30 years: Risk management & derivatives trading
“Derivatives” is a catch all term for a wide range financial products. In this series, Lindsey will cover what forwards and futures are and how to price a forward trade.
“Derivatives” is a catch all term for a wide range financial products. In this series, Lindsey will cover what forwards and futures are and how to price a forward trade.
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10 mins 54 secs
Derivatives is a catch all term for a wide range of financial products, including futures and options, interest rate swaps, oil options, FX forwards, equity swaps and credit default swaps. Forwards contracts can be used in circumstances where prices are uncertain, and thus traders lock in and hedge their risk. The calculation of the fair forward price is outlined below.
Key learning objectives:
Define forwards and futures contracts
Learn the formula for calculating the fair forward price
Identify what the price of a 3 month forward NOT involve
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Equities, interest rates, bonds, currencies, gold and oil.
Allow users to trade an asset today, at a price and in a quantity agreed today, but for a settlement at an agreed point in the future. Entering into a forwards contract eliminates the risk of a price rise, hence they are hedging this risk.
For example, for a company making jewellery, they need platinum at a point in the future, and are concerned that the price may rise well above today’s level to a level they are unable to pay. By entering into a forward contract, they can fix the price today, to purchase the platinum in the future. All of the details are agreed upfront, and then the settlement occurs say 3 months later.
Many people say that derivatives, such as the forward contract above are a “zero-sum game” - one party makes and the other loses in opposite amounts. If the platinum price rises, the jeweller makes money on the trade and the miner loses money - and they exactly offset each other - making it “zero sum”.
The way to think about this is to make your own forward trade. Imagine buying LMCorp stock now and holding the position for 3 months - how much would this cost in total?
Spot Price + Costs of Holding - Benefits of Holding
Does not involve any discussion, prediction or guessing of the price of LMCorp shares in 3 months time. We are using the spot-forward arbitrage to price the forward contract - where the arbitrageur would trade the spot an drudge with the forward and so be left with no exposure to the price of the underlying.
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