Securities, Derivatives and Foreign Exchange - Assignment Example

Securities, Derivatives and Foreign Exchange 2006 1. Checklist of the client’s background a. What is the size of the client’s investment portfolio? What is the client’s investment time horizon? b. Is the client’s investment portfolio growing or static over a period of time, that is does the client earn excess cash in its line of business that it may invest in financial derivatives and foreign exchange? c. Does the client earn only in Australian dollars or in multiple currencies? d. Does the client want to invest in money markets, that is, in interest rate derivatives, or in the foreign exchange market, that is, in currencies. In other words, is the client’s income streams related to domestic interest rates or on the foreign exchange market? e. What is the client’s cash flow like? That is, are the client’s income streams seasonal or follow a regular flow through the year? f. Is the client a net foreign exchange earner? g. What is the client’s debt position? What is its interest servicing ratio? h. Does the client require to hedge its risks in the foreign exchange market? That is, is the client’s main line of business dependent on movements in currencies in the global scenario? i. Can the client sustain the replacement cost of credit exposure? That is, can it bear the cost of replacing the client’s contract at current market price in case it defaults? j. What is the client’s expected return on investment? Does the client have any income, liquidity or capital preservation needs? k. What is the client’s risk appetite? Which categories of risks does the client want to hedge and which ones does it want to be left unhedged? 2. Derivative products Option - An option is an agreement by an investor who has the right to buy or sell a financial asset on or before a particular date. This type of derivative product is based on the underlying asset or index. With this agreement, the investor has the right to buy or sell the asset on a future date but is not obliged to do so. Options may be either call (buy) or put (sell). The buyer gets a premium for the right to buy or sell a specified amount of asset at an agreed price (strike or exercise price) on the expiry of the contract. Options differ from futures or forwards since it provides the investor a right and not an obligation to the agreement. For the buyer, the risk involved is the value of the premium. For the seller, there is no risk. The client may exercise a put option to sell its portfolio of stocks at a future date if he is confident that the market will rise by then. This type of derivative is least risky since the client gets the right to sell at a higher price but is not obliged to do so. However, premium for option contracts is usually lower than futures hence will have a lower return. Futures - With futures contract is an agreement with which the investor has the obligation to buy or sell the asset on a particular date. Futures contracts are similar to the forward contracts except that it is a tradeable instrument and is executed through a central clearing house unlike the forward contract. Besides, the futures contract is marked to market daily hence reduces the risk that the other party will not be able to meet the contract on the due date, a situation that might happen in the case of the forward contract. Future contracts are somewhat more risky than the options since the investor is under obligation to buy or sell the asset while with options, the investor has the right but no obligation, the risk can be mitigated to some extent with the use of swaps which are another type of forward-based contracts by which the parties agree to exchange a series of cash transactions on a future date either in the interest rate market or in the foreign exchange market. Swap agreements are based on private negotiations of two parties based on each one’s requirements. The client can use future contracts to reduce systematic risk in its investment in stock portfolio. However, care should be taken to study the movement in price of the underlying assets very carefully. That is, the difference in the value of the portfolio and the market index and the expected change in the two will determine the risk mitigating performance of the futures contract. Forward - Foreign exchange forward is an agreement that a bank or a financial intermediary undertakes to buy or sell a fixed amount of foreign exchange at a future date. By entering into a forward contract, an exporter or an importer could minimize the risks that large movements of exchange rates could impact its earnings (for the exporter who earns foreign exchange) or costs (for the importer who has to buy foreign exchange). These derivatives came into existence when in the 1970s, exchange rates in most countries became flexible and in the 1980s, when as a result of oil shocks, there were wild fluctuations in interest rates (Siems, 1997). As a result, companies and banks began to enter into forward agreements by which they minimized the risks borne out of these fluctuations in the financial markets. The client may use forward contracts to minimize risks in its foreign exchange portfolio. If the client knows its stream of foreign exchange income and expenses, it may enter into forward contracts with the bank or other financial intermediaries for purchase or sale of currencies. By this, it may be able to minimize fluctuations in the currency market. However, unless the currency market is closely followed, there might be errors in judgment of the forward rates. Forward rate agreement – Forward rate agreement (FRA) on interest rates is similar to futures on interest rate in that it is an agreement to buy or sell a financial asset on a future date at a particular rate. The difference is that FRA is not tradeable and settled in cash. The payout is based on the expected interest rate. The client can use forward rate agreements if it is certain of its foreign exchange requirements over the medium term. The FRA is usually of short maturity hence the client will have to settle the amount over the period. If the client wants a longer term maturity for the interest rate, swaps are a more appropriate derivative. 3. Ethics and regulatory issues A client advisory role for financial professionals involves honest and ethical conduct in all areas where actual or apparent conflict of interest arises on the personal and professional front. The advisor should at all times be honest, objective and resolve conflict of interest if there are possibilities of personal gains from a particular investment decision by the client. For example, a large investment in a particular financial instrument driving its prices may result in conflict of interest with the advisor if he is also an investor in the same instrument. In case such situations of conflict of interest arise, the advisor should report in advance to the senior management of the advising firm as well as the client. The advisor should take all reasonable measures to protect confidentiality of the client’s financial interests as well as the business interests of the clients’ customers and partners unless true and fair disclosures are required for regulatory purposes. Confidential information gained in the course of the advisory work should not be used for personal gains or be disclosed. The advisor should also act in good faith and in compliance with the norms of the client organization. Similarly, the advisor is also responsible for making full, fair, accurate, complete, objective and true disclosures for all regulatory requirements under the law of the land. The advisor should also make sure that full disclosures of consultants’ remuneration and fees are made by the client. The advisor should act in good faith and with full responsibility and due care and diligence without misrepresenting facts about the financial instruments or making the advice subjective to individual bias. The advisor should also bring to the notice of the management of the company any information related to the company’s financial strength or weakness. In case the person or the advisor brings about a disclosure in good faith, he should not be retaliated against. 4. Purpose of the following regulatory requirements Prospectus – The legal document that discloses the firm’s investments objectives, costs and performance history. It is mandatory to give to each investor prior to every Initial Public Offering (IPO) or a mutual fund launch. It is important for the investor to read the Prospectus carefully since it gives the true picture of the risks involved in the investments. It also gives details of the terms and conditions of the product and the manner in which it operates. Statement of Advice – This is a supplement to the Prospectus given to the investor providing the details of the investments made on behalf of the investor. Financial Services Guide (FSG) - It is an important document that each financial service provider licensed under Australian Financial Services must provide the clients. It outlines all the products and services that the advisor provides. The FSG is aimed to enable the client to decide in an independent manner whether or not to choose the advisor in context. It provides all details of the advisor organizations, its products and services, the fees and the person whom the client should contact in case of any dispute. It even details the types of the fees, commissions and remunerations of the employee advisors of the organizations so that the client may trust that the advice is not biased. The remuneration and commission also includes alternate forms like paying for conferences, sponsorships etc. If the client chooses to use the advisor’s services, he should also be provided with a Product Disclosure Statement that would also outline all the products and services in detail. Authority to proceed – Financial planners usually ask the investor to sign an Authority to Proceed, which is a written instruction to the advisor to make investments made on his behalf. This document is a valid legal document that the advisor must maintain in case a dispute arises with the client in the future. 5. Securities advisers’ obligations – Under Australian law, only the license-holders of Australian Securities and Investment Commission can offer financial advice to clients. The securities advisor is obliged to take the client’s objectives and needs in consideration while designing an investment strategy. On the basis of the client’s financial goals, the advisor converts the objectives into an investment strategy based on the investment horizon, the client’s requirements for liquidity and capital preservation. While making the asset allocation for the client, the advisor is obliged to explain the highs and lows of returns of each asset class so that the client can understand the probability of the expected returns from the investment. The advisor is obliged under Australian law and code of practice delineated by the Australian Securities and Investment Commission (ASIC) to offer realistic return possibilities on investments in securities. The advisor should not offer clients’ possibilities of unbelievably high returns, excessive secrecy to prevent scrutiny by banks, tax authorities or regulators, transfer of returns to a location in a known tax haven or investments in companies that are not registered with ASIC (AUSTRAC). Under Australian law, the financial service provider is under obligation to provide a Product Disclosure Statement confirming all transactions, ongoing disclosures and periodic regulatory reporting. It is also under obligation to offer dispute resolution platforms, advertisements for financial products and cooling-off periods for certain financial products (lexisnexis). 6. Salient point in Corporations Act 2001 and Financial Services Reform Act 2001 Corporations Act of 2001 – In 2001, the Corporation Law was repealed and replaced by the Corporation Act. It contains all legal provisions related to Corporations as well as financial products and services. Although the Act is similar to the earlier law, the terminologies have been changed. Financial Services Reform Act 2001 – The Act regulates financial products like securities, derivatives, retirement and superannuation savings accounts, general and life insurance, deposit accounts, payment services like smart cash and e-cash, and foreign exchange transactions other than pure money change. It requires that an advisor is licensed to operate in the financial market. The licensee is required to have necessary resources to supervise the market and follow the rules and procedures laid out. The licensed financial service providers are required to provide the retail clients a Financial Services Guide and maintain ‘know your clients’ requirements. They should maintain all disclosure norms and separate funds for clients and those required for disclosure purposes. The Act provides for transfer of legal title through electronic transfer (lexisnexis). The Act requires that all Small Self Managed Super Funds lodge the Product Disclosure Statement (PDS, providing information about the Trustees, the structure of the fund and the fees) with the ASIC. However, subsequent amendment in 2003 has made it clear that the PDS need not be given to the fund member if the financial product is in the interest of a superannuation fund and the trustee believes that the client has been provided with all relevant information regarding the fund. A PDS needs to be provided when a new member joins the fund or when a member changes from a growth to pension phase (Legalmart). 7. Investment theory The key phases of investment planning involve 1) asset allocation, 2) market timing and 3) securities selection. Asset allocation is the division of various asset classes in the client’s investment portfolio. This is determined by the client’s investment time horizon, requirements of liquidity and capital preservation and the broad financial goals, risk appetite and present financial situation. On the basis of these, the financial advisor converts the financial goals into objectives and determines the asset allocation. After this, the choice of the investment vehicles becomes crucial. Investment funds may be build and periodic investments may also be made. Some investment funds may also have an insurance element. Choice of the investment fund depends on the client’s financial goals and risk appetite. The fund manager’s performance should be assessed against a benchmark index. The manager can perform better than the benchmark only if he or she has better information regarding the products within the asset class. If the manager’s estimates are the same as the market consensus, it is safer to invest in the benchmark indices. Only if the manager’s estimates of the expected returns from the asset class are better than the market consensus, he can add value to the investment decisions by overweighing particular financial products within the asset class. However, this contrarian investment decision may also be prone to high risks. The client’s risk horizon and appetite should be the driving determinant for such a decision. Active asset management depends on the fund manager’s skills at asset value forecasts and the number of independent forecasts that he makes. Returns from investment depend on external environment factors like the economy, market capitalization, industry, dividend yields and earnings momentum. The manager’s performance depends on his skills to innovate various investment models and forecasts of individual assets (Grinold and Kahn, 2005). 8. Economy and investment environment in Australia Australia has a western-style market economy with strong Gross Domestic Product (GDP) growth over the last decade. Housing prices peaked in 2005 hence there is no possibility of interest rates to be raised to check speculation. So, the investment scenario in Australia is robust with GDP growth of 2.7% in 2005 over the previous year (CIA). Australia has a high investment rate, at 25% of GDP. In fact, Australia is one of the fastest growing among the developed countries, with average GDP growth rate of 4% since the 1990s. Besides, it has had a stable price regime with inflation at 2.4% in 2003-04 as a result of high productivity. It is a strong business-friendly production system with supporting regulatory mechanism for efficient functioning of the industrial and agricultural sectors. The export sector is also robust with current account surplus (Australian Government). Typical of most developed economies, nearly 80% of Australia’s GDP is generated from the service sector – particularly finance, property and business services. The fastest growing service sector over the recent years has been communications while construction too has grown but in a more volatile manner. Over the recent years, however, consumption spending has grown to nearly 60% of GDP while investment has stagnated at more or less the same rate. The strong consumption momentum enabled the country to tide over the recessionary phase that the south east Asian countries witnessed in the 1990s. Consumption spending and housing growth boosted the economy since the early 2000 when the global economy was in recession (Economist 2004). As a result of the buoyant economy, institutional investment of endowments, superannuation funds and foundations in the Australian securities market has grown over the recent years. These institutional investors put money in hedge funds composed of derivatives as risk management strategy. As a result, hedge fund investments have grown in Australia (Reserve Bank of Australia). 9. Checklist for regulatory requirements 1. Is the asset allocation done in a manner that there is no conflict of interest between the fund and the HNW client? 2. Is the investment made in a manner that it has no conflict of interest between the client and the advisor? 3. Has the client been provided with the Financial Services Guide and the Product Disclosure Statement at the time of entry? 4. Does the HNW client receive regular updates on the returns on the asset classes? 5. Has the client been provided with the name and the contact of the person whom he should complaint in the circumstance of a dispute? 10. Foreign exchange products The spot market in foreign exchange is when the trader buys or sells currencies at the going rate in the market. The spot contract is a binding agreement to buy or sell at the current currency price. A forward contract is a binding agreement to buy or sell at a particular price on a future date. Although the spot deal is the simplest form of foreign currency exchange, it has the risk of high volatility since the current market conditions determining demand and supply of currencies lead to the market price of a currency. The spot deal is usually settled in two days after the deal is struck. The forward rate is determined by the current spot rate plus or minus a premium or discount depending on the interest rate differential between the two countries of whose currencies are involved. It is based on a mathematical forecast of the future currency exchange rate. The forward rate protects against exchange rate fluctuations but it does not necessarily allow gains if the exchange rate moves in favor of the currency. Swaps are contracts that allow for extending the date of settlement when either party is unable to meet the delivery of foreign exchange on the due date of forward contract. It is arrived at individual negotiation of the buyers and sellers of foreign exchange. Works Cited Thomas F. Siems, 10 Myths About Financial Derivatives, Cato Policy Analysis No. 283 September 11, 1997 http://www.cato.org/pubs/pas/pa-283.html Merrill Lynch’s Code of Ethics for Financial Professionals, retrieved from http://www.ml.com/index.asp?id=7695_8134_8305_6090 http://www.institutional.invesco.com/portal/site/invescoinst/menuitem.d81d4c17a3d92f6a8f46d16af14bfba0/ http://www.ing.com.au/public/pdfs/L2196_FSG.pdf AUSTRAC Information Circular, retrieved from http://www.austrac.gov.au/resources/publications/information_circular/pdf/AIC%2014%20-%20High%20Yield%20Promotional%20Enterprises.pdf Legalmart, Product Disclosure Statements for Financial Advisors, retrieved from http://www.legalmart.com.au/topics/business/superannuation/info_tips/1h_pds_corp.asp#What%20is%20a%20PDS Lexisnexis, Australia, Finance Law of Australia, retrieved from http://www.lexisnexis.com.au/aus/academic/text_updater/horgan/legislativedevs.asp Grinold, Richard C and Ronald N Kahn, Active Portfolio Management, Probus Publishing Company, 1995 CIA Factbook, Australia, https://www.cia.gov/cia/publications/factbook/print/as.html Australian Government, A Competitive Economy, http://www.dfat.gov.au/aib/competitive_economy.html Economist, Australia Country Profie, February 24, 2004 Reserve Bank of Australia, Recent Developments in the Australian Hedge Funds Industry, http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_nov06/Pdf/bu_1106_1.pdf Read More