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Forwards Futures Swaps & Options Summary

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EBS Forwards, Futures, Swaps & Options
1
Forwards, Futures, Swaps & Options
Forwards, futures, swaps & options are derivative instruments, that is, their value is derived from the
price performance of an underlying asset.
Forwards, futures and swaps are terminal instruments, meaning that there has to be a closing
transaction to the contract (it is a legal obligation). With options, the holder has the choice of whether
they want to complete the transaction.
With forwards & futures you are locking yourself into a fixed price at some point in the future, either
you agree to buy at that price, or you agree to sell at that price.
With options you are protecting yourself against an adverse move, but if there is a favourable move in
the underlying, you can take advantage of that and simply let the option lapse.
Forwards, futures and swaps would be used by hedgers (who could be large companies), who want to
remove uncertainty from their future cash flows. This will make the company less risky and please debt
holders. Shareholders will be pleased when it works in their favour, but be less pleased when the
company would have been better off without the hedge.
If the company hedges and rivals don’t and the underlying asset moves favourably (if you were
unhedged), then the rivals have a competitive advantage and may be able to exert pricing pressure
against the hedged company.
Payoffs to Forwards, Futures & Options
Forwards and futures are very similar in nature, so the payoff diagrams are the same.
Imagine a situation where you have a user of aluminium, say a car manufacturer, and the producer of
aluminium, a large steel company. The aluminium price has been volatile over the past few years. The
car manufacturer would like to buy when the price is low and the aluminium producer would like to sell
when prices are high. But the car manufacturer cannot buy and stockpile years of aluminium. They
both have to take the prices that are in the market.
The car manufacturer is worried about having to pay higher and higher prices for the aluminium. This
will eat into the profits it makes on selling its cars. The price of aluminium is $2000 on the markets just
now. How can the car manufacturer remove some risk from its operation?
The car company’s exposure to aluminium price changes is shown below;

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EBS Forwards, Futures, Swaps & Options
2
As the price of aluminium rises from $2000, the car producer has to pay higher and higher prices for its
supply. This will impact its profitability and its cash flow. It may even affect its ability to service its debt.
The car company would like to remove this risk from its operations. To do this they could buy futures
contracts on aluminium. Say the three month futures price for aluminium is $2000 per tonne. This
would mean they have the obligation to buy aluminium at $2000 in three months time, if they buy the
futures contract.
This will lock them in at $2000. If the price of aluminium goes up to $3000, then they will have to pay
$3000 per tonne in the market place, but they could then sell their futures contract for $3000. They will
have lost $1000 relative to the aluminium price today on the underlying aluminium, but they will have
made $1000 on the futures contract, which they have just closed by selling it. They have a fixed price of
$2000.
If the aluminium price fell, they are locked in at $2000, they would be able to buy aluminium cheaper in
the market place, but they would suffer a loss on selling the futures contract (when they close the
position, as they have to).
The payoff diagram for the futures purchase is shown below;
The diagram shows that as the aluminium price rises, the futures contract (Buy futures) will rise in value,
offsetting the relative loss on the underlying aluminium, fixing a price of $2000.

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EBS – Forwards, Futures, Swaps & Options Forwards, Futures, Swaps & Options Forwards, futures, swaps & options are derivative instruments, that is, their value is derived from the price performance of an underlying asset. Forwards, futures and swaps are terminal instruments, meaning that there has to be a closing transaction to the contract (it is a legal obligation). With options, the holder has the choice of whether they want to complete the transaction. With forwards & futures you are locking yourself into a fixed price at some point in the future, either you agree to buy at that price, or you agree to sell at that price. With options you are protecting yourself against an adverse move, but if there is a favourable move in the underlying, you can take advantage of that and simply let the option lapse. Forwards, futures and swaps would be used by hedgers (who could be large companies), who want to remove uncertainty from their future cash flows. This will make the company less risky and please debt holders. Shareholders will be pleased when it works in their favour, but be less pleased when the company would have been better off without the hedge. If the company hedges and rivals don’t and the underlying asset moves favourably (if you were unhedged), then the rivals have a competitive advantage and may be able to exert pricing pressure against the hedged company. Payoffs to Forwards, Futures & Options Forwards and futures are very similar in nature, so the payoff dia ...
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