Derivatives and Foreign Exchange - Coursework Example

Derivatives and Foreign Exchange A foreign exchange derivative can be defined as any financial derivative (financial contracts which derive their values from the performances of other entities i.e., index, assets, or interest rates that are in other words called the underlying), whose payoffs fundamentally depend on the foreign exchange rates of two or several currencies of different geographical regions or countries. Such derivatives are majorly used for currency speculations and arbitrages or hedging foreign exchange risks, financial risks that are posed by exposure to unanticipated alterations within the exchange rates between two different countries (Levi, 2005). A derivative is one of the three main classifications of the financial instruments which are the debt (mortgages and bonds), and equities (stocks). Within the financial context, derivatives include several financial contracts such as the swaps, futures, options, forwards, and; variations i.e., floors, caps, credit default swaps, and collars. Quite a number of derivatives are marketed via the off-exchange (over-the-counter) or through exchanges i.e., the Chicago Mercantile Exchanges, even though a number of insurance contracts have adopted the use of separate industry (Moffett, Stone-hill, & Eiteman, 2009). Financial Exposure Risks a) Economic Exposure Economic risks or operation exposure are experienced by any business organization when its targeted market’s value has been completely influenced by any unexpected exchange rates’ fluctuations, which have the impact of severely influencing negatively the market position/share with respect to its active competitors (Moffet, Stone-hill, & Eiteman, 2009). With this happening, the organization’s future cash flows and values are also affected. Therefore, transactions exposing any organizations of firms to certain foreign exchange risks have additional potential exposure risks to the economical performance, as can be caused by any other business involvements, i.e., future cash flows from the available fixed assets. Hence, it can be concluded that a shift in the exchange rates that influences the demands for goods in some region or countries can as well be considered as an economic exposure for firms that sell that particular type of products. b) Transaction Exposure This occurs whenever a company has any payables and receivables, or contractual cash flow with any value subjected to unanticipated alterations within the exchange rates as a result of contracts being denominated in foreign currencies. To react to this change and for the company to ensure realization for its domestic values of its foreign-denominated cash flows, it has to effectively conduct an exchange of foreign currencies for the domestic types of currencies. Therefore, the process of immense negotiation contracts with the laid down prices and delivery dates in the face of a volatile foreign exchange market with exchange rates that are in a constant rate of fluctuations, such institutions are bound to face risks of changes in the exchange rates between the foreign and domestic currencies. c) Contingent Exposure Firms do face contingent exposures whenever they are in the processes of bidding for foreign projects, or while making negotiations for other contracts and/or foreign direct investments. Contingent exposure therefore steps in from the potentials of the firms to abruptly undergo the economic foreign exchange or transactional risks. d) Translation Exposure A translation exposure is an extent to which firms’ financial reporting are affected by the exchange rates’ movements. This is brought about by the fact that all firms are bound to come up with their consolidated financial statements for their reporting reasons, the consolidation process for the multinationals have to take into account the translation of foreign assets and liabilities or the stated financial reporting of foreign subsidiaries for the foreign to domestic currencies (Levi, 2005). Although such exposures may not be of massive negative effect to the firms’ cash flows, translation exposure is capable of projecting important impacts on the organizations’ financial reports under earnings, hence the stock prices. This type of exposure is distinguished from the almost related transaction risks because of the income and losses that are generated from different types of risks that have varied accounting treatments. The idea of derivatives holds significance in the context of attractive financial products for two types of traders who are hedgers and speculators. In most instances, speculators are of the interest in derivation due to the fact they are able to avail inexpensive ways to expose portfolios to various market risks with intensions of outperforming the available markets; while hedgers are for the interest of derivatives which allow investors to minimize the possible market risks to which they are already exposed. Other benefits of the derivatives are that: i. They are part of our universe of the financial instruments ii. As basic financial instruments, they can be applied in the constructions of even more complicated instruments iii. They actually allow one to effectively participate in price movements with no intensified commitments of huge amounts of financial resources as may be needed in the purchase of stock outright iv. They are also applied in the hedging of stock positions v. Their provided options allow for one to make acquisition or sell out stock at purchase prices that are more favorable as compared to the current market prices vi. Whenever one is for the selling option, he/she is capable of earning premium incomes vii. The above benefits actually show that derivatives have options. One can buy, sell or intentionally be out of the market at will viii. One is also able to tailor his or her position to his/her own financial situations and risks tolerance, and ix. Doing purchases of the derivatives which avails the opportunity for one to effectively position him/herself in accordance with the acceptable market expectations. Hence, a number of business strategies have the ability of being reconstructed to suit users. Types Derivative Contracts In general, derivative agreements are recognized to be of two clusters of derivative indentures, which are illustrious by ways in which they are traded within the markets. They include: a) Over-the-counter derivatives These are describes as agreements which are bought and sold, and confidentially agreed upon between two parties only, without the need to preview intermediaries or any exchanges as may be called for. Inventions like forward rates agreements, rare choices are traded. These derivative markets provide actually the prevalent markets for derivatives, and is principally tolerant basing on the level of exposure of information between the parties involved during any agreements. Because these markets are composed of banking institutions and other complicated components, like the hedge funds. Making reports on the total amounts used seems to be difficult since trade itself can take place in secretive situations, without any undertakings being reviled on any exchange. As stated by the Bank for International Settlements, who initially surveyed over-the-counter derivatives in 1995, the gross market values, which represent the cost of replacing all open contracts at the prevailing market prices, was shown to have increased by 74 percent since 2004, to US dollars 11 trillion by June 2007. A position within over-the-counter derivatives there was a market increase to US dollars 516 trillion as of June 2007, 135 percent higher than the level recorded in 2004. The total outstanding notional amount is US dollars 708 trillion in June 2011). Of this total notional amount, 67 percent are interest rate contracts, 8 percent are credit default swaps (CDS), 9 percent are foreign exchange contracts, 2 percent are commodity contracts, 1percent is equity contracts, and 12 percent are others. Because over-the-counter derivative is never traded on any exchanges, central counter-party lacks. For these reasons, OTC is subjected to competitors’ risks, like any commonplace contracts, because every party involved bases on the other to perform (Eun, & Resnick, 2011). b) Exchange-traded derivatives (ETD) ETDs are imitative mechanisms best bought and sold through concentrated some generally formulated exchange rates or other exchanges. Derivatives exchanges are markets within which people are allowed to trade on standardized agreements that have been defined by the exchange options. Any derivatives exchange (in this context), act like intermediaries to all related transactions, and take up the initial margins from either of the parties involved in the trade to act like assurances. The biggest derivatives exchanges in the world considering the number of transactions are; Exchange of Korea, Eurex, and Chicago Mercantile Exchange (Eun, & Resnick, 2011). Common derivative contract types The most familiar modifications of the plagiaristic contracts are as listed below: i. Forwards: A custom-made agreement between two groups, where payments are done at a definite time in the future at the current pre-determined prices. ii. Future: is a contract to buy or sell an asset on or prior to a later date at a price specified today. A futures agreements is different from a forward agreement because a futures agreement is a standardized agreement that is written by a clearing authority operating exchanges where the agreement can be sold and/or bought; the forwards bond is a non-homogeneous indenture drafted by the parties in the agreement. iii. Alternatives are pacts that provide the owners rights, although not commitments, to purchase or sell out (for put options) any assets. The prices at which the sales are set are recognized as the strike prices, and are particularized whenever both parties enter into the options. Additionally, option contract provide specifications on the maturity dates (Wang, 2005). Considering the European option cases, owners have rights of requiring sales to be carried out on or after the maturity dates as set; however, the American options allow owners to require such sales to occur within any time up to the maturity dates. In case the owners of the contract exercise this right, the contradicting-parties are compelled to carry out the transaction. Options here therefore are of two types: call option and put option. Buyers of Call options have rights of buying defined quantities of the underlying assets, at specified prices on or prior some given dates in the future, they however have no obligations at all to use these rights. Correspondingly, these buyers of Put options have the rights to sell some defined quantities of underlying assets, at some specified prices on or before some given dates in the future, they however have no obligations whatsoever to carry out these rights too (Moosa, 2003). iv. Binary options are agreements that explicitly give the owners with an all-or-nothing profit profiles. v. Warrants: except for the usually used short-dated alternatives which have the highest maturity periods of 1 year, there are also long-dated options which are called Warrants (finances). They are as well traded over-the-counters. vi. Swap is another different type of a contract that is applied in exchanging cash (flows) on or prior to specified future dates as may be applicable for the fundamental values of currency exchange rates, commodities exchanges, bonds/interest rates, stocks or other assets. An additional term that is normally linked to Swap is Swaption which is just a choice on the forward Swap. Like to Call and Put options, Swaptions are of two kinds: receiver Swaptions and payer Swaptions (Moosa, 2003). Further discussions of the Swaps categories: a) Interest rates swaps: These on the whole call for swapping just interest linked any cash flow within the same currencies, between two groups. b) Currency swaps: In this swapping, cash flows between the two parties include both principals and interests. Additionally, the money which is being swapped is in different currencies for both parties. Economic function of the derivative market Some of the outstanding economic utilities of the derivative market are: i. Prices within structured derived markets both reproduce perspicacity of the market accomplices on the future, and lead the prices of underlying to the professed future level. ii. Derivative markets reallocate risks from individuals with preference on risks aversion as opposed to individuals with appetites for risks. iii. Inherent characters of derivatives markets relate them to the underlying Spot market. Because of the imitative, considerable increments in trade volumes of the underlying Spot markets are realized. iv. As supervisions, investigations of tasks of different participants become complicated in mixed markets; the constitutions of organized forms of market become essential. v. Third parties are allowed to publicly make use of the existing derivative prices as educated forecasts of uncertain future results. In a summary, substantial intensifications in investments and savings in the final phases due to the augmented activities which are because of the derivative Market participants. Financial scrutinizes provide that there are two classes of derivative contracts, which are the privately traded over-the-counter plagiaristic like swaps which is not exposed to any exchange or any other intermediaries, and exchange-traded derivatives that are traded through specialized derivatives exchanges or other exchanges (Wang, 2005). Derivatives are mostly widespread in the current times, although their derivations map out several centuries ago. One of the earliest derivatives being the rice future, which has ever since been traded on the Dojima Rice Exchanges from the early 18th Century. Offshoots are in most cases classified by the relationships existing between the underlying assets and the derivative i.e., option, forward, and swap; the types of underlying assets like foreign exchange derivatives, impartiality derivatives, commodity derivatives, interest rate derivatives, or credit derivatives; market situations in which they trade, i.e., exchange-traded or over-the-counter; and their pay-off profiles (Moosa, 2003). Derivatives can be effectively applied either in successful risks management, or for speculations, i.e. making a financial bet. These distinctions are significant since the previous is a discreet characteristic of the financial management and operations for a number of organizations across several industries; the last proffers managers and investors risky opportunities to enhance turnover, which may not be appropriately released to stakeholders (Moffett, Stone-hill, & Eiteman, 2009). Alongside other several financial services and products, derivatives modification is a constituent of the Dodd–Frank Wall Street Reforms and the Consumer Protection Act of 2010. The Act entrusted several rule-making aspects of authoritarian oversight to the Commodity Futures Trading Commissions and other factors were never finalized nor were they effusively executed (Eun, & Resnick, 2011). Exchange buy and sell derivatives market prices are classically apparent and in most cases circulated within the real time through exchanging, derived from the contemporary offers and bids on those particular contracts during some defined period (Homaifar, 2004). Tricky situations have the possibilities of arising with Over-the-Counter or ground-traded agreements however, since trading are generally handled manually, making it intricate to automatically broadcast trade prices. Particularly with Over-the-Counter contracts, there are no central exchanges to disseminate and collate values. Under laws of the United States of America and other most other developed countries, derivatives play exceptional legal exceptions that ensure that they are particularly attractive legal forms to extend credits (Wang, 2005). Strong creditors’ protections paid for derivatives defy parties, together with their complexities and lack of transparency however, can result into capital markets to quote lower prices on the credit risks. This can contribute to credit booms, and increased systemic risks. Indeed, the use of derivatives to conceal credit risk from other members while offering protection of the derivative oppose parties which can throw in to comparable situation of financial downturn of 2008 in the US (Homaifar, 2004). Works Cited Eun, C. S., & Resnick, B. G. International Financial Management, 6th Edition. New York, NY: McGraw-Hill/Irwin, 2011. ISBN 978-0-07-803465-7 Homaifar, G. A. Managing Global Financial and Foreign Exchange Risk. Hoboken, NJ: John Wiley & Sons, 2004. ISBN 978-0-47-128115-3 Levi, M. D. International Finance, 4th Edition. New York, NY: Rutledge, 2005. ISBN 978-0-41-530900-4 Moffett, M. H., Stone-hill, A. I., & Eiteman, D. K. Fundamentals of Multinational Finance, 3rd Edition. Boston, MA: Addison-Wesley, 2009. ISBN 978-0-32-154164-2 Moosa, I. A. International Financial Operations: Arbitrage, Hedging, Speculation, Financing and Investment. New York, NY: Palgrave Macmillan, 2003. ISBN 0-333-99859-6 Wang, P. The Economics of Foreign Exchange and Global Finance. Berlin, Germany: Springer, 2005. ISBN 978-3-54-021237-9 Read More