1. What is a derivative and what are its four types?
Explain each
A derivative is a contract between two parties which derives its value/price from an
underlying asset. The most common types of derivatives are forwards, futures,
options and swaps.
a) Forward contracts - the simplest form of derivatives that are available
today. A forward contract is nothing but an agreement to sell something at
a future date. The price at which this transaction will take place is decided
in the present.
b) Futures contract – this is very similar to a forward’s contract. The similarity
lies in the fact that futures contracts also mandate the sale of commodity
at a future data but at a price which is decided in the present. However,
futures contracts are listed on the exchange. This means that the
exchange is an intermediary. Hence, these contracts are of standard
nature and the agreement cannot be modified in any way. Exchange
contracts come in a pre-decided format, pre-decided sizes and have pre-
decided expirations.
c) Option contract – this is markedly different from the first two types. In the
first two types both the parties were bound by the contract to discharge a
certain duty (buy or sell) at a certain date. The options contract, on the
other hand is asymmetrical. An options contract, binds one party whereas
it lets the other party decide at a later date i.e. at the expiration of the
option.
d) Swaps – this are probably the most complicated derivatives in the market.
Swaps enable the participants to exchange their streams of cash flows.
For instance, at a later date, one party may switch an uncertain cash flow
for a certain one. The most common example is swapping a fixed interest
rate for a floating one.
2. Describe the process of hedging using the concept of farmers and millers/manufacturing.
Strictly use FORWARD CONTRACT only as your derivative.
In making any forward contracting decisions, a farmer must first look at the purpose.
If it is to reduce exposure to price risk or establish outlets, the contract should be
entered at the time when financial commitments for inputs are made. When the
object is to profit on an expected price change, the forward selling decision usually
will be prompted by some important news event. Regardless of the enterprise,
whether it is crop production, livestock feeding, or commodity storage, good
management requires forward contracting decisions to be integrated with the
producer's overall decision process. The suggested steps are:
1. Identify the options available for production and contracting.
2. Estimate production costs.
3. Estimate prospective returns based on forward prices and anticipated
price levels.
4. Evaluate output risk.
5. Evaluate basis risk if futures contracts are involved.
6. Evaluate credit-risk of the buyer if cash forward contracts are involved;
arrange for financing of possible margin calls if futures contracts are
involved.
7. Contract for inputs and outputs and carry out the production plan.
8. Adjust forward sales and purchases to take advantage of new information
about price prospects, if- and when appropriate, during the production
process.
3. Aside from volatile asset pricing and jurisdictional risk, what do you think are the other risk
of engaging with foreign portfolio investments? Explain each.
Country Risk - Poor infrastructure such as roads, bridges and telecommunications
networks can make it expensive to operate a business in another country. Economic
conditions such as high unemployment or a largely unskilled labor force can be
barriers to entry.
Regulatory Risk - A sudden change in trade laws or a poor legal system exposes
your business to regulatory risk. For example, a country without clearly defined
intellectual property laws make it difficult for foreign software companies to protect
their investments. Changes in banking laws may limit your company's ability to
repatriate money to your home country or may limit access to funding.
Interest Rate Risk - This risk consists of unfavorable changes to monetary policy. For
instance, an emerging market economy may decide that it is growing too quickly and
act to contain inflation by hiking interest rates. These dynamics could have a
negative impact on the value of financial assets that are priced based upon those
interest rates.
4. Considering the knowledge that you have acquired from the Investment and Portfolio
Management course subject, which of the four derivatives are of vital monitoring and why?
I think it’s futures contracts because it allows investors to speculate on the direction
of an asset, commodity, or financial instrument using leverage, either long or short.
Futures contracts are also used to hedge the price movement of the underlying asset
for example an oil production company where they use future contracts to manage
risk associated with fluctuations in the price of crude oil. This prevents the company
from losses due to negative price fluctuations.
