Read and summarize chapter 4 of your Financial Management text book in at least 400 words.

* Name and describe 3 things that can make the market fluctuate. 

3. Watch the following video and answer the following questions:

*Who is Bernie Madoff?

*What did he do?

*What happened to him?

*What's a "Ponzi Scheme? 

CHAPTER 4

Firms are exposed to several risks in the ordinary course of operations and when borrowing funds. For some risks, management can obtain protec- tion from an insurance company. For example, management can insure a plant against destruction by fire by obtaining a fire insurance policy from a property and casualty insurance company. There are capital market prod- ucts available to management to protect against certain risks that are not insurable by an insurance company. Such risks include risks associated with a rise in the price of commodity purchased as an input, a decline in a com- modity price of a product the firm sells, a rise in the cost of borrowing funds, and an adverse exchange rate movement. The instruments that can be used to provide such protection are called derivative instruments, so named because they derive their value from whatever the contract is based on. These instruments include futures contracts, forward contracts, option contracts, swap agreements, and cap and floor agreements.

There has been public concern about the use of derivative instru- ments by firms. This concern arises from major losses resulting from positions in derivative instruments.1 However, an investigation of the reason for major losses would show that the losses were not due to derivatives per se, but the improper use of them by management that was either ignorant about the risks associated with using derivative instruments or management that sought to use them in a speculative manner rather than a means for managing risk. Another term for specu- lative purposes is trading purposes.

In this chapter we will discuss the basic features of each type of derivative instrument.

1 Well-publicized losses in the 1990s include Procter & Gamble’s losses related to foreign exchange derivatives, Gibson Greetings losses related to interest rates swaps, and Pier 1 Imports losses due to the trading of bond futures and options.

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84 FOUNDATIONSFUTURES CONTRACTS AND FORWARD CONTRACTS

A futures contract is an agreement that requires a party to the agree- ment either to buy or sell something at a designated future date at a pre- determined price. The something that the two parties agree will be bought and sold is referred to as the underlying for the contract or sim- ply the underlying. The basic economic function of futures markets is to provide an opportunity for market participants to hedge against the risk of adverse price movements.

Futures contracts are products created by exchanges. Futures con- tracts involving traditional agricultural commodities (such as grain and livestock), imported foodstuffs (such as coffee, cocoa, and sugar), or industrial commodities are traded. Collectively, such futures contracts are known as commodity futures. Futures contracts based on a financial instrument or a financial index are known as financial futures. Finan- cial futures can be classified as (1) stock index futures, (2) interest rate futures, and (3) currency futures.

*Is a Ponzi Scheme good or bad. Explain.