ECON4012 Financial Derivatives

Arbitrage and speculation is an effective method, which has been used by most of the investors for reducing the risk and utilising adequate opportunity of investment. Arbitrage mainly involves detailed evaluation and consists of two simultaneous trades, which are conducted by the investors. The arbitrage method mainly needs an investor to conducted both buy and sell order simultaneously in different stocks or even market. This method mainly allows the investor to hedge against any potential risk, which might incur during the reading secession. Kahraman and Giannetti (2017) mentioned that big investors mainly use arbitrage method, as it allows the company to reduce its overall risk from fluctuating exchange rate. On the other hand, Stambaugh, Yu and Yuan (2015) criticises that arbitrage conducted without appropriate evaluation could increase risk of the investors and exponentially amplify loss. Moreover, arbitrage needs high capital from investors, as two simultaneous trades are conducted. In addition, financial institutions, hedge fund managers or companies for reducing their risk and increase return from their investment mainly conduct arbitrage.

However, speculation method is opposite of arbitrage, as it increases the overall risk of investment, which is reduced by arbitrage method. The investor in speculation method only conducts one trade, where it targets to get a profit or loss for duration of the trades. Moreover, in speculation method the investors are at high risk and do not know whether the price trend is going to change to continue with the trend. The investors mainly use the speculation during a trend formation, whereas the speculator mainly trades the market if stocks are making new higher or making new lows. Scheinkman (2014) mentioned that speciation method is mainly helpful for the investors to generate exponential return for a trend continuation market. On the contrary, Barlevy (2014) argued that speculation method could be disastrous if investor does not use adequate stop loss method.  A trader using the speculation method conducts a trade and retains the investment until it acquires a certain profit or loss. Moreover, speciation trades do not need high-end capital, as it is conducted for small duration. In addition, like arbitrage the speculation method does not need two simultaneous trades, whereas it only needs one trade, which could easily be conducted by the investor. Furthermore, small traders who are searching for an opportunity in the stock market mainly conduct speculation trade.

Arbitrage and speculation has different affects on the stock market, as one inflate process and drives the market price from actual prices. While arbitrage reduces the overall, gap between actual and inflated price. Speculative method mainly inflates or deflates the value of stock more than its actual values. This mainly increases the risk of investment and needs to be adjusted, which are mostly conducted by arbitragers. The opportunity of difference in price mainly allows the arbitrager to profit from the market and minimise its profits by initiating risk free gain (Mei 2014). For example, if the share price of Microsoft in LSE in lower than the NASDAQ Microsoft then the arbitrager sees the opportunity and initiates, long and short call, which helps in reducing the difference in gap and accordingly price the stock after converting in exchange rate. Big companies to gain risk free fain mainly use the arbitrage method, which helps in depicting the actual value of stock and help in maintaining fair price value.

On the other hand, Speculation method is mainly used by short-term traders with low capital and is effective in boosting up trend in the market. The speculators mainly wait for the stock to create a trend, which could help in generating higher return. However, due to the speculators involvement, volatility and risk of investment mainly increases. The price fluctuations in the stock also increase due to continuous buying the selling pressure. On the contrary, speculation mainly helps in creating adequate volume and liquidity in the market, which is essential for commencing continuous trades (Scheinkman 2013).

Speculators mainly conduct short-term trades, which is mainly dealt in options and futures trades. These trades are mainly conducted for benefiting from the changing price of commodity or stock prices. The speculators are not interested in owing share or commodities, as they are interested in price fluctuations, which helps in generating higher revenue from investment. Furthermore, the speculators trade in option and future trades, which provide high exposure of soaring volume share. This increased investment in options and future trend mainly allows the speculator to generate higher income from positive or negative price trend. In this context, Etienne, Irwin and Garcia (2014) mentioned that due to the intervention of speculators high-end liquidity in the market could be witnessed, which attracts more investors and increases share price of the company. On the other hand, Chan, Nguyen and Chan (2014) argued that currently in the market collective speculators mainly push the market high and inflate share price to book higher profits, which is unethical and punishable if caught by adequate authorities.

Moreover, speculators could be identified as the active traders, who act quickly on the overall news of any change in profit from the company. In addition, speculator mainly takes risks that hedgers want to shed in the market. Furthermore, speculators acts quickly when news jolts the markets and, most important, creating liquidity by pouring in enough money to allow everyone to make very large trades quickly without causing wild price swings. Gutierrez (2013) stated that liquidity is the hottest gift, which is fairly presented by the speculators for the market, as speculators increase the trading volumes. The increased trading volumes mainly allow the investors to make adequate1 investment and conduct large trades, which could increase the overall share price of the stock. Thus, speculators contribute to the rising share price of the company. Lammerding et al. (2013) argued that speculators seeks the rising tend and inflates the share price of particular stock, which in turn decreases its overall demand. Thus, rising share price is mainly corrected by arbitrage trades, which care initiated by different investor seeking the opportunity in market

Thus, it could be identified that speculators mainly inflate share price and increase the naked selling pressure of a particular stock. However, continuous speculative trade might increase risk of investment and hamper growth if adequate stop loss measures are not taken into consideration (Chan, Nguyen and Chan 2014). Thus, there are relevant laws, which prevent speculators to use unethical process for inflating share price, as it might create market bubbles. These creations of market bubble mainly hamper economic growth of the country. Scheinkman (2014) stated that speculative trend conducted in the real estate industry created a market bubble and augmented the economic crisis of 2008 which liquidated majority of the financial market all around the world

Arbitrage trades are conducted among different stocks, where investors are mainly able to profit from the difference in value the same stock in different market. Furthermore, the arbitrager mainly sells a stock in one market and buys the same stock in other market, which mainly helps in achieving equilibrium prices of the stock. In this context, Mei (2014) stated that arbitrage opportunity mainly occur due to inefficiencies in the market to compensate the changing share price of the company. On the other hand, Bradbury, Pratson and Patino-Echeverri (2014) criticises that arbitrage method mainly loses its friction during an economic crisis, as the whole market is falling and actual value of the stock could not be determined in the short trend.

However, arbitrage method is mainly conducted by traders for ensuring that prices do not deviate from the fair value for longer duration, as it might increase bubble in the market, which could be drastic for the economy. Nevertheless, the increment in technology has mainly limited the identification of price deficiencies and hampered investors to profit from the arbitrage opportunity. Nonetheless, banks are mainly able to profits from the arbitrage opportunity, as they are able to identify price deficiencies in currencies and other stock value. Galichon, Henry-Labordere and Touzi (2014) mentioned that banks with currency arbitrage are still able to generate higher revenue from their investment. However, the changing technology has mainly limited banks to create high-end profits from the arbitrage opportunity.  On the other hand, Acharya, Lochstoer and Ramadorai (2013) argued that reduction in international trading laws has mainly limited the benefits of investor, who were able to generate risk less gains from initiating arbitrage trades. The arbitrage method is the necessary force in the financial market for effectively reducing the market inefficiency and eliminates price deficiencies. Moreover, with the help of latest technology the arbitrage opportunity is mainly eliminated with the matter of seconds and prolonged opportunity could not be detected. This reduction in overall price deficiencies could effectively help in pricing the stock according to fair value and reduce inflated prices. Karolyi and Taboada (2015) mentioned that financial institution to gain risk less profit mainly seizes arbitrage opportunity.

Table 1: Depicting the intrinsic value of the opportunity

(Source: As created by the author)

From the above table intrinsic value or expected value of opportunity could be identified, which could help the investor in making adequate investment decision. Moreover, the intrinsic value of the opportunity is £3, which instigates that investors would not be interested if they pay more than £3. Being a risk neutral investor payment more than £3 is not acceptable, while payment could be conducted if value is less than £3. Schlag (2013) mentioned that expected value mainly uses a probability function, which helps investors to identify the maximum amount paid for an opportunity.  On the other hand, Adesi, Engle and Mancini (2014) argued that expected valuation could be conducted wrong if any one of the factors is let out, as it might increase risk of investment. Moreover, the expected value is mainly an anticipated value, which could be obtained by multiplying the possible and probable returns from an investment. Furthermore, the expected value mainly allows the investors to identify relevant outcomes, which could arise from a situation.

In addition, with the help of table 1, overall expected valuation of the scenario could be identified, which is been used to pin point the relevant income from investment. However, the table mainly depict the risk and minimum level of the investment, which could be conducted for attaining the desired result. Barlevy (2014) mentioned that in real-life scenario probability union are effectively used by investors to identify the minimum amount of investment, which could be conducted after analysing the risk of investment. On the other hand, Kahraman and Giannetti (2017) argued that uncertainty to fluctuation in the market is mainly not accommodate in investment, as it could be seen in 2008 economic crisis, where investment value declined to the lowest point. Furthermore, EV is mainly a statistical concept, which allows the investor or executive to make adequate decision during the term of uncertainty. However, these derivations mainly help the investors identify the expected monetary value from their investment.

Table 2: Depicting the delta of long put

(Source: As created by the author)

The delta as depicted in the books was negatively depicting the impact o share on premium. Delta is mainly used to identify the adequate option prices, which could be traced by investors and minimise risk. The derivation of delta in long put is mainly negative as the investors are selling the stock and premium needs to move negative to the actual price action. Option pricing method is an effective measure, which is been used by investor to improve their ability to hedge their exposure in times of uncertainty and generate higher revenue from investment. The determination of delta is mainly essential as it allows the investor to identify the minimum change in value of option if actual stock price changes (Kallsen and Muhle?Karbe 2015).

Table 3: Depicting the delta of Short put

(Source: As created by the author)

The above table mainly depicts the delta of short put, which is valued at positive 1. This positive valuation of the overall delta short put is mainly conducted, as investor will mainly be selling the put, while betting for price action to move up. These increments in price action will also respond positivity in the option premium. The investment using short put are mainly able to gain exponentially as premium are being collected the put sellers. Liu, Chen and Ralescu (2015) mentioned investors mainly conduct that put selling, as it requires less capital and provide many opportunities for increasing its profitability.

Table 4: Depicting the delta of long call

(Source: As created by the author)

The delta of short put and long call are positive and depicts similar native of the option. The positive delta mainly indicates that increment in price could increase value of the investors and decrease when value declines. Both Short put and Long call has a positive delta, which only indicates that price action moving forward could increase the valuation of the option. In addition, the long call is mainly initiated if the investor is keen on an uptrend price action from its invested stocks. However, initiation of long call option mainly instigates a premium amount, which needs to be provided by the investor regardless of exercising the option or not (Mei 2014). The delta of long call is mainly calculated at 1.03, with an assumption of 100 shares per contract.

Table 5: Depicting the Delta of Short call

(Source: As created by the author)

The above table 5 mainly depicts the delta of short call to be -1.03 with an assumption of 100 shares per lot. Both short call and long put delta is mainly negative, as declining price action mainly increase value of these call. Investors mainly conduct the short calls, when relative decline in price action could be estimated. Muravyev (2015) mentioned that due to the amount of premium paid in short call trades investors mainly rely on buying puts rather than short calls for investment. Furthermore, the relative declines in share price mainly allow the short call option increase in value and provide higher benefits to the investors.

Figure 1: Depicting the value of call of price rises to £70

(Source: As created by the author)

Table 6: Value of the call of price level £70 at the end of the period

(Source: As created by the author)

Table 6 and figure 1, mainly depicts the value of call option, when the price of shares rose to £70 from exercise price of £60 and current price of £50. The value of call option after the calculation is mainly depicted to be at £10. This value could only be derived if share price is relatively higher than the exercise price. In this context, Devos, Elliott and Warr (2015) stated that investors by using the option method are able to hedge their actual investment from potential loss in the short term. However, Chesney, Crameri and Mancini (2015) argued that without adequate research, initiation of option trades could reduce friction of hedging process, which in turn might increase its portfolio risk.

Figure 2: Depicting the value of call of price rises to £30

(Source: As created by the author)

Table 7: Value of the call of price level £30 at the end of the period

(Source: As created by the author)

Figure 1 and table 7 mainly depicts the value of the call if price level of the share fall from £50 to £30 with the exercises price of £60. The trade will not be exercised as the overall price has mainly declined over the period and call option mainly regulates a rise in price, while rejecting the deicing share price (Ge, Lin and Pearson 2016). Thus, valuation of call option will be £0 if share price declines to £30. Many companies mainly use the call option as an effective measure to hedge its exposure in the capital market against the negative price movement of the stock.

Table 8: Depicting value of hedge ratio

(Source: As created by the author)

The overall hedge ratio could be identified in table 7, which could mainly help the investor to adequately adjust the portfolio for hedging its risk. The hedge ratio is mainly depicted to be at 0.25, which is mainly derived after calculating returns from two levels of call option, while dividing it by the different of maximum and minimum price fluctuations. This derivation of hedge ratio mainly allows the investor to hedge its portfolio against any threat, which might arise from price fluctuations. Hu (2014) mentioned that hedging process is an effective measure, which allow investors to reduce risk and maximise return from investment.

Table 9: Stocks bought to hedge the portfolio

(Source: As created by the author)

From the overall table 9, portfolio consisting of shares and option call could effectively be identified. First, the investor is mainly long in the company with 0.25 shares, which depicts if the share declines, value of the portfolio also reduces. However, the initiation of a short call option could be an effective as it might help in compensating investor for the decline price from level of £50 to £30. Thus, the following portfolio could be maintained where call option could be sold and the portfolio will consists of 0.25 short call and 0.25 assets held. Flint, Lepone and Yang (2014) stated that identification of adequate hedging needs is essential as over or under hedging could be dramatic for the investor and hamper its investment capital.

Table 10: Value of your portfolio if the stock price is £70 at the end of the period

(Source: As created by the author)

Table 11: Providing present value of the portfolio returns if Price rose is £70

(Source: As created by the author)

Table 10 and 11 mainly depicts future value of the portfolio and its present value, after making adequate adjustments. The price mainly rose to £70, which increased the overall share value, while the short call was not initiated only its premiums were paid. Thus, a profit of £17.50 was initiated, while deduction for premium of call option came to £10, which projected a net profit of £7.50. The overall hedging process mainly helped in reducing risk of the company to lose its fixed income of £7.50 from the overall trade. (Muravyev and Pearson 2016) This conformation of the overall return mainly helps in reducing risk and increases profitability of the company. Lastly, the Present value of the returns generated by the investment is calculated at £6.88.

Table 12: Value of your portfolio if the stock price is £30 at the end of the period

(Source: As created by the author)

Table 13: Providing present value of the portfolio returns if Price rose is £30

(Source: As created by the author)

Table 12 and 13 mainly states the overall position of the portfolio, if share price mainly declines to £30. The value of portfolio will still be £7.50, as it is perfectly hedged against all odds. This reduction in overall risk from falling prices has mainly helped the investor in compensating any price action taken by the capital market. The present value of the stock will also be at £6.88, as the return of portfolio has not changed. Ni and Pan (2015) mentioned that present value of future returns is mainly conducted by the investor to identify the adequate investment opportunity, which could pin point the highest return after the multiplying it with the discounting factor.

Table 14: Value of call if priced is fair

(Source: As created by the author)

The relevant price of the call option after detecting the profitability generated from option trades could be identified from table 14. The relevant fair price of call option is mainly detected to be at £5.62 for current stock price of £50 with strike price of £60. Hui and Fong (2015) stated that option price is always low, which allows the investor to hedge its exposure and mainly maximise return from investment. However, Carr and Wu (2016) argued that with the help of options speculators in the market have risen exponentially, which increases volatility in the stock.

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