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.
By adopting this approach, an investor can lock in a profit, if the stock price falls during the period of the contract, since he can exercise the option and sell at the strike price. One should not forget however, that hedging involves a cost i.e. the premium that must be paid to buy the put whether you can exercise the option or not. Options can also be used for speculation i.e. a trader can invest a small amount of money in exchange for a fast and considerable return on his investment.
What is hedging? Hedging is a strategy used to protect risks posed by worldwide currency fluctuations. One hedges the currency risk by contracting to sell foreign currency in the future, at the current exchange rate (Fries). If fund managers think the dollar is going to be stronger when they are ready to change the foreign currency back into American dollars, then they take out a foreign futures contract (a hedge). Thus, they lock in the exchange rate beforehand, so that they will not lose profits gained from holding devalued foreign currency (Hedging, 1999).
1. One question is whether firms should attempt to hedge FX risks. Explain how hedging FX risks creates value for a firm. Under what assumptions is hedging FX risk redundant? Hedging decisions whether its forecasts of foreign currency values may determine a firm hedges.
The present value model concentrates on the long-run relationship whereas the arbitrage pricing theory focuses on short-run relationship between the stock market movement and the macroeconomic fundamentals. According to these models, any new information about the fundamental macroeconomic factors such as, real output, inflation, money supply, interest rate and so on, may influence the stock price/return through the influence of expected dividends, the discount rate or both (Chen et al., 1986; Rahman et al.,
Forex Options allows investors to select the date of maturity, strike price and amount (size of the operation). This is unlike exchange-traded options, which are more restrictive with respect to maturity and the quantities set. FX Options can be traded while the Forex market is open. Why Foreign Exchange Products are important for
TITLE OF THE STUDY: Impact of Derivative Trading on the Volatility of the Underlying Assets with Special Reference to LKP Securities Limited INTRODUCTION: 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.
Before discussing the economic literature on the relationship between interest rates and exchange rates in full, it will be useful to briefly discuss some of the important theories of exchange rate determination. There are many theories such as the theory of Purchasing Power Purchase Agreement (PPP), the Flexible Price Monetary Model (FPM), Sticky Price Monetary Model (SPM), Real Interest Rate Differential Model (RIRD), and Portfolio Balance Theory (PBT) of exchange rate determination. The PPP to maintain equality between domestic and foreign prices are based on the domestic currency through commodity arbitrage. If the equilibrium is violated, the same commodity after exchange rate adjustment will be sold at different prices in different countries. As a result, commodity arbitrage or buy a commodity at the same time the lower price and sell at the higher prices will lead back to the equilibrium exchange rate.
The Determinants The market interest rate is the quoted, or nominal, rate of interest on a given security. There are many factors that can detemine the interest rate. The determinants of market interest rates are the real risk-free rate of interest, the inflation premium, the default risk premium, the liquidity premium, and the maturity risk premium. All of the determinants have different factors that make them stronger or weaker that result in a high or low interest rate. The real risk-free rate of interest would only exist if there was no inflation expected.
This form of analysis is used to predict which stock is valuable and has the potential to generate good returns. • It gives a fuller picture that is not just limited to the market but also covers the overall stock market situation. How is Fundamental analysis different from Technical analysis? Fundamental is used to evaluate the basic strength and weakness the economy, using the Top-Down and Bottom-Up approach. While Technical analysis decides on WHEN to buy a stock based on price fluctuations, Fundamental analysis determines WHAT to buy based on financial statements.