4w FinEcon 2024fall v1

Summary

This 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

00:00

🌟 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.

05:01

🔍 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.

10:01

📈 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.

15:02

💼 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.

20:03

🛠️ 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.

25:06

🌐 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.

Keywords

💡Future

A 'Future' is a type of financial derivative that obligates the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. In the video, futures are discussed in the context of trading on an exchange with daily settlement. It's a key concept in understanding how to hedge against price fluctuations, as it allows traders to lock in prices for future transactions.

💡Forward

A 'Forward' contract is similar to a future, but it is not traded on an exchange and is customized between two parties. The video script explains that forwards can be settled at any time other than the current date, unlike futures which are settled daily. Forwards are crucial for the discussion on hedging strategies as they allow for price certainty in future transactions.

💡Hedging Strategy

A 'Hedging Strategy' is a method used to reduce or manage the risk of price changes in an investment. The video discusses how futures and forwards can be used for hedging, particularly in the context of locking in prices for commodities like gold. It's a way for businesses to protect themselves from potential losses due to market volatility.

💡Spot Price

The 'Spot Price' is the current market price of a commodity, security, or currency. In the script, the spot price of gold is used as an example to demonstrate how the price of a future or forward contract is determined based on the current price plus the time value of money.

💡Settlement

'Settlement' refers to the process of concluding a financial transaction by exchanging money for the asset or vice versa. The video script differentiates between daily settlement for futures and non-daily settlement for forwards, which is a key distinction between these two financial instruments.

💡Time Value

The 'Time Value' of money is the concept that a sum of money is worth more now than the same sum in the future due to its potential earning capacity. The video explains how time value is used to calculate the forward price from the spot price, by factoring in the interest that could be earned over the period until the forward contract matures.

💡Interest Income

'Interest Income' is the return earned on an investment. In the context of the video, it's used to illustrate how the price of a forward contract is determined by considering the interest that could be earned on the spot price if it were deposited in a bank until the contract's maturity.

💡Arbitrage

Arbitrage is the practice of taking advantage of a price difference between two or more markets to make a profit. The video script mentions arbitrage in relation to how understanding the pricing mechanism between spot and forward markets can be used to identify and exploit price discrepancies.

💡Goldman Sachs

Goldman Sachs is mentioned in the script as an example of an entity that might use a hedging strategy. The video discusses a scenario where Goldman Sachs might want to lock in the price of gold for future delivery, illustrating how a forward contract could be used for this purpose.

💡FX Rate

FX Rate stands for Foreign Exchange Rate and refers to the value of one currency against another. The video script uses the example of a cabbage exporter who will receive USD in the future and might want to hedge against the risk of an unfavorable change in the FX rate by taking a short position in USD.

💡Risk Management

'Risk Management' is the process of identifying, assessing, and prioritizing risks to an individual or company's capital and earnings. The video discusses how hedging strategies using futures and forwards can be part of a company's risk management plan to mitigate financial risks, such as fluctuations in commodity prices or exchange rates.

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