Archive | November, 2011

THE VALUE OF FINANCIAL DERIVATIVES

12 Nov

I think that financial derivatives trading makes the market more efficient because risks can be isolated and spread out independently in a more consistent and diversified way, and moreover, they help reducing uncertainty (if used properly).  This relies on the fact that there is a whole market of derivatives, and thus, it is possible to attain to the same goal by using and mixing different products and choosing the best options available to maximize profits (or minimize risk). For example, given that a company has plenty of derivatives with different levels of risk, it will be able to transfer/sell those that do not fit the benchmark portfolio after some time T. This argument is further motivated by the fact that trading itself makes any market more efficient, as it if driven by the forces of supply and demand. These forces can definitely be applied to the situation since in the end derivatives are products, and as we all know, any product can be projected into a supply and demand analysis. Thus, in conclusion, derivatives makes the market better off because they provide an opportunity to reduce uncertainty and manage risks more efficiently.

Question of the week: I understand that financial derivatives are all based in a group of similar basic characteristics. The differences between derivatives rely on deeper details. Then, what do you think are the basic characteristics that give the name of a derivative to a financial product? Do you know which were the first types of derivatives that were used in the financial market and what was there main objective by then?

Midterm Corrections

7 Nov

My score was 95. I got 5 points off from question #7 because I forgot to multiply the E(K1K2) by its probability, thus I also got wrong the covariance. the right way to do it is:

E(K1K2)= 0.5(1)(2) + 0.5(2)(1)= 2
Cov(K1K2)= 2 – U1U2= 2-1.5^2= -0.25
Correlation= -0.25/(sigma1*sigma2)= -0.25/(sqrt(0.25)*sqrt(0.25))= -1

Motivating Forward Contracts

1 Nov

In general, forward contracts can become either and asset or a liability for any of the parties involved. As a result, one would only get into such contract to lock a price in the present, depending on whether the individual is expecting, or for some reason knows, that the present value of the item will fall or increase at the delivery date. In such way, I think that a realistic motivation for forward contracts should be highly seen in businesses that face exchange rate fluctuations. The best example of which I can think takes place in the agricultural industry. For example, lets say that a farmer knows will have 10 bushels by the end of the harvesting season. In order to prevent that his revenues decrease due to possible downward fluctuations, he will try to sell at a fix price the 10 bushels that he is expecting. In an opposite direction, a person who knew for some reason that the price of the 10 bushels will increase at a future time, then he will try to lock the price of the bushells in the present.

Question of the week: Considering a 2×2 matrix to solve one constraint, what is the purpose of using the determinant to calculate the inverse matrix of A if in the end the determinant will cancel? In other words, can we just skip the whole process of having to write 1/detA if we know that it will get cancelled?

Also, a more conceptual question: are futures the same as forwards?