Derivatives Part 2 - Settlement Types and Terminations

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Derivatives

Chartered financial Analyst (CFA®), Part I of the FRM Exam covers the fundamental tools and techniques used in risk management and the theories that underlie their use.

Forward Markets and Contracts

Welcome to reading 61 of the Simplilearn CFA Level I tutorial. In the last lecture we introduced various concepts of Finance Management such as derivatives markets and the features of major derivatives like forwards, futures, options and swaps. In this session we will learn in detail about the forward markets and features of forward contracts. By the end of the session you will have an understanding about the functioning of the forward markets, the delivery and settlement process as well as the credit risk associated with forward contracts. You will also have knowledge about forward rate agreements, LIBOR and EURIBOR. Let us begin our session.

Agenda

The main agenda of our discussion will be learning about the various characteristics of forward contracts. We will begin the session by learning about the settlement process for forward contracts. The contract can be settled by delivery, cash settlement or through termination. We will also highlight the credit risk associated with forward contracts which is significantly higher as compared to futures contracts. We will briefly discuss the major types of forward contracts such as equity forwards, forwards on stock portfolios, index forwards and bond forwards. We will discuss about the Eurodollar time deposits such as LIBOR and EURIBOR. Forward rate agreements will also be discussed. Finally we will end the session after a discussion on currency forwards.

Delivery / Settlement / Termination

The settlement of a forward contract can take place in multiple ways. We will discuss these briefly in this slide. The settlement can be done by making delivery of the underlying in the forward contract. For example if the contract is to deliver 100 bags of cotton after 3 months, then on the expiry date the party which is short on the contract has to make a delivery of the underlying to the party which is long after receiving the contract amount agreed at the time of contract initiation.
Another settlement method in which no delivery takes place is the cash settlement. In this process the parties exchange the settlement cash i.e. they calculate the difference in price of the underlying and the agreed price and the net amount is exchanged. For example if the current price of the underlying is more than the agreed price then the party which is long receives the difference from the party which is short.


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