Forward Contracts
A forward contract obligates one party to buy the underlying at a fi xed price at a certain future date (called the maturity) from a counterparty,who is obligated to sell the underlying at that fi xed price.Consider a U.S.exporter who expects to receive a �00 million payment for goods in six months.Suppose that the price of the euro is $1.20 today.If the euro were to fall by 10 percent over the next six months,the exporter would lose $12 million.But by selling euros forward,the exporter locks in the current forward exchange rate.If the forward rate is $1.18 (less than $1.20 because the market apparently expects the euro to depreciate a bit),the exporter is guaranteed to receive $118 million at maturity.Hedging consists of taking a fi nancial position to reduce exposure to a risk.In this example,the fi nancial position is a forward contract,the risk is depreciation of the euro,and the exposure is �00 million in six months,which is perfectly hedged with the forward contract.Since no money changes hands when the exporter buys euros forward,the market value of the contract must be zero when it is initiated,since otherwise the exporter would get something for nothing.
Options
Although options can be written on any underlying,let’s use options on common stock as an example.A call option on a stock gives its holder the right to buy a fi xed number of shares at a given price by some future date,while a put option gives its holder the right to sell a fi xed number of shares on the same terms.The specifi ed price is called the exercise price.When the holder of an option takes advantage of her right,she is said to exercise the option.The purchase price of an option – the money that changes hands on day one – is called the option premium.Options enable their holders to lever their resources,while at the same time limiting their risk.Suppose Smith believes that the current price of $50 for Upside Inc.stock is too low.Let’s assume that the premium on a call option that confers the right to buy shares at $50 each for six months is $10 per share.Smith can buy call options to purchase 100 shares for $1,000.She will gain from stock price increases as if she had invested in 100 shares,even though she invested an amount equal to the value of 20 shares.With only $1,000 to invest,Smith could have borrowed $4,000 to buy 100 shares.At maturity,she would then have to repay the loan.The gain made upon exercising the option is therefore similar to the gain from a levered position in the stock – a position consisting of purchasing shares with one’s own money plus money that’s borrowed.However,if Smith borrowed $4,000,she could lose up to $5,000 plus interest if the stock price fell to zero.With the call option,the most she can lose is $1,000.But there’s no free lunch here; she’ll lose the entire $1,000 if the stock price does not rise above $50.
Swaps
A swap is a contract to exchange cash flows over a specifi c period.The principal used to compute the flows is the “notional amount.” Suppose you have an adjustable-rate mortgage with principal of $200,000 and current payments of $11,000 per year.If interest rates doubled,your payments would increase dramatically.You could eliminate this risk by refi nancing with a fi xed-rate mortgage,but the transaction could be expensive.A swap contract,by contrast,would not entail renegotiating the mortgage.You would agree to make payments to a counterparty – say a bank – equal to a fi xed interest rate applied to $200,000.In exchange,the bank would pay you a fl oating rate applied to $200,000.With this interest-rate swap,you would use the fl oating-rate payments received from the bank to make your mortgage payments.The only payments you would make out of your own pocket would be the fi xed interest payments to the bank,as if you had a fi xed-rate mortgage.Therefore,a doubling of interest rates would no longer affect your out-ofpocket costs.Nor,for that matter,would a halving of interest rates.
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