The usage of derivative instruments - Essay Example

?Financial Services Table of Contents Financial Services Table of Contents 2 Introduction 3 Significance of Derivatives 4 Basics of Derivatives 5 Definition of Derivatives 5 Understanding Derivatives 6 Uses and Users of Derivatives 7 Benefits of Derivatives 9 Risks Associated with the Use of Derivative Instruments 13 Conclusion 15 References 16 Introduction Derivatives are considered to be a particular instrument or product the worth of which is obtained as a resultant of more than one fundamental variables referred to as an underlying asset, value associated with the reference rate and index by way of a contract. The specified underlying or rather the fundamental asset is probable to exist in the form of (Foreign Exchange rate) FOREX, equity, commodity or even other existing relevant assets. There have been stated to be numerous forms of derivatives contracts that are being used among which interest rate swaps is considered to be a common form (Hunt & Kennedy, 2004). The market related to derivative securities has been stated to be perceived similar to an insurance market in relation to the considered financial risks. The rapid rate of globalisation in terms of the capital markets has resulted to a significant rise in the level of volatility related to interest rate across the globe. Numerous companies displayed a preference in favour of purchasing insurance in opposition to the rising improbability and instability with regard to the market linked to interest rate. Owing to this particular rationale, the market related to interest rate derivatives witnessed a sharp rise and development during the past two decades (Crotty & North Carolina State University, 2006). This paper will intend to provide a lucid comprehension of the usage of derivative instruments along with assessing their relative benefits as well as the involved risks. Significance of Derivatives In the present day context, the degree of competition was observed to be witnessing a significant rise along with the environment of business undergoing a constant alteration. The constant alterations have been giving rise to unforeseen situations that calls for effectual management with respect to the companies as well as banks. Therefore, it can be inferred that in relation to the mentioned context, it becomes important for the business enterprises to effectually manage the unforeseen risks from beforehand. It was identified in this regard that the most widely used financing strategies to overcome the challenges raised by business risks are the use of financial derivatives. Examples of financial derivatives used in the current risk management strategies are options and futures, and forward contracts. Options are defined as “the right and not the obligation to buy or sell something on a specified date at a specified price” (Pandian, 2009, pp. 295). On the similar context, futures and forward contracts are also considered as significant risk management tools that are based on the value of fundamental assets. However, these techniques are subject to various factors such as credit rates, interest rates, currency fluctuations and other financial aspects which should be taken into consideration prior to the execution of this strategy (Chance & Brooks, 2009). Basics of Derivatives Derivatives have been stated to be completely diverse from that of securities. They are referred to as financial instruments which are chiefly used to safeguard against as well as dealing with the risks. These financial instruments have also been found to frequently serve the objectives related to arbitrage as well as investment and is also learnt to offer numerous different benefits in contrast with the securities (Acharya & et. al., 2009). Definition of Derivatives A derivative has been defined as an agreement that is found to take place among a buyer as well as a seller and gets initiated on the current date with regard to a particular transaction that is expected to be realised on a future date or time. For example, the transfer related to a definite amount of US currency or dollar on a future date at a precise exchange rate in relation to USD-EUR. The tenure associated with a particular derivative agreement which has been mentioned to be the time period that exists between triggering the agreement and the realisation or termination of that particular agreement can prove to be quite time consuming. Derivatives need to be differentiated from the securities as the transactions engaging the securities are believed to be executed within a matter of just few days. Notably, few of the securities have been acknowledged to possess characteristics similar to a derivative such as warrants or certificates (Acharya & et. al., 2009). Understanding Derivatives Derivatives are referred to as financial agreements the value of which is considered to be extracted from some definite fundamental assets. The underlying assets are believed to entail equity indices as well as equities, loans, exchange rates, commercial along with residential mortgages, bonds, interest rates, commodities and also natural calamities like the hurricanes and the earthquakes. The derivative contracts come out or are available in plentiful varieties; however, the most extensive structures entail forwards or futures, swaps and options (Acharya & et. al., 2009). A forward contract is referred to as a definite contract in which the involved two parties conform to trade the explicit “underlying asset” in the upcoming days at a specific period of time which has been ascertained earlier and at a stipulated price. Accordingly, it implies that the buyer conforms today to purchase an exact type of asset in the upcoming days and the other party that is the seller conforms to grant delivery of that specific asset at the granted and fixed time which was decided on earlier. In this regards, futures are believed to be standardised type of forwards that are competent of being transacted in on the exchange (Acharya & et. al., 2009). In this similar context, an option is referred to as an agreement that provides the purchaser with the right and not any kind of an assurance to purchase or put up for sale the exacting fundamental asset within a specified time period in the forthcoming days at any ascertained price in contrast to any kind of premium payment which would denote the utmost quantity of loss with regard to the purchaser of an exacting option. Therefore, it can be inferred that unlike futures and forwards, settlement of the options gets carried out only at the time of their settlement or applied only under the referred condition. However, in case of a swap contracts, two counterparties are supposed to conform to the fact or condition of transacting a single flow of cash together with the other that is considered to be founded on a theoretical principal amount (European Commission, 2009). Uses and Users of Derivatives Principally, the derivatives are considered as instruments that are made use of for the intention of speculation, hedging and arbitration in the financial market. A hedge position is learnt to make it promising for a particular investor to shield oneself from the degree of risk rudiments that he/she is revealed to. The degree or sum of risk that is feasible to be hedged with the aid of derivatives could be made possible with the help of the fluctuations associated with the market variables and even with the assistance of the constituent of credit risks (European Commission, 2009). Derivative contracts are also capable to be made use of with the intention to hypothesise on the fluctuations related to a particular market variable or even on the creditworthiness of those instruments. Speculators have been identified to put in the factor of liquidity in the market with the assistance of taking an outlook regarding the course related to such fluctuations. In view of the fact that there entails a requirement of involvement of two parties for entering into a derivative contract, it becomes necessary for the speculators to look for another party holding a contradictory perception or who would look for ways of spreading a definite form of risk (European Commission, 2009). Thus, it can be precisely stated that derivatives could also be made use of for the function of arbitration. The perception in relation to arbitrage could be elucidated to be the employment of the inconsistencies prevailing in terms of the prices amid the markets. Derivatives are also capable of being pooled to emulate the other accessible financial instruments with the intention to make them proficient to unite or connect the markets by eradicating the insufficiencies associated with the prices prevailing within the market for such instruments. Therefore, it could be figured out from the assorted applications or usages associated with derivatives that it discharges an indispensable role with respect to price detection (European Commission, 2009). Benefits of Derivatives Derivatives are believed to be priced with the aid of a hypothetical structure with regard to an imitative portfolio. The non-financial business enterprises and the individuals are supposed to encounter quite an increased degree of costs interrelated to trading in contrast to the economic institutions. As a result, the preliminary difficulty associated with the imitation of a derivative instrument, for instance a definite call option, would as an outcome prove to be excessively costly. To add more, for derivatives which engage option features, the strategy in relation to the imitation of the portfolio calls for the requirement of already performed dealings at the incidences of alterations related to prices associated with the principal. The other disadvantage that is likely to arise in this regard would be the facet of figuring out the appropriate imitating strategy (Stulz, 2005). Derivatives are considered to make available suitable solutions for the above stated problems. The principal advantage ensuing from the derivatives contract is thus observed to be the ability or sanction that is offered to the various business enterprises and the individuals with the intention of accomplishing inducements. These inducements have been mentioned to be merely attainable with the aid of derivatives or at much elevated prices. Hedging of risks is learnt to be simply realisable with the assistance of derivatives. At a definite time period, the financially viable executors are measured to be competent of treating the risk in an enhanced manner. In such mentioned circumstances the risks are learnt to be acknowledged by such considered entities or individuals who are supposed to subsist in such a position that is found to be the overriding position for the rationale of accommodating such risks. It also facilitates or enables the business enterprises to embark on riskier but progressively more rewarding projects by making use of hedging (Stulz, 2005). Derivatives are believed to facilitate deals related to future risks enabling them to trigger two vital uses related to them. The first vital purpose or use has been identified to be the factor of doing away with the ambiguity by way of swapping over the risks related to the market which is usually referred to as hedging. The corporate as well as the financial institutions have been learnt to make use of the derivatives so as to safeguard themselves against alterations witnesses in exchange rates, prices related to the relevant raw materials and the interest rates. The derivatives are believed to serve the purpose of insurance against the superfluous and unnecessary fluctuations experienced in terms of prices along with trimming down the degree of instability in relation to the cash flows with regard to the various companies. This protection in turn proved to be increasingly dependable in terms of forecasting, capitally productive and also helped in bringing down the capital requirements as well. These stated advantages have also proved to the extensive use of such financial instruments or rather derivatives across the world. To put it precisely, majority of the globe’s 500 biggest companies are learnt to deal with their respective risks related to prices with the help of making use of the derivatives (Culp & Miller, 1995; Department of Mathematics, 2008). The second vital purpose with regard to the usage related to derivatives is stated to be in the form of investments. Derivatives are believed to act as a substitute of making direct investments in assets without entailing the necessity to purchase or be in possession of the asset itself. They are considered to facilitate investments into fundamentals as well as risks which are not capable of being directly purchased. Derivatives even enable the investors to acquire positions in opposition to the market in case of likeliness in the decline of the relevant value associated with the fundamental asset (Department of Mathematics, 2008). Another noteworthy and imperative advantage recognised in relation to derivatives has been the augmented development along with the competence of the primary markets which has been believed to be probable only with the execution or with the application of derivatives. In the initial phase the derivatives markets are considered to produce information. For instance, in numerous countries, the potential reliable information regarding the enduring rates of interest is obtained through the application of swaps. The market in relation to swaps is observed and believed to be progressively more liquid along with being quite active in contrast to the existing bond markets (Stulz, 2005). The interest-rate swap is further observed to be quite popular and is used by various banks for effectually dealing with their respective exposure related to the interest-rate along with facilitating them to reap revenue apart from the customary banking functions or operations (Brewer III & et. al., 2000). The use of derivatives has already been stated to be done with the intention to hedge risks by various business enterprises. This implies that such business enterprises are in reality making endeavours to initiate the application of the mentioned kind of contracts as a kind of insurance to guard themselves from adverse outcomes in the upcoming days. In certain circumstances when the application of the derivative instruments are made with the goal of hedging risks then it implies a shift in the perceived degree of risk by the engaged derivative instruments in comparison to those individuals or hedgers who are supposed to be hesitant to tolerate the risks. The risks are reallocated to those individuals or entities, who are gauged to be proficient enough and are believed to be more equipped to put up with the complexities of the risks. Hence, it could be stated in this regard that derivatives assist in reallocating the extent of risk adeptly amid diverse groups as well as individuals with regard to the economy (Sill, 1997). The derivatives contracts are also believed to be helpful when it comes to allocation of risks. This becomes attainable and probable owing to the fact of the prospects associated with the economical leverage that are obtainable by the application or initiation of derivatives contracts with regard to the respective investors. Leverage or control has already been measured to be accomplished with the application and implementation of forward contracts. In such occurrences related to forward contracts, the leverage is obtained as an outcome of the veracity that no financial consideration is mandatory at the period or time of initiating or entering into these kinds of agreements or contracts by the concerned and related individuals (Sill, 1997). Thus, it becomes imperative to be declared in this regard that typically derivatives are considered to be instruments that aid in trimming down the extent of quantifiable risks for the already initiated investments of the investors. Vastly broadening the set of choices in relation to the reachable options assists and supports the investors to revise the degree of quantifiable risk associated with their own respective arbitraging, investment or hedging situation. Derivative contracts are gauged and are learnt to enable the investors to manipulate comparatively minimum summation of financial resources founded on an extensive assortment of assets owing to which the respective portfolios gets spread (Stulz, 2005). Risks Associated with the Use of Derivative Instruments Numerous businesses and individuals are believed to make use of the derivative instruments with regard to their overall strategy of dealing with the assorted forms of risks encountered. The refined methods related to risk management are also found to assess the riskiness associated with the investment portfolios that entail options as well as other form of derivatives. Evaluation of the risks related to these kind of portfolios usually calls for the requirement of practitioners to make use of models related to option pricing which are believed to just provide approximations. Such models fail to perform in accordance with the expectations of the practitioners which develop the business enterprises opening up to the elements of increased or decreased degree of risk than desired. Thus, the inexactness related to the assorted models of pricing might result in directing the traders as well as the investors off track (Sill, 1997). The other risk associated with the usage of derivative instruments has been stated as the credit risk. This particular risk refers to the failure of payment with regard to one party in relation to the agreement. Credit risk implies to that particular degree of risk which occurs from the improbability related to the capability of a particular obligor to carry out the obligations related to the agreement. For instance, a particular bank might initiate a swap agreement with two different business enterprises. The particular bank will be considered to be completely hedged if both the enterprises do not fail to make payments. But in case, any one of the enterprise fails to make payments, then the bank would still be liable to honour the agreement made with the other enterprise which influences the bank to witness credit risk (Sill, 1997). The other existing risk found to be associated with the derivatives instruments has been stated as the liquidity risk. This particular risk relates to the easiness that is expected while trading in a particular contract. This particular risk is considered in particular with regard to a derivative contract, but it has still been assumed to play an imperative part with respect to any kind of financial market in the course of increased instability or in case of important alterations in relation to the economic fundamentals. It needs to be mentioned in this regard that when securities are considered to get illiquid then it gets increasingly tricky to ascertain the respective market worth. Owing to this particular phenomenon a considerable distinction between the market and the book values of the securities as well as the portfolios are observed at the time of selling those definite illiquid securities by the business enterprises. The models applied by the enterprises for the reason of controlling the respective risks along with coming to financial decisions entail high chances of providing incorrect answers owing to the application of erroneous values at the time of conducting the assessment (Sill, 1997). Conclusion The derivatives markets were observed to display a marvellous and remarkable development during the past 10 years. Although, much discussion and identification of the losses related to derivatives were found, but the offered economic advantages by the derivatives instruments were still regarded as increasingly imperative. The derivatives have been learnt to aid the economy in attaining an effectual distribution related to risk. They have been found to complete the markets by way of offering the business enterprises as well as the individuals with fresh investment prospects. The derivatives are believed to make available information with regard to the contributors or applicants of the financial market which further assists in trimming down the market instability on the whole to a significant extent. References Acharya, V. & et. al., 2009. Derivatives – The Ultimate Financial Innovation. Journal of Applied Corporate Finance, pp. 1-13. Brewer III, E. & et. al., 2000. Interest-Rate Derivatives and Bank Lending. Journal of Banking & Finance, Vol. 24, pp. 353-379. Chance, D. M. & Brooks, R., 2009. Introduction to Derivatives and Risk Management. Cengage Learning. Crotty, M. T. & North Carolina State University, 2006. Assessing the Effects of Variability in Interest Rate Derivative Pricing. ProQuest. Culp, C. L. & Miller, M. H., 1995. Hedging in the Theory of Corporate Finance: A Reply to Our Critics. Journal of Applied Corporate Finance, pp. 121-127. Department of Mathematics, 2008. The Global Derivatives Market: An Introduction. Deutsche Borse Group, pp. 1-42. European Commission, 2009. Ensuring Efficient, Safe and Sound Derivatives Markets. Commission of the European Communities, pp.1-47. Hunt, P. J. & Kennedy, J. E., 2004. Financial Derivatives in Theory and Practice. John Wiley and Sons. Pandian, P., 2009. Security Analysis and Portfolio Management. Vikas Publishing House Pvt. Ltd. Sill, K., 1997. The Economic Benefits and Risks of Derivative Securities. Federal Reserve Bank of Philadelphia, pp. 1-26. Stulz, R. M., 2005. Financial Derivatives. 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