Derivatives and Risk Management - Assignment Example

Derivative and risk Table of Contents 0Question 3 1What is a derivative? 3 2What are forwards? 3 3What are futures? 4 2.0Question 2 6 3.0Question 3 10 3.1Married Put strategy 10 3.2Married put payoff diagram. 11 Bg group plc is one of the blue chip companies listed in the London Stock exchange(uk.finance,2014).BG Group plc is a British multinational integrated natural gas company(Bloomberg, 2014).Appendix attached shows the stock price movements. 11 3.3Reasons for choosing married put 12 BG Group PLC (BG.L share prices movements (Uk.Finance, 2014). 14 14 References 14 1.0 Question 1 With reference to relevant academic articles and literature, explain the key differences between Forwards and Futures with reference to the differing objectives of investors that are hedging and investors that are speculating. Based on your investigations, explain which of the Forwards and Futures instruments are likely to be more attractive to each category of investor and why? 1.1 What is a derivative? Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, foreign exchange, commodity or any other asset (Group of Thirty, 1993). For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”. 1.2 What are forwards? A forward contract is a customized contract between two parties, where settlement takes place on a specific date in the future at today’s pre-agreed price. Forward contracts are customized contracts between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging. Unlike standard futures contracts, a forward contract can be customized to any commodity, amount and delivery date. A forward contract settlement can occur on a cash or delivery basis. Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default risk. As a result, forward contracts are not as easily available to the retail investor as futures contracts (investopedia, 2009). When used to hedge risks, derivative instruments transfer the risks from the hedgers, who are unwilling to bear the risks, to parties better able or more willing to bear them. In this regard, derivatives help allocate risks efficiently between different individuals and groups in the economy (Hull J. , 1993). 1.3 What are futures? A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that they are standardized and are generally traded on an exchange (Hull J. , 1993). Future contracts are also agreements between two parties in which the buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase (investopedia, 2014). Terms and conditions are standardized (Commission, 2014). i. Trading takes place on a formal exchange wherein the exchange provides a place to engage in these transactions and sets a mechanism for the parties to trade these contracts. ii. There is no default risk because the exchange acts as counterparty, guaranteeing delivery and payment by use of a clearing house. iii. The clearing house protects itself from default by requiring its counterparties to settle gains and losses or mark to market their positions on a daily basis. iv. Futures are highly standardized, have deep liquidity in their markets and trade on an exchange. v. An investor can offset his or her future position by engaging in an opposite transaction before the stated maturity of the contract. The process of using derivatives requires the investment manager to manage the investment process in terms of risk management process (Collins & Fabozzi, 1999). Derivatives are versatile instruments and can be used for hedging, speculation or arbitrage. Sometimes traders who have a mandate to hedge risks or follow an arbitrage strategy become (consciously or unconsciously) speculators (Hull J. , 1993). The advantages of derivative trading include risk mitigation, contract flexibility, and leveraged speculation. The disadvantages are directly related to the misuse of these products, which can lead to large losses. When an investor aim is to hedge against risk, they can use forward contracts.Investors can also use derivatives to speculate and to engage in arbitrage activity. Speculators are traders who want to take a position in the market; they are betting that the price of the underlying asset or commodity will move in a particular direction over the life of the contract (National Association of Pension Funds Limited, 2013). For example, an investor who believes that the French franc will rise in value relative to the U.S. dollar can speculate by taking a long position in a forward contract on the franc. If the value of the franc on the expiration date is above the delivery rate set when the forward contract was written, the speculator earns a profit on the contract. When an investor aim is speculation, they can use forward contract. The use of a forward contract for speculation has an advantage over actually buying francs and holding them because neither party puts any money up-front when entering into the forward contract.8 Thus, the forward contract gives the investor much more leverage than buying the underlying asset in the cash market. While speculation may seem to be no more than gambling on future price movements, speculators play an important role in financial markets because they provide liquidity. This liquidity enables other investors, who may be using derivatives to hedge risks, to more easily buy and sell derivative contracts. Risk management is one of the functions of derivatives and can fall into two categories of either hedging or 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 (Sill, 1997). Today, hedging and speculation strategies, along with derivatives, are useful tools or techniques that enable companies to more effectively manage risk.  2.0 Question 2 Company A wants to borrow £25m for three years and is offered a variable rate loan commencing on 1st April 2014 at an interest rate of LIBOR + 3%, with interest re-set every six months. The company is particularly risk averse and would prefer a fixed rate loan and has a return requirement is 9% per annum. Company B believes that interest rates are likely to remain stable over the period and is happy to pay floating rate interest in exchange for receiving fixed rate payments. Assume that Company A and Company B arrange a derivative to be transacted on the 1st April 2014 so that Company A pays fixed interest over the period and Company B pays floating rate interest over the period. Assume that the fixed interest rate agreed for the it is LIBOR + 7% (fixed at inception), that LIBOR is 0.5% on 1st April 2014 and that on 30 June 2014 the LIBOR rate rises from 0.5% to 1%. a) Describe the derivative trade that would enable such an exchange, the reasons why each company might want to transact such a derivative and calculate what the swap rate would be for Company A at inception. LIBOR is London Interbank Offer Rate which is the interest offered by London banks on deposits made by other banks. A plain vanilla interest swap A swap is an agreement between two parties to exchange sequence of cash flows for a set period of time. Swaps are customized and traded over the counter (OTC). In the case above, this is plain vanilla interest rate swap where A (swap buyer) makes the fixed-rate payments in the swap, and the swap seller B makes the variable-rate payments. Company A will make fixed-rate payments and therefore is the buyer in the swap. Company B will make variable-rate payments and therefore is the seller in the swap. Why each company may prefer such a derivative? For commercial reasons. Company A might be going for the derivative for specific financing reasons. Swaps may enable managers meet their goals such as to be able to match revenue streams and liabilities. For comparative advantage. For example A might gain from receiving a floating rate interest loan but it’s required to pay fixed rate on the loan of £25m.A is said to have the comparative advantage in fixed-rate payments. A and B can use this kind of derivative to reduce market transaction costs. Because derivatives are a form of insurance or risk management, the cost of trading in them has to be low or investors will not find it economically sound to purchase such "insurance" for their positions Company A pays Company B an amount equal to 9% on the notion that the principal is £25m. Company B pays Company A an equal to LIBOR + 7%, on the notion that the principal is £25m. Calculate what the swap rate would be for Company A at inception. Rate of swap rate at inception is equal to LIBOR+7 which is equal to 0.5+7= 7.5% b) How might Company B hedge its exposure to the interest rate rises and how might it fund that protection. You are required to show the impact of the strategy proposed using both a table and a graph. B which pays a floating rate is exposed to significant risk since it loses when the interest rates go significantly high.Hedging is taking an action that’s expected to produce an exposure to a particular type of risk that’s precisely the opposite of the actual risk to which the company is already exposed to. Firm B can hedge against the adverse effect of high interest by entering into transactions that would produce a gain of roughly the same amount as the potential loss if the rate do in fact rise in the contact it has with B. For example B might acquire a Treasury bond that’s risk free. B is exposed to the risk that interest rates in June will have raised, increasing borrowing costs. To counteract that possibility, the firm might enter a contract in April to deliver (sell) bonds in June at their current price. This will provide cash flow in case of adverse interest rates in the Swap contract. c) What would the value of this derivative be on 02 September 2014 for Company A (using the Principal method)? Show how you reached your valuation using a cashflow analysis. Date Principal A fixed rate at 9% B floating rate at LIBOR+7% cash flow 1st April2014 £25m £2.25M/2=1.125 LIBOR 0.5=£1.875m/2=£0.9375 2nd September 2014 £25m £2.25M/2=1.125/6*5=0.9375 £2M=1M= 0.9375= zero The value of the swap in September will be equal to Zero since the cash outflow of both companies is the same, no one will pay each other. The cash flow for the three years for company A will be Date Principal A fixed rate at 9% B floating rate at LIBOR+7% cash flow 1st April 2014 £25m £2.25M/2=1.125 LIBOR 0.5=£1.875m/2=£0.9375 =0.1875 1st 0ctober 2014 £25m £2.25M/2=1.125 LIBOR is 1£2M=1M = (0.125) 1st April 2015 £25m £2.25M/2=1.125 £2M=1M =(0.125) 1st October 2015 £25m £2.25M/2=1.125 £2M=1M=(0.125) 1st April 2016 £25m £2.25M/2=1.125 £2M=1M=(0.125) 1st October 2016 £25m £2.25M/2=1.125 £2M=1M=(0.125) 1st April 2017 £25m £2.25M/2=1.125 £2M=1M=(0.125) d) What risks are mitigated by this trade and what would you assess are the risks that this transaction represents for both Company A and Company B? In using derivatives several risks are mitigated which include: The effects of adverse changes in interest rates are greatly reduced. The possibility of lack of finance for the said company to finance its operations. For company A, it faces the risk of higher cash flow if the interest rate goes lower in such a way that it favours company B. For company B, it faces the risk of adverse effects of the cash to pay due to the high interest rates that may arise in certain periods of the contact. As any other contract, derivatives like the interest swaps are subject to default risk.The set of mechanisms employed by traders to mitigate default risk, such as netting andmargining, vary across market types. While exchanges have not experienced anynotable credit events in the recent past, over-the-counter markets suffers several, almost systemic events (Murawski & Carsten, 2006). 3.0 Question 3 The investment management departments of your company have asked you to construct a speculative trading strategy using options for a £50,000 investment in a single FTSE 100 non-bank, non-insurance company shares for the 15 working day period between the 24th March 2014 and 11th April 2014 (inclusive). a) Supported with real market data for the shares you wish to trade and suitable academic literature, set up an options-based trading strategy given your view of market sentiment and likely market movements over the period. You must include the source of your options pricing in a suitably referenced appendix. Describe the reasons for your chosen strategy and present the expected profit/loss of your trading strategy using both a table and a graph. Option is contract that gives the buyer the right to buy or sell the underlying asset at specific price on or before the specific date. FTSE 100 is a share index for 100 companies listed in London stock exchange with the highest market capitalization (Investopedia, 2009). The FTSE 100 is calculated in real time and published every 15 seconds. To trade in options you use a basic strategy, if the market is going up, you buy calls or sell puts. There are at least 10 options strategies (Investopedia, 2009). 3.1 Married Put strategy Married Put strategy may be used here, and in this an investor who purchases (or currently owns) a particular asset (such as shares), simultaneously purchases a put option for an equivalent number of shares. In this an investor will purchase a put option against shares that you own.Investors will use this strategy when they are bullish on the assets price and wish to protect themselves against potential short-term losses(Robert & Merton, 1990). This strategy essentially functions like an insurance policy, and establishes a floor should the assets price plunge dramatically. In this case there will be a combination of two purchases; one will be the stock position and the other the put option. With the £50,000 you can pay £40,000 for the stock and £10,000 for your insurance policy. If the stock goes up above £1,500, you are now in a profit position on paper and wont have to consider the put option because it will expire worthless. If, however, BG group plummets to $ 1114 a share, then the value of the insurance quickly becomes apparent 3.2 Married put payoff diagram. Bg group plc is one of the blue chip companies listed in the London Stock exchange(uk.finance,2014).BG Group plc is a British multinational integrated natural gas company(Bloomberg, 2014).Appendix attached shows the stock price movements. In the case above, the investor can use the £50,000 topurchase 24 shares of BG Group stock trading at £1,073.45 in 24th March while simultaneously buying 20 put options trading at £1200 to protect his share purchase. Maximum loss occurs when the stock price dive to £900or below at expiration. With the 50 puts in place, even if the stock prices dive to £900, he will still be able to sell his holdings for 1,200. Therefore, his maximum loss is limited £173.45in paper loss + £173.45 in premium paid for the options = £346.9 On the upside, there is no limit to the profits should the stock price head north. Suppose the stock price goes up to £1,250, his profit will be £176.55 in paper gain less £173.45 paid for the put protection = £3.1 However, if the stock price remains unchanged at expiration, he will still lose £173.45 in premium paid for the put insurance. Breakeven Point = Purchase Price of Underlying + Premium Paid =£1,073.45+£ 173.45 Net Debit = Stock Price + Put Ask Price 1,073.45+ 300=1,373.45 Break Even = Net Debit1,373.45 Maximum Risk = Net Debit - Put Strike Price 1373.45-1200= 173.45 % Max Risk = Maximum Risk / Net Debit 173.45/1373.45= 12.6% Maximum Profit = Unlimited 12.6/ 1373.45 =0.9% Buy 24 shares at £1,073.45 per share. Then buy 1 contract 1200 strike put for £300. Married put profit/loss for BG Group plc Profit Or loss 0 £900stock prices £1,073.45 breakeven point Max risk 3.3 Reasons for choosing married put A married put strategy is usually employed when the options trader is bullish on a stock, wants the benefits of stock ownership (dividends, voting rights, etc.), but wary of uncertainties in the near term (theoptionsguide, 2014). This is also known as protective put because it protects the investor from both downside risk and opens it up for unlimited profit potential. Married puts can provide a great means of limiting your losses and helping you learn the usefulness of puts in a portfolio. This strategy is used to hedge against a temporary dip in the stock’s value. The protective put buyer retains the upside potential of the stock while limiting the downside risk (Optionseducation, 2014). These are some of the advantages of married put strategy. Potential profits are unlimited. The maximum loss is limited due to the protection of the put. Married Puts allows investors to enter a long stock position with low % risk. Provides safety against a surprise gap down in the after hours or pre-market. b) Analyse and describe the level of risk your strategy represents and explain why it is important that the risk in your transaction is managed. Married put strategy is a low risk strategy this is because an investor looks for companies that pay dividend, usually greater than 3.00% annual dividend. Although the strategy reduces the risk, it does not erase the risk. The investor may end up paying extra premiums for the extra protection. This strategy however may not fit some investors because it does take away some of the upside because of the premiums paid on the put option. For example, the bubble of 1999 and 200 stock prices plummeted and some investors never returned to the level they were in. Report on the actual profit and loss of your strategy over the period and analyse and describe why your strategy achieved the results observed. Since the investor is purchasing the stock and an equal number of puts, there is an overall net debit for the position. The total out of pocket value to enter into a Married Put trade is equal to the price of the stock plus the premium of the put option. This value is referred to as the Net Debit. The maximum profit for the position is unlimited as the stock could rise infinitely. The maximum monetary value at risk is equal to the net debit for the position minus the strike price of the purchased put (Poweropt., 2014). Appendix BG Group PLC (BG.L share prices movements (Uk.Finance, 2014). Date Open High Low Close Volume Adj Close 4/11/2014 1,107.00 1,114.00 1,098.57 1,113.50 7,602,400 1,104.19 4/10/2014 1,110.50 1,125.50 1,107.00 1,113.00 3,450,900 1,103.69 4/9/2014 1,128.50 1,131.31 1,113.00 1,117.00 5,191,200 1,107.66 4/8/2014 1,141.00 1,144.50 1,122.00 1,128.50 4,487,400 1,119.07 4/7/2014 1,127.00 1,142.00 1,125.00 1,141.50 8,578,400 1,131.96 4/4/2014 1,140.00 1,140.14 1,125.50 1,136.00 4,903,000 1,126.50 4/3/2014 1,143.50 1,148.50 1,132.50 1,137.00 4,754,400 1,127.49 4/2/2014 1,130.50 1,141.50 1,127.06 1,138.50 5,918,800 1,128.98 4/1/2014 1,125.50 1,136.14 1,117.00 1,129.00 9,389,300 1,119.56 3/31/2014 1,117.00 1,128.00 1,111.50 1,117.50 5,255,400 1,108.16 3/28/2014 1,116.00 1,120.18 1,106.62 1,111.50 4,975,200 1,102.21 3/27/2014 1,100.00 1,112.25 1,096.91 1,111.00 4,295,500 1,101.71 3/26/2014 1,105.50 1,119.00 1,098.50 1,103.50 6,108,400 1,094.27 3/25/2014 1,083.50 1,107.00 1,083.00 1,107.00 6,999,900 1,097.74 3/24/2014 1,067.50 1,082.50 1,054.50 1,082.50 7,131,900 1,073.45 References Bloomberg. (2014). bloomberg. Retrieved May 2, 2014, from bloomberg: http://www.bloomberg.com/quote/BG/:LN Collins, B. M., & Fabozzi, F. J. (1999). Derivative and equity portfolio Management. USA: Dow Jones & Company.inc. Commission, C. D. (2014). The fundamentals of interest rate swaps. California: California debt and investment advisory commision. Group of Thirty. (1993). Derivatives: Practices and Principles. Washington, D.C: Group of Thirty. Hull, J. C. (1993). Options, Futures, and Other Derivative Securities. Englewood Cliffs: Prentice-Hall. Hull, J. (1993). Options, Futures, and Other Derivative Securities. Prentice-Hall: Englewood Cliffs. Investopedia. (2014, April). investopedia. Retrieved April 27, 2014, from http://www.investopedia.com/: http://www.investopedia.com/exam-guide/cfa-level-1/derivatives/forward-contracts.asp Investopedia. (2009, June). www.investopedia.com. Retrieved April 30, 2014, from investopedia: http://www.investopedia.com/slide-show/options-strategies/ Murawski, G. R., & Carsten. (2006). Default Risk Mitigation in Derivatives Markets And Its Effectiveness. Swiss Banking Institute, University of Zurich , 1. National Association of Pension Funds Limited. (2013). Derivatives and Risk Management Made Simple. London: NAPF. optionseducation. (2014, May 1). optionseducation. Retrieved May 1, 2014, from optionseducation: http://www.optionseducation.org/strategies_advanced_concepts/strategies/protective_put.html?prt=mx Poweropt. (2014). poweropt. Retrieved May 1, 2014, from poweropt.: http://www.poweropt.com/marriedputhelp.asp Robert, & Merton. (1990). Continuous-Time Finance. Oxford: Basil-Blackwell,. Sill, K. (1997). The Economic Benefits and Risks Of Derivative Securities. PHILADELPHIA: FEDERAL RESERVE BANK OF PHILADELPHIA. theoptionsguide. (2014, May). theoptionsguide. Retrieved May 1, 2014, from theoptionsguide: http://www.theoptionsguide.com/married-put.aspx uk.finance. (2014, May 1). uk.finance. Retrieved May 1, 2014, from uk.finance: https://uk.finance.yahoo.com/q/hp?a=02&b=24&c=2014&d=03&e=11&f=2014&g=d&s=BG&ql=1 Read More