Forward and Futures Contracts

One derivative contract is a forward contract, where parties agree to trade assets at a future date at a specified price. Both forward and futures contracts are similar in terms of their nature. However, future contracts are standardized agreements, unlike forward contracts. These videos (along with the attached slides) discuss financial futures contacts in detail, including how to calculate payoffs. What are some other differences between forward contracts and futures contracts, and what determines forward and futures prices?

Finance Theory

Motivation

  • Your company, based in the U.S., supplies machine tools to customers in Germany and Brazil.  Prices are quoted in each countrya's currency, so fluctuations in the €/ $ and R / $ exchange rates have a big impact on the firm's revenues.  How can the firm reduce (or 'hedge') these risks?
  • Your firm is thinking about issuing 10-year convertible bonds.  In the past, the firm has issued straight debt with a yield-to-maturity of 8.2%. If the new bonds are convertible into 20 shares of stocks, per $1,000 face value, what interest rate will the firm have to pay on the bonds?
  • You have the opportunity to buy a mine with 1 million kgsof copper for $400,000.  Copper has a price of $2.2 / kg, mining costs are $2 / kg, and you can delay extraction one year.  How valuable is the option to delay?  Is the mine a good deal?
Exchange Rates, 1995 –2003
Exchange Rates, 1995 –2003

Caterpillar, 1980 –1989

Caterpillar, 1980 –1989

Hedging or Speculation?

Alternative Tools?
  • Futures, forwards, options, and swaps
  • Insurance
  • Diversification
  • Match duration of assets and liabilities
  • Match sales and expenses across countries (currency risk)
Should Firms Hedge With Financial Derivatives?
  • "Derivatives are extremely efficient tools for risk management"
  • "Derivatives are financial weapons of mass destruction"

View 1: Hedging is irrelevant (M&M)

  • Financial transaction, zero NPV
  • Diversified shareholders don’t care about firm-specific risks

View 2: Hedging creates value

  • Ensures cash is available for positive NPV investments
  • Reduces need for external finance
  • Reduces chance of financial distress
  • Improves performance evaluation and compensation

Examples:

Homestake Mining
  • Does not hedge because "shareholders will achieve maximum benefit from such a policy".
American Barrick
  • Hedges aggressively to provide "extraordinary financial stability...offering investors a predictable, rising earnings profile in the future".
Battle Mountain Gold
  • Hedges up to 25% because "a recent study indicates that there may be a premium for hedging".

Evidence

  • Random sample of 413 large firms
  • Average cashflowfrom operations = $735 million
  • Average PP&E = $454 million
  • Average net income = $318 million

57% of Firms Use Derivatives In 1997

  • Small derivative programs
  • Even with a big move (3σevent), the derivative portfolio pays only $15 million and its value goes up by $31 million

Basic Types of Derivatives

Forwards and Futures
  • A contract to exchange an asset in the future at a specified price and time.
Options (Lecture 10)
  • Gives the holder the right to buy (call option) or sell (put option) an asset at a specified price.
Swaps
  • An agreement to exchange a series of cashflowsat specified prices and times.