Derivatives Markets and Financial Innovations

The significance of the Derivatives Markets

Derivatives refer to all instruments that draw their value from more than one financial asset. In this case, the financial asset may consist of securities, indexes, and other commodities (Sangha 2). It is worth noting that an instrument is any financial asset tradable on the derivatives market and they include stocks, bonds among others. Businesses, governments, and corporations in accomplishing numerous objectives utilize derivatives. However, the primary objective of derivatives is to assist investors to manage their investments through minimization of financial risks while lowering the underlying costs (Sangha 2).

Derivatives markets play a significant role in providing investors with unique investment opportunities, which are unavailable at organized market exchanges. Additionally, the market provides the investors with the means to access and exploit the most unknown equity markets across the world at relatively minimal cost and risk compared o the traditional market scenario. The other imperative role played by the derivatives market is that it provides the investors with an opportunity for tax planning by utilizing the asymmetric nature of tax and other regulatory rules across various markets or countries.

The economic interrelationships between derivatives markets and underlying asset markets

The topic of the influence of the derivatives market on the underlying market has gained much academic scrutiny for the past few years. The issue under debate is more of the effects of the derivatives market in terms of the extent to which the nature of speculative trading influences the underlying market prices. The derivatives market provides favorable conditions that allow for the entry of investors into the financial markets, hence assisting in the distribution of risks across multiple markets. Generally, the concentration of investments in one form of venture potentially puts the investor in a vulnerable state of risk. The act of diversification brought about by the introduction of the derivatives market offers an opportunity to cushion the investors against risks of this nature (Hull 25).

The derivatives market leads to an increase in the number of economic speculators on the market. The increase in speculation represents an economic influence that acts to profit some traders who tend to assume and carry the challenges of trading risks avoided by others. According to many investors and market stakeholders, the transferability of these risks to the derived market substantially improves the nature of spot market transactions. On the other hand, the increased speculation arising from increased participation in the derivative market leads to market volatility (Sangha 4).

. The increased market volatility increases the derivatives market due to arbitrage strategies employed in trading at the market such as program trading. The surveys undertaken reveal that an introduction of the options markets results in a relatively small bid-ask spread, which increases the underlying market liquidity. On the other hand, it may e observed that the derivatives markets offer a higher hedge, therefore leading to increased demand. An increased demand translates to expanded growth in the volumes of trade in the spot market hence reducing the market volatility (Sangha 3).

The impact of financial crises on the functioning and efficiency of derivatives markets

Although governments and exchange authorities have stepped up means to combat the global crisis, its effects continue to impair the well-functioning of the derivatives market. Firstly, various equity and hedge funds have fallen short of necessary funds forcing the liquidation of the underlying assets. Secondly, the state of the available resources has contributed to a slow-down in the volumes of transactions in the derivatives markets. Subsequently, this has led to reduced profitability to investors, governments, and exchange authorities. The boom in housing prices motivated most investors to move colossal amounts of their investment into buying mortgages. Although this act produced returns in the short-run, the overall effects of drastic slow-down in the prices had huge losses. The mortgages began to default, which led to multiple effects on the financial markets.

Proposal for CBOEs Derivatives Markets

Owing to the financial crises and their effects on the global economy, the financial markets should be prepared to make quality changes in terms of regulations capable of sustaining efficient and well-functioning markets. These proposals entail directives and regulatory efforts aimed at supplementing the existing rules in a bid to strengthen and protect financial investors (Kolb and Overdahl 126).

In order to minimize potential conflicts of interests among investors, the paper proposes an amendment to institute rule that prohibits independent advisors and portfolio managers from making third-party transactions or such other financial gains. The proposed rule rings in stricter guidelines aimed at providing safeguards to actual and potential investors who would otherwise lose on investments through unguided transactions by middle parties.

The other strategy for adoption would be an introduction of transparency trading rules in equity markets, which will include “dark pools.” Dark pools refer to the trading of liquidity not presented to the public. Additionally, there should be a proposal to avail all relevant financial and investment data centrally to allow investors sufficient and easy access in order to make sound investment decisions.

In a bid to lead the derivatives market on the road for sustainable trade, the CBOE may incorporate the creation of a special label for small-and-medium enterprises. This framework shall seek to address the investment needs of all investors inclusively. The board shall also gain from introducing new strategic safeguards in relation to high-rate trading functionalities, which expose investors to systemic risks.

To increase efficiency in the derivatives market, mechanisms to step up supervisory authority and powers within the regulatory framework shall serve as an imperative means.

The market authorities should formulate plans that increase the level of standardization in over-the Counter (OTC) derivatives. In this endeavor, market participants will benefit from the application of standardized processes and procedures. In the same breath, the CBOE should implement the central counterparty clearing of all standardized derivative products in the over–the–counter markets. On the other hand, all non-standardized products should attract high capital requirements. This process shall foster increased liquidity, availability of financial data for proper decision-making.

Financial Innovations

In response to the increasing need for a diversified derivatives market, I propose that the CBOE introduce the following product in order to assist investors to diversify their portfolios:

The first product would be exchange-traded credit derivatives. These products offer investors an opportunity for liquidity as well as transparency by allowing the trading parties to hedge counter-party risks associated with credit transactions. By allowing this product to trade on the board, the market will b placed on a better platform to benefit from Counter-Party risk mechanisms while maintaining safeguards for all market participants (Hull 64).

Exchange-traded funds (ETFs) are fundamental products that would help investors to manage their exchange risks while trading at international markets. These shall be SEC-regulated securities, flexible investment tools that allow potential investors to expand their investment incomes by hedging their investment portfolios. The ETFs have several risks that may affect the side of the investor. Firstly, EFTs involve minimal trading volumes, which diminishes the merits of the index. Additionally, the magnitude of bid-ask spread impairs the cost-effectiveness of dealing in ETFs.

ETFs may be valued using varied methods. In this report, the paper considers the Net Asset Value per share where we divide the net value of the fund by all the outstanding shares. The ETF trades at a premium when its market value is higher than the net asset value. When using this methodology, it is important to use the most current figures in order to arrive at an acceptable value.

Arbitrage strategies

The proposed arbitrage strategies in trading derivatives

Investors may adopt various strategies in the process of trading their derivatives on the market. These strategies strive to help investors to minimize the risks of investment while maximizing the returns.

The first arbitrage strategy employed by investors is the long call strategy. This strategy applies to those aggressive investors who display bullish characters about the prospects of the stocks and indexes. This method is one of the most common strategies undertaken on the market especially by individuals with knowledge in buying and selling of stocks and interested in trading of options (Kolb and Overdahl 117). The analysis of the strategy serves to limit the downside risks involved in the trade. If an investor believes, that his or her investment would benefit from upward market movements, it is the most desirable strategy.

Secondly, an investor may decide to utilize the short call strategy with a hope that the traded stock will rise in price in the future. The strategy proposes that if the anticipation suggests a reduction in the price of stocks, an investor should undertake an opposite option by selling the options (Hull 54). The strategy is significant in the market situation because it provides an investor with limited profits and possible large loses given the underlying stock prices. Although the strategy is easily executable, an investor pursuing it is vulnerable to unlimited amount of risk because increase in stock prices leads to a loss of money in the short call, hence increasing the riskiness.

The third strategy in arbitrage trading is the synthetic or artificial long call in which we buy a stock and a put. This strategy is essential to investors who pursue bullish investment strategies. In this condition, an investor wishes to trade in a stock though with a hope of increase in prices while being cushioned against the unexpected falls in prices of the underlying stocks. In this process, the individual exercises the right to sell in case of an anticipated loss. An example is the exercise of standard & Poor Index (SPX) Bear put spreads. The spread allows a prospective investor to access an opportunity of profiting to some premium limits, while limiting the extent of investment risk through outright purchase of a put option.

Strategic findings, learning ideas, concepts, and implications of the research

Following this research, I draw numerous ideas, concepts and implications that serve as the impetus for future research and inquiry. Through this research, I have gained the knowledge that financial markets play a vital role in sustaining an economy. This draws from the assessment of the effects of global financial crisis on the financial markets, and the aftermath to the general economic trends.

On the other hand, it is worth noting that strategies aimed at safeguarding the market participants against the vulnerabilities similar to financial crisis are necessary for an efficient and sustainable market (Hull 54).

Relation between Forward Price and Spot Price

Arbitrage Opportunity

Arbitrary refers to an opportunity of making profit free from risk by purchasing an underpriced asset and reselling it at the prevailing market price. Historically, arbitrage opportunity has served as a “holy grail” taking place in the capital markets (Kolb and Overdahl 117).

  • Forward price, F0 =$24.25
  • Spot Price, S0 = $20
  • Storage Cost (in $), C =$2
  • Maturity date of Forward Contract (1 year)
  • Risk-free Rate, r =5%

Therefore, to verify the existence or absence of arbitrary opportunity, we derive the necessary equation through the table below: where r is the risk-free rate and T is the underlying time to maturity.

Sell one unit worth of $20 at a cost of $2. Receive $ (20-2) = $18 $18
Lend the remaining $18 for 1 years at 5% +$18.90
Accept the unit at a futures contract at $24.25 -$24.25
Total cash flow -$5.35

Clearly, attempting to undertake this cash-and-carry arbitrage does not serve to pay the investor as such, there exists no arbitrage opportunity from which or h would benefit (Kolb and Overdahl 117).

Verify the existence of arbitrage opportunity given the following information:

F0 = $38.50

S0 = spot price= $40

Income/ Dividends ($), I = $7

Maturity date of forward Contract (2year), T = 2

Risk- free Rate, r =5%

F0 = (S0I) erT

$38.50 = $(40- 7) e0.05*2

Where, e = 2.71828, hence we obtain the following:

= $33×2.718280.1 = 1.105 ×$33 = $36.47.

Therefore, the total cash flow is given by the difference between $ (36.47 – 38.50) = -$2.03 (negative value). From the analysis, we deduce that the resultant futures price of the underlying asset would not yield an arbitrary opportunity in the event that the investor undertakes the action. This is because the value of the outcome is less than the projected futures price.

Works Cited

Hull, John. Fundamentals of Futures and Options Markets, Solutions Manual and Study Guide. 6th ed. New York: Prentice Hall, 2007. Print.

Kolb, Robert, and James A. Overdahl. Understanding futures markets. New York: Wiley-Blackwell, 2006. Print.

Sangha, Balvinder. Financial Derivatives: Applications and Policy issues.1995. Web.