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Derivative Markets & Alternatives Investment Classes

2959 words (12 pages) Essay in Finance

23/09/19 Finance Reference this

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[Document title] 

          Derivative Markets & Alternatives Investment Classes

 

 

 

 

Table of Contents

Introduction…………………………………………………………………………….…..……………………………………………………

Definition of Derivative………………………………………………………………………….…………………………………………………1.0

Three Common Types of Derivatives……………………………………………………….……………………………….……..…………1.1

Future Contract…………………………………………………………………………………..…………………………………….…………..

Forward Contract.………………………………………………………………………………..………………………………………….…….

Swap Contract……………………………………….……………………………………………….…………………………………….……..

Comparison of Future and Forward Contracts………………………………………………………………………….…………….……….1.2

Example of the Cross-Currency Swaps………………………………………………………………..………………………………………1.3

The Limitations of Derivatives………………..……………………………………………………………………………………………..2.0

…………………………………………………………………………………………….……………………………………………………2.1

…………………………………………………………………………………………….……………………………………………………2.2

……………………………………………………………………………………………………………………………….…………………2.3

…………………………………………………………………………………………………….……………………………………………2.4

Alternative Investment Definition……………….…………………………………………………………………………………………..3.0

An Overview of Alternative Investments…………….……………………………………………………….….………………………..…..3.1

Alternative investments………………………………………………………………………………………………………….………….…….

Characteristics of Alternative Investments……………………………………………………………….…………………….………………3.2

Liquidity……………………………………………………………………………………………..……………………………….……….…..

Transparency…………………………………………………………………………………………………………………………….………..

Leverage………………………………………………………………………………………………………………………………….………..

Correlation………………………………………………………………….…………………………………………………………….……….

Analysing three Types of Alternative Investments…………………………………………………………………………………………3.3

Hedge Funds……………………………………………………………………………………………………………………………………3.4

Characteristics of Hedge Funds………………………………………………………………………………………………………………..3.5

Hedge Fund Strategy……………………………………………………………………………………………………………………………3.6

Hedge Fund Table Example……………………………….………………………………………………………………………………………

Definition of Private Equity ……………………….………………..……………………………………………………………………….4.0

Characteristics of Private Equity……………………………………………………………………………………………………….………4.1

The Aim of Private Equity……………………………………………………………………………………………………………………..4.2

Private Equity………………………………………………………….………………………………………………………………………4.3

Leverage Fund……………………………………………………………………………………………………………………………………..

Definition of Venture Capital Funds………………………………………………………………………………………………………..4.4

Venture Capital Funds………………………………………..……………………………………….……………………………………….4.5

Key Characteristics and Advantages of Venture Funds……………………………………………………………………………………….4.6

Conclusion…………………………………………..……………………………………..……………………………………………………..

Bibliography………………………………………………………………………………………………………………………………….…..

Individual Element ………………………………………………………………………………………………………………………………

Introduction

 

The objective of this group assignment is to Define a Derivative, discuss three of the Most Common Types of Derivatives, and Limitations of Derivatives. In addition to this, the report will reveal the Definition of Alternative Investments, and will analyse different types of investments which include Hedge Funds, Private Equity and Venture Capital Funds.

 

1.0 Definition of Derivative

A Derivative can be defined as an instrument which helps to manage financial risks. They are formulated as contracts which are signifying an agreement between two parties, based upon the assets or assets. The derivative price is determined by fluctuations in the underlying assets. There are six common underlying assets; stocks, commodities, currencies, bonds, market indexes and interest rates. The primarily function of these securities is to give producers and manufacturers the chance to hedge risks. (Wiley, 2018)

 

 

1.1 Three Common Types of Derivatives

 


There are numerous types of contract derivatives which can be traded. Bellow you can see five main types of Derivatives. However, for the purpose of this report this section will only be covering three of them, which are; Future, Forward and Swap Contracts.

 

A future contract is an agreement between two people e.g. seller or buyer whom purchase or sell a particular quantity of a commodity or an asset on a specific date at the specific price which is similar to forward contract. This type of contract often is used by speculators and investors who are willing to take the risks which in return offers them a possibility to make large gains. (Northcott, Alan, 2009, pp. 28-30)

Future Contract

There are a few types of future contracts. E.g. day traders and longer-term traders.

Here is an example of a longer-term trading which is adopted from the “How Stuffs Works” article written by Dave Ros.

Let’s say in January you join a futures contract and buy 100 shares of IBM stock, the price of a share costs $50 on the 1st of April. The contract has a worth of $5,000. But let’s imagine the price of a share rose to $52 per share before the set date, e.g. 1st of March, that means you can trade your contract earlier of those 100 shares you will fetch a price of $5,200 which means you gained an extra $200. But if the price per share decreases to, e.g. $48, it means you would have to sell the contract of $5,000 on the 1st of March for $4,800 which would be a 20% loss. (Ros, 2018)

Forward contracts are very similar to future contracts. They are customised to meet sellers and buyers needs and are traded over the counter (OTC). Their counterparty risk is high, they are self-regulated, and do not require collateral and their settlement depends on the maturity date. (Jain, 2017)

 Forward Contract

 

1.2 Comparison of Future and Forward Contracts

 

(Institute, 2015-2018) 

1.6 Swaps

Swaps are another derivative contract made between two counterparties who exchange cash flows in a future. The most popular swaps contracts are interest rate and currency swaps. They are usually traded over the counter and by financial institutions. The majority of interest rate swaps involve exchanging a cash flow based on a set interest rate with a cash flow based on a variable interest rate. (Northcott, Alan, 2009, pp. 35-36)

 

1.3 Example of The Cross-Currency Swaps

 

The cross-currency swaps generally are made of three cash flows;

      Primary exchange of principals at the start.

      Swaps of the interest payments are done during the contract period.

      Exchange of the principals are done at the end.

 

2.0 The Limitations of Derivatives

3.0 Alternative Investment Definition

“Alternative investments are innovative investment strategies and concepts, which are designed for diversification and optimisation of return and risk structures of portfolios. Since there is no universal definition, Alternative Investment can be recognised as investments in non-traditional assets classes (beyond shares and bonds) or investments in such classes with the aid of complex, non-traditional strategies”. (What are Alternative Investments, 2018)

 

3.1 An Overview of Alternative Investments

The European Commission from 2009 specifies Alternative Investment funds as all that are not harmonised under the UCIT’S Directive. According to the document they include: hedge funds, private equity, venture capital funds, real estate funds, commodity market and infrastructure funds (Sokolowska, 2014, p. 23).  Alternative Investments also consists of other investment choices such as coins, art, collectables, wine, mineral rights, timberland and intellectual property. (The Balance, 2018)

 Alternative Investments

Alternative investments can be defined as more complex, which involves a higher risk for investors and require a longer time to inspect all relevant information than traditional investments. (Dagostino, 2018)

For the protection of average investors, many alternative investments are offered through private investment vehicles and are obtainable only to wealthy individuals and institutional investors. (Forum, 2015)

3.2 Characteristics of Alternative Investment

 Liquidity

One of the leading alternative investment characteristics is liquidity. Majority of funds have Lock-up periods, which make it hardly possible to withdraw funds without notice. The period for withdrawals might be quarterly or even annually (Goldman, 2015).

 Transparency

Transparency and regulations are other of alternative investment characteristics as there are little regulations that require these funds to uncover their practice (Skully, 2007).

Leverage is another one, some funds have taken enormous amounts of leverage to magnify positive returns. The adverse is that losses are also magnified (Dagostino, 2018).

 Leverage

Those investments generally have a low correlation with traditional investments which makes them suitable to be used as a method of reducing overall investment risk through diversification (Silver, 2018).

 Correlation

 

3.3 Analysing Three Types of Alternative Investment Funds

 

The most important category of alternative investments is hedge funds (40% of all alternative assets) (Forum, 2015). They are most often used by the investment manager to seek an alternative investment strategy which is usually unavailable through registered investment companies (mutual funds).

Hedge Funds

The primary goal of hedge funds is to maximise the return on investment (Forum, 2015). Many hedges funds aim is to engage in different investment approach that is designed to increase returns using non-traditional strategies across both traditional and non-traditional asset classes (Forum, 2015).

Hedge funds can invest in anything, e.g. land, derivatives, stocks, currencies and real estate. By contrast, mutual funds must stick to stocks or bonds (Silver, Investopedia, accessed 2018).

 

 

3.4 Characteristics of Hedge Funds

 

Hedge funds are only open to qualified (wealthy) investors suitable enough to handle the potential risk, that come from a broader range of investment mandate. That investment vehicles re lightly governed with no borrowing or leverage limits. Usually charge high fees and reveal minimum information about the fund’s investment policy and holdings. In many cases have investment lock up period that may reduce a funds liquidity.

3.5 Hedge Fund Strategy

 

 Hedge funds attempt to reduce investment risk by purchasing offsetting positions according to neutralise exposure to market risk.

For instance, a hedge fund manager might buy shares in Volkswagen Motor Company and, at the same time short sell shares in Toyota, by that counterbalancing the risk of investing in the auto industry (Vanguard, 2014).

 A few common strategies are outlined in the table below.

 

4.0 Definition of Private Equity

Private equity is the general term for investment made into companies which are either unlisted private entities, listed entities with the intension of delisting the target company or those that behave more like a private equity-backed business (for example a buy-and- build strategy). (Hudson, 2014, p.81)

 

 

4.1 Characteristics of Private Equity

 

Private Equity firms hope to make money with each of their portfolio companies. They mostly concentrated on existing companies with strong turnaround or growth potential which can secure steady cash flow to pay off the debt that is used to buy the company.(Singhal, 2015) The fund will have a fixed investment period, it could be 7 to 10 years, to foresee the expected holding period of the portfolio investment.(Mcneil, 2012).

4.2 The Aim of Private Equity

 

The aim of private equity investment is to restructure or redirect the targeted business that may result in an increase in the value of the business, which can then be sold for profit for the investors (…) (Hudson, 2014, p.81)

Private Equity

There is a specific manner in which an investor pays money into the fund. A shareholder in private equity fund generally contribute their capital to the fund over time, upon receipt from the general partner of a drawdown notice. (Spangler, 2013)

Leverage Fund

A leverage buyout fund will invest primarily in an established business with appreciable borrowing ability. In general, the fund will acquire a controlling interest in the business and adjust the development of the business and sell the business at a later date with a profit. (Mcneil, 2012)

 

4.3 Definition of Venture Capital Funds

Venture Capital is usually defined as money supplied to young start-up firms. This money is most frequently raised by limited partnerships and invested by the general partner in firms showing promise of high returns in the future. (Mishkin and Eakins, 2016, p.594)

 

VC firms allows start-up companies to receive financing they could not obtain elsewhere. As a privately held company, it will hold equity interest in the firm, and usually will not trade the stock on the public market. As a result of not a very liquid equity, VC horizons are long-term investment. The partners do not have an expectation to earn any return for a number of years, often up to a decade. VC are not passives investors, the partners take seats on the board of directors and actively attempt to add value to the firm through advice, assistance and business contracts. (Mishkin and Eakins, 2016)

Venture Capital Funds

 

4.4 Key Characteristics and Advantages of Venture Funds

 

Generally, such types of investments are high risk project but there is potential of generating high returns. There is an exhausting process of research involved, to find a few companies with promising compensating returns. In general, many VC partnerships will manage multiple funds simultaneously to diversify the risk. (Mishkin and Eakins, 2016). They are aware that some projects can incur losses, but other profitable investments will compensate the same due to high returns. (Singhal, 2015). In the highly uncertain sector in which VCs invest, this allows the amount of money lost in unsuccessful ventures to be managed. (Kaiser and Westarp, 2010, p.15)

 

 

 

 

 

Bibliography

Erika Dovgalyte

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