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Financial Markets and Risk Management Research Paper

Research Paper on Financial Markets and Risk Management:

I would like to start by saying that the US economy just like the economy of any other country in the world follows certain patterns and is defined and represented by certain indicators and figures. In the following essay, one will explore the US economy from 1999 till 2005, evaluate it, and understand the behavior of investors involved in the market.

In order to better understand the dynamics that take place in the US market I have selected some date from United States of America regarding the following elements as shown in the essay below:

  • Movements in a major market stock index
  • Interest rates offered on Government bonds
  • Fluctuations in exchange rates between the domestic currency and the Euro and either Sterling or the US Dollar.

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The data for each of the selected indicators ranges from January 1999 till January 2005. We will use that time period for better understanding of the situation.

As one can see the major indicators of the US financial/economic health had followed a somewhat similar downward and upward sloping pattern.

Let’s start with the interest rates movement as set by the 2 year Treasure note to track one of the most important figures in the US economy. The other figures will be shown in that retrospective to assess the impact of interest rates on other figures like exchange rates and stock market (NASDAQ 100) For better understanding of the concepts, we can split the whole curve into several sections as defined by the turning points.

a. January 1999 till July 2000. The US interest rates are seen as growing as a result of Fed’s attempt to cool down the US economy (contraction monetary policy) and prevent it from overheating that apparently was about to take place that that period of time. The interest rates grew from about 4.5% till 6.75% over the selected period.

As one could see from NASDAQ 100 figures the stock market of hi-tech companies over the same period (Jan 1999 till Apr 2000) had grown dramatically despite the growing interest rates in the country. Although NASDAQ is not as accurate indicator of economy as S&P 500 it does show the general economic trends that take in the USA and defined by hi-tech companies. So far, one can see that as the index grew from slightly below 2000 in year 1999 till about 4400 in 2000, the US economy expanded despite the growing interest rates (Vinning, 98).

Speaking about the exchange rates I would like to note that they are formed primarily by the interest rate parity which in simpler terms states that the country which has interest rates higher is likely to witness its currently slip against the country which has lower interest rates for the same time period. This is exactly what one could have observed on the graph depicting the exchange rates between Euro and the US dollar. As one could see the Euro had originally been more expensive than the US dollar (equaling 1.2$ per Euro in Jan 1999), yet in July 2000 Euro cost some $093 cents. According to the no-arbitrage theory such fall in Euro price could have been created by the interest rates in Europe growing at a rate higher than that in the USA for the same time period. As matter of fact European interest rates had been historically higher than the Interest rates in the USA. Strengthening US dollar could have been the cause of market misinterpretation of the interest rates/stock market movement. In 1999, the US market had reached its new high, while the growing interest rates were interpreted as the Fed’s desire to halt the market growth to prevent overheating of the economy. As a result of a strong US economy, one usually predicts strong demand for the US currency and thus strong US dollar. Should the Fed start lowering the interest rates and the NASDAQ plummet, one would interpret that as already declining economy and would observe lowering price of dollars. In 1999, Euro had been a new currency that was supposed to cover 12 original European countries members of the monetary union. The war crisis in Kosovo/The Balkans during that period of time and mistrust towards the new currency in Europe could have also contributed to the widening gap between US dollar and Euro.

The exchange rate between the US dollar and Great Britain pound had also experienced a slight change graphically similar to that of Euro/US exchange rate graph yet with very little fluctuation. Small fluctuation could have been explained by the similar interest rates between the USA and Great Britain, and high correlation between British and American economies, which is not the case with the US, and European economy (Euro zone).

b. July 2000 till Nov 2001. This period showed a tremendous fall in interest rates as the interest rate for 2-year t-note fell from 6.75% till about 2.75%. Such rapid lowering of interest rates in a country like the USA might mean only one thing: The US economy is suffocating and it needs a powerful boost and jumpstart to return to the right place. Here we do not have additional indices yet one can assume that the inventory levels, and unemployment grew, while production fell (Strong, 148).

The US economy as represented in our case by NASDAQ 100 plummeted from 4500 in July 2000 till about 1200 in November 2001. it seemed that the Market could not cover some psychologically critical points like that of 2500 or 1500 at first yet then freely fell below these levels. Apparently this showed investors that the US economy went sour.

The exchange rates on the other hand showed US dollar appreciation as the export-driven European and British economies had probably attempted to depress their own currencies to make their goods more competitive in the declining US economy. As a result, the US dollar slightly appreciated against the major European currencies as represented by the EURO and GBP. The lowered interest rates according to the arbitrage pricing theory (interest rate parity) meant that the US dollar was supposed to appreciate.

c. Nov 2001 till Jun 2003. this period of time showed a slight decline and stabilization of the US interest rates for 2 year T notes. The interest rates despite some increases ultimately fell from 2.75% till 1.25% to reach the absolute minimum interest rate for the period. As one could understand from Japan’s experience it was a critical period since as the interest rates approach the zero, the Fed loses one of its monetary tools to control the economy, since one cannot set the interest rates below 0%.
During the same time period, the stock market NASDAQ 100 had also hit its minimum and probably its book value and just like the interest rates followed an up-and-down sloping pattern during the period (Stulz, 63)

The exchange rates for both Euro and British Pound on the other hand showed that the US dollar depreciated against these two major currencies. It is rather possible that as the global currency traders noted that the US economy was falling deep together with the interest rates and that the Fed was about to stop controlling the economy by playing with the interest rates (since they were almost non-existent) the trust in dollar fell and the currency depreciated as illustrated on the graphs.

d. Jun 2003 till Feb 2005. This was the final period selected for this report and it showed relative economic recovery of the USA. The interest rate for 2 year T-bill quickly grew from 1.25% till 3.25%, which was interpreted by the major markets as revitalization of the US economy. It was understood that the Feb raised the rates rapidly to establish another safety margin to later play with the interest rates should the economy require that.

NASDAQ 100 grew insignificantly from about 1250 till slightly over 1500 and never seemed to reach the 4000-point figures it enjoyed a few years ago.

The exchange rates between the US dollar and Euro or Great British Pound showed that the US dollar was losing ground and depreciated against Euro and Pound. One of the reasons why that happened is because the USA let loose the dollar to contribute to the competitiveness of the US goods abroad that supposedly would help revitalize the US economy. Furthermore, the strong control over Pound and Euro by the corresponding governments together with these countries’ interest rates remaining unchanged against the rapid increase in interest rates in the USA meant that the dollar depreciated (Stephens, 230).

Speaking about the risks present in the given situation, I would like to note that it was the market risk driven by misrepresentation. It is apparent that the interest rates, exchange rates or the whole economy follows a certain pattern (going up and down), yet it is uncertain how large these swings will be and how much time will pass between corresponding swings. Thus, one observed that the stock market could not pass some even number like 2500 or 1500 yet ultimately driven by fundamental causes did pass them. Investors have the major risk here of being unhedged and not going the way market goes. In this case, being unhedged is the main risk that needs to be noted.

2. Identify and explain a derivative contract, written on an underlying asset from I chosed US market, which could be used to manage the type of risk identified in your answer to part two. Explain how such a risk management strategy. would work. (50%)

Derivatives are the securities created with a direct relationship to some other fundamental securities of debt and equity, let alone commodities.

These securities fall into various categories like futures, forwards, options, caps and swaps, yet in this research paper we will focus primarily on future and options.

1. Futures. These securities are contracts to buy something at some future time. Typically futures are used to hedge the risks associated with the price changes of the underlying commodity or security. Thus, a futures contract to buy 100 barrels of oil in March, 2005 at say, $45/barrel means that the futures holder is obliged to buy 100 barrels of oil at that specified price and the oil seller must sell oil at the specified date in specified quantities at specified price. Futures contracts are obligatory, so once you are in, unless you reverse the position, you have to fulfill the obligation.

2. Options. These securities are similar to futures in terms of specifying the future product/security, time, and price. Yet, they are optional, so they may not necessarily be exercised. Call options are the options to buy something at a specified, price, time and date1. The holder of call options may choose whether or not to exercise them. Put options are the options to sell something at a specified price, time and date. Once again, put options may not be exercised if the price of the underlying security does not suffice the put holder (Siciliano, 89).

Hedging: Hedging refers to risk minimization attempts made by the company to assure reduced volatility and predictable future. Derivatives of different kinds are used to help the companies to achieve that goal.

1. Futures. Since futures are mandatory contracts to buy or sell something, they can be used to minimize risks. For instance, lets assume that a farmer wants to sell wheat on the market in the fall, yet is very much uncertain about the price for wheat at that time period. He could speculate, keep his fingers crossed and do nothing hoping that the price would be just what he expects (Fields, 139). Or he could sell wheat futures that would stipulate the price, quantity and means of delivery of wheat on the market. Once the futures are sold, the farmer should stop worrying about the price changes for wheat, but should rather do everything possible to grow the wheat. Even if the price of wheat falls, the farmer is hedged, since the future contract specified the price at which the farmer will sell the wheat in the future. If the price grows more than expected, he could reverse his position (buy futures for wheat) and then sell the wheat on the market. Futures thus can be applied to different securities, not just commodities that were illustrated above.

2. Options. Options work in a way similar to futures except for they provide more flexibility. For instance, if one holds Microsoft stock, yet believes that the price will fall, he could buy Put options (options to sell) covering Microsoft stock. Indeed once, the Microsoft stock falls (below the exercise price of options, thus making them attractive/in the money), the stockholder would exercise the put option and offset the losses in stock with gains in puts. As a matter of fact there are many mechanisms associated with hedging using puts and calls.

Speculating: This is when a person takes risks with hopes to generate extra profit in the future. The farmer, noted above, should he not hedge-he immediately speculates. Speculation involves a belief that the underlying security will move in a certain direction and the speculator does everything possible to augment the possible return. Thus, if a farmer, believes that the price of wheat will be high in the fall, he, besides growing his own wheat to sell in the fall, would also buy wheat futures, which would allow him to maximize the returns in the fall if his predictions are correct. If his predictions are false, he will incur great losses.

Options can also help in speculating. Thus, if one believes that the price of a security will increase, he would buy call options, or sell puts on them. If the price is expected to fall, he would sell calls or buy puts on the security.

The simplest way to manage risk associated with the change of price of a currency that needs to be bought at some future time is to buy futures on the given security. Thus, once the futures contract is bought one locks in the price of a currency (or a security, T note etc) and thus avoids any risks from fluctuations. If a currency (security) needs to be sold at some future time, one needs to sell futures contracts on the proper security (currency) to lock in the prices.

The agreed price at which the exchange of currencies in an option may occur is called the exercise or strike price. The date on which the option expires is called the expiry date.

The buyer of the option pays a premium. Upon payment of the premium the option buyer has no further obligation in the contract, but has the right to exchange currencies at the agreed Strike Price.

Usually if you are an importer to Europe or Great Britain, you’d need to sell EUR and GBP and buy USD, thus one would buy Put EUR/Put GBP or sell Call USD. If you are a British or Euro zone exporter you’d need to sell the USD and buy GBP or EUR, thus one needs to buy Call GBP or Call EUR or sell Put USD (Valentine, 252).

Upon the expiry date of the option if the strike price is OTM (out of money), i.e. it is cheaper to buy the security on the market, the option would expire worthless or lapse.

If the option is ‘In the Money’ (ITM) it is likely you will exercise your right to exchange currencies under the option.

Unlike a Forward Exchange Contract, where each party is always obliged to execute, an option contract enables you to take advantage of favorable exchange rate movements, by enabling you to buy/sell the currency at the prevailing rate of exchange rather than the strike price of the option.

To manage the risks associated with the price changes, one can do either of the following:

a. If a price of a given security (currency) is expected to fall, one can buy puts on the appropriate security. In the even the price of a security falls, one will exercise the bought put option and sell the currency/security at a price specified in the contract.

b. If a price of a given security is expected to increase and you need that security at some future time, then one can buy a call option (option to buy) on a security that will likely increase in price. Should it increase, one would exercise the contact and get it for a decent price (expected as defined by the contract).

In other instances, the options will expire worthless and one would enjoy positive changes that took place without a hedge. Please note that one can use rather sophisticated schemes to hedge securities and currencies using various options and futures separately and in a combined manner.
In conclusion, I would like to note that the US economy from a period of 1999 till 2005 had witnessed a tremendous growth, a rapid decline, and then gradual improvement. The interest rates, and the market showed almost perfect interaction in terms of the influence of one on the other. The changes of the exchange rates of the US dollar with respect to Euro and British Pound on the other hand were not clearly understood with the amount of information available on hand yet still followed general fundamental rules. The primary risk that a person faces in the situation illustrated in the essay when the economy is unpredictable just like the interest rates and the exchange rates, is being unhedged. The essay spoke of certain derivative securities like futures and options contracts and showed certain differences and similarities. One learnt that options and futures could be effectively used in hedging and speculating depending on the objectives and the position held with these securities. By being unhedged one automatically speculates and thus assumes market risk. In order to reduce the risk one can hedge with the help of derivative contracts regardless of be they futures, forwards, options, swaps, caps or any other.

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