The Benefits of Using Derivatives - Essay Example

Assets valuation Contents Introduction 4 Terminology specific to commodity 4 Discussion 5 The benefits of using derivatives 5 Price Discovery 5 Risk Management 6 Facilitate Transfer Risk 6 Efficient Market 6 Lower Transaction Cost 6 How and why derivatives are used for hedging and speculation? 7 Main features 7 Pros/cons of different derivatives 8 Pricing / valuation methods 8 The risks attached to using derivatives 10 The nature/features of derivatives 10 Weaknesses of valuation models 10 Limitations 11 Return distribution/risk profiles 11 Conclusion 12 References 14 Introduction The Financial Accounting Standard Board (FASB) described as “forwards, futures, swaps, option or some of the financial instruments. Derivatives are the contract between two parties in which they agreed to an exchange. Often those exchange involves can be cash flow or another financial instruments, the value can vary during the term of contracts. Forwards, futures, swaps, and option are the common example of derivatives. In this case however, it deals with the instruments which are described as commodity derivatives. These are not purely financial but it involves cash exchange for commodities like energy, precious metals, and agricultural products. In this case the focus is on the futures contract or in option for future for managing the risk. Terminology specific to commodity Futures: A firm agrees to deliver a certain amount of commodity in a specific date in future, that can be bought and sold at a particular price. These contracts are settled on daily bases on current market price. Options: A contract which allows the buyer of that contract the firm to buy or sell the commodity from the seller in a particular price. Option on Futures: An option is structured for the buyer to receive a contract in futures guaranteeing the delivery at a strike price. Option Premium: It is a fee paid to the seller by the buyer for the flexibility; it is generally paid when the contract is originally written (Chen, 2009). Strike Price: It is the contract price in which the buyer has the right to buy and sell the commodity. Discussion The benefits of using derivatives The two commonly used benefits are Price Discovery and Risk Management. Price Discovery The future market price is depended on a continuous flow of information from all over the world which requires a high range of transparency. A huge range of factors are such as climatic conditions, political situation, debt fault, refugee, displacement, land reclamation etc. This kind of information in which the people tend to absorb it constantly and change the commodity prices is called price discovery. With the help of some future market the asset can also geographically dispersed, having lots of current price in existence, the contract price which has the shortest time to expiration can serve as proxy for the asset. The price for all future contracts are served as price in which are accepted by those who are trading contract in terms of facing risk. Options are also price discovery, not correctly in terms of price but in the way the market participants view the market volatility (Blundell, Atkinson, Lee, and Hoon, 2008, pp.154-157). Risk Management It is the most important part of derivative market; it helps to identify the risk level the actual risk level and altering it latter to form equal. This is under speculation and hedging. Hedging is defined as a strategy to reduce the risk in market position while speculation is the position in the way the market move. Hedging and speculation strategies with the derivatives are helpful and enable the companies to manage risk more effectively (Cohen and Palmer, 2004, pp. 29-33). Facilitate Transfer Risk The derivatives do not involved risk but they redistribute the risk among various market participants. Derivatives can be hedge against unfavourable market movement for a premium and it provides opportunity for those who are keen to take risk and to make profit out of this process. Efficient Market The market can said to be complete only when the instruments are used for any possible outcomes; with the presence of derivatives the market is completed (Corb, 2013, pp.87-90). Lower Transaction Cost It acts as low transaction cost because for high no. of participants are taking part in the market. Derivatives are categorized in two ways, if it put to use wisely than they work effectively but if it is used recklessly than it can cause you loss. Derivatives are used to protect hedge or it can be used by the market participants, it can also be used in market by the participants for speculating of the underlying asset. It can also allow the business to manage effectively, external influences on their business in which they do not have any control. Few market operators criticized for using derivatives for speculation, the contract involves a party reducing the risk and the other taking the risk involved on the underlying asset it allows the party to speculate the valuation of the asset (Deventer, Imai and Mesler, 2013, pp. 43-46). How and why derivatives are used for hedging and speculation? Main features Derivatives have their own characteristics that distinguish them from their underlying asset or other forms of financial instruments. The key features of derivatives are as follows. Derivatives have a maturity or expiration date after which they become worthless or it get terminated automatically. For example, optional instruments have a specified life during which the holder exercise some sort of right. At the end of that life, the contract expires whether that right has been exercise or not (DeYoung, and Rice, 2004, pp. 132-135). A derivative is usually constructed by adding or combining basic components, specification, triggers and contingencies in order to create a payoff pattern. The value of this combination can be moved with a higher exponential leverage and in opposite direction with respect to the underlying. The underlying price in a forward contract could be subject to a lower and upper boundary and this creates new derivatives known as range forward contracts (Ebrahim and Hasan, 2004, pp. 67-69). Derivatives are powerful leverage tools, the values of derivative can be move exponentially relative to the value of its underlying. Notwithstanding, some derivatives have, in addition to their implicit leverage power, an explicit leverage capability such as leveraged option, leveraged swaps etc (Foos, Norden and Martin, 2009. pp.45-48). Pros/cons of different derivatives Derivatives are generally contracts that agreed between two parties where the value of the contract are tied to the value of some underlying financial instruments. Derivatives can be used in effective way for the investors to hedge the risk that have incurred. From purchasing other securities, it can be a way for the investors to speculate the price of some security at a fraction of the cost of actually purchasing the security. The downward of the financial derivatives is that they are extremely complex and lead to heavy financial losses if it is not executed properly (Hakala and Wystup, 2002, pp. 183-188) Casual investors think of investing in terms of bonds and shares, which are comparatively simple instruments but they represent a small amount of investment opportunity available. Derivatives are effective tools but like all other tools it also has some risk involved. Many investors use the derivatives primarily as a method of hedging the risk to other investment that has been made. Investors those who prefer to speculate on the prices of stocks or other securities can use derivatives. Derivatives are usually bought and sold at a small percentage of the underlying instruments. In this case the investors take relatively a small amount of derivatives contracts. With all instruments, derivatives carry significant risk, these are extremely complex and the casual investors may not understand this (Kallman, 2007, pp.48-51). Pricing / valuation methods Investments contracts are issued by AEGON are either carried by value fair value or amortized cost. These contracts are not quoted in active market and their fair values are determined by valuation techniques, such as discounted cash flow methods and stochastic modelling or in relation to the unit price of the underlying asset. All models are validated and calibrated. A variety of factors considered including time value, volatility, policyholder behaviour etc. Credit spread is considered in measuring the fair value derivatives borrowing and other liabilities (Laeven and Levine, 2007, pp.45-49). In absence of an active market, the fair value non quoted investments in financial asset estimated by present value or other valuation techniques. The fair value of non quoted of fixed interest debt instruments is estimated at discounting expected futures cash flows using a current market rate applicable to financial instruments with similar yield, the fair value of floating interest rate debt instruments and asset maturing within a year is assumed to be approximated by their carrying amount (Linda, and Julapa, 2000, pp. 69-73). The quoted market price is not available, other valuation techniques, such as option pricing stochastic modelling is applied. The valuation techniques incorporate all the factors that the market participants would consider and are based on observable market data. Fair values for over-the-counter (OTC) derivatives financial instruments represent the amount to be received form or have paid to the third party on any settlement. These derivatives are valued using pricing models based on the net present value of estimated future cash flow, directly observed price from derivatives which are traded in exchange and other trades under OTC as well as exterior pricing services (Nurullah, Sotiris and Staikouras, 2008, pp.112-115). The expected return are based on risk free rates such as the London Inter Bank Offer Rate (LIBOR) forward curve or the current rates on local government bonds. The current risk free spot rate is used to determine the net present value of expected future cash flows produced stochastic projection process (Rush, 2013, pp.63-66). The risks attached to using derivatives The nature/features of derivatives Derivatives are financial contracts which evaluate its values from the other entities such as index, asset or interest rate that are regarded as the underlying. Derivatives are of three main categories of financial instruments, the other two beings equities and debt. It include a several financial agreements that includes futures, forwards, swaps, option and variation of these caps, floors, collars etc,. Many Money managers use derivatives for a variety of purposes, such as hedging-by taking a position in derivatives, losses on portfolio holdings may be minimized or offset by profits on derivatives. For example it may be easier and quicker to purchase S & P 500 futures contracts than to invest in the underlying securities. There are two groups of derivatives contract: the privately traded over-the-counter derivatives like swaps that are not traded in exchange and mediator as well as EDTs which are traded in derivatives exchanges with specialized nature. Weaknesses of valuation models Black Scholes was first published by Fisher Black and Myron Scholes in 1973,” The pricing of option and corporate liabilities”. The Models assumption have been relaxed and generalized in a variety of directions, leading to a plethora model which are currently used in derivative pricing and risk management. Limitations The Black Scholes method is considered the standard model both in terms of approach and applicability. However, despite its popularity and wide spread use, the model is built on some of the assumptions that are under some circumstances that are unrealistic. The model is a simplification of reality, almost all the assumption can be considered to be limiting and unreal. The Black Scholes models have already overcome some of these unrealistic assumptions, e.g. allowing for dividends, transaction cost, etc. These extensions should be used in circumstances where the assumption in the original model would result in a significant distortion of reality when considered collectively. Return distribution/risk profiles The Black Scholes option pricing formula has been the mainstay behind the entire derivatives industry. Every day thousands of prices are calculated with some variation of the model, and large sums of money put at risk. Yet academics and practitioners alike have long known that one key assumption of the model-the market volatility is constant-is empirically incorrect. Because of this, Black Scholes systematically under prices out of money options, forcing market makers to build complicated adjustments such as skew and kurtosis into their pricing. While many academicians have urged that only commodities such as oil and gold were candidates for jump moves, it cannot be denied that more stocks are volatile in nature which results in sudden and large price jumps in terms of percentage return. The grabbing and sudden jumps took the downwards sloping curve. On the other hand, the vaults of derivative instruments are common nature of derivative markets of United States of America. It can also be stated that key indices impacted the air pockets of total illiquidity. Using this model Merton was able to show that the fair value of money options was typically higher than that when derived from Block Scholes, while the money options were not so expensive. The more frequent number of jumps in a year and higher the magnitude of the jumps, the more transparent the effect will be. In effect to this, Merton explained that few of the empirical observations and studies in the area of option pricing seem quite difficult for the Black Scholes. With the exceptions of some quantitative sticklers as well as oil traders Wall Street largely turned a deaf ear to the situation. This response of the people was alike since jump diffusion was not so easy to evaluate with three major inputs in its place of one. The model also provided the resolutions of different zero-sum rules of hedging which were loved by researchers in their major studies regarding the closed form of solutions. Sometimes it takes the market event to push the trading houses and academicians alike into the action. Work on stochastic volatility in the U.S equity market since last fall has rekindled interest in this field (Sadr, 2009, pp.98-103). A few option market making practitioners value the jump-diffusion model highly elaboration of it. Cutler used the models of jump diffusion in such a way for explaining initial abnormal pricing. Often it explains away an odd-looking pricing phenomenon. Other times, it spots an opportunity to think how the model works well in terms of non-contiguous movements and systematic changes in volatility over time and stock prices. Conclusion Derivatives are the contracts which take place between two parties; it can be described as forwards, futures, swaps, option and some of the other financial instruments. In derivative there are two contracts Call option and the put option. In call option the buyer has right to exercise in particular price and vice versa. The benefits of derivatives are the price discovery, risk management, efficient market, low transaction cost. In price discovery it is the continuous flow of information it can be climatic, political or any other circumstances, in risk management the risk is being reduced by the manager and to speculate the underlying asset, in efficient market it has to be completed and the instruments can only be used for the suitable outcomes. Low transaction cost is used because there is high no. of participants in the markets. Derivatives are also used for hedging and speculating in markets, it has a maturity time and after that maturity period the derivatives are worthless it cannot be used for further process. The derivatives are agreed between two parties and tied up with an amount to the underlying of asset. Credit spread is used for measuring the derivatives, borrowing and liabilities. The risk attached in derivatives is the nature of the derivative and weakness of it. References Blundell-W., Atkinson, A., Lee, P. and Hoon, S. 2008. The Current Financial Crisis: Causes and Policy Issues. OECD Financial Market Trends. 1(1), pp.18-23. Chen, Y. 2009. Generating Growth without Financial Crisis. Study Times. 1(1), pp.23-27. Cohen, M. W. and Palmer, G. R. (2004). Project Risk Identification and Management. USA: ProQuest Central. Corb, H. 2013. Interest Rate Swaps and Other Derivatives. West Sussex: Columbia University Press. Deventer, D. R. V., Imai, K. and Mesler, M. (2013). Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. USA: John Wiley & Sons. DeYoung, R. and Rice, T. 2004. How Do Banks Make Money? A Variety of Business Strategies. Economic Perspectives. 1(1), pp.17-21. Ebrahim, A. and Hasan, I. 2004. Market Evaluation of Banks Expansion into Non-Traditional  Banking Activities. New York: State University of New York. Foos, D., Norden, L. and Martin, W. 2009. Loan Growth and Riskiness of Banks. Mannheim: University of Mannheim. Hakala, J. and Wystup, U. 2002. Foreign Exchange Risk: Models, Instruments and Strategies. London: Risk Books. Kallman, J. (2007). Identifying Risk. USA: ProQuest Central. Laeven, L. and Levine, R. 2007. Is There a Diversification Discount in Financial Conglomerates?. Journal of Financial Economics. 85(1), pp.56-62. Linda, A. and Julapa, J. 2000. 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