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Analysis of Derivatives and the Perception of Investors

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Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Chapter 1: Introduction

1. Introduction:

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 market 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 market 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. 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):

  1. Treasury bills,
  2. Eurodollar,
  3. Euro yen,
  4. Certificate of deposit (CD),
  5. 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.

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 options.

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 view 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, 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. 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.

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. 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 (IBS, 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:

1. forward contracts

2. futures contracts

3. options contracts,

4. 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.

Global OTC Derivative Market Turnover, 1998-2007

Daily Averages in April, in billions of USD

Description

1998

2001

2004

2007

Foreign Exchange Power

688

959

853

1,292

Outright forwards and foreign Exchange Swaps

643

862

786

1,152

Currency Swaps

4

10

7

21

Options

41

87

60

117

Other

1

0

0

2

Interest Rate Turnover

151

265

489

1,025

FRAs

66

74

129

233

Swaps

63

155

331

621

Options

21

36

29

171

Other

2

0

0

0

Total Derivatives Turnover

880

1,256

1,385

2,410

Memo:

Turnover at April 2004 exchange rates

825

1,350

1,600

2,410

Exchange traded derivatives

1,221

1,382

2,180

4,657

Currency Contracts

17

11

10

23

Interest Rate Contracts

1,204

1,371

2,170

4,634

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:

1. Hedgers

2. Speculators

3. Arbitrageurs

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.

2.1 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. 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).

Features of Exchange Traded Currency Option Contracts

AUD

GBP

CAD

Euro

Yen

Swiss Franc

Contract Size

50,000

31,250

50,000

62,500

6,250,000

62,500

Position and Exercise Limits

200,000

200,000

200,000

200,000

200,000

200,000

Base Currency

USD

USD

USD

USD

USD

USD

Underlying Currency

AUD

GBP

CAD

EUR

JPY

CHF

Exercise Price Intervals (for 3 nearest months)

1¿ 

1¿ 

0.5¿ 

1¿ 

0.005¿ 

0.5¿ 

Exercise Price Intervals (for 6, 9 or 12 months)

1¿ 

2¿ 

0.5¿ 

1¿ 

0.01¿ 

1¿ 

Premium
Quotations

Cents per
unit

Cents per
unit

Cents per
unit

Cents per
unit

Hundredths
of cents per
unit

Cents per
unit

Minimum Premium Change

$.(00)01
per unit =
$5.00

$.(00)01
per unit =
$3.125

$.(00)01
per unit =
$5.00

$.(00)01
per unit =
$6.25

$.(00)01
per unit =
$6.25

$.(00)01
per unit =
$6.25

Expiration Months

March,
June,
September,
December
+ two
near-term
months

March,
June,
September,
December
+ two
near-term
months

March,
June,
September,
December
+ two
near-term
months

March,
June,
September,
December
+ two
near-term
months

March,
June,
September,
December
+ two
near-term
months

March,
June,
September,
December
+ two
near-term
months

Exercise Style

American and European

American and European

American and European

American and European

American and European

American and European

2.2 Future and Forward:

2.2.1 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.

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 time. 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 on maturity

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. 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.

2.3 Swaps:

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. 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).

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.

2.3.3 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

* Transport

* Insurance

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. Table 2.10 provides a snapshot of the use of derivatives by 372 Fortune 500 companies.

Frequency of Use of Derivative Instruments by Size and Industry

Research 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. 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

Source: IBS 2007

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”.

2.4 pricing derivatives:

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:

1. The first component is the current account that records imports, exports and income flows

2. The second component is the capital account that records financial flows that involve:

Ø Banking transactions

Ø Transactions by foreigners in Australian securities such as shares or government bonds

Ø 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:

Ø The status of equilibrium or in-equilibrium of international money markets; in other words, it relies on the conditions of IRP

Ø 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:

Ø To reverse an apparent overshoot, in either direction, in the exchange rate;

Ø To calm markets threatening to become disorderly

Ø 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.

2.5.6 Hedging:

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, ∞) → 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 o


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