BU4640 Derivatives & International Finance Assignment Example TCD Ireland

Derivatives are investments that derive their value from another asset or group of assets. They can also be used as hedges against adverse moves in the price of an underlying investment. International finance is the process of exchanging money and investments between different countries. This module will explore the basics of both derivatives and international finance, and will give you an understanding of how they work together.

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Assignment Task 1: Provide an understanding of derivatives and introduce the analytics of derivative valuation

Derivatives are investments whose values are determined by the value of another investment. They are generally traded over-the-counter or on exchanges, but can also be customized to suit a particular need. They derive their value from an underlying instrument that is typically referred to as the “underlying.”

The main types of derivatives:

• Options: The right (but not the obligation) to buy or sell an underlying asset at a specific price on or before a certain date.
• Futures: The obligation to buy or sell an underlying asset at a specific price on or before a certain date.
• Swaps: A contract between two parties in which one party exchanges cash flows with another, based on different indices.
• Forwards: Similar to a future, except that the contract is not exchange-traded and does not have standardized terms.
• Caps/Floors: An agreement in which one party agrees to pay the other the difference between a specified rate and the interest rate of an underlying asset if it goes above or below a certain value.

The analytics of derivative valuation:

The value of a derivative is determined by the value of the underlying, the type of derivative, and the current market conditions. The most important factors in determining a derivative’s value are its intrinsic value and its time value.

• Intrinsic value: The amount that a derivative is worth if it were to be immediately exercised.
• Time value: The amount that a derivative is worth on the basis of the expected future price of the underlying.

Other factors include volatility, which refers to the likelihood that the underlying’s price will be far from its current price over time; dividends, which refer to payments made by an underlying asset for each share outstanding; and interest rates.

Assignment Task 2: Demonstrate how to value forward, futures, swaps, and options

1. Forward: The value of a forward is equal to the present value of expected future cash flows. Thus, the value will be the current price of the underlying asset multiplied by the total number of units in question times an appropriate discount factor for that specific time period (the yield curve).
2. Futures: A futures contract has two components: the intrinsic value and the time value. The intrinsic value is equal to the difference between the underlying’s current price and its future price, if positive; zero, otherwise. The time value is equal to the product of an option’s time value and volatility (if we assume that it behaves like a call option).
3. Swaps: There are three parts to the value of a swap: fixed leg, floating leg, and the time value. The fixed leg is equal to the present value of expected future cash flows based on the interest rate differential between two countries. The floating leg is equal to the notional principal times its forward rate times one minus an option-adjusted spread.
4. Options: Deriving the value of an option is a two-step process. In the first step, we calculate the option’s intrinsic value. This is done by taking the difference between the underlying’s current price and its strike price (if positive) or by taking zero if it is at the money. In the second step, we calculate the option’s time value. This is done by multiplying the intrinsic value by the option’s volatility.

Assignment Task 3: Describe and appraise how derivatives can be used to achieve various hedging and speculative strategies

Derivatives can be used for both hedging and speculation.

• Hedging: Hedging is the use of derivatives to reduce the risk of an adverse price movement in the underlying. The most common type of hedging is using a futures contract to lock in a purchase price for an asset. An example would be an airline company that wants to lock in a future fuel price, which it uses as a raw material for its manufacturing process.
• Speculation: Speculation is the use of derivatives to profit from changes in the price of the underlying. There are two main types of speculation: buying options to gain exposure to a price increase and selling options to gain exposure to a price decrease. For example, an investor might buy a call option on a stock with the hope that the stock will go up in price and thereby increase the value of the option.

Derivatives are important financial instruments that can be used for hedging, speculation, and other strategic purposes. Their value is determined by the value of the underlying asset, the type of derivative, and current market conditions.

Assignment Task 4: Evaluate previous derivative mishaps in Ireland and what we can learn from them

The Irish banking crisis of 2008 was a major financial crisis that affected Ireland and several other European countries.

• One of the causes of the crisis was the use of derivatives by the Irish banks. The banks had used derivatives to speculate on the housing market and to make risky investments. When the housing market collapsed, the banks were left with large losses, which contributed to their insolvency.
• Second, the use of derivatives can result in a conflict of interests between buyers and sellers. In many cases, derivative products are developed by market makers that sell these same products to other customers. This may cause them to develop derivative products that favor their own position rather than the interest of the customer.
• Third, derivatives can be difficult to understand and can be easily manipulated. This was seen in the Irish banking crisis, where the banks had used derivatives to make risky investments without fully understanding the risks involved.

The Irish banking crisis provides several important lessons about the use of derivatives. First, derivatives can be very risky and can contribute to financial crises when initial conditions are not appropriate. Second, derivative products should be developed by third parties, which do not have a conflict of interests with their customers. Finally, derivatives can be difficult to understand and may result in unpredictable behavior.

Assignment Task 5: Demonstrate a good understanding of the international financial system, how the globalization of the world economy is evolving and how firms need to react to these changes

The international financial system is a network of financial institutions and markets that allow firms to borrow and invest money across borders. It is important for firms to be able to tap into this network in order to conduct international transactions.

The globalization of the world economy is the trend toward increasing economic integration among countries. This has been driven by technological advances, which have made it easier for firms to do business internationally, and by liberalization policies, which have reduced barriers to trade and investment.

The international financial system has changed as a result of these trends. One change is that there has been an increase in cross-border trade and investments, which have been facilitated by the liberalization policies implemented by many countries. Another change is that global liquidity, or the availability of capital to be loaned across borders, has increased as a result of the expansion of global financial markets.

The globalization of the world economy is continuing and firms need to be aware of these changes in order to remain competitive. One trend that is likely to continue is the increase in cross-border trade and investment. This has been facilitated by advances in technology, which have made it easier for firms to do business internationally. Another trend is that global liquidity will continue to increase as financial markets expand and become more interconnected.

Assignment Task 6: Assess the current global business environment and design appropriate international financial management strategies

The current global business environment is characterized by a number of trends. One trend is the globalization of markets, which has been driven by technological advances and liberalization policies. Another trend is that there has been a shift in power from the government to international organizations such as the WTO and IMF, which countries have joined voluntarily. Furthermore, companies have become more global, which means that they are operating in multiple countries. Finally, there has also been an increase in companies’ level of internationalization, which refers to the number of subsidiaries that a firm operates outside its home market.

Designing appropriate strategies for international financial management requires firms to assess the current global business environment and understand how it is changing. One change is the globalization of markets. As a result, firms are expanding their international operations in order to take advantage of the new opportunities available to them. Another change is that there has been an increase in companies’ level of internationalization, which means that firms are operating in multiple foreign countries.

Finally, it is important for companies to understand that they are no longer just competing against companies within their own country, but also against companies from all over the world. In order to be successful, firms need to develop a global perspective and understand how to compete in a global marketplace.

Assignment Task 7: Understand how exchange rates work, the advantages and disadvantages of various currency systems, and the theory and evidence relating to exchange rate determination

The exchange rate is the price at which one currency can be exchanged for another currency. An example would be the US dollar/Swiss franc exchange rate, which represents how many Swiss francs can be obtained in return for one US dollar.

The most common type of currency system is a fixed exchange rate system, in which an official target or “peg” is set for the exchange rate. The peg is usually based on a currency’s gold or foreign exchange reserves. In a fixed exchange rate system, the government will buy or sell foreign currency as needed to maintain the desired exchange rate.

A disadvantage of a fixed exchange rate system is that it can be difficult to maintain, particularly if there are large fluctuations in the value of the currencies involved. In addition, it can be difficult to adjust to changing economic conditions.

A more flexible exchange rate system is a floating exchange rate system, in which the market determines the exchange rate. The floating exchange rate is determined by the forces of supply and demand in the foreign exchange market. The advantage of a floating exchange rate system is that it allows the exchange rate to adjust to changing economic conditions.

The disadvantages of a floating exchange rate system are that it can be volatile and can lead to excessive fluctuations in the exchange rate. In addition, it can be difficult for companies to hedge against foreign currency risk.

There are a number of factors that determine the exchange rate of a currency.

• One factor is the relative money supply. If one country has a larger money supply compared to another, then demand for its currency will be high, which will result in an increase in its value.
• A second factor that affects the value of a currency is inflation rates. Countries with higher inflation rates are likely to have a weaker currency since investors will expect the value of the currency to decline over time.
• A third factor that affects the exchange rate is economic stability. Countries with stable economies and sound monetary policies are likely to have stronger currencies.
• A fourth factor that affects the exchange rate is interest rates. When interest rates are high, it attracts foreign investment, which increases the demand for a country’s currency.
• A fifth factor that affects exchange rates is international trade. If two countries import and export goods to one another, then they are likely to have currencies whose values are closely tied together.

Assignment Task 8: Explain the mechanisms for managing foreign exchange rate exposure

There are a number of mechanisms that companies can use to manage their foreign exchange rate exposure.

• The simplest way to manage foreign exchange rate risk is to hedge against it by using derivatives such as forwards, futures, and options.
• Another way to manage foreign exchange rate risk is to establish a foreign currency account. This allows companies to hold foreign currencies and to convert them into the currency needed when they make a foreign currency payment.
• A third way to manage foreign exchange rate risk is to use a multinational treasury management system. This allows companies to centralize their foreign currency payments and receipts in a single location.
• A fourth way to manage foreign exchange rate risk is to establish a presence in the country where the currency is denominated. This allows companies to conduct business in the local currency and to hedge against foreign exchange rate risk.
• A fifth way to manage foreign exchange rate risk is to use a credit line in the foreign currency. This allows companies to borrow money in foreign currency when needed.
• A sixth way to manage foreign exchange rate risk is to use a foreign currency bond. This allows companies to borrow money in foreign currency and maintain a low cost of borrowing.

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