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
Sturzenegger, Federico, and Jeromin Zettelmeyer. Debt defaults and lessons from a decade of crises. MIT press, 2006.
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).
It is extremely hard to just assign blame to one individual party as there are many different factors at work here. This paper will analyze how the stakeholders created a financial disaster and did nothing to prevent it, as the credit rating agencies created an amount of turmoil due to their unethical decisions and costly mistakes. II. Assessing the Housing Crisis In terms of looking at how credit rating agencies affected the market as a whole, they played a role within the mortgage crisis as they gave way to a real estate credit bubble. The mortgage crisis seems to have been caused by the manipulation of the price of credit default swaps....
Ross, S.A., Westerfield, R.W., Jaffe, J. and Jordan, B.D., 2008. Modern Financial Management: International Student Edition. 8th Edition. New York: McGraw-Hill Companies.
The expanding global market has created both staggering wealth for some and the promise of it for others. Business is more competitive than ever before, and every business, financial or product-based, regardless of size or international presence is obligated to operate as efficiently as possible. A major factor in that efficient operation is to take advantage of every opportunity to maximize profits. Many multinational organizations have used derivatives for years in financial risk management activities. These same actions that can protect multinational organizations against interest rate futures and currency fluctuations can be used to create profits for those same organizations.
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:
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.
14. From the viewpoint of the option holder, what is the difference between call option and put option?
Brealey, Richard A., Marcus, Alan J., Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2nd edn, Craig S. Beytien, USA.
According to Investopedia (Asset Allocation Definition, 2013), asset allocation is an investment strategy that aims to balance risk and reward by distributing a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. There are three main asset classes: equities, fixed-income, cash and cash equivalents; but they all have different levels of risk and return. A prudent investor should be careful in allocating each asset class to his portfolio. Proper asset allocation is a highly debatable subject and is not designed equally for everybody, but is rather based on the desires and needs of the individual investor. This paper discusses the importance of asset allocation, the differences and the proper diversification within the portfolio.
The financial objectives of the investor determines what types of assets to be used. In this paper a quantitative approach of choosing the portfolio will be discussed.
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).
Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2011). Essentials of Coporate Finance (7th ed.). New York, New York, US: McGraw-Hill/Irwin. Retrieved January 19, 2014
...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 paper will define and discuss five financial theories and how they impact business decisions made by financial managers. The theories will be the Modern Portfolio Theory, Tobin Separation Theorem, Equilibrium Theory, Arbitrage Pricing Theory (APT), and the Efficient Markets Hypothesis.