Discuss about the“The Use of Derivatives in Portfolio Management”.
Investment is the mechanism through which capital is allotted to any business or production process in order to expand and generate benefit for the future (Ahmed and Zlate 2014). Based on the sectors of goods and services being produced the type mode of investment vary. In the contemporary world of market economies, volatility and fluctuations in value are common phenomenon. This conforms to the risk factors that are associated with investment decisions or plans (Allen 2012). This has been the source of derivatives to appear in the market and guide investment design in order to minimize the through risk management.
This paper reinforces the instrumental role played by derivatives in the financial market that further facilitates the investment environment in national capital market. The report picks up two countries China and South Africa and prepares a brief case study shedding light on the financial market performances keeping relevance to the theoretical discussion. China being world’s largest economy in terms of PPP (Purchasing Power Parity) owes much importance in the world capital market that is determined by very condition of the national financial management system. South Africa having strong financial background is largest economy of Africa making a contribution of 35% to the gross domestic product of the continent. How well these two countries have been able to manage and sustain healthy financial system and what are the factors that create deviation from stability is the main area of concern here.
General report format has been followed to prepare the paper and it earns the basis from secondary research including relevant statistical information
Derivatives In Portfolio Management
Portfolio management is a scientific tool that ensures proper decision making regarding investment (Brown 2012). It helps determine the policy mix, allocation of capital or assets, matching investment decision to objectives and assessing risk embedded in investment structure (Bodie, Kane and Marcus 2014). In managing risk associated with investment, derivatives play significant role. Derivatives are process of trading in near future involving a contractual agreement between two parties based on any financial assets or securities. The contract includes transaction of some commodities or assets in future date at the price fixed at current time. The fixed price at which the contract is being made might be greater or lesser than the future market price and this fluctuation is the source of derivatives’ value in the financial market. Most common instruments that drive the exposure to risk factors are rate of interest, stocks & shares, currencies inflation and market indices. Derivatives are mostly encountered on these factors. In the presence of market volatility price fluctuation and subsequent fluctuation in the value of assets are regular phenomenon (Chance and Brooks 2015). In such case buying derivative on the stocks shares can pre-assign a threshold of return from the underlying assets. Now if the market force leads to higher price in future time than the price at which derivative contract was made, then higher gain is confirmed and if price falls below that the buyer looses out as he has to pay out for the assets whose value fall.
Common derivatives that are widely used in financial system of any country are forward contract, future contract, option contract and swap (Bezzina and Grima 2012). In the forward contract system the agreement is made at present based on today’s price and paid in future period. The information in the contract is shared by both the parties involved in the contract that may or may not be revealed publicly. Here exchange is not an intermediary component to the transactions taking place between parties which results to credit risk between counterparty.
Future contract are almost same as forward contract the only difference being the exchange as intermediary. Seller and buyer don’t encounter in personal contracts but in contracts based on exchange (Cvit, J. and Zhang 2013). Here counterparty risk of credit is negated due to settlement procedure of loss or gain from the contract that takes place on a daily basis.
Option contract differs a bit from the above two kind of derivatives. Here one party bears the obligation of buying or selling at a later date while the other has the option to make own choice at the cost of a premium charge. Two types of call exist. One being call and the other being put option. While the former confers right to buy something, the later allows to be sold in future date with pre-fixed price without any obligation. Options are also traded on exchange (Cvit, J. and Zhang 2013).
Swap is one of the complicated derivative existent in market that allows exchange in form of cash flows. Switching between uncertain and certain cash flow is common example in swapping like swapping interest rates from fixed to floating (Fischer and Fröhlich 2013).
Investment opportunity in China is pretty rich and that further is backed by the fact that the country is third largest recipient of foreign direct investment even overtaking USA (Ramasamy, Yeung and Laforet 2012). It is health of capital market consolidated by growing economic factor and political co-operation through policy making and administrative execution.
Factors Boosting Investment:
The most important reasons behind influx of higher investment in Chinese economy is the bigger consumer market that China provides to the world of investors (Ahuja and Nabar 2012). As per the World Bank source, the country is home to 13 billion people of the world of 7.1 billion people indicating almost 20% of world population. This population size is crucial component facilitating growth of consumer market and existence as well as expansion of businesses.
Multiplicity of goods produced in the Chinese territory, leads to presence of diversified market which is attracting to investors to induce more profit. The infrastructure of the country is advanced and adaptable to growing market needs with technological as well as manual skills. The country also has evolved the networking with other countries by reducing the geographical boundaries with growing transportation. Manufacturing, transportation and oil market are China’s important sector that has tapped potent for higher profit. Market pattern for Chinese Oil Companies is an upward rising with a forecast of further rise. This consolidates the ground for Chinese manufacturing and transportation to achieve growth and development.
Another contributing factor to Chinese economic growth has been the huge urbanization process taking place over time. According to 2011 data released by National Bureau of Economic Statistics, china’s rural population (656 million) is exceeded by that of urban (690 million). The growing urbanization opens scope for growth in infrastructure sector, business and services. The more urbanization implies transformation of the society toward specialization from self-sustainability (Watson et al. 2014). Specialization as the tool of channelizing the power of capitalism creates wealth in the society with the help of educated and skilled labors. With improving per capita wealth, income also rises that further creates demand and allows business to set up and sprout up over time with creating source of gain for Shareholders.
Even though from the existing economic condition of the country, the investment environment seems pretty positive with potent of rewards, the associated risk factors to any kind of investment should always be assessed and considered so that they can be handled with due care without letting them deter investment proceedings. China has free market economy that has evolved from the principles of free market. Leading a market like that amidst communist political presence calls for policies to ascertain the public welfare. The political influence has stronghold in the overall market capitalism.
Share Market Condition:
China has two national stock exchanges, Shanghai Stock Exchange and Hong Kong Stock Exchange (Creti, Joëts and Mignon 2013). The former contains concentration of large corporate listings and conducts twice the transactions take place in the Hong Kong Stock Exchange which mostly deals with small enterprises and startups hence bigger and more active. Together both the exchanges consists one of the world’s largest market capitalization and the growth has started mostly after the reform in stock exchange in the year 1990. Releasing untradeable shares of state driven enterprises for trading, increasing stock market operated mutual funds, more liquid money market are few of the reason to explain the growth which has been volatile due to existing stock market bubbles sourced from combined effect of China’s stability in growth and optimism of investors.
Advantages Of Investment
Apart from the market size and population hike, investment in China is advantageous due to some other factors like low labor costs, governmental policies that encourage special economic zones in the coastal areas (Capaldi 2013). Among the disadvantages one can mention changing context of law, corruption and complexities in the bureaucracy and administrative levels, lack of transparency, improper intellectual property rights, difficulty due to cultural differences encountered by the foreign business entities, less developed middle management and high turnover rate of staffs. Another major issue is volatility of currency value. The overall condition and performance of the Chinese stock market as well as investment get much impacted by the fluctuation of the exchange rates. To sum up it can be stated the competiveness, stability, regulatory environment, openness to trade additively contribute to build up the voluminous growth incorporating investment opportunities (Ding, Guariglia and Knight 2013).
Share Market Condition:
JSE Securities Exchange, the only licensed and full service securities stock exchange entity in South Africa shapes the financial structure of South African sophisticatedly acquiring 18th highest position all over the world in terms of market capitalization. JSE conducts listing, trading, clearing and settlement services regarding equities, interest rate and financial informational products. Proper budgetary policies of government in the country has been able to evoke cross border bond market with reasonable spread of risk stemming from rising government debt and high amount of current account deficit that earned the country poor rating (Jadhav 2012.).
The investment that the country recorded rose to 3.2% of the gross domestic product with contrast to the 2.7% global average. Private equity fund grew up to $103 billion. Investors are willing to take chance on the start-up companies that mostly deal with industries related to internet. Due to the growing trend of online shopping and business, small start ups are sprouting with opportunity of investment mostly focused in healthcare, technology and communication, green business that is energy and technology which is renewable as well as sustainable. OPIC is an assisting body that provides guidance regarding guarantee and grant of loans, insurance of risk in political domains to the US investors willing and already investing in South African market (Kavussanos, Visvikis and Dimitrakopoulos 2014). South Africa came into a bilateral agreement with USA in order to create a protocol that provide investment funds of $120 million to invest in equity within south and southern Africa. Even with existence of several positive factors in the South African economy, initially it has faced lots of challenge in order to attract moderate foreign direct investment. The situation took a turn from 2005 onwards. The ranges of investments include buying majority share of Absa Group Ltd. by Barclays, deals between Britain based Vodafone and South Africa’s Vodacom, acquiring Netbank by HSBC and acquisition of Massmart Holdings by Wal-Mart have been major inflow so far. Rich sports events that are organized here like world cup of football and cricket and emerging film industry have enormous opportunity for investment to be made.
Amidst the few risk factors that endanger further growth of investment are the stagnation of the economy, presence of higher crime level in the society as well as social unrest stemming from control risk and subsequent food price hike. Deficiency in regulatory changes and politicization of the existing policies are one of the key factors driving down the confidence of business investors. The country has poor defense and protection system against cyber crime that acts as biggest turn off.
Potential Investment Sectors:
The enriching natural resources (coal, gold, nickel, platinum and uranium) of the country and diverse market that have strategic locations geographically implies for potent of more investment. It attracts attention of oil and gas sector from various exploration enterprises worldwide. Moreover the growth of middle class indicates growing spending power. The country comes with innovation and continuous research and development that is evident in the growing infrastructure. Adherence to sustainability implied through green technologies reduced adverse impact on the environment and created more jobs (Borel-Saladin and Turok 2013). The country has strong banking sector and legal and telecommunication sector are contributing to the total share of service that the country produce.
The country is blessed with macro- economic stability that is over long period of time there are not substantial fluctuation in the performance of economic indicators. Supply of skilled labor at cheap price confirms the low cost of production at least compared to European countries. The cost of labor in manufacturing sector is one third less than that of European countries which further portfolio investments as well as direct investments in the country. The political stability is ascertained by compact and systematic legislation with provision of promotion training, development and enhancing of skills to match world class competences The ability of the country to meet prospective of the investors and traders made it a destination for trusted investment (Kevin 2015). The incentives provided to investors and interventions made by financials in industrial sector expanded volume of investment as well as boosted the trade and commercial activity. The country has strong tourism industry sourced from the drop-dead scenic beauty it has possessed and it has become business destination revolving around tours and travels (Saayman, Rossouw and Krugell 2012.).
The discussion can concluded with the fact that investment is important fact for bringing and encouraging growth in the national economy. Investment is that capital which further creates capital by being invested to expansionary business or production processes. With presence of volatility in the real world economy, risk is inevitable and requires to be successfully managed in order to promote benefit as per the plan at the heart of investment design. Derivative takes the responsibility of the risk minimization and almost every country of world has presence of derivative market in the financial systems. China being largest economy of the world carries huge potential for investments in production and business operation. The growing urbanization and population pressure create room for greater market for goods and services that further encourages business to be set up to cater to this growing demand. South Africa is not that large in terms of market size compared to China but the economic structure of the country has shaped domestic economy in a way that has been able to attract world class investments with becoming Africa’s most important destination ground for portfolio investments (Marais 2013). Investment though financial component but the success of it depends upon how they can breathe amidst political social and economic set up of the nation which additively brings forth the risk associated in investment plans and programs. Hence detection and removal of them through strategic policy making and execution are quite important to maintain economic expansionary growth that will propel the nation toward development.
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