Financial risk management

Financial risk management

Financial risk management has experienced tremendous growth in the financial sphere. It is a practice of hedging against inflation, forex and operational risk.  Traders are fast adopting financial instruments, such as derivatives and options to cushion themselves against fluctuations witnessed in financial markets. ACCA (2020) defines financial instrument as a contract that creates a financial asset for an entity at the same time and financial liability/ equity to another. They are key in stimulating economic development.  Increased innovation has seen a growth in the number of financial instruments offered by banking and finance markets. These assets generate financial claims for the owner.

Derivative is a financial instrument whose value is derived from underlying asset. It changes based on interest rate, forex, credit rating and instrument price. The aim of derivative is to transfer risk, and widely used across the board (Ostdiek, 1999). An airline can hedge the fuel price for flights throughout the financial year, a farmer can lock in selling price of commodities. Derivatives transactions are based on speculation with the expectation of profit gain. The common derivatives in the market are forwards, futures and options. Futures are contracts with an obligation to buy/sell a good at a specific future date and are traded on organized exchanges while forwards are non-standardized. Options are similar to futures, but instead of obligation the trader have an option to buy or sell.

Energy derivatives are commonly used by players intending to reduce exposure to risk of energy market changes, as increase in fuel can extremely affect cash flow of an organization and ultimately hurt profitability. For example, price fluctuations in 1998, which saw power prices in US Midwest rise from $30-60/MWh to $7000/MWh resulted in the bankruptcy of Federal Energy Sales and Power Company as they could not meet capital demands of buying and supplying energy.

According to IG.com (2020), equity options are a form of derivative used exclusively to trade shares as the underlying asset, they provide investors with a right, but not an obligation to sell the shares at the strike price before expiry of contract. For example, Xuyiz shares trades at $200, you buy an option to purchase shares before the end of the week at $ 300, and pay a premium of $15 to do so. If the shares exceed $325, then the trade is in profit, and you are free to execute the trade. Options provide traders with flexibility by allowing bespoke tailoring to meet financial situation goals and limited risk.

Discussion

Hypothesis

H1: Coca Cola options perform better than General Electric options in a 2-week period.

H2: Brent crude oil futures perform better than WTI crude oil futures in a 2-week period.

Energy Derivative

Energy derivatives get their value from an underlying asset such as oil, natural gas or coal. Following fluctuations in the energy market driven by instability in OPEC region, these derivatives rose in marketability as companies sought for ways to hedge against unexpected price volatility. A long position is initiated by a trader with the expectation of asset value increase. A short position is taken with the expectation of profiting if the asset value falls. According to Australian Stock Exchange, investors implement various strategies in their energy derivative trading. A bullish strategy is adopted when the market is likely to rise and volatility is high while a bearish strategy is adopted when market conditions are contrary to the former. An investor evaluates time and strike price when considering a derivative investment, if the asset fails to rise as expected, it is advisable to close out the position to recover time value.

Duong and Kalev (2014) conducted a study and found out that volatility of futures price increases as contract nears striking date. The study analyzed 20 futures markets and found a strong support for Samuelson hypothesis in agricultural futures, but doesn’t hold for other futures. Jaeck and Lautier (2014) assert that commodity derivative market prices are characterized by decreasing of volatilities trend along the prices curve. Samuelson (1965) held that future prices volatility increases as contract approaches expiration. Gupta and Rajib (2012) used regression techniques to examine 8 commodities (natural gas, crude oil, wheat, Aluminum, Nickel, Copper, and gold) traded on MCX India, the study revealed that Samuelson hypothesis doesn’t hold true for most commodity futures, as volatility depended on trading volume rather than maturity time.

Equity Options

Graham and Dodd (2009) define equity option intrinsic value as a value justified by assets, earnings and future environment and free from emotional manipulation. The equity option market composed of call and put option. A call option is a right but not an obligation to buy at a specified time and amount, while a put option is the right, but not an obligation to sell at a specified time and amount.

A call option is executed when the strike price is greater than the spot price.

A put option is executed when spot price is greater than strike price.

Options pricing based on Black Scholes Model assumes that stock instruments are freely and instantaneously tradable, and carry no transaction costs.

S= S_o exp( t + Wt)

Call option= N(di)St- N(d2) PV(K)

d1= 1/  /2) (T-t)

d2= d1-

PV(k)=Ke ^-r(T-t)

Hypothesis Reasoning and Allocation of Funds

Futures

Based on historical data, energy derivatives are lucrative investments, this is due to an increasing demand for energy products by transportation, manufacturing and service sector. Despite a rise in new forms of energy, especially cleaner alternatives, the crude energy companies have continued to register strong results. For this study, it will compare WTI crude oil futures versus Brent crude oil futures.

Allocation Strategy

Given the limited timeframe of 2 weeks, it is investment conscious to go for a long position in Brent crude oil futures and go short on WTI crude oil futures. While energy derivatives are stable, and carry relatively high strike price, equity options provide volatility and greater likelihood of huge returns.

Energy Derivatives

Energy derivatives are utilized in hedging against changes in energy prices. Additionally, speculators use them to gain profit through strike price margins. There are commonly traded at the Chicago Mercantile Exchange. Most energy players, such as Royal Dutch Shell, Chevron, and BP hedge using derivatives against commodity price risks, as price volatility affect profitability. A selection of a derivative depends cost and flexibility. Energy spot prices show stochastic volatility, and tend to be higher than other commodities.

Crude oil price 2015-2020

Energy Derivative Price Modelling

Derivative pricing evaluates the underlying assets, by selecting a model that encompasses characteristics of the commodity. It needs to incorporate expected changes in price. Geometric wiener process is used in price modelling

St= S_o (–

In energy market, a trader has to evaluate historical and implied/ future volatility.

Value of derivative= f (forward price, time, interest rate and volatility)

To exercise an energy derivative, it is crucial to prove;

_t,T(T-t),

_>0

Energy market is volatile and having a model that fully factors all variable is quite difficult. Crude oil prices quickly change on the slightest environment change, making them favorable for speculative trading. It is a leading source of energy. Prices are greatly affected by the dynamics of supply and demand.

Crude oil prices from 1st Oct 2019 to 17th Jan 2020 (3 month)

Based on the chart above, it shows stochastic volatility and increasing crude oil prices.

For this study, it has used this model;

Spot price * (3-month Treasury bill rate) + Spot price (5-year price volatility) + e

Strike price= (Sp* r) + (Sp*

6-month US Treasury bill rate= 1.52%

Price volatility of energy derivatives= 1.38

e= $ 2

Expected strike price= (58.58* 1.52%) + (58.58 * 1.38/)/2 +$2=63.44

Table of Energy Derivatives

Number of contracts: 6.828

Ticks: 3685.60

Tick value= 0.01/$10

Points: 36.856

USD: 441379.31

Expected return

441379.31- 400000= 41379.31

10.34%

According to Cabot Wealth Network (2016), relative performance is the performance of a stock against index. It is calculated by dividing the Friday closing price of future by Friday close of an index. The changes are plotted against a line graph. If it is moving upwards it is outperforming the market, if it is moving downwards it is underperforming.

Brent Crude Oil Futures

Relative performance

Blue line graph- WTI

Red line graph- Brent

Yellow – SP 500 futures

Given historical performance, long Brent crude oil futures and short Crude oil WTI futures

Equity Options Trade

Coca Cola option

Using Black Scholes Model

Call option= N(di)St- N(d2) PV(K)

d1= 1/  /2) (T-t)

d2= d1-

PV(k)=Ke ^-r(T-t)

Market price= 56.82

Exercise price= 58.5

t= 3 months/ 84 days

r= 1.52%

volatility= 1.06

Call option =0

Put option= 1.69

In the money, buy Coca Cola options.

General Electric options

Chart

Options index chart

Relative performance

Blue: KO options, Red: GE options, Yellow: CBOE options index

Conclusion

Energy derivatives are vital in mitigating risks prevalent in natural gas, crude oil and electricity markets. Recently, there has been an upsurge of speculators, which has led to increased liquidity and information dissemination thus enhancing derivatives market efficiency. Though supply and demand of crude oil has been relatively flat, high speculation has led to volatility in the global energy market. Options are looked at less risky than equities, and providing high returns at the same time alternatives. Brent Crude oil futures are better performance than Crude oil WTI futures, they trade at $64.5 and dictates the pricing of oil in Africa, America and Middle East, while WTI is a benchmark for N. America crude oil market.  Coca cola options are lucrative for holding in a 3-month period as they offer stability and increased returns, General Electric has been facing cash flow problems.

References

Duong, H., and Kalev, P. (2008). The samuelson hypothesis in futures markets: an

analysis using intraday data. Journal of Banking and Finance, vol. 32(4).

Energy derivatives. ASX.

https://www.asx.com.au/products/energy-derivatives/australian-electricity.htm

Gupta, S.K., & Rajib, P. (2012). Samuelson hypothesis & indian commodity derivative

market. Asia-Pacific Financial Markets, vol. 19, pp 250-352

Jaeck, E., & Lautier, D. (2014). Samuelson hypothesis and electricity derivative markets.

31st International French Finance Association Conference, pp.24

Month Crude Oil Prices and Price Charts (2020).

http://www.infomine.com/investment/metal-prices/crude-oil/3-month/

Ostdiek, S. & Flemming, J. (1999). The impact of energy derivative on the crude oil

market. Energy Economics Vol. 21(135).

Samuelson, A. (1965). Proof that properly anticipated prices fluctuate randomly.

Industrial Management Review, Vol. 6, pp. 10-49

The Coca Cola Company (KO) options.

https://finance.yahoo.com/quote/KO/options/

What is a financial instrument? (2020)

http://www.chinaacc.com/upload/html/2013/06/26/lixingcun7989928cf2cb4d6997

0e269efac8b12e.pdf