Fn6004 Options, Financial Derivatives AND Risks Essay Example

THE FINANCIAL DERIVATIVES MARKET

CONTENTS PAGE

Abstract

Financial derivatives market represent the huge platform used by the companies for the realization their activity and maintenance of the competition with the rivals. This platform assits the business unites to evaluate the value of the company and provide them with the opportunity to insure certain property with the help of economic agents opertaing in the financial derivatives market. This paper considers the role of economic agents in the financial derivatives market, their responsibilities and functions.

Introduction

Hull (2012) defines a derivative as a financial instrument whose value depends on (or derives from) the values of other, more basic, underlying variables. For the proper functioning of the derivatives market, there are several participants, which fall within the three classic categories of the economic agents: hedgers, speculators and arbitrages. These professionals deal with similar commodities within the financial market, while the companies choose the different instrument for the insurance of the capital depending on the interest of the company in the period of insurance, the revenue and perspective profit (Work, 2007).

Hedgers

Hedgers in the futures market try to offset potential price changes in the  spot market by buying or selling a futures contract (TheFreeDictionary.com, 2015). The hedger represents the person, which has the aim to avoid the fluctuation in price movement by standing for the price, which was established initially at the beginning of the deal. This generally, makes hedgers a producer or user of the financial product or commodity underlying a contract. This person locks in this price pertaining to the pivotal assess by virtue of the long standing in the futures contract or with regard to the existing sales price depending on the short position. Hedgers provide the clients with an opportunity to avoid the peak increase of price and fast falling as such changes have the detrimental effect on certain industries where such changes are not appropriate. Thus, hedgers protect their profit and limit their expenses (Taylor, 2011).
Hedgers have one purpose: the end goal of hedging is to reduce the financial impact (both positive and negative) of a transaction (Taylor, 2011). Hedges take many different forms—derivatives and futures markets are both forms of hedging (Singh, 2010; Taylor, 2011). Hedgers try to use the financial institutions of the world to protect the financial integrity of their clients, often an individual or a corporation (Taylor, 2011; Instefjord, 2005).

Speculators

Taking about the responsibilities of the speculator at the derivatives market, one should highlight that his aim is to gain the profit from the existence of the changes in the futures price for the derivatives. Speculators earn a profit when they offset futures contracts to their benefit (danielstrading.com, 2015) this respect, the speculator choses special line of the behavior dependable upon the futures contract due to the expectations of the speculator according to the variation of the price for the future.
In contrast to hedger, speculator is the professional at the financial derivatives market, which deals in the trading of commodities, equities, bonds, securities with high level of risks while at the end of the closing of the transaction the profit is maximized due to the high risks (Instefjord, 2005). Within the financial market, the speculators play the more significant role than the hedgers due to the fact that through the shorter period of time the individual or the business unit may obtain the major portion of the revenue.
Furthermore, speculators are the agents, which have the professional background at analysis of the perspective forecasts in the movement of the prices. Meanwhile, the speculators bear the risks related to all their profit as they may lose this profit in case of certain fluctuation at the market. 
Speculators gain the revenue and maximize profit upon offsetting the futures contracts in their favor. In this regard, speculator initially purchases the contracts and then refer to their realization within the financial market at the increased price. The gap between the initial price and the price established later for the realization of the contract amounts to the revenue received by the speculator. 
Talking about the role of speculator, one should state on the fact that he enters the market of futures contract if there is a possibility that prices will be changed for the shortest period of time. However, the speculators usually are afraid to put their offer at the market first as they prefer to observe the situation and analyze the further development of price fluctuation. By virtue of such activity, speculators try to avoid the unnecessary risks as they put personal money for the realization of the contracts.
As to the functions of speculators, the primary one is related to the analysis of the market and the anticipation of the next price fluctuation for the futures contracts. Speculators are responsible for the forecasting of such changes so that other participants at the financial derivatives market could rely on these forecasts. For the proper evaluation of the perspective changes the speculators usually rely on the historical background of the movements in the prices of certain market or industry where the agent is operating (Best, 2014). 
Depending on price fluctuations the activity of the speculator may be the following. If the price is going to increase the agent will buy the futures contracts in order to realize them in future with certain amount of the profit. Although, if the price fluctuation is expected to decrease then the agent will have the aim to realize the existing futures contracts and then purchase them at the lower price. 

Arbitragers

Arbitragers are the agents exercising the activity within the financial derivatives market, with certain level of risk which is lower in contrast to the activity of the speculators and differ from the hedgers. These individuals or firms often take very short-term positions in the market (Carter, 2002). Arbitrages usually have the confidential information about the value of the securities however it is quite difficult for these agents to predict the value of the securities.
In this respect, arbitrage represents the ongoing purchase and realization of the particular asset for the receipt of the profit due to the difference existing between these two prices. To some extent, one may conclude that speculation and arbitrage are similar, while the level of risk is different. Arbitrage appears upon the creation of certain inefficiencies taking place at the financial market.
As to the role and functions of the arbitragers at the financial market, one may note that usually the deals with these agents look like the following: arbitrager purchases the security or other assess the low price and realize it in some minutes for much higher price. These agents have the power to keep the prices for the securities on the same level for certain period of time in order to prevent the exposure of the prices. In addition, these agents in contrast to their colleagues usually refer to the assistance of the computer programs as the deals within the financial market represent the complex schemes and operations, while the transactions require the immediate response and actions.

Comparison of the economic agents in the financial market

It should be noted that hedgers and speculators are quite similar categories of the economic agents at the financial derivatives market. They supplement each other in order to maintain the efficient operation of the financial market. However, these agents pursue quite different objectives during the fulfillment of their functions. In particular, the hedgers refer to the trading operations covering futures contracts, equity and other commodities. The main objective in front of hedgers is to ensure the security of the future price for certain commodity in their power as the hedgers is responsible for the delivery of the commodity and its realization at the market. When the hedger enters the deal by purchasing or realization of the futures agreement, this agent gains the protection against the possible risks related to the price over the commodity (Lecomte, 2007).
Comparing the role of the hedger to the speculators, one should state that that are not interchangeable. However, the hedger may take some portion of the profit pertaining to the speculator, while the later may refer to the same actions. Of course, speculation is not an easy process, and it is riddled with risk—the mathematical models designed to assist speculators are quite complex (King, Streltchenko, and Yesha, 2005). For example, speculator could purchase the hedger's agreement at the lower price with the expectation that upon some time who's price will be increased. Thus, the hedger accepts this offer and realizes the contract the low price due to the expectation of the decrease in price. Additionally, the hedgers are the economic agencies that provide the others with the risk of price fluctuation depending on the cost of the particular hedge (Blenman, 2008). 
Although, the similar point with regard to the responsibilities of the hedger and speculator is that both of the agencies gain the profit from the price fluctuation existing permanently at the financial derivatives market.

Advantages and disadvantages of hedging

In the financial market, the hedging is quite popular mechanism, which is used by the majority of the companies having the aim to keep profit irrespectively of the situation at the market. In general, the hedging is implemented only in some spheres where the companies deem it is necessary. For example, airline companies refer to the hedging as they spare a lot of expenses for the fuel so that hedging for fuel will have the beneficial impact over the activity of these companies. This statement means that by hedging for the fuel, the airline companies will avoid the unexpected high fluctuations over the price for fuel and the cost of the services remain the same and affordable for the consumers without additional expenses on behalf of the company.
Additionally, the hedging has the positive effect for the companies operating with sensitive categories of the commodities such as oil or gas, etc. In this regard, companies use hedging in order to avoid the drop in prices for the commodity they produce. Simultaneously, despite the fact that hedging is regarded as the safest way for the insurance of the assets, the investors do not appreciate the companies using hedging. By hedging, the companies decline the participation of the investors in the managements of the risks.

Advantages and disadvantages of the speculating

Considering the role of speculators and their impact over the development of the financial derivatives market, one should state that the influence of these agents have increased since the financial crisis taking place in 2008. The market players have recognized that by virtue of speculation with the prices and transactions, it is possible to gain the high revenues for the short period of time. However, despite the nature of speculation, it should be said the speculators play the positive role for the financial markets elaboration.
In short, the speculators allow the rivals and all participants operating within the financial market to observe the changes happening to the certain commodity. Given the fact that speculators bear the high level of the risks related to their transactions, they try to predict the price fluctuations.
However, speculators are unlikely to cease their activity within the market, as many make their living manipulating these markets. These agents are professional in handling the risks and such activity attracts the majority of the companies, which desire to double the capital or play in the different way in the financial market. Speculating, according to Cohan (2010), allows for the continued health of financial markets of all types.

Advantages and disadvantages of the arbitrage

Arbitrage refers to the activity within the financial market with the lowest risk existence while the profit received by the agents upon the transaction is adequate and comparable to the received after the speculation and hedging. As to the pros and cons of arbitrage, the pivotal advantage is the low risk which amounts to nil. For example, the person may buy the shares at the stock market in New York at one price and then sell it in London at much higher price by comparing them due to the currency exchange. Upon this deal, the person will gain some profit, despite the fact that the risk was absent. Furthermore, arbitrage is the efficient tool for keeping the prices over the particular securities or commodities as the person is able to observe the prices at the stock markets which are relatively the same (Jüttner, 2009).
Meanwhile, arbitrage leads to the increased efficiency of the financial market, as the economic agents in this dimension allows to watch after the prices. In case of their absence, the financila market would be full of speculators which establish the prices at their own desire. However, there are also some disadvantages which should be noted in respect to arbitrage. Usually, the participants at the financial market forget to calculate the expenses related to the tax, costs with regard to the purchase and realization of the asset. Such misunderstanding lead to the fact that the participants wrongly estimate the profit and become unsatisfied with arbitrage as the valuable instrument. Additionally, arbitrage requires the huge financial investments to be used in order to maximize the profit upon the transaction.
It should be said, the arbitrage is used widely by the companies which are going to merge. In this regard, the arbitrageurs could earn due to the exposure of the differences in the prices as the result of the merger transaction taking place at the market.
Given the fact that arbitrage implies the minimal risk, there is one supplementary type of this instrument under the title risk arbitrage or statistical arbitrage (Gurkaynak and Wolfers, 2008). This form is the most popular nowadays among the economic agents operating in the market. Under this arbitrage, the agents place the bids for the stocks, however it is quite difficult to predict whether the purchase will be successful as the price could fall at any time to the initial one. Risk arbitrage is applied preferably by the players within the retail market where some risk is attributed to the companies. Therefore, arbitrage represents the popular form of the trading in the financial market, which requires the significant amount of the investment and patience in addition to fast reaction to the changes in the market.

Conclusion

The financial derivatives market provides the participants with vast amount of the opportunities to gain the profit with help of efficient instruments such as hedging, speculating and arbitrage. However, it isd up to the person and business unit to choose between these instruments as the profit and period for the insurance of the assets varies. Having considered the all available ways of the insurance of the capital and the measures with purchase and selling the futures contracts, the author concluded that hedging represents the safest instrument for keeping the prices for the commodities stable. In contrast, if the person is interested in the transactions with the lowest level of risk, one should refer to arbitrage. Meanwhile, speculating implies the high leverage risks, while it is quite difficult to predict that the profit will be received at the end of the day. In addition, the usage of hedging, speculating and arbitrage is dependable on the sphere where the company is operating.

Future pricing model

F0=S0erT
There are a number of ways the price of crude oil can be calculated. Some of these models are econometric models, some are quantitative models, and still others are time-series models or financial models (Behmiri and Manso, 2013). Quantitative models for understanding the price of crude oil are effective for short and medium term predictions such as the one generated here; econometric models are, however, the most commonly used models for oil price forecasting (Behmiri and Manso, 2013; Adam, 2009). Behmiri and Manso (2013) write, “The most frequently used techniques are time-series econometrics. The second most frequently used is the financial method, and the third most frequently used techniques are based on structural models and non-standard computational models. Finally, the least used technique is the qualitative knowledge-based method.” (Behmiri and Manso, 2013). The final method for developing a future-pricing model, according to the researchers, is less commonly used because it requires a more nuanced understanding of the qualitative and quantitative factors that affect a market (Gyntelberg, 2013).
The data contained in this particular chart was generated on the Eviews software. The chosen commodity is crude oil with its prices being compared over five years. Starting on 11/11/2015 the future price of oil was $83.59 per barrel and ending 27/08/2015 with $46.92. After staying relatively steady for a couple of years in both cases, it declined sharply in early 2015. The calculated future price is considerably higher than the basic uncalculated future price. From 15/01/2015 onwards, the prices have not returned to normal, however prices look pretty volatile from there on. For the purposes of the empirical testing, the pricing model used is:
F0=S0erT
Trading on economic events that have yet to occur is risky, and all futures trading and futures options are associated with risk (Bartram, Brown, and Fehle, 2009; Hull, 2012). Although there are guidelines an rules regarding how these futures can be traded, a trader must understand the market inherently before acting (Cohen, 2010; Morrison, 2005). Morrison (2005) suggests that pricing via expectation is particularly important in markets like the crude oil market, as the market is currently deep and liquid, but will become shallow and illiquid in the future—oil is, of course, an incredibly important commodity and will undoubtedly remain so for many years (Morrison, 2005; Behmiri and Manso, 2013).
For interest rate tracking and further information regarding historical crude oil pricing data, see Appendices 1.1, 1.2 and 1.3. Historical data was used to calculate the middle rate.

References

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Bartram, S.M., Brown, G.W. and Fehle, F.R., 2009. International evidence on financial derivatives usage. Financial management, 38(1), pp.185-206.
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danielstrading.com/education/futures-options-101/hedges-speculators/
[Accessed 18 Dec. 2015].
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Appendices
1.1
1.2
If the spot price of an investment asset is S0 and the futures price for a contract deliverable in T years is F0, then
F0 = S0erT
where r is the T-year risk-free rate of interest.
In our examples, S0 =40, T=0.25, and r=0.05 so that
F0 = 40e0.05×0.25 = 40.50
1.3
Historical interest rate data