The Pros and Cons of Selected Financial Derivatives

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Table of Contents

Introduction
Forward Contracts
Futures contract
Spot Contracts
Call Options
Hedges
Interest Rates Swaps
Currency Swaps
Credit Swaps
Reference List

Introduction

The nature and essence of financial derivatives has continued to affect and influence the world’s economic scene for centuries now. Presently, the estimated market size for derivatives is in excess of $200 trillion globally, based on the speculative value of contracts outstanding (Bells, n.d.). By definition, derivatives are products that allow individual and corporate entities to lessen their exposure to market moves that are inexorably beyond their control (Hunt & Kennedy, 2004).

For instance, multinational corporations operating in foreign countries are often exposed to market moves in exchange rates that may be disastrous if a financial cushion is not availed to the MNCs to guard against such moves. It is the purpose of this essay to discuss the advantages and disadvantages of some of the financial derivatives existing in the market today, including evaluating the circumstances in which these derivatives are used.

Forward Contracts

A forward contract is a customized contract between two parties to purchase or sell a particular asset at a specific time in the future for a specific price agreed by the both parties today (Nelken, 2005). The underlying asset can be in terms of building, stocks, bonds, commodities, currency, among others. Under this type of contract, the entity agreeing to purchase the underlying asset at the specific time in the future takes a long position, while the entity agreeing to dispose the asset at the pre-agreed time takes a short position.

In terms of advantages, risks in forward contracts tend to be small due to the fact that contracts are customized to meet precise needs of the two entities. No initial capital is required for both parties to participate in the contract. Also, the parties are not obliged to surrender margin calls such as collateral since no capital changes hands until the pre-agreed date.

Under this type of contract, participants, especially in the agricultural sector, have the capacity to lock on prices they may wish to trade in the future. Lastly, forward contracts are known to last longer than standardized contracts since the terms of engagement are negotiable, and the contract can be written for any amount of money and term (ESDD, 1999).

One of the major disadvantages of forward contracts is that the contract can neither be reversed nor transferred to another party. Second, prices tend to be less transparent and flexible since they are agreed upon by two parties only. Third, there is always a high risk of default since the contract does not involve a third party.

Lastly, linearity factors demands that one party will eventually run at a loss while the other benefits as a direct result of fluctuation of the underlying asset (ESDD, 1999).Forward contracts are widely used in situations that demands hedging currency, exchange rate risks, or for speculative purposes (Eichberger & Harper, 1997).

Futures contract

A future contract is a “standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date” (InvestorWords.com, 2010, para. 1).

The price is mainly determined by the immediate symmetry between the forces of supply and demand among opposing buy and sell items on the exchange at the specific time of the acquisition or sale of the contract (Eichberger & Harper, 1997). Unlike in options, a futures contract expresses an obligation to buy. A futures contract is advantageous since it can be transferred to a third party.

Second, the traded prices are fairly transparent and flexible. Third, there exist no counterparty risks since regulations and conventions of exchanges apply to all transactions in the contract. This therefore means that transactions within a futures contract are scrutinized and guaranteed by an exchange. Lastly, anyone with the required initial deposit can participate as no negotiations or concessions are necessary to participate in the market (ESDD, 1999; Hull, 2008).

In terms of disadvantages, parties must have the required capital before any contract is entered into to cover for the initial deposit payable when the market participants buys or sells the contracts. Second, the rules of engagements demand market participants to compensate for margin calls when market prices move against them (ESDD, 1999). Third, futures contracts are designed for fixed amount of money and terms of engagement, not mentioning the fact that the contract terms are indelibly short.

Lastly, basis risks are still prevalent because futures contracts are standardized contracts that are capable of offering partial hedge only (Hull, 2008). The contracts are one of the major financial tools used to hedge risks; trade in highly liquid commodity markets such as in crude oil and gold; and for speculation purposes (Low et al, 2002; Futures-Trading-Mentor.com, 2007).

Spot Contracts

Spot contracts provide the most instantaneous sale and delivery of a commodity such as the conversion of a particular currency to another (Eichberger & Harper, 1997). Specifically, “…a spot contract is a transaction with an agreement to buy or sell currency for two working days ahead” (Currency Today, 2010, para. 4). These kinds of contracts are most valuable when entities are handling payables or receivables that must entail foreign currency.

One of the major advantages of spot contracts is that currency is delivered to the concerned entities within a short period of time. According to Stephens (n.d.), spot contracts are advantageous in stimulating competition and encouraging choice and suppleness in responding to ever-changing needs.

Among the disadvantages, spot contracts are not favorable to market stability, not mentioning the fact that the lack of assurance can be damaging to service reliability and continuity (Stephens, n.d.). Monitoring the contracts in openly competitive environments also becomes a difficult affair especially when such environments have a huge number of providers.

Finally, spot contract fails to provide the market players, especially the purchasers, any probable economies of scale. Spot contracts can be used to make Payments in advance, bulk payments, open account settlements, and as a financial tool to hedge risks (Grant, 2005).

Call Options

A call option is a financial contract between two entities that gives one entity, the buyer, the exclusive right but not the obligation to purchase or sell a certain asset at a certain price value, on or before a pre-specified date (Hull, 2008). Call options have several advantages. First, the position entered into between the parties can always be reversed at their own convenience.

Second, options are known to limit likely losses especially on the buyer’s side without limiting potential gains. Options are also more flexible, and often allow a trading partner to expand leverage in stock without obligating to a trade. The risks involved are limited to the call option premium. Lastly, call options are efficient tools for hedging since they permit investors to guard their positions against fluctuations in price when it is not attractive to adjust the underlying position (Wreford, 2005).

In terms of disadvantages, the cost of trading call options is considerably elevated on a percentage basis than trading the principal stock (Wreford, 2005). These costs have been known to eat significantly into profits. Second, some call options suffers from considerably low liquidity due to a wide variety of available strike prices.

Third, according to Wreford, call options are complex financial tools that require strict observance and maintenance. Many traders may never have such values, and therefore trading becomes difficult. Lastly, some call options, especially uncovered options, are subject to basis risk (Hull, 2008). Call options are mostly used as hedging instruments and in real estate market.

Hedges

In economics, a hedge is a standpoint instituted in one market in an apparent attempt to counter exposure to adverse price oscillations in some opposite position in another financial market with the view of minimizing exposure to unnecessary risk.

There are various financial instruments used to realize this objective, including insurance policies, futures contracts, call options, swaps, and other derivative products (Nelken, 2005). Hedges have as many advantages as the disadvantages. In terms of advantages, some forms of hedges allow for professional management of the underlying hedge funds, and also allows for manager diversification.

In addition, some hedge funds have extremely low minimum investment requirement and reduced market volatility, not mentioning the fact that they are easily accessible. Still, investors have the capacity to invest in hedge funds that are closed. In single manager fund, the portfolio is entirely custom-made, guaranteeing transparency in the process (Wallace, 2009).

In terms of disadvantages, some hedge funds may not be custom-made to fit the investor’s requirements, implying that the may therefore not fit within the investor’s overall portfolio (Wallace, 2009). However, single-manager funds are not affected by this shortcoming.

In single-manager funds, it becomes costly to cover the costs of the professionals needed to develop a portfolio, not mentioning the fact that there exists a possibility for large losses by one or several managers. Large investments are required in single-manager hedge funds to ensure a fittingly diversified portfolio. Hedges are used by many investors in nearly all the sectors – oil, airlines, manufacturing, and others – to combat uncertainty in the ever-changing marketplace.

Interest Rates Swaps

In an interest rate swap, one entity exchanges a flow of interest costs or payments for another entity’s flow of cash (Nelken, 2005). Specifically, an interest rate swap is “an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a principal amount” (Investopedia, 2010, para. 1).

In terms of advantages, interest rates swaps are privately placed and may be arranged for episodes of up to ten years (Daigler & Steelman, 1988). They are better place to match or equal underlying asset or liability pricing, thereby avoiding or reducing the basis risk prevalent in other derivatives such as futures. Also, swaps can be custom-made to fit specific needs of all the participants

In disadvantages, interest rates swaps are known for not only lacking essential safeguards, but also for offering immeasurable leverage and risk. Participants in these swaps must individually negotiate and consult for a settlement or reversal of the swaps. Moreover, there is a wide-ranging lack of standardization at the marketplace, not mentioning the fact that there exists a considerable probability for credit risk inside the swap market (Daigler & Steelman, 1988).

In most occasions, interest rate swaps are used by investors in hedge funds to efficiently manage their fixed or circulating assets or liabilities. Also, the swaps are used by banks to lessen basis risk already existing between the institutions’ assets and liabilities. Still, these types of swaps are also used in situations whereby an institution wants to reduce high rate debt costs (Daigler & Steelman, 1988).

Currency Swaps

A currency swap is an over-the-counter foreign exchange agreement entered between two entities to exchange principal and interest payments features of a loan in a single currency for corresponding features of an equivalent in net present value loan using another currency (Coyle, 2000). Currency swaps has several advantages and few disadvantages.

In terms of advantages, currency swaps permits two firms that have entered into a partnership to exploit their comparative advantage in borrowing using a single currency, otherwise known as arbitraging competitive advantage in diverse markets (Eichberger & Harper, 1997).

Swaps permits institutions to exchange one flow of payments with another, in addition to hedging income gaps existing in the organizations. They are known to lessen risk; reduce borrowing costs; and assist in avoiding unnecessary costs arising from changes in the balance sheet.

However, currency swaps are subject to default risk in the scenario that interest rates fall below the expected, and are often accused due to lack of liquidity (Coyle, 2000). On most occasions, currency swaps are used by organizations when they want to borrow a loan in a currency that is different from their own, or when they want to be protected from alterations in the exchange rates that may adversely affect the worth of the loan.

Credit Swaps

According to Eichberger & Harper (1997), credit swaps are explicit types of counterparty agreements which permits the transfer or shifting of third party risk from one entity to the other. One participant in the swap is the ultimate lender, and the counter-participant in the credit swap consent to insure the credit risk in exchange of constant payments.

One of the advantages of credit swaps is that they are unfunded, thereby permitting the protection seller in the contract to invest the funds in other places to earn a return. These types of swaps engage in simplified and standardized documentation, permitting all market participants to precisely customize exposure to credit risks. Lastly, “credit default swaps are contracts, and so the rights and obligations of each party can be whatever the parties agree to” (Davi, 2009, para. 4).

In terms of disadvantages, this kind of swaps does not have much liquidity, and are always subject to default risk. Furthermore, credit swaps have been criticized for increasing an institution’s overall credit risk (Coyle, 2000). They are mostly used when two international firms are undertaking a merger or acquisition.

Reference List

Bells, A. The economics of derivatives. The National Bureau of Economic Research. Web.

Coyle, B. (2000). Currency swaps. Canterbury, Kent. Financial World Publishing. ISBN: 0852974361

Daigler, R. T., & Steelman, D. (1988). Interest rate swaps and financial institutions. Web.

Davi, C. (2009). Why Credit Default Swap? Web.

Economic and Social Development Department. (1999). Dealing with price risks, CCP: TE 99/5. Web.

Eichberger, J., & Harper, I. R. (1997). Financial Economics. Oxford: Oxford University Press. ISBN: 0198775407.

Futures-Trading-Mentor.com. (2007). The most liquid futures contracts put you in…..the drivers seat. Web.

Grant, R. M. (2005). Contemporary strategy analysis. Wiley-Blackwell. ISBN: 1405119985

Hull, J. (2008). Options, futures, and other derivatives. Pearson/Prentice Hall. ISBN: 0136015867

Hunt, P. J., & Kennedy, J. E. (2004). Financial derivatives in theory and practice. West Sussex, England: John Wiley & Sons Ltd. ISBN: 047086395

Investor Words. (2010). Futures contract. Web.

Investopedia. (2010). Interest rate swap. Web.

Low, A., Muthuswamy, J., Sakar, S., Terry, E. (2002). Multi-period hedging with futures contracts. Journal of Futures Markets, Vol. 22, Issue 12, pp. 1179-1203

Nelken, I. (2005). Hedge fund investment management. Oxford: Butterworth-Heinemann. ISBN: 0750660074.

Stephens, H. Contracting. Barnsley Social Services Department. Web.

Wallace, S. (2009). Funds of hedge funds versus single-manager funds. Web.

Wreford, T. (2005). Options Trading – Advantages and disadvantages. Web.

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