Derivative and Risk Management - Term Paper Example

Running Head: DERIVATIVES AND RISK MANAGEMENT RISK MANAGEMENT RISK MANAGEMENT NAME: COURSE: INSTRUCTOR: DATE: ASX SPI 200 INDEX FUTURES Introduction/ Brief Statement Index futures allow investors to know how various indices in Australia move by performing one transaction. Trading on indices allows them to diversify their investments in more than 200 largest stocks in Australia without having to buy or sell any shares. Using indices therefore provide major reduction in costs incurred in brokerage and transaction. In this task, the group settled on ASX SPI 200 index futures. Like many other Futures and Options, ASX SPI 200 index futures come with unlimited benefits which include leverage allowing the investors to undertake a competitively large position having a small initial outlay. ASX futures allow investors to have access to most equities at low cost almost quarter of the cost of the traditional investments. This is cheap for investors who borrow to invest. Making money from either a raising or a falling market is the other advantage that of this kind of derivative. This is a contrast of what happen to the traditional investments that only benefits from only arise in the market. One only buys the futures when the markets are expected to raise and sell when the market fall or are expected to fall. This implies that for every move in the market points make in favor of the investor; gain an amount equivalent to the contract size. Borrowing of the stock is necessary in these traditional markets hence additional cost is incurred. However in the futures market where there are no selling restrictions can be gotten rid of. Futures allow for the development of trading strategies which provide flexible opportunities to exploit variations and trends in the market. Traders are therefore able to create a wide range of profitable scenarios regardless of the direction in which the markets are moving, it is however possible to incur a loss in this increased potential to profit. Futures are widely defined as agreements to buy or sell a particular asset at a specified future dates at a price determined today. On whether one profits on makes a loss, depend on where the position of the price is at the time of expiry of the contract or the time as mentioned above, the futures are only valid on specific terms with some of the common features of futures including the terms to expiry of the futures. Other characteristics of the futures include, futures have no exercise prices. They are therefore traded at market price of the selected expiry month. They also represent an obligation of either buying or selling of the underlying index rather just a right to do so. Futures also require an initial margin to sellers and the buyers. This is marked daily in the market. Futures contracts are traded at a premium to the index just before its maturity. Trading with a discount is also possible only in some market conditions. Premium is the carrying cost is the price of holding the shares over the contract period less the dividend earned in the same period. The prices of the future tend to converge at the price of the contract as expiry of the future approaches. The ASX offers a wide range of index futures contracts including ASX SPI 200 index Futures, S&P/ ASX 200 A-REIT index Futures (commonly known as XPJ Index Futures), S&P/ASX 50 Index Futures(commonly known as the XFL Index Futures) and the S&P/ASX 200 Index Futures also referred to as the OXJ Index futures. All the indices are traded either at the SYCOM or the ITS trading platforms. These platforms are on the markets operated by the SFE Corporations Ltd and the ASX Ltd respectively The specification of the future is summarized in the table below. Contract Unit Valued at A$35 per index points() Contract Month March/June/December & Nearest two non-quarterly expiry months Commodity Code AP Listing Date 04-06-2002 Minimum Price Movement A$35 (One Index Points) Last Trading Day 13.00pm is the time that all trading in expiring contracts end. This is on third Thursday of the settlement month Trading continues for non- expiring contracts per the trading hours Cash Settlement price The Special Opening Quotation of the underlying ASX 200 index on the last trading day. Calculation of Special Opening Quotation are done using the price first traded of every component stock in the S&P/ ASX 200 index during the last trading day. The first traded price of each component stock occurs the open and close of ASX market including the close Single Price auction during the last trading day. The last traded price of the stock is calculated using the last traded price of the stock of the stock. This is done using the special opening quotation. Trading Hours 6.00 pm – 8.00am & 8.50 am -5.30pm (during US daylight time) 6.00 pm 7.00am & 8.50 am -5.30 pm (during US non daylight time) Settlement Day The first business after expiry. The final settlement price published by the SFE clearing. Cash flows are then settled during the second business day as per the settlement price. Position Limit yes Daily price Limit yes CFTC Approved no The contract unit is valued at A$35 index point. This for example means with 6000 index points the contract unit is valued at A$ 240,000. The contract months for this index are March/June/September until the six quarter months ahead and the two non-quarterly expiry months that are nearest. The contract was listed in 04/06/2002 and has a minimum price movement of one index point that is A$35. All the trading in the expiring contract stops at 11.00 pm while the non- expiring continues trading as per the stated hours of trading. This is calculated using the price of the first traded component of the stock in the S&P/ASX 200 Index on the last trading day. This is done irrespective of the when those stocks are first traded in ASX trading day. The means that between the time the ASX market opens and closes, the first price trading of the every component of the stock may occur. The ASX market close open however include the closing the single price auction which is carried out the last trading day. Should any component therefore not have traded on the last trading day, the price that was traded last will be used in the calculation of the special opening quotations. The settlement day is the first business day at the expiry day and the clearing at the SFE publishes the settlement price that is final of the particular contract. The cash flows resulting from the settlement price are settled during the second business day after expiry by the SFE clearing. This future is approved by the CFTC. It has also no position limits nor does daily price limit. Profit structure & Market observation On market movements and how traders can profit from this, directional trading using the ASX SPI 200 Index Futures can be used. In line with the Bullish view, a trader can benefit from the rising share market using the futures. This is possible by buying ASX SPI 200 Index Futures contract and selling it when the price has risen. For example, if a trader buys ASX SPI 200 when the price is at 4500 points and sells when the price rise. For instance, the if the price of ASX SPI 200 Index Future increases by 400 points to 8000 points, the value of the exposure would increase to $ 170000 that is (4000 *$35) from $ 125000. This is a profit of $6000 which is equivalent to 50% of the initial margin * outlay of. Of $20000. To realize that gain one has to sell the futures contract at the higher level. On the other hand one can also profit from falling share market. Based on the Bearish view, selling ASX SPI 200 Index Futures contract and then buy the contract at a lower price. This is commonly referred to as going short. Selling ASX SPI 200 Index Future when the price is at a high of 7100 points and buy it has the contract price fall. This by paying a brokerage fee of an initial fee $20,000, one can sell the ASX SPI 200 Index Futures contract, one can profit when the market falls, the futures price decreases by 350 points to 4550 points one can close out the future contract by buying at a lower level. If you originally sold the contract at a 4000 points and bought at $ 4,550 points one would have made a profit equivalent $7, 550 which or 52.5% profit on your initial margin of *$20,000. Market observation for the month of March 2011 Key ____Price level & interest rate ____ Traded Volume For the last three weeks of the month of March, the traded volume stood at 1,606,394 on average. The value is however lower compared to the value of the same month in the previous year that stood at 1,107,654 this equivalent to a 45.03% change. This was attributed to the changes in the foreign investor confidence and the changes in the geopolitical landscape. The open interest rate for the month was 267,955 a 1.22% change from the previous year value that was 264,731. The price of the index stood at 95.255. This was however 0.22% less of the market price at the end of February. Based on the three week observation it is notable that the theory. The front month settlement price for the three weeks range between A$4200 and A$5100. The highest price for the future was recorded in the initial days of the month and the last days before the month ended. This was as result of high demand for the futures occasioned by speculation of fall in the prices of most commodities traded at the exchanged and the increase in the respective interest rates. The open interest rate also rose during the 3 weeks in March. The rates increased fluctuated between $5000 and within $4200. The rates where high at the beginning of the month just like traded volume increased and started declining as the month matured. The interest rate rose due high increased price of most commodities traded at the exchange. The rise in the prices of commodities was as a result of increased in global oil prices caused by geopolitical unrest in the Middle East and a section of North Africa. The political stalemate for instance is seen as a major cause of increase in oil prices at it is a major producer and exporter of oil. Rise in prices of most commodities was caused by the effects of earthquake that rocked Japan in the cause of the month. Margining system The margining system used to account for this kind of futures is the SPAN or the Standard Analysis of Risk. The system was developed by the Chicago Mercantile Exchange and has been widely been adopted by the in the future industry internationally. Its use has been considered to have notable benefits from to ASX participants alongside their clients. This is because of its accuracy in its provision of the right positions of risks held. The use of SPAN has also allowed the use of futures with that are standardized to be in terms with the internationally accepted portfolio based on the appropriate margining methodology. Its attractiveness has also been increased to ASX’s markets international investors. The margin requires that the clients are efficiently margined on the SPAN basis. In its simplest way SPAN can be termed as risk based portfolio approach used in calculating the initial margin requirement. The other advantage that makes SPAN the better margining system is its ability to value the entire portfolio of futures responding to the changes in the futures in the underlying asset prices and their respective volatilities. Its algorithms also calculate the losses made in the worst cases scenarios on a contract portfolio adjusting the losses for the net premium. An initial deposit is required in the for every trader to b used in the in launching of the account. These deposits however vary with participants in the market and the amount is retrievable after the contract expires. The deposit is supposed to cover the initial margin for every future that one wishes to buy or sell. The broker then deducts or adds gains or losses from this account balance. The brokerage is sometimes obliged to make deposits to the account that can be used to bring the account back to the required minimum balance. This make up the variation margin. In case of profits made, the account will be credited accordingly. Factors influence the performance of the futures The other factors that influence the performance of the futures are the domestic market is that has remained volatile to the changes in the market prices. With overnight price swings the offshore exchanges translate to the swings that have adverse market price effects. Its seems that not night goes without the fresh news on the conditions of the market prices occasioned by the changes in the geopolitical concerns which have effects on the next day’s marketing here. Good news resulting from the growth in the domestic market which whiles it’s hard to predict the prevailing market prices for the following day. Trading/ Investment strategies For futures there are appropriate investment strategies depending on the position the trader is. Before one chooses the investment strategy, one should know whether he is on the long or short. These are natural positions and one has to identify with the commodity you are looking to hedge. If for instance you are on the long position, one owns the commodity and may sell it at a later date to generate cash flow. If you are naturally long, you are naturally required by the market to sell the commodity. This means that you need to sell before the market value of the commodity falls before you actually sell the product. To hedge this naturally long position, one may be interested in a short hedge strategy as this is used to offset the market risks. The short hedge strategy is used when selling the futures directly or indirectly by using options. Example of this long positions may include a trader may be required sell the future to offset the risk of falling prices of various commodity attached to the various indices. This is used by traders who hold large shares and are selling them. A trader can also sell the futures to avoid the risk of falling prices of shares they hold. This is the long position where the buyer has bought more shares than sold in the market. The other strategy used in the long position is to sell the futures contracts in the event that the market prices are expected to fall. This is normally used by financiers who had financed the investors in buying the shares. The other investment strategy that a trader can apply is taking the short position. When a trader takes the short position, this means that the trader does not own the commodity or share. This means therefore that will need to buy it at a later date. If naturally short, you have a natural market requirement to buy the share at some point in time. This means that you will not want the market value of the share you intend to buy to rise before you actually buy. To hedge in such a natural position that is short, a trader will have to execute the long hedge strategy in order to offset the market risk. In this case on e is looking to buy futures either directly or indirectly by using options. An example is to buy the futures in order avoid the market risk of raising share price. This short position can be taken by a trader who has sold more shares than bought. A future can also be bought to offset the risk raising market prices by trader who has forward sold more than what was produced. A trader who does not own the shares can also buy the futures if he expects that the market share price is expected to rise. In conclusion, this derivative can be termed as one of the most lucrative product traded at the AXS and been used as a benchmark product that is used to measure the performance of the market and the economy in general. This is because of its include most trading in the exchange and has always been used by most companies in all sectors of the economy. The index is sensitive to all market changes occasioned by slight changes in the economic environment. The derivative is therefore good for economic forecast. Task 2: New derivative Australian Corn futures Specification Australian Corn is a commodity derivative the group design. The derivative is designed to fall in the ASX grain futures and option segment of the Australian security market. The derivative has Corn has it underlying commodity. The contract unit is 40 metric tonnes and the quotation tick size is A$ 0.20 per tonnes while the tick value is $4 per contract. The settlement day is the business day following the notice day, and the settlement method is physical delivery. The settlement amount will calculated using the settlement price of the notice day and the final amount is adjusted for shrink, oil bonifications and admixture content. The derivative has its premiums and discounts are paid on the average basis based on the average data per approved bulk handler’s stock report. The difference between the stack average and the standard quality forms the basis of the adjustments that are made. The Gross weight adjusted by 2%deduction for each 2% impurity (admixture). The price is on the other hand adjusted according to the 2.0% of clean seed value for each 2% below or above 42% oil according to the physical grade (AOF). Benefits of Australian Corn futures The benefit of this product is that, the investors can hedge it. As previously mentioned, hedging is establishing an opposite but equal position on the futures market to the current cash position. This will allow the offsetting of the underlying commodities price risk by changing it on the basis of the risk. However for one to perfectly hedge out, the basis is suppose to remain unchanged for the duration of the hedge. This is however not the case as the as it rare to have such static as a result of the converge between the futures markets and the cash market. The effects of supply and demand of the underlying commodity have adverse effects on this. This therefore requires one to be skilled in order to recognize the good and bad basis and capitalize on the pricing opportunity. Price discovery is therefore determined by how this important information is relayed to the market and how the market takes it and reacts appropriately. The prices of the futures are then determined depending on the level of risk related or attached to it. This could be the most important purpose of the derivatives market. Risk management is the process of identifying the desired level of risk, identifying the actual level of risk and altering the latter to equal the former. This process can fall into the categories of hedging and speculation. Hedging has traditionally been defined as a strategy for reducing the risk in holding a market position while speculation referred to taking a position in the way the markets will move. Today, hedging and speculation strategies, along with derivatives, are useful tools or techniques that enable companies to more effectively manage risk. The other benefit of product is that it helps in risk management just like any other derivative. This is considered as one of the most important purpose of this derivative. The process of risk management involves identifying the desired level of risk and comparing it with the actual level. The derivative can then be used to alter the later to make sure it is in line with the later equal to the former. This is best done by either hedging or speculation. Hedging has always been used since it traditionally reduces risk by holding a position in the market. Speculation on the other hand involves taking a position in the way the market will move. The two strategies have always been considered by most companies as the best techniques to be used together with derivatives to reduce risks associated The product will also be used to improve the efficiency in the in the market of the Australian Corn which is the underlying asset. For example, if the investors who may want to be exposed to the commodity derivative market, they are required to futures and investing in the less risk product. Either of this method will give them the exposure it the future without necessarily all or part of the underlying assets in the commodity market. In the event that the two investment strategies give the same result, the investors will the take the neutral position as they choose. There price differences, investors may choose to sell the richer assets which yield more return though expensive and buy the cheaper ones in order to arrive at the equilibrium. In this case the market, this derivative will also be used to reduce the market transition costs. This is because of the fact that like any other derivative, it acts as the insurance or risk management, making the investors find no need of purchasing insurance to cushion their positions. Potential Investors The main customers or investors for this kind of product are both the producers and trader of the Australian Corn. Producer makes up a larger segment of the participant who takes part in the trading of this derivative. The producers of Corn for instance make up more than 60 % of the traders in the commodity. This is the major target for the derivative and. The other important target group for this derivative is the other traders for the other agricultural commodities that are traded at the ASX. These commodities include but not limited to wheat, barley, sorghum and other cereals. General public and especially stock investors are the other group that is target by this type of derivative. The product is therefore regarded as being one of the commonly traded as it in the main market segment that always attracts most investors both new and experienced together with the institutional ones Profit structure & market observation Hedging (short position) Being a short hedger for instance requires that one protect the future selling price of the existing inventory or that or anticipated production. One is therefore expected to short hedge or sell. For example supposing in June the prices of Corn for October delivery is determined as A$353.00/metric tonne when the November Corn futures contracts rise to A$383.00/metric tonne. The producer finds these prices attractive to the futures but sees the possibility of improving on the basis. The trader would therefore hedge 400 metric in the market and later lift the hedge after the delivery has been made and the price has fallen. The assumption is that the cash prices in the fall have dropped to A$ 300.00/mt when the market price is the 400.00/ metric tonne. This gives the producer the net return at this price as shown in the below workings. When the producer decides to sell the On June, the goes short at price of A$400.00/mt. This is A$40 more of the November payment that is expected to A$450.00/metric tonne. The producer can also decide to offsets that is buying back at a future contract value of A$264.00/ mt. the basis $40.00. The producer sells 400 metric tonnes of the Corn at harvest at aA$331.00/mt which is the market price. The result is that the producers will get $66,200. This is the selling price. The futures to A$383.00/mt less A$361.00 which gives A$22.00 as the gain. This is A$22.00 *200 mt= $4,400. The net selling price is 353.00/mt. Using the same example with the prices falling to say A$337.00and the market price standing at A$361 the net return can be calculated as shown below. When the producer decides to go short, sell the contract, he will do it at A$383.00 /mt a more than the June which is A$353.00/mt. The basis is A$30.00. The producer can offset the risk of losing by buying back the at A$361.00/mt. This is when the producer sells 200 mt of Corn sold at A$ 337.00/mt. This will give A$67, 400. The futures Gain (loss) A$383.00-A$361= A$22.00/mt gain. The A$22.00 *22 mt = $4,400. The cash selling price will $ 67,400 add future gain which is $4,400/mt. The net selling price will be $359.00/mt. Consistent flow of information is the most common phenomena in the derivative market and is termed as crucial thing that shapes the market as the market prices are determined by the nature of information that is relayed in the market and how the market takes the information and its subsequent reaction to the same. The prevailing price of the underlying is directly connected to the flow of information as it is determined by the information that relates to the daily operations in the market and the it’s related happenings. This information may include but not limited to the political situations, weather conditions among other important information. Profit structure (Long position) ) Assuming that an investor opens a long position worth A$1 million, and that the price increase by 10%, the return on investment means that each metric tonne will go for ($ 1000000 /147) = A$ 6802.72. This means that for an investor who goes long they have to buy the Corn futures at A$ 143.00/mt this means that the defer price of A$ 130.00/mt will be the cash price. The base will therefore be A$13.00. The investor will have to purchase 500 metric tonnes of the Corn from the local cash market meaning will have to offset Corn futures contract of A$160.00 / mt. the base will therefore be –A$13.00. The result of this is that; in the market price, the investor will have to cash in $147.00*500 mt which will result in the investor buying at $73,500. The future gain will be $160/mt less $143.00/mt which is $17.00/mt. the gain as a result of the future will be $ 17.00*500 mt = $8,500. The basis will be unchanged. The net buying price will be A$ ($73,500 +A$ 8,500) = A$65,000 which is equivalent to A$134.00/mt. On the other hand if the price of the underlying commodity (Corn) was reduced by 20%, with the initial investment of A$ 1 million, the investor will have to pay the same $147.00 per metric tonne. The cash paid that had been deferred delivered price will be $ 353.00/mt the futures when the investor goes short of the future contract will be 383.00/mt. the basis will therefore be -$30.00. The investor will sell 200 metric tonnes at the harvest period in order to edge at price of $337.00/metric tonnes. This will be used to offset the future contract at a price of $361.00/mt. This -$24.00. The cash market price for the item sold will be $337.00*200 mt = $ 67,400. The futures Gain (loss) will be $383.00 less $361.00/mt which will be $ 22.00/mt gain. This will be $22.00*200 mt =$ 4,400 this gives $6000 basis gain. The selling price for the commodity after hedging will be $67, 400 which is the cash selling price plus $ 4, 400 which is the result to $71,800. This equivalent to 359.00/mt. When the price remains the same, the investor will remain indifferent. Reference Abello-Rodriguez, V. (2000).Economics of Investing in the Derivative markets. Published postgraduate diploma thesis, University of Caribbean, Canbera, Territory, Australia. Balgir, H. (2000).Methods adopted by university students and their effectiveness in Stock investments and Bonds. Sydney, Australia. Bryson, J. (2004), investing on Derivatives for public and nonprofit organizations, Minneapolis: John Wiley and Sons Caffentzis, George (1998) Risk Management and Derivatives? 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