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Study On Derivatives And Their Different Types Finance Essay

Derivatives are based on the behaviour of the basic assets. Derivatives have a lot of purposes. It can be used to minimise risk. For that it is need to allow the investor to hedge an investment or exposure, and hence it should be act as a function as a sort of insurance policy against adverse market movements. It can also be used to get extra leverage for specialized market speculation. These are a type of contracts which can be used as underlying the assets. It is merely a contract between two parties and its value can be derived from the variations that have occurred in underlying the assets. Mostly the common underlying assts include stocks, bonds, commodities, currencies interest rates and market indexes. Commonly derivatives are characterised by high leverage. The ways to how to use derivatives are to hedge risks, to reflect a view on the future direction of the markets, to put a lock in an arbitrage profit, to change the nature of a liability and to change the nature of an investment without incurring the costs of selling one portfolio and buying another.

A derivative can also be regarded as a kind of asset, the ownership of which entitles the holder to receive from the seller a cash payment or possibly a series of cash payments at some point in the future, depending in some pre-specified way on the behaviour of the underlying assets over the relevant time interval. In some instances, instead of a ‘cash’ payment another asset might be delivered instead. In general an option is a derivative with a specified pay off function that can depend on the prices of one or more underlying assets. It will have specific dates when it can be exercised, that is, when the owner of the option can demand payment, based on the value of the pay off function. Derivatives are used for a variety of purposes. They can be used to reduce risk by allowing the investor to hedge an investment or exposure, and hence function as a sort of insurance policy against adverse market movements

Derivatives can also be used to gain extra leverage for specialized market speculation.

It is important to know the types of the derivatives which are used common and that are Forwards, Futures, Options and swaps. A forward contract is an agreement which is used to buy or sell an asset at a certain time in the future for a certain price that is called delivery price. It can be differentiated with a current agreement to buy or sell immediately.

Que 1 :

(1) what is swap ?

Types of swaps

There are five types of swaps and that are interest rate swaps , currency swaps, credit swaps, commodity swaps  and equity swaps. There are also many other types.

Interest rate swaps

It is an exchange of a fixed rate loan on to a floating rate loan. The life of this kind of swap can exceed from 2 years to 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa.

Currency swaps

It involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps also are motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

Commodity swaps

A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.

Equity Swap

An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do.

Credit default swaps

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer  pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure.

Other variations

There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures.

A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset.

An option on a swap is called a swap option. These provide one party with the right but not the obligation at a future time to enter into a swap.

A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement, a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap.

An Amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such as the LIBOR. It is suitable to those customers of banks who want to manage the interest rate risk involved in predicted funding requirement, or investment programs.

A Zero coupon swap is of use to those entities which have their liabilities denominated in floating rates but at the same time would like to conserve cash for operational purposes.

A Deferred rate swap is particularly attractive to those users of funds that need funds immediately but do not consider the current rates of interest very attractive and feel that the rates may fall in future.

An Accreting swap is used by banks which have agreed to lend increasing sums over time to its customers so that they may fund projects.

A Forward swap is an agreement created through the synthesis of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred to as a forward start swap, delayed start swap, and a deferred start swap.

Why use swaps to manage Duration Risk?

1. Many institutions such as federal agencies restricted or disallowed to trade in futures.

2. Swap costs are low.

3. Swaps can be tailored to meet needs where futures are more standardized.

Here , the GPL plc represents a very large portion of smith portfolio. Therefore the portfolio could be regarded as non-diversified and is exposed to very large level of specific risk. In order to reduce the specific risk elements in this portfolio entering into the swap has the consequence on effect of diversifying on smith portfolio. These will reduce its exposure through the performance of GPL stock with an equivalence of same exposure to the performance of the FTSE.

(2)

The strategy of hedging smith’s exposure to GPL could be either buy- sell strategy of the underlying securities or the use of swap. However, the swap is potentially more superior than the alternative strategy. Some of the reasons that could be suggested for these kind of view are

In order to avoid being taxed on the capital gains. The swap will reduce smith’s expose to GPL stock

The transaction cost of buying and selling of shares in the cash market will be avoided by using the swap strategy

The swap can be implemented quickly in the simple transactions, whereby avoiding any risk of being exposed to GPL’s performance during the transactional period of buying and selling.

(b) (1)

In view of the fact that GPL has out performed the FTSE 100 index, smith has to pay the difference .Therefore smith is exposed to personal liquidity and cash flow risk.

(2)

The broker has to pay and there is a high tendency that the broker could diffort. This is a counterparty risk

(3)

Smith is not hedged until it is able to enter into new swap . The possibilities of having the previous swap terms at a reasonable cost may elude in

Question : 2

(a) Calculate the outcome of each strategy if the CAC is equal to 3500, 4000, or 4500 at expiration of the contracts in June

Value of CAC at expiration

Initial portfolio (no futures or contracts)

Portfolio hedged with futures

Portfolio issued with puts 3900

Portfolio issued with puts 4000

3500

3,500,000

4,000,000

3,870,000

3,400,000

4000

4,000,000

4,000,000

3,970,000

3,900,000

4500

4,500,000

4,000,000

4,470,000

4,400,000

Working:

Value of CAC at expiration is 3500, 4000 and 4500.

Initial portfolio can be calculated by multiplying the amount into 100* 10

That is 3500*100*10 = 3,500,000

4000*100*10 = 4,000,000

4500*100*10 = 4,500,000

It is happened because the manager is buying 100 puts and options and futures have a multiple of € 10.

The portfolio is hedged with futures is 4000 and that is multiplied into 100*10 (same as above). This is because the futures on the CAC in June trade at 4000.

Portfolio issued with puts 3900

Here the strike price is 3900 and premium is 30 (€ per unit of index)

Ie, 3500- 30 = 3470*100*10= 3,470,000

4000-30 = 3970*100*10= 3,870,000

4500-30 = 4470 *100*10= 4,470,000

Portfolio issued with puts 4000

Here the strike price is 4000 and the premium is 100 (€ per unit of index)

Ie, 3500-100 = 3400*100*10= 3,400,000

4000-100 = 3900*100*10 = 3,900,000

4500-100 = 4400 *100*10= 4,400,000

(b) Recommend and justify a strategy to the portfolio manager

According to, above table, it is recommended that it is better to buy the 100 puts with a strike rate of 3900 or buy 100 puts with a strike of 4000. Here he can apply the strategy of hedging with futures. First of all, long term bilateral contracts are negotiated with the buyer and the seller. Such agreements have disadvantages. It can be say that, first, they used to expose each party to the risk that the other party may do and face failures in terms of the contract. Thus, while they cover up the companies from commodity price risk, they expose them to credit risk. Secondly, the lack of anonymity of the buyer and seller may strategic disadvantages. Finally the market value of the contract may not be easy to determine, that may making it difficult to track gains and losses. To avoid these disadvantages, as an alternative strategy hedge with futures can be used. A future contract is an agreement to trade an asset on some future date, at a price that is locked in today. Futures contracts are traded anonymously on an exchange at a publically observed market price. In this, both the buyer and seller can get out of the agreement by selling it to a third party at the current market price. These futures contracts are basically designed to eliminate the credit risk. It is determined by the market which is based on the supply and demand for each delivery date.

Protection against a drop in the market is provided by hedging with futures, however the manager is deprived of profit potential. Buying puts also provides protection in case of a drop in the market while it is still to keep most of the upside potential although the put premium is deducted from the portfolio value. Therefore the portfolio manager is advised to buy 100 puts with a strike price of 4000.

Question no: 3

The hedge fund would aim at ensuring that at end of the day the beta value of its portfolio is equal to zero. In order to achieve this goal it would meet to sell short –shares from list B, the proceeds of the actions would be used to buy shares from list A for an equal amount. The hedge funds could take long short positions for up to a sum of £ 50 million. Other strategies in the same way as this could be to borrow £25 m worth of shares in the list B and the sell them short. Use the sale profit to buy £25 m shares in list A. Deposit £9m as maintenance margin. This is 18% that the hedge fund is required as a deposit.

Hedging

Hedge fund

These are collective investments which has a purpose to make the money whether the market goes up or down or sideways. These types of funds can make money when the share prices are falling. It can be done by using some techniques that is by going long or short on a share.

How does the hedge fund works?

Whenever an investor goes short, it is believed that the equity will fall in value. There are two main ways that hedge funds can do this. The first is by shorting the stock, where the investor borrows a stock to sell it, with the hope it will decrease in value so they can buy it back at a lower price and keep the difference. However the hedge funds are not only limited to equities. They will invest in anything that makes them a profit, including foreign currency, bonds or commodities.

Abitrage pricing

Arbitrage is the key to understanding the mathematics of derivative pricing.

No arbitrage means that it is not possible to construct a strategy that on average

makes a profit higher than the risk free rate without taking some risks.

This also imples that is not possible to construct a strategy that requires no cash

input but has some positive probability of making profits without any risk of a loss.

No arbitrage also implies that given two strategies with the same initial position,

and guaranteed final positions, then these final positions must be equal. Otherwise,

by going long the strategy with the higher final value and short the other we would

generate an arbitrage. Similarly if two strategies have the same final value and involve

the same risk they need to have the same initial value.

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