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The relevance of derivatives for financial forecasting

It is a sine qua non fact that no one denies the application of derivative in todays globalize business environment. Every business owner, financial manager and risk analyst is completely aware of this critical risk analysis tool. This paper dwells on how the global derivative industry applies the different combinations of this tool, the pros and cons, application in real world with respect to market indexes and the use of derivatives by multinational enterprises in order to minimise risk. INTRODUCTION

Businesses, faced with myriad risks, seek to protect themselves from the consequences of adversity. We know the fact that investors dislike risk and managing the well diversified portfolios. Every level of corporate executives are concerned over calculating Beta (? ). Perhaps the most important aspect of risk management involves derivative securities. Basically a financial derivative is a financial instrument that may be linked to a specific financial instrument or an indicator or a commodity.

Financial derivatives facilitate the trading of specific financial risks in financial markets in their own right. According to Gerald I. White, Ashwinpaul C Sondhi, and Dov Fried (2001), different tools of derivatives include ? Options whose values depend on the price of the some underlying assets. ? Futures & Swaps whose values depend on the interest rate & exchange rate level ? Commodity Futures whose values depend on the commodity prices. Financial derivatives, derive their values from the price of underlying items, which may include the reference price.

In financial derivatives, no principal amount is advanced in order to be repaid and income investment does not accrue. Examples are futures, forwards, options, hedges, warrants and swaps. LITERATURE REVIEW When we speak of the relevance of derivatives in financial forecasting, the question that arises next is about the response of the market once the trading of derivatives commences. The pioneers of this instrument broadly suggest that market efficiency and liquidity on the spot market improve once derivatives’ trading comes in to play.

The market makers or the speculators generally have a preference over implementing their positions using derivatives rather than using a sequence of trades on the underlying spot market. If we think practically rather than theoretically that if we assess the derivatives in a feasible manner like gathering information, research and forecasting activities, these would safeguard our investment, increases the rate of return through efficient market. From a market microstructure perspective, derivatives markets may reduce the extent to which informed speculators are found on the spot market, thus reducing the adverse selection on the spot market.

Derivatives also help reduce the risks faced by liquidity providers on the spot market, by giving them avenues for hedging. These effects help improve liquidity on the spot market. Derivatives can certainly help out the business world in different ways, some of which are described below: • Debt Capacity: Derivatives can reduce the volatility of cash flows and this would help out in order to reduce the probability of bankruptcy. Firms with lower operating risk can use more debt, and this can lead to an increase in the stock prices due to interest tax savings.

• Financial Distress: Investor who hold the stock often worry about the rising interest rates on debt and this could create a situation of bankruptcy which could make the cash flow fall from the expected levels and this is what creates financial distress. • Borrowing Cost: Input costs especially the interest rate on debt raises the cost of financing, so in contrast with the problem, SWAP rescues and minimizes the interest rate risk so that the borrowing cost is cut down. • Marinating the Optimal Capital Budget: Most of the firms worry over the raising capital through equity financing because it raises the flotation cost.

So, this phenomenon suggests that capital budget is financed through debt plus internally generated funds, mainly from retained earnings. In the early period, internal cash flow is low and they may be too low to support the optimal capital budget, causing firms to either slow the pace of investment or incur high cost associated with equity financing. By smoothing the cash flows, derivative can alleviate this problem. The following table (Jorian, 2000) depicts a list of instruments that are traded and used in the derivative industry:

The following table (Jorian, 2000) reveals the importance of derivatives that are used in the industry along with their respective sizes. A Real World Example An ideal example in this case would be of IBM, as depicted by Gerald I. White, Ashwinpaul C Sondhi, and Dov Fried (2001). IBM faces a lot of risks with respect to finance that can be managed through hedging. IBM operates in about 35 functional currencies and is both a significant lender and a borrower in global capital market. It concerns interest rate and foreign currency exposures.

The company: • Uses a derivative, primarily swaps, to convert fixed rate to variable rate debt (fair value hedges) and to fix the rates on variable debt and anticipated issues of commercial paper (cash flow hedges). • Designates a significant portion of its non-U. S. dollar debt as a hedge of its net investment in foreign operations. It also uses currency swaps and forward contracts to hedge this exposure. • Uses foreign currency forward and option contracts to hedge foreign currency denominated anticipated royalties and other cash flow.

• Manages the cash and exposures of its subsidiaries centrally, and uses currency swaps and forward contracts to hedge its exposure to exchange rate changes for both functional and non-functional currencies. This highlights the fact that how multinational enterprises like IBM are working up on different forms of derivatives (hedge, swap, option, etc) to manage and forecast risk. Another important use of derivatives is when borrowing money from the futures market, using shares as a collateral. Then as a borrower one may act in a following manner: • Sell a million dollars of Nifty on the spot market.

Make delivery, and get paid. This is your “borrowed funds”. • Simultaneously, buy a million dollars of Nifty futures. • Hold these positions till the futures expiration date. • On the futures expiration date, buy back the Nifty shares on the spot market. When you pay for them, you are “repaying your loan”. This practice is worth doing when the interest rate obtained by borrowing from the futures market is lower than that which can be obtained through alternative fully collateralized borrowing avenues. Liquidity for A Market Index At one level a market index is used as a pure economic time-series.

Liquidity affects this application via the problem of non-trading. If some securities in an index fail to trade today, then the level of the market index obtained reflects the valuation of the macro economy today (via securities which are traded today), but is contaminated with the valuation of the macro economy yesterday (via securities which traded yesterday). This is the problem of stale prices. By this reasoning, securities with a high trading intensity are best-suited for inclusion into a market index. As we go closer to applications of market indexes in the indexation industry (such as

index funds, or sector-level active management, or index derivatives), the market index is not just an economic time-series, but a portfolio which is traded. The key difficulty faced here is again liquidity, or the transactions costs faced in buying or selling the entire index as a portfolio (Shah & Thomas, 1998). Policy Issues With Respect To Derivatives • Developing Derivatives Exchanges: There have been many attempts at starting derivatives exchanges. As with spot exchanges, there have been relatively few successes in terms of obtaining highly liquid markets.

(Tsetsekos & Varangis, 1997, and, van der Bijl, 1996). • Trading Through Derivative Create Threat To Financial Sector: Derivatives trading does bring a whole new class of leveraged positions in the economy. In fact, to the extent that equity derivatives make it easier for policy makers to eliminate leverage on equity spot market, it will help reduce the vulnerability of equity market. It is with OTC derivatives that there are more serious policy concerns, about the extent to which a few large failures can destabilize the financial system.

This is because OTC derivatives innately involve credit risk, and there is a clear channel for contagion – where the failure of one firm impacts upon its counterparties (Steinherr, 1998). Another important question would be whether we can use index futures and index option market in a stock market. There may be several factors that play a role in terms of the choice of index, some of which are described below: • Diversification Stock market indexes should be well diversified, in order to ensuring that speculators or hedgers are not vulnerable to the industry risk or an individual company risk.

Sharpe’s Ratio of the index is reflective of such diversification. • Liquidity of the index The index should be easily tradable on the cash market. This, in part, relates to selecting stocks in the index. The implication of a high liquidity of the index’s components would be that the index is less noisy. • Liquidity of the market Index traders have a strong incentive to trade on the market which supplies the prices used in index calculations. This market should feature high liquidity and be well designed in the sense of supplying operational conveniences suited to the needs of index traders (Shah & Thomas, 1998).

• Operational issues Regular maintenance of the index is necessary along with a steady evolution of securities in the index in order to keep pace with the changes occurring in the economy. The calculations involved in the maintaining these indexes should be accurate and reliable. Incase a stock trades at multiple venues, index computation should be done using prices from the most liquid market. Shortfalls of Some Derivative Instruments • Forward markets reflected poor liquidity and unreliability derived from counterparty risk. This is also called credit risk. • Too much flexibility is one of the basic problems of forward markets.

Forward markets can be compared to real estate markets where buyers and sellers find each other using telephones. This brings in inefficiency and time wastage. Every user faces the risk of not trading at the best price available in the country. • In the narrow sense one could state that hedge’s ineffectiveness refers to the fact that derivative may not precisely hedge the underlying risk. • In an option market the owner of the call option benefits from the price increases but has limited down size risk if the stock price decreases, since the loss of value of an option can never exceed the call premium. CONCLUSION

It is much crucial for business sector to meet with current complex environment where the bundles of information and rumors are evolving in our surrounding. With the increasing levels of globalization in a competitive environment the sword of risk is highly opened up so it requires the frame work and highly profound risk management team to cope up with the situation and adopt risk management systems that can quantify, measure and monitor to meet with tomorrow’s pace. RESULTS AND FINDINGS After all the assessment it would be safe to assume that: • Futures contracts trade at an exchange with price–time priority.

All buyers and sellers come to one exchange. This reduces search costs and improves liquidity. • Forward contract avoids the illiquidity that goes along with the unlimited customization of forward contracts. • In my point of view clearing corporation adopts an enormous risk by giving out credit guarantees to brokerage firms. • Future contract builds a sophisticated risk management system in order to survive. • Electronic trading has generated a real time risk monitoring system. • Options may vary with respect to futures which are free to enter into, but can generate very large losses.

• Problem arises in hedging when Hedge is constructed improperly due to reported high returns, using derivative for speculative purpose. • Futures contracts are standardized – all buyers or sellers are constrained to only choose from a small list of tradable contracts defined by the exchange (Shah & Thomas, 1998). • The informative note is that there are no exchange-traded financial derivatives in many parts of the world. • Worldwide, the most successful equity derivatives contracts are index futures, followed by index options, followed by security options. (Gorham, 1994).

• Hedging facilitates financial mangers by allowing them to lay emphasis on running their core businesses without having to worry about macro economic indicators. • The risk free rate of interest affects the value of an option. • In an option market as price volatility increases, the chance that the stock will go up or down in value increases. • The greater price volatility of the underlying asset, the greater the chance the stock price will increase and the greater the time value of the option. • The trading process for options is similar to the future contracts.

• The advantage of swap dealers in swap market is that they generally guarantee swap payments over the life of the contract. REFERENCES • Gorham, M. (1994), Stock index futures: A 12-year review, Technical report, Chicago Mercantile Exchange. • Hunt, Philip and Kennedy, Joanne (2004). Financial Derivatives in Theory and Practice : Wiley. p75-80, p200-202. • Jorion, P. (2000), Value at Risk: The Benchmark for Controlling Market Risk, 2nd edn, McGraw Hill. • LiPuma, Edward and Lee, Benjamin. (2005). Financial derivatives and the rise of circulation. Economy and Society. 34 (3), p404-427. • Shah, A. & Thomas, S. (1998), Market microstructure considerations in index construction, in ‘CBOT Research Symposium Proceedings’, Chicago Board of Trade, p173–193.

• Steinherr, A. (1998), Derivatives: The wild beast of finance, John Wiley and Sons. • Tsetsekos, G. & Varangis, P. (1997), The structure of derivatives exchanges: Lessons from developed and emerging markets, Technical report, World Bank. • Van der Bijl, R. (1996), Exchange–traded derivatives in emerging markets – An overview, Technical report, IFC, Washington. • White, Gerald I. , Ashwinpaul C Sondhi, and Dov Fried (2001),The analysis and uses of financial statements 3rd edition.

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