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Managing financial risk with derivatives and its applications.

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1 Managing financial risk with derivatives and its applications

2 Hedging with derivatives Future & Forward Contracts Interest Rate instruments: Cap, Floor, Collar. SWAPS Option Contracts: Put & Call

3 Future & Forward Contracts Future Contracts: -Legal standarized agreement to buy/sell a commodity at a specific time in the future. -Margin established up front -« Marking-to- Market » Foward Contracts: -Customized agreement & traded over-the- counter -Specified with 4 variables: underlier, notional amount, delivery price & settlement date. -May be cashed settled

4 Futures Contract Applications Example of a raw material transformation company Material 100,000 ounces of silver Spot price $ 13/ounce Six-months future price $ 11/ounce Long position Use: Need 100,000 ounces of silver in 6 monhs. Goal: Lock price at $11/ounce Short position Use: Sell 100,000 ounces of silver in 6 months. Goal: Ensure receiving $11/ounce in 6 months

5 Forward Contracts Four variables: - Underlier: oil -Notional amount (n): 250,000 barrels. -Delivery price (k): $ 40 U.S./barrel -Settlement date: in 3 months Goal: Exchange 250,000 barrels of crude oil for $ 40 U.S. /barrel in 3 months. Forward market value given by n(s-k) where s is the spot price.

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