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FRM-1 Study Notes

Types of traders

  • Hedgers
    • Use derivatives to hedge the risks they face from volatility in the asset prices
    • Example: a company is getting a cash inflow in 3 months time in a foreign currency. It hedges its currency risk by taking a short position in a currency forward at a particular price
  • Speculators
    • Use derivatives to bet on a particular direction of movement of the asset price
    • If a speculator believes that the SR of a foreign currency will be higher in 3 months than its present 3 month forward rate, he goes long on the forward. After 3 months if he is correct, he receives foreign currency at lower rate and immediately resells it at the higher SR
  • Arbitrageurs
    • Take offsetting positions in 2 or more instruments to lock a profit
    • Suppose that:
      • The spot price of gold is US$390
      • The quoted 1-year forward price of gold is US$425
      • The 1-year US$ interest rate is 5% per annum
      • No income or storage costs for gold. Is there an arbitrage opportunity? 
      • Forward Rate : S = 390, T = 1, and r = 0.05 so that F  = 390 (1 + 0.05) = 409.50
    • Arbitrage = Buy Low – Sell High at no risk

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