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Investment Analysis And Portfolio

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Question:

Discuss about the Investment Analysis and Portfolio Management.
 
 

Answer:

Introduction:

The overall assignment mainly depicts the use of adequate financial derivatives by portfolio managers to improve they all return from investment. Financial derivatives mainly comprises of 4 different types which allow it get investors to increased exposure in the market. The use of derivative mainly helps investors in hedging their overall exposure in the capital market. These derivative options also allow investors and Portfolio managers to adequately apply relevant investment theories and make exponential gains. The whole assignment mainly evaluates under hypothetical situation where all the four different types of the derivative instrument is evaluated and analysed. Lastly, the overall recommendation for portfolio managers, which could help in improving the overall give ability to increase profits by using different derivative instruments.

Describing the four major financial derivatives used in portfolio management:

There are different types of financial derivatives, which could be used by portfolio management these derivatives are depicted as follows.

Forward contract derivative:

Forward contracts derivatives are mainly identified as its simplest form of decorative instrument, which are applicable only for today. This is one of the oldest forms of contract, which are conducted by investors to hedge or control losses in future. The forward contract is mainly an agreement, which is made between two parties regarding sale of a product or instrument in later date. This instrument was widely used before the invention of future contracts. Many investors are still using the forward contracts effectively until day to conduct adequate exposure in the market. Berezhnoy et al. (2014) stated that forward contracts are mainly conducted between two parties or counterparties, where there is no exchange responsible for the transaction.  On the other hand, Bodie (2013) argued that use of future contracts does not allow or oblige the other party to keep commitment regarding the contract.

Details of the forward contracts can be kept secret from the public, as it is not mandatory to provide relevant details regarding the transaction.  Forward contract mainly allowed investors to effectively control the rising prices and reduce any kind of losses, which might income from volatile capital market. Forward contract are currently used in currency exchange, which are conducted by the bank (Dutta 2016).

 

Example of a forward contract:

Particulars

Value

Value

AUD payment

1,000,000

 

Current AUD/USD Rate

0.75

= 1,000,000 * 0.75 = 750,000

Forward Contract Rate

0.73

= 1,000,000 * 0.73 = 730,000

Expected AUD/USD Rate

0.72

= 1,000,000 * 0.72 = 720,000

Reduction in losses             

 

10,000

A firm using AUD USD rate for reducing any kind of volatility in the exchange market for the payment that needs to be converted in USD. The overall use of forward contract mainly helps in reducing the losses by $10,000.  This was made possible by using the forward contract, which fixed the overall exchange rate and reduced any kind of risk that may be faced by the person exchanging the payment. This mainly helps investors to fix their overall exchange rate, which help in reducing any kind of risk from capital market (Fat and Pop 2015).

 

Future contract derivative:

Future contracts are a viable transaction, which is conducted with the help of an exchange and allows investors to make adequate investment decisions. This type of contract is mainly similar to forward contracts where sale of a particular commodity is conducted on a specified future date.  However, the prices of that commodity are fixed in the current date, which helps in reducing any kind of price volatility that might think in later date. Future contracts use exchanges and are conducted through a medium, which allows and obliges different parties to fulfil their part of the bargain (Frino, Mollica and Webb 2014). Future contracts conducted on a pre designed format, which needs to be followed by an investor while conducting investments and transaction. Furthermore, the future contracts mainly follow a daily settlement contract format, where all the gains and losses are realised on the given day after commencement of the trading day. In future contracts buyers and sellers does not form any kind of contract enter or enter in an agreement, they simply transact with the exchange. Thus, exchange is mainly responsible for all the transactions conducted under the future contracts and is liable to pay the parties.

Example of a future contract:

Particulars

Value

Value

Buying Gold

100 ounce

 

Current Gold price

1258.63

= 100 * 1258.63 = 125,863

Future contract

1265

= 100 * 1265 = 126,500

Expected Price

1350

= 100 * 1350 = 135,000

Reduction in losses

 

8500

From the overall evaluation of Future contracts example it would be understood that reduction of $8,500 worth of value in Gold buying bus conductor. This reduction was mainly achieved by using a futures contract, which help in locking the current prices of the gold and allowed investors to effectively reduce extensive losses in buying the gold commodity. This type of extensive used mainly allows investors to effectively improve their current financial exposures in the market (Hou 2017).

 

Option contract derivative:

Option contract derivative is the third option, which is used by investors to effectively Hedge the exposure in the capital market.  The option contract mainly allows investors effectively hedge against any kind of future volatility that might be expected by them. There is simply two types of options, which are used extensively by investors first is the call option second is the put option. Call option is mainly a right, which allows investor to buy something at later date at a given price (Johnson 2015). However, put option mainly allows investors to sell something at later date at a given price. Furthermore, option contract provides an effective choice to the traders as they could conduct the trade in future date or not.  This relevant choice mainly allows investors to effectively speculate the market and reduce any kind of extensive losses, which might be conducted during the investment Period.

The option contract is mainly conducted with the help of an exchange, as adequate measures need to be taken when option trades are conducted. Option trades mainly allow investors to increase their exposure in the market with relevant small premium provided by them.  The investor at the cost of the premium could ignore any losses that might incur in future. Currently option contracts at high demand among investors, as it allows them to produce any kind of risk and increase their investment capacity. Option contracts is conducted based on prices related to a certain instrument, these options are conducted based on future price volatility to increase their gains from investment. The main expense, which is incurred by the option contractors, is the premium amount that they are charged for exercising the trades. The use of premium amount mainly allows investors to reduce the overall capital blockage, which were previously conducted in future contracts and help to increase their investment capacity. Khumawala, Ranasinghe and Yan (2016) argued that due to the option trading system speculators and novice traders are able to inflate and create volatility in the market, which in turn reduces market efficiency.

Example of a option contract:

Particulars

Value

Value

Selling shares of Apple

1000

Buying Put Option

Current price

152.96

1000 * 152.96 = 152,960

Strike price

150

1000 * 150 = 150,000

Premium

5

1000 * 5 = 5,000

Expected Price

140

1000 * 140 = 140,000

Actual Price

149

1000 * 149 = 153,000

Reduction in losses

 

145,000 -149,000 = 4000 loss

According to the example portrayed in the above table, option price of Apple did not follow to the relevant speculation of $140. This mainly increased the losses of the investor my $4,000 as the investor invested in a strike price on $150 and premium of $5.  This mainly indicated that prices of Apple went below $145 then the investor could get good return from investment. Thus, the price only went down by 149 dollars, which resulted in a loss of $4,000 by the investor.  If the investor does not choose to take the trade then he has to pay premium of $5,000, which is greater than the loss that was incurred (Lievenbruck and Schmid 2014).

 

Swaps derivative:

The most complicated type of contract in derivative is the swap contract, which involves adequate speculation and relevant research before conducting the trade. Swap derivatives are mainly conducted on different participants where one investor uses the fixed rate for a floating rate interest to increase its overall gains from investment. The swap trades allow investors to swap interest rates and underlying currency for increasing the overall financial income. With the help of swap trades companies are able to avoid foreign exchange rates, which might hamper the overall return from investment. Swap trades mainly conducted by private contractors to negotiate between two parties to get the relevant benefit from the spread (Neuberger 2016). Swap trades are mainly conducted by investment bankers between the two parties, as it helps in reducing any kind of risk from investment. However, swap trades mainly increase the overall risk from currency exchange rate, which might hamper and reduce any kind of income that might be generated from the investment.

Amount to be invested

 

100,000

 

Interest rate 1st country

Interest rate 2nd country

Exchange rate

4

0.25

Savings

8%

3%

Loan

9%

4%

Invested amount

400,000

 

Interest received

32,000

 

 Converted to 2nd country

8,000

 

Invested amount

100,000

 

Invested paid

3,000

 

Total income

5,000

 

From the overall evaluation of the example, it could be understood that Investment in first country could eventually help in gaining interest of 32000, which converted to 8000. In addition, a loan in second country code eventually attracts a payment of 3000, which will make a total income of 5000 for the investor.  This type of seed is mainly identified as a swap trade, which is conducted by companies and investors to increase their overall investment (Norden, Buston and Wagner 2014).

Analysing the desirability of using in derivatives in hypothetical situations with adequate critics:

After the overall evaluation of the four different types of derivative instruments option contract and futures contract is mainly identified, as the most viable investment option. As this will allow investors to conduct trades without any relevant risk. Thus, the hypothetical situations in the above examples mainly depicts that use of option trading and future trading could eventually help investors in making investment decisions and effectively conduct trades in the market (Pinzur 2016). However, forward contracts are elements used in the market, which should be avoided, by investors and Portfolio managers in their portfolio construction. In addition, swap trades also be avoided by the portfolio managers, as it only comprises of swap interest rates, which is a complicated endeavour conducted by companies. Thus, the use of future and option contracts could eventually help a portfolio manager to conduct and deliver the required rate of return from the investment.

Recommendations and Conclusions:

After the overall evaluation of the assignment, it could be understood that derivative contracts allow investors to adequately invest in the market. Investors to conduct relevant transactions in the market mainly use the derivative instruments such as forward, future, option, and swap contracts.  However, the use of future and option contracts is relevantly higher in the market as it provides an effective measure for all the investors to increase their profitability. Therefore, it could be understood that the use of option contracts is mainly and adequate investment instrument, which could help investors in conducting high end trades. Thus, portfolio managers needs to use option and future contracts to effectively conduct and prepare their portfolios and obtain the relevant return from investment.

 

References

Berezhnoy, V.I., Berezhnaya, E.V., Berezhnaya, O.V., Telnova, N.N., Ostapenko, E.A. and Shatalova, O.I., 2014. Methodology of application of the systematic and derivative analysis of the conditions of the local raw materials market development. Life Sci. J, 11(8), pp.600-602.

Bodie, Z., 2013. Investments. McGraw-Hill.

Dutta, A., 2016. A Comparative Study of Efficiency of the Market-The Pre and Post Derivative Trading Period in India.

F?t, C. and Pop, F., 2015. The Evolution of OTC Interest Rate Derivative Market: The FRA Case. Procedia Economics and Finance, 32, pp.1154-1162.

Frino, A., Mollica, V. and Webb, R.I., 2014. The Impact of Co?Location of Securities Exchanges' and Traders' Computer Servers on Market Liquidity. Journal of Futures Markets, 34(1), pp.20-33.

Hou, Q., 2017. Research on the Development of Derivative Products of Comic and Animation Advertising Video of Local Characteristic Culture. DEStech Transactions on Social Science, Education and Human Science, (icsste).

Johnson, C.A., 2015. Moving from Soft Law to Hard Law in the Derivative Area: A Case Study. The Changing Landscape of Global Financial Governance and the Role of Soft Law, p.258.

Khumawala, S., Ranasinghe, T. and Yan, C.J., 2016. Why hedge? Extent, nature, and determinants of derivative usage in US municipalities. Journal of Accounting and Public Policy, 35(3), pp.303-325.

Lievenbrück, M. and Schmid, T., 2014. Why do firms (not) hedge?—Novel evidence on cultural influence. Journal of Corporate Finance, 25, pp.92-106.

Neuberger, A., 2016.Role of risk management in the oil and gas industry: the effect of derivative contracts used to manage oil and gas price risk on stock price sensitivity in the oil and gas industry during a period of declining oil and gas prices.

Norden, L., Buston, C.S. and Wagner, W., 2014. Financial innovation and bank behavior: Evidence from credit markets. Journal of Economic Dynamics and Control, 43, pp.130-145.

Pinzur, D., 2016. Making the grade: infrastructural semiotics and derivative market outcomes on the Chicago Board of Trade and New Orleans Cotton Exchange, 1856–1909. Economy and Society, pp.1-23.

Rauterberg, G.V. and Verstein, A., 2014. Assessing transnational private regulation of the OTC derivatives market: ISDA, the BBA, and the future of financial reform.

Rifai, N., Syaukat, Y., Siregar, H. and Gumbira-Sa-id, E., 2015. Factors affecting increased export of Indonesian palm oil and its derivative products to the United States of America market. Journal of ISSAAS (International Society for Southeast Asian Agricultural Sciences), 21(1), pp.137-146.

Roukny, T. and Battiston, S., 2014. A network analysis of the evolution of the German interbank market.

Salazar, M., 2014. Swapping More than Regulations: Reexamining the Goals of the Dodd-Frank Act and the European Market Infrastructure Regulation on Over-the-Counter Derivative Markets. Sw. J. Int'l L., 21, p.217.

Sharma, P., Lee, S., Guo, T., Irwin, D. and Shenoy, P., 2015, April. Spotcheck: Designing a derivative iaas cloud on the spot market. In Proceedings of the Tenth European Conference on Computer Systems (p. 16). ACM.

Takino, K., 2016. An Equilibrium Model for an OTC Derivative Market under a Counterparty Risk Constraint.

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