Financial derivatives trading is very important concept in this present scenario, as it is mandatory for mitigating risk. Derivative is specified as contract which is used for deriving value from performance of entity which is underlying. The present report is giving brief discussion about various instruments by taking basis of different organization such as hedging, currency swaps, collar strategy and all for mitigating risk and to gain competitive advantage in their own industry and market as well. It has given discussion about EasyJet along with developing a framework for risk management on basis of financial derivatives and strategies for advanced hedging which will be specifically aim towards protection of exposure to cost of fuel and currency. In the next scenario, it will be presenting contribution of financial derivatives toward 2008 Financial crisis. The present report is also discussing about calculation of European call and put option with given duration such as maturity after one month, six months, etc. In the same series it is depicting concept of delta neutral hedge along with delta, gamma, Vega, theta and rho on basis of financial institution with its specific interpretation. If you are looking for sample paper regarding Marks & Spencer then visit Environment Analysis of Marks & Spencer Organisation.
1 Developing a concrete risk management framework on basis of financial derivatives and advanced hedging strategies of EasyJet
EasyJet is an airline company is referred as British low cost carrier airline whose headquarter is at London Luton Airport. Its operations is in domestic and international scheduled services with some specific 820 routes as in more than 30 countries. It is directly listed on London Stock exchange and it is also a constituent of FTSE 100 indices. It is also known as low cost passenger airline whose operations are throughout Unite kingdom and mainland Europe. Usually its sells it tickets via its website (Hudson, 2017). It operates along with its subsidiaries in Europe. The organization is also involved in leasing and trading aircraft along with various provisions of services of graphic design. Its financial performance is fluctuating from year to year due to various reasons which are identified in stated article.
|Year||Turnover||Profit before tax||Net profit||EPS|
Interpretation: The above graph is depicting Financial performance of EasyJet plc for consecutive five years, in which it can be easily viewed that there is presence of major fluctuations. The sales of organization are increasing but due to increase in fuel and currency cost it is not able to convert their sales into margin in efficient manner (EasyJet plc, 2018). The organization has partners such as WDL Aviation, SmartLynx and Titan Airways in very systematic manner but do raise in currency and fuel cost, they have identified decrement in margin (Bacha, 2017).
The organization must utilizes financial derivatives for managing its whole exposure in context of variation in fuel price, interest rate and foreign exchange rate variations. For mitigating with interest rate risk inherent in UK and other countries floating rate debt and its investment, the firm must create ability for entering in forward interest rate agreements with short term maturity or it should be not more than 18 months. Usually interest rate risk is directly affecting short term investments and along with variable rate debt instruments as it directly changed by alterations in LIBOR. The swap agreements should be properly utilised as they are built in context of lease and loan agreements.
The above specified graph is depicting monthly price of fuel in London as in 2014 it was declining, but in 2015 it started raising again but then too it falls in same year. There was sudden rise in 2017 January which had impacted AirJet's financial in huge aspect, as it was generating turnover but to its operation cost it had not raised its profits. So for managing its exposure organization must adopt systematic hedging strategy for hedging its position up to 50% of its consumption which should ensure about 1 year period. In the same series, contracts should be hedged must be entered after October as it comprises hedge accounting on basis of financial statement of next fiscal year. This will be depicting loss on hedged contracts which was summed up at fuel cost. In the ending of fiscal year, organization must use collor option structure in place for hedging 7.1 million tonnes as compared to 6.5 million tonnes from 2017 to 2016 year respectively. The overall emissions are due because of expansion of operations of easyJet. There was lack in context of liquidity, organization must be able to hedge along with its fuel based contracts in context of short term. The effective hedges must be applicable by entering into contracts of heating and crude oil (Rebentrost, Gupt and Bromley, 2018).
EasyJet is considering cost of fuel as second largest expense in its financial statement. There should be hedging of fuel price by using various commodity and financial instruments such as collars, futures, options and forward as well. In the same series, specific portion of expected jet fuel cost should be hedged in future so it must enter in derivative contract from time to time. For the volatility of fuel price, swaps and options are considered as best exposure as it can also use fixed price and cap arrangements. Already EasyJet has mitigated risk by US dollar exchange rate but that was due to interest rate risk but there was absence of Derivative risk as in its history it got profit of 12.3 million in fiscal 2005. It was through optimising limited no, of instruments for hedging for zero cost collars and forwards for hedging against fluctuations of fuel price. According to this policy, hedging more than 80% of fuel which is predicted as consumption of 1 year in advance and to very lesser extent it should be predicted up to 3 year in advance.
For managing volatility of foreign risk organization must be able to enter in foreign exchange forward contracts and currency swaps. As there should be presence of currency swap from third party until the termination. In airline company, usually all transactions are denominated in foreign currency which helps in generating surplus and they should be capable tomatch receipts and payments of every currency so it is first step for mitigating exposure of foreign currency. The surplus which has been gained of that foreign currency should be sold in context of spot or forward rate for US dollars or any other. The forward foreign exchange contracts are usually for utilising to cover revenues of short term future and along with its all expenses must be hedged against currency fluctuations. EasyJet must be able to manage exposure of fluctuations of currency which is originating from denominated purchases of especially flight equipments and foreign accounts payable and recievable as well. It should be directly able to manage hedging via forward foreign exchange contracts, currency swaps and options.
EasyJet is operating globally and is generating revenues and expenses from operations in multitude of specific currencies. Mostly foreign currencies are exposed to USD, Swiss Franc, EUR, Hong Kong dollar, Indian rupees, Malaysian Ringgit, UK sterling pound and Koran won. As discussed above receipts and payments should be matched and surplus should be converted. The contract should be able to settle from range of one month to 12 months for purpose of hedging but not in favour of exposure of foreign exchange. The most popular strategy should be adopted such as cross currency swap agreements for exchanging loans which are bearing floating rates of interests. The exception of US dollar, organization had managed this risk as its revenues and expenses which exclude aircraft lease, interest expense, fuel maintenance cost and insurance which is denominated in Sterling and Euro currency. As EasyJet does not use any exposure for managing risk but because of high cost products such as payments of capital lease, mortgage and proceeds along with sale of aircraft it has gained huge liability element which is denominated in US dollar (Infante and Sorvillo, 2017). Students can also get the best and affordable College Assignment Help from our writers.
2 Describing the contribution of financial derivatives which is triggering financial crisis of 2008
Derivatives are those monetary securities which are based upon some security like stocks and bonds. Financial derivatives are those legal agreements that derives its value from financial instruments. In this the seller agrees to sell the financial instruments in the particular date at a particular time. Basically these are used for the commodities like gold, oil, gasoline etc. the financial derivatives are mostly describes for two commodities (I)forward commitments or contingent claims. Financial derivatives used to protect one from financial losses and to reduce risk. It opens many doors for investors. Financial derivatives creates the more chances ofupcoming cash inflow or outflow. It permits the company to exchange the assets on a upcoming date at a price setout for today to have their future earning more quickly. Financial derivatives are based upon some instruments that are discussed as under-
1. FORWARDS -it is a legal agreement with two or more parties where the process paying of remittanceis done at a particularpoint of time in the future in present per-determined time. It is a morecustomized form of future contracts. That is why the delivery time and amount are personalized according to the needs of buyers and sellers. It is a cash transaction.
2. FUTURES - futures are those legal agreements to exchange the assetson a future date at a price specified today. Futures are the equalize legal agreement between two parties.It gives right to the purchaser to buy or sell the future contracts. Future works on the same periphery as the option do but the underlying security is different.
3. OPTIONS - It is an agreement enforceable by law among two parties to purchase or sell securities at a given price. Mainly it is used in trade stock option but can be used for other investment as well. The call option has been purchased by an investor then, when only he can purchase the right to takean asset at a givenprice on a particular time limit The option contracts also specify the due date.InEuropean option , not before the maturity date , the owner has the power to havethe sale to take place , and inAmerican option the owner can require the sale to gave up to duedate (Kahalé, 2017).
4. WARRANTS - Mostly the short dated options ere used but there lies in long dated option which are rarely used by investors are termed as warrants.
5. SWAPS - In swaps the investors have opportunity to exchange the benefits of their security with each other. For example- one party may have a bond for fixed interest , but in a line of a business they have a opportunity to prefer a varying interest rate so if they want they can perfertowards swap contract..
It has major contribution of financial derivatives in triggering the financial crisis in 2008 as financial crisis has taken place when banks are able to create too much money , to quickly and increased the prices of houses tosurmise on the financial bank.Most of the time bank creates the Loan and freshmoney introduces to the market in this global crisis . They have debt to the economy the certain amount of money they have doubled in last 7 years.It is told by many of us about the high price of the houses . It was correct that prices of houses were increased by the hundreds of billions of pounds of fresh money that introduced by the bank in the year before financial crisis. The credit derivatives had played very important role in triggering the financial crisis. The values whose derives on the credit risk on an underlying bond , loan or other financial asset are termed as financial derivatives.The financial derivatives to the some extent effects the financial crisis . Since the very big loss has been suffered by the financial institution for example Bear Stern, Lehman Brothers, AIG , etc.financial crisis has been caused the excessive derivatives transactions. Many people gave their conclusion that crisis is taken birth from the derivative transaction. .
After having a loan between local bank and homeowners , the loans are sold by them changing into securities ( securitization ) This borrowing powers combines the mortgage with other mortgages into a mortgage pool. This has convertedinto mortgaged backed securities , later they have been sold to the asset backed bond after combining them with credit loan , student loan , auto loan etc.Furthermore the asset based bonds were segmented , ranched and sold to the collaterized debt obligation. To fulfill specific risk prefrences of investors CDOs has creatively constructed with different risk ratinggs.
Then the credit default swap was the fresh to introduced in financial derivatives instruments which also played a big role to thestern of the crisis. In 1990s credit default swap has taken birth to provide option to hedge and speculate their credit.
Derivates ere designed to explore or to provide a greater financial resources to the mortgage market (Bryan and Rafferty, 2014).
Since the derivatives eventually are traded on the basisof underlying assets, any inappropriate fall in the value of underlying assets can cause the crash in financial markets.
Due to the absense of regulation the derivatives had changed the whole scenario in causing the crisis as derivatives mere traded as over the counter segment that is they are not the part of subject to regulation that means , that the hard and fast rule could play by the bank and allow their own rule for derivative trading outside concern of regulators.
By concluding it , the crisis in sub prime mortgage loan in the US has triggered the global financial crisis in 2008. Mixture of lowestinterest rate, intricate credit derivatives instruments, and excessive risks actions with incentives packages by the finance providing institution had brought expansion of sub prime security long term borrowings. Therefore, the incline value of real estate combine with the permament rise of the rate of interest had drop many sub prime borrowings in default. This enormous situation has made huge loss to the real estate industry of United States.
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European call option is replicated as option for right to purchase stock or any indices at specific price on specific date. As it varies from American style call option which could be exercised at any certain point with date. In simple words its difference can be elaborated as expiry of American call option can be exercised before date of expiry and time is not specified but in European call option it can be exercised only on date of expiry. The right time to purchase European call option is when there is increase in price of stock or index then there should be purchase of call option. In the same series strike price is referred as amount which has been agreed to purchase or selling stock at due date.
1. Calculating value of one month European call option with specific strike price of 1330.
The below chart is depicting current stock price of EasyJet with London stick Exchange as its standard deviation has been extracted as 0 whose price has been calculated by specified 1 month maturity of European call option.
|Strike price (K)||1330|
|Time to maturity||1 month|
|Formula||C = SN(d1)- N(d2)Ke^-rt|
|D1 = (ln(S/K) + (r + s^2/2)t) / s.√t|
|European call option|
|D2 = D1 – s.√t|
|European call option||C||1344|
|Current stock price||1344|
|Call option price||C|
2. Calculating value of six month European put option along with strike price of 1690.
European put option is replicated as contract which provides right to purchase or sell asset to investor at particular date along with specific price. It allows holder to exercise option of put as an exchange or along with brokerage. In the below question, current price has been given but two price for maturity after 6 months has been given which is 1625 or it might be 1715 of GlaxoSmithKline is traded on London stock exchange with given price and it has standard deviation of 1.1512.
|Current price (S)||1690|
|After six month||1625||1715|
|Risk free rate (r)||1.02%|
|Strike price (K)||1690|
|Time to maturity||6 month||180|
|Formula||P = Ke^-RT(1 – n(X-STANDARD DEVIATION√T))-s(1-n(X))|
|Normal distribution (X-standard deviation*√t)||1|
|Normal distribution x||1|
3. Explaining call option with context of delta Neutral hedge as it will increase or decrease when there is fall in stock price
Delta neutral trading is the trading is a construction of position which do not react with little change in price of the underlying stock. It does not impact to whether the value is increases or decreases the price will remain same. These are the strategies which are designed to create the position that merely affect the price. When the price of an underlying security changes , the delta value of an option measures that hoe much price of an option will change. The delta of an option is very fruitful thing to be know it gives the knowledge , option delta represents a relationship between the price movements that an option will experience. There are 10 call options on MSFT, where the option has a delta of 0.25, means you have effectively 250 shares in MSFT (10 * 0.25 * 100). Delta hedging this option position with shares means you would sell 250 MSFT stock to offset the 250 "deltas" of call options. In the above instance the underlying price has been changed by the input to the delta (Sahu, 2017). The four major factor should always keep in mind that can effect delta and can change the hedge position ;hidden price . Time , and interest rates.
As the increase or decrease in stock price takes place, the implied explosively and delta keeps on changing. This gives rises to the essential question arises that how and onwhat basis do you hedge?
In theory, the best time to hedge is when your Delta is non zero so you transact with the underlying to bring the delta back to zero.
|Number of shares||51750|
|Assumption is that falling of stock price||75000|
|Trading with Delta||-0.69|
It can be interpreted from above calculation that when there is fall in stock price then delta price will also increase due to hedging it should become zero or it should be capable for perform with market trend.
4 Calculating delta, gamma, vega, theta and rho of financial institution.
All this delta, gamma, vega, rho and theta are termed as option Greek as they reflect consensus of specific market place's reaction about variations in options for specific variables which are directly associated with option contract's pricing. There is not absence of guarantee which will be correcting forecasts. It will directly impact price of option which will be traded.
|Short||1000||7 month European call|
|spot exchange rate (S0)||0.8|
|exercise price / strike price (K)||0.81|
|risk free rate (US) (r)||8.00%|
|risk free rate (japan) (rf)||5.00%|
Interpretation: Delta can be referred as amount of price of option which is directly based on movement on $1 change in stock which is underlying. The above table is giving presentation about delta of 7 month European call as every call must have positive delta i.e. 0 to 1 and it has 0.3969 which can be interpreted as if stock price increases and there is no alteration in pricing variables and simultaneously price will go up (Weng, Wang and He, 2016). This has delta of 0.3969 and stock will increase.
|Gamma = (N'(d1)e^-rft) / S0s.d √t|
|= (0.3969 * 0.9713) / 0.80 * 0.15 * √0.5833|
|Vega =||S0√Tn' (d1) e^-rft|
|= 0.80√0.5833 * 0.3969 * 0.9713||= 0.2355|
Interpretation: Gamma can be replicated as rate where delta will be altered as per change in price of stock. The options which have the highest gamma are considered as very responsive change in price of stock which is underlying. The above European call has gamma of 4.206 with strike price of 0.81.
Vega is used for measuring alteration in option premium because of change in volatility and it is always replicated as positive number. Time value is always affected by volatility and Vega tends to vary in form of time value with option. The above European call is depicting that 0.2355 will change with 1% change in terms of volatility (Zhu and Ling, 2015).
|Theta = - (S0N'(d1)S.d E^-rft – rKe^-rt N(d2)|
|= - (0.8 * 0.3969 * 0.15 * 0.9713) / 2√0.5833|
Interpretation: Theta can be replicated as amount of price of puts and call which will be decrease for change of one day in time expiry. It is a measure of time decay which is expressed as loss of time value on basis of per day.The above table is giving theta of -0.0399 which indicates that this option is losing $.0399 of time value per day. It is minimal for perspective of long term option due to time value which decays on slow but it will expire as every day will be reflecting percentage of time which is remaining.
|Rho = Kte^rtN(d2)|
|= 0.81 * 0.5833 * 0.9544 * 0.4948|
Interpretation: Rho can be represented as change in premium because of 1% change in prevailing risk free interest rate of 5% so rho of 0.2231 is interpreted that premium will rise by 2.23% and value of put premium will fall by 2.23% due to put premium which will move opposite to rate of interest (López-Díaz,López-Díaz and Martínez-Fernández, 2018).
From the above report it is said that financial derivates play an essential role in present economy. As it fights with fluctuations of various cost such as interest rate, foreign currency exchange rate, fuel cost and many more. It has been articulated from above report that risk can be mitigated in very essential manner by using derivative instruments in efficient aspect such hedging done for purpose of EasyJet in context of increasing fuel and currency cost and various fluctuations. It is showing importance of different instruments as currency swaps and collar strategy is very important for EasyJet for managing risk exposure. Delta, Theta, Vega, Rho and Gamma are termed as very essential indicator for concept of measuring. It can be easily interpreted that every financial institution must be able to imply all these concepts in very essential manner. Further it can be summed up that, in present scenario for achieving competitive advantage in industry derivative instruments play major role with its useful implications.