Derivative Securities: Risk Management Strategies for Equities and Interest Rate - Research Paper Example

Introduction Financial derivates are probably the most important innovation in the finance industry during last forty years or so. The volume of transactions in derivates indicates the level of interest that is being shown in derivative and their power to leverage. However, financial derivatives are probably the best financial instruments available to hedge against certain risks faced by the organizations. They do not only offer to design risk management strategies for the financial firms but international firms including manufacturing firms can also take benefit of financial derivates and their power to offer strong risk management tools to secure against any adverse movements.(Kolbe & Overdahl,2009). It is however, critical to note that the careless use of financial derivatives can create situations like that one that is being faced by the US and other developed countries. Since derivative securities are highly leveraged in nature and can be dangerous if investment managers do not take into consideration the relevant factors that are considered as essential for controlling and managing the risk through financial derivatives. What is however also important to note that the same derivative instruments can be tailored in different manner to achieve the risk management objectives.(IMF,2000). Derivatives can be used for equities as well as hedging against the interest rates however the relative strategies as well as tools to be used may differ significantly and as such the investment managers must take into consideration the relevant factors. This paper will therefore provide a comprehensive analysis of the appropriateness of the various derivative instruments to manage risk for equities as well as interest rate. Financial Derivatives A financial derivative is something whose value is derived from some other asset therefore the derivative is always a derived value. As discussed above that the financial derivatives are highly leveraged in nature therefore smaller changes in the value of the underlying asset can create significantly larger changes in the value of the derivatives. Derivatives are in use since last many years however their regular use started during 1970s during the oil embargo. Further, the improvements in the technology as well as finance knowledge and use of mathematics into finance also boosted the role of financial derivatives as the major investment tools to be used. It is critical to note that financial derivatives can be used for any type of asset and can be helpful in providing effective hedging against movements in the underlying assets such as equities, commodities etc. (Kolbe & Overdahl,2009). Following section will discuss the use and appropriateness of the financial derivatives and their ability to offset the market position risk in equities as well as interest rates. Financial Derivatives and Equities Financial derivatives can be used to provide hedge against the equities and there are different instruments and strategies that can be used to provide such hedges. Following section will discuss some of the strategies that can be used to offset the market position risk in equities: Forwards Forwards are considered as most straight forward types of financial derivatives that can be used to hedge against the risk arising out of any position undertaken in equities. The forward contract is simple in the sense that it helps the investor to transfer the ownership of the underlying assets at the spot but promises the delivery at some future date. In any given forward contract, one party therefore agrees to sell at the spot whereas the other party agrees to purchase at the future given date. (Kolbe & Overdahl,2009). The most important aspect of the forward contract is the fact that it is investors does not have to pay any premium against buying or selling of the forward contract and it is relatively easy to form the forward contract. What is also critical to note that the value of the forward contract, at the time of maturity often depends upon the relationship between the delivery price i.e the price at which one party agrees to purchase and the actual price of the underlying asset in the market? Thus for a long position in the forward contract, the overall pay off is always equal to Value = Actual price of the underlying at the time of maturity – delivery price V= St – K Forward contracts are however also prone to the default risk because they are settled according to the actual delivery of the underlying assets therefore if one party is adversely affected by the changes in the movement of the underlying asset; the party can default on delivery of the underlying asset. Options Option contracts are of two types and all subsequent strategies are developed according to the relative type of the two types. The call option or the put option is two types of options which give each party to the contract to sell or buy the option at given date. One of the most important advantages of the option is the fact that both the parties are not obliged to execute the contract as against the case of forward or futures wherein parties are obliged to execute the transaction. What is also critical to note that the option holders have to pay the premium to enjoy the option of not exercising the contract? (Kolbe & Overdahl,2009). The value of a call and put option underlying any contract therefore are based on following: V= {0, S-X} - Call Option V = { 0, X-S}- Put Option Wherein S is the strike price whereas the X is the actual price of the underlying asset. The investment manager can design different strategies using option including taking positions on any given stock index such as Down Jones or S&P 500 whereas the positions on the individual stocks can also be taken. Equity Swaps Equity swaps are relatively new instruments that have been emerged out of the need to have relatively more tailored solutions to the needs of the investors. The equity swaps basically involves the swapping of the relative cash flows decided on the notional value specified against any stock index. Like most of the equity derivatives, swaps also involve the hedging to be taken against any index in order to minimize the chances of adverse movements on the value of the portfolio of the investment manager. (Kolbe & Overdahl,2009). The most important advantage of the equity swap is the fact that the maturity of the swap can be tailored according to the individual needs of the investors. Therefore if an investment manager envisages any movements on his equity portfolio and wants to hedge the same through equity swaps but also wants to tailor made the delivery date the same can be achieved through the issuance of equity swaps. What is also critical to note that the strategies can be made to tailor the equity swaps in a manner that it can reduce the spread between the large and smaller stocks. However, equity swaps specially the single name swaps can effectively create counterparty credit risk also as swapping the fixed rate against the variable rate of returns on equities can significantly present counter party credit default chances due to higher or larger spread between the payments to be made at the time of settlement of such transactions. (Kolbe & Overdahl,2009). Interest rate derivatives Interest rate derivatives are other important tools that can be used to hedge against the adverse movements in the interest rates. The instruments such as forwards, futures, options as well as swaps can also be used to hedge the interest rate risk. The following section will discuss the same in greater details: Forwards Since most of the rates offered are based on the floating rate basis that means that investors are often at the risk of paying high because the swings in the interest rates can be adverse in nature too. Forwards can be used to hedge against such risk by modeling the cash flows and then matching the forward contracts with the same to check as to which forward contract can effectively hedge that bucket of the cash flows. For example if an investor holds bonds with variable interest rates and the expectations are that due to market movements, the rate can go down therefore there is a possibility of losing the cash flows due to movement in the interest rates. As such the forward contracts and their maturities can be matched against such movements wherein the investors can lend or buy the exact cash flows to match the movements in the cash flows. (Kolbe & Overdahl,2009). What is also however, critical to note that forward contracts can carry significant credit party risks because they involve the swapping of the cash flows at a particular forward rate and counterparty can default on its obligation to pay the differential amounts at the time of maturity of the contract? Interest Rate Futures An interest rate future allows the investor to lock in an investment rate at a future date as against the borrowing rate. In interest rate futures, the underlying security is a debt instrument and its value is correlated with the changes in the interest rates. The hedging strategies adapted in the interest rate future involves that with the rate going over and above the lock in rate the buyer of the future contract will pay the differential whereas in case of rate going down the seller will pay the differential. The actual gains and losses therefore are assessed by mapping them against the interest rate future indexes. The most important advantage of hedging through the interest rate futures is therefore that it protects the buyer and seller against the adverse movements in the interest rates however; there also exists the probability of credit risk as the counterparty can default on its obligations. It is critical to note that both futures as well as forward interest rate contracts are used for the purpose of matching the cash flows therefore they can over-hedge as well as incur more cost. Interest Rate Options Interest rate options are often considered as the European Styled instruments that are cash settled in nature and are often based on the US Securities and the yield offered by such securities. Both the holders of put as well as call options will anticipate the opposite movements in the interest rates therefore the pricing of both the options relative differ according to the expectations hold by each investor. An investor can either issue a call option or put option and match the cash flows based on the expectations that are being perceived by him regarding the overall direction of the interest rates. What is also however, critical to note that the use of interest rate options provides relatively more ease with which speculative transactions can be carried out because option holders do not have the obligation to execute the contract? Some of the strategies that can be adapted to use options to secure the interest rates including issuing collars, caps, floors, swaptions etc the embedded options is another critical strategy that can be adapted which may allow the issuers/investors to embed call and put provisions. SWAPS As discussed above that the interest rate risk can arise due to changes in the interest rates therefore as the rate move upward or downward, the relative values of the interest sensitive liabilities as well as assets can change also. Using interest rate swaps therefore involve the exchanging of one stream of cash flows against others as investors can swap different cash flows based on the fixed as well as floating rates. The obvious advantage of using Swaps is the fact that they can be tailor-made and can exactly suit the specific and individual needs of the investors. Use of basis swaps is critical strategy that can be used to manage the risk as under basis swaps two floating rate instruments are exchanged so as to protect against the basis risk. Similarity, American and European Swaptions are different styles that can be tailor made to suit the individual needs of the investors to fulfill their risk appetite. For example, investors who anticipate that the due to certain risk factors, value of bonds issued by the Mexican government can go down therefore through swaptions the same can be traded with any other investment outside Mexico who may be willing to swap lower interest rate instruments with the higher interest rate paying instruments. References 1. Kolbe, R & Overdahl, J (2009) Financial Derivatives: Pricing and Risk Management. New York: John Wiley and Sons. 2. IMF, (2000). Financial derivatives: a supplement to the fifth edition (1993) of the Balance of payments manual. New York: IMF. Read More