Derivatives and Risk Management in Finance

This assignment delves into the intricate world of derivatives and risk management within financial markets. Students are tasked with analyzing various aspects, including the potential for international disease spread via air travel during the 2014 Ebola outbreak, the properties of interest rate processes, and the dynamics of volatility in equity and derivatives markets. The analysis incorporates real-world case studies, academic research papers, and legal considerations related to product liability and commercial law. Students are expected to demonstrate a comprehensive understanding of these concepts and their implications for financial decision-making.

Transnational Commercial Law

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
TASK 1............................................................................................................................................1
Functions of interest rate derivative and their role in the global economy............................1
TASK 2
Various international payment methods available for international trade or transaction.......5
CONCLUSION................................................................................................................................8
REFERENCES................................................................................................................................9

INTRODUCTION
Transnational or international commercial law refers to the set of rules, conventions,
legislation as well as commercial customs or usage. International commercial law governs all
viable transactions which take place at international level. Business dealings in which more than
two countries are involved are known as international transaction. It is also termed as trade or
business law because it also regulates the areas which are related with the business practices.
Transnational commercial law governs contracts made by an organization, customer credit,
house loan as well as other secured transactions (VerSteeg, 2015). The present report will
develop the understanding about interest rate derivative and the role which they play in the
global market. Besides this, it will also discuss the rules and regulations which are framed by
European Union competition law. Further, the present report will examine the various
international payment methods which are available to Tina on the basis of case scenario. In
addition to this, this project also helps in understand the international rules which are applied to
such payment methods.
TASK 1
Functions of interest rate derivative and their role in the global economy
Interest rate derivative may be defined as a derivative tool which offers hedge to
investors or bank in against to the changes in interest rates. Usually, investors undertake interest
rate derivative as a speculative tool which helps them in generating huge amount of profit by
making estimation about interest rate. By analyzing market trend or patter, investor can easily
make profit through the appropriate estimation of interest rate changes. Interest rate derivative is
the largest and growing derivative market in the world. According to the International swap and
derivative association, 80% of the top companies make use of interest rate derivative to control
their cash flows.
Interest rate swap is the most common type of interest rate derivative which provides
hedge to investors in relation to interest rate fluctuations. Usually two parties are involved in
interest rate derivatives (Mele, Obayashi and Shalen, 2015). In this, one party possesses fixed
interest rate derivatives whereas another party has floating interest rate derivatives. In order to
reduce the risk of interest rate fluctuations, party who is having the floating interest rate
instrument makes exchange of their securities with the fixed interest rate instruments. Through
this, party is able to hedge in against to the interest are fluctuations. Thus, in interest rate swap,
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two parties have to exchange their interest rate cash flows on the basis of specific notional
amount. In this, one party move from fixed interest rate to floating interest rate whereas another
party take decision to move from floating to fixed interest rate with the specific notional amount
for the predetermined time period (Park, 2015). Through this, one counter party is able to make
profit on the basis of his or her estimation. Whereas another secures himself with the risk of
interest rate fluctuations who select fixed interest rate over the floating interest rate.
For instance: There are two counter parties such as A and B, who are involved in interest
rate derivative. In this, A has invested £50000 @ 8% fixed interest rate. Whereas B has invested
his money in the market @ 8% floating interest rate. By analyzing the market trend, B threatened
from the interest rate fluctuation which will take place in the near future. In contrary to this, A
assumes that market will grow in the near future but he has invested his money in the fixed
interest rate instrument. Thus, both the counter parties having similar principle or notional
amount upon which they agree to exchange their interest rates. Besides this, both the parties want
to exchange their cash flows through the financial intermediary such as bank. Thus, with the aim
to increase profit margin and hedge, A and B have decided to exchange their cash flow for the
period of 5 years. For such exchange of cash flows, bank charges exchange cost which also
imposes financial cost in front of both the counter parties. In this, A receives floating rate and
thereby paid fixed rate to B. On contrary to this, by exchanging the cash flows B receives fixed
rate whereas make payment to B at floating rate. It enables A to increase his profitability aspects
by taking risk. Whereas such interest swap have offered hedge to B in against to the risk of loss
due to the interest rate fluctuations.
Functions of interest rate derivatives
 Interest rate derivative provide hedging to the investors by protecting them from the
interest rate fluctuations. It is hedging instrument that offers safe kind of return to
investors. It offers fixed return to the counter party who selects fixed interest rate
instrument over the floating rate instruments (Fernández, 2015). In this, both the parties
exchange their interest rates without exchanging the underlying debt.
 Besides this, interest rate derivative is also the investment tool that provides opportunity
to maximize their return by making investment in the floating rate instruments. Through
this, individual is able to earn high profitability by undertaking the risk.
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 Interest rate derivative also provides assistance to the organization in making control over
their cash flows. By exchanging interest rate, company can easily assess their cash inflow
and thereby able to make further investment decisions. Thus, interest rate swap also
makes contribution in the growth and profitability of an organization
Role of interest rate derivative in the context of global economy:
Interest rate derivatives play a vital role in the development of global economy. In the
present scenario, investors prefer to make use of derivatives on a large basis or scale (Russo and
Fabozzi, 2016). This aspect facilitates high level of market efficiency through hedging,
leveraging and substitutability. All these three aspects encourage investors to make profit by
reducing the risk aspect and thereby make contribution in the growth of global economy.
Hedging provide assistance to investors to transfer their risk of the underlying asset from buying
agent to the selling agent. In addition to this, derivative market also facilitates arbitration
between the two different types of asset.
Interest rate derivative places positive impact upon economy because it helps investor in
distributing the risk through hedging. In addition to this, lower cost of capital also attract agent to
make focus upon their strengths and thereby make contribution in sustain the growth aspect. In
the dynamic business environment there are high levels of uncertainty in relation to the
fluctuation of interest rate which will take place in global economy (Chang, Chen and Zhu,
2015). Derivative instrument or interest rate derivative provides hedge to individual investor in
against to inflation and deflation. Derivative instruments provide help in discovering the price of
asset and thereby help in managing the risk more effectively or efficiently.
EU competition law:
Competition laws and legislation, which is framed by European Union, helps in
restricting the unethical practices which may develop unhealthy competition at marketplace.
According to European Union (EU) competition law, there will be no collusion between the
competitors in interest rate at derivative market. If any collusion is seen in the competitors of
financial institutions, then it is considered as violation of EU competition law. During the Euro
and Yen interest rate derivatives, bank traders share information with each other. They had
consulted their negotiation and pricing strategies and thereby become the part of illegal cartel
(VerSteeg, 2015). By taking into consideration such aspect, European Union had framed the rule
that bank as an enterprise is responsible for the each and every act of their employees or traders.
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In addition to this, European Union had also declared the punishment system for banks who will
participate in any illegal cartel. In 2013, 8 banks were charged with the monetary punishment of
171 billion Euro because they had participated in illegal cartel in the market of interest rate
derivatives. Besides this, EU competition law provides support to banks that they also make the
discussion in relation to their bank rate figures with the aim to calculate EURIBOR. It also helps
other banks in framing competent trading and pricing strategies. It is considered as immunity for
them because they are free to discuss their policies with other banks. In this situation, law will
not charge any fine from them for such kind of practices. Thus, commission leniency policy
provides support to bank and thereby helps them in framing suitable trading strategies.
There are specifically two type of anti competitive activity which banks require to avoid
in order comply with EU legislation. It is strictly prohibited for banks to make any anti-
competitive agreements. Both UK and EU competition law have prohibited agreements,
arrangements and other business practices which have adverse impact upon their trade aspects.
In addition to this, banks have the right to make abuse of their dominant position in the financial
market (Mele, Obayashi and Shalen, 2015). Thus, all the banks are required to avoid such
unethical practices in the financial market. If any bank does not comply with such legislation
then they have to face serious consequences for breaching law which are enumerated below:
 If any bank or company beaches the EU competition rule then they have to pay fine up to
the 10% of their global turnover.
 In addition to this, banks or other companies are obliged to give compensation to other
customers or competitors. Financial institution has the liability to compensate the
damaged party which is occurred due to the anti competitive behavior of them.
If any person make illegal benefit from their position then they are disqualified from the
position of company’s director or else.
According to EU legislation there is no high level of exemption provided to the
companies who behave unethically or made any anti competitive agreements. On the basis of the
rules and regulation of European Union, if defendant party is able to justify the reason due to
which they have made anti competitive agreements then they are not liable to compensate the
damaged party. For example: Bank refused to his one of the customer in relation to supply of
financial instruments or asset due to their poor credit rating. They had made such decision to
protect their interest or business. In this situation, latter are exempted to pay fine for such
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activity. On the basis of European Union laws and legislation when banks do such activity out of
their business interest then it is recognized as an abuse of position. In the case unethical behavior
or activity, bank is charged with fine which up to the 10% of their global turnover.
On the basis of all the above mentioned laws and legislation which is framed by
European Union provides support to bank. In addition to this, it also provides platform to banks
to make transaction with each other. Further, they also have opportunity to discuss their trade,
policies and strategies with each other. On the basis of such laws and legislation financial
institutions are able to make interbank transaction more effectively. Usually they make huge
amount of investment in the securities in which they wishes to invest. Nevertheless, they do not
have any platform for making such transactions at very cost effective rates (Competition law -
the basics, 2016). In this situation, inter bank transactions provide assistance to make investment
in the interest rate derivative as per their requirement. Through this, they are able to exchange
their cash flows at international level.
For instance: RBS which is the international bank having 5 million @9% fixed interest
rate derivatives. On other hand, UBS is having 5 million floating interest rate derivatives. By
making analysis of the market trend, RBS have identified that market will grow in near future.
On the basis of this aspect, RBS wishes to make investment in floating interest rate derivative
instrument. As per the interbank financial arrangements, RBS can exchange their interest rate
cash flow with UBS who possess 5 million floating interest rate derivative. Through this, UBS is
able to exchange their interest rate cash flow with another bank at the very reasonable cost. It
enables them to improve their profitability and hedge the investment from interest rate
fluctuations which take place in market. Thus, interbank interest rate derivative arrangements
provide support to banks in relation to the exchange of cash flows at very cost effective charges.
TASK 2
Various international payment methods available for international trade or transaction
International payment refers to the transfer of money from one country to another for the
trade which is made by them. Each company imports some product or services which are not
available in their nation. In addition to this, they also export the goods which are available to
them in excess quantity. For such import and export, respective countries require making
payment to another country by the means of various payment mode such as letter of credit,
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cashing in advance etc. On the basis of the cited case scenario, Tina exports the children toys to
the different large and small companies which are situated around the world. Usually, she sends
her goods with the invoices and thereby prefers to get payment within 14 days. Now, most of the
purchaser makes default in payment due to their insolvency. On the basis of this aspect, Tina
needs to properly structure their transaction to prevent the risk of non-payment (Chance and
Brooks, 2015). Thus, there are several international payment methods or ways which are
available to Tina. It includes letter of credit, cash in advance, documentary collection, opening
account and international consignment. All these methods possess different types of risk which
closely affects the certainty of payment. Thus, by making assessment of risks which are
associated with different payment methods, Tina can select the best method which prevents the
risk of non-payment. Various international payment methods which are available to Tina are
enumerated below: Cash in advance: Exporter can reduce the payment risk by taking resort of cash in
advance method. Exporter can prevent the risk of default by taking cash in advance for
the goods or serviced which they going to export. It is highly secured way which mitigate
the risk of non- payment. In this, exporter is also secured from the insolvency aspect of
the importer. If importer becomes insolvent in near future then exporter will not face
difficulty in relation to payment (Bénétrix, Lane and Shambaugh, 2015). Thus, it is the
most effective way which protects them from the risk of payment. Technological
advancement also supports such method. With the help of internet, exporter can easily get
advance payment within few seconds or minutes. Nevertheless, importer hesitates to
make payment in advance for the goods because it creates financial burden in front of
them. Usually, they prefer to make payment within certain time duration and then
mitigate the situation of unfavorable cash flows. Thus, it creates difficulty in front of
exporter in relation to the adoption of cash in advance method (Chiang and et.al, 2015).
Nevertheless, it is the most effective mean of international payment which gives
assurance to exporter about payment. Letter of credit: It is another most effective method which ensures exporter that they will
receive payment for the goods which are exported by them. Letter of credit also provides
security to exporter in relation to payment from importer. In this, buyer's bank gives
guarantee to exporter on behalf of importer, if they make default in payment. Usually, it
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is not possible for exporter to assess the creditworthiness of foreign buyer. Whereas
exporter have idea about the trustworthiness of the buyer bank. Through letter of credit,
buyer’s bank gives assurance that they will make payment to exporter if importer makes
any default in payment. It provides assistance to exporter to reduce the risk of default and
thereby get payment for goods which are shipped by them (Schmidt and Hewig, 2015).
Through this, they are able to get payment within the suitable time frame Documentary collections: Documentary letter of credit or draft offers protection to
importer and exporter. Importer think that if they made cash payment in advance then
there is no guarantee that exporter will ship the goods. In addition this, exporter have
confusion that importer will make payment for the goods on time or not. In this, importer
give documentary letter of credit to exporter which contains the days within which
importer will make payment to them. In addition to this, it also contains the bank name
that makes payment to exporter on the presentment of documents or letter of credit.
Documentary collections are less expensive to the letter of credit (Bogoch and et.al,
2015). Thus, by presenting the documentary letter of credit to the concerned bank,
exporter can receive money for the goods which are shipped by them. For providing such
services, bank charges some cost from the importer. On the basis of all the above
mentioned aspects, documentary collection provides help in getting payment of the
shipment on time. Opening account: It is also the more convenient method which provides relief to the
importer. Nevertheless, it is unsecured from the side of exporter. In open account,
exporter gives bill to importer which contains the amount and time limit such as 30, 60
and 90 days. Usually, they are ready to open the account of importer with whom they
have strong relationship. In addition to this, export also prefers to open the account of
importer who has well established business and high creditworthiness. On the basis of
such account, importer has liability to pay agreed amount on predetermined date. It
imposes high level of risk in front of exporter in relation to payment (Armani and et.al,
2015). Moreover, there is absence of bank, document and other legal channels in open
account. Due to this aspect, exporter does not have legal guarantee regarding the payment
of goods which are shipped by them.
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 Consignment: International consignment sale is also one of the method which helps in
international payment. In this, exporter shipped the good to distributor in overseas
market. In this condition, exporter retains the title with itself unless the goods are sold by
the distributor. Once they are sold by the distributor then payment is transferred by him in
account of exporter (Jovanović, 2015). Nevertheless, there is no guarantee that distributor
of overseas market make payment to the exporter for the goods sold by them. Thus, it is
highly unsecured way of international payment (Export Import Payment Terms, 2016).
Highly
unsecured
Unsecured Secure Highly secure
Exporter consignment Open account Documentary
collection
Letters of
credit
Cash in
advance
On the basis of all pros and cons of international payment method, it is advised to Tina
that she needs to undertake letter of credit and cash in advance method. Both these methods
helps exporter by mitigating the risk of non-payment. As per the cited case scenario, Tina who
exports toys to the other part of world is facing problems of non-payment from large number of
her customers. In order to remove such issue, Tina needs to receive cash in advance from her
customers who are ready to give payment before taking the delivery of toys. Through this, Tina
is able to protect herself with the insolvency aspect of their customers. It is the most effective
way which gives assurance to exporter in relation to their payment.
In addition this, Tina can also undertake the letter of credit for their customers who are
not ready to pay in advance. Usually, customer or importer prefers to take some time for making
payment. In this situation, letter of credit payment system proves to be more fruitful for the
exporter. It is also one of the secured payment methods which help them in reducing the risk of
non-payment. In this, buyer's bank gives assurance in relation to the payment of shipped good if
buyer makes default in payment. In addition to this, it is very easy for Tina to assess the
creditworthiness of respective bank who issue letter of credit to buyer. Through this, Tina is able
to protect the amount of shipped goods and there by prevent the risk of default in making
payment.
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CONCLUSION
From this project report, it has been concluded that interest rate derivative or swap is the
most effective financial instrument. It offer hedge to investors from the interest rate fluctuations.
It can be seen in the report that by exchanging interest rate cash flows counter parties are able to
mitigate the risk of interest rate fluctuations. Besides this, it can be inferred that Tina needs to
make assessment of all the methods before the selection of gateway for international payment.
Further, it can be concluded that Tina should adopt cash in advance and letter of credit method
which ensures exporter that they receive payment for the shipped toys within the suitable time
period without any default.
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REFERENCES
Books and Journals
Armani, A. and et.al, 2015. DNA and Mini-DNA barcoding for the identification of Porgies
species (family Sparidae) of commercial interest on the international market. Food
Control. 50. pp.589-596.
Bénétrix, A. S., Lane, P. R. and Shambaugh, J. C., 2015. International currency exposures,
valuation effects and the global financial crisis. Journal of International Economics. 96.
pp.S98-S109.
Bogoch, I. I. and et.al., 2015. Assessment of the potential for international dissemination of
Ebola virus via commercial air travel during the 2014 west African outbreak. The Lancet.
385(9962). pp.29-35.
Chance, D. and Brooks, R., 2015. Introduction to derivatives and risk management. Cengage
Learning.
Chang, L., Chen, S. and Zhu, A., 2015. Properties of the Cox–Ingersoll–Ross Interest Rate
Processes with Two-sided Reflections. Communications in Statistics-Theory and
Methods. 44(4). pp.657-670.
Chiang, I. and et.al., 2015. Estimating oil risk factors using information from equity and
derivatives markets. The Journal of Finance. 70(2). pp.769-804.
Fernández, J. P. M., 2015. Interest Rate Swap and Rebus sic Stantibus Clause. European Review
of Private Law. 23(1). pp.133-148.
Jovanović, M. N., 2015. The economics of international integration. Edward Elgar Publishing.
Mele, A., Obayashi, Y. and Shalen, C., 2015. Rate fears gauges and the dynamics of interest rate
swap and equity volatility. Journal of Banking & Finance. 52. pp.256-265.
Park, H., 2015. Dislocations in the Currency Swap and Interest Rate Swap Markets: The Case of
Korea. Journal of Futures Markets. 35(5). pp.455-475.
Russo, V. and Fabozzi, F. J., 2016. A One-Factor Shifted Squared Gaussian Term Structure
Model for Interest Rate Modeling. The Journal of Fixed Income. 25(3). pp.36-45.
Schmidt, B. and Hewig, J., 2015. Paying Out One or All Trials: A Behavioral Economic
Evaluation of Payment Methods in a Prototypical Risky Decision Study. The
Psychological Record. 65(2). pp.245-250.
VerSteeg, R., 2015. Product Liability and Commercial Law Theories Relating to Concussions. J.
Bus. & Tech. L. 10. p.73.
Online
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Competition law - the basics. 2016. Online. Available through: <http://www.out-law.com/page-
5811>. [Accessed on 20th January 2016].
Export Import Payment Terms. 2016. Online. Available through:
<http://www.bizmove.com/export/m7m.htm>. [Accessed on 20th January 2016].
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