Bodie, Marcus, and Kane (2011) noted derivatives to be securities that derive value from some other asset, such as a stock, index, or foreign exchange currency. Options, futures, and swaps are derivatives whose payoffs are dependent upon the movement, up or down, of another asset. Derivative securities can be used by both hedgers and speculators to gain profits on or protect the value of an underlying asset. Through various options strategies, hedgers and speculators can ensure payoff amounts or insulate their portfolios from drastic losses.
This paper will discuss the different types of derivative securities options, futures, and swaps. It will also discuss how hedgers and speculators can use each type of derivative security to their advantage along with the benefits of doing so. Furthermore, it will discuss the Black-Scholes option pricing model utilized by many in valuing options.
Recall that derivatives derive their value from some underlying asset. In other words, derivatives themselves have no intrinsic value because their value is based upon the value of something else. Nevertheless, derivatives can be valuable tools for investors to either increase their profit margins or limit their losses. Regardless of the type of derivatives used, hedgers and speculators must ascertain their position on the movement of the market and decide which derivative strategies will be the most beneficial for their bottom line.
Call options give the holder the right to purchase the underlying asset up to and including the date of option expiration for a pre-determined price (Bodie et al., 2011). They are purchased for a premium, or the price the seller of the call accepts for writing the call (Bodie et al., 2011). The writer (selle...
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...ns, futures, and swaps, if used appropriately can either increase the wealth of a portfolio or insure against large losses. Options can be valued using the Black-Scholes pricing model. Overall, managing a portfolio requires understanding of the client’s needs, determining the expectations of the market, and using derivatives to grow or protect the portfolio’s assets.
Works Cited
Bodie, Z., Kane, A., & Marcus, A. J. (2011). Investments. (9th ed.). New York, NY: McGraw-Hill/Irwin.
Chernenko, S., & Faulkender, M. (2011). The Two Sides of Derivatives Usage: Hedging and Speculating with Interest Rate Swaps. Journal Of Financial & Quantitative Analysis, 46(6), 1727-1754. http://dx.doi.org/10.1017/S0022109011000391
Sharma, S. D. (2013). Credit Default Swaps: Risk Hedge or Financial Weapon of Mass Destruction? Economic Affairs, 33(3), 303-311. doi:10.1111/ecaf.12029
A investment that considers to be passive in securities that permits an investor to multiply his/her beginning capital investment on many securities all while earning profits.it consist of having power over securities by an investor along with active management by an investor over a certain period of time. The reason for the investment will be expected to be primarily for financial gain. During the course of this paper there will discussion trying to analyze a common portfolio including a beginning capital input of $10,000 given that the allocation to the portfolio. Also it will include certain investments started under the portfolio including their possible profit. This paper will consist of a table of their investment that has been offered for reference.
Many investors can benefit from using newer financial instruments and critical analysis. The tenth edition of this book also provides a clear description of the academic...
Investors familiar with the saying “don’t put all your eggs in one basket”, can comprehend the rationale behind the modern portfolio theory, pioneered by Harry Markowitz (1952). This is one of the most significant and influential economic theories in investment and finance. The theory was further developed by William Sharpe (1966) who along with Merton Miller, the three were awarded the Nobel Prize in Financial Economics in 1990.
Brealey, Richard A., Marcus, Alan J., Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2nd edn, Craig S. Beytien, USA.
The participants in the derivatives markets are generally classified as hedgers and speculators. The hedgers use derivatives as main purpose to protect against adverse changes while speculators enter a derivative contract with attempt to profit from anticipated changes in market prices. One of the biggest questions in regard to the treatment of derivatives tools is whether actually they are used for hedging or speculation. (Adam and Fernando 2006)
In 1972: International Monetary Market (IMM) for trading currency futures was created. In 1975: first interest rate futures contract create by CBOT. In 1975: Treasury bill futures contract (& options) by CBOT. In 1977: T-Bo...
After the financial crisis of the late 1990s, the demands for risk management tools have increased. The investors have been effectively utilizing such products as KOSPI 200 futures and options, 3-Year KTB futures and USD futures to meet their hedging needs.
One must get familiar with the call option and put options of option pricing to see how transactions are made. The call option is a contract between the buyer and the seller. The buyer “has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller” (Call option, 2011). The buyer has to pay a small fee for this right to make the seller sell upon the buyer’s choosing. The put option is a contract between the buyer and seller “to exchange an asset, the underlying, for a specified amount of cash, the strike, by a predetermined future date, the expiry or maturity” (Put option, 2011).
Throughout financial markets worldwide the use of derivatives as a risk management methods have increased substantially over the last few decades. Derivatives are considered a financial instrument that derive their value from another financial asset or variable and as such they contrast from more commonly known financial instruments such as stocks and bonds. The main goal of derivatives is to protect investors against risk by allowing them to hedge their risk in the future value of an underlying asset (Derivative, 2016). This can be accomplished through different derivative forms, including swaps, options, forwards and futures. Forwards and futures are legally binding agreements used by investors
The importance of the topic is including a reduction in the risk and losses. Hedging effectiveness improved portfolio risk/return. Hedging is one of the main functions provided by future market and also the reason for existence of future markets. The main purpose and benefit of hedging on the futures markets is to minimize possible revenue losses associated with the adverse cash price changes. The risk of price variability of an asset can be managed by mechanism of
A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Derivative products like futures and options are important instruments of price discovery, portfolio diversification and risk hedging. The current scenario shows that the volatility spillover between spot
This essay is concerned with understanding the key issues relative to portfolio analysis and investment. The scope of this essay will be limited to the U. S. Stock markets only. This essay will be built upon extant portfolio theory and will discuss different types of risks that investors might face and how they go about managing such risks. Under consideration will be topics such as efficient frontier and optimal portfolios as well as their relevance to investment theory, under the assumption of direct investment in the stock market.
...ting in hedging activities in the financial futures market companies are able to reduce the future risk of rising interest rates. By participating in the financial futures market companies are able to trade financial instruments now for a future date (Block & Hirt, 2005).
This assignment is concerned with your understanding of the key issues relative to portfolio analysis and investment. In completing this assignment you are to limit your scope to the US stock markets only. Use the Cybrary, the Internet, and course resources to write a 2-page essay which you will use with new clients of your financial planning business which addresses the following issues and/or practices:
In conclusion, hedging risk with financial derivatives can give firm range of benefits such as lower probability of having financial distress, lower value of debt ratio, and earn tax benefit. It can be concluded that firm should hedge risk using financial derivatives because lot evidence shows that firm using this strategy is more successful than those who are not. However, since different type of companies facing different risks, they should not necessarily use the same hedging strategy.