Derivatives and Alternative Investments

This document discusses the role of derivatives in the financial crisis of 2008 and the steps of risk management that could have prevented it. It also explores the benefits and risks of different types of derivatives and their impact on the economy. Find study material and solved assignments on derivatives and alternative investments at Desklib.

DERIVATIVES AND
ALTERNATIVE
INVESTMENTS

EXECUTIVE SUMMARY
Financial market play a very important role in the success of an organisation. There are various
instruments that are traded on market in which derivatives are becoming an increasing trend
specially in the commodity market. The report signifies the role of derivative in the financial
crisis of 2008. The steps of risk management that could have prevented the financial crisis. All
the research will give an understanding about the financial crisis and its impact.

TABLE OF CONTENTS
EXECUTIVE SUMMARY.............................................................................................................2
INTRODUCTION...........................................................................................................................1
SECTION A.....................................................................................................................................1
Question 1....................................................................................................................................1
Question 2....................................................................................................................................3
Question 3....................................................................................................................................5
SECTION B.....................................................................................................................................6
Question 1....................................................................................................................................6
Question 2..................................................................................................................................11
REFERENCES..............................................................................................................................14

INTRODUCTION
Derivative are the instrument that derives it value from the underlying assets, it does not
have value of its own. Derivatives are specially traded in commodity market. In financial crisis
of 2008 derivatives were having an significant role as banks wee exchanging the MBS packages
with derivatives whose value were uncertain. The defaults in housing loan made the banks like
Lehman Brothers to collapse. The report will reveal about the financial crisis, benefits of using
different types of benefits, causes and impacts of financial crisis.
SECTION A
Question 1
1)Duration of Bond
Period Cash Flow PV@3%
PV of Cash
Flows
Period of
Cash Flow
PV of
Period*CF
1 11 0.997 10.97 11 10.967
2 11 0.994 10.93 22 21.869
3 11 0.991 10.90 33 32.705
4 11 0.988 10.87 44 43.476
5 11 0.985 10.84 55 54.182
6 2011 0.982 1975.18 12066 11851.074
2029.69 12014.27
Macaulay Duration = 12014.2731 / 2029.68 = 5.92
9 months forward price
Particulars Amount (in €)
spot price 2000
Term of forward contract 9 months
interest rate 2.00%
time to maturity 1.5
9-month forward price 2030.23
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2)2. 6 month forward price
Particulars Amount (in €)
stocks 5000
spot price 25
monthly
dividend 0.10%
monthly
dividend 0.025
interest rate 0.30%
time to maturity 6
6-month
forward price 25.012
Fpo = So*(1+i)^t
3) 3. 5 - year spot rate
S.No. Year spot rate
1 3 61
2 4 82
3 5
Y = 21x+40
= (21*3) + 40
= 63+40
=103
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4. Price of Call option
Put option: $2.3
Strike price: €16.5
Spot price: €18.4
Maturity time: 6 months
Risk free monthly interest rate: 0.4% (Quarterly)
= 18.4 e^0.04*3/12
= 18.64
5. a.) Calculation of pay-off after 3 months and break even price.
Solution:
Call option: €1.5
Strike price: €16.8
Maturity time: 3 months
Risk free monthly interest rate: 0.3%
Formula: Call pay-off per share = (MAX (stock price - strike price, 0) - premium per share)
(i)=(18-16.8)-1.5
=-0.3
(ii) Put Option
(18-16.8)+1.5
=2.7
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Question 2
Financial centres refers to service financial service centre having direct access over big
capital pool from insurance, banks, investment funds and markets that are listed over exchange.
Financial centres refers to location with collection of participants in asset management, banking,
financial markets or insurance with support services for the activities. Future markets are
playing critical and important of strong economy. This is having different roles for playing. It
has to fulfil requirements of different market players which are involved in market.
Future trading involves two parties that agree on transacting over financial instruments
or commodity at future date over price that is agreed in present. Contract is drawn on terms at
future transaction, and parties have to abide by contract. Futures are derivative instrument as
values are derived underlying assets and they do not have value of their own. Examples of
underlying assets are corn, wheat, gold and securities. Asset whose prices are vulnerable and
have excessive volatility are best for future trade.
Price fluctuations affects every aspect of economy. Futures are generally used for
commodity markets as today markets are very deviating that affects the prices of commodities.
Trading in commodity futures requires detailed understanding & experience. The future markets
protect the investors from suffering losses due to price fluctuations in the market. As they have
to pat only the premium prices in case of losing the contract. Investing in futures market has
become an rising trend attracting large number of investors. This is helping to attract the
revenues for the companies and stock market centres have regained the investors who made a
shift from the investor market due to fluctuations in securities market.
Benefits of securities market
Most important advantage of future markets is that businesses and individuals are
allowed to protect the positions against future price fluctuations. It provide protections to buyers
against the future price increase and it provides protection to seller against the future price falls.
Derivatives are securities that derive their value from an underlying asset or benchmark.
Common derivatives include futures contracts, forwards, options, and swaps. Most derivatives
are not traded on exchanges and are used by institutions to hedge risk or speculate on price
changes in the underlying asset. The derivatives can also be define as the contract in which two
or more parties are being involved. The derivative prices can be taken from assets which are
underlying and fluctuating. The assets which are included in derivatives are stocks, bonds,
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commodities, currencies, interest rates, and market indexes. In order to purchase these assets
brokerages can be used by an individual. There are two types of derivatives currency futures and
options.
Currency futures
It can be defined as the exchange traded contract of future which provides the prices in
only one currency so that the different other currency can be purchased and brought out and sold
out at some other date in future. The future contracts related to currency are legally binding. It
has been analysed that counterparties who are not fulfilling the contracts on expiration date has
to deliver the left out amount at pre-defined price and also at the pre-defined date. Currency
future rates can be utilized to pay off different trades and risk.
Benefits of currency futures:
The currency futures can assist in opening up the market to investors. These can be used
by investors who have high risk in their business. This currency future can help investors in
participating in the market. The currency future can also provide the benefit that it can make the
market rate stable. Also in these types of derivatives there are no time boundations which has
been included. So the trader does needs to think about the future time decay. Currency futures
can also help investors in maintain the liquidity which is high.
Risks of Currency Futures
Currency futures have the risk of exchange rate fluctuations as they are dependent on the
world wide demand and supply. Interest rate risk involves the gains or losses arising due to
fluctuations in the forward amount mismatches and because of the maturity gaps. Credit risk
refers to the risk that currency position outstanding may not be repaid by counterparty.
Options
Options can be defined as those financial derivatives that provides the purchaser an
authority but not the obligation to get or give the underlying asset at the price and the date which
has been agreed upon. There are two types of options in the financial derivatives, it includes the
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call option and the put options. These techniques are mainly implemented for the task of
hedging, speculation and income. The derivative option also has various advantages. Investing in
option derivations can be risky for the investors. They have to take up very high amount of risk.
Benefits of Options
Derivative options can be used by investors to increase the cost- efficiency. It can be
beneficial for them to as these derivatives can help them in setting out saving the huge amount of
cost. It can help them in owning to less amount of risk. As they cannot sell out the equities
without owning them. In this type of derivative the investors can earn more amount of profit, as
less risk is being involved in it. This can support the traders and investors in growing. In this they
can also gain potential return which is high.
Risks associated with options
Like and bonds and other securities options also do not carry any guarantee. Investors
may lose entire principal amount. Option holders risks the entire premium amount where options
writers have high risks as they may face unlimited potential loss as cap on stock prices are not
there.
Question 3
Tools for assessing, managing and minimising risk in derivative trading
Derivatives market helps every investors as well as the economy with benefit related to
shifting of possible risk that is known as risk management or hedging or also known as
redistributing risk away from risk averse investors to those investors having more willingness to
accept such risk factor. Tools for assessing as well as minimizing risk factor while trading in
derivative markets includes following:
1. Integration – Under this form, different groups are formed whose main responsibility is
to manage derivative market trading. One group is having the role of to manage interest
rate derivatives and its related trading while another group emphasizes on management of
equity related derivatives (Roy and Roy, 2017). On the other hand third group used to
manage foreign exchange derivatives transactions.
2. Asset Class Coverage – One of the best risk assessment tools with the help of which it
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provides senior management with the facility to determine or access on immediate basis
all the requisite information related to all derivatives activities undertaken, which is
engaged in by the financial institution across all asset classes.
3. Pricing Model Flexibility – It helps in identifying problems as associated with the
derivative instruments. Also, such model risk defines problems as associated with
discrepancies in between theoretical pricing of financial instrument and manner traded on
actual basis in market.
4. Interface - One of the best key aspects for managing risk as associated with the trading
operations of derivative instruments in the financial market. It is considered as one of the
well - designed system which is related wit its flexibility (Das, 2018). By having a good
risk assessment tool along with a user interface of customizable nature, it will assist
investors in evaluating risk factors and can take measures for minimizing it. Most of the
investors makes use of Internet for carrying on their derivative transactions along with
their interface platform. It allows investors quick and efficient information exchange
across multiple market place and helps in designing reports accordingly.
SECTION B
Question 1
a) Contribution of aggressive derivative trading in collapse of the banks like Lehman
Brothers.
Actual cause behind financial crisis in 2008 was proliferations of unregulated derivatives
of the time. Derivatives are complex financial product deriving value from underlying assets or
index. Mortgage backed security is best example of derivative. In mortgaged backed security
how derivatives work. Money is lended by bank to homebuyer. Mortgage is sold by Bank to
Fannie Mae that gives funds to bank for making new loans. Fannie mae than resells mortgage in
package with other mortgages over secondary market. This is mortgage backed security.
Value of mortgages in bundle derive the value of mortgage backed securities. MBS is
divided into separate portions by investment bank or hedge fund. For instance, 3rd and 4th years of
loans are interest only are riskier as they are out. Chance of defaulting by homeowner are high in
these years but this provides with high interest payment. Sophisticated computer software
programs are used for figuring out the complexity by bank (Hemphill, 2016). Then they are
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combined with similar levels of risk of other MBS and then those portions are resold. Everything
goes smooth unless prices of housing starts to decline or rates of interests are reset and
mortgages start defaulting.
This all started when Federal Reserve begin to raise rates of fed funds. Many borrowers
adopted in loans with interest only as they are mortgage wit adjustable rate. Unlike conventional
loan when rate of fed funds rises interest rates also tend to rise with this. Mortgage holders no
longer found it easy to repay the loan when rates were raised by Fed. This occurred at same time
when interest rates were reset after 3 years. Rise of interest rate decreased demand for housing
loans and prices of home. Mortgage holders started defaulting when they found that payments or
sale of house could not be made by them.
Most importantly some parts of MBS were completely worthless but identifying which
part was not possible. True value of MBS is not known by anyone and also no one was aware of
inside MBS. The uncertainty led to closure of secondary market (Smith, 2018). Hedge funds and
banks had number of derivatives which were declining in values and they were not sold. As
result banks stopped borrowing with each other to stop receiving of defaulting derivative as
collateral. The bank bailout bill was prompted because of the above issues. This was designed to
remove the derivates from the bank books so that new loans can be made. Value for derivative
are not only provided by the mortgages but also by other types of assets and loans. The market
was not only difficult and complicated to value. This was also unregulated by securities and
exchange commission. Bankruptcy of one bank led to panic between banks and hedge funds.
This was the role of derivative in financial crisis.
b) Tools and models of risk management that have helped in mitigating risk
Risk management plan is important for every business. The effectiveness of plan depends
on the techniques and tools that are used by the business. The techniques must allow to control
the risk of company. Adherence to risk management techniques are necessary for success, but
adhering alone is not sufficient. If the risk management had gone beyond the conventional
approaches it could have avoided financial crisis of 2008.
Risk Management tool had failed to account for systematic threat both in regulatory level
and private sector. Failure was seen due to reason that whole is larger than sum of parts.
Identifying , evaluating and mitigating risks could be carried by both formal as well as informal
techniques (Wiggins and Metrick, 2019).
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Identifying the risks
Banks should have successfully identified risks of possible eventuality. They would have helped
banks in identifying
Delphi technique refers to discussion between experts panel who would have deeply
identified the risks related to the derivative instruments in package. All the experts identified the
uncertainty of derivative instrument whose prices were falling with decline in housing prices.
Root cause analysis is another techniques that would have helped banks in getting the
root cause behind which the prices were falling. If the bank in mortgaged backed security had
identified that derivative instrument in the package could lead to losses to bank than they would
have not adopted MBS packages. Risks were not identified as credit worthiness of the borrowers
was not considered by banks.
Quantitative risk analysis
Techniques and tools are used for analysing numerically impact of risk on organisation.
They are quantitative techniques that are much complex. Sensitivity analysis have different
variables for introducing the impact on risks (Gupta, 2017). Financial crisis would not have
happened if the banks has identified the predictions that have failed to materialise. When the
rates of funds were rising than banks would have analysed the impacts of not properly analysing
the effects of fall in prices of the housing loan.
Qualitative analysis
Qualitative risks helps in analysing the risks that are to be focused by banks. Tools
include red green and amber that divides risks into categories depending on time impact and
quality. Risk categorisation helps in dealing with risks more effectively. Grouping risks in
different categories allows for coordinated approach for risks management. This would have
caused bank to segregate the risks in different categories (Prates and Fritz, 2016). Risks
associated with different home buyers should have been identified by the banks at time rates
were set high.
Risk Monitoring
After identifying the risks it is also essential to monitor the risks management plan so that
defaults could be avoided. In the financial crisis banks if had monitored the risk that could arise
in the process than it would have prevented the risks. This involves risk audit and status
meetings.
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Further if there were regulation for mortgage brokers that made bad hedge funds and bad
loans using too much leverage. Banks should have identified that credibility problem can cause
the banks to collapse.
Also the financial crisis could have been prevented if financial innovation was properly
understood by the makers. Creation of derivative and MBS if would have been maintained
properly (Schapper, Malta and Gilbert, 2017).
If the risks management techniques and tools were properly followed by the banks it could have
prevented the financial crisis of year 2008.
c) Regulatory controls that have been put in place for protecting investors,clients and
public.
Regulatory control refers to the laws governing investments firms, banks and insurance
companies. They protect external parties from financial frauds and risks.
Regulatory controls are framed by authorities for monitoring the activities of various banks and
other institutions in which money of people is invested. If control of the regulatory authorities
was strong it would have not lead to financial crisis.
Glass Steagall Act which was regulating banks after the market crash should have
prohibited banks from investing in unregulated hedge funds and derivative. They could have
invested inn depositor fund for gains.
Regulation restricting the banks should have been implemented as financial firms and
bank for increasing profits and value for shareholder invested riskier derivatives.
Dodd Frank if implemented earlier would have prevented financial crisis in 2008. In this, agency
was created for threatening financial industry. Federal reserve should have the authority to
regulate big banks before they starts to fail. It was established for regulating the hedge funds,
mortgage brokers and derivatives (Christensen, Lie and Lægreid, 2017). Implementation of
Volcker Rule prohibited banks to own investor funds or hedge funds to trade in derivatives for
making profit for their own.
Control over mortgage brokers who uses very high leverage and made bad loan and
hedge funds. Regulation should have implemented control for controlling the high leverage used
by the broker so that client and people were not affected. Regulatory control over creation of
derivative instrument should be implemented so that they investors could not be deceived by
such instruments.
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d) Impact of Bailout on markets
Bailout of government bank affected economy and market. It prevented the future market
run as previously that caused economic collapse. This happened after the bankruptcy of Lehman
Brothers. Because of this investors moved their funds to the US treasuries causing yield to go
down to zero. After bailout banks started lending to one another again. Bank cuts banks on
lending. Because of this libor rate raised higher unnaturally than rates of fed funds. The libor
rates because of the bailout were set to normal again. This bailout made easier for customers to
get mortgages & loans over various other assets. Reduction in libor rates made the loans
available at lower rates so that large number of people can qualify for loans. This helped in
increasing the limit for bank deposit limit in Federal Deposit Insurance. Bill allows SEC in
suspending the mark to market rule (Vallascas, Mollah and Keasey, 2017). This helped the
market to revive from the financial crisis that occurred in year 2008. Because of the bailouts,
slowed economies due to tightened credit and international trading.
e) What can be done to restore confidence in markets.
For restoring the confidence in markets banks should be required to hold capital
increased capital. Capital should have high quality too wit standards and equity at core for
ensuring that other capital assets are loss absorbing. Prudential filters that allowed banks in
avoiding the losses on its holdings over marketable securities were removed. Then measures are
taken for protecting the capital backing. Capital frameworks are made more counter cyclical that
means banks will be holding more capital when they are having good time for preparing for the
inevitable downturns. Most important is the focus over leverage ratio and liquidity coverage ratio
that will protect investors as well as the banks.
The reforms of the regulation allowed the banks to lend money to each other that made
the credit functioning normal. As libor rates turned down it caused the loans and mortgages to be
available at lower rates. This helped to raise the consumer purchases and boosting the growth of
economy. Due to reduced rates people started purchasing the houses again allowing prices of
housing to stabilize.
Question 2
5. Application of theories and financial market.
Financial market is referred to as a market which mainly focuses on trading derivatives
and securities at relatively low transaction cost. Securities consists of bonds, shares, precious
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metal, etc. Financial markets is mainly classified into money market, derivative market,
ownership market and bond market (Fecht, Hackethal and Karabulut, 2018)).
Multi asset investment strategy is mainly associated with an effective investment strategy
which in turn focuses on involving various set of asset class. It tends to create group of assets
class while creating portfolio of assets.
a. The client is a hedge fund
Hedge fund are those investment funds which pools capital from different types of
accredited investors as well as institutional investors thereby making investment in wide range of
assets. Investment is made while keeping in mind complicated portfolio structure along with
techniques for assessing as well as managing risk at different levels.
Case Scenario - A global investor wants to seeks advise related to construction of an effective
portfolio with its base on a multi - asset investment strategy. The client is having 25 Million
USD to invest in and wants to find out better ways related to investing in the EU along with
having better return thereon.
Options available for such client to invest in are as follows:
1. Long / Short Equity – It is defined as one of the most relative low risk leveraged bet
which is made as per the best stock picking skill as well as ability of the managers
engaged in such derivative market function (McNeil, Frey and Embrechts, 2015). A
strategy as per which investors either go long and short on two competing companies in
the same industry based on the relative valuation or pricing strategies.
2. Credit funds – Are those funds which tends to prosper in case when credit spreads
narrow down during robust economic growth periods thereby suffering losses when
economy is lagging behind and spreads blow out. This hedge funds mainly focuses on
credit instead of interest rates and most of the managers sell their short interest rate
futures, treasury bonds so as to hedge rate exposure.
3. Arbitrage – One of the strategy which is related with taking advantage of price
differences in between different markets with the same asset transaction. By identifying
and classifying assets of the best and profitable nature of different companies as per its
solvency and risk, arbitrager can minimize its risk factors.
4. Defensive – One of the most important strategy for an investor which aims at gaining a
long exposure in relation to shares by ensuring its defensive characteristics. It helps
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investors in achieving high return with minimum risk by using such combination of
buying equity index call options and selling equity index put options.
b. Client is Retail investor
Retail investor is an individual who tends to purchase securities for his own personal
account. It tends to deal in smaller amounts such as pension, university endowments, mutual
funds, buying and selling of securities, exchange trade funds (Fecht, Hackethal and Karabulut,
2018). Retail investor is considered to be a non- professional marketer where they tend to focus
on investing smaller amounts in the market. Retail investment is very beneficial for the investor
who are investing in mutual funds, exchange trade funds because they are restricted to
companies who tends to carry out large percentage of business. On the contrary, it also comes
with unrealized capital funds which in turn affects the portfolio of the investor (4 Ways to Invest
in the European Stock Market, 2019). Exchange traded funds: makes it easier for the investor to helps them construct their
own set of stocks with more focused bets. Exchange traded funds is considered to be one
of the most convenient way to enter into the international European market (Moloney,
2015). This in turn helps in gaining average returns in the future which leads to higher
substantial growth of the investor.
c. The client is mutual fund
Mutual fund is considered to be as the professionally managed mutual fund investment
which helps in pooling sum of money from investors in order to purchase securities and gain
better return (Schmidt, Timmermann and Wermers, 2016). Mutual fund is considered to be as the
basket of securities which mainly comprises of bonds, shares, cash, equity funds, fixed income
funds, SIP, etc. in turn helps in gaining higher returns in the market. Investment in mutual funds
in European market helps in providing wide range of benefits which is mainly associated with
the asset diversification, attainment of economies of scale, professional investment services,
more liquidity, divisibility, etc. which in turn is useful for making a strong portfolio and generate
better returns. It helps in professionally managing the money in order to attain set goals of an
individual (Boguth and Simutin, 2018). Mutual funds are further categorized into money market
funds, balanced funds, fixed income funds, fund of funds, equity funds, speciality funds, etc. in
order to attain high set of goals. The investor tends to opt the fund according to the risk taken by
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investors which in turn leads to higher sustainable returns to the investors.
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REFERENCES
Books and Journals
Christensen, T., Lie, A. and Lægreid, P., 2017. Still fragmented government or reassertion of the
centre?. In Transcending new public management (pp. 29-54). Routledge.
Das, A., 2018. DERIVATIVE MARKET IN BANGLADESH.
Gupta, S.L., 2017. Financial Derivatives: Theory, concepts and problems. PHI Learning Pvt.
Ltd..
Hemphill, F., 2016. Organizational Leadership Impact on Lehman Brothers and AIG: Historical
Case Study Analysis(Doctoral dissertation, University of Phoenix).
McNeil, A. J., Frey, R. and Embrechts, P., 2015. Quantitative Risk Management: Concepts,
Techniques and Tools-revised edition. Princeton university press.
Prates, D.M. and Fritz, B., 2016. Beyond capital controls: regulation of foreign currency
derivatives markets in the Republic of Korea and Brazil after the global financial
crisis. Cepal Review.
Roy, R. P. and Roy, S. S., 2017. Financial contagion and volatility spillover: An exploration into
Indian commodity derivative market. Economic Modelling. 67. pp.368-380.
Schapper, P.R., Malta, J.N.V. and Gilbert, D.L., 2017. Analytical framework for the
management and reform of public procurement. In International handbook of public
procurement(pp. 119-136). Routledge.
Smith, R.C., 2018. A Decade Later, Understanding 2008 Financial Crisis. Available at SSRN
3245923.
Vallascas, F., Mollah, S. and Keasey, K., 2017. Does the impact of board independence on large
bank risks change after the global financial crisis?. Journal of Corporate Finance. 44.
pp.149-166.
Wiggins, R.Z. and Metrick, A., 2019. The Lehman Brothers Bankruptcy H: The Global
Contagion. Journal of Financial Crises. 1(1). p.9.
Online
The Options Landscape for Hedge Funds. 2019. [Online]. Available through:
<https://thehedgefundjournal.com/the-options-landscape-for-hedge-funds/>.
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