Forward and Futures Harvard Case Solution & Analysis

Introduction

Derivatives are the contracts that derive the value of the underlying asset at the spot. The underlying asset could be shares,commodities,bond and money market instruments. There are many types of derivatives, and futures and forwards are one of them. For simplicity, it is assumed that futures and forward are same thing.

Both futures and forwards can be used for hedging as well for speculative purpose. Hedging is a risk management tool that can be used to limit or offset the probability of loss from the unexpected fluctuation of prices. Speculation in derivatives can be used to speculate the price in order to earn potential return.

Case Analysis

A typical example of the derivative contract is gold futures, for example an investor holds physical holding of the gold and he is afraid that prices will be fall in the international gold market.There are two options available to the investor either he can sell the position in physical gold and take it back at lower price take a position in derivative contract. First option will not be possible he investor is gold mine or refinery company and wish to protect value of mine of gold refined. An easy and value for money method is to sell or put position in Gold traded contracts to lock in the rate.

Financial Asset with no income

There are certain financial derivatives that do not generate income and only change in value when there is change in underlying change in asset value. As delivery or cash settlement is expected to be made in future so price of derivative and underlying might not be always have same price. There is always arbitrage opportunity available. Arbitrage is difference in the price which could be due to demand and supply.

The mechanism of the non-income generating financial assets is for example,an investor wishes to hold a position in a stock, then there are several options available to him ;either he can bowwow the money from the bank and can use these funds to buy the securities or he can but it on leverage. Leverage is same as borrowing funds from the brokerage house which will charge interest on the amount of borrowed funds.

The value of the derivative contract be calculated as follow,

Spot Price

$100

Maturity 90 Days
Risk free Rate

6%

Value

103.1128

Suppose a security is traded on $100 at current spot and an investor wishes to hold it for 90 days, future price will be calculated as $103.11 based on risk free rate of 6%. Interest rate is added to the spot price because it is amount that is forgone if same amount is place and risk free return could be earned.

Financial Assets with Income

Some financial instruments generate income such as shares can generate dividend income and bond will generate interest income. The amount of dividend will be deducted from the value of the future contract in order to make it ex-divided or ex-interest rate. The formula for the valuing future price is same as above but amount of dividend is deducted.

Forward and Futures Case Solution

Dividend or interest amount is received by short seller/put holder and will not be received by the long position holder/call holder. The logic is simple and easy, short sellers are assumed to be have shares and wish to sell them, while long position holder commits to buy. This is why dividend amount is credited to the short seller account.

The value of the derivative contract without dividend can be calculated as follow,

With Dividend/Interest Income
Spot Price

$100

Maturity 90 Days
Risk free Rate

6%

Dividend

$0.50

Value

102.6128

There would be change in assumption if the dividend is not declared and paid but dividend is expected to be paid after on month, in this case present value of the dividend would be deducted and revised calculationsthat wouldbe present would always have lower value so using the risk free rate present value of the dividend would be deducted and derivative value be lowered.

Foreign currency futures/Forward prices

Interest rate parity mainly operates in the currency market. In order to value the foreign currency futures and forward, interest rate parity will play an important role in the valautaion.An investor will not able be able to earn more than the prevailing risk free rate due interest rate parity. The mechanism of hedge will be that it will have to exchange foreign currency. Ifanexporter was expecting to receive amount in three months than he can borrow loan in foreign currency and sell it in open market at spot rate and loan can be repaid when the amount is received.............

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