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CA (170,000)
UTSC (20,000)
Chapter 26

Chapter 26 Notes


Department
Management
Course Code
MGFC10H3
Professor
Derek Chau
Chapter
26

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Chapter 26 Derivatives and Hedging Risk Notes
26.1 Forward Contracts
forward contract an arrangement calling for future delivery of an asset at an agreed-upon price
taking delivery refers to the buyer’s actually assuming possession from the seller of the asset agreed upon in forward contract
deliverable instrument the asset in a forward contract that will be delivered in the future at an agreed-upon price
making delivery refers to the seller’s actually turning over to the buyer the asset agreed upon in a forward contract
cash transaction a transaction where exchange is immediate, as contrasted to a forward contract, which calls for future
delivery of an asset at an agreed-upon price
26.2 Future Contacts
futures contract obliges traders to purchase or sell an asset at an agreed-upon price on a specified future date; the long position
is held by the trader who commits to purchase; the short position is held by the trader who commits to sell; futures differ from
forward contracts in their standardization, exchange trading, margin requirements, and daily settling (marking to market)
a futures contract differs somewhat from a forward contract
1) the seller can choose to deliver on any day during the delivery month
2) futures contracts are traded on an exchange whereas forward contracts are generally traded off an exchange
3) the pries of futures contracts are marked to the market on a daily basis
marked to the market the daily settlement of obligations on futures positions
26.8 Summary and Conclusions
1. Firms hedge to reduce risk.
2. A forward contract is an agreement by two parties to sell an item for cash at a later date. The price is set at the time the
agreement is signed. However, cash changes hands on the date of delivery. Forward contracts are generally not traded on
organized exchanges.
3. Futures contracts are also agreements for future delivery. They have certain advantages, such as liquidity, that forward contracts
do not. An unusual feature of futures contracts is the mark-to-the-market convention. If the price of a futures contract falls on a
particular day, every buyer of the contract must pay money to the clearinghouse. Every seller of the contract receives money
from the clearinghouse. Everything is reversed if the price rises. The mark-to-the-market convention prevents defaults on futures
contracts.
4. We divided hedges into two types: short hedges and long hedges. An individual or firm that sells a futures contract to reduce risk
is instituting a short hedge. Short hedges are generally appropriate for holders of inventory. An individual or firm that buys a
futures contract to reduce risk is instituting a long hedge. Long hedges are typically used by firms with contracts to sell finished
goods at a fixed price.
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