(PDF) Financial Derivatives Use: A Literature Review

FINANCIAL DERIVATIVES
TRADING: OPTIONS, FUTURES
AND SWAPS

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
PART A...........................................................................................................................................1
PART B............................................................................................................................................4
(A) Portfolio setup......................................................................................................................4
(a) Quote of selected date: 19 June 2018....................................................................................4
(b) Birth date: 4 June 1990..........................................................................................................5
(B) Hedging.................................................................................................................................6
Risk faced by fund managers and hedging with futures.............................................................6
(b) Hedging.................................................................................................................................7
CONCLUSION................................................................................................................................7
REFERENCES................................................................................................................................8

INTRODUCTION
In the present era, future markets are most essential as they help in cash flow of economy.
In the present report, it has been discussed that how crude oil futures are used for managing risk
by hedging and speculation. This report is based on article of FT.com which has entitled that 'Oil
rises as US crude stocks retreat for third week' which has forecasted that oil market will be
globally cause deficit in second half of year if cartel has maintained production cuts. Further, it
has discussed about setting up of portfolio for FTSE 100 index and future. There are various
risks which are faced by fund manager and ways for fund manager for hedging risk has been
elaborated here as well.
PART A
Future markets are directly originated according to producers for stabilizing income on
supply of raw material along with fluctuations of market. It is elaborated as speculators for
betting on direction of commodity which is given (Miller, D., 2018). The prices of energy are
very important and oil crisis of 2015 has represented various important alterations in special
commodities for investors and consumers. In the present era, there is something more than prices
of oil that is crude oil futures and it provides opportunity for earning margin according to cost of
barrel of Brent crude or WTI (West Texas Intermediate), but there way of operation is unique.
They don not buy stocks of oil and gas company physically. The buyers and sellers of oil
coordinate and agree for delivering particular amount of crude oil on specific duration which is
termed as crude oil futures. West Texas Intermediate in US is considered as benchmark of future
contract. It has traded on exchange of New York that is New York Mercantile exchange and it
has been globally traded and replicated as reason of Brent crude oil futures which consist of
various grade of oil that is founded in North Sea off European continent.
The main objective of crude oil futures is to link with oil producers along with oil
consumers. Future contracts are sold by producers of oil so, accordingly current prices are
effectively locked. Each and every day prices of future have different alterations; if it goes down
then financial credit has been received by seller which is offsetting drop in price of oil market
(Fabozzi, F. J. ed., 2018). Just a small example: Future contract decreases from $70 per barrel to
$50 per barrel, then credit of $2000 will be received by seller and simultaneously to $20 which is
declined and its product to 2000 barrel which is covered by contract. In case contract rises from
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$70 to $90, seller will be in disadvantage of bearing $2000 loss, the eventual gain must be offset
to seller and in the future, it will be having high price. The buyers who have huge requirement of
crude oil as raw material like refinery organization who might ensure about appropriate future
supplies and favourable pricing which will be locked. In context of buyers, the fund of future
always work in opposite direction. If prices are rising, then financial credit has been given, prices
which are decreasing might cost them. Though net effect is set according to price criteria that is
paid to buyer for oil and it entered in future contract (O'callahan, D. M).
Hedging and speculation; both are used for managing the risk in context of financial
derivates that is crude oil futures. Hedging is termed as an investment for protecting finance from
situation which is very risky. It is done for minimizing or offsetting the possibility of assets
whose value is decreasing. The amount of loss has been specified and list has been set. Risk has
been managed with uncertainty in context of fluctuations of adverse price of asset. The producers
of crude oil set up position in future market of crude oil by hedging against decreasing price of
crude oil. They can even implement short hedge or by locking price of future selling for
production, in context of crude oil which is only said as ready for sale in the future. For
implementation of short hedge, short position can be taken up by crude oil producers of future
contract of crude oil in future market for recovering the amount of crude oil which has been
produced (Bae, Kim and Kwon, 2018). For securing the purchase price of supply of crude oil
that will require long hedge in the future and that is termed as hedging against increasing price of
crude oil. For implementing long hedge, there should be purchase of crude oil futures for
recovering the amount which is required by operator of business.
The producer is directly reliant of physical product that is cash market, where is
requirement of selling these physical products in cash transactions. Market price is not known to
producers for his product in future when it will be implied for sale. So, regarding this concept,
producer will enter in the future market. So, in this scenario, crude oil producers were also
entered in future contracts of crude oil. If prices will be increased or decreased, then it will be
generating loss and physical product will offset and if gain is generated then physical product
will offset by selling in lower price. In the scenario, if prices moves downwards then loss has
been identified in that physical market and it will be ended up by putting its position in future
market.
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Illustration 1: Example of Hedging
(Source: Hedging Instruments, 2017)
Speculation consists of trading of financial instruments which has a huge risk along with
the significant expected returns. Through the fluctuations of market they gain maximum benefit
is there main objective. In the present era, various investors trade in future market without
dealing with actual barrels (physical). If the future positions are closed before expiration of
contract of specified date, then financial gains and losses are observed from daily movements of
prices of future as of different participants. In context of trading future, margin account has been
setup along with the broker by whom future trading is handled. The losses are covered for
maintaining some proportion of equity in account (Chen and et. al., 2018). For keeping the future
position, certain amount of money has to be deposited or maintained if losses push capital which
is available in margin account.
All the energy companies invest in future with their specified account. It plays a major
contribution in the operations of energy industry; even the future market is risky for individual
investors, but it gives benefit to energy company who uses future and increase there margin.The
losses are avoided and all peers will end up suffering. In context of hedging, cross hedge can also
be applied in which long and short position both can be used simultaneously. The prices of future
market can move from hedging programme by executing big volumes and it might influence the
value of options as well.
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PART B
(A) Portfolio setup
(a) Quote of selected date: 19 June 2018
Rate of return Beta CAPM
0
1
2
3
4
5
6
7
Illustration 2: 3I Info-tech FTSE 100
Risk free
Market
Stock
Interpretation: The above graph is depicting the stock of FTSE 100 Indices that is 3I
Infotech whose risk free rate is 1.32. The market return of this company is 6.57 and return of
stock is 5.25 which is less than market return with beta of 1.
Rate of return Beta CAPM
0
1
2
3
4
5
6
7
8
9
10
Illustration 3: AstraZeneca FTSE 100
Risk free
Market
Stock
Interpretation: The above graph is depicting stock of FTSE 100 Indices that is AstraZeneca
which is a pharmaceutical company whose risk free rate is 1.32. The market return of this
company is 8.79 and return of stock is 7.47 which is less than market return with beta of 0.58.
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Rate of return Beta CAPM
-100
0
100
200
300
400
500
600
Illustration 4: EASYJET FTSE 100
Risk free
Market
Stock
Interpretation: The above graph is depicting the stock of FTSE 100 Indices that is EASYJET
which is a travel and leisure company whose risk free rate is 1.32. The market return of this
company is 527.04 and return of stock is 525.72 which is less than market with beta of -0.22.
3I Infotech AstraZencea (AZN) EASYJET (EZY)
Beta 1 0.58 -0.22
Risk free 1.32 1.32 1.32
Market 6.57 8.7979 527.04
Stock 5.25 7.477 525.72
Interpretation: The above table is giving a clear picture of comparison in between all
these three companies within portfolio, beta is of 3I and in this very less volatile which is less
than 1 AZN and EZY. The highest return is of EasyJet which should be given more weight in
this portfolio.
(b) Birth date: 4 June 1990
4 x 1000 = 4000 units of FTSE 100 index.
Equal weight Units average returns
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according to
birth date
33.33% 4000 3I Infotech 1333 0.1398 186.38136
AstraZencea 1333 0.1871 249.44172
EASYJET 1333 11.21 14945.17
(B) Hedging
Risk faced by fund managers and hedging with futures
There are various risks which are faced by fund manager:
 Interest rate risk: It is the risk where securities are purchased on fixed rate of return and
there is possibility that value of fixed debt instrument will decrease as its outcome will be
increasing with interest rate.
 Currency exchange rate risk: This risk arise from alteration in cost of one currency is
not in favour of another one. The fluctuations of foreign currency where investment is
made with context of home currency which might add risk to security valuation.
 Market risk: It is referred as a systematic risk which impacts all securities in similar
aspect. It can be controlled with diversification (Kaminska and Roberts-Sklar, 2018).
 Inflationary risk: It is also replicated as purchasing power risk in which asset's value has
been fluctuated due to shrinkage of inflation in value of currency of country.
 Credit risk: This risk is considered as specific issuer of bond that will not be capable for
payments of expected interest rate and even principal payment as well.
The most common derivatives which are used for hedging risk is known as futures
contracts. It is the understanding of two parties where specific asset is bought and sold in future
at specific place. Usually, future contracts are used for offsetting exposure of risk and for price
fluctuations, they limit themselves. Futures can be used for hedging risk in two ways that is:
 Long hedging
 Short hedging
Long hedging: Long position has been undertaken by end users when price risk has been
hedged. While taking a long position, they come in contract for buying certain products in the
future. These contracts are executed in very rare case, usually they are offset before maturity.
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The position has been offset by obtaining similar of future market of position of current future.
The earnings or losses which are obtained in these transactions are settled along with spot price.
Short hedging: Short position has been undertaken by producers or commodities for
hedging price risks. The product has been sold by applicability of futures contract. Their price is
hedged in the same manner to long hedgers. Future contracts are sold which have been offset
along with the day of maturity by purchasing future contracts equally (FTSE 100 Future, 2018).
The earnings or losses have been offset for settling price which is obtained at spot market.
(b) Hedging
Date Price
12/05/14 6817
19/06/17 22015
Future price (possibility 1) 29754
Future price (possibility 2) 18564
Difference of future FTSE 100 from stated quote is of 15198 and in the future, it will be
raising from previous quotations so in recommendations, they should give long position while
observing returns (FTSE MIB INDEX, 2018). As on 11th May 2014, market was closed and so,
quotes have been represented of 12th May 2014. According to prediction, if future price will
increase (possibility 1) then stock will be set for long position and if it will be decreasing
(possibility 2) then short position will be applied at current state. Risk will be hedged in
possibility 1 and it will earn 77739 and if possibility 2 case then it will hedge by 3451.
CONCLUSION
From the above report, it has been concluded that future markets play a vital role in
economy whether it is developed or not. It has depicted the outcome that hedging and
speculation are used for managing risk in systematic manner. Price of future should be set while
observing risk free rate, beta and past returns.
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REFERENCES
Books and Journals
Bae, S. C., Kim, H. S. and Kwon, T. H., 2018. Currency derivatives for hedging: New evidence
on determinants, firm risk, and performance. Journal of Futures Markets. 38(4). pp.446-
467.
Chen, Y. and et. al., 2018. A dynamic analysis of S&P 500, FTSE 100 and EURO STOXX 50
indices under different exchange rates. PloS one. 13(3). p.e0194067.
Fabozzi, F. J. ed., 2018. The handbook of financial instruments. John Wiley & Sons.
Kaminska, I. and Roberts-Sklar, M., 2018. Volatility in equity markets and monetary policy rate
uncertainty. Journal of Empirical Finance. 45. pp.68-83.
Miller, D., 2018. Perfect Hedge: Adding Precision to the Proposed SEC Rule on Investment
Company Use of Derivatives with a Hedging Exception. Boston College Law
Review. 59(4). p.1471.
O'callahan, D. M., Chicago Board Options Exchange Inc, 2018. Method of creating and trading
derivative investment products based on an average price of an underlying asset during a
calculation period. U.S. Patent Application 15/659,181.
Online
FTSE 100 Future. 2018. [Online]. Available through: <http://www.stockmaster.in/ftse-100-
futures-live.html>.
FTSE MIB INDEX. 2018. [Online]. Available through:
<https://finance.yahoo.com/quote/ftsemib.mi?ltr=1>.
Hedging Instruments. 2017. [Online]. Available through:
<https://budgeting.thenest.com/derivative-hedging-instruments-29661.html>
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