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 called Futures and Options might do just that if used properly. In this essay we look at certain types of derivatives called Futures and Options, and how hedgers / investors make use of them to their advantage as well as where the threats seem to lie when dealing with them in general.
These derivative markets allow hedgers to avoid risk by transferring it to speculators who seek it. We have all heard the phrase “keep your options open'; and it is along these lines that the Options derivative has arisen. As we know options are contractual arrangements giving the owner the right, but not the obligation, to buy or sell something at a given price, at some time in the future. It is these Options in general that we want to address as they offer the investor the ability to create a wide variety of risk and return alternatives from the same underlying security. Futures, being exchanged-traded forward contracts, have also provided another choice to suit the needs of the holder and the advantages for and against these will also be looked at.
After looking at the Futures and Options we will turn our attention to discussing the cases for and against the needs of further regulating this market. This issue has been strongly reinforced since many big bets have gone wrong, such as the collapse of Barings and many others. Where do the faults lie which have led to these disasters and who if anybody is to blame? These are matters that will need to be looked at. To begin with lets focus our attention on Futures contracts .
Advantages / Disadvantages from the use of Future Contracts
- As the market for future contracts is standardised ...
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...ld result in the avoidance of future disasters but more self-regulation could be encouraged and set in play also.
The bottom line is that anyone in the derivative business really needs to be more careful and have more control over what they are doing. Again Partnoy in his book FIASCO says, “ Most of us enter the investment business for the same sanity- destroying reasons a woman becomes a prostitute.’ So if you do decide to invest you should take the advice of the Office of Kansas Securities Commission which is “Investigate before you invest.’
BIBLIOGRAPHY
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The pursuit of truth, just as Socrates, has always been a distinguishing part of who I am and what I regard as a noble and worthwhile approach to life. My mother told me that when I was a child I always had another question for every answer she ever gave me. I remember it as if it was yesterday. My mother and I had brought back some flowers from the nursery to plant in her garden. As she went about her business laying down the mulch and arranging the flowers the way she wanted them, I began to take notice of the many bugs embedded in the so...
Pennings, Joost M.E. Research in Agricultural Futures Markets: Past Present and Future. Presentation Paper: Wageningen Agricultural University: Netherlands. 8 June 2001.
Caterpillar Inc. also faces the risk of its cash flow and earnings being affected by fluctuations in the exchange rates of currency, commodity prices, and interest rates. To control for this, the company’s Risk Management Policy ensures prudent management of interest rates, commodity prices, and exchange rates of foreign currency by allowing the use of derivative financial instruments. According to the policy, the derivative financial instruments are not supposed to be used for the purpose of speculation. In its pricing strategy, Caterpillar Inc. faces the risk of difficult shipping of its products. This risk can be encountered by offering its products on instalments and lease to its loyal customers (Caterpillar, Inc. (CAT), 2011).
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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). If the manager guesses correctly, he will boost the fund’s overall return because the profits will be worth even more when they are exchanged into American dollars.
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Finance theory does not provide a complete framework for explaining risk management under the fluctuated financial environment in which firm operates. Hence, for corporate managers, they rank risk management as one of their top priorities. One of the strategies to reduce risk is by hedging. This paper will discuss the advantages and disadvantages of hedging risk using financial derivatives.
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Gregor Meerganz von Medeazza, Economic and Political Weekly, Vol. 41, No. 11, Money, Banking and Finance (Mar. 18-24, 2006), pp. 949-952
Making business decisions involves choosing between alternative courses of action. Many factors affect business decisions, yet analysis typically focuses on finding the alternative that offers the highest return on investment or the greatest reduction in costs. Some decisions are based on little more than an intuitive understanding of the situation because available information is too limited to allow a more systematic analysis. In other cases, intangible factors such as convenience, prestige, and environmental considerations are more important than strictly quantitative factors. In all situations, managers can reach a sounder decision if they identify the consequences of alternative choices in financial terms. This unit
...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).
In the end I would like to say that disasters are inevitable so the authorities should be prepare beforehand and when the disaster actually occurs the response should be fast and effective. There after the recovery from the loss occurred should be well planned and future planning should be done so that much better protection steps can prevent larger damage.