Derivatives, Yield Curve, and Systematic Risk: A Comprehensive Analysis Assignment Sample

Derivatives, Yield Curve, and Systematic Risk: A Comprehensive Analysis

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Introduction: Understanding Derivatives Pricing and the Factors that Impact Demand and Supply

This report revolves around the derivates, the systematic risk involved with it and the factors that affect the derivatives pricing as a whole. It strongly also states the factors that are responsible for the changes in the demand and supply and how does the pricing of the derivates is strongly affected by macro factors. Various movements of yield curve are also being discussed below and how the shifts in yield curve determine the expectations of future rates are discussed here. Various models leading to the change in the prices or the valuation of the derivatives are also being discussed in the report.

Task 1:

Yield Curve is the static representation of the (dynamic) term structure of interest rates. A shift in the yield curve will occur for a number of reasons, connected not just with the market view on interest rates but also factors such as liquidity and supply and demand. It is also a curve that depicts the various interest rates or could also be called as a structure of interest rates. It is a curve that shows the relation with the level of interest and the time of maturity. The term structure of interest rates describes the relationship between the long-term and short-term interest rates. This statement totally contradicts with the theories which mean that the interest rates are solely a function of expected future spot rates which means that there is no uncertainty. The slope of the yield curve shows that how the bond market expects short term interest to increase in the future. The term structure of interest rates is upward sloping when long-term rates are higher than short-term rates. An upward sloping yield curve is called a normal yield. When short-term rates are higher than the long-term rates, then term structure is downward sloping. The term structure can also be humped when medium term rates were higher than either short- or long-term rates. The Expectation theory states that shape of yield curve is determined only by market expectations about future rates.

The yield curve can be calculated from prices available in the bond market or the money market and the various or different methods lead to different results. But yes, there is no single yield curve describing the cost of money for every market participant since borrowing costs depend on the currency in which the securities are denominated as well as the creditworthiness of the borrower. So, it could be correctly said that the yield curve plays a vital role in the prediction of the future interest rates.

There are some general principle s also which play a vital role here like the value of an asset is the present value of its expected cash flows and the Basic Steps which are Estimate expected Cash flows, Determine the appropriate interest to discount cash flows and Calculating the present value of expected cash flows fund by using the determined interest rate. So, if the interest rates tend to increase in the nearby future and totally corrected by the investors can give a good amount of profit. It is also very to analyze the yield curve so if one gets to know the proper theory and what is it all about it is one of the best practices so forth. And it is very important to know that the interest rates and the bond price have inverse relationship with each other (Chen et al, 2013).

The Pure Indication Theories indicate that how the slope of yield curve indicates direction of future rate changes in the nearby future, which could be:

Upward Sloping: Short-term rates expected to rise

Downward sloping: Short-term rates expected to fall

Flat: Short-term rates expected to remain constant

Another Liquidity Theory-It also compensates for the risk rate and also suggests that that investors are price discovers and also are there for investing in bonds for long term view and also compensates for the risk in future and mostly out of expectations and it also has been found that the yield curve is upward sloping in this case according to the investors but this could be the case or not it is totally the uncertainty.

Preferred Habitat theory in this also expectations play a vital role but the premium does not particularly linked or increased in the maturity and the bond market can be long term short term or medium and also the investors will have preference and buy accordingly. The yield curve has definitely no impact because of the preferences.

Valuation of the asset is the most important thing which we all keep in mind and when we value any forward contract the price of the underlying asset changes. When the price changes there could be 2 cases:

• Long (buy): Gains when price of underlying increases
• Short (sell): Gains when price of underlying decreases (Aguiar-Conraria et al, 2012)

Task 2:

The pricing and valuation of derivates is most important as Derivates are priced by creating a risk free combination. The derivative pricing through the arbitrage also determines the risk for the premium. The demand for a particular derivate absolutely changes the price and the supply of one. Options are one of the most common derivative and also in options the buyer has the right and not the obligation to sell the underlying asset at a predetermined price. The primary goal of the options theory is to determine the price of the underlying asset. Price of any commodity or a financial instrument is of utmost importance because it only determines that whether there will be profit in the future or not. Anything valued at a future price is not always at the higher value but it is always presumed to be so, and these models always help the investors to minimize the risk upto the extent so that they could earn a good amount of profit in the future nearby.

Derivates is a financial contract which is also called as contingent claims and is frequently considered as new. A forward contract is an agreement between a buyer and a seller to transfer ownership of some asset or commodity at an agreed upon price at an agreed upon date in the future. The future price moves in relation to the spot price for the commodity that is based out of the demand an supply. Forwards are simply but similar to futures in which also demand and supply plays a major role. The interest rates are also considered as the integral part of it (Hull & White, 2014).

The above statement is absolutely incorrect as the option pricing theory estimates the value of an options contract by giving a price which could be stated as premium. There are many useful models or methods which help or assist us with the valuation and pricing of futures /Forwards and options. As we know that through options we can earn a lot of profit and also the time value is attached to it. There are two valuing options such as:

• Binomial: Next period, variable will change to one of two possible values as to thick whether the Stock price or interest rates
• Why create the tree?: Given the evolution of the stock price, we can determine the payoff to an option in the two states.

In other words it could be said that The best-known pricing model for options is the Black-Scholes method. This method considers the underlying stock price, option strike price, time until the option expires, underlying stock volatility and risk-free interest rate to provide a value for the option. Other popular models exist such as the binomial tree and trinomial tree pricing models. Swaps are another derivative instrument that could be a contract between the two parties for the underlying asset. In the derivatives market also we have seen that the property holds less value and the price holds major value because the contractor and the parties are price-conscious (Schiller et al, 2012).

Black-Scholes-Merton also have some assumptions to this such as Underlying asset price follows a lognormal distribution (continuous returns are normally distributed),The (continuous) risk-free rate is constant and known, The volatility of the underlying asset is constant and known ,Markets are “frictionless”, Underlying asset has no cash flow, Options are European.

For example consider a 6 month forward moving zero coupon bond which has a selling price of $600 and the risk free rate of this is 3% then the forward price would definitely be greater than this because the underlying asset proves to be profitable. So, the money that is going to be earned is 618app. It is also been seen that in hedging we always try to cover the loss and not to earn profit which could also be stated as covering the losses. Hence, the models are of utmost importance when comes to valuation (Kolb et al, 2014).

Task 3:

• Derivates being a new tool in the market have proven to be a important tool in the financial industry, institutions now. In this era where people want to take most risk derivates play a vital role so systematic risk is always undertaken by the people. The importance of the financial instruments are that they are flexible and they try to manage the risk and not increase the systematic risk. In broader terms the systematic risk could be defined as the risk that is a shock to the financial system significantly impairs crucial functions, such as asset valuation, credit allocation, and settlements and payments. It can also be said that financial instruments closely monitor the macro economic factors so that the systematic risk could be optimized and everybody could bear the risk. And when we create the portfolio the systematic risk could be minimized upto a extent. A systematic risk model should always have a proper portfolio. A systemic crisis involves a "loss of confidence" by investors (Khan et al, 2013). Typically, this means that investors or financial institutions cut back the amount of liquidity they are willing to provide to firms or other financial institutions. Substantial real cost are also included in the systematic risk and it also includes the real costs. The derivative markets serve as an efficient mechanism for disseminating new information affecting financial markets, thereby facilitating timely risk management responses to potential systemic disturbances. Both of these effects serve to reduce the degree of fragility in financial markets. There are many risk which are associated with the derivates like market risk, interconnection risk and liquidity risk. Today more and more people are purchasing derivatives and are undertaking the systematic risk. The market of financial derivatives is one of the largest markets of financial products in the world. The impact of volatility on systemic risk is quite evident – larger fluctuations increase risk and uncertainty in the financial system, which in turn increases systemic risk. These are main type of risk associated with the derivatives
• Contraction risk: Average life decreases when rates fall and prepayments increase Lower rates lead to more refinancing, More refinancing shortens average MBS life
• Extension risk: Average life increases as rates rise and prepayments fall, Rates rise causing prepayment to decline, Average MBS life lengthens

In the collateral debt obligation system also there are pool of debt obligations which include investment corporate bonds, distressed market bonds, emerging market bonds etc. It could been seen that

• If the market of financial products is perfect, then existing different correlations between products decrease systemic risk
• If the market of financial products is perfect, then similarly fluctuating prices of products increase systemic risk
• If the market of financial products is concentrated, then existing different correlations between products decrease systemic risk
• If the market of financial products is concentrated, then similarly fluctuating prices of products increase systemic risk (Bomfim, 2015).

There are certain activities by bank also which hamper the price and the market conditions too. It is rightly said that the hedging activities also plays role in determining the prices off the financial securities and the financial instruments. So, this statement holds a great and important part because its holds true in nature. The more diverse portfolio the greater probability of the reduced risk, so it means that the in spite of the factor that macro economic only come into force and determine the systematic risk the diversified portfolio also helps in the reduction of the systematic risk. Hence nowadays everybody is trying to have a diversified portfolio so that if some price fluctuate of one the other price of the various shares or bonds could set off the loss, in other words it could be said that do not bound yourself in one single portfolio but have a diversified one (Bielecki et al, 2013).

Conclusion

By analyzing all the factors and the options of derivatives in the market it can be stated that diversity belongs to the derivatives and a diversified portfolio plays a vital role when it comes to the systematic risk. The yield curve also helps in understanding the demand and supply prevailing in the market and the factors that are responsible to it. The pricing factors and the valuation factors determining the derivates worthiness also has been discussed above and at last

How the future rates can affect the systematic risk and does not impact one of that people who has a diversified portfolio.

References

Aguiar-Conraria, L., Martins, M.M. and Soares, M.J., 2012. The yield curve and the macro-economy across time and frequencies. Journal of Economic Dynamics and Control, 36(12), pp.1950-1970.

Bielecki, T.R. and Rutkowski, M., 2013. Credit risk: modeling, valuation and hedging. Springer Science & Business Media.

Bomfim, A.N., 2015. Understanding credit derivatives and related instruments. Academic Press.

Chen, Y.C. and Tsang*, K.P., 2013. What does the yield curve tell us about exchange rate predictability?. Review of Economics and Statistics, 95(1), pp.185-205.

Hull, J. and White, A., 2014. Valuing derivatives: Funding value adjustments and fair value. Financial Analysts Journal, 70(3), pp.46-56

Khan, S.U. and Abbas, Z., 2013. Does Equity Derivatives Trading Affect the Systematic Risk of the Underlying Stocks in an Emerging Market: Evidence from Pakistan's Futures Market. The Lahore Journal of Economics, 18(1), p.63.

Kolb, R.W. and Overdahl, J.A., 2014. Financial derivatives. Lulu Press, Inc.

Schiller, F., Seidler, G. and Wimmer, M., 2012. Temperature models for pricing weather derivatives. Quantitative Finance Assignment, 12(3), pp.489-500.