Derivatives Markets and Financial Innovations - Assignment Example

Question Derivatives Markets and Financial Innovations] Introduction Capital markets facilitate the free trading in all securities. It has two mutually supporting and indivisible segments: the primary market and the secondary market. In the primary market companies issue new securities to raise funds. Hence it is also referred to the new issue market. The secondary market deals with the second hand securities, this are securities that have already been issued by companies that are listed in a stock exchange. Since the securities are listed and traded in the stock exchange, the secondary market is also called the stock market. In primary market, companies interact with investors directly while in the secondary market investors interact with themselves. In both cases, the capital market intermediaries play an important role .The secondary market, based on all available information, determines the price and risk of the issued securities, it provides useful signals to both listed companies and investors to act in the primary markets. The secondary market may also include the over the counter market and the derivatives market. In the stock market share prices are determined by the demand and supply forces. On the other hand, in the over the counter market prices are negotiated between the buyer and the seller. The derivatives market deals in futures and options. In the derivatives markets, securities or portfolios of securities are traded for future delivery. In case of options, the future delivery is conditional as the buyer has a right to exercise or not to exercise the option. The derivatives market and my proposed derivative product The emergence of new markets for derivatives such as forwards and futures can be traced back to the willingness of risk adverse economic agents to protect themselves against uncertainties occurring from price fluctuations in various asset categories. Naturally, financial markets are very volatile. Through derivative products, however, it is possible to fully or partially transfer price risks by locking in prices of assets. By doing so derivative products reduce the impact of fluctuations in prices of assets on the cash flow and profitability situation of risk averse investors (Morrison and Winston 34). The derivative instruments are in use by all business sections, for instance, corporates, SMEs, financial institutions, banks and retail investors. My motivation for this derivative is the ability to trade while conserving the environment through the hampering of the big problem of global warming which is getting worse as firms continue to produce. The trading is also focused on trading carbon credits with the aim of controlling or reducing pollutants produced from business activities of firms. Therefore, the central driver of carbon emissions trading would be the impact on the climate and the degradation of the environment as a result of emissions of various gases. The immaturity of this market of derivatives also gives hope that there is a growth potential for this business. Currently there are smaller numbers of firms that offer such certificates. An appropriate pricing model for derivatives on the carbon emission certificates is certainly the first step in coming up with the derivative there is need to investigate the price dynamics. Product Design and Specifications The proposed derivative is a futures contract. Via the American Climate Exchange (ACX) carbon derivatives will be based upon 3 types of carbon related units. The following table gives an overview of my product in terms of price, quantity, unit of underlying asset, maturity date, delivery policy, margin requirement and daily settlement and transaction costs. Type Carbon Emission Derivation: futures contract Trading Units 1000 carbon dioxide EUA allowances, with each allowance allowing 1 tonne of carbon dioxide equivalent gas Minimum trading 1 lot Strike Price Intervals Quotation US dollar per metric tonne Minimum Tick $ 0.01 per tonne Minimum price flux $0.01 per tonne Maximum price No limits Contract Months Annual expiry cycle: DEC Expiry Last exchange trading day in November Settlement Price Respective of the futures contract, on the last day of trading Margin Initial and Variation The Carbon Derivatives Market Trading in carbon emission certificates has brought about a wide range of derivative products with carbon trading as the underlying. This is the unique product that I would like to come up with. The main targeted pollutants are sulfur dioxide, nitrogen oxides and carbon dioxide with the focus being on carbon dioxide which is the root cause of global warming. The EU Emission Trading Scheme came into force in 2005. Its main aim was to cut carbon emission in order to meet the emission reduction targets that were set by the Kyoto Protocol in 1997. Carbon dioxide emission is supposed to be cut down by 8 percent, in comparison with the 1990 level. Emission trade has ensured that emission reduction goals are met at the minimum cost since this is a market based mechanism. If this is anything to go by, then carbon emission derivatives could prove to be a vital element of commodity index fund formulas. I think that depending on the traders’ formulation of the commodity mixes in the fund formula, there is a possibility of carbon emissions becoming dominant in the fund formulas, to the extent of displacing well. Quantitative Pricing Model and To price the derivatives in the carbon market, I identified specificities of the market and analyzed carbon as a commodity. The right to pollute is said to be a tradable asset since its price can be determined from the market forces of demand and supply. My derivative products are priced based on the Monte Carlo methods. A research done by Taschini and Paolella (21) to determine the most efficient pricing model in the carbon market derivatives gave results as displayed on the graphs below. Results are compared with the market prices by computing error statistics and this favors the Normal-inverse-Gaussian (NIG) process which has a lower pricing compared to the Brownian motion. NIG is also an efficient way to model the carbon derivatives. Policy Recommendations Within the American context, treatment of carbon permits means a lot for carbon-based derivatives. For instance, free allocation of permits to emitters, with the ability to squeeze permit prices since there are allocated instead of being auctioned, and means that the ability to manipulate carbon based derivatives increases significantly. Considering that environment policy is usually not the easiest of topics, combining it with economic matters overlaid with derivatives makes the topic more complex. Carbon market in the US is has fairly matured over time but debate the approach to carbon dioxide emissions is still heated. At this stage, it may seem that carbon emission derivatives should be used once a fixed priced period put in place. Conclusion The primary market is trading in the permits or quotas in the spot markets. Carbon emissions derivatives whether they are forwards or futures on the price of the permit/quota are a logical extension of trading. The spot market of the carbon emission trading means that the derivative is tradable. I expect the major users of the carbon emissions trading to be the producers of the carbon emissions for instance the utility companies like power producers and other polluting industries. The underlying asset is artificial and will reflect the fact that emission quota is an artificial creation of the regulatory policy through the government. The concept of trading here creates an opportunity to trade in various analogous property rights. Question #2 [Arbitrage Strategies] Arbitrage is a cross-border approach of playing on differences by looking for absolute economies instead of the scale economies which are habitually expanded through standardization (Tyson 91). Opportunities are treated as opportunities and not constraints. Despite the long history of arbitrage it often planed over in modern discussions of globalization and strategy. There are a few reasons why arbitrage does not get much attention. First, arbitrage is not glitzy and most people underestimate the complexity needed to implement it in a semi-globalized world. Secondly, there are only limited offers for competitive advantage for arbitraging fundamental factors for instance labor and capital. The third stereotype involves the notation that profit potential of arbitraging is limited, which of course is not true. I would like to propose a convertible arbitrage strategy. Convertible arbitrage generates returns from a convertible security’s equity, embedded equity call option futures and bod. Typical trade being long Firm A’s convertible security, for instance preferred share or bond, and a short Firm A’s stock. The strategy has various approaches, for instance one my “reverse hedge” the trade if he/she feels the security is overvalued. This will, therefore, involve selling the convertible bond short and buying the stock. The following example illustrates my proposed strategy: Say, the initial price of a convertible security is 108. The arbitrage manager invests $202,500 as the initial capital plus $877,500 of borrowed funds to bring the total investment to $1,080, 000. The security’s conversion ratio is for 34.7 common shares. Assume only 26,000 shares are sold initially at a price of $26.626. Assume a 1 year holding period. I. Determining Total Return Return Source Return Assumptions/Notes Cash Flow Interest Income 50,000 5 percent on 1,000,000 USD face amount Short Interest Rebate 8,653 1.25% interest on 692,250 USD short earnings, based on initial hedge ratio of 75% (26,000 shares sold short at 26.625 USD = 692,250 USD, relative to 34,783 shares of CB stock Less Cost of leverage (17,550) 2 percent interest on 877,500 USD borrowed funds Dividend payment (6,922) 1 percent dividend yield on 692,250 on the 26,000 shares sold short Total cash flow (1) 34,181 Arbitrage Return Bond return 120,000 Stock return (113,750) Total Arbitrage Return (2) 6,250 Total Return (1) + (2) 40,431 Managing a convertible arbitrage strategy Planning and execution will play a crucial role in executing this derivative. The fund manager is vested with the responsibility of providing guidance to the business when and as it is needed. The fund manager should thus busy himself with ensuring that both the long-term and short-term financial demands of the fund are met. Most investors are emotionally attached to financial investment, which has in recent years been doing exceptionally well. This attachment is rumored to be associated with the high returns of this portfolio. Though the investment, portfolios have been diversified, most if not all of these bear some exposure to the property investment. Historically, prices have shown risen with the rise in inflation rates effectively cancelling the effects of inflation on the financial markets. Owing to the fact that the share market takes less than 2% of the world’s share market capitalization, it is prudent for investors to participate in the trading of the carbon derivatives. Furthermore, other leading corporations such as Ford and Microsoft do not trade their shares on the counters of the Australian Stock Exchange. It is recommended that the investor purchases shares that are globally diversified. In addition to the normal risks associated with investments in derivative market, the international market bear an additional inherent risk associated with the frequent currency fluctuations Challenges A number of challenges may occur in managing a convertible strategy. There is the issue of the sustainability of arbitrage strategies and how they may be affected by firm level resources, specifically management capabilities, as opposed to the market level differences in costs, pricing and many more. It is worth noting that while sustaining a competitive edge from the convertible arbitrage may be an objective worth pursuing, it is not necessarily for convertible arbitrage to make sense. Even when it does not offer a sustainable advantage, a convertible strategy may still be worth undertaking if only to avoid ending up at a disadvantaged position relative to your competitors that take part in arbitrage (Wensveen & Wells 230). The diagnosis of semi globalization suggest that differences in prices or costs for most products and services plus most kind of inputs are more likely to be large, unlike the short lived spreads associate with the financial arbitrage of some types. Conclusion The convertible arbitrage strategy is poised to produce attractive returns, uncorrelated with traditional equity and bond returns. Manager risk is the principal risk rather than bond market or directional equity risks. Moreover, high leverage is a potential risk factor. The strategy is therefore a good portfolio hedge if equity markets become more volatile. However, these risks should not deter investors from investing in the international markets. Such kinds of investments ensure that the investor’s portfolio is well spread; this ensures that he takes full advantage of all the available investment markets. Global diversification for investors in stock and real estate markets also serve to protect them from risks associated with concentrating their investments derivatives only. The investors can also plan their dealings in such a way that they invest in markets where the overall cost of operations is low so as to maximize on their gains. Financial planning is thus vital in both personal finance and international investment financing. Works Cited Tyson, Eric. Mutual Funds for Dummies. Indiana: Wiley Publishing, 2004. Print. Wensveen, J, and Wells, A. Theory of arbitrage pricing. 6th ed. Aldershot, England: Ashgate, 2007. Print. Morrison, Smith, and Winston, Christian. Derivatives Markets and Financial Innovations, Washington, D.C.: The brookings Institution. 1986. Print. L. Taschini , M. Paolella, “An econometric analysis of emission trading allowances”, Research papers 06-26, Swiss Finance Institute, 2006. Product design and specification with data and numerical examples policy recommendations Read More