large price fluctuations at times – Can can be graded on a universally accepted scale in terms of its quality – Is in plentiful supply, or cash settlement is possible

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 22 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.4 Futures Market Instruments (cont.) Example – Commodities  Mineral (e.g. silver, gold, copper, petroleum and zinc)  Agricultural (e.g. wool, coffee, butter, wheat and cattle) – Financial  Currencies (e.g. pound sterling and euro)  Interest rates (e.g. US 90-day bills, 3-month euro deposits)  Share price indices (e.g. All Ordinaries)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 23 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 18.1 Introduction 18.2 General Principles of Hedging Using Futures 18.3 Main Features of Futures Transactions 18.4 Futures Market Instruments 18.5 Futures Market Participants

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 24 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.5 Futures Market Participants Four main categories of participants – Hedgers – Speculators – Traders – Arbitragers These participants provide depth and liquidity to the futures market; thus, improving its efficiency

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 25 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Four main categories of participants Hedgers – Attempt to reduce the price risk from exposure to changes in interest rates, exchange rates and share prices – Take the opposite position to the underlying, exposed transaction – Example: exporter has USD receivable in 90 days. To protect against fall in USD over next 3 months, exporter enters into a futures contract to sell USD

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 26 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Four main categories of participants (cont.) Speculators – Expose themselves to risk in the attempt to make profit – Enter the market in the expectation that the market price will move in a favourable direction for them – Example: speculators who expect the price of the underlying asset to rise will go long and those that expect the price to fall will go short

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 27 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Four main categories of participants (cont.) Traders – Special class of speculator – Trade on very short-term changes in the price of futures contracts (i.e. intra-day changes) – Provide liquidity to the market

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 28 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Four main categories of participants (cont.) Arbitragers – Simultaneously buy and sell to take advantage of price differentials between markets – Attempt to make profit without taking any risk – Example: differentials between the futures contract price and the physical spot price of the underlying commodity

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 29 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 18.6 Hedging: Risk Management Using Futures 18.7 Risks in Using Futures Markets for Hedging 18.8 Forward Rate Agreements (FRAs) 18.9 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 30 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.6 Hedging: Risk Management Using Futures Futures contracts may be used to manage identified financial risk exposures such as – Hedging the cost of funds – Hedging the value of a money market investment – Hedging a foreign currency payable – Hedging the value of a share portfolio

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 31 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.6 Hedging: Risk Management Using Futures (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 32 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.6 Hedging: Risk Management Using Futures (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 33 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.6 Hedging: Risk Management Using Futures (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 34 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.6 Hedging: Risk Management Using Futures (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 35 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 18.6 Hedging: Risk Management Using Futures 18.7 Risks in Using Futures Markets for Hedging 18.8 Forward Rate Agreements (FRAs) 18.9 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 36 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.7 Risks in Using Futures Markets for Hedging The risks of using the futures markets for hedging include the problems of – Standard contract size – Margin risk – Basis risk – Cross-commodity hedging

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 37 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.7 Risks in Using Futures Markets for Hedging (cont.) Standard contract size – Example  90-day bank bill—$1,000,000 face value  3-year T-bond—$100,000 face value  Listed company share—1000 shares – A perfect hedge may not be possible i.e. due to contract size, the physical market exposure may not exactly match the futures market exposure

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 38 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.7 Risks in Using Futures Markets for Hedging (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 39 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.7 Risks in Using Futures Markets for Hedging (cont.) Margin risk – Initial margin required when entering into a futures contract – Further cash required if prices move adversely (i.e. margin calls) – Opportunity costs associated with margin requirements

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 40 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.7 Risks in Using Futures Markets for Hedging (cont.) Basis risk – Two types of basis risk  Initial basis The difference between the price in the physical market and the futures market at start date  Final basis The difference between the price in the physical market and the futures market at end date – A perfect hedge requires zero initial and final basis risk

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 41 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.7 Risks in Using Futures Markets for Hedging (cont.) Cross-commodity hedging – Use of a commodity or financial instrument to hedge a risk associated with another commodity or financial instrument  Often necessary as futures contracts are available for few commodities or instruments – Select a futures contract that has price movements that are highly correlated with the price of the commodity or instrument to be hedged

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 42 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 18.6 Hedging: Risk Management Using Futures 18.7 Risks in Using Futures Markets for Hedging 18.8 Forward Rate Agreements (FRAs) 18.9 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 43 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.8 Forward Rate Agreements (FRAs) The nature of the FRA – A FRA is an over-the-counter product enabling the management of an interest rate risk exposure  It is an agreement between two parties on an interest rate level that will apply at a specified future date  Allows the lender and borrower to lock-in interest rates

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 44 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.8 Forward Rate Agreements (FRAs) (cont.) The nature of the FRA (cont.)  Unlike a loan, no exchange of principal occurs  Payment between the parties involves the difference between the agreed interest rate and the actual interest rate at settlement – Disadvantages of FRAs include  Risk of non-settlement i.e. credit risk  No formal market exists

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 45 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.8 Forward Rate Agreements (FRAs) (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 46 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.8 Forward Rate Agreements (FRAs) (cont.) Settlement amount = FRA settlement rate - FRA agreed rate (18.2)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 47 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.8 Forward Rate Agreements (FRAs) (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 48 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.8 Forward Rate Agreements (FRAs) (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 49 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.8 Forward Rate Agreements (FRAs) (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 50 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 18.6 Hedging: Risk Management Using Futures 18.7 Risks in Using Futures Markets for Hedging 18.8 Forward Rate Agreements (FRAs) 18.9 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 51 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.9 Summary (cont.) Limitations include margin calls, imperfect hedging due to basis risk, and availability FRAs are over-the-counter contracts specifying an agreed interest rate to apply at a future date

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 52 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 18.9 Summary (cont.) A futures contract is an agreement between two parties to buy or sell a specified commodity or instrument at a specified date in the future, at a price specified today Futures may be used as a hedging strategy by opening a position today that requires a closing transaction that is the reverse of the exposed transaction in the physical market