Financial Perfromance Questions

Question No.
1:
Derivatives can be defined as type of financial contracts in which the value of underlying asset is
directly linked to the value of the instrument. These financial instruments despite of their
complexity can be used for different purposes. Those purposes may include hedging and getting
entrée to additional markets or assets. Most of the derivates can be traded on OTC (Over-The-
Counter). While on the other hand, specialized exchanges are used for other contracts like
options and futures. The concept of modern finance can not be viewed without the use of
derivatives. The company can use following three types of derivatives
1. Forward and Futures
In this type of financial contract, the buyers of the contract are obligatory for purchasing an
asset at pre-defined price on a specified date in the future. Both forwards and futures are
same in the nature. But from the other side of the picture, it reveals that forward contract are
more flexible for the company than the futures. Forward contracts provide the flexibility to
customize the underlying asset along-with the quantity and date of the transaction to either
parties while futures on the other hand are just standardized contracts that are traded on
exchange.
2. Options
Buyers in the options contract are facilitated with the right and not the obligation to buy or
sell the underlying asset at pre-defined price and date. Buyers bound in this contract can
exercise their rights on the date of maturity as by the European options or on any date before
the maturity as by US options.
3. Swaps
These are the types of derivative contracts which allow the exchange of cash flows between
two parties. Mostly a fixed cash flow is exchanged for a floating cash flow. There are many
types of swaps which can be used by the company as deemed appropriate; Interest Rate
Swaps, Commodity Swaps and Currency Swaps. Interest Rate Swap is recommended here as
the company is seeking derivatives which can manage the interest rate risk.
Advantages of Using Derivatives

The importance of derivatives for modern finance is already acknowledged by numerous analysts
as it exerts significant impacts on it. Ultimately numerous benefits are attained which are
delineated below:
1. As mentioned above the value of derivates is directly linked with the value of asset
underlying with derivative. These are primarily used for hedging the risk. Given that, if
the company purchases a derivative contract and the value moves in the opposite
direction of the asset owned by the company. Profits in these types of contracts can
counterbalance the losses in the assets underlying.
2. Derivatives can be used frequently to determine the price of the underlying asset with the
specific derivative. The following example will help understanding the concept better.
Spot prices of the futures can assist as an estimate for the price of article in trade.
3. Derivatives are capable of increasing the market efficiency. Derivate contracts can help
the company in replicating the payoff of the assets. In this way arbitrage opportunities are
avoided when the underlying asset and the derivate are in equilibrium.
4. These derivates can also help the companies to access to assets and markets which are
otherwise unviable. By application of interest rate swaps, company obtains more
satisfactory interest rates as compared to the interest rate available for borrowing directly.
Disadvantages of Using Derivatives
Despite all the distinctive benefits that derivatives provide to the modern financial markets there
are some significant disadvantages which accompany the derivatives. Disadvantages which
derivatives carry are expressed in detail as follows:
1. There is high volatility in the derivatives which ultimately makes them vulnerable to
huge losses. Valuation of becomes extremely complicated or even impossible due to the
sophisticated design of the contracts. Ultimately, the high risk gets accompanied.
2. Derivatives are taken as a tool of conjecture. As these derivatives are extremely risky by
nature and the behavior is also unpredictable. Thus, unreasonable spectrum leads to huge
loss.
3. The risk of the country party also persists in the derivates. Even though these derivates
are traded on exchanges and go through a thorough process of due diligence, some of the
contracts that are traded through OTC do not include the due diligence benchmark. Thus,
the risk of counter party fault arises.
Question No. 3
As it is known that yield curve is used for the graphical representation of interest rates applied on
a debt for a specific range of maturities. The expected yield on an investment can be shown.
Yield on the vertical axis is shown on the graph while time to maturity is show on the horizontal
axis. As far as the curve is related it may take different shapes at different points accordingly in
the complete economic cycle but typically it is generally sloping upward. A yield curve may lead
the fixed income analyst towards the economic indicator. The downturn is signaled when the
shape of the curve gets inverted as short-term returns are higher than the returns in longer run.
There are basically five types of shapes of curves which are delineated below:
1. Normal
2. Inverted
3. Steep
4. Flat
5. Humped
The curve in the graph shows clear indication of steep curve. This logically explains that yields
in the long-term are rising at an enhanced rate as compared to the yields in short-term. The
curves historically indicate the start of an expansionary economic period. It is pertinent to
highlight that both normal and steep curves are grounded on similar market conditions. The only
difference that the curve is showing is the huge difference between the yield’s expectations of
short and long term. There are few factors involved behind the shape of curves which influenced
accordingly. A key factor is inflation which declines the purchasing power which ultimately
gives rise to the investors to expect an increase in the interest rate in the short-run. Increase in the
aggregate demand may also be another factor by the strong economies which lead to inflation.
These strong economies also indicate a strong capital competition with various options for the
investments. Thus, this strong economic growth influences the yield growth which consequently
shapes the steeper curve. There are many theories which explain the terms accordingly and are
discussed below.
Pure Expectation Theory

The assumption of this theory is that numerous maturities are alternatives. Market’s expectation
for the future interest rate shape the yield curve. This theory also defines that with the passage of
time yields tend to change. It is pertinent to mention that this theory fails to describe the details
of shapes of yield curves. This theory also ignores reinvestment risk and interest rate risk.
Liquidity Preference Theory

This theory may be considered as the extension of the above-mentioned theory. As this theory
adds liquidity premium. It may be noted that this theory reflects the greater risks involved in
holding both the long-term and short-term debts.
Segmented Market Theory

This theory is grounded on the demand and supply of short-term and long-term securities. It
emphasized that different maturities pertaining to the securities cannot be replaced for one
another. The investment is generally preferred more in the short-term than long term investment
because of the lower risk. The price of short-term securities will consequently be higher which
will result in lower yield.
Preference Habitat Theory

This is an extension of the above-mentioned market segmented theory. This theory explains the
preference of investors in certain horizon. A premium will be required to invest outside this
horizon. This theory consequently briefs the reasons behind the greater yield in long run than in
short run.

Financial Perfromance Questions

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Question No.

Advantages of Using Derivatives

Pure Expectation Theory

Liquidity Preference Theory

Segmented Market Theory

Preference Habitat Theory

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