Role Played By Speculators and Hedgers in the Derivatives Market - Assignment Example

1(a) Role played by speculators and hedgers in the derivatives market: The derivatives market has three types of traders: i) Hedgers. ii) Speculators. iii) Arbitrageurs. Hedgers use derivatives for hedging their risks on the underlying assets. The hedges are designed to eliminate or reduce their downside risk. The objective of hedgers is not to gain from derivative trades but to eliminate or reduce their risks. Derivatives were originally designed with the objective of hedging (John C. Hull, 2008). Speculators trade in the derivatives market with the objective of making gains from taking positions in the derivatives market. They enter into long and short positions. Speculators also use a lot of leverage. The advantage from speculation is that it adds to the liquidity of the market. The big disadvantages of speculation are that it increases volatility in the market and excessive speculation creates bubbles and artificial price rises. The regulatory activity is designed to check excessive speculation (Boumlouka, Makrem,2009). Arbitrageurs are a third important group of participants in the derivatives market. Arbitrage involves locking in a riskless profit by simultaneously entering into transactions in two or more markets (John C. Hull, 2008). 1 (b). Hedging strategy of the fund manager: The appropriate hedging strategy for the hedge fund manager would be to go long ( buy) put options. These put options have: i) Strike price of 2500. ii) Expiry in December. The current value of the FTSE 100 index is 2600. For each 100* 2600 ( value of the index) pounds in the portfolio, the fund manager should buy one put option. Therefore total number of put options that the fund manager needs to buy is: Value of the portfolio / (2600*100) = 10,000,000/ 260000 = 38.5. Rounding the above figure, the total number of put options that the fund manager needs to buy is 39. Such a hedging strategy will protect the fund manager against all downside risks if the index goes below the level of 2500. Take for example, that in December, the index is at 2100 points. Therefore loss in the value of index from the 2500 mark is: ((2500-2100) / 2100 )* 100 = 19.047%. Now the Beta of the portfolio of the fund manager is 1. Therefore, the percentage loss in the value of the portfolio will be equal to the percentage loss in the value of the index. Value of the portfolio when index is at 2600: 10,000,000. Value of the portfolio when the index is at 2500: (2500/2600) * 10,000,000 = 9615384.615. Value of the portfolio when the FTSE 100 index is at 2100: (2100/2500) * 9615384.615= 8076923.077. The put options will be exercised in this case. Pay-off from the exercise of the put options: 39* (2500 – 2100)* 100 – price of the options ( 40 p * 39) = 1559984.4 Value of the portfolio when the index is at 2100 + the pay-off from the exercise of the put options = 8076923.077 + 1559984.4 = 9636907.477. The value at 9636907.477 is slightly more than the value of the portfolio at the index value of 2500. Therefore we can see that by buying the put options the fund manager has effectively hedged his portfolio against the index going down below the 2500 mark. If the value of the index is above 2500 mark then the put options will not be exercised. Speculative strategy of the sophisticated investor: As a sophisticated speculator I will take positions. I strongly believe that the FTSE 100 index will rise to 2800 in December. Futures contract with exercise price of 2700 are currently available. I have GBP 10 million available I will take a long position in this futures contract with exercise price of 2700. One futures contract is for 100 times the size of the index. Therefore, the total number of future contracts in which I will have a long position will be: 10,000,000/ 270000 = 37 contracts. If my belief turns out to be right and in December the FTSE 100 index rises to 2800 mark, my pay-off will be: 37* (2800-2700)* 100 = 370,000. The mark-to-market settlements have been ignored here. But the total net pay-off will be 370,000 if the index rises to 2800 mark. If the mark-to-market settlement is ignored, I can also invest GBP 10 million at risk free interest rate. If the risk free interest rate is ‘r’ and time till December is T, then 10,000,000 will grow to: 10,000,000 * e^ rT (compounded continuously) My total pay-off in this case will be: 10,000,000 *e^rT+ 370,000. However if my speculation does not turn out to be right and the FTSE 100 index instead of going up, goes down, then I will make huge losses. Speculation is a very risky business. Outcome under different scenarios: FTSE 100 index is at 2080: Fund manager: The put options will be exercised. The gain from the exercise of the put options will be: (2500 – 2080) * 39 * 100 – 15.6 = 1,637,984.4. Value of the original portfolio when the index is at 2080: 9615384.615* 2080/2500 = 8000000. Total value of the hedged portfolio = 8000000 + 1637984.4 = 9637984.4. Therefore because of the hedging strategy there is no unfavorable impact on the value of the original portfolio because of the slide in the value of the index. Speculator: Under the strategy of speculation, if the FTSE 100 goes down to 2080 in December, the pay-off will be: (2080-2700 ) * 37* 100 = - 2,294,000. The negative pay-off means that the speculative strategy will lead to a loss of GBP 2,294,000. If the speculator had invested 10,000,000 at risk free rate of interest r , and we ignore the mark-to-market settlements of future contracts, the pay-off of the speculator will be: (10,000,000e^rT- 10,000,000) – 2,294,000. FTSE 100 Index is at 2600 in December: Fund Manager: The fund manager will not exercise the put options because the exercise of put options will lead to a negative pay-off. The value of the original portfolio will remain unchanged because the FTSE 100 index is at its original level of 2600 and Beta of the portfolio is 1. Speculator: The pay-off from speculation will be: 37*(2600-2700)*100 = - 370,000. The speculation will therefore lead to a loss of GBP 370,000. However, if we assume that the GBP 10 million was invested at risk free rate of interest, r, then the pay-off from speculation will be: (10,000,000e ^ rT- 10,000,000) – 370,000. If the FTSE 100 rises to 3120 in December: Fund Manager: The put option will not be exercised because it will give negative pay-off. The rise in the value of the index: (3120-2600)/2600 = .20 or 20%. Since the Beta of the portfolio is 1, the portfolio will also rise by 20%. Rise in the value of the portfolio: (20/100) * 10,000,000 = 2000000. Therefore total value of the portfolio will be: 10,000,000 + 2000000 = 12000000. Speculator: The speculation will bring a pay-off of: 37 * (3120-2700)*100 = 1554000. The speculation, in this case, will lead to a gain of GBP 1,554,000. If we assume that GBP 10 million have been invested at risk free rate of interest r then, the pay-off will be: 10,000,000*e^rT- 10,000,000 + 1554000. 1 (c). My friend is sure that the FTSE 100 index will move, but he is not sure about the direction of that movement. Therefore appropriate strategy for him will be strangle. In strangle, the investor buys one put option and one call option of different strike prices ( the strike price of call option being higher than the strike price of the put option) but same maturity ( December). Therefore my friend should buy 39 call options with exercise price of 2700 and 39 put options with strike price of 2500. The price of one call option is 50 p while that of put option is 40 p. If, the value of index rises above 2700, my friend will exercise the call option and will not exercise the put option. If the value of the index is between 2500 and 2700 then both the options will not be exercised and the strangle strategy will have zero pay-off. Pay-off of the strangle strategy: Range Pay-off from the exercise of the call option Pay-off from the exercise of the put option Total pay-off of from the strangle < 2500 0 ( will not be exercised) 2500 – value of the index ( put option will be exercised) Total pay-off from the exercise of the put option. 2500 ≤ Value of the FTSE 100 index ≤ 2700 0 ( will not be exercised) 0 ( will not be exercised) 0 >2700 Value of the index - 2700 0( will not be exercised) Pay-off from the exercise of the put option. Diagrammatic representation of the pay-offs under the strangle strategy: A2 (a): The treasurer of Fox plc has the following two strategic options available: i) A current forward rate agreement ( FRA ) is available at 6%. The treasurer can enter into this forward rate agreement with the counter-party and borrow 30 million at 6% rate of interest. Through this forward rate agreement ( FRA ), the company will be protected from the increased outflows due to rise in interest rates above 6%. ii) Three months sterling futures, starting six months from now, are currently available at 94.00. The market therefore is of the opinion that in six months time, the interest rates will be 6% (100-94). If the market rate rises by .01% (1 basis point) to 6.01%, the increase in annual cash outflows due to increased interest rates will be: ((6.01% * 30,000,000 – 6% * 30,000,000) /12) * 3 = (1803000 – 1800000)*.25 = 750. Therefore the treasurer of the Fox Plc. can sell three month sterling futures available at 94.00 for 750 per basis point. A2 (b) Scenario Analysis: If the interest rate goes down to 4%: If the interest rate falls to 4%, under the Forward Rate Agreement, Fox plc. will have to continue to pay interests at 6% . Therefore because of the Forward Rate Agreement it will have a notional loss of: (.06*30,000,000 - .04* 30,000,000)* .25 = (1800000 – 1200000) * .25 = 150,000. Under the second strategy of selling interest rate futures, the price of the futures contract will now be 96.00 (100 – 4%). Closing position will therefore be: 96.00*100 = 9600 Opening position: 94.00*100 = 9400. Difference: Opening position – closing position = 9400 – 9600 = - 200. Pay-off: Difference * 750 = -200 * 750 = - 150,000. The second strategy will lead to an actual loss of – 150,000. However this loss will be totally offset by the lower interest rates that the company will pay on its loan because of lower interest rates. If the interest rate rises to 8%: If the treasurer has opted for the Forward Rate Agreement strategy, then Fox plc. will continue to pay interests at the rate of 6% on its loan. This means that it will realize a notional gain of: (.08 * 30,000,000 - .06*30,000,000)*.25 = (2400000 – 1800000)*.25 = 150,000. Under the selling of sterling interest futures (STIRs), the price of the futures contract will drop down to 92.00 (100 – 8%). Closing position: 92.00 * 100 = 9200 Opening position: 94.00 * 100 = 9400. Difference: opening position – closing position = 9400 – 9200 = 200 Pay-off: Difference * 750 = 200 * 750 = 150,000. Pay-off from the sterling interest rate futures at 4% and 8% This gain of 150,000 will be completely offset by the higher interest rate at 8% that Fox plc. will pay on its loan. Advantages of Forward over Futures: i) Forward contracts are traded over-the-counter and not on exchanges. There are no margin requirements or mark-to-market settlements. ii) The parties involved in the forward contracts can customize the contracts according to their needs. iii) Transaction costs are totally eliminated in forward contracts. Disadvantages of Forward over Future: i) Futures are traded on exchanges while forward contracts are entered over-the-counter. Unlike futures there is no mark-to-market settlement in forward contracts. The credit risk is the risk that one of the counter-parties will default in its obligations. Such a risk is very high in the case of forward contracts (Whaley, Robert ,2006). ii) Forward contracts are often entered into through various financial intermediaries like investment banks. These financial intermediaries charge their commission. This increases the cost of entering into forward contracts and sometimes offsets the benefits of lower transaction costs (John C. Hull, 2008). 3a. Swap: The interest rate for the dollar loan for company ABC is 10%. For company XYZ this is 7%. The interest rate on the sterling loan for company ABC is 10%, while this is 8.5% for company XYZ. Company XYZ has a comparative advantage on the dollar loan while company ABC has a comparative advantage on the pound sterling loan. Company XYZ wants to borrow in pound sterling while company ABC wants to borrow in dollar. Difference between the dollar interest rate of the two companies = 10% - 7% = 3%. Difference between the sterling interest rate of the two companies = 10% - 8.5% = 1.5%. Therefore the net gain from the Swap agreement should be: 3% - 1.5% = 1.5%. Company XYZ should enter into a Swap agreement with company ABC, through the intermediary bank. Company XYZ should borrow in dollars while company ABC should borrow in pound sterling. Company XYZ will pay 7.85% of the loan amount in pound sterling to the bank. The bank in turn will pay company ABC 10% of the loan in pound sterling. Company ABC should pay 9.35% of the loan amount in dollars to the bank. The bank in turn will pay 7% of the loan amount in dollars to company XYZ. Now because of this Swap agreement each party gains .65%. Company XYZ pays only 7.85% instead of 8.5% which it would have paid if it had directly accessed the market for the pound sterling loan. Company ABC pays only 9.35% instead of 10% which it would have paid if it had directly accessed the market for the dollar loan. The financial intermediary, the bank, accepts 7.85% from XYZ and pays 10% to ABC, while it gets 9.35% from ABC and pays 7% to XYZ. Therefore the bank will net: 7.85%- 10% + 9.35% - 7% = .2% per annum. 7.85% ` 10% 7% 9.35% The total gain to all the three parties: .65% + .65%+ .2% = 1.5% 3(b). Risks associated with banks that act as intermediary in Swap agreements: The intermediary in Swap agreements like the above one will have to bear the obligations if any of the parties to the Swap defaults on its obligation (John C. Hull, 2008). For example, if in the above Swap agreement company ABC failed to honor its part of the contract i.e. pay 9.35%, the bank acting as the intermediary would have to take its place and pay 7% to company XYZ. The spread that banks or intermediaries earn (.2% in the above case) is a compensation for this risk. Role of derivatives and financial innovation in the banking sector’s failure in the financial crisis: Excessive financial innovation and financial engineering led to the designing of exotic derivative instruments like collateral debt obligations, credit default swaps, mortgage debt securities and numerous other exotic derivative contracts. Many of these exotic derivatives were traded only in the over-the-counter markets (Brigo, D, Pallavicini, A, and Torresetti, R, 2010). The trading books of many banks were burdened by these exotic derivative instruments. The 1996 Bank of International Settlements requires banks to revalue the trading book on a regular basis (Brigo, D, Pallavicini, A, and Torresetti, R, 2010). Banks have to calculate the 10 day, 99% confidence, Value at Risk ( VaR) on their trading book. They then need to hold capital that is k times this value. The minimum value of k is 3 for banks with excellent well-tested VaR estimation procedures. Now the banks failed to calculate accurate VaRs on the complex and exotic derivatives. This left them under-capitalized when the risks materialized. The actual losses were much more than the Value at Risks calculated by the banks. The situation was exacerbated by the defaults on the mortgage loans in United States. This caused the property bubble to burst (Steverman, Ben ,2008),. A chain reaction started which froze credit growth. This brought an economic slowdown which soon turned into an economic recession and spread from the United States to United Kingdom and the rest of the world. A kind of vicious cycle of lower or negative growths, increased defaults and decreased credit started. References: John C. Hull, 2008, Options, Futures And Other Derivatives, Prentice-Hall. Boumlouka, Makrem (2009),"Alternatives in OTC Pricing", Hedge Funds Review Brigo, D, Pallavicini, A, and Torresetti, R, (2010), Credit Models and the Crisis: A Journey into CDOs, Copulas, Correlations and dynamic Models, Wiley and Sons. Liebowitz, Stan (2008). "The Real Scandal – How feds invited the mortgage mess". New York Post. Steverman, Ben (2008), "The Financial Crisis Blame Game", Businessweek Baily, Martin Neil & Elliott, Douglas J. ( 2009). "The U.S. Financial and Economic Crisis: Where Does It Stand and Where Do We Go From Here?". Brookings.edu Whaley, Robert (2006). Derivatives: markets, valuation, and risk management John Wiley and Sons Read More