Essay Example on Derivatives, Financial Instruments

Derivatives can be defined as financial instruments, whose prices are influenced by the value of the underlying asset. The underlying asset may refer to the stock indices, oil, cotton, interest rates, exchange rate, stocks, bonds, gold, and other commodities. The derivatives are used to reduce the risk associated with the fluctuation of the price of the underlying asset or fluctuation of the prices of the derivative. Before investing in either of the derivatives financial instrument, it will be essential to understand how the price of the underlying asset fluctuates and the financial risks linked with each of the derivates. Moreover, it will be important to find out what other alternatives will be available to reduce the risk in question. It will be beneficial to take such precaution so that to reduce the risk related to the underlying asset price volatility effect. When considering this, it is important to note that not fluctuation of the prices of the underlying asset and derivatives differs. Some derivatives have large price fluctuation while other have small (Corb, 2012). On the same note, some small changes in the market may have significant adverse effect on a customers financial position.

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Most of the payment of the returns are made in future and sells or purchase of the derivatives is fully settled at the time of the transaction. In some cases, during the transactions, it is a requirement of the customer to provide a guarantee or collateral. On the same case, the customer will be required to increase the amount of collateral or guarantee due to changes in the market price. The financial institution has the obligation of terminating the derivative in a case whereby the customer does not increase collateral or guarantee due to adverse changes in the market prices. It is due to this reason that it would be important for a fund portfolio manager to have adequate knowledge about the derivative instruments nature, potential returns, principles, and risk associated with each instrument (Kolb, 2010). Each derivative has different potential returns and risks. Therefore, an experience of making an investment in one derivative does not guarantee knowledge of making an investment in other financial derivative instruments. Moreover, some derivatives are long-term while others are short term. In other words, the term of maturity differs in all the financial derivatives available.

This paper will assess the three instruments so that to identify and examine the benefits and the risk associated with each derivative. In other words, it will analyse the potential return and risk of each derivative. As a hedge fund portfolio manager, I recommend investing in three derivative financial instruments, which are forwards, options, and swaps. The company has set aside 1 million for investing in three derivatives. 40 percent of the of amount will be utilised to invest in forwards and 60 percent of the funds will be utilised to invest in swaps and options equally that it 30 percent each.

Potential returns

Forwards exchange contracts

Forward exchange rate contract is defined as an agreement between an entity and a financial institution, whereby the company agrees to buy currency at a specific foreign exchange price so that to hedge the risk associated with the fluctuation of exchange rates. Apart from hedging, a loss that may occur in future, the company may generate a gain from the speculated future prices. The gains gained by the investor depend on spot exchange rate and the interest rate of both currencies, which depend on the status of the economy of the two countries. In this case, investing in a forward exchange contract will lead to either a premium or a discount depending on the interest rate differential (Corb, 2012).

The main purpose of investing in the forward exchange contracts is because the company imports products from Europe and most of the products are paid on delivery. The company has a dollar account with Barclays bank, but products purchased in Euros. Therefore, it would be significant to invest in forward exchange contract so that to mitigate the risk associated with the appreciation of the dollar and Euro due to change in economic aggregates. The company wishes to import products worth $ 400,000 from Europe and the current Euro/USD is 1.3427. The products will be paid once they are delivered that is after 6 months. The company wishes to exchange the amount in the same exchange rate in future so it has entered into a forward exchange contract with Barclays Bank. In future, the exchange rate is expected to reduce to 1.39 and this means that the Euro will be strong than that dollar. Therefore, the company will need to add more cash so that to be able to purchase the same products. By entering into this contract, the company is in a position to hedge itself from the fluctuating foreign exchange rate. Therefore, the company will be avoiding the loss that will be incurred if the exchange rate increases due to a high interest rate of the Euro.

Options

An option is defined as a contract between a buyer and a seller, whereby the contract gives the buyer the right to hold an option, but not the obligation, to sell or buy the underlying financial instrument at a specific price and date depending on the nature of the option. The strike price of the instrument such as shares may be set using the market price or may be fixed at a discount or premium. There are two different forms of options, which are put option and call option. The call option conveys to the owner the right to purchase the security at a specific price while the put option conveys to the owner the right to sell the security at a specific price (Walmsley, 2000).

As a hedge fund manager, I recommend the company to purchase the call options when investing in stock market. It will be suitable to allocate 300,000 for investing in the stock market using the call options so that to generate income for the company. Moreover, it will be essential to hedge the risk associated with stocks since they fluctuate depending on the performance of a company and the economic status of a country. The IBM Corporation has been successful in its performance for the last five years compared to other international companies in the U.S. The change in its performance can be noticed due to the increase in its stock price for the last previous years. Currently, the stock market price of the company is trading at 150 and the stock price was trading at an average of 120 at the end of 2016. It would be beneficial for the company to invest in IBM stock since the company stock market price is expected to increase in future. The company will be investing $300,000 in purchasing IBM stocks using the call option contract. Currently, the stock is trading at $150 per share and it is expected to increase after a month to $155 per share. Currently, one call option contract goes for $2.00 per contract at a strike price of $150 per share. Therefore, the company will purchase 1970 shares and the cost of buying the shares will be $3940 (1970* $2). When the option expires, the IBM stock price is expected to be trading at $155 per share. Since the call option gives the buyer the right to purchase the shares at $150, the company will buy the shares at this specific price and sell the same shares in the open market at $ 155 per share when the contract expires. In this case, the company will be at an advantage since it will gain from investing in the call option. When the company sells the shares at $ 155 per shares, it will have a total sale of $ 305,350. Since the cost of buying each share is $2, the total return gained per share is $5 minus $2. Thus, the total gain is $3 per share and the total gain for a month will be $5,910 (1970*$3).

Interest Rate Swaps

An interest rate swap can be defined as a derivative financial instrument whereby two parties come to an agreement of exchanging interest rate cash flows based on the notional amount from a floating rate to a fixed interest rate. Similarly, the exchange can be from fixed exchange rate to floating exchange rate depending on the specified notional amount. The main purpose of investing in the interest rate swap is for hedging and speculative purpose. When making a swap, the parties agree to pay the other party either a fixed or a floating rate that it is dominated in a specific currency. The rate is multiplied by the notional principal amount and the accrual factor that is provided depending on the appropriate day count convention. In reality, the notional amount is never exchanged when both legs are in the same currency. In this case, the notional amount is used to calculate the amount of cash flows to be exchanged between the two parties (Corb, 2012). However, when the two legs are using different currencies, the notional amount is exchanged and this type of interest swap is referred to as a cross currency interest rate swap.

As a hedge fund portfolio manager, I would recommend investing in the plain vanilla interest rate swap derivative with World Bank whereby the company will receive a floating interest rate after swapping with a fixed interest rate. The settlement period is five years and the specified payment will be made annually. The London interbank offer rate will be used to determine the floating interest rate. The two terms used in the contract state that the company would pay World Bank an amount equal to 15% on the notional amount, which is $300,000. On the other hand, the company will receive payment from World Bank an amount equal to one year LIBOR plus 1 % annually of the notional amount. Therefore, at the beginning of the year company will pay 15 % * $300,000, which is equal to $45,000 and at the end of the year the company, will receive $51,000 from the World Bank. The floating rate at the end of the year is expected to increase from 15% to 16%. Therefore, the World Bank will pay 17% of the notional amount.

Potential losses

Interest rate swap

In an interest rate swap, it is not mandatory to reserve the total cash value of the transaction or the parties may not transact using the notional value and they only exchange the cash flow. However, in some cases the company, which is the customer, will be required to provide collateral or guarantee by the bank when making the transaction. Another disadvantage is that, when there is an adverse change in the market price, the company will be required to increase the guarantee, or collateral that was provided. If the company is not in a position to make the specified increment, the bank has the up hand since it has the right to terminate the contract before the due date and this will be termed as a loss to the company. It is termed as a loss if the transaction is terminated before the due date since the transaction is revaluated at the market rate (Paskov, 1995). When the company is the fixed-rate payer and there is a decrease in the interest rate, the transaction will have a negative value in most scenarios and the bank might as the company to cover the full amount of transaction after the termination. In other words, due to termination before the due date, the company will incur some losses and other additional expenses.

Options

Since the company will be willing to invest in buying a call option on IBM stock market, the call option might expire and the stock price becomes less than $152 per share. Even though the IBM stock is expected to increase, there may be a negative change in the stock price, which might be triggered by an economic down turn. In this case, the company will incur a loss investing in IBM since the cost of buying the call option is $2 and the cost of one share is $150. This means that the company will be breaking even at $152 per share and when the stock price reduces below $152, the company will be making a loss.

Forwards exchange con...