Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries
Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries
Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries
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Hong Kong does go up and the HSI rises to 15,000, the speculator can sellthe three-month futures contract at 15,000 and take a 500 po<strong>in</strong>t profit. Butwe know that the chance for the market to go up or down is 50/50 if themarket follows a random walk. In other words, the speculator has a 50percent chance of los<strong>in</strong>g and a 50 percent chance of w<strong>in</strong>n<strong>in</strong>g. The speculatormay lose a substantial amount of money if his prediction of market does notmaterialise.The third k<strong>in</strong>d of participants are arbitrageurs. Arbitrageurs look foropportunities to lock <strong>in</strong> a riskless profit <strong>by</strong> simultaneously buy<strong>in</strong>g and sell<strong>in</strong>gthe same (or similar) f<strong>in</strong>ancial product <strong>in</strong> different markets. The fundamentalbeh<strong>in</strong>d arbitrage is that f<strong>in</strong>ancial markets are not perfect. From time totime, price differential of the same product between different markets <strong>in</strong>different parts of the world at the same time does exist, especiallycomb<strong>in</strong><strong>in</strong>g the currency element. For us, arbitrage strategy will not work,because the transaction cost will probably wipe out the profit even if wedo f<strong>in</strong>d an arbitrage chance. Big <strong>in</strong>vestment houses <strong>in</strong>cur very little transactioncost. They are the major players <strong>in</strong> this market. But remember Bar<strong>in</strong>gs, itsmanagement put the company to the ground us<strong>in</strong>g a supposedly risklessarbitrage strategy.When bank regulators conduct exam<strong>in</strong>ations, it is sensible for them to f<strong>in</strong>dout what the <strong>in</strong>stitution's strategic goal <strong>in</strong> derivatives bus<strong>in</strong>ess is. Is it a hedger,speculator or arbitrageur? Regulators can also review the <strong>in</strong>stitution's revenuereport to identify the sources of treasury revenues. If 80 percent of an<strong>in</strong>stitution's treasury revenues are from position-tak<strong>in</strong>g activity, exam<strong>in</strong>ers usuallywould watch that <strong>in</strong>stitution's treasury operation a bit closer. The reason isthat position-takers <strong>in</strong> treasury <strong>in</strong>struments, both cash and derivatives, arespeculators. In other words, they are gamblers. As we have just discussed,when you take an out-right position <strong>in</strong> any f<strong>in</strong>ancial <strong>in</strong>strument, there is a50 percent chance that the price of that <strong>in</strong>strument will go up and a 50percent chance it will go down. As soon as you have taken an out-rightposition, you have no control over what the price will be <strong>in</strong> the next m<strong>in</strong>ute.Some Fundamentals of <strong>Derivatives</strong>