Market Risk Management Through The Use Of Options

What is the role played by options, futures and forward contracts in managing market risks? The research critically analyzes this through the case study of Vodafone Group Plc. It first identifies the various factors that determine these risks since market risk includes different types of risks like commodity price risks, interest rate fluctuations risks and currency risks. Through the case study, it further aims to evaluate the effectiveness of using above derivatives, in managing market risks. By considering the portfolio of company designed to hedge a particular amount of risk; the research also aims to critically evaluate the individual contributions of each of the above in risk management and also of the portfolio as whole.

Introduction:

Oxford dictionary defines risk as “a situation involving exposure to danger� or “expose (someone or something valued) to danger, harm, or loss� (Oxford Dictionary). For a business entity “Risks� are connected to possible uncertainties that can result in negative effect on the entity. With the emergence of World Markets and various types of risks, risk management has become an integrated part of firms today. Different types of risks require different methods to handle, prevent or sometimes to absorb and benefit from risks. The downfall of risks has always been highlighted however they do have some arbitrage that results in potential gains.

The Basel Committee that was formed in 1974 laid the regulatory framework for Financial Risk Management. (McNeil, Frey and Embrechts, 2005). Basel II (2001) defines Financial Risk Management to be formed of 4 steps: “identification of risks into market, credit, operational and other risks; assessment of risks using data and risk model; monitoring and reporting of risk assessments on a timely basis and controlling these identified risks by senior management.�(Alexander, 2005). It thus determines the probability of a negative event taking place and its effects on the entity. Once identified risk can be treated in following manners:

Eliminated altogether by simple business practices. These are the risks that are detrimental to the business entity.

Transferred to other participants.

Actively managed at firm level. (Alexander, 1996).

The risks basically depend on the time value of assets. Moreover with the increased level of multinational functioning of business entities and the highly volatile nature of markets, risk management has now become a critical part of running the business. It therefore becomes essential to understand as well as analyze the various factors that determine risks and the preventive measures implemented against them. Also the hedging techniques being considered do not always ensure profits. The research would thereby include a detail study of the effectiveness of the methods implemented. One more important factor is the cost incurred. Risk management incurs certain costs and the process would therefore prove to be futile if the costs incurred don’t offer proportionally benefits.

Literature Review:

Market Risk constitutes of commodity risk, interest risk and currency risks. Commodity price risk includes the potential change in the price of a commodity. The rising or falling commodity prices affect the producers, traders and the end-users of the various commodities. Moreover if they are traded in foreign currency, there arises the risk of currency exchange rate. These are normally hedged by offering forward or future contracts at fixed rates. This is especially important for commodities like oil, natural gas, gold, electricity etc whose prices are highly volatile in nature. (Berk and Demarzo, 2010)

Interest Risk relates to the change in interest rates of bonds, stocks or loans. A rising rate of interest would effectively reduce the price of a bond. Increased interest rates result in increasing the borrowing costs of the firm and thereby reduce its profitability. It is hedged by swaps or by investing in short term securities.

Currency risks arise from the exceedingly volatile exchange rates between the currencies of different countries. For e.g. Airbus, an aircraft manufacturing company based in France requires oil for its production. Oil being traded in US dollars and the company doing trading in Euros, has a foreign exchange risk. It would be therefore beneficial for Airbus to enter a forward contract with its oil suppliers. Options are another way of hedging against currency risks. (Berk and Demarzo, 2010).

Forward contracts, Futures and Options are called the Financial Derivatives and are used largely to reduce market risks.

Walsh David (1995) explains that if two securities have same payoffs in future, they must have same price today. Thus the value of a derivative moves in the same way as that of underlying asset. This is called arbitrage.

Hedging of risks is nothing but the holder of an asset has two positions in opposite directions. One is of the derivative and opposite position is on the under-lying asset respectively. As such if the value if the asset decreases then value of the derivative will also decrease. But the change in value is off-set by the opposite positions to each other. Thus risk is reduced. This is called hedging. Long Hedge refers when an investor anticipates increase in market price and therefore buys future contracts. Short Hedge is when an investor already has a futures contract and expects the value of asset to fall and therefore sells it beforehand. (Dubofsky and Miller, 2003)

Long Hedge Short Hedge

Change in value of position

Change in price

Change in value of position

Change in price

Fig.1 Hedging (Dubofsky, D and Miller, T. Jr. 2003)

Forward Contracts- These involve buying or selling specific asset at a specific price at a specified time. It is basically a contract between two parties to trade a particular commodity or asset at a particular rate on a specified time. The buyer is said to be in ‘long position’ while the seller hols the ‘short position’. These are Over the Counter (OTC) Derivatives. These are used for locking-in the price and require no cash transfers in the beginning, thereby involve credit risks. Their main feature is the flexibility as forward contracts can be tailored as per the requirements of the traders. They are typically used to hedge the exchange rate risks. (Claessens, 1993)

Futures- These are more standardized than the Forward contracts. They are traded at Foreign Exchanges. The standardized contract specifying the asset, price and delivery time is either bought or sold through broker. The delivery price depends on market and determined by the exchange. The default risk in futures is minimized due to clearinghouse. It acts as centred party and does the ‘marking to market’ of traders’ account; by doing profit-loss calculations daily. Initial margin amount is required and futures hence involve margin calls. Minimum credit risk is involved; but being standardized contracts, these cannot be tailored to individual demands. (Hinkelmann and Swidler, 2004). Futures could be contracts on real assets for e.g. gold, oil, corn etc. or they could also be contracts of financial nature for e.g. currency, interest rates etc. (Tamiso and Freedman, 1995).

Fig.2: Hedging through Futures. (Walsh, D. 1995)

Options- The holder can buy from or sell to, the asset at a strike rate at a future maturity date. However the holder of the option has no moral obligation to do so. The cost of buying the option involves a premium which is to be paid up front. The option that enables the holder to buy an asset is called Call option while in Put option the holder is able to sell the asset. (Claessens, 1993) These can be bought Over the Counter (OTC) at a bank or can be exchange traded options. An American option could be exercised at any time before it expires. On the contrary, a European option has to be exercised on maturity.

Option is normally executed when its strike price is less than price of the stock. However, is the price of the stock is less than the strike price; the holder will not execute the option. Black and Scholes (1973) gave the formula to determine the price of a European option. According to the formula, the value of Call option is given by:

where

The value of Put option is given by:

P = Ke-r (T-t) – S + C = N(-d2) Ke-r (T-t) – N(-d1) S.

Where N (.) is a cumulative normal distribution function

s- standard deviation of the share price,

rf- risk-free interest rate per annum and t- time to expiry (in years).

The above formula, also known as the Black-Scholes option pricing model; is based on the assumptions that the stock doesn’t pay any dividends, it is possible to buy or sell even a single share, there are no costs incurred in these transactions and that arbitrage opportunity doesn’t exist. According to Black and Scholes (1973), “the option value as a function of the stock price is independent of the expected return of the stock. The expected return of the option, however, will depend upon the expected return of the stock.� Hence as the price of underlying asset increases, the price of option will also increase owing to their linear relationship.

Black and Scholes (1972) further carried on various empirical tests to validity of the formula. They observed that price paid by the buyers of the option was higher than that shown by the formula. This was mainly because the transaction costs that are incurred are always paid by the buyers of the options. These costs were found to be high for options of high risks and vice-versa. The sellers of options thus got the price that was predicted by the formula. The case study would make use of this formula to determine the value of options held by the company.

Walsh David (1995) explains that options have a non-linear relation with payoff. Its payoff increases with the price of the asset if it is in-the-money and has a constant payoff which is the option premium if it is out-of-the-money. On the contrary, futures and forward contracts have a linear relation with the payoffs in both, profit as well as loss. Therefore options might be preferred over futures and forwards for hedging. He further highlights the difference between hedging through futures and forward contracts. While in forward contracts, the company merely sets up a rate for future trading, it doesn’t involve any monetary transfer. Futures however make use of margin account and marking to market is done daily. Hence the results of futures over their time span vary greatly with those of forward contracts. Hence the individual contributions of each to risk management would be calculated during the research. The case study would also include a study the similarities and differences in futures, forward contracts and options and their individual effects on risk management.

Data and Methodology:

Objectives:

The research aims to:

Increase the understanding of the factors that determine market risks.

Understand the haven provided by financial derivatives against these risks.

Have a clear understanding of the methods or risk management techniques.

Understand the process of risk management.

Understand the intricacies of derivative markets.

Data and Methodology:

The Research is essentially a case study of Vodafone Group Plc. Primary data would include the information of the forward contracts with service providers, options and futures of the company in the market. Secondary data would be Qualitative in nature, comprising online journals, relative case studies and books.

The research would be carried out in the following steps:

Depending upon the nature of company, determine that factors that would affect the risk faced by the company.

Evaluate the percentage of risk faced by the company. Determine the amount of this risk, which the company would want to hedge.

The data would then be utilised to determine the amount of risk hedged by each of the above and then determine the total risk hedged by portfolio as whole.

Calculate the cost of hedging the risk.

Compare and contrast the findings with the defined ‘Effective Risk Management.’

Critically analyze the results.

Suggest improvements if any, in the portfolio.

Calculate the risk hedged with the suggested changes.

Proposed Timetable:

Date

Activity

6th May, 2011

Submission of final proposal

(By) 20th June, 2011

Collection of data as required by case study and start working on calculations.

1st July, 2011

Define the parameters for ‘effective risk management’ and complete calculations. Complete the initial declaration pages of report.

15th July, 2011

Complete the literature review pertaining to case study. Finish report writing till that part. (up to 5000 words)

1st August, 2011

Compare and contrast the findings to the

established parameters. Evaluate results. Some more relative literature review.

15th August, 2011

Finish writing the calculations, explaining results. Complete up to 10,000 words of report.

1st September, 2011

Complete the report and submit the first draft for feedback.

15th September, 2011

Redraft using the suggested changes.

Final draft for submission

19th September, 2011

Final submission of the report.

REFERENCES

Alexander, C. (1996). The Handbook of Risk Management and Analysis. West Sussex: John Wiley & Sons.

Alexander, C. (2005). ‘The Present and Future of Financial Risk Management.’ Journal of Financial Econometrics, 3 (1), pp. 3-25. JSTOR (Online). Available at http://jfec.oxfordjournals.org/ (Accessed: 8th March, 2011).

Berk, J and Demarzo, P. (2010). Corporate Finance. 2nd edn. Boston: Pearson.

Black, F. and Scholes, M. (May - Jun., 1973). ‘The Pricing of Options and Corporate Liabilities.’ The Journal of Political Economy.81 (3) pp. 637-654. JSTOR (Online). Available at http://www.jstor.org/stable/pdfplus/1831029.pdf?acceptTC=true (Accessed: 5th May, 2011).

Black, F. and Scholes, M. (May 1972). ‘The Valuation of Option Contracts and a Test of Market Efficiency.’ The Journal of Finance.27 (2) pp 399-417. JSTOR (Online). Available at http://www.jstor.org/stable/2978484 (Accessed: 5th May, 2011).

Claessens, S (1993). World Bank Technical Paper no 235.Washington DC: The World Bank.

Dubofsky, D and Miller, T. Jr. (2003). Derivatives: Valuation and Risk Management. Oxford: Oxford University Press.

Hinkelmann, C & Swidler, S. (2004). ‘Using futures contracts to hedge macroeconomic risk in the public sector.’ Derivatives Use, Trading & Regulation. 10(1), pp. 54-69. ABI/INFORM Global (Online) available at http://proquest.umi.com/pqdweb?index=0&did=679304171&SrchMode=2&sid=1&Fmt=6&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1304643921&clientId=18060 (Accessed: 21st March, 2011).

McNeil, A.J., Frey, R., Embrechts, P. (2005) Quantitative Risk Management. Princeton and Oxford: Princeton University Press.

Oxford Dictionary (Online) available at http://oxforddictionaries.com/?attempted=true (Accessed: 21st March, 2011).

Tamiso, R. & Freedman, R. (1995). ‘Confronting Uncertainty: Intelligent Risk Management with Futures.’ Artificial Intelligence in the Capital Markets: State-of-the-Art Applications for Institutional Investors, Bankers and Traders, Probus Publishing, Chicago. pp. 209-222. Available at http://www.inductive.com/RMR-FUT.pdf . (Accessed: 4th May, 2011).

Walsh, David.  (1995). ‘Risk management using derivative securities.’ Managerial Finance. 21(1), pp. 43. ABI/INFORM Global (Online). Available at http://proquest.umi.com/pqdweb?index=6&did=4708471&SrchMode=2&sid=3&Fmt=6&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1301258415&clientId=18060 (Accessed: 27th March, 2011).