Example Of Research Paper On Arbitrage, Speculation And Hedging Application
Statement of purpose
Increase in international trade and businesses have resulted in increased derivatives use in international finance markets. In that respect, businesses and investors increasingly adapt strategies o benefits from exchange rate fluctuation as well as for managing his related risks. Those strategies include speculation, arbitrage and hedging with varying application by firms and investors. In that view, his analysis seeks to study the three techniques application by firms.
Study objective and question
In view of the study topic, the study will seek to achieve two objectives. The first objective is to find the characteristics of the firms ha use each of the three strategies. The other objective will involve identifying the instrument most applied by the companies. In that view, the study will answer the question “What are the characteristics of the firms using hedging, speculation, and arbitrage and which is the most applied financial instruments with he strategies?”
Research paper overview
The research paper is organized into sections including the literature review, data, methodology, analysis and findings as well as a conclusion. The literature review will entail overview of the three strategies and related derivatives as well as their application. In addition, the reviews will entail pas study’s findings. The data and methodology sections will involve describing the data used and the research techniques applied to the study. In respect to analysis and findings, the section will provide the analysis of research data in line with the study question and objectives. Finally, the study findings will be summarized and evaluated in view of the literature review findings.
FX forward contracts are those that sell or buy a currency at a future delivery for the yield differential between the two with a rate adjacent to account. It is the most commonly traded FX hedge over the counter. It is customized in terms of quality, delivery date and size. FX swap is the contract to sell or buy a currency at a delivery future date and then reversing the same position by either buying or selling the currency. For instance, if a forward contract is due and the foreign funds are yet to be due or to be received, the client offsets the maturing contract using the new swap at the current date of delivery, then later re-establish a new delivery date`s desired position. Rights are given by foreign exchange (FX) options but not obligations, for a specified period at specified exchange rate to buy or sell a currency with another. Over the counter derivatives, market is where these contracts are traded. They help but without honoring the contract obligation lock in the exchange rate. Example, if it is expected U.S dollar will depreciate against Canadian dollar; with U.S. assets a Canadian investors by buying on the U.S. dollar a put option they can hedge currency risk since there should be an increase in the value of option if U.S dollar value falls. Foreign exchange (FX) futures are, exchanges- traded that are standardized cash-settlement contracts between pairs of two specific currencies, although they can be exchanged for physical currencies. On the future, exchange is where these contracts are traded. (Bank of Canada, 2014)
Interest swaps are over the countertrade agreements to exchange one stream of interest payment for another between two parties over a specific period. “Vanilla” swaps are the most common interest rate swaps traded, where fixed-rates payment are exchanged with floating-rate payment. For example, 24% firms in oil and mining, 14% in technologies, 37% in diversified fields and 245 in all other sectors. (Forest products, media and communication, and life science) Use at least a single derivative contracts mentioned above. In Oil, mining and diversified industries, interest rate swap is the most commonly used derivative. In technologies, the most prevalent instruments are FX forwards, followed by FX futures and options. During the times of uncertainty is when the use of financial derivatives increases. It is use was slightly higher in 2005-07 pre-crisis and post-crisis in 2011-13 for both small and large firms. Interest rate swap use was higher in 2008-10 seasons in comparison to the other two seasons as the firms wanted to lock in the least cost of debt in the times of low rates of interest that elevated uncertainty about the economy’s outlook. With the interest rates been expected to increase, the interest rate swap reliance would allow firms to pay interest rates that are fixed while underlying payment debts remains hedged but variable. FX derivatives (forward, swap, options and future) which large firms uses and in 2008-10 they were more prevalent than in other periods. (Bartram, Brown & Fehle, 2009).
Financial derivatives are used by corporations to reduce their earning streams volatility by hedging exposure to exchange rate, commodity price risks, and interest rate. About one-third of firms in Canada that are publicly listed use financial derivatives. It is used in all sectors of the economy is widespread and increases especially at times of uncertainty. Non-financial firms that use it are more profitable and typically larger and have lower earnings volatility than those which do not use derivatives. Canadian hedgers’ characteristics seem to rhyme with those in other jurisdictions. Financial derivatives such as future, forwards, swaps and options allows corporation to cover themselves against the unpredictable changes in interest rates, commodity prices and exchange rates hence reducing the financial risk exposure. Although, in derivatives markets, financial corporations are the most important, non-financial corporations in Canada are important; for example, in Canada, they are counterparties to about 15% foreign exchange (FX) turnover. Stylized facts are given by this article about the financial derivatives use by the publicly listed firms in Canada from 2006 to 2013.This is currently an important topic owing o he challenges that firms experienced during the 2009-13 period, Canadian Dollar, and commodity prices fluctuated significantly in comparison to earlier periods. Such fluctuations lead to unpredictable losses and profit margins for corporations.
Therefore, holding other things constant, profit volatility can increase firm`s distress and enhance their ability to acquire external funding. The extent to which export revenues are relied on by the Canadian economy, financial derivatives hedging may enhance domestic welfare by smoothing income from export. Knowing the extent to which firms use and rely on the use of derivatives has changed over time; it can be useful in gauging exchange rates and interest rates potential impacts on an economy. For example, a firm may be a shield from a temporary exchange rate shock and hence a temporary exchange rate volatility pass-through is forestalled. However, if there is a persistence or permanent exchange rate shock, hedges only delay the pass through. The consensus in the literature of pass-through is that pass-through may be slowed by the exchange rate hedges for a period of hedging instruments average maturity. However, derivatives use in arbitrage; speculation and hedging have proved to be difficult due to lack of firms’ data for use of derivatives. For use to get some light in terms of many firms’ characteristics on how non-hedgers differ from hedgers, we collected derivative data at the firm level. (Ludger & Kothari, 2001)
Corporate use of derivatives discussions focuses on if firms use derivatives to increase or reduce risks. In contrast, corporate derivatives use empirical academic studies take it for granted that companies hedge with derivatives. Using financial statement data of 425 large U.S corporations, we analyze whether firms use derivatives to increase systematically or reduce their riskiness. Nonetheless, firms that use derivatives shows few if any, measurable differences with those which do not use financial derivatives to risk related to use of derivatives. (Ludger & Kothari 2001)
Arbitrage, hedging, and speculation
Hedge: Uses the existing positions to reduce future risks
Speculation: Is the process of using futures with hope of making a profit by taking on risk
Arbitrage: Uses the difference between the future prices and spot to generate risk-free profit
Arbitrage is the exploitation of price inefficiency that is observable, and hence, pure arbitrage is thought to be riskless. Arbitrage is more complicated in practice, but in investing practices, three trends have opened up arbitrage strategies of all sorts: the use of trading software, various trading exchanges, and derivative instruments. For example, foreign exchange and electronic communication networks make possibility of taking advantage of the arbitraging of prices “exchange arbitrage” among different exchanges. There are only few arbitrageurs that are hedge funded, but historical studies prove that when they are; they are always perfect source of reliable-moderate; low-risk returns. However, due to the small price inefficiencies, pure arbitrage needs large high turnover and usually leveraged investment. Further, arbitrage is self-defeating and perishable; if a strategy is very successful, it is duplicated and then slowly disappears.
Arbitrage strategies are mostly better labeled as a relative value. These strategies mostly capitalize on price differences but are never risk-free. Convertible arbitrage, for example, entails buying of convertible corporate bonds, which can be changed into common shares while at the sometimes selling short stock of a company that has also issued the bond. Relative prices are what this strategy tries to exploit of the stock and convertible bond; this strategy arbitrager would think that the stock is a little expensive and bond a little cheap. Making money when stocks go up and also when stock goes down from the short sale is the idea. However, as the stock and convertible bond can move independently, the arbitrager can lose on both the stock and the bond, meaning the position carries risk. (Bartram, Brown & Conrad, 2011)
In pure arbitrage, you take no risks, invest no money and walk away with sure profits. In the real world, you can categorize arbitrage into three groups:
Pure arbitrage; you risk nothing and earn beyond the riskless rate.
Near arbitrage; you have assets with cash flows that are identical or almost identical, trading at different prices. The investors are always forcing convergence, but there is no guarantee of prices converging.
Speculative arbitrage, which in the first place may not be an arbitrage. Therefore, investors tend to take advantage of the mispriced assets, selling the most expensive and buying the cheaper one.
Individual investors, corporations and portfolio managers use hedging techniques to reduce various risks exposure. Hedging becomes more complicated in financial markets than simply paying an annual fee to an insurance company. Strategic use of instruments in the market is mainly for hedging against investment risk in the market for offsetting risk price movements. In other words, making another investment by investors hedging one.
Basic hedging strategies
While the use of long and short hedges can reduce or in some cases eliminate both upside and downside risk. The reduction of upside risk is a limitation certainly for using futures to hedge. (Bartram et al., 2011)
This is where short position is taken on futures contracts and is most appropriate when an asset is expected o be sold in the future. It is also used by anticipating speculator when they expect contract prices to decrease.
This is the strategy where a long position is taken on future contracts, and it is the most appropriate when an asset is expected to be bought in the future. Alternatively, it can be used by speculators who anticipate that the price of a contract will increase.
On Toronto Stock Exchange (TSX) listed firms, he researchers took some samples and collected data on use of derivatives for the following contracts: foreign exchange futures, forwards, interest rate swaps, swaps, forwards and options. Excluding financial utilities and firms, they got the information for the use of contract derivatives over the 2005-13 periods for 1,522 non-financial firms. There is a significant portion of Canadian firms that relies on derivatives; 33% of the total sample firms use at least one of the above-listed contracts; 24% of them use at least one FX contracts; 18% use interest rate swaps. Of the firms that use FX contracts, 54% use FX forwards, 25% use FX swaps and 46% use either FX options or FX swaps.
Speculators make Bets or guesses depending on where they believe the market is going. For instance, a speculator may short sell a stock if she or he believes it is overpriced and wait for the price to go down at the price that she/he will buy back the stock and receive a profit. Thus, Speculators are exposed to both the upside and downside of the market. Hence, it can be very risky. Overall, hedgers are seen as risks averse are what while risk lovers are what speculators are typically seen to be. Risks related to uncertainty are what hedgers try to reduce while betting on the market movements while what speculators does is to try and make a profit from the fluctuating security prices. (Campello, Lin, Ma, & Zou, 2011).
The credit crisis of 2008 is still debated on by experts as to what caused it. Simply, changes in the market did not primarily cause the credit crisis; it was as a result of law changing. In particular, the crisis was foreseeable and direct (authors and others foresaw it) consequences of sudden CFMA`s and removal of wholesale which is centuries-old constraints on over the counter (OTC) speculative trading in derivatives. Probabilistic bets on future events are derivative contracts; they reduce risks by hedging but also attractive vehicles providers for disagreement-based speculations leading to risk increase. Therefore, as an empirical matter, derivative trading social welfare consequences depend on whether hedging or speculative transactions dominates the market. (Stout, 2011)
The doctrine called “the rule against difference contracts” is the one through which the law recognized the consequences of the differing welfare of speculation and hedging which treated derivative contracts which did not serve the purpose of hedging as unenforceable wagers. The response by the speculators was by shifting their derivative trading to exchanges that are organized which through clearinghouses they got private enforcement in which members of the exchange had contract of the performance agreement. Social costs of derivatives risk were effectively combined and limited by the clearing house. The Commodity Exchange Act (CEA) in the twentieth century largely replaced the common law. CEA confined speculative derivative trading just like the common law to the organized (and now regulated) exchanges. This regulatory system for many decades kept derivatives from causing to the larger economy significant problems. The legal traditional restraints on OTC speculations were dismantled systematically in the 1980s and 1990s, and with the CFMA enactment in 2000, it was culminated. That was where the 2008 crisis were set at by legalizing in the history of U.S for the first time, OTC trading in derivatives. Experiential increase of OTC market was the result in 2008 culmination with speculators failures of many important financial institutions systematically (and many others near failures)as a result of bad derivative bets. (Stout, 2011)
Bank of Canada survey
The period of 2008-2010 was marked by high volatility in exchange rate compared with the other two periods, for 2008-10 period daily exchange rates standard deviation was 8.4 percent while that of 2011-13 was 4 per cent. The hedging activity intensifies in times of volatile markets as corporation revenues stream become exposed adverse price movement, and firms are more eager to rely on derivatives in response. The Bank of Canada’s survey results on Canadian Foreign Exchange Hedging in indicated that Canadian companies used more derivatives in relatively more volatile exchange rates period. In the survey, Foreign exchange market volatility change, as reported by Canadian firms, has driven the shift in activities of hedging. (CFEC, 2014)
Hedging and Firm Characteristics
The modern financial theory firms imply value is not affected by financial decisions like hedging in the absence of market imperfection. However, hedging can affect the value of the companies in various ways as financial markets are not perfect. The Bank of Canada provided some characteristics facts about non-hedging and hedging firms. First, hedging firms tend to be mature and large corporations, Based on the set of data used; the derivatives use in large firms is more pronounced than for smaller ones. Definition of large firms is those firms with higher volume of the market than the sample median, which was Can $250 million. Example, Interest rate swaps was used by 25% of the large firms, while only 5% of the small firms used it; FX swaps were used by only 1% of the small firms, while the contract use had been reported by 10% of large firms. Moreover, mature firms with 20 years of average age are the ones that tend to hedge more, as opposed to non-hedging ones that have an average age of 12 years. It is a consistency observation in Canada that more mature and large firms tend to hedge which is a consistent pattern is found in other countries (Bartram e al., 2009).
The finding was not surprising given that hedging strategies development requires financial management that are fairly sophisticated and long-term investment, which mature and large firm are more likely to develop or have in place. Large firms are highly likely to have better access o derivatives markets due to the availability of their credit ratings. A bank needs to check the firm’s credit risk when entering derivatives contract with it and allocate the appropriate credit line, depending on the credit risk of the firm this may need to be collateralized. As the mature and large firms, banks would easily enter with them a derivative contract as they are the most likely to have their credit rating. Secondly, there are higher profits for the firms that tend to hedge and their income stream is less volatile. Canadian non-hedgers and hedgers, in our data we find returns on assets for hedgers is more profitable than non-hedging at 10 percentage points higher; and much lower volatility in their earning compared with non-hedgers measured by return on assets volatility. Finding in other countries is consistency with the findings here in Canada. With the use of international firms, (Bartram, Brown & Conrad, 2011) showed the use of derivatives is associated with cash-flow volatility and standard deviation which are low. (Bartram e al., 2009).
Using 175 samples of publically traded BHCs, Wohar and Whidbee (1999) found out that external monitoring and managerial incentives affect the banking industry decision to use derivatives. If the incentives of the managers are closely aligned with shareholders interests, as reflected in CEO shareholding high percentage, if insider holdings exceed 10%, they are less likely to use derivatives. Similarly, if outside director owns substantial equity, derivative use is less. These results show that large equity holding managers take advantage of the opportunity of risk-shifting of deposits by not hedging. With below 10% as the insider holding for BHCs, however monitoring by external directors has a high likely hood of using derivative. This suggests that outside directors are monitoring leads to a more risk-averse character on small equity stake managers.
Further, Pontiff & Lynch (2002) investigated the use of derivatives by investment managers by comparing equity mutual funds return distributions that use and do not use derivatives. In contrast, users of derivatives have risks exposure and performance return just like the non-user according to the public. They also analyzed fund risk response changes to prior fund performance. Risks changes are less severe for derivative using funds, as per the explanation on reduction of performance risk that managers use. They provided new prove on the managerial gaming and the cash flow implication in relation between risk and performance.
Reasons for speculation and characteristics of the firm
The literature shows different reasons as to why companies speculate derivatives. Many factor help in creating firm size and speculation relationships. If the cost of transactions is important, and speculation has economies of scale, large companies will mostly speculate on the derivative market. However, if the company size is a proxy for firms financial constraints faced. Therefore, more small (constrained) companies should speculate than big companies. For example, analysis of companies’ data from gold mining sector and in the relationship between speculation and size of the firm found a negative relationship. The total assets of the company are the calculation log for the variable size (SIZE) of the companies which are included so as to study this relationship. In getting firms to speculate, foreign exchange market information can be important. I is also argued that when a company believes that over the rest of the market it enjoys comparative informational advantage and thus in a better placed to make gains, speculation can occur. Empirically, a relationship was identified between companies speculating probability and international orientation on the market of foreign exchange, they confirmed this hypothesis. We then use the ratio between total sales (Foreign sales) and foreign sales, the ratio of total debt (Foreign debt) and foreign-currency-denomination and dummy variables if there are subsidiaries of the company oversea (Foreign operations) for this hypothesis testing. (Che & Rajiv, 2014)
The possibility of there being relationship between financial distress and speculation was discussed and the companies with low risk of bankruptcy according to the author should be more likely to speculate as it will be easier to absorb the effect of negative outcome which may be as a result of speculation. It is also suggested that managers of the company may be lead by principle-agent relationship to be more likely to speculate in a firm that is in distress because the shareholders will benefit from this action whereas the likelihood of the of good outcomes will be reduced by the risk management that improves the situation of the company. The difference between the asset totals and the book long-term debt value (Debt Ratio) can also be used in the analysis of that relationship. It was also suggested that there may be links between speculation and the existence of the convex investment function. Thus companies with low short-term liquidity but good growth opportunities and high external cost of financing should be more likely to speculate with derivatives. The ratios between current liabilities and current assets (Quick) and market-to-book ratio (Growth) in this analysis played a role as growth opportunities and liquidities proxies. Speculations may be seen by the companies as firm risk increasing. Speculation is also more prone to companies that are riskier as a risk-taking measure we add daily return volatility as a risk-taking behavior measure. (Farahi, 2009)
Furher, a relationship exist between use of derivatives and corporate Governance for speculation. It is observed by author that companies with lower levels of governance are more likely to be speculate but that internal control systems specific to the use of derivatives can limit potential abuses External and internal structure of corporate structure impacts were analyzed on the derivative use for many companies exposed to risks of foreign exchange. The study result suggests that firms with strong governance use derivatives to reduce their exposure to exchange rate changes, while companies whose governance is weak use derivatives in a way that is harm risking the firm. In a related story; a sample made up of firms from many countries was used to show that policies for risk management add value to strongly governed companies. In this study thus, for firm governance levels, the proxy variable was the use. The groups of São Paulo stock exchange firms as per their different governance level from lowest to the highest: market that is new, 1st level, 2nd level, traditional and organized counter. This classification system is used in the study for analyzing the relationship between speculation and governance. I was finally shown that in foreign exchange rate, past movements are important factors in the decision for the company to speculate. Thus, time dummies in this study were also used in the likely hood analysis that common macroeconomic factors to all firms would affect speculation decision. (Farahi, 2009)
Derivatives User, Hedger and Speculator Profile
In 2008, 38 companies out of the 98 that used derivatives (38.7% derivatives users) it's in the foreign market where they speculated. The number decreased to 16 (20%) those that were classified as speculators out of those the 76 that used derivatives in the year 2009. Positions that were unexpected were taken by 16 of the 38 speculators in the year 2008 whether derivatives were used for hedging reasons given their exposure to foreign exchange, and there was markedly increase in derivative volume by 22 without a proportion increase in their exposure to the foreign exchange. 11 of the 16 speculators in 2009 fell in the 1st category while in the 2nd there were 5 of the 16. In the years 2008 and 2009 the number of hedgers (users of derivatives which are not classified as speculators) was stable; companies classified as hedgers were 60. The fact that it is possible to use this study data in examining the derivatives net position of the firms and their exposure to foreign exchange over time is one of the advantages of this study over the previous studies. By the use of the data, it is shown that it is exhibited negative exposure on foreign exchange by the hedgers and are, on average, long in US dollars. The fact that swaps are the most derivatives used widely by the companies of Brazil, which they have used as their dominated liabilities of foreign exchange; this is consistent with this evidence. (Farahi, 2009)
For the period on average, there was a positive exposure exhibited by the speculators and short net positions in US $. That is, among those who bet on domestic currency appreciation are a net of exporters hoping to via their positions gain. Interestingly its only two types of speculators who this view is common too. The companies who because they have taken position inconsistent with their exposure and have been classified as speculators (SPEC1) their average figures of exposure to foreign exchange show a negative figure (net imports) and in dollars they hold short positions, with derivative net position similar to that of classified companies according to the second classification (SPEC2) but with rate of exposure to foreign exchange that is positive (net exporters). Similarly, in study resembling this analysis but only the first type of speculators is considered, it was discovered that the positive rate of foreign exchange companies (net exporters) was in the year 2002 long in dollars: on domestic currency depreciation is where they were betting. This phenomenon was argued by the authority that the year’s extraordinary domestic currency volatility made it happen, which was caused in turn by the new government election uncertainty. (Che & Rajiv, 2014)
Three types of comparison were also made among the samples companies. Initially its compared with the data of the derivative using companies with all the companies in the sample. Next it is made comparison between the hedge classified companies and speculators and finally it compares the two types of speculators. The difference between the two groups means null is the null hypothesis. Where null hypothesis is rejected is shown by asterisks.
Derivatives users are shown to be larger than the on-users confirmation of the existence of the derivatives uses this finding does cost existence. It is also confirmed that as represented by large debts and revenues fraction held in foreign currencies and by overseas subsidiaries operations there is a greater integration in international, led to this firms using derivatives.
It is also indicated in the data that between existence of distress financial possibility and derivative use there is a positive relationship given that derivative using companies have higher ratios of debt than those that don’t.
Analysis of derivatives, empirical results used by Brazilian companies are presented in this section. An estimate of the logic model in all regression; the dependent variables varied according to the performed regressions. Included in the regressions are the time dummies, sectoral in additional to the company’s characteristics. It is confirmed by the results that an important role is played by the transaction cost in the companies’ use of derivatives. The results show that with more increase in the company size the more likelihood it will use the derivatives. A relationship which is positive is also shown between the debts and foreign currency revenues; this confirms that the higher the exchange exposure of the firm the greater it is likely to use the derivatives. It is also identified that it is more likely to use derivatives for the companies that have a greater growth opportunities as it was also suggested. There is no other theory with the explanation for the decision of using derivatives by the Brazilian firms.
The data used in the analysis is the information about companies use for the three strategies in their risk management. The data will take the descriptive form and has been collected from the marker reports on companies’ financial practices. The data provides an overview of the type of companies that apply derivatives through he here strategies.
The study will involve descriptive techniques in identifying the characteristics of the firms mainly applying the three strategies as well as finding the most applied techniques by fund managers. That is because the search will involve both qualitative and quantitative aspects.
Owing to the challenges in accessing data on firms’ financial strategies, the study will rely on secondary data collection method. The method will rely on market reports and existing literature.
The analysis applied in this case involves descriptive method ha describes the situation in the financial markets. It relies on the market data and findings for the characteristics of the firms using the three strategies as well as in finding he mostly used strategy by the companies.
Analysis and findings
Brazilian cases of large firms use of financial instruments and strategies are worth of note, for instance; Sadia reported non-recurrent loss of 777.4 million Reais that was associated with derivatives instruments, in the third quarter of the year 2008. Most of the Sadia’s losses resulted from the company’s speculative operations. Foreign exchange, as well as smaller portion, was a result of investments in Lehman Brothers’ securities. Aracruz is also another large Brazilian company that was most exposed to the risk in derivatives operations and recorded losses of US$ 2.13 billion in liquidating 97% of the company position. In addition to the big firms, many medium companies also succumbed to appeal for the ﬁnancial earnings that seemed so easy. In late October 2008, there were more than ﬁve hundred firms involved in foreign exchange derivatives. (Farahi, 2009)
Data on ISDA members using speculation, hedging and arbitrage on various financial instruments by industry
Source: (ISDA, 2015)
ISDA represents the participants in privately negotiated derivatives market; it is among the largest global financial trade associations measured by the number of is member firms. ISDA had over 820 member institutions from 57 countries on six continents and was chartered in 1985. The members include the world’s major institutions dealing with privately negotiated derivatives and other end users relying on the OTC derivatives to efficiently manage financial market risks in their economic activities. (ISDA, 2009)
In view of the Brazilian companies and the ISDA members, it is clear that the firms using speculation, hedging and arbitrage are mainly large firms and those in the finance industry. That is in line with the literature finding of he high need for large firms with more assets, as well as financial companies with high risks and that are more liquid to use the techniques for profit making and risk management.
Usage of derivatives creates a significantly different picture today with many companies still using hem for hedging purpose as the ISDA discovered ha 94% of major firms use the derivatives in their risk management strategies. Hedging through with the use of derivatives is also popular with major financial firms; they frequently use the instruments to offset heir counterparty risk exposures, as well as their risk positions
Further, new uses for derivatives have appeared including speculation. Speculators do not mainly own the underlying assets or even intend to exercise the contract. The direction of the housing market epitomizes and demonstrates how speculators use derivatives for speculation purposes. The speculators undertake contracts as a method of making money and not a hedging tool. The common outcome of speculation in the derivatives market is mainly contracts with opposing speculators. That means that all hose in the contract end up using the contract as a method of trying o make money if the market follows a certain direction. Thus, neither party is hedged; both undertake significant risk with the contract. The contracts demonstrate ha here is a shift from the original derivatives purpose to hedge; as speculation creates risk for both companies in a trade.
Finally, derivatives are now commonplace in arbitrage strategies. However, although by definition the companies are supposed to act as market neutral or be hedged, companies are not using derivative contracts as methods of achieving hedged status. The companies increasingly see discrepancies markets pricing and hen use derivatives as a means of utilizing the discrepancies for profit making.
In terms of the characteristics of the companies that use the three strategies; hedging, speculation and arbitrage, large companies, and those in he finance industry have been found to be the common ones in applying the strategies. That is in line with the literature review findings in which various past studies have identified large companies and fund managers to be the common users of the strategies.
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