Lecture 5 Financial Management Derivatives An arrangement or product (such as a future, option, or forward) whose value derives from and is dependent on the value of an underlying asset, such as a commodity, currency, or security. Hedging A risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities. In effect, hedging is a transfer of risk without buying insurance policies. A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security. Hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another. Technically, to hedge you would invest in two securities with negative correlations. Speculation Speculation involves trading a financial instrument involving high risk, in expectation of significant returns. The motive is to take maximum advantage from fluctuations in the market. Description: Speculators are prevalent in the markets where price movements of securities are highly frequent and volatile. A high-risk investment strategy aimed at making quick, substantial gains from the buying or selling of stocks, currencies or other assets. Trading on the basis of speculation is called speculative trading. Those who speculate are called speculators. 1 | P a g e Difference between hedging and speculation : Speculation involves trying to make a profit from a security's price change, whereas hedging attempts to reduce the amount of risk, or volatility, associated with a security's price change. Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset. Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions contrary to what the investor currently has. The main purpose of speculation, on the other hand, is to profit from betting on the direction in which an asset will be moving. Forward contract A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation. • As with the case of spot rates, there is a bid/ask spread on forward rates. • Forward rates may also contain a premium or discount. – If the forward rate exceeds the existing spot rate, it contains a premium. – If the forward rate is less than the existing spot rate, it contains a discount. 2 | P a g e PROBLEM : Currency Futures Contracts Currency Futures Contracts are contract specifying a standard volume of a particular currency to be exchanged on a specific settlement date. Currency Future Contact are similar to forward contract in terms of their obligation, but differ from forward contracts in the way they are traded. They are used by MNCs to hedge their currency positions, and by speculators who hope to capitalize on their expectations of exchange rate movements. 3 | P a g e Difference between Forward market and future Market : 4 | P a g e How Firms use Currency Futures: Firms with open positions in foreign currencies can consider purchasing or selling currency future contracts to offset their positions. • They may purchase currency future contract- – To hedge future payables; • They may sell currency future contracts- – To hedge future receivables; Currency Option A currency option is another type of contract that can be purchased or sold by speculators and firms. Currency option provide the right to purchase or sell currencies at specified prices. Options can be purchased or sold through brokers for a commission. Brokers require that a margin be maintained during the life of the contract. The margin is increased for the clients whose option position has deteriorated. This protects against possible losses if the clients do not fulfill their obligations In addition to the exchanges, there is an over-the-counter market where commercial banks and brokerage firms offer customized currency options. 5 | P a g e There are no credit guarantees for these OTC options, so financial institutions may require some collateral from individuals or firms desiring to purchase or sell currency options. Currency options are classified as either- • Calls Option or • Puts Option. Currency Call Option A currency call option grants the holder the right to buy a specific currency at a specific price (called the exercise or strike price) within a specific period of time. There are monthly expiration dates for each option. If the spot rate of the currency rises above the strike price, owners of call options can “exercise” their options by purchasing the currency at the strike price. The futures contracts require an obligation, while the currency option does not. The owner can choose to let the option expire on the expiration date without ever exercising it. At most, they will lose the premiums they paid for their options. Why Firms uses Currency Call Options: Firms with open positions in foreign currencies may use currency call options to cover those positions. • They may purchase currency call options- – To hedge future payables; 6 | P a g e – To hedge potential expenses when bidding on projects; and – To hedge potential costs when attempting to acquire other firms. Currency Put Option A currency put option grants the holder the right to sell a specific currency at a specific price (the strike price) within a specific period of time. The owner of the put option is not obligated to exercise the option. Therefore, the maximum potential loss to the owner of the put option is the price (or premium) paid for the option contract. Why Firms uses Currency Put Options: Corporations with open foreign currency positions may use currency put options to cover their positions. ¤ For example, firms may purchase put options to hedge future receivables. 7 | P a g e Speculating with Combined Put and Call Options: One possible speculative strategy for volatile currencies is to purchase both a put option and a call option at the same exercise price. This is called a straddle. By purchasing both options, the speculator may gain if the currency moves substantially in either direction, or if it moves in one direction followed by the other. Although, two options are purchased and only one is exercised, the gain could more than offset the costs. Currency Bid & Ask price The bid price represents the maximum price that a buyer is willing to pay for a security. The ask price represents the minimum price that a seller is willing to receive. A trade or transaction occurs after the buyer and seller agree on a price for the security. The difference between bid and ask prices, or the spread, is a key indicator of the liquidity of the asset. In general, the smaller the spread, the better the liquidity. If you are buying a stock, you pay the ask price. If you sell a stock, you receive the bid price. 8 | P a g e .