Derivatives Demystified by A.Chisholm.

By A.Chisholm.

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With certain assets such as perishable commodities that cannot be stored or shorted the cash-and-carry method does not apply. Outright forward foreign exchange deals are extensively used by investing institutions, banks and corporations to hedge against the risks posed by fluctuations in currency exchange rates. The fair forward rate is determined by the spot rate and the interest rates in the two currencies. A foreign exchange or FX swap is the combination of a foreign exchange deal and an outright forward deal with a later value date in the opposite direction.

The carry costs might include 34 Derivatives Demystified funding, storage, insurance, etc. Although futures contracts operate in a slightly different way to forwards, it is conventional to extend this so-called ‘cash-and-carry’ method to the calculation of certain theoretical or fair futures prices. We also saw in Chapter 2 that the method works well with financial assets and some commodities but not with others. In the oil market, for example, the spot price is often higher than the futures prices although the simple cash-and-carry method suggests that the situation should be the reverse.

The invoiced amount for a low and for a high coupon bond are adjusted downwards and upwards respectively. The actual method of calculating the invoice is explained in more detail later in this chapter. 870183 Source: Eurex Gilt and Euro bund futures A wide variety of bond futures contracts is now available around the world. For example, LIFFE offers a gilt (UK government bond) futures that is similar to the US Treasury contract traded on the CBOT. Each contract is a commitment to deliver or take delivery of £100 000 notional gilts with a 6% coupon at a fixed price.

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