Analysis of Statements about Hedging Instruments and Risk Management - Essay Example

?Derivative Markets Table of Contents Table of Contents 2 Section A 3 ment 3 ment 2 4 ment 3 5 ment 4 6 ment 5 7 Section B8 Hedging 8 Arbitrage 9 Speculation 9 References 9 Bibliography 12 Section A Statement 1 “Hedging a sterling interest rate risk is impossible when using a Eurodollar futures contract” Future contracts are regarded as common hedging products. It is a contract that is held between two prevailing parties to purchase or sell any property at a specific time in upcoming days with a specific rate. Through future contracts organisations can restrict themselves from any price variations. One of the best dynamic future contracts in international market is the ‘Eurodollar future contracts’. Several investors concluded that Eurodollar futures deliver a valuable, commercial instrument for hedging variations in ‘short-term USD interest rates’. Eurodollar futures contract returns market potential for interest rates on Euro Dollar securities for particular times in future. The ‘5 year E-Mini Bundle Futures’ of Eurodollar contracts offer organizations to get disclosure to the 5 year term on USD interest rate interchange. This pack allows transaction of the monetary equivalent of 20 quarterly Euro Dollar terminations in a single contract. Through Eurodollar contract, organizations can get the following benefits: Supreme liquidity with reliably strong bid and lower operational costs Diversity of transaction prospects which comprises of hedging, arbitrage, dispersal against other contracts and money equalization tactics Price clearness where swapping takes place in exposed, reasonable and unidentified markets Greater functionality on the organisation’s automated trading platform which provides apparent and competitive performances and effective ‘around the clock’ contact Thus, from the above explanations it can be said that statement 1 is not true. The Eurodollar future contract is designed to hedge sterling short-term USD interest rate (CME Group, n.d.). Statement 2 “Futures arbitrage will always ensure that the price of futures contracts can only move within clearly defined limits” Limits of arbitrage are usually seen as one of two building blocks needed to clarify irregularities. The presence of price limits and margin necessities on futures contract are usually disregarded in the assessment and arbitrage settings. There are several limitations in the price of future contracts and it is ensured by future arbitrage. The existence of price limits help to minimise the instability of prices by defending organizations against market overreaction. However, price limit can also make future contracts less liquid. Future arbitrage makes future contracts more valuable. Arbitrage generates a strong connection among the futures and commercial values (New York University, n.d.). Limit of arbitrage is significant for behavioural descriptions of irregularities and wider revision of asset valuation. Limit of future arbitrage is a portion of finance plan to clarify variances based on investors’ emotional prejudices. Arbitrageurs can face the following price limitations: Fundamental and non-fundamental risks Short-selling costs Leverage and margin constraints Constraints on equity capital Thus, the above statement 2 is true i.e. there are some defined limitations in future arbitrage in pricing future contracts (Gromb & Vayanos, 2010). Statement 3 “A swap contract can create a win/win situation for two swap players plus the financial intermediary arranging the swap” The interest rate swap is a derivative to interchange interest rate for accomplishing lesser borrowing rates. Swap players can change interest rate from static to floating and vice versa. Swapping is beneficial when one player desires to get an amount with a floating interest rate while other player wishes for preventing future risks by getting a static interest rate in its place. In swapping, both players have their own primacies and desires, thus it (swapping) can create win/win situation for them (players) (Rose & Hudgins, 2010). In interest rate swapping, two players exchange for static interest rate and fluctuating interest rate. For instance, one player might have a security which gives London Interbank Offered Rate (LIBOR) while other player grasps a security which gives a static amount of 6%. If LIBOR is estimated to remain at 4%, then the swap agreement would likely to clarify that the player giving the interest rate will pay LIBOR as well as extra 2%. In this way both players can anticipate to get similar amount. The principal amount will not be dealt, but the players will come to an agreement on the base price of the security to compute cash flow that is going to be swapped. Swap is also considered as a ‘zero-sum game’ where one player loses the money and other player gains the equal amount of money (Brown & Et. Al., 1995). Financial intermediary who arrange the swap contract for its clients also gets payment if it (intermediary) agrees to assure return. Usually, the income of intermediaries is amounted to almost 0.25% - 0.50% of the sum involved in swap. Thus, it can be seen that the above statement 3 is true that swap contract create win/win situation for each player and the financial intermediaries also for assuring real payment (Rose & Hudgins, 2010). Statement 4 “A covered call ensures that an investor can never lose by holding a long position in the underlying asset” Covered call is known as an exceptional approach in which the investor grasps the principal asset and trades a call. With the help of this strategy investors can dodge infinite losses by selling principal assets when needed. In a covered call, stockholders protect the short position in the underlying asset. The amount of call traded is determined by the market perspective of investor and size of holding asset. The covered call approach also can be applied to who is confident on ‘scrip’ but assumes that the share/security rate will not change further than a specific boundary. Covered call strategy allows investors to decrease the general effective cost. For instance, if a company is reciting shares at ?385 and investor believes that the price of share will not move beyond ?400 in the corresponding month, he/she can purchase the shares for ?385 and instantaneously trade a call on the share with strike price of ?400. In this way, investor can lessen the effective cost of attainment, but there is a possibility of opportunity loss in case the price increases beyond ?400 (Pathak, 2011). For that reason, it can be said that, the above statement 4 is not true. Covered call ensures profit on short option position in the underlying asset. As long as an investor has short position there is need to grasp the asset, otherwise investor’s loss will surpass the buying cost over the exercise cost of the call. As investor assumes prices to stay static or increase, he/she creates a location of long underlying asset, which is purchasing the stock and trade a call option on it. A Put strategy is beneficial when an investor anticipates market rates will drop. Put strategy increases the rate of purchase and hitches the risks (Pathak, 2011). Statement 5 “A long strangle and a long straddle offer the same opportunities and outcomes so there is no logical reason why these two different option strategies should exist” Long strangle is similar to the long straddle strategy. A long strangle is composed of purchasing same amount of Call and Put that have the same expiration time. In case of long straddle, the broker considers that market will make substantial changes but do not know the direction of those changes. A long straddle involves the instantaneous acquisition of Call and Put option of same debt with similar expiration date. If both strategy (Call and Put) perish at the cash it signifies that the market neither progresses nor drops. In that case broker losses money which was given as premium (DeMark & DeMark, 1999). On the other hand, the long strangle is appropriate for a highly unpredictable market. The risk and return system in long strangle is identical with long straddle. Both strategies provide limited return and infinite risks (Saliba, 2006). The above statement 5 is partially true. Though long strangle and long straddle are identical because both deal with purchasing equal amount of Call and Put with equal expiration time, but long strangle has two diverse rates and long straddle has one common rate. There is logical reason for existence of strangle and straddle. For instance, if an investor desires to straddle AAPL Inc., he/she can purchase 200 Call of September 2011 and 200 Put of September 2011. Investors use straddle strategy when they anticipate large change in the market is approaching, but is uncertain about the direction. If the direction is good the underlying security is expected to increase with Call while halting a Put premium, and if the direction is bad the underlying security is expected to drop and it might halt the Call premium while forcing the Put to increase. In case of strangle strategy, if the rates and market viewpoints are progressive, investors can observe a positive influence on the stock but if the rates and market viewpoint are awful, the stock could drop quickly (Cooper, 2009). Section B In recent times, the world has converted into an uncertain place for financial organisations. Fluctuations in interest rates have extended, and stock markets are running through growing unpredictability. As a consequence of these variations, the financial organisations have happened to be more anxious about minimising the risks. As the demand for risk reduction techniques has enlarged, it has generated innovative financial tools named financial derivatives. These tools are very convenient in minimising the risks and help financial organisations to hedge (Pearson Education, n.d.). Hedging Hedging is a method which is used by financial organisations to counteract the regular risks of price variations. It is considered as important risk managing instrument for portfolio managers, bank executives and corporate accountants. Through minimising the risk, hedging lets organisations to concentrate on the main business. Each market has its own sole individualities which make handling the risks a challenge for organisations. The tools needed for accomplishing operational hedging are specific for each market (Cusatis & Thomas, 2005). Arbitrage In any derivative contract, the seller comes to an agreement to provide asset at a particular period in future and purchaser approves to pay fixed value for that asset. One can build a clean arbitrage if the future contract is mispriced. Majority of future contracts are priced according to arbitrage. Arbitrage can develop a price range at which investor is unable to construct situations concerning the future contracts and the principal asset which create riskless profit with no early investment. Arbitrage association delivers a degree of the elements of future prices on a wide series of assets (New York University, n.d.). Speculation In derivative contract, organisations need to choose investments which can provide good return with estimated price measures. It is also termed as speculation. Speculation is a procedure used in finance for securing profit from riskier investments, but it does not ensure security on investment or principal amount. Speculators use several approaches to make a decision prior to obtaining additional risks through investment. References Brown, K. C. & Et. Al., 1995. Interest Rate and Currency Swaps: A Tutorial. Wiley-Blackwell. Cusatis, P. & Thomas, M. R., 2005. Hedging Instruments and Risk Management. McGraw-Hill Professional. CME Group, No Date. Eurodollar Futures. Interest Rate Products. [Online] Available at: http://www.cmegroup.com/trading/interest-rates/files/IR148_Eurodollar_Futures_Fact_Card.pdf [Accessed September 25, 2011]. Cooper, I., 2009. Straddle & Strangle Options Strategies. Wealth Daily. [Online] Available at: http://www.wealthdaily.com/articles/straddle-strangle-options/1729 [Accessed September 25, 2011]. DeMark, T. & DeMark, T. Jr., 1999. Demark On Day Trading Options: Using Options To Cash In On The Day Trading Phenomenon. McGraw-Hill Professional. Gromb, D. & Vayanos, D., 2010. Limits of Arbitrage: The State of the Theory. London School of Economics and Political Science. [Online] Available at: http://www.google.co.in/url?sa=t&source=web&cd=1&sqi=2&ved=0CCgQFjAA&url=http%3A%2F%2Fwww2.lse.ac.uk%2Ffmg%2FworkingPapers%2FdiscussionPapers%2FLimits%2520of%2520Arbitrage%2520The%2520State%2520of%2520the%2520Theory.pdf&ei=rSB8TozOMMOTiAeEsJypDg&usg=AFQjCNE9bxTySSE6fLAJiRnuNNkPF1qnjA&sig2=OrDxl-Spb2cnMElG9ESb-A [Accessed September 25, 2011]. New York University, No Date. Valuing Futures and Forward Contracts. Chapter 34. [Online] Available at: http://people.stern.nyu.edu/adamodar/pdfiles/valn2ed/ch34.pdf [Accessed September 25, 2011]. Pearson Education, No Date. Financial Derivatives. Web Chapter. [Online] Available at: http://wps.aw.com/wps/media/objects/3000/3072002/bonuschapters/webch02.pdf [Accessed September 25, 2011]. Pathak, B. V., 2011. The Indian Financial System: Markets, Institutions and Services Third Edition. Pearson Education India. Rose, P. S. & Hudgins, S. C., 2010. Bank Management and Financial Services. Tata McGraw-Hill Education. Saliba, A. J., 2006. The Options Workbook: Fundamental Spread Concepts and Strategies for Investors and Traders. Kaplan Publishing. Bibliography Dubofskly, D. A. & Miller, T. W., 2003. Derivatives Valuation and Risk Management. Oxford University Press. Read More