Dissertation On Market Risk Management Through The Use Of Options
Get dissertation help for this at assignment4finance@gmail.com
Introduction:
Oxford dictionary defines risk as “a situation
involving exposure to danger” or “expose (someone or something valued) to
danger, harm, or loss” (Oxford Dictionary). For a business entity “Risks” are
connected to possible uncertainties that can result in negative effect on the
entity. With the emergence of World Markets and various types of risks, risk
management has become an integrated part of firms today. Different types of
risks require different methods to handle, prevent or sometimes to absorb and
benefit from risks. The downfall of risks has always been highlighted however
they do have some arbitrage that results in potential gains.
The Basel Committee that was formed in 1974 laid
the regulatory framework for Financial Risk Management. (McNeil, Frey and
Embrechts, 2005). Basel II (2001) defines Financial Risk Management to be
formed of 4 steps: “identification of risks into market, credit, operational
and other risks; assessment of risks using data and risk model; monitoring and
reporting of risk assessments on a timely basis and controlling these
identified risks by senior management.”(Alexander, 2005). It thus determines
the probability of a negative event taking place and its effects on the entity.
Once identified risk can be treated in following manners:
Eliminated altogether by simple business
practices. These are the risks that are detrimental to the business entity.
Transferred to other participants.
Actively managed at firm level. (Alexander,
1996).
The risks basically depend on the time value of
assets. Moreover with the increased level of multinational functioning of
business entities and the highly volatile nature of markets, risk management
has now become a critical part of running the business. It therefore becomes
essential to understand as well as analyze the various factors that determine
risks and the preventive measures implemented against them. Also the hedging
techniques being considered do not always ensure profits. The research would
thereby include a detail study of the effectiveness of the methods implemented.
One more important factor is the cost incurred. Risk management incurs certain
costs and the process would therefore prove to be futile if the costs incurred
don’t offer proportionally benefits.
You should be like some related chapter:Evaluation of Accounting Research Application
Literature Review:
Literature Review:
Market Risk constitutes of commodity risk,
interest risk and currency risks. Commodity price risk includes the potential
change in the price of a commodity. The rising or falling commodity prices
affect the producers, traders and the end-users of the various commodities.
Moreover if they are traded in foreign currency, there arises the risk of
currency exchange rate. These are normally hedged by offering forward or future
contracts at fixed rates. This is especially important for commodities like
oil, natural gas, gold, electricity etc whose prices are highly volatile in
nature. (Berk and Demarzo, 2010)
Interest Risk relates to the change in interest
rates of bonds, stocks or loans. A rising rate of interest would effectively
reduce the price of a bond. Increased interest rates result in increasing the
borrowing costs of the firm and thereby reduce its profitability. It is hedged
by swaps or by investing in short term securities.
Currency risks arise from the exceedingly
volatile exchange rates between the currencies of different countries. For e.g.
Airbus, an aircraft manufacturing company based in France requires oil for its
production. Oil being traded in US dollars and the company doing trading in
Euros, has a foreign exchange risk. It would be therefore beneficial for Airbus
to enter a forward contract with its oil suppliers. Options are another way of
hedging against currency risks. (Berk and Demarzo, 2010).
Forward contracts, Futures and Options are
called the Financial Derivatives and are used largely to reduce market risks.
Walsh David (1995) explains that if two
securities have same payoffs in future, they must have same price today. Thus
the value of a derivative moves in the same way as that of underlying asset.
This is called arbitrage.
Hedging of risks is nothing but the holder of an
asset has two positions in opposite directions. One is of the derivative and
opposite position is on the under-lying asset respectively. As such if the
value if the asset decreases then value of the derivative will also decrease.
But the change in value is off-set by the opposite positions to each other.
Thus risk is reduced. This is called hedging. Long Hedge refers when an
investor anticipates increase in market price and therefore buys future
contracts. Short Hedge is when an investor already has a futures contract and
expects the value of asset to fall and therefore sells it beforehand. (Dubofsky
and Miller, 2003)
Long Hedge Short Hedge
Change in value of position
Change in price
Change in value of position
Change in price
Forward Contracts- These involve buying or
selling specific asset at a specific price at a specified time. It is basically
a contract between two parties to trade a particular commodity or asset at a
particular rate on a specified time. The buyer is said to be in ‘long position’
while the seller hols the ‘short position’. These are Over the Counter (OTC)
Derivatives. These are used for locking-in the price and require no cash
transfers in the beginning, thereby involve credit risks. Their main feature is
the flexibility as forward contracts can be tailored as per the requirements of
the traders. They are typically used to hedge the exchange rate risks.
(Claessens, 1993)
Options- The holder can buy from or sell to, the
asset at a strike rate at a future maturity date. However the holder of the
option has no moral obligation to do so. The cost of buying the option involves
a premium which is to be paid up front. The option that enables the holder to
buy an asset is called Call option while in Put option the holder is able to
sell the asset. (Claessens, 1993) These can be bought Over the Counter (OTC) at
a bank or can be exchange traded options. An American option could be exercised
at any time before it expires. On the contrary, a European option has to be
exercised on maturity.
Option is normally executed when its strike
price is less than price of the stock. However, is the price of the stock is
less than the strike price; the holder will not execute the option. Black and
Scholes (1973) gave the formula to determine the price of a European option.
According to the formula, the value of Call option is given by:
where
The value of Put option is given by:
P = Ke-r (T-t) – S + C = N(-d2) Ke-r (T-t) –
N(-d1) S.
Where N (.) is a cumulative normal distribution
function
s- standard deviation of the share price,
rf- risk-free interest rate per annum and t-
time to expiry (in years).
The above formula, also known as the
Black-Scholes option pricing model; is based on the assumptions that the stock
doesn’t pay any dividends, it is possible to buy or sell even a single share,
there are no costs incurred in these transactions and that arbitrage
opportunity doesn’t exist. According to Black and Scholes (1973), “the option
value as a function of the stock price is independent of the expected return of
the stock. The expected return of the option, however, will depend upon the
expected return of the stock.” Hence as the price of underlying asset
increases, the price of option will also increase owing to their linear
relationship.
Black and Scholes (1972) further carried on
various empirical tests to validity of the formula. They observed that price
paid by the buyers of the option was higher than that shown by the formula.
This was mainly because the transaction costs that are incurred are always paid
by the buyers of the options. These costs were found to be high for options of
high risks and vice-versa. The sellers of options thus got the price that was
predicted by the formula. The case study would make use of this formula to
determine the value of options held by the company.
Data and Methodology:
Objectives:
The research aims to:
Increase the understanding of the factors that
determine market risks.
Understand the haven provided by financial
derivatives against these risks.
Have a clear understanding of the methods or
risk management techniques.
Understand the process of risk management.
Understand the intricacies of derivative
markets.
Data and Methodology:
The Research is essentially a case study of
Vodafone Group Plc. Primary data would include the information of the forward
contracts with service providers, options and futures of the company in the
market. Secondary data would be Qualitative in nature, comprising online
journals, relative case studies and books.
The research would be carried out in the
following steps:
Depending upon the nature of company, determine
that factors that would affect the risk faced by the company.
Evaluate the percentage of risk faced by the
company. Determine the amount of this risk, which the company would want to
hedge.
The data would then be utilised to determine the
amount of risk hedged by each of the above and then determine the total risk
hedged by portfolio as whole.
Calculate the cost of hedging the risk.
Compare and contrast the findings with the
defined ‘Effective Risk Management.’
Critically analyze the results.
Suggest improvements if any, in the portfolio.
Calculate the risk hedged with the suggested
changes.
No comments:
Post a Comment