Description of Derivatives and Risk – Free Essay Examples

Description of Derivatives and Risk

Roles played by speculators and hedger in the derivatives market

Derivatives play a vital role in risk management; nevertheless, they also create a threat to the financial market and economy stability. The forward rate agreements (FRAs), Swaps, Future contracts and options are examples of derivative instruments (Dodd, 2001). These instruments can be used together to produce a hybrid instrument and the hedge instrument can be found in a derivative exchange where they are actively traded. Derivatives by definition are “financial agreements or contracts that are intended to generate price exposure to asset or underlying commodity changes”; this means that there is no exchange of principal amount; derivatives usually capture price movement (Dodd, 2001).

In a derivative market there are two participants; the speculator and a hedger; a speculator seeks to maximize the risk exposure while the hedger seek to minimize the risk exposure (Chance and Brooks, 2009). In addition a speculator makes profit after counterbalancing their benefit with future contract by purchasing a contract and sells it at a higher price (Dodd, 2001). On the other hand, the hedger buys or sells a contract in order to lock in and shield himself against price changes (Dodd, 2001).

Speculators go into the future market with high expectation that prices will change and analyzes the market and establish whether the prices will rise or fall (Dodd, 2001). They study the market fundamentals that have an effect on price movement or use technical price movement to predict the future prices; this means that they do not enter the market blindly.

If the speculator foresees that prices will move upward they takes advantage by purchasing the future contracts which they sell later on if the forecast proves to be of accurate profit (Dodd, 2001). While if they forecast that price will fall, the speculator will sell the contract immediately and buyback when the price is low (Dodd, 2001). Finally, hedgers use derivative contract to pass on risk exposure to speculators, these contract are agreed upon by two parties; whose price differ depending on the price of the asset (Dodd, 2001).

Hedging/Speculating strategies

Hedge using option

An option contract is similar to an insurance contract and can be defined as ”a contract that gives its holder the right, but not the obligation, to buy or sell an asset on a future date at a specified price” (Milton, 2011). There are two types of options; the call and put option, “a call option is the right to purchase and Put option is the right to sell the underlying asset (Milton, 2011).

Expiration is used to classify options, in this regard, there is an American Style and the European Style; the European Style is implemented on maturity while the American Style is put into effect at any time after it has been bought (Milton, 2011). Any person who purchases an option contract has the right to exercise it (Tradersedgeindia.com, 2011).

Every option contract has a premium which is payable to the other party, this is known as an option price; a buyer of an option can make profit or loss after exercising this option. A call option holder makes profit when the market price exceeds the exercise/ purchase price and makes a loss if the market price is lower than the purchase price (Milton, 2011). While a put option holder makes money when the market price is lower than the purchase price and makes loss when the market price exceeds purchase price (Tradersedgeindia.com, 2011).

Buyers and sellers set the option prices, which are subject to future prices expectations and the connection between asset prices with option’s price (Tradersedgeindia.com, 2011).

The market upturn is expected, so the fund manager settles on a short position on European Style FTSE 100 Index call to circumvent the risk of the portfolio (Tradersedgeindia.com, 2011).

The FTSE 100 Index is now at 2600

A European Style Dec FTSE 100 Call contract with a strike price of 2700 can be bought at 50p.

1 contract = index value x £10

Where the index value is 2700 (the Dec FTSE 100 Index)

= 2700 x £10 =£27,000

The portfolio is worth £10 million and the fund’s beta is 1.0

Therefore, the number of contract = [£10,000,000/ £27,000] x 1.0

Number of contract = 370.37 contract let us take 370 contracts.

Option premium = call option purchase price x value of an index point

1 call contract premium = 50p x £10= £500

Total premium = 370 contracts x £500 = £185,000

If FTSE 100 Index in the Dec is

  • 2080
    • The FTSE 100 index has dropped from 2600 to 2080
    • This means that the market value of the fund has also dropped by 20% [(2600-2080)/2600] x 100
    • Therefore the total fund = £ 10,000,000 x 0.8 = £8,000,000
      • The fund market value £8,000,000
      • Less call Premium (£185,000)
      • Closing value £7,815,000
  • 2600
    • The fund market value £10,000,000
    • Less call Premium (£185,000)
    • Closing value £9,815,000
  • 3120
    • The FTSE 100 index has increased from 2600 to 3120
    • This means that the market value of the fund has also increased by 20% [(3120-2600)/2600] x 100
    • Therefore the total fund = £ 10,000,000 x 1.2 = £12,000,000
    • Profit on call= (3120-2700) x 10 = £2,200 per contract
      • The fund market value £12,000,000
      • Plus: profit on call (4,200×370) £1,554,000
      • Less call Premium (£185,000)
      • Closing value £13,369,000

Nil hedges (speculator)

  • The FTSE 100 index on Dec is 2080

The total cash available to invest is £10,000,000

The speculator predicts that the December FTSE 100 index will be 2800 he/she will not hedge but will rather wait till December. This means that the speculator will buy the stock at the FTSE 100 index of 2600 prevailing at that time. The FTSE 100 index in December turns out to be 2080.

The FTSE 100 index has dropped from 2600 to 2080

This means that the market value of the fund has also dropped by 20% [(2600-2080)/2600] x 100

Therefore the total fund = £ 10,000,000 x 0.8 = £8,000,000

Loss incurred (2600-2080) = 520 x £10 = 5200

Fund value £8,000,000

Less loss on selling (£5200)

Closing value £7,994,800

  • The FTSE 100 index on Dec is 2600

No profit or loss

Original fund value £10,000,000

Profit/loss 0

Closing value £10,000,000

  • The FTSE 100 index on Dec is 3120

The FTSE 100 index has increased from 2600 to 3120

This means that the market value of the fund has also increased by 20% [(3120-2600)/2600] x 100

Therefore the total fund = £ 10,000,000 x 1.2 = £12,000,000

Profit made (3120-2600) = 520 x £10 = 5200

Fund value £12,000,000

Plus profit on selling £5200

Closing value £12,005,200

The speculator’s friend

He/she predicts that FTSE 100 in December may rise far above 2700, or drop far below 2500, strategy to be employed is a strategy that entails both a ceiling and a floor on the price of the active stock should be employed; this type of strategy is called spread strategy (Tradersedgeindia.com, 2011). He/ she should purchase a call option at FTSE 100 index of 2700 and purchase a put option at FTSE 100 index of 2500 both expiring on December.

1 put contract premium = 40p x £10 = £400

The table and diagram below shows variation of speculator’s friend’s profit/loss with the FTSE 100 index.

Dec FTSE 100 Index Profit on written call (spread x £10 Profit on written put Profit on stock purchased at 2700 Profit on stock purchased at 2500 Subtotal (purchased at 2700 Subtotal (purchased at 2500) Grand Total
2080 -500 4200 6200 4200 5700 8400 14100
2500 -500 -400 2000 0 1500 -400 1100
2600 -500 -400 1000 -1000 500 -1400 -900
2700 -500 -400 0 -2000 -500 -2400 -2900
3120 4200 -400 -4200 -6200 0 -6600 -6600

Fox plc will borrow £30 million in six months time in the money market. The corporate treasurer expects that Interest rates will rise from the current level of 6%. A Forward Rate Agreement (FRA) at 6% and a three-month sterling interest futures (STIRs) starting in six months time and priced at 94.00 are available.

Hedging strategies using Forward Rates Agreements and Future contracts

The futures contracts are agreed upon between the buyer and the seller where seller and the buyer meet in a centralized future market. The contract determines the amount to be paid and also time of delivery; in this market buyers and sellers do not exchange or deliver commodity.

The market daily variations determine the profit or loss for the contract and are calculated every day (Investopedia.com, 2011). A Forward Rate Agreements signify a delivery of a particular amount of asset at future date at a specified price (Tradersedgeindia.com, 2011). The real transfer of cash takes place at a time succeeding the Forward Rate Agreement contract initiation (Investopedia, 2011).

The clearing house creates the future contract, thus it act as the intermediary between the contracts holders, this eliminates default risk as the party to the contract are expected to pay the initial margin (Investopedia, 2011). Future contracts are available in standardized amount such as Eurodollar is 1000,000 and GBP is 500,000, this makes it possible for buyers and sellers to trade (Investopedia, 2011). Pricing for long term futures follow the cash market which they represent that is bond price. Bonds are priced and quoted per 100 nominal values; the future market price mirrors the actual bond market which in turn reflects the interest yields currently applicable in the market (Investopedia, 2011). The movements in interest rates future are tracked in terms of minimum fluctuations known as ticks where a tick is often but not always 1bp for interest rate futures such as GBP or Eurodollars (Investopedia, 2011). A Sterling future contact and Eurodollar contract have a tick value of £12.5 and $25 respectively (Investopedia, 2011).

Future contracts

In this case, Fox plc’s treasurer will sell the future contracts at a price of 94.00, where each contract will have an initial margin (assume the initial margin per contract is £750).

The treasurer will sell the December 60 future contract at a price of 94.00 and pay the required initial margin of 750*60 = £45,000 on 1st October. On 1 December the future price will change, let say to 90.00 and the treasurer hedged at a price of 94.00. The contract cash flow will be as follows;

Number of contract= £30,000,000/500,000= 60 contacts

1stOctober Sell 60 future contract and pay initial margin -45000
1stOctober Hedge 94.00
1stDecember future price 90.00
4.00
x100
Ticks 400
Number of contract x60
24000
Tick value x12.5
300000
Refund initial margin 45000
Net gain 300000

The treasurer will be able to offset the gain from hedge (future) of £300,000 against increase in price.

Forward Rate Agreements (FRAs)

In this case the treasurer will buy a three months FRA starting in 6 months time (6v9 FRA) at 6% to hedge against interest rate increase. Assume as above that the December future will change to 90.00, this means that the interest rate is 10% compared to the 6%. Since interest rates have increased the Fox plc will receive compensation, which will be determined on the actual day of borrowing or commencement of the loan period. Therefore, because it is payable at the commencement date rather than at the end of the loan period it is discounted at the present period. The compensation payment will be calculated as follows;

= Notional principal x [FRA LIBOR outturn – FRA lock in rate] x days of borrowing days in a year

[1+ (FRA LIBOR outturn x (days of borrowings/days in a year)] = (£30,000,000 x [10% – 6%] x 92/365)/ [1 + (10% x 92/365)]

Compensation received = £295,029.40

Therefore the expected cost of business expansion will be equal to principal plus the interest calculated as follows;

  • Interest= (£30,000,000 – £295,029.40) x 10% x 92/365= £748,728.03
  • Principal £30,000,000
  • Compensation receivable (£295,029.40)
  • Total cost £30,453,698.63

Interest rates change and Advantages and disadvantages of Forward over future

If interest fall to 4% or rise to 8%

Future contract

Number of contract = 60 contracts and the initial margin is £45,000 for the 60 contracts. The profit or loss will be as follows;

At an Interest rate of 4%

1stOctober Sell 60 future contract and pay initial margin -45000
1stDecember future price 96.00
1stOctober Hedge 94.00
2.00
x100
Ticks 200
Number of contract x60
12000
Tick value x12.5
150000
Refund initial margin 45000
Net gain 150000

The treasurer will be able to offset the gain from hedge (future) of £300,000 against increase in price

At an interest rate of 8%

1stOctober Sell 60 future contract and pay initial margin -45000
1stOctober Hedge 94.00
1stDecember future price 92.00
2.00
x100
Ticks 200
Number of contract x60
12000
Tick value x12.5
150000
Refund initial margin 45000
Net gain 150000

FRAs

  • At an interest rate of 4%

= £30,000,000 x [4% – 6%] x 92/365 [1 + (4% x 92/365)]

Compensation payable = £149,723.34

The company will have to part with £149,723.34

  • At an interest rate of 8%

= £30,000,000 x [8% – 6%] x 92/365

[1 + (8% x 92/365)]

Compensation receivable = £148,243.64

Advantages and disadvantages of FRAs over futures

FRAs are tailor-made, this means that every forward agreement rate is decided upon by the parties to the contract; it implies the contract is negotiated upon by the parties, while future has a standardized amount of delivery time and amount (Acharya, Cooley, Richardson and Ingo, 2009). FRAs also require minimal administration when compared to future contract which require more time in taking daily variation (Acharya et al, 2009). FRAs also do not require margin payment unlike futures contact; Futures are traded on an exchange while FRAs are traded over the counter market which implies that the derivatives are privately traded through a contract between two persons (Chance and Brooks, 2009).

ABC and XYZ

SWAPs

A Swap is a contract between two counterparties to exchange streams of periodic cash flows over a specified period of time (Chance and Brooks, 2009). These streams of periodic cash flows are normally calculated on different interest basis and are based on a specified notional principal which are not physically exchanged (Acharya et al, 2009).

Company ABC prefers a loan in Dollars while company XYZ prefers a loan in Pounds. The loan amount is £20 million or $30 million for 10 years. Using comparative advantage principle ABC Company will borrow the pounds loan of £20,000,000 and XYZ will borrow the dollar loan of $30,000,000.

ABC company XYZ company
$ 30,000,000 10% 7%
£20,000,000 10% 8.50%

The interest rate swaps (IRS) is LIBOR + 0.2%; this means that ABC Company pays XYZ Company LIBOR + 0.2% and XYZ Company pay ABC Company LIBOR. Therefore,

$ £
ABC company 10% 10%
XYZ company 7% 8.50%
XYZ advantage 3% 1.50%

The comparative advantage gain = 3% – 1.5%= 1.5%, at comparative advantage ABC borrows at 10% and lend at ABC% while XYZ Company at 7% and lends at XYZ%; all the parties to the contract will gain including the bank.

Risks associated with the bank that provide swaps

The international standard requires the banks to show capital amount on their financial position statement; the banks are also required to weigh up and embrace capital to protect itself against business and market risks (Meir, 2008). For this reasons, each country should protect banks from failing because their failure will have a wave-like effects to the entire economy (Acharya et al, 2009).

Financial innovation has improved banks efficiency in risk management

because innovations have also forced new challenges for market counterparts and their managers in part of systematic risk (Acharya et al, 2009).The recent global financial crisis exposed the important weak spot in managing risks in the financial sectors (Acharya et al, 2009). Banks have to avoid risk in order to remain buoyant because a bank’s cash shortage is exposed to high risks (Acharya et al, 2009). Therefore a bank must be in a position to pay the depositors’ money if they ask for it.

Basel Accord gives guideline to the banks on how to keep away from risk that could put it into receivership since the basel accord is structure of policies and regulations that make sure that banks attain their required capital sufficiency (Acharya et al, 2009). Additionally, banks can avoid risks by not using financial derivatives since derivatives are underlying instruments whose price depends on the bonds and securities performance and these derivatives include; option, futures, Swaps, FRAs which, banks have to include when offering hedging strategies (Acharya et al, 2009). Therefore, banks should do a thorough analysis on the derivative contracts risk before signing any one of them (Acharya et al, 2009).

The global financial crisis was as a result of financial derivatives position that produced external adverse factors from the failing firms in a banking sector that was unregulated and this brought down the whole financial sector (Acharya et al, 2009). The crisis that faces the financial sector was an inherent contradiction of reserve banking and all banks that were caught up by the crisis were occupied in intermediation of different types, in turn, these banks turned out to be illiquid as they could not pay the depositors money back due to inadequate reserves (Acharya et al, 2009). Additionally, awful primary mortgage exposed

banks to high peril that caused the financial sector to be illiquid; this resulted in lack of credits, which eventually led to lack of funds by small enterprises that affected the economy (Acharya et al, 2009).

References

Acharya, V., Cooley, T., Richardson, T and Ingo, W. 2009. Market failures and regulatory failures: lessons from past and present financial crises. Web.

Adam Milton. 2011. Derivative securities and risk management.

Don M. Chance and Robert Brooks. 2009. Introduction to derivatives and RiskManagement. Web.

Gheorghe voinea and Sorin G. Anton. 2008. Lessons from the current financial crisis: a risk management approach. Web.

Investopedia.com. 2011. Futures Fundamentals: How The Market Works.

Meir, L. 2008. Financial ratio analysis.

Randall Dodd. 2001. Derivatives Markets: Sources of Vulnerability in U.S. Financial Markets. Web.

Tradersedgeindia.com. 2011. Beginners guide to options. Web.

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