Advanced Corporate Finance (ACFN – 551)

(Credit hours: 3)

DEPARTMET OF
ACCOUNTING AND FINANCE
April, 2020
 Chapter One

Fundamentals of Financial
Management/Corporate Finance
 The Nature and Purpose of Financial Management

Meaning of finance
 Finance may be defined as the art and science of managing

money.
 Finance also is referred as the provision of money at the

time when it is needed.

 Finance function is the procurement of funds and their

effective utilization in business concerns.

 The field of finance can be considered to comprise three

broad categories: financial management, investments, and

financial institutions:
 Cont’d
 Financial management. Sometimes called corporate
finance or business finance, this area of finance is
concerned primarily with financial decision-making
within a business entity.
 Investments. This area of finance focuses on the behavior

of financial markets and the pricing of securities.

 Financial institutions. This area of finance deals with

banks and other firms that specialize in bringing the

suppliers of funds together with the users of funds.
 Cont’d
DEFINITION OF FINANCIAL MANAGEMENT
 Financial management is an integral part of overall

management. It is concerned with the duties of the financial

managers in the business firm.
 Financial Management deals with procurement of funds

and their effective utilization in the business

 Thus, Financial Management is mainly concerned with the

effective funds management in the business.

Financial Management Decisions/Activities/Functions
 Financial management / corporate finance encompasses
many different types of decisions. We can classify these
decisions into four groups
1. Investment decision-What long-term investments
should the firm engage in?
2. Financing decision-How can the firm raise the
money for the required investments?
3. Dividend decision-Dividend payout/retained
earning
4. Liquidity decision-How much short-term cash flow
does a company need to pay its bills?
 OBJECTIVES OF FINANCIAL MANAGEMENT
 Objectives of Financial Management may be broadly divided into
two parts such as:
1. Profit maximization
2. Wealth maximization.
A. Profit Maximization
 Main aim of any kind of economic activity is earning profit. A
business concern is also functioning mainly for the purpose of
earning profit.
 Profit is the measuring techniques to understand the business

efficiency of the concern.

 Profit maximization is also the traditional and narrow approach,

which aims at, maximizes the profit of the concern.

 Cont…
 Profit maximization consists of the following important
features.
1. Ultimate aim of the business concern is earning profit,
hence, it considers all the possible ways to increase the
profitability of the concern.
2. Profit is the parameter of measuring the efficiency of the
business concern. So it shows the entire position of the
business concern.
3. Profit maximization objectives help to reduce the risk of
the business.
 Cont’d
Drawbacks of Profit Maximization
(i) It is vague
(ii) It ignores the time value of money

(iii) It ignores risk

B. Wealth Maximization
 The term wealth means shareholder wealth or the wealth

of the persons those who are involved in the business

concern.
 Wealth maximization is also known as value
maximization or net present worth maximization.
 This objective is an universally accepted concept in the

field of business.
 Cont’d
 Wealth maximization is superior to the profit maximization
because the main aim of the business concern under this
concept is to improve the value or wealth of the
shareholders.
 Wealth maximization considers both time and risk of the

business concern.
IMPORTANCE OF FINANCIAL MANAGEMENT
 Finance is the lifeblood of business organization. It needs to

meet the requirement of the business concern.

 The business goal can be achieved only with the help of

effective management of finance.

 Importance of Financial Management

1. Financial Planning
2. Acquisition of Funds
3. Proper Use of Funds
4. Financial Decision
5. Improve Profitability
6. Increase the Value of the Firm
7. Promoting Savings
Time Value of Money – Present Value Concept
• A dollar received today is worth more than a dollar
received in the future: A Birr today is higher than
a Birr tomorrow!
• In financial management decisions, it is mandatory
to work with present values of cash flows.
• In this topic the main concern is on the present
value concept.
• Apart from the present value concept, you are
expected to work on future value computations
and related concepts such as effective interest
rates, yield to maturity, etc.
 Time preference for money
• It is an individual’s preference for
possession of a given amount of money
now, rather than the same amount at some
future time.
• Three reasons may be attributed to the
individual’s time preference for money:
–  risk - the future is uncertain
–  preference for consumption
–  investment opportunities
• The time preference for money is generally
expressed by an interest rate. This rate will
be positive even in the absence of any risk.
It may be therefore called the risk-free rate.
• An investor requires compensation for
assuming risk, which is called risk premium.
• The investor’s required rate of return is:
Risk-free rate + Risk premium.
 Time Value Adjustment
• Two most common methods of adjusting
cash flows for time value of money:
– Compounding—the process of
calculating future values of cash flows
and
– Discounting—the process of calculating
present values of cash flows.
 Present Value

Present value of a future cash flow (inflow

or outflow) is the amount of current cash
that is of equivalent value to the decision-
maker.
Discounting is the process of determining
present value of a series of future cash
flows.
The interest rate used for discounting cash
flows is also called the discount rate/factor.
 Stakeholders and The Agency Problem/Theory/Cost
• The main aim of a company is to maximize its stock
market value.
• Managers of the company are responsible for achieving
that aim, i.e. for maximizing shareholders’ wealth.
• The performance that a company achieves reveals how
successful the management is in adapting to changing
circumstances.
• The ability to quickly and properly react to changes in
the business environment characterizes the quality of the
company’s management.
 Cont’d
• The aim of company, which was earlier noted to be
maximization of the market value of the company, often is
not compatible with the interests of managers, as they
prefer to maximize their own personal interests, if
possible, even at the expense of owners.
• This discrepancy of interests leads to agency conflicts,
which are especially severe in public companies.
• The separation of ownership and control causes serious
conflicts of interests, among which the conflict between
shareholders and managers, and shareholders (represented
by managers) and creditors are the most important. .
 1. Conflicts of interest between managers and shareholders
• It should be stressed that the most severe conflict of interests exists
between shareholders (principals) and managers (agents). These
conflicts arise for the following four reasons:
1. managers prefer greater levels of consumption and less intensive
work, as these factors do not decrease their remuneration and the
value of the company’s shares that they own;
2. managers prefer less risky investments and lower financial
leverage, because in this way they may decrease the danger of
bankruptcy, and avoid losses on their managerial capital and
portfolios;
3. managers prefer short-term investment horizon;
 2. Conflicts between creditors and mangers
(shareholders)
• Conflicts between creditors and managers
(shareholders) are the second, most severe, and
most important conflict of interest that exist in
companies.
• Conflicts between shareholders and debt
holders arises from the choice of projects to
take (investment decisions) and in determining
how to finance these projects and how much to
pay out as dividends.
 Agency Cost
• Agency costs are the costs which arise from the
conflicts of interest among shareholders,
bondholders, and managers. They may be defined as
the costs of resolving these conflicts. They include:
• The costs of providing managers with an incentive to
maximize shareholder wealth
• The cost of monitoring the behavior of managers, and
• The cost of protecting bondholders from
shareholders.
 Cont’d
• A solution to the problem of agency costs may be
found in the use of managerial incentives and the
effectiveness of managerial monitoring.
• The incentive solution is to tie the wealth of the
executives to the wealth of shareholders. In this way
the interests of these two groups are aligned.
Executives may be given stock or stock options, or
both, as a significant component of their
compensation.
• The second solution is to set up mechanisms for
monitoring the behavior of managers
 The Nature and Role of Financial Markets, Money
Markets and Institutions
• This subtopic is assumed to be covered in your
course financial markets, institutions and
instruments.
• Independent reading Assignment – refresh your
knowledge on the following main points.
– Financial intermediaries
– Financial markets
– Capital market instruments
– International money and capital markets
– Money market instruments
 Risk and Return
Return
 The measure of reward that is used in investment
analysis is called the return.
 Income received on an investment plus any change
in market price, usually expressed as a percent of
the beginning market price of the investment.
 The return is defined as the increase in value over a
given time period as a proportion of the initial value
 The time over which the return is computed is often
called the holding period.
 Example 1
An initial investment is made of $10,000. One year
later, the value of the investment has risen to $12,500.
The return on the investment is given by the formula:
r=(V1-Vo)/Vo
r = (12500−10000)/10000 = 0.25. Expressed as a
percentage, r = (12500−10000)/10000 ×100 = 25%.
 Example 2
• The price of IBM stock trading in New York on May
29 2002 was $80.96. The price on May 28 2003 was
$87.57. A total of $0.61 was paid in dividends over
the year in four payments of $0.15, $0.15, $0.15 and
$0.16. The return over the year on IBM stock was
given by the formula:

r=(P1+d-Po)/Po
r =(87.57 + 0.61) − 80.96/80.96= 0.089 (8.9%).
 Risk, variance and covariance
 Risk is the variability of returns from those that are
expected.
 The standard measure of risk used in investment analysis is
the variance of return
 An asset with a return that never changes has no risk. For
this asset the variance of return is 0.
 Any asset with a return that does vary will have a variance
of return that is positive.
 The more risk is the return on an asset the larger is the
variance of return.
 Cont.
 When constructing a portfolio it is not just the risk on
individual assets that matters but also the way in which
this risk combines across assets to determine the
portfolio variance.
 Two assets may be individually risky, but if these assets
are combined then a portfolio composed of the two
assets may have very little risk.
 The risks on the two assets will cancel if a higher than
average return on one of the assets always accompanies
a lower than average return on the other.
 Cont.
 The measure of the way returns are related across
assets is called the covariance of return. The
covariance will be seen to be central to understanding
portfolio construction
 The covariance indicates the tendency of the returns
on two assets to move in the same direction (either up
or down) or in opposite directions.
 Cont’d
• Covariance can be used to maximize
diversification in a portfolio of assets. By
adding assets with a negative covariance to a
portfolio, the overall risk is reduced. This risk
drops off, quickly at first, but more slowly as
additional assets are added. Formula for
population covariance:
 Portfolio Return and Risk
 By investing in many different stocks to form a
portfolio, we can lower the risk without lowering the
expected return.
 A portfolio is a bundle or a combination of individual
assets or securities.
 The effect of lowering risk via appropriate portfolio
formulation is called diversification.
 By learning how to compute the expected return and risk
on a portfolio, we illustrate the effect of diversification
 Portfolio Return
 The return of a portfolio is equal to the weighted
average of the returns of individual assets (or
securities) in the portfolio with weights being equal
to the proportion of investment value in each asset.
Expected return on a portfolio
=weight of security x*expected return on security x+
weight of security y*Expected return on security y
 Example: portfolio return
Consider the portfolio of three stocks described below.
Stock Holding Initial Price Final Price
A 100 2 3
B 200 3 2
C 150 1 2
 Cont.
The return on the portfolio is r =(100 × 3 + 200 × 2 +
150 × 2) − (100 × 2 + 200 × 3 + 150 × 1)/100 × 2 + 200
× 3 + 150 × 1= 0.052 (5.2%).
 Example on portfolio proportion
Consider the portfolio in Example above. The initial
value of the portfolio is 950 and the proportional
holdings are XA =200/950 , XB =600/950 , XC
=150/ 950
The returns on the stocks are : rA =(3 − 2)/2=1/2 , rB =
(2 − 3)/3= −1/3 , rC =(2 − 1)/1= 1
The return on the portfolio is therefore: r =200/950 ×1/2
+600/950 ×−1/3+150/950 × (1) = 0.052(5.2%).
 Example on covariance
The table provides the returns on three assets over a
three-year period. calculate covariance and variance?
Asset Year 1 Year 2 Year 3
A 10 12 11
B 10 14 12
C 12 6 9
 Cont.
The mean returns are rA = 11, rB = 12, rC = 9.
The covariance between A and B is
σAB =1/3[[10 − 11] [10 − 12] + [12 − 11] [14 − 12] +
[11 − 11] [12 − 12]] = 1.333,
while the covariance between A and C is
σAC =1/3[[10 − 11] [12 − 9] + [12 − 11] [6 − 9] + [11 −
11] [9 − 9]] = −2, and that between B and C
σBC =1/3[[10 − 12] [12 − 9] + [14 − 12] [6 − 9] + [12 −
12] [9 − 9]] = −4.
 Correlation Coefficient
 It is a standardized statistical measure of the linear
relationship between two variables.
 While covariance can show the direction between two assets, it
cannot be used to calculate the strength of the relationship
between the prices. Determining the correlation coefficient
between the assets is a better way to measure the strength of the
relationship.
 Correlation coefficient=covariance / standard deviation
 Its range is from -1.0 (perfect negative correlation), through
0 (no correlation), to +1.0 (perfect positive correlation).
 Portfolio Risk: Two-Asset Case
 The portfolio variance or standard deviation depends
on the co-movement of returns on two assets.
Covariance of returns on two assets measures their
co-movement.
 The formula for calculating covariance of returns of
the two securities X and Y is as follows:
Covariance XY = Standard deviation X * Standard
deviation Y * Correlation XY
 The variance of two-security portfolio is given by the
following equation:
Cont.
 Example

A portfolio is composed of 12 of asset A and 12 of asset

B. Asset A has a variance of 25 and asset B a variance of
16. The covariance between the returns on the two
assets is 10. The correlation coefficient is
ρAB =10/ 5 × 4= 0.5, and the variance of return on the
portfolio is
σ2P =(1/2)2*25 +(1/2)2*16 + 2(1/2)*(1/2)0.5 × 5 × 4 =
20.25.
 Risk classification
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk is the variability of return on
stocks or portfolios associated with changes in
return on the market as a whole.
Unsystematic Risk is the variability of return
on stocks or portfolios not explained by
general market movements. It is avoidable
through diversification.
 Cont.
 Systematic sources of risk (such as inflation, war,
interest rates) are common to most investments
resulting in a perfect positive correlation and no
diversification benefit.
 Systematic risk can not be eliminated through
diversification, as a result, no matter how many assets
we put into a portfolio, the systematic risk doesn’t go
away. Thus, for obvious reasons, the terms systematic
risk and non-diversifiable risk are used
interchangeably.
 Cont.
 Systematic risk is measured by beta coefficient,
which estimates the extent to which a particular
investment’s returns vary with the returns on the
market portfolio or it is the amount of systematic risk
present in a particular risky asset relative to that in an average
risky asset.

 The beta of a portfolio measures the systematic risk of the

portfolio and is calculated by taking a simple weighted
average of the betas for the individual investments contained
in the portfolio
 Cont.
 The unsystematic risk is the element of risk that does not
contribute to the risk of the market. This component is
diversified away when the investment is combined with other
investments. For example: Product recall, labor strike, change
of management.
 Unsystematic risk is essentially eliminated by diversification,
so a portfolio with many assets has almost no unsystematic
risk.
 The terms diversifiable risk and unsystematic risk are often
used interchangeably.

 An investment’s systematic risk is far more important than its

unsystematic risk.
 Security Market Line
It is a positively sloped straight line displaying
the relationship between expected return and
beta.

Rm
Rf

bM = 1.0
Systematic Risk (Beta)
 Risk Premium
 Risk premium is the difference between the return on
a risky investment and that on a risk-free investment
or it is the difference between the expected return on
a risky investment and the certain return on a risk free
investment.
 Capital Asset
Pricing Model (CAPM)
 CAPM is a model that describes the relationship
between risk and expected (required) return; in this
model, a security’s expected (required) return is the risk-
free rate plus a premium based on the systematic risk of
the security or it is the equation of the SML showing the
relationship between expected return and beta
 The key insight of CAPM is that investors will require a
higher rate of return on investments with higher betas.
The relation is given by the following linear equation:
Rj = Rf + bj(RM - Rf)
 Cont’d
Where,
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
bj is the beta of stock j (measures systematic
risk of stock j),
RM is the expected return for the market
portfolio.
 Assumptions of the CAPM
•Market efficiency the capital market efficiency implies that share prices reflect all
available information. Also, individual investors are not able to affect the prices of
securities. This means that there are large numbers of investors holding small
amount of wealth.
•Risk aversion and mean-variance optimization: investors are risk averse. They
evaluate a security’s return and risk in terms of the expected return and variance or
standard deviation respectively. They prefer the highest expected return for a given
level of risk. This implies that investors are mean variance optimizers and they
form efficient portfolios.
•Homogeneous expectations: all investors have the same expectations about the
expected returns and risks of securities.
•Single time period: all investor’s decisions are based on a single time period
•Risk free rate: all investors can lend and borrow at free rate of interest. They form
portfolios from publicly owned securities like shares and bonds
 Determination of the Required Rate of
Return
• ABC company is attempting to
determine the rate of return required by
their stock investors. ABC is using a
6% Rf and a long-term market expected
rate of return of 10%. A stock analyst
following the firm has calculated that
the firm beta is 1.2. What is the
required rate of return on the stock of
ABC company?
 ABC Required Rate of Return

R = Rf + bj(RM - Rf)
R = 6% + 1.2(10% - 6%)
R = 10.8%
The required rate of return exceeds the
market rate of return as ABC’s beta exceeds
the market beta (1.0).
 Beta estimation
Direct Method—The ratio of covariance between
market return and the security’s return to the market
return variance:
 Example
Returns on NYSE index and ABC limited
Year Market return (rm) ABC (rj)

1 18.6% 23.46

2 -16.50 -36.13

3 63.83 52.64

4 -20.65 -7.29

5 -17.87 -12.95
 Cont.
Year Rm (1) Rj (2) (rm - ̄rm) (3) (rj- ̄rj) 3*4 (rm- ̄rm)2
(4)

1 18.6% 23.46 13.11 19.51 255.91 171.98

2 -16.50 -36.13 -21.98 -40.08 880.83 483.08

3 63.83 52.64 58.35 48.69 2841.35 3404.85

4 -20.65 -7.29 -26.13 -11.24 293.64 682.96

5 -17.87 -12.95 -23.35 -16.90 394.57 545.35

̄rm=5.48 ̄rj=3.98 =4666.30 =5288.23

 Cont.
Cov m,j=4666.30/5=933.26
σ2m=5288.23/5=1057.65
βj=Cov m,j/σ2m=933.26/1057.65=0.88
 Limitations/Disadvantages of the CAPM

1. The model makes unrealistic assumptions

2. The parameters of the model cannot be estimated precisely
- Definition of a market index
- Firm may have changed during the 'estimation' period'
3. The model does not work well
- If the model is right, there should be a linear relationship
between returns and betas
the only variable that should explain returns is betas
- The reality is that
the relationship between betas and returns is weak
Other variables (size, price/book value) seem to explain
differences in returns better.
 Verifying the CAPM empirically

• The CAPM has not been verified completely. Different

empirical finding are available in the literature, some
supporting while others against the CAPM.
• Some argue that there are additional risk factors, other
than the market risk premium, that must be considered.
Which results in APT model (Arbitrage Pricing Model).
 Arbitrage Pricing Theory (APT)

• CAPM is criticized because of the difficulties

in selecting a proxy for the market portfolio as
a benchmark
• An alternative pricing theory with fewer
assumptions was developed: Arbitrage Pricing
Theory (APT).
 Assumptions of APT

1. Capital markets are perfectly competitive

2. Investors always prefer more wealth to less
wealth with certainty.
3. The stochastic process generating asset
returns can be expressed as a linear function
of a set of K factors or indexes
 APT Mathematical Formula

For i = 1 to N where:
= return on asset i during a specified time period
Ei = expected return for asset I
bik= reaction in asset i’s returns to movements in a
common factor k
= a common factor with a zero mean that influences the
returns on all assets
 = a unique effect on asset i’s return that, by assumption, is
i completely diversifiable in large portfolios and has a
mean of zero
N= number of assets
 APT Factors

Factors expected to have an impact on all assets:

– Inflation
– Growth in GNP
– Major political upheavals
– Changes in interest rates
– And many more….
Contrast with CAPM insistence that only beta is
relevant
 Cont’d
bik determine how each asset reacts to this common
factor
Each asset may be affected by growth in GNP, but the
effects will differ
In application of the theory, the factors are not identified
Similar to the CAPM, the unique effects are
independent and will be diversified away in a large
portfolio
 Cont’d

• The expected return on any asset i (Ei) can be

expressed as:

where:
= the expected return on an asset with zero
systematic risk where
= the risk premium related to each of the common
factors - for example the risk premium related to
interest rate risk
 Cont’d

bik = the pricing relationship between the risk premium

and asset i - that is how responsive asset i is to this
common factor k
 Example of Two Stocks
and a Two-Factor Model
= changes in the rate of inflation. The risk premium related to
this factor is 1 percent for every 1 percent change in the rate

=percent growth in real GNP. The average risk premium related

to this factor is 2 percent for every 1 percent change in the rate

= the rate of return on a zero-systematic-risk asset (zero beta:

bik=0) is 3 percent
 Example

= the response of asset X to changes in the rate of inflation is 0.50

= the response of asset Y to changes in the rate of inflation is 2.00

= the response of asset X to changes in the growth rate of real

GNP is 1.50

= the response of asset Y to changes in the growth rate of real

GNP is 1.75
Cont’d
 Portfolio Beta
 In general, if we had a large number of assets
in a portfolio, we would multiply each asset’s
beta by its portfolio weight and then add the
results to get the portfolio’s beta.
 Example
 Suppose we had the following investments:
Security Amount Invested Expected Return Beta
Stock A $1,000 0 8% 0 .80
Stock B $ 2,000 12% 0.95
Stock C $ 3,000 15% 1.10
Stock D $ 4,000 18% 1.40
 Cont.
 What is the expected return on this portfolio? What is
the beta of this portfolio? Does this portfolio have
more or less systematic risk than an average asset?
 To answer, we first have to calculate the portfolio
weights. Notice that the total amount invested is
$10,000. Of this, $1,000/10,000 = 10% is invested in
Stock A. Similarly, 20 percent is invested in Stock B,
30 percent is invested in Stock C, and 40 percent is
invested in Stock D. The expected return, E(RP), is
thus:
 Cont.
E(RP ) =.10 * E(RA) + .20 * E(RB ) + .30 *E(RC ) + .
40 * E(RD)
E(RP ) =.10 * 8% +.20 * 12% + .30 *15% +.40
*18%= 14.9%
Similarly, the portfolio beta, βP, is:
βP = .10 * βA + .20 * βB + .30 *βC + .40 * βD
= .10 *.80 + .20 *.95 + .30 * 1.10 +.40 * 1.40
= 1.16
 Cont.
 This portfolio thus has an expected return of
14.9 percent and a beta of 1.16. Because the
beta is larger than 1, this portfolio has greater
systematic risk than an average asset.
 Risk Management Through Derivatives

• Risk is an uncertainty of outcome.

• Simply it is the difference between the expected and
actual. Risk is as a usual and fundamental component
of doing business. However, when the level of risk is
too high, it can unfavorably affect the financial
position of the firm.
• It is this need to manage risk that led to the genesis of
the derivative market. Risk Management is an
integral part of managing a business.
 Cont’d
• The entire process of identifying, evaluating,
controlling and reviewing risks, to make sure that the
organization is exposed to only those risks that it
needs to take to attain its primary objectives, is
known as risk management.
 Types of Risk

1. Operational risk
2. Investment risk
A. Market risk (adverse price movement and handled
by using derivative products)
B. Credit risk (Risk arises due to unwillingness or
inability of counterparty to fulfill its obligations on
the agreed date):less for future as compared to
forward
C. Liquidity risk (refers to the ease with which the
contract can be traded)
 Tools Available to Manage Risk

• There are various tools available to manage risks.

1. Derivative products like Forwards, Futures, Options
and Swaps.
2. The others involve having better internal controls in
place, due diligence exercises, compliance with rules
and regulations, etc.
 Hedging and Price Volatility

• In broad terms, reducing a firm’s exposure to price or

rate fluctuations is called hedging. The term
immunization is sometimes used as well.
• Frequently, when a firm desires to hedge a particular
risk, there will be no direct way of doing so.
• The financial manager’s job in such cases is to create
a way by using available financial instruments to
create new ones. This process has come to be called
financial engineering.
 cont’d
• Corporate risk management often involves the buying
and selling of derivative securities.
• A derivative security is a financial asset that
represents a claim to another financial asset. For
example, a stock option gives the owner the right to
buy or sell stock, a financial asset, so stock options
are derivative securities.
 Why do firms place greater emphasis on
hedging now than they did in the past?
• Basically it is due to:
1. Price volatility
2. Interest rate volatility
3. Exchange rate volatility
 Hedging with Forward Contracts
• A forward contract is a legally binding agreement between two
parties calling for the sale of an asset or product in the future at a
price agreed upon today. The terms of the contract call for one
party to deliver the goods to the other on a certain date in the
future, called the settlement date.
• The buyer of a forward contract has the obligation to take
delivery and pay for the goods; the seller has the obligation to
make delivery and accept payment.
• The buyer of a forward contract benefits if prices increase
because the buyer will have locked in a lower price.
• Similarly, the seller wins if prices fall because a higher selling
price has been locked in.
• Note that one party to a forward contract can win only at the
expense of the other, so a forward contract is a zero-sum game.
 Hedging with Futures Contracts
• A futures contract is exactly the same as a forward
contract with one exception. With a forward contract, the
buyer and seller realize gains or losses only on the
settlement date. With a futures contract, gains and losses
are realized on a daily basis.
• The daily resettlement feature found in futures contracts is
called marking-to market.
• As we mentioned earlier, there is a significant risk of
default with forward contracts. With daily marking-to-
market, this risk is greatly reduced
 Hedging with Swap Contracts

• An agreement by two parties to exchange, or swap,

specified cash flows at specified intervals in the
future.
• Types of Swap
1. Interest rate swap
2. Currency swap
 Hedging with Option Contracts

• The contracts we have discussed thus far forwards,

futures, and swaps—are conceptually similar. In each
case, two parties agree to transact on a future date or
dates. The key is that both parties are obligated to
complete the transaction.
• In contrast, an option contract is an agreement that
gives the owner the right, but not the obligation, to
buy or sell (depending on the option type) some asset
at a specified price for a specified time.
 Option Terminologies

• Call option
• Put option
• American option
• European option