Risk and Capital Markets - Case Study Example

Risk and Capital Markets Table of Contents Introduction 3 Risks in financial market after the failure of Bretton Woods agreement 3 Forward 5 Future 6Option 6 Swap 7 Problems encountered by investors and market in employing the derivatives 7 Conclusion 7 Reference List 9 Introduction The Bretton Woods agreement in 1944 had given a new shape to the international financial system. However, in 1970, when currency of United States was under pressure due to a number of factors (Vietnam war and increasing trade deficit), the agreement failed to deliver any support to nations (NASDAQ, 2012). The end of Bretton Woods system brought in financial globalisation worldwide, which was encouraged by deregulation of currency markets and rules related to banks and investments. This enabled easy flow of money to poor and rich nations, which assisted the world economy to grow faster (Schifferes, 2008). The failure of this agreement to bring any changes in financial market entailed significant risk for the investors. The type of risk that was encountered by nations was systematic risk. These risks not only affected the investors, but also brought in changes in overall financial market. The investors were exposed to these risks when they invested in a sector that is affected by systematic risk (Alexander, 2008). The systematic risk emerges due to economic crisis, interest rates and political turmoil and affects the market as a whole. The portfolio of a particular investor is subject to systematic risk, when the market encounters changes in interest rate and other factors. The investors, thus, try to reduce this kind of risk through hedging. There were many investment instruments present in market, namely mutual find, bank fixed deposits and stocks. Even so, all of these were exposed to risk and main contributors of the risk were change in interest rate, fluctuations in exchange rate and market risk. So, investment diversification became popular when the agreement ceased to exist. Diversification was encouraged to reduce investment risk. Apart from diversification, there were other ways to reduce the risk. Investing in other instruments would cancel out price variation, which is the main risk in investments. This particular method of risk reduction is known as hedging (Lumpkin, 2011). Derivatives were the new financial instruments that were employed in foreign markets for hedging the risk. Derivatives are still used for the same purpose. Despite the advantages of derivatives in reducing risk of investors, there are several disadvantages too. Potential problems of using these financial instruments are highlighted in the report. Thus, this report elaborates on benefits of using derivatives in the financial market along with its problems. Risks in financial market after the failure of Bretton Woods agreement Systematic risk identifies the risk that is inherited by a particular market, after any adverse event. It is defined as the un-diversifiable risk and also known as market risk. The main causes of systematic risk are wars, recessions as well as interest rate and exchange rate fluctuations. These affected the whole market and could be eradicated through diversification. This type of risk had severe impacts on range of securities. This can be reduced only by hedging. It defines the overall risk that is present in capital market investments. The rise and fall in the stock market depends on a number of issues that collectively affects a number of investors’ portfolio. The decision taken by the investor to invest in a particular stock plays an important role in determination of stock price. It is noticed that even if a company is passing through a bad phase, the stock price may increase since the stock market is improving (Smith, 2008). Conversely, price of stock may fall when the stock market is not steady, even if company is performing well. So, it can be inferred that these types of risk are generally encountered by investors (Smith, 2008). This type of risk can be hedged by using derivatives. Hedging is characterised by the nature of risk trading that is employed in financial markets. Companies are quite aware of these types of risk and control the same in order to run a smooth business. The companies trade the risks that arise daily during normal operation of the business. In the financial or commercial or industrial businesses, financial assets are traded along with the risk and are reflected in the balance sheets during the course of business. The companies have traded with these risks as they consider it to be challenge to trade in such a situation. They even focus on the developmental process, which assists them to mitigate risks. The investors hold long position in stocks or shares and bonds or loans. In this case, the investor is exposed to risks that are associated with the securities. The risk stems from features of the security itself; however, it is related with common characteristics that are shared across the securities (Saxena and Villar, n. d.). There are two main macroeconomic risks: fluctuations in exchange rate and changes in interest rate; these bring in challenge for the companies while performing well in the stock market. Both the risk can be traded separately. When the securities are pooled together in portfolios, these experience the advantages of distinctive nature of risks. The securities try to reduce the risk that is associated with it on behalf of the investors. Derivatives Derivates are the new financial instrument, which is used to hedge risk in the foreign markets. They are products that are related to functioning of the market. It is the “contract between two parties with respect to a certain underlying security (asset)” (Saxena and Villar, n. d.). The derivatives are defined as financial contracts that exist between two parties through which exchange of cash takes place. The payment of cash is related to value of financial asset or underlying asset. There is no actual delivery of underlying asset. The derivatives help investors to cope up with sources of risks individually or assist in restricting the set of risks that are associated with financial assets (Saxena and Villar, n. d.). The derivatives that are used most commonly in the foreign market are forward, future, option and swap. The derivates that has gained importance since establishment comprise stock options, stock futures, stock index futures, commodity futures, interest rate futures and currency options. Forward The forwards contracts are traded on an underlying asset at a date in future. However, this differs from another set of derivatives known as the futures contract. The forward contracts are traded Over the Counter (OTC). This is basically an agreement that takes place between the seller and buyer. The agreement defines exchange of financial asset or commodity at a specified future date for a specified amount of cash. This differs from spot contract in a way that the latter is an agreement to sell or buy a financial asset at price prevalent at the time of agreement. The party who has agreed to buy an underlying asset in future is assumed to be in long position and when the same party agrees on selling the asset, he is predicted to be in short position. The price that is fixed for the asset is called the delivery price. The price is fixed for the asset at the time of making the contract and is paid in future at the end of the specified date (Saxena and Villar, n. d.). The payment for the underlying asset is made before control on the instrument shifts from the seller to the buyer. Forward contracts can be used to hedge risk, which is associated with exchange rate or currency. This allows the parties (buyer or seller) to take advantage of quality of underlying asset, which is time-sensitive. Thus, it can be underlined that use of this new instrument has convinced investors to make an investment without ascertaining the fluctuations in return. This is because the return is specified at the time of making the contract (Smith, 2008). Future The futures are exchange traded contracts that are purchased or sold on an underlying asset at a date in future. The contracts are written off over a wide range of assets such as, foreign currency and interest rates. So, future contract can be defined as an agreement for selling or buying a particular underlying financial asset at a price that is fixed at a future date. The seller of a future contract is obliged to deliver the financial asset to the buyer. The latter has the obligation to pay the price that is agreed to former at a future date. The transaction that involves sale of future stocks, while owning the same, is known as short hedge. Conversely, the transaction that involves purchase of future stocks at a current price is known as long hedge. The traders of the commodities use these “short/long hedging strategies in commodities market to cover the risk against the possible commodity price variations” (Brenner, 2009). The stock index future is used to hedge the overall rise or decline in the stock market. The investors who own a substantial amount of stock can hedge their portfolio against the risk of exchange rate or interest rate by using stock index futures. Hedging of risk is practiced in order to complete portfolio valuation with usage of futures. The main disadvantage of this kind of future is that it limits the profit potential, regardless of eradicating the risk associated with the stock. Many established institutions make use of this concept of hedging in order to avoid their risky positions. Hedging eliminates or reduces the risk of encountering loss and allows investors to participate in earning profit by taking advantage of favourable stock price movements. Dynamic hedging strategy is developed through sale of index futures for wrapping inequitable portfolio valuation. The main advantage of the stock market future is that this improves the hedging procedure in case of bearish market and adversely affects the same in case of bullish market (Brenner, 2009). Option Option is known as a special type of future contract. This contract enables the buyer to get an option of either to sell or buy an underlying asset from a seller at predetermined price. Nevertheless, the seller is obligated to deliver the asset to the buyer. The purchaser of option makes payment of the upfront fee/premium to the trader of option. However, if the purchase fails to exercise the option within the specified future period, then the option expires and loses its value (Brenner, 2009). Options can be divided into two forms – put option and call option. The call option enables the buyer to get the option of purchasing an underlying asset at a price that is determined from before. This enables the buyer to get the option to sell the asset to seller of the put option at pre-determined price (Sriram, 2011). Therefore, it is inferred that “a seller of call/put option has an obligation to sell/buy the underlying asset” (Sriram, 2011). Swap The swap transactions are used to exchange a set of cash flows for another set of securities and represent the keystone of derivatives trading. From the time of its foundation in derivative market, swaps have encountered extensive growth as they have been increasingly employed by corporate treasuries and financial institutions. As corporate treasuries and financial institutions employed swaps, market size for the swap holders increased. There was need for professional guidance to understand the essentials of swaps for its various participants (Smith, 2008). Problems encountered by investors and market in employing the derivatives Derivatives have encouraged more and more people to hedge the risk associated with their securities and have helped them to earn a substantial amount of profit. Nevertheless, the derivative has posed challenges to investors and market as a whole (Alexander, 2008). Opportunities are double-edged sword; if they are grabbed at the right time, then they bring in profit. In a reverse case, opportunities entail huge loss. This is because these contracts are made for a specific period of time and has a specific date of maturity. If the date expires and the investor does not pay back at the specific date, the contract gets dissolved; hence, he or she encounters loss of the invested money. This has also created unnecessary speculation in the market, which is not at all healthy for small investors who form the main pillar of stock market. The strategies underlying the derivatives are important to be understood in order to know functions of the same. Yet, it is observed that there are only few participants in the stock market, who has an in-depth knowledge regarding the complex structure of derivatives. Therefore, usefulness of derivatives is limited to common people who are not able to hedge their investment risk (Alexander, 2008). Conclusion After breakdown of the Bretton Woods agreement, investors deemed derivatives as a useful mode of hedging their investment risk. The future and forward contracts were used extensively for hedging the risk of losing the invested amount after a period of time due to change in exchange rate and inertest rate. It is still used by traders who trade more frequently in the stock market. The swaps are extensively employed by large financial institutions to hedge their investment against counter party risk. The benefit of derivatives enables investors and the market as a whole to earn huge profit (Alexander, 2008). Apart from advantages of derivatives, there are also limitations; these are the main challenges for investors and market. Derivatives include complex financial structure, which needs to be understood properly. Most of the traders lack knowledge regarding complex structure of the futures and forward contract needed to make their trade successful. It needs expertise knowledge as well as calculation skill to determine whether the contract will yield profit or loss. It has been observed that even professional traders get into trouble on misusing any derivative contracts. Reference List Alexander, C., 2008. Market risk analysis, pricing, hedging and trading financial instruments. New York: John Wiley & Sons. Brenner, M., 2009. New financial instruments for hedging changes in volatility. Financial Analysis Journal, 45(4), pp. 61. Lumpkin, S., 2011. Risks in Financial group Structure. [pdf] OECD. Available at: [Accessed 27 March 2014]. NASDAQ, 2012. Return To Bretton Woods: Economic and Investment Implications. [online] Available at: [Accessed 27 March 2014]. Saxena, S. and Villar, A., no date. Hedging Instruments In Emerging Market Economies. [pdf] n.p. Available at: < http://www.bis.org/publ/bppdf/bispap44d.pdf > [Accessed 27 March 2014]. Schifferes, S., 2008. How Bretton Woods Reshaped The World. [online] Available at: [Accessed 27 March 2014]. Smith, A., 2008. Top Five Risks of Investing in the Stock Market. Available at: [Accessed 27 March 2014]. Sriram, K., 2011. Managing stock market risks. [online] Available at: [Accessed 27 March 2014]. Read More