BFIN 335
VALUATION OF FINANCIAL DERIVATIVES
The financial risk faced by companies has increased tremendously over the last two decades and
the
... [Show More] payoffs of managing risk successfully are very high. In response to this increased risk and the
incentive to manage it, older instruments of risk management such as forwards and futures have
been expanded in scope, and many new instruments devised. The process of adaptation of
existing financial instruments and processes to develop new ones, in order that financial market
participants can effectively cope with the changing situation, is known as financial engineering.
A derivative is a financial instrument whose value depends on (or derives from) the value of
other, more basic, underlying variables. Very often the variables underlying derivatives are the
prices of traded assets. A stock option, for example, is a derivative whose value is dependent on
the price of a share/stock.
The term "financial risk" covers the range of risks affecting financial outcomes, faced by a firm.
Financial risk is essentially of two kinds: systematic and unsystematic.
Systematic risk is that portion of risk which cannot be diversified away. Some of its components
are listed below.
Business risk is the risk of fluctuations in sales revenue.
Financing risk arises from leverage.
Inflation risk arises from unanticipated inflation.
Default, or credit risk is the risk of default of payment by debtors of the firm.
When it is difficult to buy or sell a financial instrument at its market price, then there is a
marketability, or liquidity risk associated with it.
Operating risk: Operating leverage is the commitment of the firm to fixed production
charges (fixed costs).
Unsystematic risk comprises primarily of price risks.
Interest rate risk arises both from fixed and floating rate debt.
Currency (or foreign exchange) risk arises when cash inflows or outflows take place in
foreign currency.
Commodity price risk arises from unanticipated changes in commodity prices.
FORWARD CONTRACTS
A forward contract is a legally binding agreement between two parties calling for the sale of an
asset or product at a certain future for a certain price agreed upon today. The terms of the
contract call for one party to deliver the goods to the other on a certain date in the future, called
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the settlement date. The other party pays the previously agreed-upon forward price and takes
the goods.
One of the parties to a forward contract assumes a long position and agrees to buy the underlying
asset on a certain specified future date for a certain specified future price. The other party
assumes a short position and agrees to sell the asset on the date for the same price.
Forward contracts can be bought and sold. The buyer of a forward contract has the obligation to
take delivery and pay for the goods; the seller has the obligation to make delivery and accept
payment. The buyer of a forward contract benefits if prices increase because the buyer will have
locked in a lower price. Similarly, the seller wins if prices fall because a higher selling price has
been locked in. Note that one party to a forward contract can win only at the expense of the
other, so a forward contract is a zero-sum game.
No payment is made at any time at the commencement or during the term of the contract, making
it an off-balance sheet instrument. Forwards have one major disadvantage: Whichever way the
price of the deliverable instrument moves, one party has an incentive to default. Therefore,
forward contracts usually involve counterparties who have prior knowledge of each other.
In general, the payoff from a long position in a forward contract on one unit of an asset is:
ST – K
Where K is the delivery price and ST is the spot price of the asset at maturity of the contract.
FUTURES CONTRACTS
A futures contract is exactly the same as a forward contract with one exception. With a forward
contract, the buyer and seller realize gains or losses only on the settlement date. With a futures
contract, gains and losses are realized on a daily basis. If we buy a futures contract on oil,
then, if oil prices rise today, we have a profit and the seller of the contract has a loss. The seller
pays up, and we start again tomorrow with neither party owing the other. The daily resettlement
feature found in futures contracts is called marking-to-market.
In futures contracts, the sale and purchase of a specified asset at some specified future date is
contractually agreed to, at a price determined now. The buyer places a small initial margin,
usually tendered in T-bills or other forms of security, with the broker. Essentially, therefore, a
position can be taken without investment in the futures market, and they are therefore offbalance sheet transactions. [Show Less]