International Bank Usage of Financial Derivatives To Minimize or Hedge The Risks

International Bank usage of Financial Derivatives to Minimize or Hedge the Risks
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Richard A. Brealey. Principles of Corporate Finance, 2005§
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International Bank usage of Financial Derivatives to Minimize or Hedge the Risks
University Of The West Of The Scotland Corporate finance 14h May, 2010 Faculty
Advisor:
Abstract xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx
Table of Contents Abstract 2 30Chapter 1- Introduction 6Chapter 2 – Literature
Review 14Chapter 3– ResearchMethodology 28 Chapter 4 – Findings and Analysis 38
Chapter 5 – Conclusions andRecommendations§ 48 References List 53 CHAPTER 1-
INTRODUCTION 1 2.1 Introduction The conventional swaps, options, and futures
originate from debts and entail sale and purchase of liabilities/debts. In general,
products such as stock options and futures, interest rate swaps, current futures
etcetera are called derivatives. Therefore, derivates are instruments obtained from
the anticipated future performance of the specific underlying assets. They can be
regarded as complex and risky contracts currently valuing trillions of dollars in the
market all over the world. According to the views of prominent economists, the
global financial market is increasingly becoming fragile as ‘hedging’ instruments
and ‘bulking’ derivatives emerge§ (Ayub, n.d). 2For a detailed analysis of

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derivatives, it is good to first revisit the terms call option and put option. Call option
is simply an option to buy a certain commodity. On the other hand, put option is an
option to sell a commodity. Options have a nominal size, the amount of underlying
asset that option holders may buy or sell commodities at the strike price. The strike
price in this case signifies the price at which the option holders may buy or sell
commodities upon exercising the option. In situations whereby the price shifts
favorably,the option is performed and the commodity is bought or sold at the
settled price. If the price shifts unfavorably,the person buying the option simply
discards it. Therefore, option contracts grants the right but not the obligation to
engage in an underlying contract of exchange before or at a specified date in future
option buyers paythe seller of theoption§ a price called premium. Options pricing of
assets also called Real Options Valuation are able to evaluate such contingent cash flow
and it appears to be a very useful valuation method when there are a high probability of
uncertainty in the future cash flows. By using the Real Options model, the corporation
has the opportunity to modify in the future an investment strategy 37in order to take
advantageof the good newsthat§ may arise and to protect itself against bad ones.
Therefore, the investor benefits from a certain level of flexibility in the management of
its investment project. 1.2 Problem Definition & Research Questions After alternative
strategies have been analyzed, managers choose one of those strategies. If the analysis
identified a clearly superior strategy or if the current strategy will clearly meet future
company objectives, then the decision is relatively simple, such clarity is the exception,
however, and strategic decision makers often are confronted with several viable
alternatives rather than the luxury of a clear-cut choice. Under the circumstances,
19several factors influence the strategic choice. Some of the more important are:§
1. Role of the current 19strategy. 2. Degree of the firm’s external dependence. 3.
Attitudestoward risk. 4.§ Managerial priorities different from stockholder interests. 5.

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Internal political considerations. 196. Competitive reaction. Role of currentstrategy§
Current strategists are often the architects of past strategies. If they have invested
substantial time, resources, and interest in those strategies, they logically would be
more comfortable with a choice that closely parallels or involves only incremental
alterations to the current strategy. Such familiarity with and commitment to past
strategy permeates the entire firm. Thus, lower-level managers reinforce the top
managers’ inclination toward continuity with past strategy during the choice process.
Research in several companies found lower-level managers suggested strategies
choices that were consistent with current strategy and likely to be accepted while
withholding suggestions with less probability of approval. 5Research by Henry
Mintzbergsuggests that past strategy strongly influences current strategic choice.
The older and more successful a strategy has been, the harder it is to replace.
Similarly, once a strategy has been initiated it is very difficult to change because
organizationalmomentum keeps itgoing. Even as a strategy begins to fail due to
changing conditions,strategists often increase their commitment to it.§ Thus, firms
may replace top executives when performance has been inadequate for an extended
period because replacing these executives lessens the influence of unsuccessful past
strategy on future strategic choice. If a firm 10is highly dependent on one or more
environmental elements, its strategic alternatives and its ultimate strategic choice
must accommodate that dependence. The greater a firm’sexternal dependence, the
lower its range and flexibility in strategic choice. While externaldependence§ can
restrict options, it isn’t necessarily a strategic threat. The last decade has seen firms’
efforts to enhance quality and cost include decisions to ‘sole-source” certain supplies or
services, even ones central to the firms’ strategic capabilities. This increases “external
dependence,” but it is seen as a way to “strategically partner’ that allows both firms to
share information, and improve and integrate product and process design and
9
development, to mention a few benefits that may accrue to both partners. 5Attitudes
toward risk exertconsiderable influence onstrategic choice. Where attitudes
favorrisk, the range of the strategic choices expands and high-risk strategies are
acceptable and desirable. Where management is risk averse, the range ofstrategic
choices is limited and risky alternatives are eliminated before strategic choices are
made. Past strategy exerts far more influence on the strategic choices of risk-§
averse manages. Industry volatility influences the propensity of mangers toward risk.
Top managers in highly volatile industries absorbed and operate with greater amounts
of risk than do their counterparts in stale industries. Therefore, top managers in volatile
industries consider a broader, more diverse range of strategies in the strategic choice
process. Industry evolution is another determinant of managerial propensity toward risk.
A firm in the early stages of the product market cycle must operate with considerably
greater risk and uncertainty than a firm in the later stage of that cycle. In making
strategic choices; risk-oriented managers’ lean toward opportunistic strategies with high
payoffs. They are drawn to offensive strategies based on innovation, company
strengths, and operating potential. Risk-averse mangers lean toward stage,
conservative strategies with reasonable, highly probable returns. They are drawn to
defensive strategies that minimize a firm’s weaknesses, external threats, and the
uncertainty associated wit innovation-base strategies. Corporate managers are hired,
theoretically, to act as agents of shareholders and to make decisions that are in
shareholders best interest. An increasing 17area of research known as agency theory
suggests that managers frequently place their own interestabove those of their
shareholders. This appears to be particularlytrue when thestrategic decisions
involve diversification. While stockholder value may be maximized by selling a
company, the§ idea of sharing core competencies may encounter resistance form
mangers suspicious about diluting their valued capability. “Shared infrastructures”

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usually means fewer managers are needed. ‘Balancing financial resources” realistically
means resources controlled by one management group become shared or diluted to
support other businesses. Similarly, some managers may seek diversification to
accelerate sales growth, although continued focus in a narrow market area ensures
increase competitive advantage to sustain long-term shareholder value. “growth”
achieved by combining two companies increases the basis on which some mangers are
compensated, regardless of whether the combination is truly advantageous to
stockholder. The bottom line is, particularly where diversification decisions are being
made. Managerial self-interests can result in strategic choices that benefit mangers to
te detriment of stockholders. In these situations, strategic decision main can take on a
political context like that described in the next section. 10Power/political factors
influence strategieschoice. The use of power to further individual or group interestis
common in organizational life.§10A major source of power in most firmsis the§ chief
executive. Coalitions are power sources that influence strategic choice. In large firms,
subunits and individuals have reason to support some alternatives and oppose others.
Mutual interest draws certain groups together in coalitions to enhance their position of
major strategic issues. These coalitions, particularly the more powerful ones, exert
considerable influence on the strategic choice process. Numerous studies confirm the
frequent use of power and coalitions in strategic decision making. Organizational
5politics must be viewed as an inevitable dimensionof organizationaldecision
making that strategic management must accommodate. Some authors argue that
politics is a key ingredient in the “glue” that holds an organizationtogether.§ Formal
and informal negotiating and bargaining between individual, subunits and coalitions are
indispensable mechanisms for organizational coordination. Accommodating these
mechanisms in the choice of strategy will result in greater commitment and more
realistic strategy. The cost of doing so, however, are likely to be increased time spend
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on decision making and incremental change. In weighting 10strategic choices, top
management frequently incorporates perception solikely competitor reactions to
those choices. For example, if it chooses an aggressive strategy directly challenging
a key competitor, that competitor can be expected to mount an aggressive
counterstrategy. In weightingstrategic choices, tomanagement must consider the
probable impact of such reactions on the success of the chosen strategy. An
assessment onthe benefits and limitationsof§ financial derivatives is also developed
as well as the effectiveness of their use by international banks on meeting pre-
established corporate goals. 1.3 1Purpose The purpose of this dissertation is to gain
an understanding of how multinational companies use the§ hedging to solve the
problem of market fluctuations of prices. Due to a potential insufficiency in the area of
Real Options Valuations, it is apparent that studies need to be undertaken in this area.
For capital investment projects where uncertainty plays an important role, the standard
Net Present Value (NPV) techniques such as Discounted Cash Flow (DCF) tends in many
points to undervalue the investment opportunity. Therefore, I shall prove that real
options should be used to value firms and identify investment opportunities, sales of an
investment or even an expansion of an investment. 11.4 ContributionThe aimof this
dissertation is to§ find out how international baks are using financial derivatives to
manage risk.. That being said, the purpose of this dissertation aim: ❖ To examine the
content of financial derives usage by international banks policies in managing risk ❖ To
examine the effectiveness of these financial derivatives From the above aims, it can
confer that the most relevance would be provided to managers because they
understand the company operations and performance of derivatives in the market. This
study is just as relevant for international banks because it increases the awareness on
the importance of financial derivatives in managing risk, and on the awareness on the
fact that success is largely influenced by proper management of the risk. The study can
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also be deemed relevant for international banks as well, students because it provides a
guideline on what proper risk management. 4In terms of an academic contribution,
this dissertation adds a more in depth insight to§ the effectiveness of derivatives and
hedging in international banks. Research on hedging is innumerable, however most of
this research 1is based on American, European and Japanese§ international banks,
which leave the door, open for the examination of a rather limited research in internal
risk management. 1There is still relatively little empirical research documenting the
hedgingstrategies and practices of§ international banks. Overall, this dissertation
contributes 1from both an academic and professional vantage point. 1. 5
DelimitationThis dissertation focuses on the hedgingprocess in two international
banks.The study is limited to only§ hedging using financial derivatives and
international banks 11activities are not being investigated thoroughly.§ The
international banks 1will not be compared and analyzed in terms of their business
activities as that is beyond the scope of this dissertation, butthey will be analyzed
and cross-analyzed on the processthey take in hedging.1. 6Outline of
DissertationThe dissertation§ is broken down into three main parts. The first part,
Chapter 1, presents the reader with an introduction of the topic that is researched as
well as setting the theoretical foundations of the dissertation. In the second part,
1Chapter 2, the literature review is presentedwhereby all relevant literature
concerning the options, hedging. Hedgingis discussed in detail along with the
riskmanagement of international banks.Moreover, specific attention is paid to§
international risk. 1Chapter 3 is concerned with the methodology of the study. In this
section, a conceptual framework is constructed based on the research questionsand
literature review. The§ methodological part of the dissertation 1elaborates on the
reasons for choosing semi-structured interviews as the main data collection method
as well as how the data collected withthe interviewsis§ analyzed. Finally, the last part
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of the dissertation, (i.e. chapter 4, 5) consist of the presentation of results, conclusions,
managerial implications, limitations 38and areas for future research. CHAPTER 2 –
LITERATURE REVIEW 2.1§ Moody's ratio Moody's ratio provides investors to look at
financial statements of banks and credit union, to see if they can invest. Also Moody's
has the following, 33“numerical modifiers, 1, 2, and 3, in each generic rating
classification from Ato B” (Investing Minds). Eachmodifier indicates§ a particular level
of risk management in both the banks and credit unions. S & P is referred to the “price
to sales ratio” that allows investors to decided where to invest their money. In the other
hand, the investors look at the S & P of banks with a, “lower ratio of 1.0” (How to Use
the S & P). Indicating an opportunity for investors to invest and take advantage. In the
other hand if the ratio is low then there is the probability that the investor would
decided not to invest because there is a high risk of loosing money. Credit Index ratio is
most of the time use in commercial banks that their credit derives in expositing the risk
of an investor. Presently banks use the credit index in a form of, 24“credit risk transfer,
such as securitizations, to shed risk in several areas of their credit portfolio” (Credit
Derivatives§ and Risk Management). Also banks today use what most of the investor
called a “credit default swaps” (Credit Derivatives and risk Management). Most of the
time 24banks can transfer theircredit index intoa portfolio to showinvestors§
financial transactions of the bank. 2.2 Options Credit risk can happen to banks that are
in business in term of lending money. Traditionally, risk can be range from caution, to
regulatory consideration, to the desire to maintain consistent shareholder return
(Stewart). Risk management in an investment can be avoided until the banks have a
problem or change regulatory environment force the pace of modification. By changing
risk management to turn to a profitability of each investment will be adapt to bank’s
circumstance. By reducing cost and become more efficient, and generate higher, more
sustainable and better quality returns for its shareholder. Banks could change the way
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they undertake risk management. By placing a risk management into business so that
they can function, plan, and strategic process, bank could have increase compete on
their risk product and make in a long term winner (Stewart). 2.3 Markets for derivatives
Although 39over-the counter contractsare tailored to meetthe specific hedgingneeds
of individual firms,the§ types of risks that are most often hedged with derivatives are:
(1) foreign exchange rates (2) Interest rates (3) Commodity prices and (4) Equity prices.
Foreign Exchange Derivatives With the increasing amount of trade among foreign
countries and the increased volatility in exchange rates due to breakdown in 1973 of
the previous system of fixed foreign exchange rates. Most multinational companies
utilize 13derivatives to manage their foreign exchange exposures. The most
commonly used currentlyderivatives are swap and forward contracts. Interest Rate§
Derivatives 29:-Several factors have contributed to the use of interest rate
derivatives to hedge against changes in value due to interest rate changes.§ One
factor is the high level and volatility of interest rates in the 1970s and 1980s, which
resulted from high levels of expected inflation as well as changes in expected inflation.
Also, in 1979 the Federal Reserve changed its policy of trying to stabilize interest rates
directly instead started targeting monetary aggregates. The consequence of this
change in policy was to increase interest rate volatility substantially. 13Interest rate
futures, options, and swaps are frequentlyused to hedge interest rate risk.§
Commodity Derivatives:-Derivative contract on agricultural commodities have existed
for a long time. For example, the Chicago Board of Trade has traded futures contracts
since 1865, and forwards and options on agricultural products date back several
centuries. Users and producers of commodities such as metals and oil also frequently
trade both over-the counter and exchange-traded derivatives. The use of electricity
derivatives also has grown significantly in recent years due in part to deregulation of
the industry. Equity Derivatives:- 13Equity derivatives are contracts derived from
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stock market indexes§ like the standard & poor’s 500. 13Futures contracts exist that
are based on US stock market indexes and on foreign stock market indexes,§ such
as the Nikkei index for the Japanese stock market. In addition, options have traded on
individual stocks for some time. 2.3.1 Hedging market risk with futures A large amount
of hedging activity occurs in the Treasury bill futures markets. Most of this is initiated by
corporations. The side of market they are in depends on whether they are hedging an
existing investment in a portfolio of money-market securities an anticipated future
investment, or a short-term security issue. Careful hedgers of Treasury bill futures
monitor their net short-term cash position at various maturities and place the hedging
trades accordingly. Most large institutions have sizable amounts of both short-term
liquid assets and liabilities. Their exposure to interest risk will depend on the gap
between the amounts and maturities of their short-term position. Some institutions
prefer to hedge only specific positions in short-term investments or borrowing because
of the greater ease with which they can define their interest-rate-risk exposure thereby
reducing it with specific futures contracts. 2.3.3 Futures on Long-Term Securities
Financial futures calling for delivery of long-term fixed-income securities, these futures
contracts all call for delivery of securities either 32issued or guaranteed by the U.S.
government.§ Futures contacts on other fixed-income securities and indexes are in the
planning stages. One will restrict our discussion to U.S. Treasury bond futures. The
existing fixed-income futures markets developed well before cash settlement was a
possibility. The most successful contract, futures on U.S. treasury bonds, has a
deliverable instrument with a very liquid market; dealer positions are easily financed by
repurchase agreements and default risk is nonexistent. Futures on four-to six-year
treasury notes were introduced in June 1979 but had little success. In May 1982, the
CBOT began trading a new note contract calling for delivery of treasury obligations
maturing in 6.5 to 10 years from contract delivery. This contract has been more
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successful. Treasury bond futures call for delivery of Treasury bonds with $100,000 face
value at any time during the delivery period. These bonds must have a maturity date or
call date no sooner than fifteen years from the delivery date. There are always several
bonds acceptable for delivery. Deliverable notes are those maturing no less than 6.5
years and no more than 10 years from the delivery date. Price quotations in the
Treasury bond futures market are based on a bond with 3an 8 percent coupon rateand
a twenty-year maturity. The§ actual amount paid or received at delivery will be
determined by this price, accrued interest, and a conversion factor that adjusts the
futures price for the characteristics of the particular bond being delivered. These
conversion factors are equal to the ratio of the price of the futures contract. A detailed
discussion of conversion factors is beyond the scope of this book. The actual invoice
price at delivery is determined as a function of the conversion factor applicable to the
bonds delivered. Invoice amount= $100,000 x Settlement price x Conversion factor for
x Accrued interest Of futures bonds delivered Bonds may sell in the cash-bond market
at prices above or 32below the convertedprice of the futures contract.The bondthat
is‘cheapestto§ deliver” is the bond that Treasury bond futures traders focus on in
making their transaction decisions. The same procedure is used in invoicing Treasury
note contracts. Here an 8 percent, ten-year note is used as the standard not for
exchange future price quotations. Knowing the cheapest-to- deliver Treasury bond or
Treasury note at any time is critical to constructing trading strategies for Treasury bond
futures. Speculators and arbitrageurs analyze the relative prices of cash future using
the cheapest- to-deliver bond as the benchmark for the cash market price. 2.4 Valuation
of fixed –income futures The valuation of fixed-income contracts is not considered in
depth here due to its very complex and arcane nature. We will restrict our discussion to
the pricing of Treasury bill futures contracts because they are the easiest to understand.
Initially, however, it is appropriate to highlight some of the underlying fundamentals

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that contribute to the valuation complexity associated with many fixed-income futures
contracts. The valuation of fixed-income futures contracts is both easier and more
complex than the simple procedures used with stock-index futures. First, the income
received form the underlying securities are more certain with fixed-income securities. In
contrast, the timing and amount of the separate cash dividends in a basket of stocks is
highly uncertain. Second, delivery differs between stock-index and fixed income futures
normally involve physical delivery of underlying securities. Further, some fixed income
futures allow for alternative securities to be delivered. The seller may have the option to
deliver the security with the highest invoice price as compared to its purchase cost in
the cash market. Moreover, futures sellers can choose to execute delivery on any day in
the contract month. 2.4.1 The carry-cost model of future prices The simplest process for
valuation of futures applies to those contracts that call for delivery of a security that has
a liquid cash market, has a supply that is relatively fixed in quantity, and provides no
intermittent cash flows such as interest or dividends. An example of future that meets
most of these criteria is the Treasury bill future. The carrying-cost concept of futures
pricing links current prices of futures to current cash prices and to the cost of “carrying”
deliverable securities until the futures contract expires. This linkage is possible because
purchasers and sellers of treasury bills view the cash and futures market as a
competing means of acquiring and selling these securities. When prices in either the
cash or futures market are cheap relative to the other market after reflecting carrying
costs, marginal purchasing will occur in the market with the lowest price and selling will
occur in the market with the highest price. The trader with the cheapest assess to funds
will dominate the price-setting mechanism in the market place. Eventually, selling
pressure in the futures market will force the future price to fall to a level where no clear
advantage exists to buying in the cash market and selling in the future market. If this
does not occur, 10 basis points or $10/$10,000 treasury bills can be earned risk- free for
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each Treasury bill purchased in the cash market. FPt ≡ CP + (CP x r x t ) Future prices =
cash price = carrying costs Where: FPt = current price of a futures contract calling for
delivery in t months CP = current price of a security deliverable into the future contract
r = rate of interest per month t = number of months until delivery Note that we use a
basis time period of a moth in the formulas and examples. These could be easily
restructured in terms of a daily interest rate and days until delivery. The future price will
equal the price of the deliverable security CP plus the cost of financing the purchase of
that security for t months until delivery at the monthly interest rate r. form another
perspective, we can say that the futures price equals the amount that would be
accumulated if one delayed purchase of the treasury bill until the delivery of the futures
and deposited the cash price in the bank to earn r interest for t months. Other
implications 37can be analyzedas well. The difference betweenthe§ futures and cash
prices should approximate the carrying cost 3as a percentage of the securities’face
value.§ This difference between cash and futures price 3is often referred to as the§
basis. For financial futures, the basis is primarily a function of the financing cost of the
cash security. Similarly, the difference between the rate implied by the futures price
and the rate on a Treasury bill deliverable into the future should equal the financing
rate for the period prior to futures delivery. Finally, the sum of the rate on a 90-day bill
(r0.1) and a future calling for delivery in 90 days (R1.2) should approximate the rate of
a 180-day treasury bill (r0.2). This result is an approximation because it ignores the
compounding of interest on a monthly basis. 2.4.2 Strategies using fixed income futures
Myriad strategies can be employed using fixed-income futures. One will consider three;
changing duration, enhancing yield, and hedging. 2.4.3 Changing the duration of the
portfolio Investors with strong expectations about the direction of he future course of
interest rates will adjust the duration of their portfolio to capitalize on their
expectations. Specifically, if they expect interest rates to decrease, they will lengthen
19
the duration of the portfolio. Also, anyone uses structured portfolio duration to match
the duration of some benchmarks. Although investors can alter the duration of their
portfolios with cash-market instruments but there are quick and less expensive means
for doing so that is to use futures contracts. By buying futures contracts on Treasury
bond or notes, they can increase the duration of the portfolio. Conversely, they can
shorten the duration of the portfolio by selling futures contracts on treasury bonds or
notes. The formula that can be used to approximate the number of futures contracts
necessary to adjust the portfolio duration to a new level is; Approximate number of
contracts = (Dr – Dl ) Pl DF PF Dr = target modified duration for the portfolio Dl = initial
modified duration for the portfolio DF = modified duration of the futures contract Pl =
initial market value of the portfolio PF = market value of the futures contracts 2.5 Fixed
Investing Analysis Every investment offers equilibrium between potential return and
risk. A risk is the probability that an investor might lose a portion or the entire money
put in an investment. Note that the return is the money an investor stands to make
after the investment turns to be a success. The balance between return and risks varies
depending on the entity that issues it, the type of investment, the trend of the securities
markets, and the nature of the economy. Financial experts are of the opinion that the
greater the risk taken, the higher the returns. On the contrary, lowest returns are
associated with least risky investments. Bodie, Kane & Marcus(2006) claim that a huge
number of investors put their money in bond investments. This investment involves an
investor giving his/her money to an institution with the expectation getting the money
back plus an interest. When used haphazardly, bonds can mess up one’s financial life;
however, bonds are among the best tools for managing your investment kit. In many
cases, business firms, private institutions, and governments issue bonds to investors
with the aim of expanding business or funding public programs and projects
respectively. Bond investment is a tricky investment entity; therefore, investors are

20
advised to be keen before involving themselves. The way one invests in bonds depends
on many factors, which include; investment time frames and goals, one’s tax status,
21and the amount of risk the investor is willing to take.§ On the same note, the
investor must understand the importance of diversification when going for a bond
investment strategy. Having discussed the above, this paper is going to describe
interest rate risk applied to bond investing. In general sense, risking is the possibility of
attaining something undesirable from an entity or venture someone gets involved in.
People invest in bonds because they expect the greatest return possible for their
money. However, there are risks involved and the bond market has not been spared by
these risks (Bodie, Kane & Marcus, 2006). 23Interest rate risk is the risk borne by§23a
bond investordue to variability of interest rates. Generally,as interests fall,the price
of a fixed-rate bond will rise, andvice versa.§ When 35thought of in terms of market
rates,§ the 20price of abond will fall if theinterest rates rise.§ This will occur so that
the yield can 35match the new market rates. It is imperativeto§ understand that
3interest rate riskis usually measured by§ the duration of the bond. The analysis of
interest risk rate is often founded on simulation movement of the yield curve using the
Heath-Jarrow- Morton framework. This framework was designed to help investors
monitor the movement of the yield curve. Its movement is expected to be consistent
with other current market yield curves and that no riskless arbitrage can occur (Bodie,
Kane & Marcus, 2006). Investors are advised to venture into bond investments only if
they are assured of interest rates rise in the future. Moreover, they should be wary of
the duration of the investment. A shrewd investor should avoid long-term maturity
bonds by shortening the average duration of the bond holding. 3Here is an example
showinghow interest rate§ risk applies to bond investing. The seesaw relationship
between bond prices and interest rates 9is a basicconcept of bonds. However,some
bonds have greater sensitivity to changes in theirinterest rates. Therefore,bond

21
investors§ should not guess at this exposure. The bottom line is that the sensitive
movement 3in interest rates lieson the durationof a bond§ (CNN, 2010). It becomes
obvious that when interest rates change, while the other market factors remain equal;
then the discounted cash flow will fall. Many investors invest in bonds because they are
less risky than stocks because of the following reasons. First off, the bond market has
historically been less susceptible to volatility or price swings as compared to stock
markets. Similarly, investors are 3paid a fixed rate of interest§ income by the bonding
firm; moreover, the interest income might be backed by a promise from the issuer.
Stocks occasionally pay dividends to their investors, but the issuer has no compulsion
whatsoever to make the payment to shareholders. To end with, bonds bear the promise
of the issuer to give the face value of security back to the investor at maturity. In
contrast, stocks have no such promise to the investor. Nevertheless, investors have
some options in which interest rate risk can be controlled, they include; buying interest
rates derivatives. A derivative is a form of security, 3whose value depends on the
value of another asset.§ Moreover, investors can decide to invest in floating rate
securities, instead of investing in fixed-rate securities. Similarly, an investor should only
invest in securities that are due to mature in the short term. Since earning interest is
the goal of every investor, they are advised to practice a “buy and hold” strategy (CNN,
2010). Under this strategy, an investor should invest in a bond and hold that bond to
maturity. Such an investor will be assured of interest payments, which occur twice a
year. Eventually, the investor will receive the face value of his/her bond upon maturity.
One of the most salient considerations one should have in mind before venturing into
bond investment is the duration. Fredrick Macaulay was the brain child behind this
concept which was born back in 1938. The duration is used to measure the bond price
volatility by measuring the span of the bond. In bond investment, the term duration
refers to the 20weighted-average periodto maturity of the bond’s cash§ flow. In this
22
context, the weight has been used to present the 20value of everycash flow as a
percentage of the bond’s wholeprice§ (SIFMA, 2005). A Solomon Smith Barney study
compared duration to a chain of tin cans evenly placed on a seesaw. The volume of
each tin represents the cash flow due; the tin’s contents correspond to the current
values of the cash flow due, and the distance between the tins to represent the
payment period. Eventually, the study claimed that duration would be the distance to
the fulcrum that would stabilize the seesaw. Having a closer look at this definition, one
would not fail to notice that a zero-coupon security would be the same as its maturity
period because the cash flow (weights) is at the other end of then seesaw. Moreover,
greater percentage volatility would be determined by a greater duration of a bond.
Generally, duration falls with the regularity of coupon payment, and rises with maturity.
Regarding bond investment, duration is a straight forward concept because 9it
measures how longa bond would take torepay its exactcost. The longer the
duration,the more exposedthe bond isto the interest environment§ (SIFMA, 2005). It
is imperative to understand that a bond’s duration is affected by several factors.
Investors are therefore required to delve deeper into these factors before venturing into
bond investment. One of the key 21factors that affect a bond’ sduration istime to
maturity. Let usconsider two bonds, each co0sting TT$10000and yield 5%.§ An
investor who goes for 9a bond that matures in one year would§ experience quick
returns to the true cost as compared to an investor who would go for 9a bond that
matures in tenyears. This means thatthe shorter-maturity bond would have less
price riskand§ a lower duration as well. In simple terms the higher the duration, the
longer the maturity. Another factor that should be considered is the 9coupon rate
sincea bond’s payment periodis the determiningfactor whencalculating duration.
Whentwo identical bonds are paid usingdifferent coupons, thenthe bond with the
uppercoupon will pay back its initialcost fasterthan the low-yielding bond. This
23
means thatthe lowerthe duration,the higherthe§ coupon. Investors are therefore,
expected to know the portfolio of a bond or the duration of a bond. This will be
advantageous to an investor in two ways. First off, it will help them to speculate the
interest rates. It is particularly common to find investors who anticipate falls in market
interest rates. These declines can transpire from stimulant rate cuts by the Federal
Reserves. Under such circumstances, an investor would attempt to augment the
standard duration of their bond portfolio. Similarly, eager investors would wish to lower
their average duration incase the Fed raise the interest rate (SIFMA, 2005). Secondly,
knowing the duration of a bond would enable an investor to match the risks to his/her
test. When choosing 9from bonds of different yieldsand maturities,or matching up
tobond mutual funds, duration enables an investorto quickly determine which bonds
are more susceptibleto modificationin market interest rate,and to what§ extent
(Maeda, 2009). Investors should have privy information about the four principal types of
duration calculations. Note that every method vary 15in the way they account for
factors like redemption features,interest rate changes, and the bond’s fixedoptions.
The four keytypes of duration calculation include;Macaulay Duration, Modified
Duration, Effective Duration, and Key-Rate Duration. Calculatingduration§ should
9start by establishingthe value of thebond’s annualcash flow,§ this value should be
9adjusted to give bigger valuesto payments that are made sooner and notlater.§
The answer should be divided by the initial price to calculate its duration. Given below is
an example. Normally, 25bonds with a lowduration have a lowprice fluctuation than
bonds with high durations.It is imperativeto understandthat there are other factors
that decidehow a bond’s price§ affects 15interest rates. These factors include
yieldto maturity, coupon rate, and termto maturity§ (Maeda, 2009). Note that when a
bond’s initial price and term to maturity remain stable, it will mean that the 15lower
the volatility, the higherthe coupon, andthe higher the volatility, the lower
24
thecoupon.§ There are other risks that are related to fixed-income securities, these
risks are either of a general nature or specialized. Maturity and yield-curve are
important in equivocating positions, where the assortment of bonds is hedged with
bonds of dissimilar interest rates and maturities. These bonds are implicit to transform
under changes in prevailing rates. Yield-curve risks occur when prices of bonds with
different maturities swerve from this postulation when existing rates change. Chapter 3
– Research 6Methodology 3.1 Introductions The methodology of research would be
exploratory research. Secondary research has been conducted in order to obtain all
the required information.§14Research is generally assumed to be a complicated
task which is actually not if the various parts or phases of the research are clearly
understood. Aresearch project is basically a well-structured process which has a
beginning, intermediate part and the end. In today’s world, research is alternatively
being termed as logical reasoning. In a nutshell,research is§16a methodical and
purposeful study conducted to obtain solutions for specific problems. Research is a
process of collection of data in an organized manner with subsequent recording and
analyzing of such data that will help in an effective decision making process.§ The
6most important benefit of using secondary data is that is very economical. This is
because the cost of original data collection is saved (Careerforum.in). Also
secondary data collection needs lesser effort to be put in when compared to
primary data collection. Making use of secondary data for conducting research
saves immense amount of time for the researcher. This would lead to prompt
completion of the research. Search for secondary data is very useful, not just
because secondary data may be helpful but due to the acquaintance with such data
dignifies the deficiencies and spaces. Therefore, the researcher can make the
collection of primary data more precise and more pertinent to the research study. It
is on the above mentioned premises that this research paper was written
25
fundamentally through secondary data. 3.2§1Research Purpose Common
classifications of research purpose include exploratory, explanatory and descriptive.
According to Yin (1994), exploratory research is sometimes considered a prelude to
social research and may be used for doing casual investigations. It is important to
be flexible when performing this research because it is possible to come across
findings, which may unexpectedly change the direction of the research (Tellis,
1997). Therefore, exploratory research often starts with a very broad focus that
progressively changes through the course of the research. Descriptive research on
the other hand, requires that a descriptive theory be developed before commencing
the research (Yin, 1994). Descriptive research includes identifying and mapping by
signifying, registering and documenting based on the researcher’s choice of
perspectives, level of depth and definitions (Glesne & Peshkin, 1992). It can be
inferred that in order to progress onto exploratory research, the descriptive
research needs to be executed well. Lastly, explanatory research aims to make an
analysis of cause and effect relationships, which is similar to that of the descriptive
stage (Yin, 1994). In other words, the analysis should be based on various
predetermined conditions. This dissertation takes the approach of descriptive
research as information is collected in order to describe what risk managementin§
international market. 1Nevertheless, the research is also exploratory and
explanatory due to cause and effect relationships§ are sought out as well. For
example, the research attempts to determine why certain hedging techniques are or
are not taken in accordance or not in accordance to internationally recognized best
practices for hedging. In 1short, the research devotes time to the exploratory stage
by examining at the purpose of this dissertation, then at the descriptive stage and
limited time in the explanatory stage where conclusions of the descriptive stage are
26
presented. 3. 3Research Approach There are mainly two approaches ofconducting
research; a quantitative and aqualitative approach. These methods are used to
generate, arrange and analyze the information and data that have been collected
(White, 2000).The difference between the two ways of conducting research is that
quantitative research relies on mathematical and statistical treatment in the
evaluation of results, whereas qualitative research relies on description in the
evaluation of results. To generalize, qualitative research is usually better for
exploring understanding and uncovering, while quantitative research is usually
better for confirming and clarifying.§22Common quantitative data gathering
techniques involve the use of questionnaires and interviews where responses are
given a numerical value. Qualitative data gathering techniques on the other
hand§1involve the use of interviews, observations, diaries and even case studies
and action research (White, 2000). As perYin (1994), the qualitative research
approach is used in management and business to study the way organizations,
groups and individuals behave and interact. This dissertation is based on qualitative
research§ as it falls 1very much in line with the§ aims of this dissertation. 1Since the
purpose is to gain an understanding of how§ international banks manage their risk, 1a
qualitative approach ofconducting this research is chosen. According to White
(2000, pg, 28), “qualitative research is a descriptive, non-numerical way to collect
and interpret information”. Researchers who support this approach argue that no
two situations are the same and every phenomenon is unique.§1Qualitative
research is descriptive in that the researcher is interested in process, meaning, and
understanding gained through words or pictures (White, 2000). The process of
qualitative research is inductive in that the researcher builds abstractions,
concepts, hypotheses, and theories from details (Glesne & Peshkin, 1992).
27
Furthermore,§ they state 1three central aspects in qualitative research, the first
aspectis the researcher’s possibility to see and interpret the reality from the
respondent’s perspective. The second aspect focuses on studying the relationship
between theory and research with the qualitative tradition and finally,the lastaspect
is to decide onhow much of the qualitative research results can be generalized. In
other words, the non-standardized and complex data that is collected has to be
classified into categories before it can be analyzed in a meaningful way. Therefore,
the qualitative approach to research is much moresuitable for this study as rich and
extensive data is gathered to understand the§ financial derivatives and hedging 1and
thereby reach the purpose of the dissertation. Additionally, the qualitative approach
to research is appropriate for this studybecause it is inductive in nature, which
means that the researcher gains insight and understanding from the patterns in the
data collected§ (Marshall & Rossman, 1980). 4Quantitative & Qualitative Modes of
Inquiry (Marshall & Rossman, 1980) |Quantitative Mode |Qualitative Mode | |
Assumptions |Assumptions | |Variables can be identified and|Variables are complex,
interwoven,| |relationships measured |and difficult to measure | |Social facts have
an objective |Reality is socially constructed | |reality | | |Purpose |Purpose | |
Generalizability |Contextualization | |Prediction |Interpretation | |Approach |
Approach | |Begins with hypotheses and |Ends with hypotheses and grounded | |
theories |theory | |Manipulation and control |Emergence and portrayal | |Deductive |
Inductive | |Seeks consensus, the norm |Seeks pluralism, complexity | |Component
analysis |Searches for patterns | |Researcher Role |Researcher Role | |Objective
portrayal |Empathic understanding | |Detachment and impartiality |Personal
involvement and | | |partiality | 3.4Research Strategy The previous section
discussed the research approach taken to conduct this dissertation andthis section
28
focuses on the technique taken to gather the data. A multiple case study approach
using international banksis conducted to reach the purpose of the dissertation. Case
studies are not a single qualitative technique since a number of methods are used.
Many case studies include “quantitative questionnaires, although they tend to make
more use of descriptive evidence such as interviews and observation,” (White,
2000, pg. 39). They are an inquiry that uses multiple sources of evidence and
investigates a contemporary phenomenon within its real life context when the
boundaries between phenomenon and context are not clearly evident (Yin, 1994).
Case studies are very popular and are especially good in situations that are
complex andinvolve a number of different issues. This dissertation looks at
international banksand their policies on§ managing international risk. In 1this regard,
the use of a case study is ideal because it answers the questions why and how,
which are in line with the purpose and research questionsof this dissertation. Case
studies can be typical, atypical, precursor or multiple (White, 2000). This
dissertation takes a multiple case study approach, which allows for comparative
treatment and as a result helps build and confirm accepted theory. Withcase study
research, itis§28important to set the scene for the reader becausethis gives the
research more credibility and makes it academically more valid (White,
2000).The§1scene will be set for the reader regarding the companies being
investigatedin Chapter 4. Case studies are an excellent vehicle for a dissertation
because they are more suited to small-scale research (Marshall & Rossman, 1980).
A case study will always generate empirical data and information, so it is not solely
dependent on already published work, andwhile the data may not be present in vast
amounts, it will always be interesting and specific to the example under scrutiny
(Tellis, 1997). Yin (1994) mentions that case studies tend to be selective, focusing
29
on one or two issues that are fundamental to understanding the system being
examined. He proposes four statesto carry out an appropriate case study; 1. Design
the case study – determine required skills, develop and review the protocol 2.
Conduct the case study – prepare for data collection, conduct interviews 3. Analyze
the case study evidence – analytical strategy 4. Develop the conclusions,
recommendations and implications These steps follow closely in line with the topics
discussed in this section of the dissertation. For example, the research strategy
section resembles the design of the case study step recommended by Yin, the data
collection and sample collection sections resemble the conduct the case studystep
and the data analysis section resembles the analyze the§ case study evidence 1step.
The conclusions, recommendations and implications step is presented in the last
sections of this dissertation, namely in Chapter 4and§ 5. 1Finally, a case study is
more favorable to deal with relationships and social processes in a way that other
research approaches might not because it takes place in a natural setting within an
actual organization thereby givingthe work a reality,which is often absent from
surveys and similar types of investigation (Glesne & Peshkin, 1992). For all of the
above reasons, a case study approach was chosen as the most suitable vehicle for
qualitative research.§ 3.5 1Data Collection Data collection can provide, when
properly executed, a rich source of material. The following section presents the data
collection methods used to carry out the research needed for the dissertation.
Primary & Secondary Data: As indicated by White (2000),§11information can be
classified into primary data and secondary data. Secondary data includes material,
which has been published before, such as a textbook. This type of material is less
specialized and not up to date, although it tends to provide general background and
theory (White, 2000).Conversely, primary data is new and original and tends to be
30
very specialized, such as theses and trade literature. Simply, primary material
represents data that has been collected for the purpose of actual research.§1As
secondary data, this dissertation makes use of the Internet, published books, online
journals and databases.§1Yin (1994) identifies six primary sources of evidence for
case study research, namely, documentation, archival records, interviews, direct
observation, participant observation and physical artifacts. While not all sources are
essential in every case study, the importance of multiple sources of data
onlyestablishes reliability§ of the study. Table 42 presents the reader with the
sources used in this dissertation and the advantages and disadvantages of each.
Table 3: Sources of Primary & Secondary Data (Yin, 1994, pg. 80) |Source of |
Strengths |Weaknesses | |Evidence | | | |Documentation |Stable - repeated review |
Retrievability– difficult | ||Unobtrusive - exist prior to |Biased selectivity | ||case
study |Reporting bias - reelects | ||Exact - names etc. |authorbias | | |Broad
coverage - extended |Access - may be blocked | | |time span | ||Archival Records|
Same as above |Same as above | |(ex. Company |Precise and quantitative |Privacy
might inhibit access||records) | | | |Interviews |Targeted - focuses on case|Bias due
to poor questions | ||study topic |Response bias | ||Insightful - provides |Incomplete
recollection | ||perceived causal inferences |Reflexivity - interviewee | | | |expresses
what interviewer | | | |wants to hear | Interviews:- Telephone interviews were chosen
to collect primary data for the dissertation. Interviews in general can be used in a
variety of contexts and situations, and in conjunction with other research methods
(Yin, 1994). “The type of interview will depend on the nature of information you
want to collect, and it may range from a highly structured predesigned list of
questions to free ranging conversations,” (White, 2000, pg.29).§ To elaborate, an
36interview could take one of several forms: open- ended, focused or structured.§
31
Tellis (1997) recommends that an open-ended interview is best when the research
wants to know the informant’s opinion on events or facts. He 1further goes on to
mentionthat a structured interviewis§ shorter and more useful if a formal survey is
going to take place. 3.6 1Reliability, Validity & Pilot Testing Since the research design
is the blueprint for the research and dissertation, it§ would be amiss not to mention
the concepts of validity and reliability into the design as well. 1These concepts, along
with pilot testing are examined in this section of Chapter 3. 3. 6.1 Reliability
According to§ White (2000), 1reliability is about consistency and research, and
whether or not another researcher could use the design and obtain similar findings.
Even so, this does not imply that another researcher would come up with the same
interpretations or conclusions as researchers before.The interview used in this
research is reliable in the sense that the results will be replicable when the research
would be conducted again with a similar sample, assuming of coursethat all other
factors remain the same. In addition, to verify thatthe answersof§ the interviewees
are consistent, 1some questions about what the interviewees thought about§ pre-
departure and cross-cultural training 1were asked again in a different form. For
instance, the question “Does the company provide pre- departure training? If so,
what types of training methods are provided? (Ex.pre visits, lectures, computer
simulation, language lessons)”§ is an open ended question, encouraging the
respondents to elaborate. Similarly, the question, 1“How is cross-cultural training
incorporated into the training programs for expatriates? Please check all that apply
and rate which ones you deem the most effective among simulation, case studies,
interactive language training, role plays, videos, lectures and books, area briefings,
and other”§ is a closed ended question where the respondents have to give a rating of
their opinion. 3.6 1.2 Validity Validity, on the other hand, is concerned with the idea
32
that the research design fully addresses the researchquestions and objectives the
researcher is trying to achieve andthis implies that as much planning as possible
must be done beforehand (White, 2000).To ensure that the interview questions in
this research study were not ambiguousand understandable, one pilot test was run
through a§ international banks. 1After some minor adjustments to the questions, the
final version of the interview questions was created and sent to the prospective
interviewees.§1Yin (1994) describes three types of validity; content validity,
criterion-related validity and construct validity. In order to ensure the presence
ofcontent validity, the interview questions were constructed to form five sections,
where different parts of pre-departure preparationwere assessed. In orderto ensure
criterion-related validity is reached,the results of the interviews matched the
expectations of the researcher, in this case that§ pre-departure training is helpful.
1Finally, construct validity is presentbecause the outcome of the interviews is in line
with most empirical studies done in this area of study.§ Chapter 4 – Findings and
Analysis 2Considering derivatives in other financial institutions, a striking difference
is prominent. Institutions engaging in hedge funds and derivatives claim that the
heterogeneity of hedging products protect their clients against market instability
and avail a wider spectrum of risk management to the society. However, volatility is
actually caused by the institutions’ activities when they deal with derivatives as a
portion of rip-off factor selling nothing for something to the clients-protection
against a danger that should have not existed in the first place. By doing so, the
financial institutions acquire huge profits at the expense of others. Nevertheless,
the profits do not necessarily indicate the productive efforts. According to the
chairman of Berkshire Hathaway Mr. Warren Buffet, derivatives acts as financial
weapons of mass destruction often as result of opaque pricing and swaps

33
accounting policies, options and several other complex products whose prices are
unlisted on exchanges. He continues to say that credit derivatives and cumulative
return swaps that are agreed upon to guarantee counterparty against bankruptcy or
default merit special concern§ (Ayub, n.d). The 2macro-economic opinions about the
existence of derivatives claim that they are not convincing; derivatives minimize
risks which do not require existing§ (Ayub, n.d) 2as stated earlier. Currently, the
global foreign exchange market is more or less a fruitless pursuit since it exists as a
result of unnecessary monetary expansion. It would make more sense to organize
the financial system in such a way that it is free facing the repercussions of the
continuing volatility. Whatever is being witnessed in the Western world is the
surfacing of financial products that are mere symptoms of a faulty system. For an
effective economy, there is need to promote systems that allow people to work in
productive interests instead of unproductive ones. The system should be changed
to relate it well with real sector activities and the clever dealers who siphon huge
profits out of thin air could alternatively become industrialists, doctors, business
people or teachers. Therefore, Islamic financial systems seem to be on the right
track. A careful analysis of the trend of the derivatives market discloses that it has
the capacity to contribute significantly to a severe breakdown in the financial
system. The extent of leverage availed by option contracts can be very high to such
a level that large unpredictable market fluctuations in underlying prices may a time
contribute to the insolvency of a big financial institution. Debts or liabilities cannot
be properly hedged even if it was intended so and some traders intentionally fail to
hedge their option portfolios since such deeds would minimize the potential for high
returns. A good evidential case demonstrating the kind of risks that can be incurred
is the one involving the Long Term Capital Management which was saved by a bail
34
out from the Federal Reserve in 1998§ (Ayub, n.d). The 2big question however is
whether other authorities or the central bank can be able to respond swiftly enough,
or in quantitative measure, to avert failings. For instance, considering the
Collateralized Debt Obligations (CDOs), they are sophisticated derivatives designed
in a clever way to exploit anomalies in credit ratings. Several loans or debt
securities owed by various companies are placed in a pool, and new securities
released which carryout payments with respect to the pool’s collective
performance. The new securities are further divided into three sub-divided into
three or more levels of risk. The lowest level, equity tranche, assumes the first loss
in case a company in the pool defaults. If enough losses consume that, the next
level, mezzanine, suffers. The senior tranche level is the most protected level and
should remain safe unless the whole pool has serious losses. It only takes a few
defaults in a pool of hundred companies to ruin the equity tranche. According to
Moody, investment grade corporate bonds downgrades in America were 22% in
2002 and bond defaults worth 160 billion dollars worldwide were recorded in the
same period§ (Ayub, n.d). The 2equity tranche and mezzanine levels of many CDOs
have been hit by severe losses and several of them wiped out. In addition, the
senior tranches have also been downgraded since losses are yet to reach them§
(Ayub, n.d). 2Therefore, the whole idea of CDOs can be seen as absolute risk and
exploitation. Considering the Islamic financial system again, it strongly prohibits the
element of interest. The concept of interest has been a contentious issue in history
even outside Islam. For instance, Aristotle and Plato opposed interest in the same
manner Hindu and Roman rulers did (Kamali 1997).It is worth to remember that
important financial instruments such as the check lay and bill of exchange
originated from Christian financiers who were searching for instruments that would
35
balance supply and demand for funds which would be loaned without necessarily
charging inflated interest. Even in the current western economies, ceilings on the
allowable rate of interest are always placed to protect vulnerable borrowers.
Therefore, it is clear from this discussion and the preceding one about exploitation
through derivatives that the issue of interest can have serious implications if not
dealt with effectively. In as much as interest on finances can be oppressing
especially to the poor, no financial institution can succeed without charging it. That
is perhaps why even in Islamic financial systems they accept interest on basis that
it is paid willingly. Financial systems cannot rely on willingness to pay and the only
viable idea is to impose a reasonable interest that will cater for plight of both
investors and customers.§ Predicting short term stock market performance is
extremely hard and has been called a futile exercise by many in financial academia and
professional circles (BPP, 2008). This is because, due to the inefficiency of stock
markets with regard to information asymmetry, many of the fundamental factors
effecting stock market performance do not fully reflect themselves in stock prices in the
extreme or near short term. However, despite the above, a general guide (as opposed
to quantified prediction) is provided below of the expected short term performance
(covering the period from January 5th to April 05th 2010 ) of two major international
stock markets; 3the New York Stock Exchange (NYSE–with the§ Standard & Poor 500
(S & P 500) Index as our main subject of analysis) and the London Stock Exchange (LSE)
– with the FTSE 250 (Financial Times Stock Exchange 250) index as our main subject of
analysis). New York Stock Exchange / S & P 500 Index Following the subprime mortgage
crisis, the ensuing credit crunch and the resultant global economic meltdown which
plunged the world into a global recession, the US administration responded with fiscal
stimulus measures (including a $787 Billion fiscal stimulus plan and the cash for
clunkers scheme), near zero interest rates, a plan to buy troubled assets (the $700
36
Billion TARP), funding of commercial and investment banks to help them shore up their
balance sheets and extended government support to save jobs through nationalization
and restructuring of car manufacturers Chrysler and General Motors (Financial Flicker,
2009). All of the above have now started showing results with many banking companies
(once battered down by the financial ambush) returning to profitability along with many
S&P 500 companies returning to profitability as consumer spending increases and job
concerns are alleviated. It is expected that this momentum in financial markets will
continue going forward. However, concerns over the strength of the recovery will
remain prevalent with US economic date, most particularly on unemployment and
consumer spending, to look out for as the same can dent investor expectations. Apart
from this, by and large, the stock market will continue its upward march. London Stock
Exchange / FTSE 250 Index The effect of the subprime mortgage crisis hit the British
economy hard with London's place as the center of international finance severely
dented as a result of the credit crunch and the global economic slowdown. The
nationalization of mortgage specialist Northern Rock and the too big to fail types of RBS
and HBOS prompted the rise of Singapore, Hong Kong and Shanghai as new centers of
financial services. Insurance and shipping also suffered declines as a result of a drop in
world trade. All of this has had adverse effects on the services driven British economy
(Financial Flicker, 2009). [pic] Hence, going forward, the FTSE is expected to remain
range bound with market performance as a whole largely depressed (Schweser, 2008).
Overseas income by British multi nationals will drive positivity, especially for those
companies whose operations are located in the rebounding Asian market. Index price,
during30th January – 5th April 2010. 26P/E Ratioand Long-Term Stock Market
Performance:-§ For the growth perspective and concern for the contented returned
investors have long used price earning (P/E) ratios, because by argued some economist
shows 26that the average P/Eratio for thestock market index (S&P 500) can help
37
predict inlong or shortterm changes.§ Some of the economist follows that 7P/E ratioto
temporary and sometimes extreme fluctuations in the business cycle. Their solution
was to divide the price by the 10-year average of earnings, which we'll call the
P/E10. I
n recent years,§ [pic] Source: businessinsider.com On the above chart 7historic P/E10
has never flat-lined on the average. On the contrary, over the long haul it swings
dramatically between the over- and under-valued ranges. If we look at the major
peaks and troughs in the P/E10, we see that the high during the Tech Bubble was
the all-time high of 44 in December 1999. The 1929 high of 32 comes in at a distant
second. The secular bottoms in 1921, 1932, 1942 and 1982 saw P/E10 ratios in the
single digits.§ And 7after dropping to 13.4 in March, the June 2009 monthly average
P/E10 has rebounded to 16.7 — a bit above the average.§8Analysis of movements
of price earnings ratio |Price |Price| Earning|Action | |earning| |s | | |s ||per | | | | |
share | | |↑ |↑ |→ |Price earnings ratio increases due to higher | | | | |price, while
earnings (EPS) remain stable. | | | | |Investors pay higher price per unit of company |
| | | |earnings. | |↑ |↑↑ |↑ |Stock price grows in higher pace than company | | | | |
earnings. Subsequently, this leads to higher P/E. | | | | |Investors react on growth of
company earnings. | | | | |Investors may have high expectations of future | | | | |
growth or overvalued the current growth of company| | | | |earnings. | |↑ |→ |↓ |
Despite a decrease in company earnings the stock | | | | |price remains stable. | | | | |
Investors do not react on the decrease of company | | | | |earnings. | |↑ |↓ |↓↓ |
Stock price decreases in slower pace than company | | | | |earnings. Investors have
not reflected full impact| | | | |of company earnings decrease into stock price. | |↑ |↑
|↓ |Stock price increases despite the decrease of | | | | |company earnings. Investors
do not reflect | | | | |decrease of company earnings in stock price.§ | 12Dividend

38
Yield vs. P/E Ratio:- Many studies presentdividend yield of the stock market is
relatively low by historical standards. Reasonsare,§ firstly 12corporations are paying
a smaller percent of earnings in dividends. Historically, over the past century, the
dividend payout ratio has averaged 35% to 60% of earnings. Today, the average
payout ratio is near the low end of the range.§ And secondly, 12valuation directly
affects dividend yields. As the price-to-earnings ratio (P/E) rises, the price-to-
dividends ratio rises as well.§ [pic] Index Price Chart:- Based on the financial market
trading structure on the last month (January, 2010) US market performed higher. After
the former posted second quarter profit, expected sales are performed optimistic
forecast. Oracle paced further gains, amid expectations of receiving clearance from the
European Union in January 2010 for its $7 billion acquisition of Sun Microsystems.
Motorola added 5.2%, amid reports that company. Shoe-maker, Nike, rose 1.9%, after
forecasting a return to revenue growth in the next quarter. Whereas, UK markets closed
preformed lower at the same time. Banks, Lloyds Banking Group, Royal Bank of
Scotland and HSBC dropped between 0.6% and 4.7%, amid ongoing concerns over
Basel Committees proposal to maintain more funds in reserve. Insurers, Prudential,
Standard Life and Aviva, lost between 0.9% and 2.1%, in line with a fall in equity
markets. UK markets closed lower on Friday, as gains in defensives and miners failed to
offset the losses in banks and insurers. FTSE 250 declined 0.6% to 8,999.1. Source: ETX
Capital, From The Floor 1st February 2010. S&P 500 and FTSE 100 Composite
(05/01/2007- 19/02/2010) Source: Thomson One Banker So according on above
discussion and helping within the graph (Thomson One Banker) my proposed settlement
price 4% (+/_) from the current one. With basis of “Thomson One Banker” in S&P 500
and FTSE 250 index price chart on (19/02/2010) was for 1,109.10 and 9,431.36.
Subsequently, on 5th April 2010 after adjustment of 4%, in S&P 500 and FTSE 250 index
price will be consequently within 1,153.46 to 1,064.73 and 9,808.61 to 9,054.11.

39
Whereas now in FTSE 100 index, price is 5358.17 and adjusting the same percentage it
will be 5,571.46 to 5,143. Constructing Other Derivatives Futures contracts are
essentially the same as forward contracts at this introductory level of analysis. Call and
put options give asymmetric payoffs. While there are many other types of derivative
contracts, they generally can be constructed from the basic contacts we have already
described. For this reason, many practitioners and academics find it useful to view
options and forwards as building blocks that can be used to construct other derivative
contracts. The building block approach starts with the basic payoffs. The usefulness of
the building block approach, suppose that A company decides that it wants protection
from high oil prices, but that it does not believe oil prices will rise above $18 a barrel. If
Company hedged by 3buying a call optionwith an exercise price of§ $15, it would be
buying protection against any increase in oil prices above $15, including protection
against oil prices above $18. Since it does not believe oil prices will rise above $18, it is
buying protection that it deems as having little or no value. Company therefore would
like to have a derivative contract with a payoff that increases with prices between $15
and $18, but that does not increase when oil prices are above $18. Company can obtain
its desired payoff by buying a call option 3with an exercise price of $15and sellinga
calloption with an exercise price of§ $18. To see this, you simply need to graph the
payoff on each option separately and then vertically add the payoffs. Figure 24.9
illustrates the payoffs from the two options with dashed lines. Swap Contracts The final
type of derivative contact that we will highlight is called a swap contract. 34Swap
contracts have payoffs likea series of§ forward contracts. That is, 18instead of having
just one payoff at the contract’s expiration, a swap contract has a series of payoffs
overtime.Each payoff depends on the difference between the market price of the
underlying asset and a predetermined price, callthe swap price.§ CHAPTER 5 –
CONCLUSSIONS AND RECOMMENDATIONS 2Financial derivatives are very influential

40
in any financial system. They can lead to oppression of customers through
exploitation or insolvency of big financial institutions if not well framed. Derivatives
in the Islamic financial system§2are strongly based on moral grounds protecting
customers from paying interests unwillingly among other provisions like option
contracts. This places the financial institutions at heightened risk to insolvency due
to lack of adequate funds to run them. It would make more sense if the derivatives
were formulated in such a way that neither party looses or gains unduly.§ Even if
hedging is costless, 3transactions undertaken solely to reduce risk are unlikely toadd
value. There are two basic reasons§ for this: • Reason1. 3Hedging is a zero-sum
game. A companythat hedges a risk does not eliminate it. It simply passes the risk
onto someone else. For example, suppose that a heating-oil distributor agreeswith a
refiner to buy all of next winner’sheating-oil deliveries at a fixed price. This contract
is a zero-sum game, because the refiner loses what the distributor gains and vice
versa. If next winter’s price of heating oil turns out to be unusually high, the
distributor wins from having locked in a below-market price but the refiner is forced
to sell below market. Conversely, if the price of heating oil is unusuallow, the refiner
wins because the distributor is forced to buy at the high fixed price. Of course,
neither party knows next winter’s price at the time that the deal is struck, but they
consider the range of possible prices and§3negotiate terms that are fair on both
sides of the bargain. • Reason 2: Investors do-it-yourself alternative.
Companiescannot increase the value of their shares by undertaking transactions
that investors can easily do on their own.§ We came across this idea when we
discussed whether leverage increases company value, and we met it again when we
came to dividend policy. It also applies to hedging. For example, 3when the
shareholders in ourheating-oil distributor§ invested in the company, 3they were

41
presumably aware of the risks of the business. If they did not want to be exposed to
the ups and downs of energy prices, they could have protected themselves in
several ways. Perhaps they ownshares in both distributor and therefiner and do not
care whether one wins at the other’s expense. Of course, shareholders andadjust
their exposure only when companies keep investors fully informed of the
transactions that they have made. For example, when a group of European central
banks announced in 1999 that they would limit their sales of gold, the gold price
immediately shot up. Investors aregold-mining shares rubbed their hands at the
prospect of rising profits. But when they discovered that some mining companies
had protected themselves against price fluctuations and would not benefit from the
price rise, the hand-rubbing turned to hand-wringing. Some stockholders of these
gold-mining companies wanted to make a bet on rising gold prices; others didn’t.
But all of them gave the same message to management.§3We have seen that
although hedgingreduces risk,§ this doesn’t in itself firm value. So when does it make
sense to hedge? Sometimes hedging is worthwhile because it makes 3financial
planning easierand reducesthe odds of an embarrassing cash shortfall. Ashortfall
might mean only an unexpected trip to the bank, but§ on other occasions the firm
might have to forgo worthwhile investments, and in extreme cases the shortfall could
trigger bankruptcy. Financial distress can result in indirect as well as direct costs to a
firm. Costs of financial distress arise from disruption to normal business operations as
well as from the effect that financial distress has on the firm’s investment decisions. If a
company has a 31better the risk management policies, the less chance thatthe§ firm
will incur these costs of distress. 31As a side benefit, better risk management
increases the firm’s debt capacity.§27In some cases hedging also makes it easier to
decide whether an operating manager deserves a stern lecture or a pat on the

42
back.§ Suppose that your export division shows a 50 percent decline in profits when the
dollar unexpectedly strengthens against other currencies. How much of that decrease is
due to the exchange rate shift and how much too poor management? If the company
had protected itself against the effect of exchange rate changes, it’s probably bad
management. 3If it wasn’t protected,you have to§ make a judgment 3with hindsight,
probably by asking, “What would profits have been if the firmhad hedged§ against
exchange rate movements? Finally, hedging extraneous events can help focus the
operating manager’s attention. We know we shouldn’t worry about events outside our
control, but most of us do anyway. It’s naïve to expect the manager of the export
division not to worry about exchange rate movements if this bottom line and bonus
depend on them. The time spent worrying could be better spend if the company hedged
itself against such movements. A sensible risk strategy needs answers to the following
questions: • What are the major risks that the company faces and what are the possible
consequences? Some risks are scarcely worth a thought, but there are others that might
bankrupt the company. • Is the company being paid for taking these risks? Managers
are not paid to avoid all risks, but if they can reduced their exposure to risks for which
there are no compensating rewards, they can afford to place larger bets when the odds
are stacked in their favor. • Can the company take any measures to reduce the
probability of a bad outcome or to limit its impact? For example, most businesses install
alarm and sprinkler systems to prevent damage form fire and invest in backup facilities
in case damage does occur. • Can the company purchase fairly priced insurance to
offset any losses? 3Insurance companies have some advantages in bearing risk. In
particular,they may§ be able to spread the risk across a portfolio of different insurers. •
Can the company use 34derivatives, such as options or futures, to hedge therisk?§ In
the remainder of this chapter we explain when and how derivatives may be used.
5Diversification has traditionally been recommended as a way to manage, or

43
diversify, risk.§ Said another way, “not having 5all your eggs in one basket”
allowscorporate managers to potentially reduce risk to company stockholders.
Balancing cyclical revenue streams to reduce earnings volatility is one way
diversification may reduce risk. So managers need to ask this question as a part of
their strategic analysis and subsequent choice. Likewise,revenue growth can be
enhanced by diversification.§ Many companies in the hazardous waste industry
maintained the steady growth investors had come to expect by continuously making
acquisitions of other businesses to gain immediate sales growth. Bothe risk and growth
are 5assumptions or priorities corporate managers should carefully examine as they
undertake strategic analysis and choice.§ Many companies have pursued growth to
gain market share without accompanying attention to profitability. Similarly, companies
have built diverse business portfolios in part to manage overall risk. In both instances,
the outcome is often a later time when subsequent management must “look in the bag”
of businesses and aggressively divest and downsize the company until true value-
adding activities and synergies linked to sustained competitive advantages are
uncovered.
Reference xxxxxxxxxxxxxxxx

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