Question 1
What is the potential damage of government derivative rules on derivatives users?
Derivative markets are normally subject to derivative regulations by federal governments. The Commodity Future Trading Commission (CFTC) formulates rules that govern futures and options contracts while the Security Exchange Commission formulates rules to control options exchanges. These derivative rules are meant to enhance trustworthiness of the market and improve performance of the market.
However, government derivative rules usually have potential damages on derivative users.
First, complying with derivative rules set by the government involve costs on the side of derivative users. Executing transactions on an organized exchange involves costs such as fees, market impact costs and bid-ask spreads. Increased trading costs implies that speculators will earn less returns on their investments while investors who seek to mitigate risk will also incur higher operational costs and hence lower returns. Secondly, rules regulating options and futures exchanges require that all trading activities should be executed in public. This makes large firm anxious that rival firm may obtain confidential information concerning their trading strategies and trading positions. Their efforts to develop an edge against rival firms will be futile since rival firms will react. Large firms therefore prefer contracts negotiated in private away from the market with a single party (Kim , 2011).
Lastly, derivative rules lengthen transaction processes and consequently the time required to execute a trade. Speculators may therefore make huge losses when they are unable to execute a transaction when the price is right. In highly volatile markets especially in emerging markets prices tend to fluctuate randomly and rapidly. Therefore to make positive returns in such markets speculators need to react fact when the price is right before it rises or falls. However, this is impossible when the derivative rules to be complied with are lengthy.
Question 2
If you expect short-term interest rates to rise more than the yield curve should suggest, would you rather pay a fixed long-term rate and receive a floating short-term rate, or receive a fixed long-term rate and pay a floating short-term rate?
If the short term interest rates are expected to raise more than the yield curve suggests, I would rather pay a fixed long term interest rate and receive a variable short term interest than receiving a fixed long-term interest rate and pay a variable short term interest rate.
Yield curve is a curve showing the relationship between the interest rate and time to maturity of a debt security with a fixed interest rate. If the short-term interest rate raises more than the yield curve suggest, the short term interest rate will be higher than the fixed long term interest rate on a debt instrument. By paying a fixed long term interest rate and receiving a variable short term interest rate, I would be exposed to changing interest rates. However, if the short term interest rate turns out to rise more than the yield curve as expected I would make a profit equal to the difference between the variable short term interest rate and the fixed long term interest rate. The magnitude of the profit will depend on the difference between the two rates of interest.
On the other hand, if I paid a variable rate of return while received a fixed rate of return I would make a loss equivalent to the difference between the differences between the fixed long term interest the variable short term interest rate. The magnitude of the loss will depend on the difference between the two interest rates. Therefore, as a rational investor, it would be more prudent to receive a variable short term interest rate and pay a fixed long term interest rate. Since it would maximize returns on my investments.
Question 3
What are major limitations of financial swaps?
Financial swaps are financial instruments used by investors to speculate and mitigate risk on the market performance in the future. In financial swaps, speculators pledge to pay a fixed rate of interest or price on a financial investment to a group of investors who seek to mitigate risk in exchange for a variable rate of interest or a floating price on the same sum of money. There several limitations of financial swaps markets as discussed below. In financial swap markets, contacts are privately negotiated and tailored to suit the needs of the contracting parties.
First, swap agreements cannot be terminated be terminated before its maturity date without the consent of both parties. This is because financial swaps are legally binding agreement between two parties. Terminating or altering the contract terms amounts to breach of contract and the aggrieved party can sue for damages. Secondly, financial swaps markets do not have a guarantor. In futures and options markets, the clearing house guarantees that all parties will perform their contractual agreement. However, this is not the case in financial swaps since they are private agreements between two parties. Parties to financial swaps must therefore be certain of the credit-worthiness of their counterparty.
Another limitation of financial swaps is the lack of standardization. Since contracts are privately negotiated they differ which makes it difficult for unsophisticated investors to deal in the financial swap market. This limits participation in the financial swap market to institutional investors and individual investors of high net worth. Lastly, financial swap markets are poorly regulated. Regulation of financial swap market relies more on contract law and very little on direct regulation by the government. This disadvantages low net worth investors who cannot afford legal advice and have limited legal knowledge .
Question 4
The beginning spot rate is $0.1854 per South African rand and the ending spot rate is $0.20394 per rand. Calculate the percentage change in the exchange rate for the rand against the dollar.
Percentage change = (Ending spot rate – Beginning spot rate)/ Beginning rate
Percentage change = ($0.20394 -$0.1854)/ $0.1854 = 100%
References
Kim, K. A. (2011). Global Corporate Finance: A Focused Approach. New York: World Scientific.
Kim, S. H., & Kim, S. H. (2006). Global corporate finance: text and cases (6, illustrated ed.). New York: John Wiley & Sons.
Kolb, R. W., & Overdahl, J. A. (2003). Financial derivatives (3, illustrated ed.). New York: John Wiley and Sons.
