Derivative securities generate profits that are functions of changes in the price of underlying assets. Why do investors use derivatives? Theoretical work has advocated derivatives as a useful tool that allows investors to utilize information better, manage risk, and reduce transaction costs. In contrast, recent popular press commonly portrays derivatives as speculative, high-risk investments. Public concern has been strong enough to prompt the Securities and Exchange Commission to reevaluate risk disclosure requirements for mutual funds and to provoke possible regulatory initiatives. Although derivative use has generated substantial attention from many communities, no empirical evidence those documents how derivative securities are actually used by investment managers. Second, investors investing in derivatives may improve net portfolio performance, either due to lower transaction costs or because managers better utilize information. Finally, managers may use derivatives to affect inter temporal changes in the fund's risk exposure, for example, to respond to cash flows from investor purchases and redemptions, or to allow fund managers to game incentive systems. Although funds that use and do not use derivatives may, on average, have similar return distributions, it is possible that derivative users are more heterogeneous. Specifically, it is possible that some funds that use derivatives have higher standard deviations due to speculative activity, and others have lower standard deviations as a result of hedging. Mutual fund risk exposure is likely to vary with fund performance. Consistent with prior research, we posit that fund risk should decrease following good performance and increase after poor performance. If investors use derivatives to manage unexpected cash flows, funds using derivatives will be able to maintain desired risk exposure more easily. In this case, the relation between past performance and changes in risk should be weaker for funds using derivatives. On the other hand, if investors want to game performance systems, derivatives provide a low cost way to change risk, and thus we expect that funds that use derivatives will have a stronger relation between performance and risk.
The stock market is characterized by volatility, which creates uncertainty in the market and makes predictions regarding future exchange rates difficult, both in the short and long term. However, it is these constant fluctuations in the stock market that make it possible for companies or individuals to take advantage of the movements in exchange rates through speculative activities. These fluctuations also pose a threat for any importer/exporter trading in the global marketplace as international businesses are naturally exposed to currency risk. This necessitates the adoption of hedging strategies to mitigate risk. The volatility in the stock market needs to be dealt with in a proper, prudent and timely manner. Otherwise, adverse currency fluctuations can inflict painful lessons on a company or individual. Later in this thesis we will investigate in detail the volatility of the stock market and the potential risk exposure faced by all market participants. People enter into the stock market for various reasons and the above mentioned potential for profit is a very important motivation. Indeed, some traders who come with the intention of making profit by taking advantage of market fluctuations engage in speculative activities in the stock market and accept the risks involved, while others attempt to protect themselves from volatility by engaging in hedging activities. Traders in this first category are commonly known as speculators, whereas the latter are known as hedgers. Speculators enter the market, in effect, by placing their "bets" on the currency movements. Should their prediction come true, they make profits; if their predictions are not realized, they suffer losses. Hedgers enter the market with the intention of insuring themselves against any adverse currency movements they may encounter in their business operation. Hedging involves the creation of a position that offsets an open position occurring in their business operations; so that the gain in the business (hedge) position will offset the loss of the hedging (business) position. In this thesis we will analyze these players in the stock market using the Expected Utility Theorem of Aliprantis. There are various financial instruments used for trading in the stock market. The most common are spot contracts, forward, futures, options, swaps and various money market instruments. Forward, futures, options and swaps are derivatives instruments. Commonly used instruments in the money market include (but are not limited to):
- Treasury bills,
- Euro yen,
- Certificate of deposit (CD),
- Commercial paper
In fact, the money market represents most of the financial instruments that have less than twelve months maturity. This margin is also known as the leverage ratio and can range from twenty to two hundred, depending on the financial institutions involved. If the given leverage ratio is twenty, the trader using a leveraged spot contract can have access to a credit line twenty times larger than his/her initial margin (collateral). Clearly, the leveraged ratio allows traders (both speculators and hedgers) to trade at a significantly lower capital requirement when compared to the spot market. The general mechanism of each of these markets (forward, futures, options, swaps and money markets) will be explained in detail in this thesis. Nevertheless, it is essential for us to provide a brief explanation of our new hedging tool and its related market, the leveraged spot market as we are introducing it in the context of this thesis in this section. This is mainly because leveraged spot contracts are not as commonly used financial instruments as are the forward, futures, swaps, options and spot contracts. Moreover, the fundamental motivation for this thesis is to develop a model for using the leveraged spot market (contract) for both speculative and hedging purposes. The thesis not only illustrates how to use leveraged spot contracts as both a speculative and hedging technique (like the forward, futures, swaps, options and spot contracts), but also shows that under specific circumstances, the leveraged spot contract is superior to these traditional financial tools.
1.2 Research Context:
The selection of the particular research approach depends on the kind of information required. Qualitative research collects, analyzes, and interprets data that cannot be meaningfully quantified, that is, summarized in the form of numbers. For this reason, qualitative research is sometimes referred to as soft research. "Quantitative Research" calls for very specific data, capable of suggesting a final course of action. A primary role of quantitative research is to test hunches or hypotheses. These suggest that qualitative approach is a soft research approach in which collected data cannot be meaningfully quantified and more importantly in this approach non-structured research is conducted. But so far as quantitative research approach is concerned, through this approach structured research is conducted with approaching larger respondents and the collected data can be meaningfully quantified. Research data can be collected either in the form of secondary or primary or both. This assumption is obviously not realistic. With the aim to close this gap between theory and practice, a new model is developed in this thesis using the assumptions that the interest rate definitely changes according to economic conditions or policies and that the exchange rate movement follows the pattern of a random walk, which is a stochastic process. Moreover, during the course of our research, we did not encounter any literature that dealt with leveraged spot contracts as both speculative and hedging instruments. It is obvious that the leveraged spot market is relatively less commonly used by financial derivatives traders, compared to traditional instruments such as forward, futures, options, swaps, and the money market. Our objective is therefore to develop a model using leveraged spot contracts as an effective financial instrument that can be used for both speculative and hedging purposes.
1.3 Research Objective:
* Analysis of Derivatives and the perception of investors"
1.4 Research Questions:
- Illustrate how the leveraged spot market can be utilized both as a speculating as well as a hedging tool.
- Derive insights into how real world data will affect the optimal number of contracts that a trader should trade (or invest) at any given time.
- Present a Black scholes model for speculation using leveraged spot contracts based on Krugman's model of exchange rate dynamics within a target zone.
- Demonstrate how a trader can hedge an open position in the leveraged spot market with a simultaneous position in the forward market to generate profit.
- Explain how a hedger can hedge an existing business transaction exposure using the leveraged spot.
1.5 Research Boundary and Scope:
This thesis is organized into chapters/sections. The first chapter is an introduction to the thesis. Next chapter provides a review of previous literature on hedging and the volatility of the Stock market. These two parts: the first part covers a background of hedging and explores the common applications and techniques of hedging; and the second part covers the volatility of Stock market movements, providing a brief background on the economic fundamentals of exchange rate determination and dynamics, exchange rate systems, international financial markets, and government policies affecting exchange rate systems. How the leveraged spot market can be used as a speculating tool. We have adapted model of exchange rate dynamics within a target zone Based on Krugman, we assume that the exchange rate movement follows the pattern of a random walk and we develop a model showing how the leveraged spot contract can be used as a superior financial tool when compared to forward and spot contracts under certain circumstances.
However, before developing this model illustrates the mechanism of trading in the leveraged spot market with a numerical example. This describes how to eliminate the risk which arises from speculative leveraged spot transactions using a forward contract. Moreover, several numerical examples are used to illustrate how companies can utilize leveraged spot contracts as a hedging tool. We show in this chapter that the leveraged spot contract, when used in conjunction with a forward contract, can indeed derive risk free profits for its users. The effectiveness and profit generated from using leveraged spot contracts depends on the leverage ratio and the interest rate differential between the home and foreign countries.
Chapter 2: Literature Review
The financial world has witnessed several major catastrophes in the last dozen years. The first catastrophe was the collapse of Barings Bank in Britain in 1995. The bank's collapse was a direct result of Nick Lesson's aggressive trading in the futures and options markets. Between 1992 and 1995, the self proclaimed "Rogue Trader"1 accumulated losses of over 800million. In February 1995, the 233 year-old Barings Bank was unable to meet the Singapore Mercantile Exchange's (SIMEX) margin call. The bank was declared bankrupt and was bought by the Dutch Bank, ING, for only 1. The second catastrophe was the Asian financial crisis in 1997. Much literature had been written about the crisis as the financial world tries to understand what went wrong that led to the crisis. Some authors claimed that the crisis was triggered by the run of panic investors on those economies as well as depositor on banks which led to the burst of a bubble economy; while others blamed the crisis on the moral hazard in the Asian banking (financing) systems. We believe that the Asian financial crisis was due mainly (but not limited) to the structural imbalance in the region, caused by large current account deficits, high external debt burden, and the failure of governments to stabilize their national currencies. These problems were worsen by the poor prudential regulation of 1 Nick Lesson wrote an autobiography called "Rogue Trader" detailing his role in the Barings scandal while imprisoned, the Asian financial system during the 1990s. The combination of these factors contributed to the long-term accumulation of problems in fundamentals, such as large amount of 'over-lending' and bad loans in banking systems which led to the bankruptcies of large firms/banks in the economy, and eventually destroyed the confidence of investors and triggered the panic run of both investors and depositors of the Asian financial system. As part of the efforts, governments tried entering the derivative markets to stabilize their currencies. The Thai Government, for instance, utilized the forward market. However, as the world witnessed the collapse of several Asian currencies during the course of the 1997 financial crisis, it was obvious that these stabilizing efforts were not successful. As the Asian countries continued their recovery efforts, Enron collapsed in 2001 as a result of imprudent use of financial derivatives. It had been reported that Enron's management engaged in questionable transactions in the options market, in an attempt to keep the true economic losses of various investments off Enron's financial statements and to try to conceal the actual financial situation of the company. The consequences of these catastrophes were devastating. They impacted not only on the governments and companies directly involved in the events, but also their stakeholders, such as shareholders, employees and ordinary citizens. Many studies examining international financial markets have been designed to prevent the future occurrence of a similar catastrophe. Most of these studies are still attempting to learn from past mistakes through analyzing what exactly triggered such catastrophic events. Amongst those many studies, some have been undertaken to assist companies to minimize their exposure to fluctuations in the currency market, and to implement better techniques and supervision of corporate risk and management.
As a result, topics such as currency exposure, hedging strategies and prudent, ethical company practices have become mainstream issues in international financial markets. This thesis is concerned with hedging techniques in relation to the risk faced by companies and individuals of currency fluctuations. We will point out the limitations and strengths of common hedging techniques and then derive a new technique for hedging. This new model aims to minimize or eliminate the limitations of existing hedging techniques. The importance of understanding the underlying economic and financial fundamentals, which were possibly responsible for the 1997 Asian financial crisis, is noted. These underlying issues are peripheral to the main theme of this thesis. Nevertheless, they do need to be addressed. This chapter begins with a background discussion of hedging and explores the common applications and techniques of hedging. It continues by addressing exchange rate volatility through providing a brief background of the economic fundamentals of exchange rate determination and dynamics, and government policies. Information regarding the history of hedging, and the cost and benefits of hedging are provided in Appendix A1 to A4; information on the international financial market and exchange rate system can be found in Appendix A5. Appendix A6 includes brief discussions on the mechanisms of the common financial instruments. Discussions regarding the parity relationships and government intervention in the financial markets are included in Appendix A7 and Appendix A8.
Globally, operations in the foreign exchange market started in a major way after the breakdown of the Bretton Woods system in 1971, which also marked the beginning of floating exchange rate regimes in several countries. Over the years, the foreign exchange market has emerged as the largest market in the world. The decade of the 1990s witnessed a perceptible policy shift in many emerging markets towards reorientation of their financial markets in terms of new products and instruments, development of institutional and market infrastructure and realignment of regulatory structure consistent with the liberalized operational framework. The changing contours were mirrored in a rapid expansion of foreign exchange market in terms of participants, transaction volumes, decline in transaction costs and more efficient mechanisms of risk transfer. The origin of the foreign exchange market in India could be traced to the year 1978 when banks in India were permitted to undertake intra-day trade in foreign exchange. However, it was in the 1990s that the Indian foreign exchange market witnessed far reaching changes along with the shifts in the currency regime in India. The exchange rate of the rupee, that was pegged earlier was floated partially in March 1992 and fully in March 1993 following the recommendations of the Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and an important step in the progress towards current account convertibility, which was achieved in August 1994. A further impetus to the development of the foreign exchange market in India was provided with the setting up of an Expert Group on Foreign Exchange Markets in India (Chairman: Shri O.P. Sodhani), which submitted its report in June 1995. The Group made several recommendations for deepening and widening of the Indian foreign exchange market. Consequently, beginning from January 1996, wide-ranging reforms have been undertaken in the Indian foreign exchange market. After almost a decade, an Internal Technical Group on the Foreign Exchange Market (2005) was constituted to undertake a comprehensive review of the measures initiated by the Reserve Bank and identify areas for further liberalization or relaxation of restrictions in a medium-term framework.
The momentous developments over the past few years are reflected in the enhanced risk-bearing capacity of banks along with rising foreign exchange trading volumes and finer margins. The foreign exchange market has acquired depth. The conditions in the foreign exchange market have also generally remained orderly. While it is not possible for any country to remain completely unaffected by developments in international markets, India was able to keep the spillover effect of the Asian crisis to a minimum through constant monitoring and timely action, including recourse to strong monetary measures, when necessary, to prevent emergence of self-fulfilling speculative activities.
2.1 Option Market:
Similar to futures markets, options markets provide impersonal transactions between two participants in an organized, orderly and cost-efficient open outcry auction market. Examples of these markets are the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX) and the Australian Stock Exchange (ASX). An options contract gives the contract holder the right but not obligation to buy or sell an asset at a will be specific price and delivery date. For a currency options contract, that asset will be a currency. The contract holder is also known as the options buyer. The counterparty of a contract holder is known as the contract writer or contract seller, who is obligated to respond to the contract holder. In other words, if the contract holder chooses to exercise the contract, the writer is obligated to respond.
Call Options Right and Obligations
Buyer (holder) Seller (writer)
Has the right to buy a futures contract at a predetermined price on or before a defined date. Grants right to buyer, so has obligation to sell futures at a predetermined price a buyer's sole option.
Expectation: Rising prices Expectation: Neutral or falling prices
Put Options Right and Obligations
Buyer (holder) Seller (writer)
Has the right to sell a futures contract at a predetermined price on or before a defined date. Grants right to buyer, so has obligation to buy futures at a predetermined price a buyer's sole option.
Expectation: Falling prices Expectation: Neutral or rising prices
The Options markets offer two styles of contracts: the American and the European. The style of an options contract dictates when it can be exercised. The American options contract gives the buyer (holder) the right to exercise the option at any time between the date of writing and the expiry date; the European options contract, on the other hand, can only be exercised on its expiration date, but not before the expiry date. Further information on how to quote a currency options contract and the factors affecting the pricing of options contracts can be found in Appendix A6.3. In Australia, the Australian Stock Exchange (ASX) only offers standardized options contracts. Overseas options markets do offer options contracts in two forms: customized and standardized. The customized options contracts are also known as the over-the-counter (OTC) options. It is usually written by banks for US dollars against the British pound sterling, Swiss francs, Japanese yen, Canadian dollars and the euro. These customized options contracts can be tailored to suit individual needs, in terms of delivery dates, contract size and strike price. The contract size of these over-the-counter options contracts can reach $1 million or more with maturity of up to one or two years. The standardized option contracts are also known as exchange traded options (ETOs). These standardized options contracts were first introduced in the United States by the Philadelphia Stock Exchange (PHLX) in December 1982. Other markets such as the Chicago Mercantile Exchange later followed suit. Like the futures contracts, these exchange traded options are settled through a clearinghouse. The clearinghouse acts as the middleman and handles both sides of an options transaction. Acting as the counterparty of all options contracts, the clearinghouse guarantees the fulfillment of these contracts. Until this time, currency options contracts are still not available for trading through many of the Stock Exchanges. In fact, the Australian Stock Exchange only offers equity options and index options. For traders wanting to speculate or hedge using currency options contracts, they can utilize overseas options markets that offer currency options contracts, for example the Philadelphia Stock Exchange (PHLX). The exchange traded currency options offer standardized features such as expiration months and contract size. The following Table 2.8 consists of some of the standardized features of an exchange traded currency options contract as listed by the Philadelphia Stock Exchange (PHLX).
2.2 Future and Forward:
In 1982, a study had been conducted based on the random sampling of the Fortune 500 companies. In that study, it had been found that the extensive adoption of forward contracts amongst Fortune 500 companies that were involved in currency hedging, it is by far the most commonly adopted hedging instruments. This popularity is perhaps due to the long history of usage, dating back to the early days of civilization and the trading of crop producers. Forward contracts were the first financial derivatives derived from those early "buy now but pay and deliver later" agreements. In contemporary business world, forward contracts are commonly known as over-the-counter transactions between two or more parties where both buyer and seller enter into an agreement for future delivery of specified amount of currency at an exchange rate agreed today. They are generally privately negotiated between two parties, not necessarily having standardized contract size and maturity. Both parties in the forward contracts are obligated to perform according to the terms and conditions as negotiated in the contracts even if the parties' circumstances have changed. In other words, once a forward contract has been negotiated, both parties have to wait for the delivery date to realize the profit or loss on their positions. Nothing happens between the contracting date and delivery date. Indeed, a forward contract cannot be resold or marked to market (where all potential profits and losses are immediately realized), because there is no secondary market for a forward contract. Although, technically, the forward contract can be re-negotiated with the original counterparty, it is usually practically too costly to proceed with. In fact, the counterparty is not obliged to proceed with the renegotiation. Forward contracts have one obvious limitation: they lack flexibility, and therefore do not allow companies to react in a timely manner to favorable market movements. This disadvantage is widely acknowledged and often criticism by authors and hedgers. So, why are forward contracts still the most popular hedging instrument? We believe this is mainly because forward contracts allow the hedging of large volumes of transactions with extremely low costs. Indeed, the parties involved in negotiating a forward contract are typically companies that are exposed to currency risk and their nominated banks. The nominated bank typically charges a service fee, of less than 1% of the face value of the hedge amount, for acting as the counter-party in the transaction. So it is the nominal service fee that is the low cost. Appendix A6.1 provides further discussion on the calculation of forward rates for a currency as well as example of typical forward transaction.
2.2.2 Futures Markets:
Futures contracts are the first descendant of forward contracts. Futures contracts were derived, based on the fundamental of forward contracts, but with standardized quality, quantity, time (maturity), as well as place for delivery. Like other financial derivatives, futures contracts were initially designed for commodity trading, but as commercial trading continually evolved, the initial definition of "commodity" broadened to include floating world currencies. In 1972, the Chicago Mercantile Exchange pioneered the industry by introducing the first currency futures contract. Today, currency futures contracts are common financial derivatives available to all global investors. Futures contracts inherited many significant traits of forward contracts, in that futures transactions are also commitments to purchase or deliver a specified amount of currency on a specified. However, the futures contracts also possess certain traits which are absent in forward contracts and are thought to promote more efficient trading. In fact, unlike forward contracts, futures contracts are seldom used to take physical delivery. These futures contracts are commonly used by both speculators and hedgers. It allows the traders to take advantage of price movements.
Major Difference between Forward and Futures Contracts
Forward Contract Future Contract
Customized contracts n terms of size and delivery dates; ; Standardized contracts in terms of size and delivery dates
Private contracts between two parties Standardized contracts between a customer and a clearing house
Difficult to reverse a contract Contract may be freely traded on the market
Profit and loss on a position is realized only on the delivery date All contracts are marked to market -the profit and loss are realized immediately
No explicit collateral, but standard bank relationship necessary Collateral (margins) must be maintained to reflect price movements
Delivery or final cash settlement Contract is usually closed out prior to
Source: NSE India 2007
The integrity of futures markets is safeguarded by clearinghouses, which are created by member participants of the organized exchanges (such as the New York Mercantile Exchange (NYMEX), the Chicago Mercantile Exchange (CME), and the Sydney Future Exchange). These clearinghouses handle both sides of the transactions, acting as the middlemen for both buyers and sellers of futures contracts. To eliminate the counterparty risk, the clearinghouses exercise marked-to-market practices, that is, to mark individual transactions to market on a daily basis, which then requires transfer of value from one individual to another individual in a zero-sum game. In other words, as the spot rate of that currency changes daily, the profit/loss is recognized and is posted to an individual account by the clearinghouse. These daily profits or losses are then added (or subtracted) to the contract holder's margin account. There are two kinds of players in the futures markets, hedgers and speculators. Hedgers open a position to protect themselves against adverse changes in the underlying asset price that may negatively impact on their business. Speculators, on the other hand, accept these price risks that hedgers wish to avoid. In order to trade a futures contract, there has to be two parties opening the exact opposing positions with their resulting contracts registered with the Clearing House. (For more information on the mechanism of futures markets, please refer to Appendix A6.2. Futures contract holders do not pay or receive the full value of the contract when it is first established. Indeed, contract holders only pay a small initial margin, and over the life of the contract, buyers/sellers (of the contract) will either pay or receive variation margins as the price of the futures contract varies. The profit or loss on the futures contract is determined by the difference between the price of the opening position and the price at which the position is closed. As futures contracts are legal contracts that obligate the contract holder to deliver at a specified time and price, contracts holders have to settle the positions at maturity regardless of the profit/loss status. However, as an alternative to settling the position at maturity, contract holders can close out the position prior to maturity. For instance, if the holder bought futures, then he/she can close out the position by selling futures with the same maturity date, and vice-versa. Such closing out activity will effectively cancel the opened positions.
First introduced in the early 1980s, swaps have grown to become one of the mainstream financial instruments in the world. In 2001, International Bureau of Statistics (IBS) conducted a survey which showed that swaps were the second most popular derivative amongst companies involved in hedging. Swaps are not exchange-traded derivatives. They are over-the-counter transactions; the main participants include major commercial and investment banks, which belong to the International Swaps and Derivatives Association (ISDA). This association has pioneered efforts in identifying and reducing risk associated with using swaps. Chartered in 1985, their work actually began in 1984 when a group of 18 swap dealers and their counsel started to develop standard terms of interest rate swaps. Today, the ISDA represents 725 member institutions from 50 countries on six continents. It is the largest global financial trade association, in terms of number of member firms. These member institutions range from the world's major institutions that deal in privately negotiated derivatives to end users that rely on over-the-counter derivatives to efficiently manage their exposure to financial risk. For further information regarding the role of ISDA, please refer to Appendix A6.4. Companies adopt swaps to manage their long-term exposure to currency and interest rate risk. Currency swaps can be negotiated for a wide range of maturities for up to ten years. If funds are more expensive in one country than another, a fee may be required to compensate for the interest differential. There are several types of swaps available in the swaps market. Currency swaps, interest rate swaps, and currency-interest rate swaps are amongst the most popular swap transactions. Other swaps include (but are not limited to) commodity swaps, equity swaps, bullion swaps, and total return swaps (ISDA, 2002). As the focus of this thesis is on the foreign exchange market, it is only logical for our following discussion to be on currency swaps.
Typical Example of Currency Swaps
A typical currency swap first requires two firms to borrow funds in the markets and currencies in which they are best known. For example, a Japanese firm would typically borrow yen on a regular basis in its home market. If the Japanese firms were exporting to the United States and earning U.S. dollars, however, it might wish to construct a natural hedge that would allow it to use the U.S. dollar earned to make regular debt service payments on U.S. dollar debt. If the Japanese firm is not well known in the U.S. financial markets, though, it may have no ready access to U.S. dollar debt. Thus, it could participate in a currency swap. The Japanese corporate could swap its yen-denominated debt service payments with another firm that has U.S. dollar debt service payments. The Japanese corporate would then have dollar debt service without actually borrowing U.S. dollar. The swap agreement can be arranged by professional swap dealer who will generally search out matching currency exposures, in terms of currency, amount, and timing. In other words, the swap dealer plays the role of middleman, providing a valuable currency management service for both firms.
One of the limitations of using swaps is that, just like the forward contracts, there is no organized secondary market for swaps transactions. There are however three alternatives for companies to exit a swaps contract. The first alternative is a voluntary termination with the original counterparty. This is a popular choice, as it is simple and implies only a lump-sum payment to reflect the changes in market conditions. A condition for this alternative is that it requires the consent of the other party. The second alternative is to write a mirror swap with the original Pay Dollars Japanese Corporate U.S. Corporate Swap Dealer Pay yen pay yen Pay Dollars a typical currency swap first requires two firms to borrow funds in the markets and currencies in which they are best known. For example, a Japanese firm would typically borrow yen on a regular basis in its home market. If the Japanese firms were exporting to the United States and earning U.S. dollars, however, it might wish to construct a natural hedge that would allow it to use the U.S. dollar earned to make regular debt service payments on U.S. dollar debt. If the Japanese firm is not well known in the U.S. financial markets, though, it may have no ready access to U.S. dollar debt. Thus, it could participate in a currency swap. The Japanese corporate could swap its yen-denominated debt service payments with another firm that has U.S. dollar debt service payments. The Japanese corporate would then have dollar debt service without actually borrowing U.S. dollar. The swap agreement can be arranged by professional swap dealer who will generally search out matching currency exposures, in terms of currency, amount, and timing. In other words, the swap dealer plays the role of middleman, providing a valuable currency management service for both firms. Counterparty, that is, to write an opposite (mirror) swap with the same maturity and amount but at a current condition. This alternative is different from the first alternative in that the settlement is paid over the remaining maturity of the swap instead of a lump-sum payment. Moreover, for the second alternative some credit risk tends to remain on the differential interest rate payment. The third alternative of exiting of a swap contract is to write a reverse swap in the market with a new counterparty. It is the easiest way amongst these three alternatives. However, it also had two main disadvantages. Firstly, it is difficult and expensive to find a new counterparty that can offset the exact amount of the previous swap contract; secondly, engaging in two swaps at the same time exposes the company to even more credit risk.
2.3.1 Money Markets:
Money markets refer to financial markets in which short-term funds are bought and sold. The maturity of these money market instruments normally are less than twelve months. There are two major money markets: the local money markets and the Eurocurrency markets. Each currency sector has its own interest rate pattern that is usually linked to the interest rates in its country of origin. For example, the Eurodollar interest rate tends to follow the interest rate movement in the United States. In this market, the commodities traded are mostly term-deposits with short-term maturities.
The trading of money market instruments requires international banks to operate an international money trading desk. In some cases, these trading desks are filled with dozens of dealers, each specialized in particular money market instruments, such as Treasury Bills, foreign currencies or Eurocurrencies. These trading desks are scattered around the globe. It is because of this wide distribution of trading desks that investors in the money markets have access to around-the-clock trading. The need for sophisticated computer and telecommunications hardware and software (required for effective handling of each dealing position) means that these dealing room operations generally represent substantial investments for banks and financial institutes. The money market and forward market are identical because interest rate parity holds. So hedging in the money market is like hedging in the forward market. A money market hedge also includes a contract and a source of funds to fulfill the contract. Those hedgers who use money market hedges borrow in one currency and convert the borrowing into another currency. We have included a discussion on the mechanism of hedging using the money market.
2.3.2 Leveraged Spot Market:
The leveraged spot contract is fundamentally the same as a spot contract. Indeed, the mechanism of trading a leveraged spot contract involves borrowing a certain amount of money from a country, say, Japan, for a specific period at a specific interest rate, then converting the amount of Japanese yen into another currency, say, the US dollar, at the existing spot rate and investing the US dollar in the American money market at the US interest rate, and finally converting the US dollar back to Japanese yen to repay the Japanese yen borrowing. The only difference between the leveraged spot contract and a spot contract is the leverage ratio available in all leveraged spot contracts. The leverage ratio can range from twenty (1:20) to two hundred (1:200), and is specified by the trading financial institutions. This leverage ratio is a powerful feature of the leveraged spot contracts. Indeed, if the leverage ratio is twenty (1:20), this means that the leveraged spot contract trader will have access to a credit line twenty times larger than his/her initial collateral. It is obvious that this distinct feature of the leveraged spot contracts will allow traders to trade at a significantly lower capital requirement when compared to the spot market. In the following chapters, we will illustrate in further detail regarding the mechanism of leveraged spot market and how the leveraged spot contract can be utilized as an effective speculative and hedging financial instrument.
2.3.3 Determinants of Derivative Selection:
A survey based on four hundred and sixty nine (469) Japanese firms found that the industry in which a company operates can influence their attitude and usage of financial derivatives. For example, the use of derivatives is most prevalent among firms in the following industries:
- Other metals
- Diversified resources
- Alcohol and tobacco
Where as firms operating in the telecommunication industry are seemingly less attracted to using financial derivatives, with less than 50% of the sample telecommunication firms reporting derivative usage.
Frequency of Use of Derivative Instruments by Size and Industry
Frequency of use of derivative instruments by 372 large US firms for fiscal year-end 1991 that have foreign exchange rate exposure as of fiscal year-end 1990. Companies are among the 500 largest firms (by sales) in the Fortune 500. A firm has foreign exchange rate exposure if it has nonzero foreign pretax income, positive foreign sales or debt, or is in the upper quartile of the sample firms on the basis of imports as a percentage of total industry sales. Currency Derivatives include currency swaps and foreign exchange forwards, futures, and options. Any Derivatives include interest rate, commodity, and currency derivatives. All data on derivatives use are from annual reports and 10-K disclosures. The 1st quartile for firm size includes the smallest firms based on 1990 sales; the 4th quartile includes the largest firms.
Research also found that the nationality of the company can influence attitudes toward financial derivatives. In fact, varying economic circumstances, taxation systems, derivative usage reporting systems, as well as other legal and legislation systems can affect the choice of derivatives adopted by companies. For instance, when compared to the US firms, the New Zealand and German firms are more likely to adopt foreign currency hedges. This is because both New Zealand and Germany are relatively smaller open economies compared to the United States, leading to greater exposure of the New Zealand and German firms to financial price risk. Moreover, US companies generally enjoy a much larger single-currency home market when compared to companies from other countries; therefore, US companies typically face less exposure, which can further reduce their motivation for hedging. There are also identified three other factors that tend to influence the company's derivative selection:
- Leverage level
- Liquidity level
- Company size (In terms of financial distress and setup costs and foreign exchange turnover).
According to the observations, currency derivatives are more likely to be used by large companies that have more debt within their capital structure; whereas interest rate derivatives are more likely used by large companies that are more levered, more liquid and pay higher dividends. Furthermore, currency derivatives are more likely to be utilized by smaller-sized companies that pay higher dividends and have more debt. There is also found that the high fixed cost of a hedging program can make derivative usage uneconomic for smaller-sized companies, in turns discouraging their usage of derivative. In terms of financial instruments selection, a survey on derivative usage and financial risk management in New Zealand found that currency forward is the most popular derivative for hedgers. Figure 2.7 shows that a similar preference for over-the-counter (OTC) forward contracts is also found amongst US and German firms. The popularity of forward contracts and swaps is definitely also shared among Australian businesses. Indeed, Reserve Bank of Australia reported in 2002 that Australian international businesses predominantly utilize forward foreign exchange contracts to manage their foreign currency exposure with the second most used derivative contracts being cross-currency interest rate swaps. Data gathered from the International Bureau of Statistics (IBS) revealed that in 2005 the total principal value of outstanding bought derivative contracts (of both forward and cross currency interest rate swaps) was $1080 billion; whereas the total principal value of outstanding sold derivative contract was $950.9 billions.
Preference among FX Derivative Instruments
2.3.4 Financial Models:
Much literature have been written on financial models, with the most commonly available discussions surrounding models such as Black-Scholes, Black, Merton, Cox-Ross-Rubinstein (commonly known as the Binomial Model) and Garman-Kohl Hagen (Black and Scholes, 1973; Merton, 1973; Cox and Ross, 1976; Cox, Ross and Rubinstein, 1979; Garman and Kohl Hagen, 1983). Others had either derived models as extension of those classic models, for example the Ekvall et al. (1997) model is a revision of the Garman-Kohl Hagen currency option pricing model, or proposed their own models based on studies and research conducted on corporate hedging strategies, such as Brown and Toft. The following section will point out differences, in terms of application and intention, between these models and our model. The Black-Scholes model, which was first proposed by Fischer Black and Myron Scholes in 1973, is considered to be a revolutionary step in option pricing theory originally formulated in the early 1900s. The fundamental principal behind the Black-Scholes model is that 'if options are correctly priced in the market, it should not be possible to make profits by creating portfolios of long and short positions in options and their underlying stocks'. In their original paper, Black and Scholes claimed that their model is applicable to valuation of common stock, corporate bonds and warrants. However, in practice, this model is commonly recognized as an analytic solution to pricing the European options. As the marketplace evolved, many researchers attempted to derive financial models capable of enabling corporations in making better hedging decisions. However, studies have revealed certain feelings of disenchantment among currency traders with the performance of these models. This may be due to the fact that majority of the existing models (especially those classical models mentioned above) had been derived based on the original Black-Scholes Option Pricing Model; being descendents, these models also inherited many traits and flaws of the Black-Scholes model. For instance, the Black, the Binomial, and the Garman-Kohl Hagen models all suffer the same weakness as the Black-Scholes, where they all assume that the volatility and interest rate will remain constant during the option's lifetime. This assumption is decidedly unrealistic and has resulted in the under pricing of many options. Moreover, like the Black-Scholes model, the Garman-Kohl Hagen model also assumes that transaction cost and taxes are zero. These assumptions are also far from being realistic as taxes are an implied part of our daily life, and transaction costs are unavoidable in most, if not all, transactions. Moreover, amongst those models mentioned above, the Garman-Kohl Hagen model is the only one designed to be applicable in the foreign exchange market, while the others are focused on the share markets. It is also interesting to note that all models mentioned above are option pricing models; in this implies, they were all developed to enable hedgers to make judgments on "when to hedge", but not "how to hedge optimally". According to these models, mathematical formulae can assist corporations or traders in valuing the prices of any commodity options (or currency options in the case of the Garman-Kohl Hagen model), in turn ruling out any arbitrage opportunities. In simpler terms, these option pricing models enable hedgers to calculate the theoretical 'fair value on an option to get an indication of whether the current market price is higher or lower than fair value', this in turn, allows hedgers to make judgment on trading of the particular options contract. This is a major difference between these classical models and our model, as our model is intended to assist companies and individuals to deal with the "how to hedge" facet of hedging, but not "when to hedge". Our model will be designed and developed specifically for the trading of foreign currency using leveraged spot markets. We also aimed to develop a more realistic model for currency traders (both speculators and hedgers); by taking into account currency volatility among other things.
2.3.5 Exchange Rate Volatility:
Since most of the countries adopted the free-floating currency system in 1983, countless researches, to better understand the volatility of the exchange rate movement against other currencies and its effects on international businesses. Companies which trade internationally would almost inevitably expose themselves to changes in value of currencies. More specifically, these companies are more likely to face large fluctuations on their annual profit statement. The effects of these currency exposures will be most apparent if the company is operating without a proper currency risk management mechanism such as proper a hedging strategy. Note that the currency risk exposure applies to importers and exporters, as well as companies with foreign subsidiaries because their headquarters will, at some point of time, exchange cash flow or funds in foreign currency with their foreign subsidiary. International businesses are exposed to currency risk because of exchange rate volatility. In fact, the higher exchange rate volatility, the higher currency risk for companies. In order to manage the currency risk, it is important that companies understand the underlying economic and financial fundamentals. As we mentioned earlier, these issues are peripheral to the main theme of this thesis, however, they do need to be addressed. Therefore, in the following section, we will commence with a brief background of the economic and other fundamentals that determine the value of the currency as well as the risk to it is exposed to in the international market.
2.4 pricing derivatives:
2.4.1 Financial Derivatives Markets:
With the ever increasing total notional value of derivative contracts outstanding worldwide, it is little wonder that there has been continuous interest in unlocking the "mystery" of hedging using financial derivatives. Studies have shown that in 1994, the total value of hedging was USD 18 trillion. This is more than the combined total value of shares listed on the New York Stock Exchange and the Tokyo Stock Exchange. The amount exceeded USD 55 trillion in 1996, and in 1998, the figure had already reached USD 70 trillion, which is almost four times more than in 1994. Moreover, according to Bureau of Information Statistics (2005), from 1995 to 1998, spot foreign exchange transactions increased by 15%, reaching a total of USD 600 billion-a day, while over-the-counter currency options doubled to a total outstanding daily value of USD 141 billion. According to the Central Bank Survey 2004, the average daily turnover in foreign exchange derivatives contracts rose to $1,292 billion in April 2004 compared to only $853 billion in April 2001 (BIS, 2005). Table 2.1 shows that outright forward and foreign exchange swaps hold the record as the most popular derivatives traded over the counter. As such figures continue to climb strongly, it is important to understand the mechanism of the foreign exchange derivatives markets, including what motivates companies to enter the market, and how corporations utilize the market as a hedging mechanism. According to an author Robert W. Kolb, "a derivative is a financial instrument based upon another more elementary financial instrument. The value of the financial derivative depends upon, or derives from the more basic instrument. The base instrument is usually an underlying asset, as cash market financial instrument, such as a bond or a share of stock". The underlying instrument can also be based on movements of financial markets, interest rates, the market index, commodities, or a combination of these assets. For example, consider the derivative value of oil, which indicates that the price of an oil futures contract would be derived from the market price of oil, reflecting supply and demand for the commodity. In fact, as oil prices rise, so does the associated futures contract. It is noted that in order for the derivative market to be operational, the underlying asset prices have to be sufficiently volatile. This is because derivatives are risk management tools. Hence, if there is no risk in the market, there would be no need for the existence of any risk management tool. In other words, without manageable risk, the use of derivatives would be meaningless. Derivatives commonly used as hedging instruments include the foundational form of:
- forward contracts
- futures contracts
- options contracts,
- Swaps, which involve a combination of forward and spot contracts or two forward contracts.
However, with the rapidly changing business environment, many hedgers have also given increasing attention to other more sophisticated and "exotic" derivatives which evolved from these basic contracts and often consist of a combined use of two or more foundational contracts, such as Options Futures.
The 2004 survey is the sixth global survey since April 1989 of foreign exchange market activity and the fourth survey since March/April 1995 covering also the over-the-counter (OTC) derivatives market activity. The survey includes information on global foreign exchange market turnover and the final statistics on OTC derivatives market turnover and amounts outstanding.
2.4.2 Types of Players in Derivatives Markets:
There are three categories of players in a functioning derivatives market:
While each of these players use the market with varying intention, their combined and balanced influence ensure the market liquidity and volatility that allows the derivatives market to operate. It is easy yet important to differentiate the varying motives of these players. In terms of their level of risk aversion, arbitrageurs are by definition highly risk intolerant (risk averse individuals) who only trade in risk-free transactions; whereas speculators are on the other side of the spectrum (risk-seeking individuals), as they make profit by taking risk; hedgers are risk neutral individuals, as they choose their strategies by ranking the expected value of any given strategy. Based on their varying attitude towards risk these players tend to engage in the derivatives market with very different transaction patterns. More specifically, an arbitrageur who seeks risk-free profits will simultaneously take up a position in two or more markets, for instance, simultaneously buy spot and sell forward the INR, in an attempt to exploit mis-pricings due to a market that is not in equilibrium. However, such price differentials are almost non-existent in a well-functioning market, mainly because supply and demand tends to rapidly restore market equilibrium. As opposed to the arbitrageur, a speculator seeks profit by taking risk. For example, speculators who anticipate an appreciating INR will put their "bets" on the rising INR. They can do so by buying the INR at a lower value, and then selling it when the value is higher should the prediction come true. A hedger enters derivatives markets mainly with intention to insure against price volatility beyond their control. Based on this intention, it is not surprising that hedgers are mostly acting on behalf of corporations. The mechanism of hedging mainly transfers risk to others who are willing to accept the risk. Indeed, the risk is never nullified but merely transferred from one party to another. In most cases, speculators are those who absorb the risks transferred by hedgers. It is perhaps due to these notions that some have referred to the derivatives market as the 'zero-sum game market, where the gain of one party is exactly equal to loss of another party'. Over the last decades, the foreign exchange markets have experienced explosive growth. Indeed, according to the Central Bank Survey 2004, the average daily turnover in traditional foreign exchange markets rose to $US 1,880 billion in April 2004 compared to $US 1,200 billion in April 2001.
2.4.3 Exchange Rate Determination, Dynamics and Responses:
Researchers have been attempting to model and explain the volatility of the currency for example say Australian dollar (AUD). For example, Simpson and Evans attempted to verify the importance of the relationship between the nominal Australia/US exchange rate and an index of commodity prices. Here it would have been concluded that the countries which are rich in commodity say Australia is a commodity rich country; therefore, movements in commodity prices are reflected the volatility of the exchange rate. It would have been also concluded that the study found evidence that commodity price changes can lead to movements in the Australian dollar versus US dollar exchange rate. An earlier study by investigated the effects of the status of the current account on the currency and interest rates. The study by claiming that before the easing of monetary policy, 'interest rate may not have been allowed to rise in response to a larger deficit announcement, and so the effects of the current account news on exchange rates and interest rates were insignificant'. The Trade Weighted Index of the countries used at the central bank of the respective country there is one aspect of the currency which differentiates it from other floating currencies is 'the observed strong relationship between the value of the currency and the terms of trade, particularly over longer time horizons'. Having identified some of the previous research done in an attempt to model and explain the volatility of the currency, we now continue to examine the following factors that are important in analyzing the volatility in the movement of the exchange rate:
- Parity relationships
- Flow of balance of payment model
- Portfolio balance model
- Covered interest arbitrage
2.4.4 Parity Relationships:
The parity condition in international finance attempts to establish relationships that explain inflation, exchange rates and interest rate movements. As Figure 2.8 shows, there are four parity relationships, including the following:
- Interest rate parity (IRP)
- International Fisher effect
- The Fisher effect
- The purchasing power parity (PPP)
These form the basis for a simple model of the international monetary environment. A brief discussion on these four parity relationship is provided in the following figure.
Parity Relationships Model
2.4.5 Balance of Payments (BOP) Flow Model:
The balance of international payments presents a summarized accounting statement of international economic transactions between the reporting country and the rest of the world during a given time period. If a nation sends more currency abroad than it receives, it will have a deficit in its balance of payments, and vice versa. There are three major components of balance of payment:
- The first component is the current account that records imports, exports and income flows
- The second component is the capital account that records financial flows that involve:
- Banking transactions
- Transactions by foreigners in Australian securities such as shares or government bonds
- Overseas borrowing by Australian companies
3. The third component is official settlement (reserves) account, which measures changes in the so-called balancing items, as well as holdings of gold and foreign currencies (reserve assets) by the nation's official monetary institutions.
The balance of payments flow model basically presents the importance of capital inflows and outflows in foreign exchange markets. It reflects the sensitivity of the value of the currency with respect to interest rate differentials, financial deregulation, or terms of trade, etc. We can also say that the balance of payment model represents the capital inflow and outflow with regard to government policies, financial deregulation and changes in economic fundamentals. These in turn determine the currency exchange rate from a national perspective. There are broader implications within the balance of payment flow model. For instance, current account deficits triggered hot debates due to public concerns. Research found that unexpected current account deficit news leads to exchange rate depreciation as well as increases interest rates. Therefore, as a policy decision, the effects of raising interest rates tend to be considered irrespective of whether it was consistent with monetary policy.
2.4.6 Portfolio Balance Model (PBM):
The portfolio balance model suggests that the exchange rate is the relative price of bonds denominated in different currencies. In other words, the exchange rate can be determined by the supply and demand of financial assets that are denominated in different currencies. Under the portfolio balance model, these assets should include not only domestic and foreign currency and bonds, but also equities and other securities. This is different from other model, as most models restrict the term "asset" to include only domestic and foreign currency and bonds. Due to the behavior of the portfolio balance model, there may be a positive relationship between exchange rate changes and interest rate differentials across countries. For instance, the capital movement from country to country in seeking the highest return on investment (ROI) is actually seen as a large source of foreign exchange transactions. The portfolio balance model also includes people's expectations of those economic fundamentals across countries. Note that this model is based on maximizing the return on investment in those assets that mostly account for bonds, and domestic and foreign currencies. The portfolio balance model assumes imperfect substitutability and attributes changes in exchange rates to a change in the relative supplies of money and bonds at home and overseas.
2.4.7 Covered Interest Arbitrage (CIA):
With the constantly changing supply and demand, the spot and forward currency markets are not always in a state of equilibrium. When the markets are imbalanced, the potential for "risk-free" or arbitrage profit exists. Arbitrageurs that recognize the disequilibrium will take advantage of such imbalance by investing in whichever currency that offers the higher return on a covered basis. This mechanism is known as the covered interest arbitrage (CIA), or the covered interest rate parity. The potential of covered interest arbitrage would be subject to the following:
- The status of equilibrium or in-equilibrium of international money markets; in other words, it relies on the conditions of IRP
- Transaction cost
In practice, this would be the main problem of covered interest arbitrage. Indeed, there are many opportunities of covered interest arbitrage for speculators within one minute travel time from international money markets. However, transaction cost has become a major technical barrier of covered interest arbitrage for speculators.
2.4.8 Government Policies:
The Government played an important role to stabilize the currency of that respective nation. For example since the countries like Australia adopted a free-floating exchange rate, the central Bank of Australia has devoted considerable effort into not only understanding the movement of the Australian dollar, but also applying that relevant knowledge to its intervention and impact on the value of the Australian dollar. Indeed, according to the Reserve Bank of Australia, it can intervene in the foreign exchange market, using either direct or indirect intervention, to influence the Australian dollar exchange rate for the following reasons:
- To reverse an apparent overshoot, in either direction, in the exchange rate;
- To calm markets threatening to become disorderly
- To give monetary policy greater room for maneuver
According to the International Monetary Fund, the Reserve Bank of Australia also tended to intervene when the central bank wanted to maintain an inventory of net foreign currency assets; that is, reserve building can also motivate the Reserve Bank of Australia to intervene in currency markets.
2.5 Research Gap:
2.5.1 Derivative Instruments in India:
Authorized Dealers (ADs) (Category-I) are permitted to issue forward contracts to persons resident in India with crystallized foreign currency/foreign interest rate exposure and based on past performance/actual import-export turnover, as permitted by the Reserve Bank and to persons resident outside India with genuine currency exposure to the rupee, as permitted by the Reserve Bank. The residents in India generally hedge crystallized foreign currency/ foreign interest rate exposure or transform exposure from one currency to another permitted currency. Residents outside India enter into such contracts to hedge or transform permitted foreign currency exposure to the rupee, as permitted by the Reserve Bank.
2.5.2 Stock market Rupee Swap:
A person resident in India who has a long-term foreign currency or rupee liability is permitted to enter into such a swap transaction with ADs (Category-I) to hedge or transform exposure in foreign currency/foreign interest rate to rupee/rupee interest rate.
2.5.3 Foreign Currency Rupee Options:
ADs (Category-I) approved by the Reserve Bank and ADs (Category-I) who are not market makers are allowed to sell foreign currency rupee options to their customers on a back-to-back basis, provided they have a capital to risk-weighted assets ratio (CRAR) of 9 per cent or above. These options are used by customers who have genuine foreign currency exposures, as permitted by the Reserve Bank and by ADs (Category-I) for the purpose of hedging trading books and balance sheet exposures.
2.5.4 Cross-Currency Options:
ADs (Category-I) are permitted to issue cross-currency options to a person resident in India with crystallized foreign currency exposure, as permitted by the Reserve Bank. The clients use this instrument to hedge or transform foreign currency exposure arising out of current account transactions. ADs use this instrument to cover the risks arising out of market-making in foreign currency rupee options as well as cross currency options, as permitted by the Reserve Bank.
2.5.5 Cross-Currency Swaps:
Entities with borrowings in foreign currency under external commercial borrowing (ECB) are permitted to use cross currency swaps for transformation of and/or hedging foreign currency and interest rate risks. Use of this product in a structured product not conforming to the specific purposes is not permitted.
Hedging is a preventive strategy used by individual investors or companies to protect their portfolio from adverse currency, interest rate, or price movements and is aimed specifically at reducing any uncertainty in the market. The hedge ratio is explained as the percentage of the position in an asset that is hedged using derivatives. Some see hedgers as risk averse individuals. However, we see hedgers as risk neutral individuals as they choose their hedging strategy based on the expected value (return) of any given strategy. To better justify our view of hedgers being risk neutral individuals, we need to further address risk aversion.
Risk aversion, also known as attitude towards risk, refers to our tolerance for risk and normally affects the way we make our decisions under uncertainty. An author Aliprantis characterized an individual's risk taking tendency by the nature of their utility function u: [0, 8) ? R, and the utility generated by wealth w is written as u (w). The utility function over wealth, u (w), is intrinsic to the individual and represents the individual's preferences over different levels of wealth. If the utility function is linear in wealth, that is, u (w) = aw + b, then, we say the individual is risk neutral. If the utility function is strictly concave, then the individual is risk averse. If the utility function is strictly convex, then the individual is risk seeking. Hedging involves taking an opposite position in a derivative in an attempt to offset or balance any gains or losses of the initial portfolio. The ideal result for a hedge would be to cause a "seesaw effect" where one effect will cancel out another.
"For example, assume a transportation company for which oil is one of the main inputs (costs). With the current volatile oil price, the company believes the oil price may increase substantially in the near future. This may severely affect their operation cost and reduce any potential profit. In order to protect itself from this uncertainty, the company could enter into a six-month futures contract in oil. By doing this, if oil price increases by 10%, the futures contract will lock in a price with profit that will offset the loss which the company experiences in their daily business operations. Note that by hedging, the company is not only protected from any losses (if the oil price increase by 10%), but also restricted from any gains (if the oil price falls by 10%)".
In general, there are two main categories of hedging, interest rate hedge and currency movement hedge. Investors or companies can use an interest rate hedge when they are involved in substantial borrowings. An interest rate hedge allows hedgers to minimize the cost of borrowing through transferring risks of any expected, unfavorable interest rate movements. Currency movement hedge, on the other hand, is used by international companies or investors that hold an international portfolio. A currency movement hedge allows hedgers to manage and minimize their exposure to any adverse exchange rate movement. Note that it is only the currency movement hedge that will be the focus of this thesis. We aim to develop a new hedging method that will assist any investor or international company to manage and minimize their exposure to adverse exchange rate movements.
International businesses are naturally exposed to currency risk. With the rapid integration of the global economy, many efforts have been directed to study those risks associated with exchange rate. Transaction risk and translation risk are the two most commonly discussed currency risks for international businesses.
Transaction risk can be defined as the impact of unexpected changes in the exchange rate on the cash flow arising from all contractual relationships. On the other hand, translation risk refers to the risks which arise from the translation of the value of an asset from a foreign currency to the domestic currency. Authors, such as Mannino and Milani, Hollein, and Homaifar, also defined translation risk as the change in book value of assets and liabilities, excluding stockholders' equity as residuals, due to changes in the foreign exchange rate. International companies that trade and receive revenue in foreign currencies would incur translation risk. The most common cases of companies experiencing translation risk are when overseas subsidiaries translate the subsidiaries' balance sheet and income statements into the functional currency of the parent companies for consolidation and reporting purposes as required by legislations. During this translation process, movement in the exchange rate can produce accounting gains or losses that are posted to the stockholders' equity.
2.5.7 Hedging and International Businesses:
Risk management is an important part of business operations. Its importance should never be underestimated, as it is part of all business life. The corporations must always be aware which risks they are taking and how to hedge from the unwanted risks. There are several types of risk involved in business, and of those, currency risk will be examined closely in this paper. The growth in the markets for derivative instruments has provided managers with more effective tools to manage the financial risks they face.
Hedging is an approach to risk management, which uses financial instruments to neutralize the systematic risk of price changes or cash flows. For several market participants, portfolio managers, bank managers, pension fund managers and corporate treasurers, hedging is an important tool, but they each have a different motivation for hedging. By reducing risk exposure, hedging allows companies to focus on their core business.
A few examples of risks that the different parties face: multinational corporations are exposed to the fluctuations of currency markets, which may significantly increase the volatility of their cash flows. Lenders are exposed to interest rate fluctuations, because changes in interest rates affect the demand for and value of loans. Portfolio managers may hedge to eliminate risks they are not willing to take, for example price risk or default risk. No matter what the motivation is, all hedgers face the challenge of selecting a hedge that provides the best protection while causing the least amount of expense.
Every market has its own characteristics that make the risk management a challenge. In some markets, hedging is a simple task that does not need much effort and monitoring, in others, hedging is a daily activity and requires continuous follow-up. Therefore, specific tools for effective hedging differ from market to market and finding the right solution is crucial.
The hedging process is closely related to the financial derivatives market. Forwards, futures, swaps and options are important tools in the process and these measures will be explained in this paper together with some natural hedging methods.
The financial world has experienced a rather long yet continuous evolution in global hedging mechanisms. In context of Australia as a part of Asian countries however, the importance of managing currency risks among Australian international businesses only surfaced in Australia after it adopted the floating currency system in 1983. Regarding the risk exposure to Australian international businesses, hedging can be a worthwhile practice because the Australian dollar is allowed to appreciate or depreciate freely against other currencies. This volatility affects all importers and exporters by exposing them to exchange rate risk. Consider the example of Australian manufacturing industry; indeed, according to the Bureau of Industry Economics in 1986, the Australian manufacturing industry reported an increase in the hedging of foreign currency risk during 1984-86 in response to the depreciating Australian dollar and the increased volatility of the Australian exchange rate movement against other currencies. Australian businesses are highly exposed to foreign currency risk as over 70% of Australian trade has been invoiced in foreign currencies. Figure 2.1 shows Australia's trade which has been invoiced in foreign currencies from 1998 to 2005, the main foreign currency exposure for Australian enterprises is to the US dollar. In fact, in a 2005 survey on hedging practices, the Australian Bureau of Statistics (ABS) showed that the US dollar constituted at least 50% of the private sector foreign currency exposure, with the Euro accounting for around 15%. Other currencies such as the British pound, Japanese yen, and Swiss franc played a noticeable but relatively smaller role when compared to the US dollar and the Euro.
Trade Invoice Currencies
There has been a significant increase in attention on practicing prudent corporate hedging programs after the recent high-profile derivatives trading disasters and corporate finance scandals.
2.5.8 Fundamental Philosophy behind Hedging:
We now proceed to address the fundamental philosophy behind hedging. The commonly accepted views on the facets of hedging fall into two general groups, firstly, as insurance for companies facing foreign exchange risk in any sense, and secondly as a value-enhancing tool for management that can secure a less volatile and well-managed corporate revenue. A very famous pair of authors Anac and Gozen claim that hedging is the basic function of any commodity market, such as the London Metal Exchange in England and the Australian Stock Exchange (ASX) in Australia. They also suggest that the fundamental idea behind hedging 'is to take it as a form of insurance against volatile market movements'.
For example, in support of this view, the main purpose for corporate hedging activities is to 'match assets with liabilities' and avoid losses that may be caused by uncovered exchange rate movements. It is based on the fundamental principal that hedging is not to be considered as a gambling or speculative activity for corporations. We found that many multinational corporations involved in hedging tend to include clauses or statements in their annual reports declaring that they do not use financial instruments/derivatives for trading or speculative purposes. However, despite their declarations and signs of supporting (on hedging as insurance for the company), throughout our research we have found examples where companies are involved in questionable hedging activities (See Appendix 3). It is indisputable that imprudent or speculative attitudes towards hedging can be potentially harmful instead of helpful to companies. These examples of bad hedging practices often come to light when the company involved got into irreversible financial damage, as witnessed in the case of Enron. The second group views that hedging as a value-enhancing tool for management. Several authors, including Nance, Smith and Smithson, have expressed their views on hedging as a value-enhancing exercise. According to these authors, the function of hedging is especially obvious when multinational companies are faced with taxes, financial distress, investment costs and agency costs. We have presented that authors embrace hedging as insurance, and hedging as a value-enhancing tool. We believe the common view of hedging can be summarized as follows.
- Hedging is one of the three most fundamental reasons for the existence of the financial market, alongside speculative and arbitrage activities.
- The hedging industry is evolving just like the rest of the business world. In fact, there is no definite set of tools or technique that can define hedging. As the world changes, new hedging mechanisms are derived; and as time passes, these mechanisms are refined and evolve into something new that can be better applied to the contemporary commercial marketplace.
- Hedging is not a way of making money, but to assist management in better managing corporate revenue through reducing the corporate exposure to volatility in the foreign currency markets.
- When used prudently, hedging can be effective insurance as well as a value-enhancing exercise for corporations. Effective hedging programs have been proven to allow corporations to minimize or transfer their foreign currency exposure. The diminished exposure to foreign currency fluctuations allows more stable and predictable cash-flows, notably in terms of revenue. As a result, firms are then capable of making more comprehensive financial plans, including more reliable estimations on tax, income after tax and dividends payable to shareholders. It is believed that a dividend payout is often of significant appeal to long-term, current or prospective shareholders.
Hedging Decision Tree
The following example illustrates the above Figure 2.2. Assume that Company A is an Indian MNC company that imports photocopy machines from Japan. The chief financial officer of Company A has just concluded a negotiation to purchase 100 photocopy machines from Company J, a Japanese photocopy manufacturer. The contract is for JPY10, 000,000 and is signed in March with payment due three months later in June. Since the account is payable in Japanese yen, Company A (the Indian company) is faced with a currency exposure problem. Company A would be very happy if the Rupee (INR) appreciated versus the Japanese yen. Concerns will rise if the Japanese yen becomes stronger against the INR. As the chief financial officer decides on the hedging strategy that can minimize the company's currency exposure, he/she typically faces three questions:
- when to hedge,
- what to hedge, and
- How to hedge.
The first question ("when to hedge") depends on the estimation of the future currency movements. For our example, if Company A expects the Japanese yen to become stronger against the INR at the end of June, then the company should prepare a hedging strategy that can minimize the currency exposure due to the expected adverse currency movements. Otherwise, if Company A expects the INR to appreciate against the Japanese yen, then there is no need for the company to hedge. In fact, Company A can benefit from the favorable currency movement by using less INR to pay off the Japanese yen account. The second question ("what to hedge") refers to the portfolio or account in which the company will hedge, including the amount and the currency to be hedged. For our example, the currency to be hedged is the Japanese yen. The decision on the amount to be hedged can be affected by the hedger's tolerance to risks. Depending on the chief financial officer's risk tolerance, he/she can decide to hedge 100% of the JPY10, 000,000, 50%, or 10%. In fact, technically, the hedge ratio can be any ratio between 0.1% and 99.9%. If the chief financial officer of Company A decided to not hedge their account, then the company is fully participating in the currency movement. If the decision is to hedge the account, then there are several alternatives available to Company A to manage this currency exposure. The company can hedge using financial tools and non-financial tools. Since our purpose in this thesis is to derive a contemporary hedging model using leveraged spot contracts, we focus our discussion on those hedging alternatives that use financial tools. The third question ("how to hedge") refers to the mechanism of hedging. It involves choosing from those currently available financial tools, such as forward, futures, options, swaps, money market, and leveraged spot contracts. Indeed, once Company A decides to hedge their account, a decision then will be made regarding which financial tool(s) will be used to best manage the currency exposure. The company can use a plain single financial tool or a combination of several. The value created by hedging strategies depends on the answers to the above questions. The following Figure 2.3 is a customized hedging decision tree for the example. As shown in the figure, if Company A chooses not to hedge, then the result will be fully dependant on market movement, the interaction between the INR and the Japanese yen. If Company A chooses to hedge, the value created by their strategies will depend on their hedge ratio as well as the financial tools they select. If the hedge ratio is less than 100%, the company will be faced with a portion of exposed hedge and a portion of covered hedge. For instance, if the hedge ratio is 50%, then the company will be faced with 50% uncovered and 50% covered hedge. The uncovered portion will be exposed to currency risk and fully dependant on the market movements. If the hedge ratio is 100%, then the company will be fully covered for any currency risk. Note that as we mentioned earlier in this chapter, by hedging (notably when hedging 100%), Company A is not only protected from losses caused by adverse currency movement, but is also denied any gains from favorable currency movement.
Customized Hedging Decision Tree
2.5.9 Hedging with Financial Derivatives:
The mechanism of hedging is actually accomplished through the utilization of financial derivative contracts, such as forward, futures, options, and money market instruments. Hence, it is important to understand that in order to formulate effective strategies, hedgers must not only be fully aware of the surrounding economics/business environment, but must also gain sufficient knowledge on each of those currently available financial instruments and the operating mechanism of the financial markets to be fully equipped to choose the most efficient tools that will best fit the company's profile. Based on this reasoning, we must discuss the background of financial derivatives markets and what are those non-financial instrument alternatives that firms can choose as risk minimizing tools. Further we discuss:
- what are those financial tools that are currently available;
- why do firms choose one derivative over another;
- what are the strengths and weaknesses of those currently available derivatives, especially when compared to the proposed Leveraged Spot technique;
- what are those commonly adopted financial models; and
- The limitations of these classical financial models .
2.5.10 Contemporary Financial Derivatives:
Financial derivatives, also known as financial instruments, tools or techniques, exist to serve three main groups of players:
Our research also identified forward, futures, options, money market instruments, and swaps as the key financial derivatives. Many authors, for example Hull, recognize the interest rate as one of the derivatives commonly used. However, since this thesis aims to derive a hedging mechanism specifically for assisting corporations to minimize their currency risk exposure, the discussion on contemporary financial derivatives will not concern interest rates. The above mentioned key financial derivatives are sometimes referred to as the plain vanilla contracts. As the commercial trading market continues to evolve, many "exotic" contracts are being derived from these plain vanilla contracts. These exotic contracts normally refer to the combined use of two or more financial instruments. The use of these "exotic" contracts have increased; nevertheless, many authors in the financial field still acknowledge forward contracts as the most extensively used empirical hedging instrument. Forward contracts are undeniably the most commonly used hedging instrument. In 1992, forward contracts accounted for 47% of the total derivative trading in London. This is significant especially if we compare it to the mere 3% of total trading of futures and options contracts in the same year. In a 2002 study of 469 Indian companies also found a significant distribution difference between the usage of forward and other financial derivatives as hedging instruments. The findings showed that out of the 469 Indian companies, 264 companies reportedly used forward/futures contracts as hedging instruments. They also showed that 263 companies adopted swaps and 127 companies utilized options contracts as hedging instruments. In other words, from the 469 Indian companies reportedly using financial derivatives as hedging instruments, almost 76% claimed that they used forward/futures contracts, about 75% used swaps and only 36% utilized options contracts. The findings of this research have been summarized in the following Table 2.3. Similar findings from ABS (2005) and BIS (2005) are shown in Figures 2.4 and 2.5. Our research found that many authors documented the functions of these financial instruments in assisting hedgers to reduce risk as well as supplementing profits generated by traditional banking activities. Indeed, financial derivatives allow hedgers to "lock in" exchange rates, for instance, using a forward contract to lock in a specified exchange rate for a specified amount of currency to be delivered by a specified date. Hence, for these financial derivatives to perform their function, it is important that hedgers have the sound judgment and knowledge on the surrounding environment (such as expected future currency movements as well as the economic and financial circumstances), in order to accurately "lock in" the correct exchange rate direction. Otherwise, locking in the wrong exchange rate due to bad estimation on the currency movement can be fatal to any corporation. Furthermore, it is also vital for hedgers to understand the strengths and weaknesses of the selected financial tool(s), as their unique characters generate different responses to a given set of contract parameters (such as contract size, maturity, and transaction cost) and can either help amplify the benefits of hedging or expose the company to even more risk. The following section will discuss the most commonly used financial tools of financial derivatives traders.
2.5.11 Non-financial Tools Hedge (Natural Hedge):
It is perhaps due to these conflicting aspects of hedging that, despite its fundamental function of transferring hedgers' unwanted risks to those who are willing to absorb them, not all corporate treasurers are fond of using financial derivatives as risk management alternatives. Their reluctance is understandable especially in the wake of those failed hedging attempts (see Appendix A3). As an alternative to hedging using financial derivatives, some treasurers choose to tighten up receivable policies, that is, limiting the outstanding period to an average of 30 days. According to the Chief Financial Officer of National Semiconductor Corporation, this method has been useful in minimizing the company's vulnerability to currency fluctuations. However, during the uncovered period, the company is still exposed to currency fluctuations. Therefore, we believe that such methods, even if executed very efficiently, can only partially offset the company's currency exposure. A survey had been done based on multinational corporations of US have reported that multinational corporations (MNCs) in the United States generally use foreign-denominated debt as their alternative to hedging with financial derivatives. The MNCs also matched their foreign sales and foreign assets as an attempt to naturally minimize their companies' foreign currency risks. Another alternative to hedging using financial derivatives is to control the currency risk exposure by modifying the company's capital structure and maintaining a low level of debt. Nonetheless, this risk management alternative is claimed to rarely be used in reality, due mainly to the significant transaction costs. Despite the higher transaction costs, generally remained supportive of the use of the above mentioned natural hedging techniques. Indeed, they highlighted that the benefits of natural hedging is especially noticeable when future currency movements and the associated exposure to changing exchange rates are unknown. These methods are also particularly cost efficient when dealing with long-term exposure, mainly because most derivatives contracts tend to be limited by their contractual terms and amount. The limitations of common financial tools will be further discussed in subsequent sections.
220.127.116.11 Hedging Tools and Techniques:
We continue the discussion on hedging to cover:
- What are the financial tools currently available?
- Why do firms choose one instrument over another?
- What are the strengths and weaknesses of currently available derivatives, especially when compared to the proposed leveraged spot technique?
- What are the commonly adopted financial models?
- The limitations of these classical financial models
There are mainly five types of transactions in the foreign exchange derivatives markets, namely:
- Money (spot) market
However, most hedging transactions occur in the forward and swaps. In both their 2001 and 2005 study of Australian hedging practices, the Australian Bureau of Statistics (ABS) found that forward and swaps contracts continue to be the most popular hedging instruments for non-financial Australian companies. Similar surveys of non-financial companies across the United States, Germany, Switzerland, Sweden and Korea also found that forward contracts are the clear preference for these companies. The popularity of the forward contracts is perhaps due to their longer existence when compared to other derivatives. There was not any previous literature that had been written on leveraged spot contracts. This comes as a surprise, as leveraged spot contracts have been widely adopted in overseas markets, such as Hong Kong and China. I therefore believe that limited (if any) effort has been invested in exploring the leveraged spot market, let alone utilizing leveraged spot contracts to implement corporate hedging strategies. Non-financial companies refer to corporations and governments, whereas financial companies refer to financial institutions including commercial and investment banks, securities houses, mutual funds, pension funds, hedge funds, currency funds, money market funds, building societies, leasing companies, insurance companies, other financial subsidiaries of corporate firms and central banks. In the following sections, we will discuss all of these contemporary financial derivatives, including forward, futures, options, swaps and money market instruments, and introduce the mechanism of the leveraged spot market.
2.6 Research Question:
Analysis of Derivatives and the perception of investors"
Derivative securities have penetrated the Indian stock market and it emerged that investors are using these securities for different purposes, namely, risk management, profit enhancement, speculation and arbitrage. High net worth individuals and proprietary traders account for a large proportion of broker turnover. Interestingly, some retail participation was also witnessed despite the fact that these securities are considered largely beyond the reach of retail investors (because of complexity and relatively high initial investment). Based on the survey results, the authors identified some important policy issues such as the need to bring in more institutional participation to make the derivative market in India more efficient and to bring it in line with the best practices. Further, there is a need to popularize option instruments because they may prove to be a useful medium for enhancing retail participation in the derivative market.
Chapter 3: Research Methodology
The selection of the particular research approach depends on the kind of information required. Qualitative research collects, analyzes, and interprets data that cannot be meaningfully quantified, that is, summarized in the form of numbers. For this reason, qualitative research is sometimes referred to as soft research. "Quantitative Research" calls for very specific data, capable of suggesting a final course of action. A primary role of quantitative research is to test hunches or hypotheses. These suggest that qualitative approach is a soft research approach in which collected data cannot be meaningfully quantified and more importantly in this approach non-structured research is conducted. But so far as quantitative research approach is concerned, through this approach structured research is conducted with approaching larger respondents and the collected data can be meaningfully quantified. Research data can be collected either in the form of secondary or primary or both. Secondary Data usually factual information can be obtained through secondary data that has already been collected from other sources and is readily available from those sources. The definition and characteristics of secondary data presented above suggest us that secondary data are data that have already been collected for purpose other than the problem in hand. Before detailing as how and what secondary data were collected in this research, in would be worth to examine the advantages and disadvantages of such data.
Secondary data are easily accessible, relatively inexpensive, and quickly obtained. Some secondary data are available on topics where it would not be feasible for a firm to collect primary data. Although it is rare for secondary data to provide all the answers to a non-routine research problem, such data can be useful in a variety of ways. Primary data is collected for the specific purpose of addressing the problem at hand. The collection of primary data involves various steps. Thus obtaining primary data can be expensive and time consuming. These suggest that primary data are those data that are collected for the particular purpose of research in hand. The disadvantage of collecting primary data is that it is lengthy and resource and time consuming process, but the advantage of primary data is that they are first hand information and comparatively more reliable. A researcher originates primary data for the specific purpose of addressing the problem at hand. The collection of primary data involves all six steps of the marketing research process. Obtaining primary data can be expensive and time consuming.
3.2 Black scholes:
The term Black-Scholes refers to three closely related concepts:
- The Black-Scholes model is a mathematical model of the market for an equity, in which the equity's price is a stochastic process.
- The Black-Scholes PDE is a partial differential equation which (in the model) must be satisfied by the price of a derivative on the equity.
- The Black-Scholes formula is the result obtained by solving the Black-Scholes PDE for a European call option.
Fischer Black and Myron Scholes first articulated the Black-Scholes formula in their 1973 paper, "The Pricing of Options and Corporate Liabilities." The foundation for their research relied on work developed by scholars such as Jack L. Treynor, Paul Samuelson, A. James Boness, Sheen T. Kassouf, and Edward O. Thorp. The fundamental insight of Black-Scholes is that the option is implicitly priced if the stock is traded.
Robert C. Merton was the first to publish a paper expanding the mathematical understanding of the options pricing model and coined the term "Black-Scholes" options pricing model.
Merton and Scholes received the 1997 The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for this and related work. Though ineligible for the prize because of his death in 1995, Black was mentioned as a contributor by the Swedish academy.
3.3 Black-Scholes model:
The Black-Scholes model of the market for equity makes the following explicit assumptions:
- It is possible to borrow and lend cash at a known constant risk-free interest rate.
- The price follows a geometric Brownian motion with constant drift and volatility.
- There are no transaction costs.
- The stock does not pay a.
- All securities are perfectly divisible (i.e. it is possible to buy any fraction of a share).
- There are no restrictions on short selling.
From these ideal conditions in the market for an equity (and for an option on the equity), the authors show that "it is possible to create a hedged position, consisting of a long position in the stock and a short position in [calls on the same stock], whose value will not depend on the price of the stock."
S, the price of the stock (please note below).
V(S,t), the price of a derivative as a function of time and stock price.
C(S,t) the price of a European call and P(S,t) the price of a European put option.
K, the strike of the option.
r, the annualized risk-free interest rate, continuously compounded.
, the drift rate of S, annualized.
s, the volatility of the stock; this is the square root of the quadratic variation of the stock's log price process.
t a time in years; we generally use now = 0, expiry = T.
?, the value of a portfolio.
R, the accumulated profit or loss following a delta-hedging trading strategy.
N(x) denotes the standard normal cumulative distribution function,.
N'(x) denotes the standard normal probability density function,.
3.5 Black-Scholes PDE:
Simulated Geometric Brownian Motions with Parameters from Market Data
3.6 Scholes PDE:
With the assumptions of the Black-Scholes model, this partial differential equation holds whenever V is twice differentiable with respect to S and once with respect to t.
3.7 Other derivations of the PDE
Above we used the method of arbitrage-free pricing ("delta-hedging") to derive some PDE governing option prices given the Black-Scholes model. It is also possible to use a risk-neutrality argument. This latter method gives the price as the expectation of the option payoff under a particular probability measure, called the risk-neutral measure, which differs from the real world measure.
3.8 Black-Scholes formula:
Black-Scholes European Call Option Pricing Surface
For both, as above:
- N() is the standard normal cumulative distribution function
- T - t is time to maturity
- S is the spot price of the underlying
- K is the strike price
- r is the risk free rate (annual rate, expressed in terms of continuous compounding)
- s is the volatility in the log-returns of the underlying
N(d1) and N(d2) are the probabilities of the option expiring in-the-money under the equivalent exponential martingale probability measure (numraire = stock) and the equivalent martingale probability measure (numraire = risk free asset), respectively. The equivalent martingale probability measure is also called the risk neutral probability measure. Note that both of these are "probabilities" in a measure theoretic sense, and neither of these is the true probability of expiring in-the-money under the real probability measure.
3.11 Extensions of the model:
The above model can be extended to have non-constant (but deterministic) rates and volatilities. The model may also be used to value European options on instruments paying dividends. In this case, closed-form solutions are available if the dividend is a known proportion of the stock price. American options and options on stocks paying a known cash dividend (in the short term, more realistic than a proportional dividend) are more difficult to value, and a choice of solution techniques is available (for example lattices and grids).
3.12 Instruments paying continuous yield dividends:
Exactly the same formula is used to price options on foreign exchange rates, except that now q plays the role of the foreign risk-free interest rate and S is the spot exchange rate. This is the Garman-Kohlhagen model.
3.13 Instruments paying discrete proportional dividends:
Chapter 4: Questionnaire Analysis
Chapter 5: Recommendation and Conclusion
This find that forty percent of those firms that do not use derivatives indicate "concerns about perceptions of derivative use by investors, regulators and the public" as one of their three top reasons for not using derivatives. Investors have several sources of information about the direction and, in many cases, magnitude of actual outcomes. First, investors can easily learn of the direction of market rate movements during a period and, therefore, can determine if a company experienced a poor or good outcome. Assume a company uses a variable-to-fixed interest rate swap to convert variable-rate debt into de facto fixed-rate debt. They recommended that derivatives lowered their yearly fuel expense, and they document this good outcome by comparing actual fuel expense to what it would have been (i.e., a higher number) had they not used derivatives. Finally, investors can learn about outcomes from the unrealized gains and losses on derivative contractsinformation that is often explicitly disclosed in the financial reports. Although research suggests that investors perceive derivatives as riskier than non derivatives, it is unclear whether those results predict how investors judge derivatives once actual outcomes are known. Specifically, they draw on research about outcome effects, decision justification theory, and exceptionality to develop predictions about investors' satisfaction with management's derivative decisions and about investors' judgment of the regret that management experiences because of their derivative decisions. The firm, therefore, uses a short futures contract to protect itself from the risk of a price drop. If the price does drop, the firm experiences an economic gain as compared to the situation with no futures contract, because the futures contract locked the firm into selling the asset at the higher (contracted) price.
If outcomes determine how investors evaluate management's decisions, then management's decisions regarding derivative use will matter only insofar as they result in good or poor outcomes. In the asset sale example above, a price drop would represent a good outcome if the firm used a short futures contract but a poor outcome if the firm did not use such a contract. According to the outcome-effects perspective, investors will evaluate management positively in the former situation and negatively in the latter. Considering this theory in the context of derivatives, it is possible that investors will believe that decisions to use derivatives that address risk exposures are the output of a careful decision process. Using the earlier futures-contract example, the company's decision to enter into the futures contract suggests that management considered the potential repercussions of having versus not having the futures contract, implying that management used decision making care. Consequently, investors will perceive greater decision-making care and, thus, be more satisfied when management uses (versus does not use) derivatives to address the financial exposure. Similarly, investors will judge management to experience less regret when they use derivatives that address exposures. These reactions occur even if the actual outcome is the same for the derivative and non-derivative situations. Thus, in contrast to the outcome effects perspective, decision justification theory posits that the decision to use derivatives, as well as the outcomes of these decisions, will affect investors' judgments. Based on their research, one might expect that investors will judge less satisfaction and more regret when derivatives are used, particularly when the outcome is unfavorable. This expectation is consistent with predictions based on research in psychology indicating that when reacting to unfavorable outcomes, individuals tend to mentally undo, or mutate, the outcome by changing relatively exceptional events or conditions back to their normal states. Individuals tend to blame these exceptional items for the unfavorable outcome.
5.3 Future Scope:
Derivatives allow risk about the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available due to causes unspecified by the contract, like the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counterparty risk.
From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: The farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counterparty is the insurer (risk taker) for another type of risk.
Hedging also occurs when an individual or institution buys an asset (like a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and then can sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset.
That was all the boring stuff, but then also asked that what about the real tail events, the very unlikely but still more likely than most people would think, that is most people completely exclude: for the tails they have to be very opening minded and still they will get it wrong:
On the positive tail, they talked about finding completely new ways of hedging, new money system that changed their way of looking at derivatives, super computers that also resulted in super derivative models, that is complex models taking into account all types of market details... etc. etc. and let them not forget space-time finance far out on the upper tail in case they soon meet some intelligent Aliens
To the far left tail risk they mentioned derivatives again getting outlawed. This is not the first time it would happen, even if much less unlikely today. In particular because derivatives are so complex to understand for most people and in particular for politicians derivatives could even be blamed for destruction cased by potentially major crash in underlying markets.
Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low. Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. Speculative trading in derivatives gained a great deal of notoriety, when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and by regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution. Derivatives can be used by investors to speculate and to make a profit if the value of the underlying moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level). Alternatively, traders can use derivatives to hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out.
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