Financial Instruments
Introduction 1
Chapter 1 - introduction to all financial instruments 6
Chapter 2 – Mechanics of futures markets 10
Chapter 3 - Hedging strategies using futures 13
Chapter 5 - Determination of forward and future prices 16
Chapter 7 - Swaps 24
Chapter 10 – property of stock options 37
Chapter 12 – Binomial trees 43
Chapter 13 – the Black-Scholes-Merton-Model 48
Formula overview 57
Introduction
Unpredictable movements in exchange rates, interest rates and commodity prices not only can affect
a firm’s reported quarterly earnings but even may determine whether a firm survives. In the 70s and
80s there was a lot of volatility in exchange rates, commodity prices and interest rates, so traders
came up with ways to hedge against these risks.
Financial risks
Exchange rate risks
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. It happens when the value of money
changes, for example: if you're buying or selling something internationally, and the exchange rate
changes after you've agreed on the deal but before you actually exchange the money, it can alter
how much you end up paying or receiving.
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 Delhaize has a lot of subsidiaries in the
United States). if a company has stores or investments in another country and the value of that
country's currency changes compared to the company's home country currency, it affects how much
those assets are worth when translated back into the home currency.
Economic exposure: (competitive exposure): Changes in foreign exchange rates will change the
amount that a firm sells or buys. if a company imports materials from abroad and the cost of those
materials goes up due to changes in exchange rates, it might decide to buy fewer materials or raise
prices on its own products, which can affect its competitiveness in the market. The competitiveness
of European firms will be influenced by a real appreciation of the euro.
,Example questions:
Example 1: structure of costs and revenues of firm K and its competitor firm L
buy costs production costs sell revenues
K Netherlands GBP Euro Dollar
L Switzerland Euro Swiss Francs Dollar
• 1: For which currency (or currencies) has firm K a transaction exposure?
A) GBP, Dollar, Swiss Franc B) GBP, Dollar C) Dollar, Swiss Franc
Firm K has transaction exposure in GBP and Dollar, as changes in the exchange rates for
these currencies will directly impact the amount of money received or spent during
transactions.
• 2: For which currency (or currencies) has firm K an economic exposure?
A) GBP, Dollar, Swiss Franc B) GBP, Dollar C) Dollar, Swiss Franc
Because Firm K buys using the GBP currency, it might buy less when the GBP appreciates in
value. Firm K sells in dollars, if the dollar depreciates in value, demand for the product it sells
could rise, therefor they change their output. Also because Firm K is involved in international
trade they would likely be affected by changes in the Swiss francs value.
Risk management
In the past, companies were confronted with the increased volatility in financial prices. They 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. As an alternative they came up with risk management. There are 2 types
On Balance Sheet Methods (Inflexible): This involves making changes directly on the company's
financial statements. For example:
- Moving Production Abroad: Sometimes, companies choose to move their production
operations to countries where costs might be lower or where they can reduce exposure to
certain risks.
- Borrowing in Competitor’s Currency: Companies might choose to borrow money in the
currency of their competitors to offset risks associated with exchange rate fluctuations.
Off Balance Sheet Instruments: These are financial tools that don't directly impact the company's
financial statements. Examples include:
- Forwards and Futures: Contracts that allow companies to lock in future exchange rates or
commodity prices to reduce uncertainty.
, - Swaps: Agreements where two parties exchange cash flows or liabilities, often to manage
interest rate risk.
- Options: Contracts that give the holder the right, but not the obligation, to buy or sell an
asset at a predetermined price, helping companies hedge against unfavourable price
movements.
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 = $1.095 / €1
- Forward rate: F0 = $1.110 / €1 (in six month)
*Spot rate: the rate at which currencies are traded right now, on the spot, without any delay. For
example, if the spot rate for the euro (EUR) to U.S. dollar (USD) exchange is $1.095 per euro, it means
that at this moment, one euro can be exchanged for $1.095.
Oce can now do one of the 2 following things:
1. Scenario 1: Shifting Exchange Rate Risk to the US Firm:
Oce signs a contract to sell 10 machines to a US company for €10,000 each. The spot
exchange rate is $1.095 per euro. This means if Oce receives payment in euros, it's the US
firm that bears the risk of any changes in the euro-dollar exchange rate. So, regardless of
how the exchange rate changes, Oce will still receive €10,000 per machine.
2. Scenario 2: Using the Forward Market
Oce decides to hedge its exchange rate risk by using the forward market. The forward rate is
$1.110 per euro, applicable in six months. Oce knows it will receive $10,000 per machine,
and it wants to ensure it receives the equivalent amount in euros after six months. By using
the forward rate, Oce calculates that it will receive €9009,01 in six months for each machine.
Options trading
An option contract is a financial agreement that gives the buyer the right (but not the obligation) to
buy or sell an asset at a predetermined price within a specified time frame. It offers the flexibility to
choose whether or not to execute the trade, depending on what's more advantageous when the
contract expires.
- A seller of an option contract, also known as the option writer, profits from the contract by
earning the premium paid by the buyer. When the option is initially sold, the seller receives a
payment called the "premium" from the buyer. This premium is the price paid for the right to
buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.
American option: These options can be exercised (bought or sold) at any time before or on the
option's expiration date
European option: These options can only be exercised at the end of the option's expiration date.
, Call option:
A call option gives the owner the right to buy an asset at a fixed price during (or at) a particular
period. There is no restriction on the ‘underlying’ asset, but the most common ones are options on
shares and bonds.
- When an option is "out of the money," it means that exercising the option at the current
market price would not be profitable for the option holder. In other words, the option's
strike price (the price at which the option can be exercised) is not favourable given the
current market conditions.
Example 1: 21 January 2021: stock price Randstad = € 55.50
Call option 19 February (Third Friday in February)
Exercise price € 56, Price call option (Premium) = € 1.50
- If on 19 February, Price Randstad = € 60. Value of the call option= € 4.00
o (Profit: € 4.00 - € 1.50 = € 2.50)
- If on 19 February, Price Randstad = € 51. Value of the call option: € 0
o The option is out of the money and will not be exercised, you have loss of 1.50
Put options
A put option gives the owner the right to sell an asset at a fixed price during (or at) a particular
period. There is no restriction on the ‘underlying’ asset, but the most common ones are options on
shares and bonds.
- Strike Price: It's the price at which an option allows you to buy (in the case of a call option) or
sell (in the case of a put option) the underlying asset.
- Put Value: For a put option, the put value is the difference between the strike price and the
current market price of the asset. It represents the potential profit if you exercised the put
option. If the market price is lower than the strike price, the put option has value; if it's
higher, the put option has no value.
Example 1: 21 January 2021: stock price Randstad = € 55.50. Put option 21 February (third Friday in
February)
Exercise price € 56, Price put option = € 2.00
- If on 19 February, Price Randstad = € 60. Value of the put option: € 0 (Loss of € 2.00)
- If on 19 February, Price Randstad = € 51. Value of the put option: € 5.00
o (Profit: € 5.00- € 2.00 = € 3.00)
Example Oce – Options
Oce signs a contract to sell 10 machines to a US company for $10,000 each.
The spot rate (current exchange rate) is $1.095 per euro.
In this case, Oce buys put options to sell $100,000 for €0.91 per dollar. This means Oce has the right
to sell $100,000 at a rate of €0.91 per dollar if it chooses to exercise the option. There are 2 possible
scenarios:
