Hedging is a way to offset or avert risk and is considered a good risk management strategy in most of the financial instruments. So, is it always good to go for long-term hedging strategy?
The simple answer may be NO. Lets see a good financial instrument for which this hedging strategy doesn't hold good. BOND- the financial instrument whose yield relationship is non-linear is a good example of a financial instrument that will fit in this category
In case of bond, interest rates determine the price/yield. Whenever there is a large fluctuation in interest rates the yield follows a non-linear trend. Hence duration can not be factored in determining the price of the bond
Duration based hedging is found to workout for some commodities like gold, whereas not all the financial risk could be circumvent using this strategy
Describe contrast and calculate the payoffs from speculative strategies involving futures and options
Speculators
- Use derivatives to make bet on the market whereas hedgers try to eliminate exposures
- Speculators use futures contract since limited amount of initial investment creates significant leverage and can result in large gains or loses and contract payoffs are symmetrical
- Speculators use options since investor needs to pay only the premium to purchase the option instead of the face value of the underlying and payoffs in options are asymmetrical
- Losses using futures contract can be large whereas loses using options contract in speculation is limited only to the contract premium
FRM AIM: Calculate an arbitrage payoff and describe how arbitrage opportunities are ephemeral (i.e., short lived)
Arbitrageurs
- Use derivatives to earn risk free profit in excess of risk free rate by manipulation of mispriced securities
- Riskless profit is earned by entering into equivalent and offsetting positions in markets
- Opportunities do not last long since supply and demand will quickly eliminate the arbitrage situation
Risk from Derivatives
FRM AIM: Describe some of the risks that can arise from the (mis) use of derivatives
- Traders use to speculative instead of hedging the derivatives (Operational Risk)
- Loses suffered using hedging, speculation, arbitrage is high
- Control mechanism needed to monitor risk that arises out of hedging, speculation, arbitrage opportunities
FRM AIM: Define market, limit, stop-loss, stop-limit, market-if-touched, discretionary, time-of-day, open, fill-or-kill order
Market Orders:
- Order to buy/sell at current price
Limit Orders:
- Orders are bought/sold at a price above/below the current price and a limit is placed on the order
Stop-Loss Orders:
- Prevent losses and limit exposure
- Types are Stop-Loss Buy/Stop-Loss Sell order
Stop-Limit Orders:
- Combination of stop and limit orders
- Used as a hedging strategy
Market-if-Touched Orders:
- Orders become market orders if specified price is reached, otherwise they remain unexecuted
Time-Of-Day Orders:
- Orders remain active until certain time period specified in the order
Good-Till-Cancelled Orders:
- Also known as open orders
- Valid till the order is executed
