Question

Talk about your trading idea or strategy of options, futures or derivatives. Then briefly explain why you choose the strategy. There are no requirements or format rules for this short answer question.

Answer 1

Financial derivatives are the hedging instruments. Financial derivatives are used by finance manager managers to secure the returns on investments and its value.

We should cover few derivatives which are commonly used. The following are the derivatives which are used to hedge the financial risk:

1. Forward contracts: Forward contracts are agreement between two parties on future date at pre-determined price. Forward contracts are OTC – Over the Counter forward agreements. They are highly customized because right from small farmer to large corporates can form the contract. The lot sizes are also customized. Forward contracts are done by producers and manufactures to ensure the purchase and sale price attain a stability or linearity so that bottom lines can be secured.

Example: Major wheat producing farmer and Kellogg form a forward contract. Farmer can decide to sell his produce to Kellogg on some future date and at fixed price. Say, 3 months from now at USD 100,000 per 1000 Kg of high quality wheat. This mitigates the risk of price fluctuations for farmer and Kellogg. However, 3 months later either of the party could be at opportunity loss.

1. Future contracts: These are similar to forward contract with same buy and sell feather but futures are exchange traded contracts (Not OTC) the contracts are standardized (means lot size and prices are as per index). Basic functions remain same as forward contracts. But in future market lot of financial institutions participate along with the other producer and manufactures.

Example: Suppose a company has purchased a stock. Now this stock has huge probability of falling in future. Company can go ahead and sell the future contracts on same stock hence this will make the asset delta neutral. Delta neutral means if that stock falls by a unit then portfolio would lose by one and future contract would gain by same unit. This will make purchased securities completely hedged against market movements.

1. Options: Options are complex derivatives. In option buyer of the contract has option to exercise the contract or not exercising it. Premium is minimum amount which is required to purchase option. It is like taking a term insurance plan. Paying of premium for unforeseen event. Types of option:
   
   a) Call option: Buyer has expectations that the price underlying would go up. Hence, he buys option. Seller of options has reverse expectations
   
   b) Put options: Buyer has expectation that price of underlying would fall in future.

Option hedges the portfolio at cheaper cost. Because the premium amount is lesser than blockage of cash in future contracts. But it has its own demerit that it becomes insensitive with passage of time and moneyness (in the money and out of the money). Out of the money means strike price are moving away from the present price (at the money) and no gains for the buyer and vice versa in case of in the money.

The above is brief coverage on options. Let’s see an example so that at least we can cover the hedging potential of the option and its underlying risk.

Example: Lets take example that a company has bought X stock which is of worth $ 10 million in market. Now, as per market information that, there will be huge downfall in stock prices. It will be too costly to buy the future contracts because of high margin. In this case risk manager can go ahead and buy option quantity applying the hedge ratios and should capture gamma or curvature of option. This will help make portfolio risk neutral.

4)     Swaps: Swaps are basically interest rate swap contracts. Interest rate swaps can be based on same currencies or it can be based on cross currencies. Interest rate swaps are hedging instruments. Used to hedge interest rate movement.

Finance managers can go for fixed to floating or floating for fixed contract. Basically, depending on the expectations. This also called cash flow hedging or fair value hedging.

Example:
Interest Rate Swap is the contract on interest rate. The interest rate movement is hedged here.

Let’s take A and B are two parties. A has investment in a bond of USD 1 Million and gets fixed coupon of 3% p.a. B has invested in a bond of USD 1 Million and earns floating interest of 3% p.a.

A is looking to earn floating rate as he is expecting interest rate to go up.

B is looking to earn fixed interest rate as he wants to ensure his all future income to be stable.

Here the expectations are totally reverse and hence eligible to form a contract.