Pay-Off Structure - Assignment Example

Answer Derivatives are a financial contract whose pay – off structure is defined by the value of an underlying commodity, securities, share price index etc. A derivative actually means the future exchange of securities, interest rate etc so there is a need to speculate the future or estimate the future. Following are the people who can carry out the activities in a derivative market – Hedgers. Hedgers are the persons who defend themselves from the various risk related by way of the cost of an asset with the use of derivatives. An individual maintains a close observes upon the costs found out in deal and when the comfortable cost is reflects according to his requirements; he put up for sale in future agreements. In this method he obtains a guaranteed fixed cost of his produce. In broad sense, hedgers make use of future for protection in opposition to unfavourable future cost actions in the underlying money commodity. Hedgers are frequently traders, or persons, who at one point or a further contract in the fundamental money commodity. One of the examples for this situation is that: A Hedger disburses more to the merchant or farmer of a manufacture if its costs escalate. For guard in opposition to higher costs of the manufacture, he hedges the risk or danger exposure by purchasing an adequate amount of future agreements of the manufacture to cover the quantity of manufacture he anticipates to purchase. In view of the fact that money and future costs do be inclined to shift in tandem, the futures place will income if the cost of the manufacture rise sufficient to counterbalance money loss on the manufacture. Speculators: Speculators are the person who acts like a middle man. They are under no circumstances interested in real owing the goods. They will purchase from one point and put up for sale it to the other point in expectation of future cost actions. They really bet on the potential movement in the cost of an asset. They are the one the second main grouping of futures group of actors (players). These contestants consist of self-governing floor dealers and investors. They hold trade for their private patrons or brokerage companies. Purchasing a futures agreement in expectation of cost enlarges is recognized as ‘going long’. And at the same time Selling a futures agreement in expectation of a cost diminishes is identified as ‘going short’. Speculative involvement in futures dealing has enlarged by way of the accessibility of alternative means of involvement. Speculators have benefits above other savings they advantages are as follows: If the dealer’s judgement is excellent, he can construct more cash in the futures marketplace quicker for the reason that prices be inclined, on average, to modify more speedily than any other services like stock costs or real estate. Futures are extremely leveraged savings. The dealer puts up a very small portion of the cost of the underlying agreement as margin; nevertheless he can ride on the complete cost of the agreement as it goes up and down. The real cost of the agreement is only exchanged on those rare circumstances when release takes place. ANSWER (B) Construct the hedging/speculating strategies that you and this fund manager can employ. Calculate the outcome for the strategies employed by you and the fund manager if FTSE 100 Index in the Dec becomes (1) 2080, (2) 2600, (3) 3120. (20 marks) ----------------------- BUY 2500 PUT FOR 40 SELL 2700 CALL FOR 50 AND BUY FUTS @ 2700 AT 2080 ON PUT +380 ON CALL + 50 ON FUTS -620 NET LOSS -190 AT 2600 ON PUT -40 ON CALL +50 ON FUT -100 NET LOSS -90 AT 3120 ON PUT -40 ON CALL -370 ON FUT + 420 NET PRF +10    ANSWER TO C: If your friend thinks the FTSE 100 in the Dec will have the possibility to rise far above 2700, or drop far below 2500, what kind of strategy he can employ to speculate his view for profits by using 1 put and 1 call options. Describe such strategy and draw a table as well as a diagram showing the variation of your friend’s profit/loss with the FTSE 100 index level. (10 marks) BUY STRADDLE: - BUY 2500 PUT (1 LOT) AND BUY 2700 CALL (ONE LOT) (IN THIS CASE TOTAL COST WILL BE 90) A MOVE BELOW 2410 OR A MOVE ABOVE 2790 WILL GIVE U UNLIMITED MONEY. Question No.2 To expand its business, Fox plc expects to pay £30m in six months’ time. A large amount of money receivable to Fox plc is expected to be enough to cover such business expansion however will become available to Fox plc in nine months time. Therefore, in the intervening 3 months £30m will have to be raised from money markets. The corporate treasurer is concerned that interest rates will rise from the present level of 6 per cent over the next six months, resulting in a higher cost of capital for the business expansion. A forward rate agreement (FRA) is available at 6 per cent. Three-month sterling interest futures (STIRs) starting in six months time are available, priced at 94.00Assume there are no transaction costs and that a perfect hedge is possible. You are required to: (a) Describe the TWO hedging strategies that the treasurer could employ. (20 marks) (b) Show the profit/loss on the underlying and the derivative under each strategy if market interest rates fall to 4 per cent, and if they rise to 8 per cent. Discuss the advantages and disadvantages of forwards over futures for hedging. (10 marks) Answer Amount payable by Fox Plc: £30m in 6 months Receivables expected in 9months. £30m has to be raised from money markets for a period of 3 months Current Interest Rate: 6% Forward rate: 6% 3 month futures @94.00 sterling Hedging simply refers to an activity that reduces risk. It is basically concerned with the reduction of market risk, it makes financial planning easier and reduces the effect of incurring huge loses. Hedging is like buying insurance against potential risk, most business hedge to reduce risk not to profit from it. Two types of hedging strategies employed here are – a) Hedging Strategy 1 Enter into a forward contract to sell £30m within 9 months. Take a loan of £30m @ 6% interest rate and make the payments at the end of 6 months. At the end of 9 months when Fox Plc receives money, sell £30m at the forward rate fixed. Thus the exposure is minimised and hence hedging done. Hedging Strategy 2 Borrow £30m @ 6% interest rate and make the payments at the end of 6 months. Enter into a 3months futures contract (STIR) @94.00 sterling at the end of six months. Exercise the contract at the end of 9 months. The bank loan can be repaid and the risk is reduced. Hence hedging is done. b) Profit/Loss under Strategy 1 If interest rate falls to 4% Profit= £30m*6%*3/12-£30m*4%*3/12=£0.45m-£0.30m =£ 0.15m If interest rate rises to 8% Loss = (£30m*8%*3/12)-(£30m*6%*3/12)=£0.60m-£0.45m =£ 0.15m Profit/Loss under Strategy 2 If interest rate falls to 4% When future contract is exercised =>£30m-0.94*£30m = £1.8m Loss = £1.8m-£30m*4%*3/12 = = £1.5m If interest rate rises to 8% Loss = £1.8m - £30m*8%*3/12 = = £1.2m Advantages and Disadvantages of forwards over futures for hedging Forwards Futures Counter Party risk is high Counter party risk is low Expiry date depends on transaction Expiry date is standardized No guarantee of settlement until the date of maturity only the forward price, based on the spot price of the underlying asset is paid. Both parties must deposit an initial guarantee (margin). No institutional guarantee Institutional guarantee provided by Clearing house Size of contract is decided by buyer and seller Standardised in each contract It is traded over the counter Stock exchange trade Price of contract remains fixed till maturity. Price changes every day. There can be any number of contracts Number of contracts fixed between 4 and 12. 3. (a) A spread trading strategy involves taking a position in two or more options at the same time. i.e. 2 or more call (or) 2 or more puts. Three types of spread are their – Bull spread Bear spread Butterfly spread. In this problem, we can calculate spread in the following manner – Spread = (10.0%-7.0%) – (10.0%-8.5%) = 1.5% Spread to be divided equally between ABC and XYZ taking into consideration that the swap bank is allowed 0.2% per annum while acting as intermediary. So, spread divided among the two companies equals: (1.5%-0.2%)/2, i.e. 0.65% each. Hence, on taking up a loan in dollars, Company ABC will have to pay interest @ (10.0%-0.65%) i.e. 9.35% to the Swap Bank who in turn would take its share of 0.1% from the 0.2% p.a. allowed to it in the deal and the Swap Bank would pay @ 9.25% to Company B thereafter. Similarly, Company B would take up a loan in pounds and pay interest @ (8.5%-0.65%) i.e. 7.85% to the Swap Bank who after deducting its share of 0.1% will pay Company A @ 7.75% in pounds. Thus, Company A gets an advantage of paying lesser than the market rate of 10.0% as well as Company B gets an advantage of paying at a lesser rate compared to the market rate of 8.5%. This swap can be designed as given below: (b) There is a high degree of credit default risk associated with that of swap banks. It is the same as Counterparty Risk that would have been faced by the two companies involved in the swap transaction in case there had been no such bank acting as intermediary. Also, foreign currency risk and interest rate risks are the most common risks faced by the swap banks during such transactions involving foreign exchange. Derivatives play a major role in reducing risks to parties involved in financial transactions. The various forms of derivatives like the forward contracts, futures, options, etc. help in hedging such transactions to minimize losses to the maximum that would be ought to be incurred due to fluctuations in the economy as well as the values of currencies involved in these transactions. Derivative is a financial instrument or it can be defined as a financial contract whose pay off structure is defined by the value of the following – Underlying commodity Security Interest rate Share price index Exchange rate Oil price etc. Thus a Derivative derives its value from the above mentioned variables. Derivatives are mainly divided in to following types – Futures Forwards Options Swaps. Future contract is an agreement to buy or sell a standardized quantity of a commodity or instrument at a pre – established price on a future date through regulated exchange (stock exchange). Forward contract is an agreement to buy or sell an asset on a certain future date at an agreed price. This contract is usually between two parties in which one party takes a long position and agrees to buy while other takes a short position and agrees to sell underlying assets on a future date at a specific price. Option gives the buyer or seller of the contract the right (but not the obligation) to buy or sell the underlying asset at predetermined price within (or) at the end of specified period. SWAPS are an agreement between two companies to exchange cash flows in the future. It specifies the date when cash flows are to be paid and the way in which they are to be calculated. Swap actually means a contract between two parties to exchange two streams of cash flows through an intermediary called financial institution. Mainly there are two types of swaps: Interest Rate Swaps Currency Swaps. Interest rate swap is an agreement between counter parties to exchange a series of interest payment for a stated period of time. It typically involves exchanging Fixed and Floating interest payment in same currency. Currency Swap involves exchanging principle and fixed rate interest payment on a loan in another currency. SOLUTION : Q1; Here I have to design a swap that will net a bank 0.2% and which will appear equally attractive to both the parties - COMPANY REQUIREMENT POUND ( £ ) U. S Dollars ( $ ) ABC U.S Dollars ( $ ) 10 % 10 % XYZ Pound ( £ ) 7 % 8.5 % Co: ABC has a competitive advantage in British Pound (£), but wants to borrow U.S Dollars ($). Co: XYZ has a competitive advantage in U.S Dollars ($), but wants to borrow British Pound (£).Here, we have to calculate the Interest Rate Differential (IRD) between the two currencies. The calculation is as under: The Interest Rate Differential of British Pound (£) between the companies ABC and XYZ is 3 % (10 % - 7 %). While the Interest Rate Differential of U.S Dollars ($) between the companies ABC and XYZ is 1.5 % (10 % – 8.5 %).Therefore, Total gain to all parties is 1.5 % (3% - 1.5%). i.e., (IRD of £) – (IRD of $).Since, Bank requires 0.2 % per annum as profit, it should be deducted from the total gain i.e., 1.5%. Hence, 1.5 % - 0.2 % = 1.3 %, which should be divided equally between Co: ABC and Co: XYZ in order to attain equal benefits for both the companies. So 1.3 % when divided equally it will yield 0.65 % to both Co: ABC and Co: XYZ. The SWAP will lead to: Co: ABC borrowing $ at 10% – 0.65% = 9.35% per annum. Co: XYZ borrowing £ at 7% - 0.65% = 6.35 % per annum. Therefore, Co: ABC can borrow US Dollars ($) at a rate of 9.35% per annum, whereas Co: XYZ can borrow British Pound (£) at a rate of 6.35% per annum. SOLUTION: Q2; Risk involved here for banks acting as an intermediary is systematic risk. The risk which affects the entire market is known as systematic risks. Some of the sources of systematic risk are: Interest rates Recisions Wars etc. All this factors have a direct influence on the market. Here though we are dealing with SWAPS which is related to interest rate and currency, it will always have a direct influence on the market. So is clear that the risk involved with banks acting as an intermediary is systematic risk. Derivatives derive its value from some underlying commodities or assets. The use of derivatives is now becoming critical for the credit system and our economy. Derivatives also allow the investors and the holders to take either a long position or short position in the market, the long position allows to buy where as short position allows selling underlying assets on a future date at a specific price. Derivatives also provide an option either to buy or sell an underlying commodity. (The Role of Derivatives, n.d). Financial innovation was mainly carried with the aim of reducing risk and cost in the banking sector. Many new services and products were introduced in the banking sector as a part of this reform. They are as under: ATM (automatic teller machine) Debit card Prepaid cards Online banking etc. Two popular measures were introduced to measure and to control financial risk in the banking sector. They are: Value at risk (VaR) Stress Testing. Both methods were mainly used to measure the level of capital required by bank to face unlikely situations in the banking sector. (Digal, 2010). Though financial innovations had made Risk management very effective, it has lead to various challenges in the area of systematic risk. Financial risk arises due to variability in cash flows and market values due to unpredictable factors in the market. Derivatives usually allow hedgers to take a large position in the market even with a small amount of capital which ultimately leads to financial risk. Reference List Digal, B., 2010. Technological Change & Financial Innovation in Banking. [Online] Indian MBA. Available at: http://www.google.com/search?ie=UTF-8&oe=UTF-8&sourceid=navclient&gfns=1&q=financial+innovations+in+banking+sectors [Accessed 31 March 2011]. The Role of Derivatives, n.d. [Online] national investor. Available at: http://www.google.com/search?ie=UTF-8&oe=UTF-8&sourceid=navclient&gfns=1&q=role+of+derivatives+in+banking+sectors#sclient=psy&hl=en&q=Role+of+derivatives+in+banking+sector&aq=0p&aqi=p-p1&aql=&oq=&pbx=1&bav=on.2,or.r_gc.r_pw.&fp=3ea5322f77d9e72d[Accessed 31 March 2011]. Read More