Free Custom «Risk Management» Essay Paper

This paper discusses the role of exchange traded currency options in risk management. In the recent times, risk management has become an essential topic of concern in trade patterns in the undertakings of countries more so in the areas of investment, banking and other decisions that may be undertaken by private companies. Currency option is a type of contract that gives the owner the right of buying or selling currency at a certain price in a particular time period. Nevertheless, the owner is not obligated to trade currency. In this case, investors may evade the risk of foreign currency by purchasing a call or put currency option. Exchange traded currency options make use of such aspects as standardized contracts taking an account of the principal currency, the exercise price and the ending date. This system of trade is currently carried out in Philadelphia in a stock exchange popularly known as NASDAQ and the Chicago Mercantile Exchange (MCE). Options are traded based on the U.S. dollar parameter in FINEX, a branch of the New York Trade Board. Generally, exchange traded currency options are employed in hedging currency positions with an aim of alleviating risks that may be incurred during exchange. The fundamental advantages of traded currency options may be the capability of locking in a selling or buying price, which as a result permits the sellers or buyers to hedge against possible rises or falls in prices. In addition, exchange traded currency options are typically deemed liquid investments due to the fact that they may be sold or bought fairly without difficulty.

 

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Risk management has in recent times become a vital topic of concern in trade patterns in the undertakings of countries more so in the areas of investment, banking and other decisions that may be undertaken by private companies (Poitras 2002, pp. 12-16). Furthermore, this topic has been of great use to the financial engineers in their quest to develop the level of risk in the business enterprises by use of linear combinations, eventually building up to structured products and use of professional trading systems, which upon their interpretation give a meaningful conclusion about risk analysis (Marshall 2000, p. 9).

Introduced in 1982, exchange traded currency options make use of such aspects as standardized contracts taking an account of the principal currency, the exercise price and the ending date (Hoque et al. 2008, p. 98). This system of trade is currently carried out in Philadelphia in a stock exchange popularly known as NASDAQ and the Chicago Mercantile Exchange (MCE) among others. Options are traded based on the U.S. dollar parameter in FINEX, a branch of the New York Trade Board. Several bodies are put in place to regulate the undertakings of the trade in these securities, such as the Securities and Exchange Commission that is mandated to keep check on the foreign currencies being traded. The other body is known as the Commodity Futures Trading commission, which is in charge of currencies traded that are not securities exchanges. Upon its introduction in 1999, the Euro trades in the market, although not a major currency, those that dominate include the U.S. dollar, Deutsche mark, Canadian dollar, Japanese yen, British pound and the Swiss franc with the markets in Montreal, Amsterdam stock exchange, Philadelphia and Vancouver. In addition, the London stock exchange trades the British pound integrating leverage (Wystup 2006, p. 8). These foreign exchange options have maximum returns and the low risk. This is achieved by setting a low limit on the profit making aspect to accommodate a low possibility of risk occurrence.

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According to studies, the majority of investors have recognized the various benefits by employing exchange traded currency options. The fundamental advantage may be the capability of locking in a selling or buying price, which as a result permits the sellers or buyers to hedge against possible rises or falls in prices (Hoque et al. 2008, p. 54). Additionally, exchange traded currency options are typically deemed liquid investments due to the fact that they may be sold or bought fairly without difficulty. This is viewed to be a further advantage to the sellers or buyers who desire to uphold their assets liquidity. Studies have revealed that sophisticated traders frequently utilize exchange traded options with an aim of speculating on probable trades. Through this, traders are able to benefit from their perceptions regarding the future trend of a currency option and they do this by locking in prices beforehand. For instance, buyers might try to buy exchange-traded stock options at much lower prices rather than the quoted ones. This may result in considerable profits reliant on the shifts in the markets. Another advantage of the exchange traded currency option is that they may offer the capability of generating income via the employment of strategies such as short selling in addition to writing options against subsisting shares (Chisholm and Chisholm 2010, pp. 65-70).

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Exchange traded currency option contracts are usually bought or sold on regulated exchanges. Nevertheless, their terms are typically dictated by the principles, which are relevant to such type exchanges. Generally, exchange traded currency options are transacted via discount brokers, full service brokers or advisors who offer trade operation services (Coyle 2000, p. 98). It is however important for the investors to seek further market advice on the risks involved with certain kinds of options before making various investments decisions.

According to Pong Wong (2002), the purpose of prevarication of the currency decision is two different basis of insignificance to the subject: the degree in the cost and risk in the exchange, and the marginal efficacy of the firm (p. 7). The editorial replicates the one of the findings of Nathan Joseph’s on the way he arrives to the fact of how a firm in the UK centres on a particular way of hedging methods, and the different ways of making added application of derivatives instead of domestic hedging methods. By stating that, the consequences depend on the kind of experience that is prevaricated, whether externally or internally. Marshall (2002, p. 65) states that companies might not prevaricate plainly due to the lack of experience whilst others might not prevaricate because of their behaviour in the FX rate and the self-assurance, or be deficient in the use of derivatives. This may be due to these recently brought in products that may prove to be untrustworthy as previously produced hedging methods.

Generally, exchange traded currency options are employed in hedging currency positions with an aim of alleviating risks that may be incurred during exchange (Cooper, 2012). For instance, investors may make use of exchange traded currency option to prevaricate tentative upcoming cash flows. A manufacturer in the U.K. may be anticipating to be recompensed in the U.S. dollars for the specific equipments. Their fear is that in case the sterling pound becomes stronger in the next few months, they may obtain less money after converting their pay to pounds. In order to hedge this, they may purchase a call option in sterling pound that grants them the right, however not a requirement, of purchasing the sterling pound at a set price in the future (Cooper 2012). On the other hand, the exchange rate for the dollar becomes weaker compared to the call option, the investors may allow the option to terminate and in turn, exchange their dollars, which they have been paid in the open market. Nevertheless, they would employ the call option if the exchange rate was strong.

A variety of systems are used to examine the level of risk exposure bearing in mind that it may differ considering the assumptions taken in that particular model. Among these models is hedging which involve a person who wants to own gain assets and is concerned that its price may change before its time of purchase. A hedger is concerned with the risk as this is related to price swings, which are prohibited in many enterprises.

Nowadays, the purchases and sales of the majority of corporations, small and large, are dominated by foreign currency. In order to benefit from this, it is significant to make a way of hedging against an adverse exchange rate movement (Narayanasami 2011). For instance, an exporter may purchase a one-month long call (call option) at a specific rate. In case the rate goes down much, lower than it has been agreed upon, the owner of the option may exercise it and in turn be recompensed for the difference. Certainly, put options are employed when the risk tends to move downwards, whilst call options are employed when the risk of the currency price tend to move upwards.

In order to understand this better, it is important to take up an illustration. In this case, we will take the example of the Reliance Industry that necessitates buying crude oil in the United States dollars in six months. In case the Reliance Industry purchases a call option, in which the right of buying a certain quantity of the U.S. dollars on a particular date and at a fixed price, there emerge two situations. The first scenario is that if the dollar decreases in value meaning that the exchange rate trend is good, the Reliance Industry may purchase them at that rate, since they are cheaper (Narayanasami 2011). The second scenario is that if the dollar increases in value compared to the current spot rate, the Reliance Industry may buy it at an agreed price. Apparently, the Reliance Industry benefits from either case, as it is able to purchase the dollar at a lower price.

The Philadelphia Stock Exchange (PHLX) was established in 1970. The company initiated and commenced the idea of exchange traded currency options for securities account owners in the year 1982. Currently, PHLX has started trading the global currency options on the Euro (Jaworski 2007). The euro currency options began trading in 2007 with the XDE symbol, but are estimated based on the U.S. dollars of the underlying currency and, besides, the premium is recompensed and obtained in dollars (Jaworski 2007). The specialist in this case is the Interactive Brokers Group.

The product was developed by the vice president of the Philadelphia Stock Exchange, Daniel Carrigan, with regards to the various feedbacks he received from retail brokerage companies (Jaworski 2007). According to Carrigan, the exchange traded currency options can be termed as the absolute piece of asset for security dealers who desire to use strategies of the foreign exchange options. In addition, it is a significant development since the retail investors owning securities accounts may trade the trend of the main foreign currencies (Jaworski 2007, par). According to Carrigan, the exchange traded currency options does not require physical delivery and settles ad trades in the U.S. dollars; and these characteristics makes it similar with the index option. Nevertheless, the fact that it remains being a currency option goes against the responsibility of making physical delivery, and this is the reason for why the product is suitable for online trade investors (Jaworski 2007). In 2006, the Philadelphia Stock Exchange declared that it would be going electronic, thus doing away with its floor functioning. The company trades 2308 equity options, 7,000 stocks, 17 currency options, sector index and futures.

There are various kinds of exchange traded options as explained herein:

• Financial options: these types of exchange traded options have financial assets, for instance, a currency or an interest rate which act as their fundamental assets. The various kinds of financial options encompass:
• Currency option: this is a type of contract that gives owner the right of buying or selling currency at a certain price and time (DeRosa 2000, pp. 13-18). Nevertheless, the owner is not obligated to trade currency. In this case, investors may evade the risk of foreign currency by purchasing a call or put currency option. There are two types if currency options: put options and call options. A put option offers the purchaser the right of selling the underlying currency whilst a call option offers the purchaser the right of buying the underlying currency at a specific price and at a certain future date (EconomyWatch 2010).

• Stock options: these are also referred to as equity option and benefits that are traded between parties. Generally, stock options offer right to the buyer, but it is not requirement, to call (buy) or put (sell) a stock at a specific price that has been agreed upon on a certain date or time period.
• Bond option: this is a type of option contract whereby a bond is the fundamental asset. Apart from the various features of the fundamental asset, bond and stock options have no major difference. A bond option, like other options permits investors to evade bond portfolio risks or speculate the trend of the prices of bond with lower risks. For instance, a purchaser of a call bond option usually anticipates reducing interest rates and increasing the prices of bonds. And, on the other hand, a purchaser of a bond put option generally anticipates interest rates to rise and prices of bond to decrease.
• Index option: this is a put or call option, for instance S&P 500 or NASDAQ. Studies have proven that investors who trade index options are basically gambling on the general progress of the stock market as characterized by the basket of stocks.
• Interest rate option: this is a kind of option whereby the fundamental asset is linked to the modification in the rates of interest. They are cash settled, European style options on the yield of the United States Treasury Securities. Some examples of interest rate options encompass the options on the five-year Treasury note, options on the thirteen-week Treasury bill and options on the ten-year Treasury note (DeRosa 2000, p. 25). In most cases, the purchaser of the call option anticipates an increase in the rates of interest, whilst on the other hand, a purchaser of a put option expects a decrease in the rates of interest as this will amplify the worth of the put option position. Studies have proven that the greatest portion of the globes derivative market is made up by the interest rate options. In fact, it has been predicted that sixty trillion U.S. dollars of the interest rates derivative contracts were traded as of May 2004 (EconomyWatch 2010). In addition, the International Swaps and Derivatives Association put forth that 80 percent of the globes top 500 corporations made use of interest rates derivatives with an aim of controlling their cash flow by April 2003.

As explained above, currency option is a type of contract that gives the owner the right of buying or selling currency at a certain price in a particular time period. Nevertheless, the owner is not obligated to trade currency. In this case, investors may evade the risk of foreign currency by purchasing a call or put currency option. Exchange traded currency options make use of such aspects as standardized contracts taking an account of the principal currency, the exercise price, and the ending date. Being the only all time running option market, its true volume cannot be predicted, as most of the transactions are done over the counter (What Are Exchange Traded Options? 2003). Options are traded based on the U.S. dollar parameter in FINEX, a branch of the New York Trade Board. Several bodies are put in place to regulate the undertakings of trade in these securities, such as the Securities and Exchange Commission, which is mandated to keep a check on the foreign currencies being traded. The other body is known as Commodity Futures Trading commission in charge of currencies traded that are not securities exchanges. Generally, exchange traded currency options are employed in hedging currency positions with an aim of alleviating risks that may be incurred during exchange (Cooper 2012). The fundamental advantages of traded currency options may be the capability of locking in a selling or buying price, which as a result permits the sellers or buyers to hedge against possible rises or falls in prices. In addition, exchange traded currency options are typically deemed liquid investments due to the fact that they may be sold or bought fairly without difficulty.