The term derivative market refers to a financial market for financial instruments such as options and contracts derived from other assets. For instance, the financial markets for forward and future contracts are delivered from changes that occur in foreign exchange rates (Dinçer, Hacioğlu, and Yuksel, 2018). Similarly, the markets for call and put options are delivered from changes in foreign exchange rates, but with a different perspective from that of future and forward contracts even though they are almost similar (McDonald, 2013). Given the immense effects that slight changes in foreign exchange rates have on international trade, there is no doubt that these markets play important roleinon money markets. However, one important thing to note at this point is that the market can be divided into the financial transactions that are conducted over-the-counter and those that are exchange-traded (Spiegeleer, Schoutens, and Jabre, 2013). Legally, the nature of the products traded in the two markets is quite different from each other even though both markets are normally active.
Despite the differences, the international derivative market plays important roles in international trade. Firstly, it helps market players to derive a feeling of what might happen in the future thereby helps them to determine current and future prices that are utilised to settle investment contracts (Madura, 2008). The prices that are derived converge with underlying ones athe t expiration of derivative contracts thereby the market helps traders ithe n international market to transact business.
Secondly, it helps market players to re-allocate risks from risk aversive people to those who hava e high appetite for risks. Accordingly, it facilitates international trade by allowing all groups of people to participate in it with a guarantee of some level of certainty. Thirdly, besides re-allocating risks, the market helps many people to engage in international trade because of the underlying spot market. In a nutshell, it helps people to speculate thereby acts as an investment vehicle (McDonald, 2013). In so doing, it allows investors to engage in highly leveraged trades that would not be possible in the absence of high leverage levels. Because of this, there is increased participation in the international market by other people who would not engage in it due to its inherent risks. However, because they are able to transfer risks to those wita h high appetite for iwhenen they engage in it anyway. In addition, some people are able to leverage their little money to speculate in Forex trade. For this reason, the market tends to be active with increased activities that may not be there if there was no such market.
Fourthly, the market plays an important role in promoting efficient supervision – a role that would otherwise be hard to implement if there was no such market. It introduces a form of organisation ia n speculative industry so that it can be controlled and conducted in the right manner. In its absence, it would be almost difficult to organise players because they would conduct it in their own ways without anyone regulating them. However, in its presen,ce it is possible for financial market regulators to regulate it more effectively. Fifthly, the market plays an important role in providing vital information to speculators to determine with some level of certainty the extent to which corporations may default debts (Madura 2008). These people use derivative prices that are publicly available for all people to scrutinise, and with the help of that information, they predict possible uncertainties wita h high level of accuracy. With regard to risk management, the market enables firms and investors doing business across borders to reduce risk by entering into different types of contracts such as futures or forwards.
As an illustration, take an example of a trader who transacts businesses across international borders. This person needs to transfer money across borders, and because his/her home currency may be different from the one utilised in the other market, then the person needs to exchange currencies to facilitate business transactions. Because foreign exchange rates are bound to change due to many factors, then the person needs to secure himself/herself against such fluctuations. In the absence othe f derivative market, the person would transact businesses at spot rates meaning that he/she would take foreign exchange rates the way they would be in the market at the time of transacting businesses. Accordingly, the person may end up paying more than would be reasonable to do ithe f business transaction was conducted locally or at stable foreign exchange rates that are rare to find in the international market (Dickinson, 2000). Nonetheless, in the presence othe f derivative market, the person would have the option of either purchasing future or forward contract or alternatively securing those transactions through currency options. If the person would brisk-aversese meaning that he would do anything possible to avoid risks, then the derivative market would give him/her the opportunity to transact business across borders without the fear of losing money (Madura, 2008). This would allow him/her to transfer risks to people who would be willing to take more risks, and in so doing, allow such person and other like-minded people to transaction businesses across borders. Consequently, transactions ithe n international market be it money market or any other type of market would increase significantly.
In the above case, the call option would be utilised to reduce risks associated with financial losses that would emanate from high spot rates that would reduce the net payables. For instance, if the person is an American, and is expecting to make payments to UK-based suppliers at a given time in the future. Then the person would purchase a call option to lock the maximum amount of British sterling pound he would pay to suppliers. If at the time of making payment the spot rate for sterling pound would be lower thathe n strike price, then he would exchange US dollar at the spot rate in the market (Madura, 2008). Conversely, if the spot rate would be more thathe n strike price, then he would exchange the US dollar at strike price to hedge himself against the high spot rate that would be in the market. This would reduce the financial loss thereby manage risks associated witthe h international market.
Alternatively, take an example of a person who wishes to speculate in the international market. The person may hypothesise thaa currency would appreciate sometimes in the future. Accordingly, he may go ahead to purchase a call option that would give him the opportunity to purchase that currency at a specified price within a specified time. As soon as the spot rate for that currency appreciates beyond the strike price, the person may purchase the currency and sell it at the prevailing spot rate. Take an example of a call option for a British pound with a premium of £0.01 per every unit, and a strike price of £0.70. Assuming that the trader purchases a contract worth £50,000, and decides to exercise it shortly before it expires at a spot rate of £0.75 and sell it athe t spot rate. Then the person would obtain the following net profit.
Table 1: A sample call option
|Price per unit||Price per contract|
|Selling price||£0.75||(£0.74 X 50,000 units) = £37,500|
|Less purchase price||-0.70||(£0.70 X 50,000 units) = -£35,000|
|Premium paid for the option||-0.01||(£0.01 X 50,000 units) = -£500|
|Net profit||£0.04||(£0.04 X 50,000 units) = £2,000|
Source: (Madura 2008)
In the above case, the trader would exercise the option at the strike price of £0.70, and then sell it at a spot rate of £0.75. Consequently, because he/she would incur a premium of £0.01 per every contract, then the net profit per contract would be £0.04. This would be multiplied by 50,000 units to obtain a net profit of £2,000.
Before looking at the reasons that may prompt firms to hedge net receivables or net payables using currency options as opposed to forward contracts, it would be important to start by evaluating what the two exercises entail. On one hand, currency options provide firms with rights to either sell or purchase currencies at specified prices, and they are of two categories namely: put and call option. A call option offers firms rights to buy specified currencies at designated prices at specified timeframes (Coyle, 2000). This type of option is desirable when firms wish to lock maximum prices to be paid for particular currencies they suspect would be affected significantly by market forces. If spot rates rise beyond the prices they are allowed to buy, which are referred to as exercise or strike prices, they may purchase currencies at specified prices thereby hedge themselves against excessive fluctuations. The beauty of this option is that firms are normally at liberty of determining whether to purchase those currencies at strike prices or not. However, the problem is that if firms do not purchase currencies at strike prices, which are normally cheaper than spot rates, they lose premiums they pay as they purchase the option contracts (Madura, 2008). Nonetheless, this is normally the highest amounts of money they can lose in call options.
In contrast to the above, a put option offers firms the opportunity to sell currencies at strike prices within specified timeframes, and like in the above case, they are not obligated by the contract to implement options at expiry date meaning that they can execute them or not. Once again, firms lose only premiums they pay fooptionson contracts if they do not execute them.
On the other hand, forward contracts indicate the amount of a particular currency that would be sold or purchased at a specified future point in time at a given exchange rate. In so doing, firms engaging in businesses across borders do not have to worry about the possible fluctuations on foreign exchange rates till they settle net payables or receivables because they can determine the amount of money they would receive or pay with high degrees of certainty. These contracts are mostly offered by commercial banks as opposed to being sold on exchanges; as such, they are normally utilised by large multinational corporations. For this reason, most of these contracts do not go below the $1 million mark (Dufey et al., 2005). Even though they allow traders to determine the possible income with high levels of certainty, they deny them the opportunities to take advantage of changes in foreign exchange rates that may be favourable to them at the time of executing their trade deals. For instance, they deny firms the opportunity to exchange home currencies with foreign currencies at relatively higher exchange rates, which may give them added advantage in such cases. Similarly, they deny financial institutions such as banks the opportunities to exchange foreign currencies with firms at relatively low exchange rates that may be favourable to them when purchasing foreign currencies. Because of this restriction, firms that hava e higher appetite for risk may opt to hedge their net payables or receivables using currency options as opposed to forward contracts so that they can take advantage of the possible fluctuations in exchange rates that would be favourable to them.
Taken as whole, it may appear that currency options and forward contracts are almost the same because they help firms to achieve almost similar objectives and goals. However, a closer look at them indicates that they differ slightly. On one hand, currency options offer firms rights to purchase or sell currencies at specified rates without necessarily obligating them to execute the rights at their expiration dates. As such, firms may opt to execute the rights at expiration dates or let them expire without necessarily executing them. With this in mind, then firms may prefer this option over forward contracts especially when they engage in business transactions with high levels of uncertainty to the extent that they may be cancelled by business partners without informing them beforehand (Madura, 2008). In such instances, firms would have the alternative of letting currency options to expire without executing them.
Similarly, the option would be preferred over forward contracts in bidding projects to lock potential expenses. In such businesses, the purchase of items that would be required to complete bided tasks would depend on whether firms would be hired or not. If a firm would be hired, then it would be advisable to implement the currency option if the options would be profitable whereas if the firm would not be hired to execute the task, then it would be advisable to let the option expire without executing it. The one notable advantage of using currency option is that firms are at liberty to implement the strategy or not because they are not bound by it. However, they normally lose the premiums they pay to enjoy this benefit even though their sizes are normally small and determined by contracts sizes. Another advantage is that they are readily available in exchanges meaning that they can be accessed easily and on demand without necessarily going through the lengthy processes of negotiating them with providers (Madura, 2008). The unfortunate thing about this advantage is that they are not tailored to suit specific needs like forward contracts are normally tailored to do. For this reason, even if they may be good because they can be allowed to expire without executing them, they do not address specific issues; hencemaybebe a bit expensive.
In spite of the above, it would be possible to negotiate a forward contract thereby tailor it to specific firms’ needs. In contrast, it may not be possible to negotiate currency options because they are normally standardised and provided in exchanges. Nevertheless, under forward contracts, firms would be obligated to exchange currencies at specified prices at the expiration date meaning that the benefit they would enjoy in negotiating forward contracts would be taken away by mandatory obligation to execute them on specified dates (Madura, 2008). The beauty of forward contract would be that they would not be obligated to pay initial payments in form of premiums like they would have to do under currency option.
In summary, firms may opt to hedge net receivables or payables using currency options as opposed to forward contracts because under currency options they would not be obligated to implement option contracts athe t expiration date. This means that they can allow them to expire without necessarily implementing them. For this reason, they would be able to determine independently when to implement or not implement option contracts based on the amount of money they would make or lose out of the contracts (Madura, 2008). In so doing, they would be able to take advantage of the possible increases in foreign exchange rates especially when receiving money from international traders and minimise expenses when sending money abroad at low exchange rates.
In spite of the above, they would not be able to negotiate favourable currency options because they would take them the way they would be provided in exchanges. In addition, they would have to pay initial premiums as a way of commitment even though they would not be obligated to execute them on expiration dates. Despite this, the extent to which a firm may opt to utilise currency option in such a case would depend on the risk appetite of a firm because even though the strategy would allow it to take advantage of the possible changes in foreign exchange rates the process might be costlier thathe n forward contract (Madura, 2008). Consequently, the decision has to be made in the midst of many competing interests that would have to be balanced.
The hypothesis of efficient market argues that security prices adjust rapidly as soon as new information gets into the money market suggesting that current security prices reflect all information that is readily available in the market. Assuming that this was true, then those prices would be equal to their present values so that return on investment would equal equilibrium returns for given risk levels. In this respect, no investment strategy that would be based on historical or current information would generate extraordinary large profits. The hypothesis presumes that with the presence of many independent investment advisory servicesa , multitude of investors and huge loads of information then security prices adjust instantaneously. The assumption is that the many profit-maximising people in the market analyse information independently and thereby value securities accordingly (Chandra, 2008). In addition, it is presumed that new information gets into the market oa n random basis and that competing investors try to adjust security prices as soon as possible to reflect the impact of that information.
Based on the above assumptions, then it would be expected that changes in security prices would be independent of each other because information gets into the market randomly and independently. This is in relation to the fact that each price should reflect its own risk based on information released into the market. In spite of this, the available literature on efficient market hypothesis depicts that changes in security prices are not independent of each other because with historical data, it would be almost possible to predict future security prices with some levels of certainty even though not wita h high degree of accuracy (Lee, Lee , and Lee, 2008). Other scholars support the hypothesis suggesting that security prices adjust instantaneously to new information that is released into the market.
A market is said to be of weak-efficient form when security prices entirely incorporate information enclosed in past prices. That information may include trading volume data, rates of return, and historical price sequences together with information generated by the market. Nonetheless, since the hypothesis presumes that current security prices reflect all information available in the market, then it would be pointless to analyse past prices with a view to predict future prices. The simple reason is that such analysis would not have any significant effect on future rates of returns and prices thereby render technical analysis ineffectual (Chandra 2008). In contrast, a market is considered to be of semi-strong efficient form when security prices integrate all information that is available publicly. This form of efficiency takes care of weak-form hypothesis because it encompasses all information covered by that form othe f hypothesis. Finally, a market is said to be othe f strong form if it encompasses all information both private and public. The problem is that it may not be possible to obtain inside information oa n timely basis; as such, price changes would be gradual as opposed to being instantaneous (Ogilvie and Graham, 2008). For this reason, it may be argued that it would be practically impossible for security prices to reflect all publicly available information at any given time. Based on this understanding, it may be argued that market tends to be of weak form most of the time.
While the above is the case, the efficient market hypothesis has been found to have a number of anomalies that investors exploit to make abnormal profits. Firstly, some anomalies emanate from firms’ specific characteristics due to sizes, neglect or institutional holdings. For instance, while the hypothesis claims that it may not be possible for investors to earn huge profits, it is rather obvious that some of them earn huge profits based on institutional holding (Ogilvie and Graham 2008). Others earn huge profits due to oversight by analysts whereas others earn such profits based on the small size of their firms.
In other instances, despite the claim by the hypothesis that it may not be possible for investors to earn huge profits, seasonal anomalies enable investors to make huge profits. For instance, they are able to make huge profits in January due to pre-conceived January effect. In addition, security prices tend to be down on Mondays and up on Fridays thereby competent investors are able to take advantage of these seasonal changes. Furthermore, event and accounting anomalies also enable investors to make extraordinary profits (Bhalla, 2008). As such, despite the claim by the hypothesis that it would be almost impossible for investors to make huge profits, it is rather obvious that it may be possible to take advantage of anomalies in the market and make extraordinary profits.
Normally, a weak-form test of the hypothesis would be a noble strategy for determining the level of independence of security prices based on market efficiency. The process would entail conducting an autocorrelation test on stock’s returns over a specified period. In addition, it would involve conducting a serial correlation on the returns to determine their relationships othe n consecutive timeframe. A positive correlation that would be significant would be interpreted as evidence for price momentum in the stock market whereas a zero correlation would be interpreted as absence of such momentum. Furthermore, a negative correlation that would be statistically significant would similarly depict price momentum in the market, but in the opposite direction (Bhalla, 2008). Theoretically, it would be possible to exploit a positive serial correlation to earn huge returns, but because such transactions involve different types of costs, then the correlation should be huge to cover those costs. To some extent, it might be argued as the hypothesis claims that it is possible to exploit positive serial correlations without necessarily earning huge returns. However, this claim is bound to face various challenges due to market anomalies and inefficiencies in the market.
To determine the level of information efficiency in the market, the historical daily performance data for the Barclays PLC (BCS) stock for the period between 31 December 2018 and 29 January 2019 was downloaded from Yahoo finance database. Then the daily returns were calculated as log (BCSt/BCSt-1) and results plotted on graph as Figure 2.1 depicts. Furthermore, an autocorrelation of the daily returns was calculated using Excel program and results provided in Table 2.1. The results indicated that there was moderate negative autocorrelation between corresponding daily returns on the stock’s returns suggesting that there was negative price momentum in the stock’s performance.
The implication of the above findings is that while the hypothesis presumes that changes in security prices would be instant thereby there would be no correlation between historical prices and current ones then it appears that market adjusts slowly to new information. This is irrespective of the fact there appears to be sudden changes in security prices at some points following the release of sensitive data. In this respect, traders may be able to develop rules that would enable them to detect the way security prices may change based on information released to the market and in so doing act ahead of other traders in the market (Maheshwari, 2008). This is in contrast to the narrative propagated bthe y efficiency market hypothesis that discredits the potential of technical analysis.
Another set of implication is that no single group of analysts and investors would be able to beathe t market on a consistent basis using the ordinary investment strategies. For this reason, in an efficient market, it would be costly to conduct relevant researches and value securities accordingly. This being the case, it would be argued that the process of diversifying stocks and conducting little or no analysis on information would be far much better than that of creating large pools of information that increases transactional costs. Consequently, it would not make sense hiring portfolio managers who would act as investment strategists while it is known that their value would be minimal (Mohapatra, 2012). These would be some of the negative implications of the above findings, which largely would be contested bthe y majority of the people. However, it is rather obvious that if security prices would adjust to new information oa n gradual basis to the extent that every investor would be able to makan e informed decision using it, then it would be immaterial to hire experts to do that job.
The issue of inflation targeting entails setting the numerical figure of an inflation rate that is considered acceptable in an economy. In most advanced economies such athe s European Union anthe d USA, the actual figure tends to be 2 percent. Beyond this point, most governments tend to take deliberate measures to control it by way of restricting it to the figure that has been set. According to McDonald (2013), the process of targeting inflation involves five elements namely: declaring publicly the medium-term numerical inflation target, utilising an information inclusive strategy in making decisions, transparency in declaring monetary policy strategies, increased accountability within central bank and a commitment to stabilising prices. In the UK, the practice was started officially in 1992 following the country’s withdrawal from EU monetary system (House of Commons, 2012). From that time, the governor of the central bank normally provides an inflation report to the members of the public oa n quarterly basis detailing progress made to maintain the rate below the target.
The inflation targeting mechanism is different from other monetary mechanisms in the sense that it focuses on targeted rates to stabilise prices in the market as opposed to targeting exchange rates. In addition, because the exercise tends to be elusive, then it requires some degree of independence, accountability and transparency. Overall, there is no doubt that changes in inflation rates have considerable effects on international trade activities that in return influence the supply and demand for foreign currencies. These effects whether small or large are translated to exchange rates that countries are focused on stabilising to strengthen their economies. Aware of this factthe , majority of advanced economies use different strategies to target inflation as one way of stabilising their economies and money markets in general. Some of the mechanisms may entail quantitative easing whereas others may entail raising and lowering interest rates where necessary.
By definition, a Quantitative Easing (QE) program entailthe s large-scale purchase of assets or alternatively an extension of new credit facilities bthe y central bank. In most cases, central banks purchase government-guaranteed or long-term bonds issued bthe y government even though they may as well purchase private bonds and equities (Soikkeli, 2002). Doing this helps central banks to expand their balance sheets and reduce funding costs thereby enhance the availability of credit to certain sectors othe f economy. Because of this, the program lowers bond yield in three different ways. Firstly, purchases from central bank help to minimise possible crises in the market by depicting authorities in governments as focused on helping the market to stabilise and by way of acting as credible buyers (Nordstrom et al., 2009). Secondly, it enhances the credibility of guidance provided by central banks especially those relating to rates remaining low in the future. In so doing, the exercise acts as signallingng channel. Thirdly, the program reducethe s amount of assets with term risks and sometimes those with liquidity or credit risk held by private investors (Brand, 2001). Because of this, it raises their prices by a process known as portfolio channel.
In spite of the above, some people claim thathe t QE program operates efficiently at the time of panic meaning that it may not be effective in the absence of such cases. Such claims may be countered by acknowledging the fact that the market-calming channel of the program tends to work effectively during financial stress whereas portfolio ansignallingng channels prove effective in different circumstances. Nonethelessthe signallingng channel may be limited in some instances because central banks may not commit credibly to maintaining policy rates at lower bounds forever. One notable thing about yields othe n bond is that it has certain lower bounds meaning that beyond those points investors may opt to switch to holding cash as opposed to investing it in bonds or bond market in general (Truman, 2003). As a result, in some countries such as Japan and Switzerland yields from long-term bonds have turned negative.
Normally, when interest rates fall below zero, investors may opt to hold cash as opposed to invest it in bonds ana d capital market that may not returhigh-interestst rates. Similarly, banks and firms would opt to do the same. As a result, since 2012the , majority of central banks have focused on pursuing interest rate policies that do not fall below zero mark (Hausken and Ncube, 2013). In spite of this, some central banks have resolved to setting interest rates to negative values, and in some way demonstrated that such practices may not necessarily result to scramble for cash or even impairing the performance othe f financial sector. Nonetheless, the practice has demonstrated that negative interest rates may affecthe t capital and money markets through usual channels. In some instances, the response to negative rates may be sluggish whereas in others it may be fast.
Figure 3.1 depicts that the money and bond markets responded faster to negative rates in Denmark. One notable thing about the change is that the rate fothe r money market had a longer maturity rate than policy rate because of the eminent expectations that policy rate would rise at some point. This is a natural thing because so long as investors expect lower bounds to prevail in policy rates, they would be reluctant to respond to those rates. The most unfortunate thing about such practice is that investors may expect negative rates to prolong thereby lower long-term yields from money and bond markets. This explains the reason behinthe d decline in government bonds below zero rates foa r prolonged period thaextendsnd to ten years.
A similar trend has been witnessed in other parts of the world. For instance, in theurozonene, money markets and bond yields have declined following declines in interest rates as Figure 3.2 depicts. As a result, it would be expected that increase in interest rates would boost stock prices, bond yields and performance of the capital market. In contrast, reduction in interest rates would reduce yields from these markets (Listokin, 2019). On the other hand, it would be expected that QE program would decrease bond yields even though the effects would be transitory. The effect may extend even to corporate bonds that are not purchased bthe y government indicating the deep effects of the program. As a result, central banks may utilise this instrument to control inflation rates to the extent of restricting them to pre-determined values. In spite of this, the program has the capacity to raise equity prices even though it may as well reduce yields on foreign bonds. With this in mind, then most advanced market economies have resulted into utilising money markets to target specified inflation rates. In some instances, they utilise QE programs or interest rate policies to sway market movements in their favour or in projected directions.
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Chandra, P., 2008. Investment analysis and portfolio management. New Delhi: Tata McGraw-Hill.
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Figure 2.1: Barclays’ stock daily return
Table 2.1: The Barclays stock’s autocorrelation analysis output
|Money market rate|
|10-year Treasury bond yield|
Figure 3.1: The effect of QE program on money and bond market
|5||Interbank/money market rate|
|4||10-year government bond yield|
|AAA corporate bond yield, 4Y maturity|
Figure 3.2: The effects of QE program on 10-year bond and corporate bonds