Financial Derivatives
This study emphasized the importance roles of financial derivatives, which has been known for the last decade and its effects on the Global financial crisis. It further analyzes the impact of financial derivatives and how it can be controlled to prevent corporations from incurring a lot of risks. It also explains the existence of financial derivatives since 1970, to the recent Global Financial Crisis which occurred in the 2006.
Risk is a feature associated with all productivity. As a result, financial markets adjust themselves to the fluctuation of exchange and interest rates. Hedging risk, these corporations highlight the importance of risk management tools known as Derivatives. Derivatives are defined as financial tools providing investors with effective solutions when avoiding risk caused from market volatility (Dodd, 2006). Financial derivatives are considered to be an effective risk management tool associated with Financial Engineering creating solutions to financial problems (Marks, 2010). In this…...
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Works Cited
Angel, James, and Douglas McCabe. "The Business Ethics Of Short Selling And Naked
Short Selling." Journal Of Business Ethics 85.(2009): 239-249. Business
Source Elite. Web. 1 Apr. 2012.
Barth, Mary E., and Wayne R. Landsman. "How Did Financial Reporting Contribute To
The developments of credit derivatives began in 1980s as a new financial innovation after the swap market started. Swap market provided derivative organizations with profit due to their intermediary position while the credit margins for borrowers were reduced. As the swap market developed there was the development of new interest derivatives so that there were additions to the list of products. Credit derivatives are relatively recent introductions and these are mechanisms for the credit institutions to separate the credit risk from their loans and treat market risk as a separate category so that their pricing efficiency could be more competitive and the concerned organizations could be more competitive in the market. (Credit Derivatives Move Beyond Plain Vanilla)
Thus one can say that credit derivatives are a recent form that can be used by bankers to reduce risk, or increase risks and thus meet their corporate objectives. The general form of…...
The Black-Scholes-Merton model assumes (circle one)
The return from the stock in a short period of time is lognormal
The stock price at a future time is lognormal
The stock price at a future time is normal
None of the above
11. Volatility can be defined as (circle one)
The standard deviation of the return, measured with continuous compounding, in one year
The variance of the return, measured with continuous compounding, in one year
The standard deviation of the stock price in one year
12. A stock price is $100. Volatility is estimated to be 20% per year. What is the an estimate of the standard deviation of the change in the stock price in one week (circle one)
$0.38
$2.77
$3.02
$0.76
13. To create a range forward contract in order to hedge foreign currency that will be paid a company should (Circle one)
Buy a put and sell a call on the currency with the strike price of the put higher than…...
financial derivatives? What are they used for? Types of derivatives. Types of derivatives markets (where are they negotiated).
What are financial derivatives?
Financial derivatives are essentially a financial contract between two people or two entities that depends on the fulfillment of an economic asset in the future, such as a stock, a bond, commodity, or a currency. The two parties make agreements between each other to ensure that all aspects of it will be covered and work in a specific way by a certain date. Financial derivatives, by the way, are called so since the term 'derivative' denotes that their value 'derives' from underlying assets like stocks, bonds and commodities. These financial derivatives can range from something as simple as a private agreement to something that is controlled by rules and restrictions.
Different types of derivatives
There are various derivatives that meet different needs.
S. firms. he ambiguity can therefore not be ignored.
he work of Gomez-Gonzalez et al. (2012) investigated whether the use of foreign currency derivatives have any effect on the market value of firms using evidence gathered from Colombia. heir results indicated that an increase in the level of hedging ultimately leads to a higher growth in the value of a firm. he use of financial derivates (hedging) is therefore indicated to have a positive impact on a firms' value.
he work of Clark and Mefteh (2010) investigated the relationship between foreign currency derivative usage and firm value using evidence gathered in France and found that the value effect of the financial derivative usage is about 1.5 times higher and was much significant with relatively larger exposure to depreciation while remaining insignificant for firms with lower levels of exposure. his implies that the effects of the hedging instruments depends on the type of…...
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The work of Bartram et al. (2011) indicated that the effect of derivative use on firm value is very positive but is more sensitive to endogeneity as well as omitted variable concerns .The work of Ameer (2009) confirmed this.
Conclusion
The literature suggests that hedging has a value adding effect on firms. The effect however depends on that the type of exposure (whether short or long-term) as well as the type of instruments (options, forwards, foreign currency debt and swaps).The effect is more sensitive to endogeneity as well as omitted variable concerns.
The article that was written by Conley (2011) discusses the impact that collateralized debt obligations (CDO's) would have upon the subprime loans. These were created in 1987, by the Wall Street firm Drexel urnham. In this product, the investment bankers would take a number of different articles and combine them together as one investment. The various assets that were used included: junk bonds, mortgages and other high yielding investments from the debt. The idea with these different products is that the investment bank could offer customers a stated return on their investment. The way it worked is the brokerage firm would distribute each investor, the stated amount of returns that they would make off of the tranche (the CDO investment). This was derived using a complex mathematical formula that would divide the total amount of interest that was received, from the various high yielding products that were inside the CDO.…...
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Bibliography
Case Study, 2011, Investopedia. Available from: [14 February 2011]
Citi Merger a Mistake, 2008, Huffington Post. Available from: [14 February 2011].
Deregulation Redux, 2011, FCIC. Available from: {14 February 2011].
Derivatives, 2011, Financial Dictionary. Available from: [12 February 2011].
Miller, Winchel and Koonce (2015) made use of psychology research (which encapsulates an important derivatives context element - that organizational leaders display careful decision-making and, hence, have a right to employ derivatives), to posit that financial backers' perceptions of companies utilizing derivatives is based on company or industrial norms. The contention is that if companies suffer a negative result owing to its derivative action, financiers will more favorably assess the company, believing that its executives were more careful and had a sound basis for their choice, if derivative application is in line with company or industrial norms, as opposed to contradicting the norms. That is, the authors posited that company or industrial norms systematically changed the way an investor perceived a company's derivative usage.
In a Turkey-specific study, authors Ayturk, Yanik and Gurbuz (2016) studied the application of rate of interest, currency, commodity and other financial derivatives, together with its…...
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References
Ayturk, Y., Gurbuz, A., &Yanik, S. (2016). Corporate derivatives use and firm value: Evidence from Turkey. Borsa Istanbul Review, 108 - 120.
Hoffman, A., Post, T., &Pennings, J. (2015). How Investor Perceptions Drive Actual Trading and Risk-Taking Behavior. Journal of Behaviour Finance, 94 - 103.
Iqbal, Z. (2015). CEO age, education, and introduction of hedging in the oil and gas industry.Journal of Economics and Finance, 189 - 200.
Koonce, L., Miller, J., &Winchel, J. (2015).The Effects of Norms on Investor Reactions to Derivative Use.Contemporary Accounting Research Conference.CAAA.
Banc One wanted to manage its interest rate exposure without using swaps, what could it do? Specifically, how could it move from being asset-sensitive to either neutral or mildly liability-sensitive without using swaps? What are the pros and cons of using swaps vs. these other means of adjusting the bank's interest rate sensitivity? What impact do they have on the bank's interest rate sensitivity, liquidity, accounting ratios, and capital ratios? Make sure you work through the Appendix to the case.
Yes, if Banc One wanted to manage interest rates without swaps it could do it. The bank could attempt to match the duration of its assets with the duration of its liabilities. In addition, the bank would need to match the interest rate exposure of its assets and liabilities on the balance sheet. For example, the assets on the balance sheet may be predominately fixed while the liabilities are floating.…...
Interest rates are set at the national level, and the state of the economy is also national. Additionally, trends in investment flows (particularly into real estate) also proved to be national. As a result, the level of market risk remained high even when the level of asset-specific risk was reduced through the securitization process.
It is not inevitable that this had to happen this way. Banks, however, overinvested in the mortgage-backed securities, believing them to be safe. This reflected a lack of understanding of the true risks associated with mortgage markets, and in general the risks associated with the underlying assets of many MBSs. There are two reasons for this. Securitization created a false sense of security, that diversification would lead to these products having low risk levels. AAA ratings from ratings agencies confirmed this view, despite it being false.
The second reason is that the securitization process was complex. A…...
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Works Cited:
Fender, I. (2000). Corporate hedging: The impact of financial derivatives on the broad credit channel of monetary policy. BIS Working Papers No. 94. In possession of the author.
Gomez, E.; Vasquez, D. & Zea, C. (2005). Derivative markets' impact on Colombian monetary policy. Banco de la Republica. In possession of the author.
A swap is arranged between counterparties who can set the terms of the swap. A bank is usually one counterparty but as with forwards it does not have to be. The swap is settled with an exchange of the difference, rather than the full flows. Companies typically use swaps to manage interest rate exposure, for example when they have a floating rate loan in a foreign country. If a company has a Chinese subsidiary that borrows from the Industrial and Commercial Bank of China, but is concerned about inflation in the country because the yuan pegging distorts interest rate parity, it can use interest rate swaps to hedge this risk by locking in the amount it will pay to settle the floating rate loan, even though the rate might change in the interim.
Options include puts and calls, which are rights to buy or sell a given asset (usually a…...
These strategies can also be used to reduce the risk of a drop in the stock price without regard to tax issues. In deciding whether to employ these strategies, it is necessary to consider the cost of the option and any related transaction costs.
A swap is an agreement in which counterparties (generally two) agree to exchange future cash flows arising from financial instruments. For example, in the case of a generic fixed-to-floating interest rate swap, company a agrees to pay company . periodic fixed interest payments on some "notional" principal amount (say $100 million) in exchange for variable rate payments on that notional. The floating "leg" is typically periodically reset based on some reference rate such as LIOR. Usually, one leg involves quantities that are known in advance (e.g. The "fixed leg" in an interest rate swap) the other involves quantities that are uncertain or variable (e.g. The "floating…...
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Bibliography
McMillan, Lawrence G., 1986, Options as a Strategic Investment: A Comprehensive Analysis of Listed Option Strategies, 2nd edn, New York Institute of Finance, New York.
Smith, Courtney, 1987, Option Strategies: Profit-Making Techniques for Stock, Stock Index, and Commodity Options, John Wiley & Sons, New York.
Coates, C. Robert, 1978, Investment Strategy, McGraw-Hill Book Company, New York.
Bookstaber, Richard M., 1987, Option Pricing and Investment Strategies, Protus Publishing Company, Chicago.
Utility and Benefits of Derivative Instruments
A European asset manager believes there is an elevated risk of extreme volatility in the markets during the next 3 months and wish to fully hedge their portfolio against all risks. However, they are mandated to remain fully invested at all times so selling securities is not an option. Their portfolio currently comprises the following positions.
Notional/Amount Security Term
€1,000,000 Schatz 2-year on-the-run [Futures contract 2-year German debt as underlying]
€10,000,000 Euro Interest ate swap 5-year Fixed eceiver [As fixed rate receiver, the buyer of an Euro-Swap Futures contract is obliged to accept the delivery}
$50,000,000 USD LIBO Interest ate deposit 1 year
Current data for pricing and obtaining rates can be found at www.ft.com under data archive.
The asset manager wants to fully hedge the interest rate risk on the bond by using bond futures. Calculate the appropriate number of bond futures that should be sold. (bond future data…...
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References
Balasubramaniam, K. (2015). How does leverage work in the forex market?
Derivatives in Risk Management
One of the uses for derivative products is in risk management. Organizations have recognized that derivatives can be used to manage risk by offering guaranteed outcomes for a set up-front cost. For firms that face risk due to fluctuations in asset prices -- typically commodities or currencies -- beyond their control, derivatives represent a means of achieving cash flow certainty, if not profit certainty. This paper will explore the different forms that derivatives take, and the different ways in which they are used as a risk management tool. Some recommendation will be given with respect to the use of derivatives in risk management in order to optimize results.
Derivatives and Risk Management
In finance, a derivative instrument is one that has a price that is based on the price of a real underlying asset -- agricultural commodities, metals, sources of energy, currencies, stocks and bonds (Chance & Brooks, 2008).…...
Thus, the company is not attempting to either "win" or "lose" with its transactions. Thus, either may occur over any given period. An example of a fuel hedging "loss" occurred in late 2008 and into 2009. During this period of high volatility, fuel prices shot up as high as $140 per barrel in mid-2008, only to quickly crash down to $40. This volatility is a tremendously challenging environment. The company's policies of hedging six months out would have helped as the fuel prices skyrocketed in the spring of 2008. Under that situation, the company would have been paying prices from January for fuel in June, delivering significant savings. On the way back down, however, the company would have been paying June prices in December. hen the latter hit the annual income statement in FY 2009, it was recorded as a £330 million loss on fuel price hedging. During this…...
It is difficult to understand or explain why throughout history some negative investor philosophies continually repeat themselves. Far too often investors miss blatant signs that lead to major collapses in the free markets. The purpose of this report is to discuss derivative securities in detail and how they affect those investor philosophies. Even unsophisticated investors understand that the stock and commodities markets are supposed to fluctuate on a daily basis. A key in the minds of investors is to avoid overly large swings in either direction and to also take advantage of those market swings that are heading in the right direction. To solve this ageless dilemma, investment bankers and individual investors themselves have historically created new and unique systems, methods and processes that help avoid those big swings. But what happens when the new and unique systems, methods and processes actually become the problem. Over…...
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References
Black Tuesday.(n.d.) lowrisk.com. Retrieved on October 23, 2009, from .
Hoadly Training and Investment Tools. (2009). Option Pricing Models and the "Greeks." Retrieved on October 23, 2009, from http://www.hoadley.net/options/bs.htm
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