Currency Derivatives: Instruments Fixed and Open Outcomes - Essay Example

Q. Currency derivatives can be ified into instruments with symmetrical (fixed) and asymmetrical (open) outcomes. Define their respective characteristics, and use examples to illustrate your answer. A. The currency derivative is a financial instrument which is a contract, characterized by different types of products like, forward, future, option, and swap. The basic characteristics features of these instruments include, 1. Basically these consist of one or more notional amounts or payment provisions or both those are based on some terms of the settlement. 2. The instruments don’t require any initial net investment 3 The instruments facilitate the delivery of an asset that puts the recipient in a position not to differ from the net settlement Symmetric and asymmetric returns: 1. A return from a contract or investment is said to be symmetric when it gives either a profit or loss. Returns from forwards and futures are symmetrical: if one can enter into a forward at a particular price, the price might either go up or come down, and so, one can make either profit or a loss. Forwards are quite common in commodities, and can be used either for speculation or for hedging. Eg: If a person has an order to ship 10000 tons of steel for a period of 6 months at a prefixed price of $1000 per ton. And the person is expecting the price of steel to increase. So, to hedge against the price risk, the person enters into a forward purchase agreement, for 10000 tons 6 months hence. The person position is now fully hedged: if the price of steel increases as expected, person will either claim a delivery from the forward seller, or a net settlement. If the price comes down, person will be obliged to settle by making a payment for the price difference to the forward seller, but will be fully compensated by the pre-fixed price it gets from its own forward sale contract. 2. Options have an asymmetric return profile: an option is an option with one party. The option will be exercised only when the purchaser of the option is in-the-money. Therefore, the only loss in an option is the cost of writing and carrying the option. Hence, options have an asymmetric return profile. On the other hand, the option-seller only makes returns by way of fees or premium for selling the option, against which the person takes the risk of being out-of-money. If the option is not exercised, person makes fees, but if the option is exercised, considerably, the person may lose. For example, if one person is holding a security of $1000 buys an option to put the security at its current price with some other person. Now if the price of the security goes down to $900. The person may exercise to sell the option of the security to some other person at the agreed price of $1000 to protect against the loss of account of turn down in the market value. If, on the other hand, the price of the security is increased to $1100, the person is out of the money and exercising the option of selling the security does not yield any gain at a price of $1000 as agreed. Therefore, the person will not exercise the option. In other words, the option buyer can only get paid and will not in a position of loss. 2. Compare the pay-off profiles of an open position and a forward contract with the pay-off profile of an option. Demonstrate that, on an ex post basis, a currency option is always second best. A. The most popular derivatives instruments are forwards, future and option. The Forward contract obligate the buyer to purchase an asset at the pre agreed price where as seller can sell the asset at the exercising price. This is not standardized one. These represent the trade over the counter. The buyer and seller discuss about the contract, which yields to flexibility. This flexibility leads to liquidity of price. If any party wants to get out of agreement, they must find another party, who is willing to purchase that contract. In forward contract during the contract and at the time of forming the contract, no payments will be prepared; the value of contract is realized only at the expiration date, the forward contract payoff is based on actual price of asset on delivery date. Whereas, Option gives the right to purchase, but has no obligation to sell. The advantages of option are maximized return potentials with limited risk. Options are best for serious investors, who have less time to investment research and to execute trade. Option gives three benefits to the individual investors. Options are the best options for intermediate or long-term investment as they do not alter with daily fluctuations 1. Limited risk: option is becoming more popular across the corporate board, because option allows preserving capital and decreasing the risk, with minimal pay for entry. If one wants to purchase an option, one can pay the premium and enter into the trade. 2. Greater Returns: Currency option is advantageous for the average investor, who has no desire to become a full trader. In option it gives high potential as 4:1 leverage is available in equities and 20:1 in Futures, and if the scale is higher, leverage offers higher profits 3. Ease of use: The trading in the option is simple. One can place call option when trend is rising and puts if its headed down. In option one has no need of special account to place trade like spot market. Option is right tool to minimize risk. The currency option is best, where the probability of company’s foreign currency receipts depends on the exchanging rate. Usually, currency options offer an imperfect hedge, whereas forward contracts are more effective. Though, currency option is perfect tool to minimize the risk or loss for the kind of exposure that a firm itself having implicit currency option to another party, it is less effective, when the firm’s natural position can be altered with the exchanging rate. It means with effect of exchanging rate, firm can get loss or gain. Because of exchange rates alone, contracts are not won or loss in option. In this case forward contracts are suitable. In general, Corporates use currency options to yield best results in the case of hedging combined with view, as statements show that the currency options are good way to get profits. But in practical, the gain or loss on Options is non linear function of the currency value and also the relationship varies with anticipated volatility, time and with the level of interest rates. So, options are not ideal to corporate investments. 3. Briefly outline how international arbitrage leads to interest rate parity. A. Arbitrage can be defined as capitalizing on a difference in quoted prices, with no risk tied up on funds and little trading time. In other terms, Arbitrage is the purchase of something in one market and its sale in another market to take advantage of price differential. Here market can realign the prices to eliminate mispricing. It adjusts the prices to an equilibrium level. The Types of arbitrages include Locational arbitrage, Triangular arbitrage and Covered interest arbitrage. Interest rate parity is the equilibrium state where covered interest arbitrage is no longer possible to exist. It eliminates the covered interest arbitrage. Interest rate parity is of two types, 1) forward rate that differs from 2) spot rate to counter balance the difference interest rate. In a free market, the currency with the higher interest rate will sell at a discount in the forward market and vice versa. This outcome is a result of arbitrageurs who enter into forward contracts to avoid the exchange-rate risk Covered-Interest Arbitrage is the movement of short-term funds between countries to take advantage of interest differentials with exchange risk covered by forward contracts. Such activities lead to equilibrium, i.e. interest rate parity. Whenever the covered interest parity condition did not hold true, an arbitrage situation would arise where investors could take advantage of the differential. References: 1. Basics of Derivatives, accessed on 22 July, 2007, available from < http://72.14.235.104/search?q=cache:aS3kCjcJBZgJ:www.india-accounting.com/derivbasics.htm+.+A+return+from+a+contract+or+investment+is+said+to+be+symmetric+when+it+gives+either+a+profit+or+loss.&hl=en&ct=clnk&cd=1&gl=in&client=firefox-a> 2. Interest Rate Parity, accessed on 23 July 2007, available from < http://moneyterms.co.uk/interest-rate-parity/> Read More