Question

Pls do not handwrite the answer, this is for easy reading

Questions 3)

3a)Explain the differences between the following derivative products and discuss how each of these instruments may be used for hedging by a Singapore exporter, receiving US dollars for the goods he sells, with a simple example.

i)Forward contracts
ii)Future contracts
iii)Options(calls and puts)
iv)Interest rate swaps

3b)Select three different Central Banks that had previously employed or are currently employing the following exchange rate system respectively.

i)A fixed exchange rate system
ii)A floating exchange rate system
iii)A managed exchange rate system

Critically analyse and discuss each of these exchange rate systems. In your analysis and discussion, please cite actual market events that took place and the successes and/or limitations faces by each of the Central Banks as market events unfolded.

Answer 1

3(a)

(i)

Forward Contracts

These are the simplest form of derivative contracts. They are over the counter contracts and are not traded on any exchange. The contract entails an agreement between two parties where one party agrees to buy a certain quantity of a security or a commodity at a pre-determined price (known as the forward price) for delivery at an agreed future date (known as the settlement date) and the other party that agrees to sell the security or commodity at the agreed price on the agreed future date. The delivery quantity, the delivery price and the settlement date are all negotiable and are finalised between the parties according to the need of the trade.

The Singapore exporter may not find any significant benefit in hedging his goods using this kind of derivative instrument.

(ii)

Future Contracts

Futures Contracts are similar to Forward Contracts but offer added security and standardization of the terms of the contract. The contract entails an agreement between two parties where one party agrees to buy a certain quantity of a security or a commodity at a certain price (known as the futures price) for delivery at the end of the contract period (known as the settlement date) and the other party that agrees to sell the security or commodity at the stipulated price at the end of the contract period. These contracts are not negotiable and the parties have to accept the terms of the contract as stipulated.

Since Futures Contracts are traded through an exchange, they are very liquid and extremely popular. A wide variety of instruments are traded through futures contracts e.g. bonds, foreign exchange, stocks, commodities, indices, money market instruments,etc.

A certain amount of margin money is paid upfront at the time of buying or selling the contract and settlement is done either in cash or by taking and giving physical delivery of the stipulated instrument/asset. In case of physical delivery the locations pre-decided by the exchange and stipulate in the contract. The quote currency is the national currency of the country in which the exchange is present.

The Singapore exporter may hedge his goods by selling futures of US Dollars for the value of the goods being transacted. Thus if the US Dollar rate falls he will not lose any money and if he finds that the price of US Dollar is rising he may quickly sell the future at the current market price.

(iii)

Options

This is another kind of derivative instrument which is extremely popular and traded widely. As seen earlier, both Forward contracts and Futures Contracts require the buyer as well as the seller to fulfil their part of the obligation i.e. the buyer is obliged to buy the instrument/asset at the agreed/stipulated price on the agreed/stipulated date and the seller is obliged to sell the instrument/asset at the agreed/stipulated price on the agreed/stipulated date. However, options, as the name suggest, offer the buyer a choice to buy the particular instrument/asset on the stipulated date or forgo the same and he is under no obligation.

Thus an option is a contract between a buyer and seller where the buyer of the option has a choice to buy/sell the instrument/asset at the stipulated price on the stipulated date or to forgo it. The option however is only with the buyer of the option and the seller of the option does not have a choice. Thus if the buyer of the option decides to take/give delivery of his goods, the seller of the option is obligated to deliver/receive the same.

There are mainly two kinds of options(a) Call Options, and (b) Put Options

(a) Call Options

A call option gives the buyer the right to buy a particular quantity of an instrument at a particular price within a specified period. Thus, the buyer of the call option, anticipating the price of the instrument/asset to go up by the end of the stipulated period, pays a small amount as premium to the seller and agrees to buy the same. If at the end of the period the price of the asset actually rises he would choose to accept delivery of the same. However, if the price of the said asset falls he has the choice of not accepting the delivery and forgoing the premium amount.

(b)Put option

A put option gives the buyer the right to sell a particular quantity of an instrument at a particular price within a specified period. Thus, the buyer of the put option, anticipating the price of the instrument/asset to fall by the end of the stipulated period, pays a small amount as premium to the seller and agrees to buy the same. If at the end of the period the price of the asset actually falls he would choose to effect delivery of the same. However, if the price of the said asset rises he has the choice of not affecting the delivery and forgoing the premium amount.

The Singapore exporter may hedge his goods by buying put options of US Dollars for the value of the goods being transacted. Thus if the US Dollar rate falls he may exercise his put option or else he may forgo it. He can thus insure the value of his goods by investing a small amount on the premium of the option.

(iv)

Interest Rate Swaps

This is an agreement between two parties to exchange one stream of future interest payments for another on a specified principal amount. The main advantage of such an arrangement is that the cash flows of a fixed rate loan may be exchanged for the cash flows of a floating rate loan.

The Singapore exporter may not find any significant benefit in hedging his goods using this kind of derivative instrument.