Impact of Future Derivatives on Stock Market Volatility

Hedging is a significant measure of financial risk management. Since the 1970s, the increasing number of powerful companies started to control the risk of the exchange rate, the interest rate and commodity by using financial derivatives. ISDA (2013) based on the Global 500 Annual Report 2012 survey found that 88 percent of companies use foreign exchange derivatives. Modigliani & Miller (1958) believed that if the financial markets were under perfect conditions, for instance, there was no agency costs, asymmetric information, taxes and transaction costs, hedging would not increase the company 's value because investors can hedge by themselves. However, a large number of practical studies have shown that hedging is beneficial

Mr. Brown readily admitted that he was not at ease discussing the most recent approaches to risk reduction or hedging. He had received his MBA from Harvard in the 1960s and had spent most of his career working for a company that had little international exposure. Moreover, he was not familiar with derivatives such as currency options, which until recently were not widely traded. However, Mr. Brown had recently hired an assistant, Mr. Dan Pross, who had some knowledge of hedging and derivatives. As a student at UCLA, Mr. Pross had traded various types of derivatives for his own portfolio and was familiar with how they were traded. Although Mr. Pross did not have a finance background, he was, in Mr. Brown’s opinion, extremely intelligent and highly capable. Mr. Brown suggested that Mr. Pross make a presentation to the senior management on the use of derivatives to reduce risk.

Analyze the derivatives market and determine the use of derivatives to efficiently manage investment risks in an investment portfolio.

This document is authorized for use only by Yen Ting Chen in FInancial Markets and Institutions taught by Nawal Ahmed Boston University from September 2014 to December 2014.

Nestlé S.A. is a Swiss company and owns a prestigious position being the world’s leading nutrition, health and wellness group (Nestlé, 2016). According to its annual report (2015), this company is exposed to many risks caused by movements in foreign currency exchange rates, interest rate and market prices. The foreign exchange risk comes from transactions and translations of foreign operations in Swiss Francs (CHF). The interest rate risk faces the borrowings at fixed and variable rates. The market price risk comes from commodity price and equity price. The former risk arises from world commodity market for the supplies of coffee, cocoa beans, sugar and others. The later risk arises from the fluctuations of the prices of investments held. (Nestle annual reports, 2015). Thus, financial derivatives instruments are used by this multinational corporation in order to hedge these risks.

Second, research on Flash Crash stated that HFT has the impact to create irregular volatility because HFTs sold the S&P 500 stocks which E-Mini was linked and reinforced the illusion of event to scared fundamental buyers out of the market. Under normal market conditions, HFT decreases a short term volatility by making it possible to buy and sell without significantly altering prices. (Prewitt, 2012). In addition, Brogaard showed HFT data from 120 US stock from the period 2008 to 2010 that high levels of HFT performance led to lower volatility, but Foucault et al. conflicted that investors provide more stock market volatility when they have faster access to news. (Manahov et al, 2014).

“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

Derivatives trading take place in two markets, the over-the counter-market (OTC) and the organized derivative exchange markets. Contrary to the OTC markets that allow derivatives contracts to be individually customized to the risk

Investors in volatility market should make no move waiting for the market to steady it self as volatility doesn’t change stocks valuations. Based on analyst’s opinion most of them recommend

Predicting asset price movements with a high degree of certainty is harder than ever in today’s dynamic environment which includes a greater focus on quantitative trading. The finance profession is no longer confined to well connected MBA candidates from Wharton claiming to have a knack for stock picking. Many of the best and brightest in physics and mathematics now hold high profile positions on Wall Street and are responsible for defining the mathematical models to unlock potential mispricing opportunities in the market. But given the increasing complexities and intricacies of the market, building an accurate model requires choosing a set of complementing factors which accurately explain and understand the pattern of security returns.

Initially this rule became prominent in literature and widely accepted by both academics and practitioners. However, recent financial events such as the crisis which is said to be proceeded to the stock market crash and large movements in the asset prices in Japan and the United Sates, has lead to increased scrutiny on the impact of volatility in stock prices and its relationship and impact on

Volatility is main important variable in finance. Its appears mainly in pricing, portfolio theory ,risk management , derivatives , business finance , investment valuation and financial econometrics. Volatility cannot be directly observed. Hedging volatility risk is main for investors fluctuating from individuals to pension funds. Volatility risk followed the 1987 crash. Example: Barings Bank , Long Term Capital Management. In Hedging volatility risk there are three issue. First, a strong volatility measure has to be specified. Second, the properties of this particular measure have to be modeled. Third, the suitable instrument should be priced.

Studying the impact of MacroEconomic factors such as Inflation, Interest Rate, Dollar Value and FII on conditional stock market volatility also has important implications for investors and policymakers. In many

Among the most fundamental risks, associated with exchange-traded derivatives, is variable degree of risk. According to Ernst, Koziol, & Schweizer (2011), the transactions in

Derivatives are traded in two different ways – they are traded either on an exchange or over-the-counter (OTC). The advantage of trading derivatives on an exchange is that the contracts are standardized by the exchange and credit risk is eliminated. Open-outcry system was used