Derivatives and Alternative Investment

This study material provides insights into derivatives and alternative investment strategies. It covers topics such as foreign currency assets, Bitcoin futures, and financial securities. Learn about the risks and benefits associated with these investment options.

Running head: DERIVATIVES AND ALTERNATIVE INSTRUMENTS
Derivatives and Alternative Investment
Name of the Student:
Name of the University:
Author’s Note:

1DERIVATIVES AND ALTERNATIVE INVESTMENTS
Table of Contents
In Response to Question 1..........................................................................................................2
In Response to Question 2..........................................................................................................5
In Response to Question 3..........................................................................................................8
Reference..................................................................................................................................12

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In Response to Question 1
Investment in foreign currency assets involves has its pros and cons and is dependent
on an individual investor how an investment strategy is constructed for mitigating and
overcoming the risk associated with the overseas investment. Foreign investment result in
foreign currency risk and which is ultimately dependent on the various business factors and
conditions under which the company operates. There are many factors that influences the
movement of the foreign exchange rates in which the company operates the macro-economic
conditions and the business factors plays a significant role (Prampolini and Morini 2017). It
is necessary for the Adventure Planet Inc. to forecast and asses the key factors, which could
significantly influence the exchange rate in the economy. The prevailing level of interest rate,
inflation rate in the economy and the global macro condition are some of the factors, which
significantly influence the foreign currency rate, and the same should be analyzed by the
Adventure Plc Inc. Foreign exchange risk influences the company in the form of financial
risk and results in volatile financial position of the company (Kieschnick and Rotenberg
2016). Adventure Planet Inc. is a US based company but is having its operation based is
Austria the functional currency for the company is the Euro Dollars and the reporting
currency for the company is the Dollars (Ramirez 2015). The volatility in the Euro dollars
will affect the company financial position and the same will result in financial gain or loss for
the company in the form of forex gain/loss. The company should mitigate the risk associated
with the foreign currency by applying effective trading strategies and hedging techniques.
The strengthening of the US Dollars in comparison to the Euro dollars will affect the
company in the term of exchange loss arrived for the company, which will destroy the
profitability for the company. The company should use derivative contracts such as Forward
contract and currency options in order to mitigate the risk associated with foreign investment
(Schied and Voloshchenko 2016).

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The risk identified for the company with the foreign investment in the Euro dollars is
known as currency risk. Currency risk is the risk associated with the movement of the
functional currency of company in respect to the reporting currency of the company
(Bouchard and Chassagneux 2016). The application of forward contract involves an
agreement between the two common parties interested to buy or sell an asset on a specific
date and at a specific price. The contract will be helpful for the companies in mitigating and
hedging the foreign exchange risk associated with the foreign investment (Hoberg and Moon
2017). The application of the foreign contract will enable the company in mitigation of the
risk and locking in a specified amount of value. The application of currency forward contract
would require the Adventure Inc. Company to deposit an initial deposit amount with the
currency broker (Leoni, Vandaele and Vanmaele 2014). The company can enter into the
forward contract with current or the prevailing exchange rate that is 1.25 U.S Dollars for one
Euro and lock in the specific rate for the purpose of settlement at that specific rate. There will
two outcomes possible in this type of scenario the U.S Dollars can strengthen in comparison
to the Euro Dollars. The U.S Dollars in contrast to Euro dollars can move to around 1.15 $/£.
In this scenario the loss that will be incurred by the company while exchanging the amount
would be recovered from the forward contract done by the company such that the financial
position for the company remains unaffected. The other scenario under this case will be
weakening of the US dollars and the value of the US Dollars to Euro dollars would be around
1.35 $/£. The company will be exchanging the amount at 1.35 $/£ and the relevant loss
incurred in the forward contract to the tune of 0.10 $/£ will make the effective exchange rate
of the company stable at an effective rate of 1.25 $/£. Thus, the option of applying the
forward contract in the context of hedging the transaction will make the effective currency
exchange rate of the company at the current rate.

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The application of the currency option will give the investor a right but not an
obligation for buying or selling the currency at a specified rate at the specific date or before
the specific date. The application of the currency option does not comply the investors for
exercising the option at the maturity date only unlike the forward contract. The Adventure
Inc. has the option for the exercising the option whenever the company feels that the option
exchange rate is more favourable for the company in contrast to the current spot market rate.
The Adventure Plc Company will get the advantage of exchanging the amount at the
specified rate and lock in the rate thereby making the currency exchange rate sustainable for
the company. The other scenario applicable under this case will be when the call option rate
would be ineffective for the company and the company would not exercise either option in
the call market and exercising at the spot market. The explanation of the above hedging
strategy could be applied in the context of the option theory where the company can use the
currency option. The company will be buying call option with respect to U.S Dollars and the
movement in the underlying assets of the company will get hedged by the derivative contract.
The rise in the U.S Dollars will result in a loss in the exchange rate but the gain in derivatives
will result in a effective exchange rate system of 1.25 $/£. If the volatility in the currency
exchange rate rises then the company will enjoy the volatility in the currency. The value of
the call option price rises, as the call option will be offsetting the rise in volatility.
The application of the above derivatives strategies will hedge the currency movement
of the Euro and the US dollar and the company will be able to enjoy the current exchange rate
as the effective exchange rate. Adventure Inc. should incorporate and asses various factors by
which it can create value for the investors. The incorporation of the derivatives trading
strategies would assess the effectiveness of the company in removing the volatility from the
international market and risk associated with the currency risk. It is very important for the
company to assess the changes in the market value and the various macro-economic factors

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under which the operations of the company is affected such that the same does not influence
the operations of the company. The application of the forward contract in managing the
currency effective exchange rate system for the company will help the company in reducing
the volatility in the financial statements of the company. However, it is critical for the
company to assess and evaluate the various derivative trading strategy and apply the same in
the context of managing the foreign exchange risk or the currency risk of the company.
In Response to Question 2
Bitcoin futures have started trading on the Chicago Board Option Exchange from
December 2017 as they were introduced in the year 2017 on the two leading derivatives
exchanges like Chicago Mercantile Exchange and Chicago Board Option Exchange. The US
Commodity Futures Trading Commission approved the Bitcoin futures as a digital currency
to be recognized and to be used as a source of an alternative investment tool for the various
financial and private institutions (Corbet et al. 2018). Futures are a common financial
derivatives where the investor is obliged to buy or sell asset at a predetermined price and
date. Future contract are usually standardized contract, which trades on exchanges and is
marked to market on a daily basis where the daily gain or loss is settled (Hattori and Ishida
2018). Futures contract gives the buyer of the contract an option to buy the asset at a specific
price by getting a physical delivery of the asset or to an option to settle the price difference
observed from the seller of the contract (Shi 2017). In each day of period around 3600
Bitcoin are created and around 16.5 million Bitcoin are in the circulation. The underlying
assets of the Bitcoin futures is the Bitcoin Crypto Currency (Baur and Dimpfl 2018).
The Bitcoin futures gives an option for the investor of the Bitcoin to bet on the price
movement of the Bitcoin and getting a exposure with the price movement of the Bitcoin
thereby getting exposure with the underlying assets (Hale et al. 2018). The investment in

6DERIVATIVES AND ALTERNATIVE INVESTMENTS
Bitcoin futures allows the investor to enjoy the benefits of liquidity as the future contract
have sound liquidity and are traded often. In the initial stage of trading, the trading of the
digital currency was not at peak stage but later on with know how about the product the
liquidity assessed with the product increased with the increased trading activities associated
with the (Bitcoin Köchling, Müller and Posch 2018). Bitcoin Futures additionally gives the
investors and institutional investors an option to hedge themselves against the market crash or
market risk they are exposed. The investors and institutional investors can short the crypto
currency or the digital currency if they feel that the price of the crypto currency or the Bitcoin
is going to fall they can short the futures contract. Investors and institutional investors can
also short the futures contract on the Bitcoin if they belief that there is going to be a market
crash following way bthereby reducing the overall reducing the crypto asset market risk
(Exchange 2017).
A common instance of an investor or an institutional investor willing to take exposure
with the crypto currency can buy Bitcoin futures today at the spot rate or the current market

7DERIVATIVES AND ALTERNATIVE INVESTMENTS
price of the futures. The expiry of the futures contract will be in March 2018 where the
investor will have the option for settlement of the contract. Let say the price the investor
would be paying for one Bitcoin would be around $20,000 when the futures contract is worth
one Bitcoin. Now the investor can distort the price belief thereby trading from buying or
selling the asset and accordingly trade. If the investor goes long on the Bitcoin futures and the
price of the Bitcoin increases to $24,000 then the investor will earn a profit of $4,000 on the
trade done. Similarly, the investor can sell the futures contract if the price belief for the asset
is bearish and the investor can trade accordingly (Köchling, Müller and Posch 2018). The
Chicago Board Options Exchange (CBOE) launched after getting necessary approval and
license from the Commodity and Futures Trading Commission (CFTC). The regulators of the
market has warned the investor about the potential risk associated with the high level of
volatility and risks associated with the market trading of the Bitcoin. The volatility and the
movement of the Bitcoin needs to be assessed with care and the relevant data needs to
incorporate for assessing the movement of the Bitcoin. One of the key factor associated with

8DERIVATIVES AND ALTERNATIVE INVESTMENTS
the Bitcoin futures is the movement of the futures contract and the liquidity associated with
the futures contract.
The application and the involvement of the Bitcoin futures will enable the investor by
investing into crypto currency and investment in the same will help the investor get exposure
with the Crypto-Assets. Bitcoin is criticized on the ground that it is not regulated by the
central bank of the country and the relevant actions required for the removing the volatility in
the same.

9DERIVATIVES AND ALTERNATIVE INVESTMENTS
The value for the Bitcoin is determined by the process of the investors willing to pay
the price of the crypto currency and the other party willing to pay for the same. The Chicago
Board Option Exchange (CBOE) has the most active traded number of Bitcoin contract on
the exchange beating the Chicago Mercantile Exchange. Investments in Crypto-currency and
Bitcoin is associated with high amount of risk related to the market risk and the risk
associated with the market and the futures of the Bitcoin. There has been many instances
where the spike in the volatility of Bitcoin was observed where the value of the crypto-
currency has been volatile. Investors should asses the various aspects of the market and
factors that can influence the price and valuation of the Bitcoin in order to eliminate and
reduce the risk associated with the same.

10DERIVATIVES AND ALTERNATIVE INVESTMENTS
In Response to Question 3
A financial security is one that derives its values from the underlying financial asset
and a contract between two parties for buying or selling an asset at a specific date or at a
specific price. There are various common underlying assets, which are included as an
underlying asset in the derivatives contract and the same are in the form of stocks, bonds,
commodities, interest rates and currencies (Bhujwalla, Laurain and Gilson 2016). Derivatives
are traded in the form of Over the Counter or in the exchange and the contracts are based on a
common basis, which are not standardized. Many factors affect the movement of the foreign
exchange rates in which the company operates the macro-economic conditions and the
business factors plays a significant role. The application of the derivatives contracts are
usually applied by the institutional investors and institutions for the purpose of hedging or
exploring the price belief for an asset (Ceci and Colaneri 2017).
The application of the derivatives is usually based on the purpose for hedging an asset
return or for the purpose of speculation. The Derivatives contract acts as a key tool for
providing liquidity and marketable opportunity for the investor in the capital market. The
application of derivative contract in the context of investment helps the investors get a

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financial advantage of reducing market and financial risk associated with investment
(Atangana and Baleanu 2016). For example an U.S Investor investing in the Switzerland
Stock Exchange is associated with the market risk of the Singapore and the currency
risk/forex risk any rise or fall in the single factor can significantly influence the return on the
investment done and the return generated from the same. The rise or the fall in value of the
Swiss Franc in association with the US dollar will significantly influence the value of the
investment done (Vakili et al. 2014). If the value of the US dollars rises in terms of Swiss
Fran then the loss generated in the form of currency risk will reduce the amount of return
generated from the assets. The investor can apply the derivatives in the context of reducing
the currency risk by buying options or futures contract with respect to the US dollars and
similarly mitigate the risk associated with the same. The investor with the help of the options
and futures and price belief of the investor can mitigate the market risk associated with the
stock (Corbet et al. 2018). Investor can buy put option or sell futures contract in respect to the
stock in which the investor or the institutional investor is exposed with (Fligstein and
Roehrkasse 2016). The futures or the option contract will hedge the investor with the fall in
the price of the underlying assets thereby providing them an opportunity to level the loss in
the stock with the profit gained in the derivatives contract thereby providing the investor with
a stable or a sustainable return in the long-term (Gao, Schultz and Song 2017). Many
investors and institutional investor for the purpose of speculation also apply the derivatives
contracts where the investor not having an exposure with the underlying basset trade with the
derivatives contract to explore the price belief associated with the same resulting in the
speculation of the derivatives contract. This result in huge loss and credit risk associated with
the investor as the investor is exposed with the derivatives contract which is volatile if the
volatility with respect to the market and the with respect to the particular stock thereby
increasing the overall risk associated with the derivatives contract (Fligstein and Roehrkasse

12DERIVATIVES AND ALTERNATIVE INVESTMENTS
2015). The hedging perspective in the creation of value for the company and providing a
sustainable income in the form of reducing the credit risk and there market or the forex risk
associated with the investment. The derivatives contract helps in revenue neutrality thereby
providing an option to hedge the market risk associated with the same. The derivatives
contract helps the investor to get an exposure at a high value in compare to the amount-
invested with the derivative contract. Derivatives contract are generally in the form of
leverage contract which helps the investors get an exposure with the assets such that the rise
or the fallen the value of the asset could significantly and materially influence the value of the
investment. The Derivatives contract acts as a key tool for providing liquidity and marketable
opportunity for the investor in the capital market. The application of derivative contract in the
context of investment helps the investors get a financial advantage of reducing market and
financial risk associated with investment.

13DERIVATIVES AND ALTERNATIVE INVESTMENTS
The other derivatives contracts such as credit default swaps and mortgage-backed
security are the other form of derivative contract primarily applied by the institutional
investors for hedging. The credit default swaps are the derivatives contracts where investors
can swap the return of the US dollar with the return on the Swiss Franc Currency and a
notional amount of money will be deposited at the initial stage. The investor can exchange
the return generated by receiving the return generated on the Swiss Fran Currency and by
paying the interest rate on the US Dollars. The mortgage backed security is the other form of
credit default swap where the underlying asset associated with the investment is the mortgage
property and the bruise or fallen the investment is dependent on the price of the mortgage.
The value invested in the mortgage-backed security is generally risky as the fair value of the
property is not assessable and the fall in the price of the property could significantly reduce
the value of the mortgage-backed security. The mortgage-backed security are generally very
risky and the volatility in the assessment of the value are the main reason for the spike in the
volatility in these type of investments. The underlying assets associated with the mortgage-
backed security are properties where the fair value of the assets is associated with the rise or
the fall in the property rise. The assessment of the same needs to be frequent so that the fair

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value of the assets could be assessed on the value of the same could be assessed. The key
reason behind the problem associated in the financial crisis of the 2007 was the failure of the
mortgage backed security and the risk associated with the same.
The rise in the failure of the mortgage backed security was due to the improper
assessment of the underlying assets of the contract and the fall in the value of the same
underlying asset lead to the fall in the MBS and which ultimately lead to the increase in the
credit and financial risk associated with the derivatives contracts. The derivative contracts
associated with the underlying assets should be evaluated and assessed based on various
factors and the effect on the investment should be evaluated. The derivatives contract helps in
revenue neutrality thereby providing an option to hedge the market risk associated with the
same. The derivatives contract helps the investor to get an exposure at a high value in
compare to the amount-invested with the derivative contract. Investors and Institutions should
asses the various types of risk and key factors associated with the derivatives contract in
order to remove the market risk and the financial risk associated with the same.

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Reference
Fligstein, N. and Roehrkasse, A.F., 2016. The Causes of Fraud in the Financial Crisis of 2007
to 2009: Evidence from the Mortgage-Backed Securities Industry. American Sociological
Review, 81(4), pp.617-643.
Gao, P., Schultz, P. and Song, Z., 2017. Liquidity in a Market for Unique Assets: Specified
Pool and To‐Be‐Announced Trading in the Mortgage‐Backed Securities Market. The Journal
of Finance, 72(3), pp.1119-1170.
Fligstein, N. and Roehrkasse, A., 2015. The Causes of Fraud in Financial Crises: Evidence
from the Mortgage-Backed Securities Industry (No. 122-15). IRLE working paper.
Chernov, M., Dunn, B.R. and Longstaff, F.A., 2017. Macroeconomic-driven prepayment risk
and the valuation of mortgage-backed securities. The Review of Financial Studies, 31(3),
pp.1132-1183.
Bhujwalla, Y., Laurain, V. and Gilson, M., 2016, July. The impact of smoothness on model
class selection in nonlinear system identification: An application of derivatives in the RKHS.
In American Control Conference (ACC), 2016 (pp. 1808-1813). IEEE.
Ceci, C. and Colaneri, K., 2017. Recent Advances in Nonlinear Filtering with a Financial
Application to Derivatives Hedging under Incomplete Information. In Bayesian Inference.
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Gholami, Z. and Amouzgar, P., 2014. Application of chitosan and its derivatives as

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adsorbents for dye removal from water and wastewater: A review. Carbohydrate
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Gholami, Z. and Amouzgar, P., 2014. Application of chitosan and its derivatives as
adsorbents for dye removal from water and wastewater: A review. Carbohydrate
polymers, 113, pp.115-130.
Corbet, S., Lucey, B., Peat, M. and Vigne, S., 2018. Bitcoin Futures—What use are
they?. Economics Letters, 172, pp.23-27.
Hattori, T. and Ishida, R., 2018. Do Investors Arbitrage in the Cryptocurrency Market?
Evidence from the Bitcoin Futures Market.
Shi, S., 2017. The Impact of Futures Trading on Intraday Spot Volatility and Liquidity:
Evidence from Bitcoin Market.
Baur, D.G. and Dimpfl, T., 2018. Price Discovery in Bitcoin Spot or Futures?.
Hale, G., Krishnamurthy, A., Kudlyak, M. and Shultz, P., 2018. How Futures Trading
Changed Bitcoin Prices. FRBSF Economic Letter, 2018, p.12.
Köchling, G., Müller, J. and Posch, P.N., 2018. Does the introduction of futures improve the
efficiency of Bitcoin?. Finance Research Letters.
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Köchling, G., Müller, J. and Posch, P.N., 2018. Do Institutional Investors Improve the
Efficiency of Bitcoin?.
Exchange, C.B.O., 2017. The beginner’s guide to Bitcoin futures.
Prampolini, A. and Morini, M., 2017. Derivatives hedging, capital and leverage.