Assessing derivatives

Assessing derivatives

Defend the current utilization of futures contracts for financial institutions

A futures contract is a treaty between two parties to purchase or sell an asset in the future at a specific price. Futures contracts are also referred to as derivatives since the underlying asset value determines the predetermined

price. These underlying assets may be in the form of equipment or physical assets as well as financial instruments. The futures contacts are essential in a company as they enable the company or an investor to predict the price of a certain commodity. When an investor enters into a futures contract, he purchases the right to buy or sell. When an investor purchases the right to buy, he anticipates benefiting from the price increment of the underlying assets. On the other hand, when he purchases the right to sell, he anticipates benefiting from the price fluctuation of the underlying asset. They are most beneficial to hedgers and speculators. The hedgers protect their products against volatile price shifts. Speculators treat future contracts like they do financial instruments, and they trade these financial instruments when it favors them most.

Example of future contracts

A farmer who sells maize can protect his yields by locking the prices. For instance, a farmer speculates that the prices of maize will fall next year due to its high supply. He is also worried that all his maize might fail to sell, and they may end up rotting. Thus, he enters into a contract where he vows to sell 1000 bushels of corn at $ 30 per bushel come next May. Indeed in May, the prices sell, and the bushel sells at $20. If the framer hadn’t locked the prices, he would have sold his maize at $20,000. But thanks to the futures contracts, he sells his yields at $30,000 and guards his $10,000 profit.

Incorporation of option securities for financial institutions

The options are also derivatives. They are financial instruments whose value is based on the value of the primary financial instruments e.g., bonds or stock. The options are contracts that give the trader the chance to buy or sell. This is solely dependent on the type of contract at hand. It is different from the futures contract because, in this case, the holder of the contract is not required to sell their assets if they do not want to. There are two types of options used in financial institutions. They include the call options and put options. The call options give the contract holder a chance to sell assets at the agreed price within the agreed timeframe. Put options give the contract the mandate to sell the asset at the specified price within the set duration.  As seen, the options contracts usually have to parties: the buyer and the seller. A buyer ought to pay options premiums to be granted the rights held by the contract, and this is how the financial institutions benefit from the contracts because of the paid premiums. Options contracts make up 100 shares of the primary securities and the buyer ought to buy each of the contracts for instance when an option has a premium of 35 cents per contract, purchasing the option will cost $35.

Identify the positives and negatives of derivatives, and how could employ derivatives?

Advantages and disadvantages of derivatives

Derivatives can be described as financial contracts whose value is gauged according to the value of an underlying asset. Trading of derivatives happens over the counter and holds both advantages and disadvantages.

Positives of Derivatives

Hedging

Hedging means transferring risks, whereby the investor sees to offset foreseen losses without having to buy an insurance policy. An investor can invest in a derivative contract and fix the prices of his assets. This way, the value of his assets will remain constant even if they decrease in value in the market and the investor will benefit more derivatives are also essential in that they can be used to estimate the price of an asset. They also increase the effectiveness of financial markets because the contracts are associated with the prices of the underlying assets. This equilibrium helps to prevent arbitrage opportunities. Derivatives also allow companies to access assets that would have otherwise been unavailable. A company can get more advantageous interest rates that are not available when one borrows direct.

Disadvantages of derivatives

The derivatives are volatile investments and are exposed to potentially high losses. Investors do not always speculate in the right way. Sometimes the speculations may be unreasonable and may lead to huge losses.

Applications of derivatives in real world

Derivatives are applicable in the field of business and mathematics/physics. They allow an entrepreneur to understand the bigger picture of the business from a small perspective. For instance, in an ice cream selling business, an entrepreneur can be able to decide the amount of ice cream he should sell to make profits. Mr. Johnson receives a report from his manager on his ice cream business performance; he tabulates and draws a curve. The price of the ice cream is ten bucks. The x-axis represents the number of ice-creams sold, and the y-axis shows the cost of production. From the curve, it is clear that the curve steepens as production increases, and the manager says that it is due to an increase in production, causing an increase in the production cost. With derivatives, when Mr. Johnson uses the derivatives, he can tell the marginal cost in every unit produced. When the cost goes over ten bucks, then he is making losses. During the speculation of prices, an oil company can speculate the falling of oil prices and decides to enter a contract with the distributors. Thus, it enters a contract where it will sell one liter of oil at $0.39 per liter come 2020. Unfortunately, the price of oil rises to $.42 per liter. The company cannot change these prices and will go at losses, unlike the companies that did not bid the contract.

How the value of a derivative is determined

The derivatives are of different types. Hence their prices are also determined using different pricing mechanisms. Derivatives are either options, swaps, futures, or forward contracts. The cash price of the commodity determines the value of Future contracts. For instance, if the current price of corn is $5 per sack, then for 5,000 sacs, the future contact will be $25,000.

The set amount of time determines the prices of options. For instance, an investor holding this contract has the right to sell 100 shares at a fixed price up to the set time.

The binomial option pricing model

This model evaluates the prices of options. It allows iteration and the specification of points in time during the period between the valuation date and the expiration date. This model assumes that there are two outcomes; either an increase or decrease of prices.

The black-Scholes is a model that can be used in the calculation of the call price of options. It is determined by five elements, which are the price of a stock, strike price, expiration time, interest rate, and risk-free. The model provides numerical results based on these inputs. Still, the binomial model allows an investor to calculate the price of the asset and option along with a range of periods while using the same probability for each period until its expiry date.

References

Cyree, K., Huang, P., & Lindley, J. (2012). The Economic Consequences of banks’ derivatives use in good and bad times.

Schon, w. (2016). Regulation and Taxation of the Financial Markets.

Trapp, R. & Weib, G. N. (2016). Derivatives usage, securitization, and the crash sensitivity of bank stocks.