4w FinEcon 2024fall v1
Summary
TLDRThis session delves into the nuances of futures and forwards trading, highlighting their similarities and differences. It emphasizes the importance of understanding the pricing mechanism between spot and forward markets, which hinges on the concept of time value. The presenter illustrates how to calculate forward prices from spot prices by incorporating interest rates, crucial for hedging strategies. The discussion also touches on long and short futures positions, using gold as an example to demonstrate how to lock in prices and manage risk, ultimately encouraging businesses to focus on their core operations rather than speculation.
Takeaways
- 📈 Futures and forwards are similar financial instruments, with the primary difference being that futures are traded on exchanges and forwards are traded over-the-counter.
- 💼 Futures have daily settlement, whereas forwards do not necessarily have daily settlement, but can be customized for different settlement periods.
- 🔄 The relationship between spot and forward prices is crucial for understanding how to use futures and forwards for hedging and arbitrage.
- 💡 The concept of time value is key to understanding the pricing mechanism of futures and forwards, as it represents the interest income from holding the asset until the settlement date.
- 📊 Moving from spot to forward involves calculating the time value of money, which is essentially the spot price multiplied by (1 + interest rate).
- 📉 To move from forward to spot, a discounting process is used, which involves dividing the forward price by (1 + interest rate) to get the spot price.
- 🏦 A practical example is given where借金 (borrowing gold) and depositing the proceeds at a bank with interest can help lock in a forward price for gold.
- 🔒 Locking in a forward price can be achieved by either entering a long or short position, depending on whether you expect to buy or sell the asset in the future.
- 🌐 Hedging strategies are important for companies to mitigate risks arising from interest rates, exchange rates, and other market variables, allowing them to focus on their core business.
- 📚 The speaker emphasizes the importance of understanding the time value concept and the relationship between spot and forward prices for effective hedging.
Q & A
What is the main difference between a future and a forward contract?
-The main difference is that futures are traded on an exchange, while forwards are traded over-the-counter (OTC). Futures have daily settlement, whereas forwards do not necessarily have daily settlement; they can be settled at the maturity date.
How are future and forward prices determined based on the spot price?
-Future and forward prices are determined based on the spot price plus the time value of money. The time value is calculated by adding the interest income that could be earned if the spot amount were deposited in a bank until the future or forward contract's maturity.
What is the concept of time value in the context of futures and forwards?
-Time value represents the growth of money over time due to interest. In the context of futures and forwards, it is the additional amount that the spot price must be adjusted by to account for the interest that could be earned or paid until the contract's maturity.
How can one move from the spot price to the forward price?
-To move from the spot price (S) to the forward price (F), one would calculate the time value by multiplying the spot price by (1 + interest rate) for the time period until maturity. This adjusted spot price would then be the forward price.
What is the formula to move from the forward price back to the spot price?
-To move from the forward price (F) back to the spot price (S), the formula used is S = F / (1 + interest rate). This is essentially discounting the forward price by the interest rate over the time period until maturity.
Why would someone want to lock in the price of gold using a forward contract?
-Someone might want to lock in the price of gold using a forward contract to hedge against price fluctuations. This ensures a known price for future transactions, reducing the risk of adverse price movements.
What is a long futures hedge and when would it be appropriate?
-A long futures hedge is when an investor expects to buy an asset in the future and wants to lock in the current price to protect against potential price increases. It is appropriate when the investor plans to purchase the asset at a future date.
What is a short futures hedge and when would it be appropriate?
-A short futures hedge is when an investor who expects to sell an asset in the future wants to lock in the current price to protect against potential price decreases. It is appropriate when the investor plans to sell the asset at a future date.
How can an investor lock in the price of an asset like gold in a year using a forward contract?
-An investor can lock in the price of gold for a year by entering into a forward contract at the current spot price plus the interest income that could be earned on that amount over a year. At maturity, the investor will pay the agreed-upon forward price and receive the gold.
What is the rationale behind using hedging strategies like futures and forwards for businesses?
-Businesses use hedging strategies to mitigate financial risks associated with price fluctuations in the markets. By locking in prices, they can focus on their core business operations without being exposed to uncertainties in the market.
Can you provide an example from the script of how a business might use a hedging strategy?
-In the script, an example is given of a cabbage gimchi business that will receive $5 million in three months. The business owner might take a short position on USD to hedge against the risk of currency exchange rate fluctuations, ensuring a stable revenue in their local currency.
Outlines
🌟 Introduction to Futures and Forwards
The speaker begins by introducing the topic of the session, which is about using futures and forwards as a hedging strategy. They clarify the difference between futures and forwards, explaining that futures are traded on exchanges and have daily settlement, while forwards are traded over-the-counter and can have different settlement terms. The focus then shifts to the importance of understanding how future and forward prices are determined based on spot prices, which is crucial for utilizing these instruments effectively in hedging and arbitrage.
🔍 Understanding the Spot and Forward Pricing Mechanism
The speaker delves into the relationship between spot and forward pricing. They use the example of gold trading in both the spot and forward markets, explaining that while spot gold can be bought and sold for immediate delivery, forward gold is an agreement to buy or sell gold at a future date. The key takeaway is the concept of time value, which is the difference between the spot price and the forward price, taking into account interest rates. The formula provided illustrates how to move from the spot price to the forward price by factoring in the time value of money.
📈 Hedging with Futures and Forwards
The discussion continues with a practical example of how to hedge using futures and forwards. The speaker suggests a strategy for a friend who works at Goldman Sachs and needs to lock in the price of gold for future delivery. The strategy involves borrowing gold, selling it at the current spot price, and depositing the proceeds in a bank to earn interest. This way, the friend can lock in the current price of gold for future delivery by entering into a forward contract. The speaker emphasizes the importance of understanding the pricing mechanism to effectively use hedging strategies.
💼 Practical Application of Hedging Strategies
The speaker provides a detailed walkthrough of the practical steps involved in hedging using the example of borrowing and selling gold, then depositing the proceeds to earn interest. They explain that after one year, the friend would need to buy gold in the market to return to the lender and would also have interest income from the deposited amount. This strategy effectively locks in the gold price at the current spot price plus the interest income earned during the year, illustrating how the forward price is determined based on the spot price and interest rates.
🛠️ Long and Short Hedging Strategies
The speaker contrasts long and short hedging strategies using the example of buying or selling gold in the future. They explain that a long hedge is appropriate when someone plans to buy an asset in the future and wants to lock in the current price, while a short hedge is suitable when someone plans to sell an asset in the future and wants to lock in the current price. The speaker also touches on the importance of hedging for businesses to focus on their core operations and minimize risks arising from interest rates, exchange rates, and other market variables.
🌐 Managing Foreign Exchange Risk
In the final paragraph, the speaker discusses the risk of foreign exchange rate fluctuations and how hedging can be used to manage this risk. They use the example of a cabbage exporter who will receive USD in three months and needs to protect against currency fluctuations. The speaker suggests that the exporter should take a short position in USD to hedge against the risk of currency devaluation. The paragraph concludes with the idea that hedging allows companies to focus on their main business operations while minimizing risks from market variables.
Mindmap
Keywords
💡Future
💡Forward
💡Hedging Strategy
💡Spot Price
💡Settlement
💡Time Value
💡Interest Income
💡Arbitrage
💡Goldman Sachs
💡FX Rate
💡Risk Management
Highlights
The difference between futures and forwards is that futures are traded on exchanges, while forwards are traded over the counter.
Futures have daily settlement, whereas forwards do not necessarily have daily settlement.
The concept of how future and forward prices are decided based on spot prices is crucial for hedging and arbitrage strategies.
Spot trading involves immediate buying and selling, with settlement occurring on the same day.
Forward trading involves agreeing to buy or sell an asset at a future date, with settlement occurring at that future date.
The price of gold in the spot market is denoted as S, while the forward price is denoted as F.
The relationship between spot price (S) and forward price (F) is determined by the time value of money.
To move from spot to forward, you need to consider the time value, which is calculated as S times (1 + interest rate).
The formula to move from forward to spot involves discounting, which is F divided by (1 + interest rate).
Goldman Sachs might want to lock in the gold price for delivery in one year to mitigate the risk of price fluctuations.
A friend working at Goldman Sachs is advised to enter a short forward position to lock in the current gold price.
The strategy involves borrowing gold, selling it at the spot market price, and depositing the proceeds in a bank with interest.
After one year, the borrowed gold must be repaid by buying it back at the market price, and the interest income is used to offset the cost.
The forward price of gold should be equal to the spot price plus the interest income earned on the cash from selling the gold.
Hedging strategies can be long or short, depending on whether you plan to buy or sell an asset in the future.
Long futures hedging is appropriate when you plan to purchase an asset in the future and want to lock in the price.
Short futures hedging is suitable when you plan to sell an asset in the future and want to lock in the price.
Hedging can help companies focus on their core business by minimizing risks arising from interest rates, exchange rates, and other market variables.
The example of cabbage gimchi and its export to the USA illustrates the use of hedging to manage foreign exchange rate risk.
Transcripts
hello everyone uh today's topic is about
hatching strategy using a
future or
forward in the previous session we
talked about what is Future and forward
only difference between future and
forward is
what future is uh traded in The Exchange
and forward is traded outside of
exchange and future you know has daily
uh settlement however for it's not only
uh you know
forward can have you know Cal exchange
but this is not equal to daily ass
set other than this you know there is
not really different
uh between you know future and forward
so you know using future using forward
Hing strategy not really uh you know
different and spot and
forward see uh you know you guys are
still uh not clear how the future price
or forward price will be decided based
on uh spot price this
concept uh I think
uh it's really uh in
know import important part
because without this concept you
not you have no idea how to uh utilize
future and forward in terms of heading
and in terms of uh Arbitrage in terms of
calculation so let's see one more
time what is the mechanism between uh
spot and forward in terms of
pricing now there are two
words one is
spot the other one is
forward what future you know it can be
forward a
future in the spot
world people are trading a
gold as a spot which
means you can buy and sell today and
settled will be done
today you don't need to
wait you know several uh weeks or month
to
have gold so you buy gold and you have
it right
away in the SP you know
gold is TR
it in the in the in the forward
World gold a also tried
it which gold is traded
gold
to
be
settled to
be
settled
in one
year so in the in the forward world and
people are trading uh
gold every day but that gold cannot be
coming into cannot you know coming into
coming into your pocket right
way it doesn't matter like uh trading a
go in the forward world but the goal
itself will
arrive and one year that is only uh
difference so gold to be settled in one
year
people belong
to spot world and
also belong to forward
world so let's
suppose we can make a journey
from
from Spar word to forward
world or from forward world
to spot
world now thing
is what is what is
price of you know 1 o of
gold in the SP world that is
just
this is price for the one o of
gold this is
price and for the
world gold is also tr8 what
price that is
F this is also
price
you still you know don't
forget gold is traded in the for world
that Cod will be accepted in one year
not
now but still you know f is also traded
with
price the question
is what is the relationship
between S
and
F to understand the relationship between
S and
F is to know about the pricing mechanism
the in the previous uh in know session
we talked about s such
as
1100 for 1 o of
gold
and rate
a
2% yeah based on this
information we like to
move from s
to
F this
is now
this is one
year it's simply you are depositing you
know
1100 into the bank and wait for the one
year then how much you're going to get
in one
year
1100 plus
what
interest
income this
say uh how can I
say we can say this is time
value this interest
income is nothing but time
value so which
means moving from now to one year
there should be always time value is
associated so that's why
from s to F so moving from s to F we
need to think about what is time
value so this
why we reviewed in the previous
session as
times 1
+
2%
is
f to move from s to
f
s
increase as much as time
value uh let's make
simple then you
arrive to the fold one
word in the fourth
word what is price of gold that is
f in
theory your time
value
of golds in the
spot should be equal to
to F this is also gold
price is in the B
market got
it and the other one is how
about we move back from F to
S now we starting from F to
S how we can move this is also part of
like a discounting
so
now this why you can
move from F to
S through this
formula which means
f
s this is in know uh relationship
between uh Spar world and forward world
where you know time value should be
considered time value should be factored
into based on this understanding uh
let's move
on Yeah question
now Goldman sax will have one o of gold
in one year not now they are going to
have one of gold in one year but let's
suppose your
friend as an employee of gold MX intends
to lock in a gold price may they may
think uh in one year they have one o of
gold what about the you know the gold
price going down that's not
it's not you know they're not happy uh
to have you know just let you know one
owns of gold price go down so they like
to like lacking
lacking the current price such as
11,100 yeah
to to lack in uh you know gold price how
they are going to
do what is the re what would be
reasonable transaction you like to
suggest for your friend locking in the
price on gold such as one
$1,100 that gold is going to be
delivered in one
year
okay so you if your friend uh agreed to
uh one year gold forward short
position because you suggested yeah
let's do have you know for short
position
on one o of gold maturity is one year so
if your friend agrees so need to some
advice from you on the price of gold
forward yeah ke next question is what is
gold price is okay to take position of
you know one year gold forward short
position then what is the price how you
can help him to decide the price of gold
forward based on
following yeah
let's understand what it is your friend
is able to
borrow just suppose borrow one of gold
from Bad reserve for one
year then he can sell it in the gold
market with
$1100 and deposit that amount in the
bank with 2% interest for one
year yeah think you
understand
now
gold
spot sell it
and
money your friend have money is
deposit
okay then just
wait
for one
year okay after one year your friend
need
[Music]
to need to return
back the one o of gold to F
Reserve then he should buy because he
already sold
out before you know I mean the one year
before now he's going to return back to
the F
result so that's why he need to buy one
o of
in the
market
now what is uh you know what is
Cash uh you know interest income from
1,00 which he has been deposited in the
bank that is interest
income so which
means in one year you need to
buy 1 o of
gold in the
market and also he
has some interest income from the cash
amount that cash amount was
generated is sold out gold that gold was
borrowed from Federal Reserve in theory
in
theory he
shoot
by
one o
of
C in one
year Lely equal
to
spot spot
or plus interest
income
interest income
yeah this would make
sense uh this would make a sense still
you know you don't do you do not
understand this part and please let me
know I think this this uh principle is
very important I think uh uh without
understanding uh this processing
mechanism uh between spot and forward in
terms of In Time Value uh not easy to
move
forward
so either way uh you
know this uh you know can be uh one uh
additional angle for you to understand
how forward price will be decided based
on spot price and plus interest income
when you are sold up your borrowed gold
and deposit into a bank and your
additional interest income that would be
added
so it is going to be you know similar to
fold
price okay and long and short hatch so
long future hatch age proper when you
know you will purchase an asset in the
future I want to lack in the price such
as
gold and short future hatch is
appropriate when you know uh you will
sell an asset in the future I want to
lack in the
price see in one year period in one year
period you buy you
buy one o of
gold and or you receive you
sell one o of
gold which means you're going to receive
one o of gold in one
year okay this one you're going to buy
one o of gold because you need
to yeah you need to uh use that on of
gold for like making ring
Etc so question is you like
to you like to lock in the gold price in
one year such as
1100 this is
similar and as like a current gold
price to buy one o of gold in one year
then what is your hatching
strategy in one year you like to buy one
o of world What is hting strategy to
lock in the
price
long
future on gold one on of
go then in one
year through like your uh future you
will
have you will pay $1,100
and then you will get delivered one o of
gold which means you have lock in your
gold
price at around
$1,100 and this one what is your
hatching
strategy
short
future
okay so in one year you are going to
have one o of
gold as you know uh spot but uh you like
to uh sell that into the gold market how
you do that you know you you exercise I
mean you know future is obligation so
you have to deliver one o of gold and
you receive cash $1,100 for from your
counterparty your
friends the argument is argument in
favor of hatching why uh why you know
Goldman sucks uh need to make a hatch
and also we talked about the cab
business kab uh you know made gimchi uh
cabbage gimchi and exported into uh you
know USA and uh he will uh
receive five five million US dollar you
know $5 million in three months and in
that
case p uh strategy
was he has
to take a you know short position on
USD that uh short position has three
months maturity yeah we talked about
already
why he doesn't do that because FX
rate related profit and
loss that is our main
business by Caleb Caleb main business is
he made a good quality of G and uh
exported and see
you know make some gaining from uh the
set of you know cabage b cavage g not
like uh you know betting on
FX you know a foreign exchange asset
which
means to
do hat the company can focus on the main
business such as you know gimchi uh you
know cabbage gimchi business
and they are in and take step to
minimize RIS risk arising from interest
rates and exchange rate and other Market
variable so like you know K of case he
doesn't do anything at all on the you
know FX uh amount will be uh delivered
in uh three months then he may expose to
you know the risk of foreign exchange
rate but he like to minimize how
hatching
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