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Plenary Lecture Notes Project Financial Instruments
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Plenary Lectures notes of the course Project: Financial Instruments Radboud University
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Lecture 105-02-2019
In the 70s and 80s there has been much volatility in financial prices:
• Exchange Rates (I)
• Commodity Prices (including Oil prices) (II)
• Interest Rates (III)
Financial risks
• The value of the firm is influenced by unexpected changes in financial prices
• The impact of increased financial price risks on firms: virtually every firm considers accounting – based
exposures – those exposures that would be reflected directly in the firm’s financial statements.
Exchange rate risk:
a. Exchange rate exposure
b. Exchange rate volatility
1- Transaction exposure: a transaction exposure exists when a change in one of the financial prices (exchange
rates) will change the amount of a receipt or an expense.
The risk is created at the moment that contracts (to import or export goods) are signed
2 – Translation exposure: a translation exposure reflects the change in the value of the firm as foreign assets
are converted to the home currency (Example: Ahold has a lot of subsidiaries in the United States)
3 – Economic exposure: (competitive exposure)
Changes in foreign exchange rates will change the firm’s receipts or expenditures not only because of the direct
price change but also because the price change will change the amount that the firm sells or buys.
The competitiveness of European firms will be influenced by a real appreciation of the euro.
Example: structure of costs and revenues of firm K and its competitor firm L
Buy production sell
costs costs revenues
K Netherlands GBP Euro Dollar
L Switzerland Euro Swiss Francs Dollar
MC Questions:
1. For which currency (or currencies) has firm K a transaction exposure?
a. GBP, Dollar, Swiss Franc
b. GBP, Dollar
c. Dollar, Swiss Franc
2. For which currency (or currencies) has firm K an economic exposure?
a. GBP, Dollar, Swiss Franc
b. GBP, Dollar
c. Dollar, Swiss Franc
An overview of the risk management process
1 - Confronted with the increased volatility in financial prices, companies found that the first and most obvious
approach was to try to forecast future prices more accurately … however economists were generally
unsuccessful in predicting changes in exchange rates, interest rates and commodity prices
1
,2 – Alternative: Risk Management:
• On balance sheet (inflexible) methods
o moving production abroad
o borrowing in the competitor’s currency
• Off balance sheet instruments
o forwards and futures
o swaps
o options
Forward contract: (Future contract) obligates its owner to buy a given asset on a specified date at a price
(exercise price/ forward price) specified at the origination of the contract
Exchange rate risk (transaction exposure)
Example: a Dutch company (Oce) signs a contract to sell 10 machines to a company in the USA for $10.000 /
machine.
• Spot rate: S0 = $1.15 / €1
• Forward rate: F0 = $1.155 / €1 (in six month)
• If Oce specifies the price in euros, the exchange rate risk is shifted to the US-firm
• If Oce uses the forward market: Oce is sure it will receive:
o $10.000 * 10 / ($1.155 / €1) = €8658
Option contracts: a right and not an obligation to buy or sell an asset
Call option: right to buy an asset by a certain date for a certain price
European options: only on expiration date
American options: before or on expiration date
Stock price value call option
on expiration date on expiration date
Higher than exercise price Stock price – exercise price
Smaller than exercise price 0!
Example 1: 1 February 2019: stock price Arcelor Mittal = € 20.55
Call option 15 March (Third Friday in March)
• Exercise price € 21, Price call option (Premium) = € 0.80
• If on 15 March, Price Arcelor Mittal = € 23
Value of the call option: € 2.00 (Profit: € 2.00 - € 0.80 = € 1.20)
• If on 15 March, Price Arcelor Mittal = € 19
Value of the call option: € 0! (Loss: € 0.80)
Put option: right to sell an asset by a certain date for a certain price
Stock price value put option
on expiration date on expiration date
Higher than exercise price 0!
Smaller than exercise price Exercise price – stock price
Example 1: 1 February 2019: stock price Arcelor Mittal = € 20.55
Put option 15 March (third Friday in March)
• Exercise price € 21, Price put option = € 1.25
• If on 15 March, Price Arcelor Mittal = € 23
Value of the put option: € 0 (Loss € 1.25)
• If on 16 March, Price Arcelor Mittal = € 19.00
Value of the put option: € 2.00 (Profit: € 2.00- € 1.25 = € 0.75)
2
,The box of financial building blocks:
• To understand the off – balance sheet instruments, you don’t need a lot of market specific knowledge;
you need to know how the instruments can be linked to one another (with implications for the price –
making process)
Which type of traders use financial instruments?
• Hedgers: (firms) hedge against unexpected price risks
• Arbitrage: (banks/ readers of Hull’s book!) try to profit from differences in prices on the same
moment on different markets
• Speculators: try to profit from differences in prices on different moments
3
, Lecture 2
08-02-2019
Chapter 1: Introduction
The Nature of Derivatives
A derivative is an instrument whose value depends on the values of other more basic underlying variables.
A derivative can be constructed on anything that has a price.
Examples of Derivatives
• Futures Contracts
• Forward Contracts
• Swaps
• Options
Ways Derivatives are Used
• To hedge risks
• To speculate (take a view on the future direction of the market)
• To lock in an arbitrage profit
• To change the nature of a liability
• To change the nature of an investment without incurring the costs of selling one portfolio and buying
another
Futures Contracts
• A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain
price
• By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a
very short period of time)
Futures Prices
• The futures prices for a particular contract is the price at which you agree to buy or sell
• It is determined by supply and demand in the same way as a spot price
Trading
• Traditionally futures contracts have been traded using the open outcry system where traders
physically meet on the floor of the exchange
• Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers
Examples of Futures Contracts
Agreement to:
• Buy 100 oz. of gold @ US$1050/oz. in December
• Sell £62,500 @ 1.5500 US$/£ in March
• Sell 1,000 bbl. of oil @ US$75/bbl. in April
Terminology
• The party that has agreed to buy has a long position
• The party that has agreed to sell has a short position
Example
• January: an investor enters into a long futures contract to buy 100 oz of gold @ $1050 in April
• April: the price of gold $1065 per oz
• What is the investor’s profit?
4
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