Investment and the Derivatives Market
Outline
This paper dwells on the topic of derivatives. It describes the derivatives market existing writer, which is Hong Kong. In addition, the paper explains how effective these derivatives are in spreading the risk. Further, the paper is designed in such a way as to first of her a brief introduction which will be followed by the discussion of the topic.
Introduction
The term derivative is common in the investment world. Derivatives can be defined as “a financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency.” (Derivative: definition n.d.)
The above definition makes it clear that the value of derivatives derives from the value of another instrument. Risk plays an important role in derivative transactions.
The Hong Kong Derivatives Market
The derivatives market in Hong Kong is well organized and it is designed in such a way that the traders can easily engage in trading in the market. The transactions of derivatives in this country are carried out through HKATS (Hong Kong Futures Automated Trading System). The traders can participate in trading with the help of HKATS in such a manner that when they place orders these get placed into a central order book, which is in the electronic format. The information placed in the order book is simultaneously also transferred to the concerned authorities in the country.
“Hong Kong’s derivatives market is among Asia’s largest, reflecting the increased sophistication of its financial markets. Currency derivatives contracts (including currency swaps, options and other over-the-counter derivatives).” (Hong Kong as an international financial centre n.d.).
Derivatives warrant is a kind of derivative instrument that is common in Hong Kong. Such warrants are traded in the stock exchanges like options. (Chow, Li & Liu n.d.)
In Hong Kong, derivatives market, different futures and options are traded. Futures traded include Hang Seng Index Futures, Stock Futures, HIBOR Futures, etc. The options traded include Hang Seng Index, H – Share Index Options, Stock Options, etc. (Tai 2005).
How effective are the derivatives in spreading risk?
It is seen that the OTC derivatives have brought about several improvements in the financial risk management practices, thus reducing the financial risk associated with it. It can therefore be stated that derivatives are risk managing instruments rather than risk creating agents. Institutions and investors use derivatives as hedging instruments to reduce pitfalls like foreign exchange risk, interest rate risk, etc
Derivatives are regarded as zero-sum game as it offers gain with reduced chances of risk. Derivatives further help to transfer the price risk to another party who is willing to take it. In case the hedging is uncertain for the given assets, one can use derivatives. This can be explained with the following example: if an investor owns foreign stocks expecting a dividend, he has to face the exchange rate risk and the amount of dividend paid. Thus he can enter into a futures contract to hedge the risk.
Hong Kong financial market is very sophisticated and the role of derivatives has come under some controversy. It was supposed that derivative markets have led to outright speculation. “Many believe that Hong Kong’s highly volatile property market provides potential arbitrage opportunities for property derivatives in an economy whose foundations and fortunes are built on strong property prices.” (Batra 2007, p.8). However, it has also contributed to redistributing risk and thereby increasing the market efficiency and liquidity in the Hong Kong market. An evident example is a use of derivative instruments like interest rate futures, caps and swaps…etc by banks to reduce the risk of increased interest rate of the Hong Kong currency system. In addition, credit derivatives are used to trade and insure against the risk of non-repayments from the customers. (Carse 1998).
Conclusion
The risk aversion capacity of derivatives has led to the growth of derivatives in the country over the past decade. Derivatives have a major role in providing leverage to users. In a survey conducted by the Bank of International Settlements, the ratio of derivatives over GDP of Hong Kong shows 75 and over trade, flows shows 31. (Jadresic & Selavie 2004). From this, it is clear that the Honk Kong derivatives market is a strong one and plays a key role in the economic development of the country.
References
- Batra, 2007, Property derivatives: a brief overview: property derivatives- its time to go global, Global Strategy & Investment Consulting. Web.
- Carse, D 1998, Speech to the Hong Kong financial market association: supervision and disclosure of derivatives trading in Hong Kong.
- Chow, YF, Li, JW & Liu, M n.d., Making derivative warrants marketing in Hong Kong.
- Derivatives: definition n.d., Investor Words.com.
- Hong Kong as an international financial center n.d., Hong Kong 2000. Web.
- Jadresic, E & Selavie, J 2004, Is the FX derivatives market effective and efficient in reducing current risk: some evidence, with focus on Chile.
- Tai, C 2005, Derivatives market of Hong Kong exchanges and clearing limited, HKEX.