Analysis of Derivatives and the Perception of Investors

Chapter 1: Introduction

1. Introduction:

The stock market is characterized by volatility, which creates uncertainty in the market and makes predictions regarding future exchange rates difficult, both in the short and long term. However, it is these constant fluctuations in the stock market that make it possible for companies or individuals to take advantage of the movements in exchange rates through speculative activities. These fluctuations also pose a threat for any importer/exporter trading in the global marketplace as international businesses are naturally exposed to currency risk. This necessitates the adoption of hedging strategies to mitigate risk. The volatility in the stock market needs to be dealt with in a proper, prudent and timely manner. Otherwise, adverse currency fluctuations can inflict painful lessons on a company or individual. Later in this thesis we will investigate in detail the volatility of the stock market and the potential risk exposure faced by all market participants. People enter into the stock market for various reasons and the above mentioned potential for profit is a very important motivation. Indeed, some traders who come with the intention of making profit by taking advantage of market fluctuations engage in speculative activities in the stock market and accept the risks involved, while others attempt to protect themselves from volatility by engaging in hedging activities. Traders in this first category are commonly known as speculators, whereas the latter are known as hedgers. Speculators enter the market, in effect, by placing their “bets” on the market movements. Should their prediction come true, they make profits; if their predictions are not realized, they suffer losses. Hedgers enter the market with the intention of insuring themselves against any adverse market movements they may encounter in their business operation. Hedging involves the creation of a position that offsets an open position occurring in their business operations; so that the gain in the business (hedge) position will offset the loss of the hedging (business) position. There are various financial instruments used for trading in the stock market. The most common are spot contracts, forward, futures, options, swaps and various money market instruments. Forward, futures, options and swaps are derivatives instruments. Commonly used instruments in the money market include (but are not limited to):

1. Treasury bills,
2. Eurodollar,
3. Euro yen,
4. Certificate of deposit (CD),
5. Commercial paper

In fact, the money market represents most of the financial instruments that have less than twelve months maturity. This margin is also known as the leverage ratio and can range from twenty to two hundred, depending on the financial institutions involved. If the given leverage ratio is twenty, the trader using a leveraged spot contract can have access to a credit line twenty times larger than his/her initial margin (collateral). Clearly, the leveraged ratio allows traders (both speculators and hedgers) to trade at a significantly lower capital requirement when compared to the spot market. The general mechanism of each of these markets (forward, futures, options, swaps and money markets) will be explained in detail in this thesis.

1.2 Research Context:

The selection of the particular research approach depends on the kind of information required. Qualitative research collects, analyzes, and interprets data that cannot be meaningfully quantified, that is, summarized in the form of numbers. For this reason, qualitative research is sometimes referred to as soft research. “Quantitative Research” calls for very specific data, capable of suggesting a final course of action. A primary role of quantitative research is to test hunches or hypotheses. These suggest that qualitative approach is a soft research approach in which collected data cannot be meaningfully quantified and more importantly in this approach non-structured research is conducted. But so far as quantitative research approach is concerned, through this approach structured research is conducted with approaching larger respondents and the collected data can be meaningfully quantified. Research data can be collected either in the form of secondary or primary or both. This assumption is obviously not realistic. With the aim to close this gap between theory and practice, a new model is developed in this thesis using the assumptions that the interest rate definitely changes according to economic conditions or policies and that the exchange rate movement follows the pattern of a random walk, which is a stochastic process. Moreover, during the course of our research, we did not encounter any literature that dealt with leveraged spot contracts as both speculative and hedging instruments. It is obvious that the leveraged spot market is relatively less commonly used by financial derivatives traders, compared to traditional instruments such as forward, futures, options, swaps, and the money market. Our objective is therefore to develop a model using leveraged spot contracts as an effective financial instrument that can be used for both speculative and hedging purposes.

1.3 Research Objective:

* Analysis of Derivatives and the perception of investors”

1.4 Research Questions:

• Illustrate how the leveraged spot market can be utilized both as a speculating as well as a hedging tool.
• Derive insights into how real world data will affect the optimal number of contracts that a trader should trade (or invest) at any given time.
• Present a Black scholes model for speculation using leveraged spot contracts based on Krugman’s model of exchange rate dynamics within a target zone.
• Demonstrate how a trader can hedge an open position in the leveraged spot market with a simultaneous position in the forward market to generate profit.
• Explain how a hedger can hedge an existing business transaction exposure using options.

1.5 Research Boundary and Scope:

This thesis is organized into chapters/sections. The first chapter is an introduction to the thesis. Next chapter provides a view on hedging and the volatility of the Stock market. These two parts: the first part covers a background of hedging and explores the common applications and techniques of hedging; and the second part covers the volatility of Stock market movements, providing a brief background on the economic fundamentals of exchange rate determination and dynamics, exchange rate systems, international financial markets, and government policies affecting exchange rate systems. How the leveraged spot market can be used as a speculating tool. We have adapted model of exchange rate dynamics within a target zone, we assume that the exchange rate movement follows the pattern of a random walk and we develop a model showing how the leveraged spot contract can be used as a superior financial tool when compared to forward and spot contracts under certain circumstances.

However, before developing this model illustrates the mechanism of trading in the leveraged spot market with a numerical example. This describes how to eliminate the risk which arises from speculative leveraged spot transactions using a forward contract. Moreover, several numerical examples are used to illustrate how companies can utilize leveraged spot contracts as a hedging tool. We show in this chapter that the leveraged spot contract, when used in conjunction with a forward contract, can indeed derive risk free profits for its users. The effectiveness and profit generated from using leveraged spot contracts depends on the leverage ratio and the interest rate differential between the home and foreign countries.

Chapter 2: Literature Review

The financial world has witnessed several major catastrophes in the last dozen years. The first catastrophe was the collapse of Barings Bank in Britain in 1995. The bank’s collapse was a direct result of Nick Lesson’s aggressive trading in the futures and options markets. Between 1992 and 1995, the self proclaimed “Rogue Trader”1 accumulated losses of over £800million. In February 1995, the 233 year-old Barings Bank was unable to meet the Singapore Mercantile Exchange’s (SIMEX) margin call. The bank was declared bankrupt and was bought by the Dutch Bank, ING, for only £1. The second catastrophe was the Asian financial crisis in 1997. Much literature had been written about the crisis as the financial world tries to understand what went wrong that led to the crisis. Some authors claimed that the crisis was triggered by the run of panic investors on those economies as well as depositor on banks which led to the burst of a bubble economy; while others blamed the crisis on the moral hazard in the Asian banking (financing) systems. We believe that the Asian financial crisis was due mainly (but not limited) to the structural imbalance in the region, caused by large current account deficits, high external debt burden, and the failure of governments to stabilize their national currencies. These problems were worsen by the poor prudential regulation of 1 Nick Lesson wrote an autobiography called “Rogue Trader” detailing his role in the Barings scandal while imprisoned, the Asian financial system during the 1990s. The combination of these factors contributed to the long-term accumulation of problems in fundamentals, such as large amount of ‘over-lending’ and bad loans in banking systems which led to the bankruptcies of large firms/banks in the economy, and eventually destroyed the confidence of investors and triggered the panic run of both investors and depositors of the Asian financial system. As part of the efforts, governments tried entering the derivative markets to stabilize their currencies. The Thai Government, for instance, utilized the forward market. However, as the world witnessed the collapse of several Asian currencies during the course of the 1997 financial crisis, it was obvious that these stabilizing efforts were not successful. As the Asian countries continued their recovery efforts, Enron collapsed in 2001 as a result of imprudent use of financial derivatives. It had been reported that Enron’s management engaged in questionable transactions in the options market, in an attempt to keep the true economic losses of various investments off Enron’s financial statements and to try to conceal the actual financial situation of the company. The consequences of these catastrophes were devastating. They impacted not only on the governments and companies directly involved in the events, but also their stakeholders, such as shareholders, employees and ordinary citizens. Many studies examining international financial markets have been designed to prevent the future occurrence of a similar catastrophe. Most of these studies are still attempting to learn from past mistakes through analyzing what exactly triggered such catastrophic events. Amongst those many studies, some have been undertaken to assist companies to minimize their exposure to fluctuations in the currency market, and to implement better techniques and supervision of corporate risk and management.

As a result, topics such as currency exposure, hedging strategies and prudent, ethical company practices have become mainstream issues in international financial markets. This thesis is concerned with hedging techniques in relation to the risk faced by companies and individuals of currency fluctuations. We will point out the limitations and strengths of common hedging techniques and then derive a new technique for hedging. This new model aims to minimize or eliminate the limitations of existing hedging techniques. The importance of understanding the underlying economic and financial fundamentals, which were possibly responsible for the 1997 Asian financial crisis, is noted. This chapter begins with a background discussion of hedging and explores the common applications and techniques of hedging. It continues by addressing exchange rate volatility through providing a brief background of the economic fundamentals of exchange rate determination and dynamics, and government policies.

Globally, operations in the foreign exchange market started in a major way after the breakdown of the Bretton Woods system in 1971, which also marked the beginning of floating exchange rate regimes in several countries. Over the years, the foreign exchange market has emerged as the largest market in the world. The decade of the 1990s witnessed a perceptible policy shift in many emerging markets towards reorientation of their financial markets in terms of new products and instruments, development of institutional and market infrastructure and realignment of regulatory structure consistent with the liberalized operational framework. The changing contours were mirrored in a rapid expansion of foreign exchange market in terms of participants, transaction volumes, decline in transaction costs and more efficient mechanisms of risk transfer. The origin of the foreign exchange market in India could be traced to the year 1978 when banks in India were permitted to undertake intra-day trade in foreign exchange. However, it was in the 1990s that the Indian foreign exchange market witnessed far reaching changes along with the shifts in the currency regime in India. The exchange rate of the rupee, that was pegged earlier was floated partially in March 1992 and fully in March 1993 following the recommendations of the Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and an important step in the progress towards current account convertibility, which was achieved in August 1994. A further impetus to the development of the foreign exchange market in India was provided with the setting up of an Expert Group on Foreign Exchange Markets in India (Chairman: Shri O.P. Sodhani), which submitted its report in June 1995. The Group made several recommendations for deepening and widening of the Indian foreign exchange market. Consequently, beginning from January 1996, wide-ranging reforms have been undertaken in the Indian foreign exchange market. After almost a decade, an Internal Technical Group on the Foreign Exchange Market (2005) was constituted to undertake a comprehensive review of the measures initiated by the Reserve Bank and identify areas for further liberalization or relaxation of restrictions in a medium-term framework.

The momentous developments over the past few years are reflected in the enhanced risk-bearing capacity of banks along with rising foreign exchange trading volumes and finer margins. The foreign exchange market has acquired depth. The conditions in the foreign exchange market have also generally remained orderly. While it is not possible for any country to remain completely unaffected by developments in international markets, India was able to keep the spillover effect of the Asian crisis to a minimum through constant monitoring and timely action, including recourse to strong monetary measures, when necessary, to prevent emergence of self-fulfilling speculative activities.

2. Financial Derivatives Markets:

With the ever increasing total notional value of derivative contracts outstanding worldwide, it is little wonder that there has been continuous interest in unlocking the “mystery” of hedging using financial derivatives. Studies have shown that in 1994, the total value of hedging was USD 18 trillion. This is more than the combined total value of shares listed on the New York Stock Exchange and the Tokyo Stock Exchange. The amount exceeded USD 55 trillion in 1996, and in 1998, the figure had already reached USD 70 trillion, which is almost four times more than in 1994. Moreover, according to Bureau of Information Statistics (2005), from 1995 to 1998, spot foreign exchange transactions increased by 15%, reaching a total of USD 600 billion-a day, while over-the-counter currency options doubled to a total outstanding daily value of USD 141 billion. According to the Central Bank Survey 2004, the average daily turnover in foreign exchange derivatives contracts rose to $1,292 billion in April 2004 compared to only $853 billion in April 2001 (IBS, 2005). Table 2.1 shows that outright forward and foreign exchange swaps hold the record as the most popular derivatives traded over the counter. As such figures continue to climb strongly, it is important to understand the mechanism of the foreign exchange derivatives markets, including what motivates companies to enter the market, and how corporations utilize the market as a hedging mechanism. According to an author Robert W. Kolb, “a derivative is a financial instrument based upon another more elementary financial instrument. The value of the financial derivative depends upon, or derives from the more basic instrument. The base instrument is usually an underlying asset, as cash market financial instrument, such as a bond or a share of stock”. The underlying instrument can also be based on movements of financial markets, interest rates, the market index, commodities, or a combination of these assets. For example, consider the derivative value of oil, which indicates that the price of an oil futures contract would be derived from the market price of oil, reflecting supply and demand for the commodity. In fact, as oil prices rise, so does the associated futures contract. It is noted that in order for the derivative market to be operational, the underlying asset prices have to be sufficiently volatile. This is because derivatives are risk management tools. Hence, if there is no risk in the market, there would be no need for the existence of any risk management tool. In other words, without manageable risk, the use of derivatives would be meaningless. Derivatives commonly used as hedging instruments include the foundational form of:

1. forward contracts

2. futures contracts

3. options contracts,

4. Swaps, which involve a combination of forward and spot contracts or two forward contracts.

However, with the rapidly changing business environment, many hedgers have also given increasing attention to other more sophisticated and “exotic” derivatives which evolved from these basic contracts and often consist of a combined use of two or more foundational contracts, such as Options Futures.

Global OTC Derivative Market Turnover, 1998-2007

Daily Averages in April, in billions of USD

Description

1998

2001

2004

2007

Foreign Exchange Power

688

959

853

1,292

Outright forwards and foreign Exchange Swaps

643

862

786

1,152

Currency Swaps

4

10

7

21

Options

41

87

60

117

Other

1

0

0

2

Interest Rate Turnover

151

265

489

1,025

FRAs

66

74

129

233

Swaps

63

155

331

621

Options

21

36

29

171

Other

2

0

0

0

Total Derivatives Turnover

880

1,256

1,385

2,410

Memo:

Turnover at April 2004 exchange rates

825

1,350

1,600

2,410

Exchange traded derivatives

1,221

1,382

2,180

4,657

Currency Contracts

17

11

10

23

Interest Rate Contracts

1,204

1,371

2,170

4,634

The 2004 survey is the sixth global survey since April 1989 of foreign exchange market activity and the fourth survey since March/April 1995 covering also the over-the-counter (OTC) derivatives market activity. The survey includes information on global foreign exchange market turnover and the final statistics on OTC derivatives market turnover and amounts outstanding.

2.4.2 Types of Players in Derivatives Markets:

There are three categories of players in a functioning derivatives market:

1. Hedgers

2. Speculators

3. Arbitrageurs

While each of these players use the market with varying intention, their combined and balanced influence ensure the market liquidity and volatility that allows the derivatives market to operate. It is easy yet important to differentiate the varying motives of these players. In terms of their level of risk aversion, arbitrageurs are by definition highly risk intolerant (risk averse individuals) who only trade in risk-free transactions; whereas speculators are on the other side of the spectrum (risk-seeking individuals), as they make profit by taking risk; hedgers are risk neutral individuals, as they choose their strategies by ranking the expected value of any given strategy. Based on their varying attitude towards risk these players tend to engage in the derivatives market with very different transaction patterns. More specifically, an arbitrageur who seeks risk-free profits will simultaneously take up a position in two or more markets, for instance, simultaneously buy spot and sell forward the INR, in an attempt to exploit mis-pricings due to a market that is not in equilibrium. However, such price differentials are almost non-existent in a well-functioning market, mainly because supply and demand tends to rapidly restore market equilibrium. As opposed to the arbitrageur, a speculator seeks profit by taking risk. For example, speculators who anticipate an appreciating INR will put their “bets” on the rising INR. They can do so by buying the INR at a lower value, and then selling it when the value is higher should the prediction come true. A hedger enters derivatives markets mainly with intention to insure against price volatility beyond their control. Based on this intention, it is not surprising that hedgers are mostly acting on behalf of corporations. The mechanism of hedging mainly transfers risk to others who are willing to accept the risk. Indeed, the risk is never nullified but merely transferred from one party to another. In most cases, speculators are those who absorb the risks transferred by hedgers. It is perhaps due to these notions that some have referred to the derivatives market as the ‘zero-sum game market, where the gain of one party is exactly equal to loss of another party’. Over the last decades, the foreign exchange markets have experienced explosive growth. Indeed, according to the Central Bank Survey 2004, the average daily turnover in traditional foreign exchange markets rose to $US 1,880 billion in April 2004 compared to $US 1,200 billion in April 2001.

2.1 Option Market:

Similar to futures markets, options markets provide impersonal transactions between two participants in an organized, orderly and cost-efficient open outcry auction market. Examples of these markets are the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX) and the Australian Stock Exchange (ASX). An options contract gives the contract holder the right but not obligation to buy or sell an asset at a will be specific price and delivery date. For a currency options contract, that asset will be a currency. The contract holder is also known as the options buyer. The counterparty of a contract holder is known as the contract writer or contract seller, who is obligated to respond to the contract holder. In other words, if the contract holder chooses to exercise the contract, the writer is obligated to respond.

Call Options Right and Obligations

Buyer (holder)

Seller (writer)

Has the right to buy a futures contract at a predetermined price on or before a defined date.

Grants right to buyer, so has obligation to sell futures at a predetermined price a buyer’s sole option.

Expectation: Rising prices

Expectation: Neutral or falling prices

Put Options Right and Obligations

Buyer (holder)

Seller (writer)

Has the right to sell a futures contract at a predetermined price on or before a defined date.

Grants right to buyer, so has obligation to buy futures at a predetermined price a buyer’s sole option.

Expectation: Falling prices

Expectation: Neutral or rising prices

The Options markets offer two styles of contracts: the American and the European. The style of an options contract dictates when it can be exercised. The American options contract gives the buyer (holder) the right to exercise the option at any time between the date of writing and the expiry date; the European options contract, on the other hand, can only be exercised on its expiration date, but not before the expiry date. In Australia, the Australian Stock Exchange (ASX) only offers standardized options contracts. Overseas options markets do offer options contracts in two forms: customized and standardized. The customized options contracts are also known as the over-the-counter (OTC) options. It is usually written by banks for US dollars against the British pound sterling, Swiss francs, Japanese yen, Canadian dollars and the euro. These customized options contracts can be tailored to suit individual needs, in terms of delivery dates, contract size and strike price. The contract size of these over-the-counter options contracts can reach $1 million or more with maturity of up to one or two years. The standardized option contracts are also known as exchange traded options (ETOs). These standardized options contracts were first introduced in the United States by the Philadelphia Stock Exchange (PHLX) in December 1982. Other markets such as the Chicago Mercantile Exchange later followed suit. Like the futures contracts, these exchange traded options are settled through a clearinghouse. The clearinghouse acts as the middleman and handles both sides of an options transaction. Acting as the counterparty of all options contracts, the clearinghouse guarantees the fulfillment of these contracts. Until this time, currency options contracts are still not available for trading through many of the Stock Exchanges. In fact, the Australian Stock Exchange only offers equity options and index options. For traders wanting to speculate or hedge using currency options contracts, they can utilize overseas options markets that offer currency options contracts, for example the Philadelphia Stock Exchange (PHLX). The exchange traded currency options offer standardized features such as expiration months and contract size. The following Table 2.8 consists of some of the standardized features of an exchange traded currency options contract as listed by the Philadelphia Stock Exchange (PHLX).

Features of Exchange Traded Currency Option Contracts

AUD

GBP

CAD

Euro

Yen

Swiss Franc

Contract Size

50,000

31,250

50,000

62,500

6,250,000

62,500

Position and Exercise Limits

200,000

200,000

200,000

200,000

200,000

200,000

Base Currency

USD

USD

USD

USD

USD

USD

Underlying Currency

AUD

GBP

CAD

EUR

JPY

CHF

Exercise Price Intervals (for 3 nearest months)

1¿ 

1¿ 

0.5¿ 

1¿ 

0.005¿ 

0.5¿ 

Exercise Price Intervals (for 6, 9 or 12 months)

1¿ 

2¿ 

0.5¿ 

1¿ 

0.01¿ 

1¿ 

Premium
Quotations

Cents per
unit

Cents per
unit

Cents per
unit

Cents per
unit

Hundredths
of cents per
unit

Cents per
unit

Minimum Premium Change

$.(00)01
per unit =
$5.00

$.(00)01
per unit =
$3.125

$.(00)01
per unit =
$5.00

$.(00)01
per unit =
$6.25

$.(00)01
per unit =
$6.25

$.(00)01
per unit =
$6.25

Expiration Months

March,
June,
September,
December
+ two
near-term
months

March,
June,
September,
December
+ two
near-term
months

March,
June,
September,
December
+ two
near-term
months

March,
June,
September,
December
+ two
near-term
months

March,
June,
September,
December
+ two
near-term
months

March,
June,
September,
December
+ two
near-term
months

Exercise Style

American and European

American and European

American and European

American and European

American and European

American and European

2.2 Future and Forward:

2.2.1 Forward:

In 1982, a study had been conducted based on the random sampling of the Fortune 500 companies. In that study, it had been found that the extensive adoption of forward contracts amongst Fortune 500 companies that were involved in currency hedging, it is by far the most commonly adopted hedging instruments. This popularity is perhaps due to the long history of usage, dating back to the early days of civilization and the trading of crop producers. Forward contracts were the first financial derivatives derived from those early “buy now but pay and deliver later” agreements. In contemporary business world, forward contracts are commonly known as over-the-counter transactions between two or more parties where both buyer and seller enter into an agreement for future delivery of specified amount of currency at an exchange rate agreed today. They are generally privately negotiated between two parties, not necessarily having standardized contract size and maturity. Both parties in the forward contracts are obligated to perform according to the terms and conditions as negotiated in the contracts even if the parties’ circumstances have changed. In other words, once a forward contract has been negotiated, both parties have to wait for the delivery date to realize the profit or loss on their positions. Nothing happens between the contracting date and delivery date. Indeed, a forward contract cannot be resold or marked to market (where all potential profits and losses are immediately realized), because there is no secondary market for a forward contract. Although, technically, the forward contract can be re-negotiated with the original counterparty, it is usually practically too costly to proceed with. In fact, the counterparty is not obliged to proceed with the renegotiation. Forward contracts have one obvious limitation: they lack flexibility, and therefore do not allow companies to react in a timely manner to favorable market movements. This disadvantage is widely acknowledged and often criticism by authors and hedgers. So, why are forward contracts still the most popular hedging instrument? We believe this is mainly because forward contracts allow the hedging of large volumes of transactions with extremely low costs. Indeed, the parties involved in negotiating a forward contract are typically companies that are exposed to currency risk and their nominated banks. The nominated bank typically charges a service fee, of less than 1% of the face value of the hedge amount, for acting as the counter-party in the transaction. So it is the nominal service fee that is the low cost.

2.2.2 Futures Markets:

Futures contracts are the first descendant of forward contracts. Futures contracts were derived, based on the fundamental of forward contracts, but with standardized quality, quantity, time (maturity), as well as place for delivery. Like other financial derivatives, futures contracts were initially designed for commodity trading, but as commercial trading continually evolved, the initial de