INTRODUCTION
“A derivative is like a razor, you can use it to shave and make yourself attractive for your girlfriend, you can slit your throat with it or you can use it to commit suicide.’(Anon.) This statement describes to us the problems, and on the other hand rewards, that the proper use of derivatives can bring. The derivatives market has developed responding to the uncertainty about prices, and therefore provided a means of separating out this price volatility. The tendency of the market to move up or down in what appears to be a random manner has brought about the need for financial products which will protect or hedge the investor against the ill effects of market volatility. Certain types of derivatives
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- Holder of a futures contract is locked in an effective selling price therefore if he sells the contract against their position and then sees the market go up rather than down, he cannot take advantage of that upswing.
- If an investor wishes to take advantage of favourable yields but is aware this may increase interest rate exposure, the financial futures markets will provide an opportunity to hedge against possible loss.
- Gearing effect of the margining system means investors can quickly loose 100% of their investment, which wouldn’t be likely if they invested directly in bonds and shares.
-Holder of the contract can enter an offsetting contract with the same delivery month as the original contract and by this close out their position.
- Purchaser is forced to go through with the futures contract even if this is detrimental to them as mentioned earlier potential loss is unlimited.
- Futures contracts can provide great gains or losses (symmetric risk )
- Clearing House system guarantees that all contracts will be fulfilled.
- Risk of default is very low and the absence of some risk along with the presence of low transaction costs, ensures that the secondary market is highly liquid (i.e. A contract can be opened in one countries exchange and closed in another such is the high quality of the futures market.)
- Offers a cash efficient means of taking position in a market as futures are traded on margin. This allows for a geared
5. Compare and contrast selling Eurodollar futures and being a fixed rate payer in a swap as a risk management technique. Explain in detail.
If an unforeseen and/or uncontrollable event happens to either party, they may have the option to back out of the contract, for a negotiated period of time, for repairs or termination of the contract, if necessary. Conditions such as but not limited, but not limited to, weather conditions, store, warehouse, or personal property damage. The contract will be kept in force, until canceled or terminated by agreed upon terms by all parties.
American Barrick is the largest gold producer in North America. The implementation of the gold-hedging program differentiated the firm from other major gold rivals and improved its reserve and financial strength. In 1995, American Barrick ’s latest gold find necessitated the company to determine a new hedge strategy for its gold production.
The derivatives program was reducing risk when the firm was investing in foreign currency futures for the first four months from the implementation date (February 1991 to May 1991). This is seen by the negative correlation of (0.94226594) between the derivative (futures) cash flow and the unhedged cash flow. A purpose of a perfect hedge is to obtain a net of zero or in other words, reduce your risk to nothing not including the cost of the hedge. If a correlation is negative, as it was for the first three
If Seller fails to comply with this contract for any other reason, Seller will be in default and Buyer may, as Buyer's sole and exclusive remedy, terminate this contract and receive from Seller the deposit, thereby releasing both parties from the contract.
The definition of "derivatives" is also very wide, and includes options and warrants, whoever they are issued by, as well as rights and interests in respect of listed securities (or other derivatives).
Analyze the derivatives market and determine the use of derivatives to efficiently manage investment risks in an investment portfolio.
The best futures contract for hedging a cash market risk exposure is one whose price sensitivity to interest rate changes is as close as possible to the sensitivity of the cash market risk exposure to interest rate changes. The higher the correlation between the interest rate on the futures contract and the interest rate in the spot market, the higher the immunization achieved against the losses / gains from the interest rate risk. Thus, the best futures
But, even though the possibility of winning exists, the company is exposed to a greater risk if it does not hedge. Moreover, the policy of the company is to ensure against the risk, not to speculate on the foreign exchange market.
Most firms hedge at least some of their risks. Hedging can take two basic forms—namely, natural hedging and hedging by means of derivative instruments. The use of derivatives as hedges has expanded greatly in recent years.
Hedging can be defined as a risk management mechanism or strategy which is used to prevent the chances of incurring losses which arise as a result of fall in prices commodities or currencies. It is a technique which is majorly used by the investors in protecting their capital against the effects of the economic situations such as inflation whereby the investors invests in the high yield financial instruments or take a position to cushion them against such effects (Investopedia, 2012).
Like an ordinary stock trade, two parties will work through their respective brokers, to transact a futures trade. An investor can only trade in the futures contracts that are supported by each exchange. In contrast, forwards are entirely customized and all the terms of the contract are privately negotiated between parties. They can be keyed to almost any conceivable underlying asset or measure. The settlement date, notional amount of the contract and settlement form (cash or physical) are entirely up to the parties to the contract.
According to Goel and Gutierrez, they investigated that fluctuating procurement price is one of the causes of inventory risk and through trading appropriate numbers of futures or forward commodity contracts reduces inventory related costs for effective hedging. Hedging and the price discovery functions of futures markets facilitates not only a better inventory management but enhances the efficiency of marketing operations, production and storage.
2. Terminate of the agreement and the confiscation of the bank guarantee (the final insurance) and the claim for damages caused to the first party.