Application of Derivatives to Portfolio Investment Management Finance Essay Essay
The financial crisis of 2008 has been a turning point in the financial systems and economies across the globe. According to (Marshall and Grant, 1997) companies face many types of risks, some of which can be controlled and some cannot. However, recent decades have observed drastic changes in the nature of risk in global financial markets, where the volatility of many asset classes has increased. In an atmosphere where investors are consistently exposed to a comprehensive range of risks, derivatives have become a valuable tool used in risk management practices of many institutions. However, (Junior, 2011) identified that the recent global financial crisis shows that it is possible for firms to utilise derivatives for reasons other than minimizing the volatility of their cash flow. In many countries, especially emerging countries such as Brazil, Poland, and Mexico, several companies reported severe financial losses immediately after the devaluation of local currencies. (Hull, 2008) also explained that in the last few decades, derivative contracts have tended to make the headlines only when they have led to large financial losses in both companies and financial institutions. (Simon, 2008) recognized that although derivatives were used to hedge risks that were previously left open, there were those who became doubtful about the benefits of these financial instruments. This study will examine the benefits and limitations of the use of derivatives in portfolio management. Portfolio management deals with the analysis of individual securities as well as with the theory and practice of optimally combining securities into portfolios. Background
Explore the application of derivatives in portfolio management and its use as a tool in minimizing risk and maximizing return in a portfolio.
To apply various hedging and arbitrage strategies using derivative instruments in portfolio/fund management. To understand the derivatives market with respect to pricing, volatility as well as forecasting. To analyse potential upside and downside risk implications of the associated instruments. To identify the influence of derivatives on the underlying securities and markets. To critical analyse the performance and risk of portfolios that use derivatives against portfolios those do not.
Investment management ideally covers two key areas: security analysis and portfolio management. Security analysis involves estimating the merits of individual investments, whereas portfolio management is concerned with the construction and maintenance of a collection of Investments (Strong, 2005). Classic security analysis is a three-step process that starts with analysis of economic prospects, then moves to analyse particular industry prospects based on forecasted economic conditions and ends with a choice of investment from within the favoured industry. This form of security analysis is called the EIC analysis i.e. economy, industry and company. Portfolio management on the other hand is management of diverse assets or investments made in different asset classes of various risk levels ranging from Equity and Preferred stock to fixed income and corporate bonds in order to meet specific investment goals that benefit the investors. Most of the academic research over the last two decades has supported the efficient market hypothesis. The element of market efficiency is that a market determined security price accurately reflects the relative risk and potential returns associated with the security. Markets are kept efficient because of the vast amount of market participants who are able and quick to take advantage of security mispricing. This implies that any effort made to identify undervalued securities is usually fruitless. Portfolio management primarily involves reduction of risk rather than increasing return. Although the return is important, the ultimate objective of a portfolio manager is to achieve a chosen level of return by incurring the least possible risk. Asset allocation plays a significant role in portfolio management as it is a process of determining how to distribute an investor’s wealth among different countries and asset classes for investment purposes. An asset class is encompasses of securities that have analogous characteristics, attributes and risk/return relationships. In developed countries there are five major asset classes which are common stocks, bonds, cash equivalents, real estate, and alternative instruments. Alternative instruments are usually subsets of an existing asset class for example derivative instruments such as options and futures. Financial derivatives are risk management instruments. A derivative’s value depends on the changes in value of one or more fundamental underlying assets. Most commonly used derivatives include forwards, options, future and swaps. If the underlying assets are stocks, bonds, foreign exchange rates and commodities then the appropriate derivative instruments are stock options (futures), bond options (futures), currency options (futures) and commodity options (futures). Derivatives have become increasingly popular tools used by arbitrageurs and hedge fund managers because of their risk-averse nature. Arbitrageurs only enter into those transactions which provide them risk-less profit.
The literature review covers journal articles from finance, economics and investment management. It reviews research papers and models that are utilized in the working of derivatives and portfolio management and, although the internet was used for sporadic research, no specific references have been made to interned websites. Various books on Portfolio management and investment analysis were also consulted but only for reference to academic explanations.
1.1 Modern Portfolio Theory
For several years Markowitz Portfolio Model (1952) has been a standard framework of the modern portfolio theory. According to this theory an efficient portfolio is one which seeks to maximize returns for a given level of risk or alternatively minimize risk for a given level of return. This is also known as the mean-variance analysis, where mean is a measure of return and variance is a measure of total risk. The essential idea of the modern portfolio theory is diversification. MPT ideally breaks risk into two sections i.e. systematic risk and non-systematic risk. Systematic risk is basically the market risk and is the portion that cannot be diversified. Non-systematic risk on the other hand is the firm-specific risk. The most important conclusion of the MPT is that one can minimize the unsystematic risk through diversification. Portfolio management involves the apportionment of funds across different asset classes so as to achieve the ultimate objective of the mean-variance analysis depending on the risk-return profile of the investor. The Modern Portfolio Theory (MPT) is based on several underlying assumptions according to which an investor will be to maximize his expected return while reducing the variability of returns by investing in a diversified portfolio of assets that have different price movements in a given market. According to (Bourachnikova and Pfiffelmann, 2011) the MPT is consistent with the expected utility theory only if the stocks are normally distributed or if the utility function can be estimated closely enough by a second order Taylor expansion. In 2008, the performance of endowments and pension funds was challenged as diversification failed and mostly every market, regardless of the risk produced negative returns. As a result, many foundations and endowments have been forced to limit their targeted spending policy and pension funds are underfunded. Although, risk management was addressed to some degree, risk management of portfolios was often not even part of the investment policy statement. (Winthrop Capital Management, 2009) identified that foundation, endowment and pension fund portfolios are driven by achieving a targeted spending policy or a funding rate. Thus, their asset allocation is a function of what a consultant views as the expected return of a hypothetical asset allocation. Unfortunately, these asset allocations are often based on faulty assumptions which therefore place the portfolio assets at severe risk of loss. (Lhabitant, 2000) identified limitations of the mean variance analysis that contradict the efficient market hypothesis according to which overwriting calls or purchasing insurance should not improve the risk-adjusted portfolio returns. Traditional portfolio performance evaluation relies heavily on the mean variance analysis. It assumes buy-hold strategy with normally distributed returns over a specified time horizon, and compares the results attained with those of an efficient market index. These assumptions are no longer valid when options are involved in a portfolio. Moreover, many experimental studies conducted by (Edwards, 1953; Kahneman and Tversky, 1979) show the overweighting of low probability with extreme outcomes which is inconsistent under the linear treatment of probabilities assumed under Markowitz portfolio theory. (Freidman and Savage, 1948) also questioned the strict risk-aversion implied by the use of a quadratic utility function in the Modern Portfolio theory. They observed that individuals who buy insurance policies indicating risk-averse behaviour often buy lottery tickets which indicate risk seeking behaviour. To accommodate these anomalies some behavioural studies recommend an alternative to the traditional portfolio theory.
1.2 Arbitrage Pricing Theory and the law of one price
The Arbitrage Pricing Theory (APT) suggests that an investor could derive the price of a specific investment opportunity from the underlying indices that affect its price. However, it does not consider any economic characteristics that can affect the expected return. According to (Chan, 1995) unlike the MPT, the APT does not require the investor to choose investments on the basis of expected return and variance. APT provides the basic theoretical framework for the pricing of various complex financial assets with non-linear payoff patterns. The basis for the arbitrage pricing theory is the law of one price, which states that two identical assets will always sell for the same price; otherwise, it will allow investors to make arbitrage profits which is profit generated with no risk and no investment by buying the item in the cheaper market then selling it in the more expensive market. Another implication of the law of one price used in arbitrage pricing theory is that, if the assets are not identical items should still cost the same if their return and risk are identical. The rationale for this is that the primary purpose for the purchase of a financial instrument is to earn a return for a certain amount of risk. Hence, the law of one price requires that any two financial instruments or portfolios that have the same risk-return profile should sell for the same price. If this is not true, then a profit can be made by selling the security or portfolio with the lower return and buying the higher return portfolio.
1.3 Behavioural Portfolio Theory
The Behavioural Portfolio Theory (BPT) is an alternative model to the one proposed by Markowitz. This theory is drawn on the Roy’s safety first approach and the (Lopes, 1987), (Kahneman, 1979) and (Tversky, 1992) behavioural studies. BPT indicates that different investors have different risk/return preferences and investment objectives have to be tailor made in order to meet these preferences. The model suggests that an investor chooses a portfolio that maximizes his behavioural expected wealth and that meets a safety first criteria. The expected wealth is called behavioural because it is computed with decision weights instead of objective probabilities. Satisfy the security constraint means that the wealth of the investor might not fall below an aspiration level in an acceptable number of states of nature. The transformation of probabilities into decision weights permits to account for optimistic and pessimistic behaviour that coexists in each individual. The main result of this behavioural portfolio model is that the optimal portfolio of a BPT investor is generally not mean variance efficient. According to (Das and Statman, 2011) derivative instruments and structured products have no roles in mean-variance portfolios, but they have roles in behavioural portfolios. Moreover, behavioural portfolios are composed of mental account sub-portfolios, each linked with a goal such as retirement income or bequest. Investors improve each mental account by finding the assets and asset allocation that maximizes the expected return of each mental account sub-portfolio subject to the state that the probability of failing to reach pre-set threshold aspiration level not exceed a pre-set probability. The mean-variance portfolio theory offers investors tools for recognizing portfolios on the mean-variance efficient frontier, but it does not explain why investors place money in those portfolios and what they plan to do with it.
1.4 Introduction to derivatives
Derivatives refer to financial securities whose values are determined by the market price of an underlying asset, such as shares, interest rates, equity bonds or even commodities. According to (Schwegler, 2010) the elementary idea behind derivatives is that two parties agree on a certain price today in order to deliver a certain underlying asset, of a certain quantity, on a certain future date. In case of commodity derivatives, issues surrounding the quality of the underlying asset also come into play. Over the past years, the derivatives industry has evolved and the different types of derivative products and instruments have been increasing at a fast pace. This is mainly due to financial engineering, the development of new financial products, and the fact that financial institutions continuously develop new products offering high returns. (Brigham and Ehrhardt, 2005) also identified this as the reason for the increase in complexity and riskiness of financial products that are available which is often hardly understood by the people creating and using these instruments. The early development of derivatives was less complex and risky, and served a simple purpose, namely protecting profits and securing prices. According to (Bloss, Ernst and Häcker, 2008) the first types of derivatives were simple forward rate agreements and futures on agricultural products, such as rice and wheat, where two parties agreed on a certain future price, payment and delivery date. The most successful and currently most used derivatives are options and futures. According to (Bossu and Henrotte, 2006) these two products are often referred to as plain vanilla options and futures, as they are the simplest forms of derivatives and do not have any special features. Both instruments can be bought on underlying assets, such as single stocks, equity indices, commodities, currencies or bonds. According to (Acar, 2002) Futures can be bought either as long or short, whereas options are available as call long, call short, put long and put short combinations, both derivative instruments are used for hedging and trading purposes. Apart from the plain vanilla options and futures, more exotic products were introduced by financial institutions over the years. This was done to make derivatives more attractive to clients and investors. These structured products often have special features, such as performance ranges or knock-out levels and are known as bonus, outperformance or range certificates as well as Can-Do options. They are often a combination of simple put or call options and underlying assets, such as individual shares or bonds. The next trend in the derivatives market was and still is that of securitisation. With securitisation financial institutions, particularly banks, group their debt instruments, such as loans and mortgages to special purpose vehicles (SPV), and generate sellable assets of these loans. (Brigham and Ehrhardt, 2005) identified the most common forms of securitisation are asset-backed securities (ABS) and mortgage-backed securities (MBS), such as asset-backed bonds. According to (International Swaps and Derivatives Association, 2008) the latest innovation in terms of derivatives includes specific forms of asset-backed securities, namely collateralised debt obligations (CDO) and credit derivatives, such as credit default swaps (CDS).
1.4.1 Derivative Instruments-
A derivative is a financial security whose performance strongly depends on the price development of the underlying asset, such as shares, interest rates, commodities or indices. Derivatives are not usually considered as an individual asset class, like bonds, shares or commodities, but rather as a tool in portfolio management. According to (Bodie, Kane and Marcus, 2009) what differentiates a derivative instrument from other asset classes is that buyers and sellers of the instrument reach a mutual agreement today, but only settle for delivery in the future. Based on their characteristics derivatives can be classified into two broad categories i.e. conditional and unconditional derivatives. Conditional derivatives give the holder the right but not the obligation to exercise the derivative held by him. Options are conditional derivatives. Unconditional derivatives include forwards rate agreements, futures and swaps. According to (Reilly and Brown, 2003) the holder of unconditional derivatives is obligated to buy or sell the underlying asset. The study will focus on the use of forwards, futures and options as tools in investment management as these are the most commonly and widely used derivative instruments in portfolio risk management. Futures and Forwards- Futures and forwards are unconditional derivatives i.e. they are obligatory contracts since the buyer (long) of a future or forward has to pay the predetermined price of the underlying asset and the seller (short) has to deliver the underlying asset at the predetermined price. According to (Bossu and Henrotte, 2006) with futures and forwards two parties reach a mutual agreement today about a specific amount of a certain underlying asset to be bought (buyer) and to be delivered (seller) at a certain future date at a certain price. Furthermore, the difference between futures and forwards is that futures are standardised and forwards are not. Thus, futures predetermined characteristics that cannot be altered by the buyer or seller and are traded on exchanges, whereas forward rate agreements are individual mutual agreements that are traded predominantly over-the-counter. According to (Bloss, Ernst and Häcker, 2008) the benefits of having a standardised product which trades on exchange are that it is more convenient and faster to find contracts or trading partners and it is possible to close open positions very fast. Unlike other derivatives, futures are ‘marked to market’, which means that the gains or losses incurred by the investor are recorded on a daily basis in their ‘margin account’. (Bloss, Ernst and Häcker, 2008) acknowledged that before investors can trade futures they have to open a margin account with the exchange clearing house. The margin account helps in the reduction of counterparty risk/default risk. According to (Estrada, 2005) investors have to pay an initial margin ranging between five to ten per cent of the investment in order to open a margin account, however the margin depends on the exchange and assets traded by investors. Usually a minimum of 75 per cent of the initial margin must be kept in the account, this is also known as maintenance margin. If the value in the account falls below the maintenance margin then the investor will be called on to deposit more money. As an example, it is assumed that one futures contract on the FTSE 100 is worth ten times the value of the FTSE 100 index. Therefore, if the index is valued at 5,800 basis points, the investor would need £58,000 to trade FTSE 100 futures. Nonetheless, this amount is not necessary, as investors only pay the initial margin of, for example five per cent, thus depositing £2,900 into the margin account. If the index level increases by 100 basis points the next day to 5,900 basis points, then the value of the futures contract will increase to £59,000 consequently increasing the margin account value to £3,900 and an additional amount of £1,000 will be deposited into the margin account. Conversely, if the FTSE 100 index fell the next day from 5,900 to 5,700 basis points, the value of the futures contract will reduce to £57,000 thereby resulting in a decrease in value of the margin account by £2,000 and a balance of £1,900. The investor will then receive a call to deposit an additional £1,000 into the margin account in order to bring the value up to the initial margin. This example shows the leverage characteristics inhabited in futures, which is why futures markets are often fairly volatile and investors have to pay in if they make losses. According to (Steinbrenner, 2001) unlike options, futures have a symmetric pay-out profile, since investors participate as much in increasing as in decreasing prices. Futures operate with leverage, which enables investors to make significant return; conversely they could also lose significant sums of money. According to (Reilly and Brown, 2003) leverage for a future on an index can be can be calculated by multiplying the current index points with the value of one future and dividing this by the margin invested. In other words leverage is the value of the total assets divided by the equity invested. In the above example, the value of one futures contract is £10 and the FTSE 100 index is valued at 5800 basis points. Therefore the value of total assets held by the investor is £58000 (£10 * 5800 bps). The initial margin i.e. total equity invested is £2900 i.e. 5% of the value of the futures contract. The leverage in this case is 20%. According to (Hull, 2002) in case of a futures long, the contract would increase in value by 20 per cent if the index moves up one per cent, however the investor would also lose 20 per cent if the index declines by one per cent. Settlement in case of futures is done in two ways i.e. cash or physical. In case of cash settlement, investors do not receive the underlying asset, but only funds amounting to the difference between the current price and the strike price, if the market developed in their favour. Physical settlements are commonly used by industrial and manufacturing industries for commodities such as oil and coal. In case of financial markets cash settlements are more acceptable. Investors who want avoid settlement and would rather continue to invest in futures ideally have to sell the current futures contract before it expires and use the money to invest in the next future. However, it should be noted that the next futures contract or the new contract is usually more expensive than the current one which is close to expiration. This concept is called contango, whereas the abnormal situation, in which the next future contract is usually more expensive than the current one, is called backwardation. According to (Reilly and Brown, 2003) a futures contract that has a longer time to maturity is usually more expensive because the underlying asset has to be stored or held longer by the seller. (Schwegler, 2010) explained that backwardation mainly occurs with futures on commodities, as short-term shocks, such as when poor harvests can create high current future values. As this is only a temporary shock, the next futures will be worth less under normal circumstances. Futures long- An investor that takes a long position in a futures contract believes that the underlying asset price will increase in the future and thus, speculators try to make a profit or hedgers on the other hand hedge their positions against that increase. According to (Firer and Ross, 2004) in a futures long position buyers are obligated to take a certain amount of a certain underlying asset such as shares, bonds, etc at a certain time (expiry date) at a certain predetermined price also known as the strike price. Consequently, the sellers hold the short position and are obligated to deliver the underlying asset at the expiry date at the strike price. (According to Bodie, Kane and Marcus, 2009) in a futures long investors will make a profit, when the current price is higher than the pre-set strike price as the investor could buy the underlying asset at a lower strike price and sell it on the spot market at its higher current value. However, the investor would incur a loss if, the current price is lower than the strike price as they would have to buy the underlying asset at the higher strike price and could only sell it at a lower current price in the stock market. Futures short- An investor takes a short position in a futures contract when he believes that the price of the underlying asset will decrease in the near future. This strategy is often used when investors have a long position in the underlying asset and believe that the asset will gain in value in the long-run. However, in order to reduce short-term risks, investors use futures short on the underlying asset to hedge those long positions and to off-set the losses they experience when then underlying asset’s value is decreasing. According to the (International Swaps and Derivatives Association, 2009), hedging strategies mainly for managing currency (94%), interest rate (88%), commodity (50%) and equity (30%) risks. (Steinbrenner, 2001) explains that futures short are also used by speculators and traders, as they allow investors to participate in decreasing markets, which is hardly possible with any other instruments other than derivatives. According to (Estrada, 2005) investors will make a profit when the current price of the underlying asset is lower than the predetermined strike price. This is because investors can buy the underlying asset on the spot market at a lower price than the predetermined strike price at which seller is obliged to buy the asset from the futures short investor. Although, (Bodie, Kane and Marcus, 2009) explained that if the underlying asset’s price is higher than the strike price, then investors would incur a loss, as they would have to pay on the spot market and can only sell the assets at a lower strike price. Options- According to (Ashton, 2010) financial options, like futures, are useful tools for risk management. (Firer and Ross, 2004) explains an option as an instrument that gives the holder the right to exercise to buy or sells a certain amount of the underlying asset, at a certain future date, at a specified price, by paying out a certain amount of money today. The key difference however between options and futures contract is that the former are optional derivatives indicating that buyers are not obligated, but rather obtain the right to exercise an option. Another important difference is that no margin account is required when trading options. According to (Mayo, 2008) an investor would only exercise their options when they can gain a profit from them. Otherwise the options would expire and the investors would only lose the option premium paid. (Brigham and Ehrhardt, 2005) identified that there are two categories of options available, namely European and American options. European options allow investors to exercise their options only on the expiration date, whereas American options can be exercised at any time before maturity. Furthermore, options have a strike or exercise price, at which investors can choose to buy or sell the underlying asset. The underlying asset can be shares, equity indices, currencies or fixed interest bearing securities. A key benefit of call (put) options is that investors stand a chance to buy (sell) an underlying asset at a lower (higher) price than the current market price, and can sell (buy) them at the current market price, thus making profits without actually investing directly in the underlying asset. (Estrada, 2005) explained that another major advantage of options is that the investors can only lose money to the value of the premium paid for the options when they do not exercise them. Thus, options are more expensive than futures contracts. According to (Steinbrenner, 2001) call and put options are often divided by their ‘moneyness’. The ‘moneyness’ of options is divided into three categories, namely in-the-money, at-the-money and out-of-the-money. Call options are considered to be in-the-money when the current price of the underlying asset is greater than the strike price; thus investors make a profit when executing their call options. Call options are at-the-money when the current price equals the strike price and out-of-the-money when the current price is less than the strike price. The intrinsic value of an option is the difference between the current price of the underlying asset and the strike price. Options also have a time value, which is the difference between the current option price and the intrinsic value of the option. According to (Bloss, Ernst and Häcker, 2008) the time value can be considered as the value of the preferences the option holder has, compared with that of the investors who invest directly in the assets. The time value declines with each day the option nears its expiration date and is zero on the expiration date itself. (Steinbrenner, 2001) identified that options usually have a hedge ratio, which determines how many underlying assets the investor can purchase with one option. For example, hedge ratios of 0.1 (10:1) or 0.01 (100:1), means that an investor will need 10 or 100 options to buy one share. Call option- In case of a call option long, investors acquire the right but not the obligation to exercise the buy option. According to (Firer and Ross, 2004) a call option enables the investor to buy a certain amount of an underlying asset based on the hedge ratio at a certain future date at a certain price also known as the strike price by paying a certain price (premium) for the option today. Ideally, an investor that has taken a long position in a call option will exercise the option if the current price of the underlying asset is higher than the strike price, thus making a profit. However, (Estrada, 2005) explains that if the current price is below the strike price, investors will not exercise the option, but would rather allow the option to expire, thus experiencing a loss. This allows the investors to cap their losses to the option premium, whereas having infinite upside potential. Options thus have an asymmetric pay-out profile. Call options can also be sold short. An investor will sell a call option short when they expect that markets will not increase in near future, hence the buyers of the call option, which hold the option long, will not exercise their option and leave the sell with the option premium as profit. According to (Steinbrenner, 2001) if prices increase and investors execute their rights the short sellers will experience a loss, as they will have to deliver the underlying asset at the current market price which is higher than the pre-set exercise price. Put option- Put long are appropriate for investors that believe the underlying asset value will be decreasing in value in the near future. Put options are similar to call options as they can be used to hedge positions or to speculate on market movements. A put option gives the holder the right to sell a certain amount of a certain underlying asset at a future expiration date at a certain price to the seller of the option. Again, the buyer of a put option has to pay the option premium. According to (Bodie, Kane and Marcus, 2009) a buyer of a put option will only exercise the option when the price of the underlying asset is lower than the pre-determined strike price. This is because they can buy the underlying asset at its current price, but can sell it to the option seller at the higher strike price, thus making a profit. However, if the underlying asset price is higher than the strike price, then the investor would not exercise their option, but would let it expire and experience a loss as high as the option premium. Furthermore, the pay-out profile of a put option is also asymmetric, but unlike the call option, the profit of a put option is limited. According to (Schwegler, 2010) the maximum profit an investor can achieve in case of a long put option is when the value of the underlying asset is valued at zero. However, investors can also experience a partial loss if the current price of the underlying asset is lower than the strike price. The maximum loss the investor can experience if the option expires unexercised is the option premium paid. Short put investors or put option sellers do not participate in the increasing movements of the underlying asset, but only receive the option premium paid by the option buyer. According to (Bodie, Kane and Marcus, 2009) this branches from the fact that when investors sell put options, there must be buyers that have those put options long, and who believe that the underlying asset’s value will decline. Therefore, if the price of the underlying asset increases beyond the strike price, the buyer of the put option will not exercise the option as it is out-of-the-money thus leaving the short put investor with the option premium as profit. On the other hand, should the price fall, then the put long investors will exercise the option and the put option seller will experience a loss. A short put therefore has a pay-out profile with unlimited downside potential and profits capped to the option premium. Other derivative instruments- There are many other derivative instruments that can be used in portfolio and risk management. These instruments include swaps, warrants, structured notes, contracts for difference and exotic derivatives. According to (Hirt and Block, 2008) Swaps are similar to forward rate agreements, with the difference that the two parties entering into a swap, exchange cash-flows not only once, but several times on specific future dates. The major characteristics of swaps are that their pay-out profile is symmetric which is similar to that of a futures contract. Thus, it is similar for both parties entering into the swap. Swaps are only traded over-the-counter and their volumes are usually large. According to (Maier, 2004) swaps, unlike forward rate agreements, options or futures are long term agreements. As no premium has to be paid the costs of swaps are low in general. Warrants are similar to option contracts. They give the buyer the right to buy a certain number of a company’s shares which offers the warrants. According to (Hirt and Block, 2008) unlike options, which usually have maturities of three to six months, warrants have a much longer time to maturity; up to ten or more years. (Mayo, 2008) acknowledged that warrants are often issued along with debt instruments, such as bonds in order to make the bond more attractive to investors. Warrants are, like ordinary options available as puts and calls. (Brigham and Ehrhardt, 2005) identified a structured note as a debt obligation that is derived from another debt obligation. The interest payments of structured notes are derived from the development of underlying assets, such as currencies, interest rates, indices, commodities or individual stocks. According to (Kolb and Overdahl, 2003) the interest paid on a structured note depends on different variables, such as the current interest rate, the volatility of the underlying asset, the underlying asset price and the time to maturity. Furthermore, a key benefit of structured notes is that interest payments on debt obligation are not fixed, but the payments depend on the issuer’s interest earnings on the debt instrument and the performance of the underlying derivative instrument. Thus, allowing the issuers of structured notes to integrate their interest payments with their cash-flows. The higher the cash flow the more interest they can pay to buyers and vice versa. According to (Kuhn, 2010) contracts for difference (CFDs) are financial securities with which investors can speculate on price differences of a particular underlying asset. Investors attempt to profit from the price differences between the buy and sell price, this is also called the spread. Contracts for difference have a hedge ratio of 1:1 which means that one contract for difference is essential to hedge one underlying asset. Furthermore, investors contribute to the same extent in the price movement as investors who acquired the underlying asset directly. However, unlike futures contracts and options, contracts for difference do not have an expiration date and could theoretically run until infinity, and they are not traded on regulated exchanges. According to (Standard Bank, 2010) these instruments are predominantly issued and traded between brokers, often online brokers and banks. Financial engineering has led to the development of a broad range of exotic derivatives. According to (Schwegler, 2010) futures, forwards, options and swaps can be considered as the basic derivatives. Exotic derivatives instruments are derived mainly from options, futures and from a mixture of derivative instruments. The main difference between an exotic derivative and an ordinary derivative instrument is that exotic instruments have special performance features, knock-out barriers or themes.
1.4.2 Why use derivatives
According to (Chance, 2008) derivatives are instruments that allow the transfer of risk from one party to another. Each derivative transaction has two parties, a buyer and a seller. For example, in case of an option the buyer ideally pays to transfer the risk to the seller. The seller accepts this payment as compensation for the assumption of risk. In case of other derivative instruments such as forwards, futures and swaps there is no direct payment from the buyer to the seller, but it can be viewed as having indirect payments in the form the buyer promising to give up potential future gains. Derivatives are not only means of transferring risk. For example, an investor could purchase a put option to protect a stock or portfolio against downside loss, this strategy is also known as a protective put. This a much more cost effective strategy, as opposed to the investor liquidating the actual stock or portfolio and then re-investing the money in another stock, index, bond, or a risk-free asset as transactions in actual assets can incur high amount of transaction costs and tend to be extremely expensive. (Chance, 2008) explained that the cost of liquidating stocks and bonds is not very high, but moving the money to other assets does add another layer of costs. And, then at a later date the investor might want to reverse the transaction and return to the original position. And transacting in some assets can be quite expensive. For investors extreme market movements, such as experienced in the financial crisis of 2008 are not easy to deal with, especially as correlations between global markets are high. (Brigham and Ehrhardt, 2005) acknowledged that diversification is almost useless as investors cannot off-set losses in one asset or security with gains in another one. (Schwegler, 2010) identified that in turbulent times investors are essentially left with three alternatives: (1) they can either keep their investment positions, thus wait until the storm is over and prices recover again, (2) they can sell their securities with possible (high) losses and invest again once markets are at lower levels or (3) they can introduce hedging strategies before markets start to deteriorate. According to (Steinbrenner, 2001) hedging, which protects an investor’s portfolio against return losses stemming from declining prices in their long positions, such as shares or bonds, seems to be the most cost-effective, and when applied properly the most return-efficient of the above mentioned options. Derivatives are not only used for hedging but also for speculation purposes. Due to their leverage capabilities many investors favour derivative products over direct investments in the underlying asset, as the initial investment is less and the potential return is higher. (Schwegler, 2010) identified this to be highly beneficial for private investors who do not have the required funds available to purchase large volumes of shares. Nevertheless, leverage can also lead to huge losses, which need to be considered by investors at any time. (Maier, 2004) elucidated that the selection and combination of the various asset classes and financial securities depend on numerous variables, such as investors’ wealth, their needs and investment objectives as well as, the risk investors are willing to accept. Furthermore, Knowledge of capital markets, different asset classes and financial securities, as well as knowledge regarding political, social and economic conditions also influence investment decisions. How those variables are best dealt with depends on the skills and knowledge investors possess. According to (Brigham and Ehrhardt, 2005) one rule investors should always keep in mind is that the higher the expected return of an asset, the greater the risk an asset bears. (Maier, 2004) identified another problem that arises is that investors are often uncertain as to what assets to use to diversify their portfolios in order to reduce risks, and still meet their return expectations. This is certainly more of a problem for private investors who do not have as much information available and easy access to financial markets as institutional investors.
1.4.3 Derivatives and the 2008 financial crisis
The 2008 global credit crunch had a massive impact on the equity markets across the globe. Although developing countries were not as heavily influenced as their developed counterparts, the problem faced by emerging markets was that not only the equity markets, but also commodity prices declined. According to (Boorman, 2009) countries where economy relied highly on commodities, declining prices in metals such as gold, platinum and other precious metals as well as agricultural commodities such as sugar, wheat, rice posed serious economic problems. The world was quick in accusing derivatives as the main reasons for the global financial crisis that started in 2008, and of which the consequences are still felt today. Although the use of derivatives certainly played a major role in accelerating the crisis, they cannot be blamed solely (Shah, 2010). According to (Tomlinson and Evans, 2007), it is important to understand that the true origins of the crisis were declining housing prices and increasing interest rates in the United States of America (USA), which in turn led to debtors defaulting on their home loans. Furthermore, this was aggravated by banks that pooled those loans in special purpose vehicles and sold them as packaged securities to investors, mainly other financial institutions across the world. (Schwegler, 2010) explained that in order to make asset-backed securities more attractive to a larger number of investors and increase returns, banks divided the underlying mortgages and loans into different risk classes, with the most risky class promising very high returns. According to (Dodd, 2007) Investors who contributed strongly in the trade of asset-backed securities were other banks, hedge funds, pension funds and insurance companies, who all projected safe returns from these products and did not (want to) see the risks involved in them. As a further innovation, banks established collateralised debt obligations. According to (Lucas, Goodman and Fabozzi, 2006), collateralised debt obligations are a mixture of debt instruments, such as credit card payments, consumer credits and mortgages or bonds. Other structured products that played a key role in the development of the financial crisis besides collateralised debt obligations and asset-backed securities are credit derivatives, such as credit default swaps. According to (Longstaff, Mithal and Neis, 2005) these instruments permit investors to sell the credit risk separately from the underlying credit. (Beeken and Eversmeier, 2008) explained that credit default swaps also promised high returns at almost no risk, according to rating agencies, such as Fitch, Moody’s and Standard and Poor’s as they issued AAA – BBB ratings for most of these products. In times when interest rates were low, stock markets were at their peaks and bond prices were high; only low returns were available for investors, increasing the demand for these products. According to (Lien and Zhang, 2008) Many financial institutions divided collateralised debt obligations and credit default swaps into smaller and smaller and riskier packages, and sold them in order to increase returns. The sub-prime and credit derivatives bubble however burst when borrowers were no longer able to meet their interest payments, and as a result financial institutions had to provide their special purpose vehicles with large sums of money.