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Pricing Forwards
Forward price (F) is linked to the spot price (S) by an arbitrage
relationship.
For FX forwards:
Ft ,T St
(1 rt ,T )
(1 rt ,T *)
For Gold:
T-Bond futures:
F S
1 r
1 c
F S
1 r
1 ytm
c = cost of depositing
ytm = yield to maturity
r(len)=1%
Fbid
(1 rbor )
Sbid
(1 rlen *)
Fask
(1 rlen )
Sask
(1 rbor *)
FUTURES MARKETS
Futures are standardized forward contracts, traded
in organized exchanges and ensured by a central
clearing house.
A margin is always required, deposited at the
Clearing House. (Initial Margin vs. Maintenance margin)
Standardized contracts permit centralized trading
without market makers.
In a futures market, the size, the maturity (delivery)
date, and the specifications of the traded asset (for
commodities and agriculturals) are standardized.
Eurodollar futures:
F = 100 r
(a bet on the interest rate that will prevail on T)
Used to hedge interest rate risk.
OPTIONS
An option is the right but not the obligation to buy or
sell a financial asset at a predetermined price.
It is an agreement whereby the option seller (writer)
gives the option buyer this right, in exchange for a
premium (called option price)
Two types of options: Call Options: The right to buy
Put options: The right to sell
Two styles of options:
American options: Can be exercised at any time till expiration,
European options can only be exercised on the maturity date.
(S = 1.4260)
Delta:
Ct / St
or
Pt / St
Exercise Questions
Do you think an American or European option identical in
other respects (type, maturity date, strike price, etc.) should
have a higher price ?
How and when would you use options to hedge against
exchange rate risk? Give examples.
S=2.29/31. A Bulgarian exporter expects a profit of BGN
50,000 from an export transaction of GBP 500,000. The
finance manager of Bulgarian exporter expects GBP to rise,
however he would get fired if the export transaction ends up
with a loss. What can he do?