A Detailed Study of the Role of Options, Futures and Forward Contracts in Market Risk Management

Basel Committee that was formed in 1974 laid the regulative model for Financial Risk Management. ( McNeil, A.J. , Frey, R. , Embrechts, P. 2005 ) . Basel II ( 2001 ) defines Financial Risk Management to be formed of 4 stairss: “ designation of hazards into market, recognition, operational and other hazards, appraisal of hazards utilizing informations and hazard theoretical account, monitoring and coverage of hazard appraisals on a timely footing and commanding these identified hazards by senior direction. “ ( Alexander, C. 2005 ) . It determines the chance of a negative event taking topographic point and its effects on the entity. Once identified hazard can be treated in following manners:

Eliminated wholly by simple concern patterns. These are the hazards that are damaging to the concern entity.

Transferred to other participants.

Actively managed at steadfast degree.

Market Risk constitutes of trade good hazard, involvement hazard and currency hazards. Commodity monetary value hazard includes the possible alteration in the monetary value of a trade good. The lifting or falling trade good monetary values affect the manufacturers, bargainers and the end-users of the assorted trade goods. Furthermore if they are traded in foreign currency, there arises the hazard of currency exchange rate. These are usually hedged by offering frontward or future contracts at fixed rates. This is particularly of import for trade goods like oil, natural gas, gold, electricity etc whose monetary values are extremely volatile in nature. However the hedge does n’t ever guarantee net incomes. ( Berk, J and Demarzo, P. 2010 ) .

Interest Hazard relates to alter in involvement rates of bonds, stocks or loans. A lifting rate of involvement would efficaciously cut down the monetary value of a bond. Increased involvement rates result in increasing the adoption costs of the house and thereby cut down its profitableness. It is hedged by barters or by puting in short term securities.

Currency hazards arise from the extremely volatile exchange rates between the currencies of different states. For e.g. Airbus, an aircraft fabrication company based in France requires oil for its production. Oil being traded in US dollars and the company making trading in Euros, has a foreign exchange hazard. It would be hence good for Airbus to come in a forward contract with its oil providers. Options are another manner of fudging against currency hazards. They facilitate the holder to interchange currency at a fixed pre-determined exchange rate. If the option rate is higher than the exchange rate, the company will non exert the option. However if the rate increases the company would profit by exerting the option. ( Berk, J and Demarzo, P. 2010 ) .

The above hazards fundamentally depend on the clip value of assets. Furthermore with the increased degree of transnational operation of concern entities and the extremely volatile nature of markets, hazard direction has now become a compulsory portion of running the concern. It hence becomes of import to analyse the assorted methods of measuring hazards, mensurating them and the preventative steps implemented against them. Besides the fudging techniques stated supra do non ever guarantee net incomes. The research would thereby include a item survey of the effectivity of the methods implemented. It would besides analyze the jeopardies of the failures of the enforced methods.

Market hazards are measured by Value at Risk ( VaR ) theoretical account. This theoretical account is used extensively to mensurate market hazards. It aggregates the portfolio market hazards in a individual figure. However writers McNeil, Frey and Embrechts ( 2005 ) have debated over the theoretical account saying that it does n’t take into history the costs of settlement. It takes into history historical information and a series of premises. Therefore its ability to mensurate future hazards is extremely debatable. The research would thereby include the survey of VaR and other comparative theoretical accounts used to mensurate market hazards.

Literature Reappraisal:

Forward contracts, Futures and Options are called the Financial Derivatives and are used mostly to cut down market hazards.

Walsh David ( 1995 ) explains that if two securities have same final payments in future, they must hold same monetary value today. Thus the value of a derivative moves in the same manner as that of implicit in plus. This is called arbitrage.

Hedging of hazards is nil but the holder of an plus has two places in opposite waies. One is of the derivative and other of the under-lying plus severally. As such if the value if the plus decreases so value of the derived function will besides diminish. But the alteration in value is off-set by the opposite places to each other. Thus hazard is reduced. This is called fudging. Long Hedge refers when an investor anticipates addition in market monetary value and hence buys hereafter contracts. Short Hedge is when an investor already has a hereafters contract and expects the value of plus to fall and hence sells it beforehand. ( Dubofsky, D and Miller, T. Jr. 2003 ) .

Long Hedge Short Hedge

Change in value of place

Change in monetary value

Change in value of place

Change in monetary value

Fig.1 Hedging ( Dubofsky, D and Miller, T. Jr. 2003 ) .

Forward Contracts- These involve purchasing or selling specific plus at a specific monetary value at a specified clip. They are Over the Counter ( OTC ) Derivatives. These are used for locking-in the monetary value and necessitate no hard currency transportation in the beginning, thereby affect recognition hazards. They are typically used to fudge the exchange rate hazards. ( Claessens, S. 1993 ) .

Futures- These are more standardised than the Forward contracts. They are traded at Foreign Exchanges. The standardised contract stipulating the plus, monetary value and bringing clip is either bought or sold through agent. The bringing monetary value depends on market and determined by the exchange. Initial border sum is required and profit-loss computations are done daily. Hence involve border calls. Credit hazard involved is minimal but these can non be tailored to single demands. ( Claessens, S. 1993 ) . These exist typically for trade goods, involvement rate hazards, currencies etc. ( Walsh, D. , 1995 ) .

Fig.2: Hedging through Futures. ( Walsh, D. 1995 ) .

Options- The holder can purchase from or sell to, the plus at a work stoppage rate at a future adulthood day of the month. However the holder of the option has no moral duty to make so. The cost of purchasing the option involves a premium which is to be paid up forepart. The option that enables the holder to purchase an plus is called Call option while in Put option the holder is able to sell the plus. ( Claessens, S. 1993 ) . These can be bought Over the Counter ( OTC ) at a bank or can be exchange traded options.

Walsh David ( 1995 ) further explains that options have a non-linear relation with final payment. Its final payment additions with the monetary value of the plus if it is in-the-money and has a changeless final payment which is the option premium if it is out-of-the-money. While hereafters and frontward contracts have a additive relation with the final payments in both, net income every bit good as loss. Therefore options might be preferred over hereafters and forwards for fudging. The research would include the elaborate features, similarities and differences in hereafters, frontward contracts and options, along with the construct of delta hedge in which perfect hedge is created by usage of options.

Data and Methodology:

The Research would be Qualitative in nature, based on the primary informations available though on-line diaries and books. The popularity of the derived functions and their exponential growing has favoured the handiness of many articles on this subject and would thereby organize the footing of research. It might include interviews of professionals holding extended research or expertness in this country.

Mentions

Alexander, C. ( 2005 ) . The Present and Future of Financial Risk Management, Journal of Financial Econometrics, 3 ( 1 ) , pp. 3-25. JSTOR ( Online ) . Available at hypertext transfer protocol: //jfec.oxfordjournals.org/ ( accessed: 8 March, 2011 ) .

Berk, J. and Demarzo, P. ( 2010 ) Corporate Finance. 2ndedition. Global edition: Pearson.

Claessens, S ( 1993 ) World Bank Technical Paper no 235.Washington District of columbia: The World Bank.

Dubofsky, D and Miller, T. Jr. ( 2003 ) Derived functions: Evaluation and Risk Management. Oxford: Oxford University Press.

McNeil, A.J. , Frey, R. , Embrechts, P. ( 2005 ) Quantitative Risk Management. Princeton and Oxford: Princeton University Press.

Walsh, David.A ( 1995 ) . Risk direction utilizing derivative securities.A Managerial Finance, A 21 ( 1 ) , A pp. 43. ABI/INFORM Global ( Online ) .A Available at hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” & amp ; HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” did=4708471HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” & amp ; HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” SrchMode=2HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” & amp ; HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” sid=3HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” & amp ; HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” Fmt=6HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” & amp ; HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” VInst=PRODHYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” & amp ; HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” VType=PQDHYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” & amp ; HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” RQT=309HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” & amp ; HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” VName=PQDHYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” & amp ; HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” TS=1301258415HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” & amp ; HYPERLINK “ hypertext transfer protocol: //proquest.umi.com/pqdweb? index=6 & A ; did=4708471 & A ; SrchMode=2 & A ; sid=3 & A ; Fmt=6 & A ; VInst=PROD & A ; VType=PQD & A ; RQT=309 & A ; VName=PQD & A ; TS=1301258415 & A ; clientId=18060 ” clientId=18060 ( accessed: March 27, 2011 ) .