The purpose of determining the investment is profitable and the risk is minimal. To achieve this, various instruments, practices and strategies and recent developments. And the opening of the border to trade and international trade, the global enterprise is gaining momentum over the past decade, a new phase of international cooperation and global liberalization. The integration of financial markets around the world has led to an increase in financial risk and frequent changes in interest rates, exchange rates and stock prices. Global financial co-operation has led to an increase in financial risk and constant changes in interest rates, exchange rates and stock prices. Risk settings from different criteria and increasing dependence on other capital markets for other risk management practices have also been improved and produced as a risk factor that can be reduced. Popular new instruments, called ‘derivatives’, not only reduce the financial risk, but also create new opportunities for those in high risk.
Definition of Terms
In the broadest sense, derivatives are contracts of any economic gain from their value from underlying assets. This explanation, however, does not give a real idea of ??what a derivative is or what it could be. The market content of this is larger (about $516 trillion in 2008) and the fastest growth through the late ‘ 90s and early 2000 years and experience. As such, it is a grave mistake to leave the definition of the derivative as financial weapons of mass destruction without described Mr. derivatives some fall into this category, while others are as simple as buying a home owner insurance.
According to Buffett first referred to derivatives as “financial weapons of mass destruction,” the potential derivatives bubble has grown from an estimated $100 trillion to $516 trillion in 2008, according to the most recent survey by the bank international settlement. In addition, 2008 was marked by Society General’s Jerome Kerviel’s orchestration of the largest bank fraud in world history via derivatives trading (a £3.6 billion loss). This makes previous rogue trader incidents pale in comparison:
Nick Leeson at Barings Bank in 1995 (a £791 million loss and bankruptcy for his employer)
National Westminster Bank PLC in 1997 (a $125 million loss)
John Rusniak at Allied Irish Bank in 2002 (a $691 million loss)
David Bullen and three other traders at National Australia Bank in 2004 (a $360 million loss)
Even in other derivatives arenas, the stakes appear to be increasing at an equally alarming rate. For example, Orange County, California lost $1.7 billion in 1994 from debt and derivatives used to expand its investment fund and log term capital management lost $5 billion in 1998.
Derivative is a contract between two parties which gives the right, and sometimes the obligation, to buy or sell an underlying asset, and specifies conditions (for example: the dates, the price, the quantities and value of underlying variables) in which the payment has to be made between the participants. (Arnold, 2010, p 202)
There are two types of derivatives.
Derivatives products and derivatives. First derivatives originated as a tool for managing risk in the marketing of the product. In product derivatives, basic goods are goods. It may be an agricultural products like wheat, soybeans, rapeseed, cotton etc. or precious metals such as gold, silver, etc. Financial derivative of the word denotes the type of equipment finance including stocks, bonds, Government securities, interest rate, foreign exchange and other hybrid securities.
Major categories of financial derivatives
Futures contracts are traded exchange rate contracts for the property before deciding to be delivered in the initial steps agreed to in the future at a price agreed today. The buyer makes payment of margins to display the value of the transaction. Buyer is said for a long time and the seller have gone short. Counterparties can from volunteers and took similar but temporary budgetary deficit positions and Exchange, so the exact position is zero and delivery only and cash flows for the sake of profit or loss.
Term contracts are non-standard agreements between two parties to buy or sell an asset at a certain future time at a price agreed today. For example, pension funds often use currency futures to reduce exchange rate risk when foreign currency positions are required at known future dates. Because the contracts are tailor made, they can be for non-standardized amounts and dates, such as delivery of 23,967 euros against payment of 32,372 USD on January 16, 2014.
Option contract is an agreement that entitles the holder to buy or sell currency at an agreed price and to a certain currency at a certain time in the future. However, the option holder is not required to exercise the contract. Therefore, the proprietor must pay a premium to the broker, company or person who orders to buy or sell currency option contracts on behalf of the proprietor (Pike * Neale, 2009)
Classification of option contract according to (Bodie ; Kane ; Marcus, 1999)
Call option, this gives the holder the right to buy a certain quantity of currency at the exercise/strike price in a specified period of time.
Put option, this gives the holder the right to sell a certain quantity of currency at the exercise/strike price in a specified period of time.
Two types of option contract basing on the terms on exercise in the contract according to (Bodie ; Kane ; Marcus, 1999)
European style options, this allow the holders to exercise the option only on the expiration date.
American style options, this allow the holders to exercise the contract at any time up to the expiration date.
According to (Nguyen, 2012), there are two parties engaged in the option contract which are option holder and option writer.
Figure 2. Participants in option contract
Option holder/option buyer/option taker is the party which grants another one the option but not an obligation to do or not to do something. In addition, this party has a right to choose to purchase or sell currency at specified price within a certain period of time.
Option writer/option seller/ option granter is the party who is obliged to fulfill that choice in accordance with the terms of contractual option.
Premium is the non-refundable cost for which holder is required to pay to gain the possession of option at the outset regardless of whether option will be exercised or not (Wilmott, 2000).
Swaps by Watson ; Head (2010) are agreements to exchange one series of future cash flows for another (Although the underlying reference assets can be different, such as equity or interest rate, the value of the underlying asset will characteristically be taken from a publicly available price source. For example, under an equity swap the amount that is paid or received will be the difference between the equity price at the start and end date of the contract.
Hedging by Stulz (2005) refers to a strategy designed to reduce or eliminate risks of adverse movement in financial terms. Currency hedging is defined by Hull (2011) as an attempt to insure companies’ business against exchange rate moving in the direction opposite to their positions in the future market by purposefully taking on the offsetting position in the related currency. This means making investment in another negatively correlated instrument in a hope of minimizing risks of the to participants unfavorable shifts in the monetary market.
Hedgers are parties at risk with an underlying asset and they decide to take out (buy or sell) derivative instruments to offset their risks. There are 2 hedge positions which are;
This is maintained by the party who commits to purchasing the currency in the future. This is because this party is currently not holding any contractual currency and expects to possess it sometime in the future. Since the party is seen to be short on the cash position therefore, the party wishes to lock in purchase prices and use a long hedge, which reduces the risk of a short position (Jones, 2002).
This is maintained by the party who commit to selling the currency in the future. This is because the party is currently holding the contractual currency. Since the party is seen to be long on the cash position so the party needs to protect themselves against a decrease in prices. Hence, a short hedge mitigate the risk taken in a long position (Hull, 2011)
Figure1. Hedge positions in future or forward contracts (Nguyan, 2012).Risk Management
Risk Management can be defined as “all measures and activities carried out to manage risk” (Aven, 2008) and it is the correct management of uncertainty that has a positive impact on a project’s success.
The purpose of risk management
There are many purposes of risk management in relation to financial derivatives the following are some of these purposes
To determine risk sources and mechanisms of managing those risks; risk management helps in establishing categories of risks and provides a thoroughly mechanism for collecting and organizing those risks. The mechanisms help to ensure an appropriate scrutiny and a transparent awareness to management by drawing attention on the expected consequences to the company’s objectives.
To define the parameters used to analyze, categorize risks, and control the risk management effort; in risk management system there is risk management plan in which all parameters for evaluating, categorizing, and prioritizing risks are formulated for the purpose of managing risk. Also the risk parameters are used to provide relevant and consistent criteria for comparing the various risks to be managed.
To establish and maintain the strategy to be used for risk management; also, the purpose of risk management is to establish a comprehensive risk management strategy that addresses items such as scope, methods and tools, sources of risks, parameters, risk mitigation techniques, risk measures, and time intervals. Since the risk management strategy is often documented in a company’s risk management plan it is reviewed with relevant stakeholders to promote commitment and understanding.
To develop a risk mitigation plan as defined by the risk management strategy; in the risk management strategy, the mitigation plan is a critical component of developing alternative courses of action, workarounds, and fallback positions, with a recommended course of action for each critical risk. In this phase, risk avoidance, risk control, risk transfer, risk monitoring and risk acceptance are established aiming at handling risks.
Ways to hedge risks by financial derivatives
Financial risks are hedged in different ways, some of them are documented as follows;
Hedging with Forward Contracts
Fluctuations in the foreign exchange rate can have significant impact on business decisions and outcomes. Instrument used for exchange rate risk management is the forward contract. To hedge with forward contract, one need to get a counter party that will agree on the exchange by fixing the forward exchange rate today that will be used to convert the expected future cash flows as speculated for their transaction. This simple arrangement would easily eliminate exchange rate risk.
Assume that a US construction company, Group 6 ltd just won a contract to build a stretch of road in Tanzania. The contract is signed for TZS 10,000,000 and would be paid for after the completion of the work. This amount is consistent with Group 6 ltd minimum revenue of TZS 1,000,000 at the exchange rate of $0.10 per TZS. However, since the exchange rate could fluctuate and end with a possible depreciation of TZS, Group 6 ltd enters into a forward agreement with CRDB to fix the exchange rate. By entering into a forward contract Group 6 ltd is guaranteed of an exchange rate of $0.10 per TZS in the future irrespective of what happens to the spot Rupee exchange rate. If Rupee were to actually depreciate, Group 6 ltd would be protected. However, if it were to appreciate, then Group 6 ltd would have to forego this favourable movement and hence bear some implied losses. Even though this favourable movement is still a potential loss, Group 6 ltd proceeds with the hedging since it knows an exchange rate of $0.10 per TZS is consistent with a profitable venture.
Hedging with Futures Contracts
Futures contracts are standardized contracts used to manage risk associated with future exchange rate of the cash flows. It is used to hedge risk tired to exchange rate of the future cash flows of the company. In fact the futures contracts are legal contracts and similar to the forward contract but are much more liquid. They are liquid because are traded in an organized exchange futures market. As for hedging with futures, if the risk is an appreciation of value one needs to buy futures and if the risk is depreciation then one needs to sell futures.
Let’s assume accordingly that Group 6 ltd sold Rupee futures at the rate RM0.10 per Rupee. Hence the size of the contract is RM1, 000,000. Now say that Rupee depreciates to RM0.07 per Rupee – the very thing Group 6 ltd was afraid of. Group 6 ltd would then close the futures contract by buying back the contract at this new rate.
Hedging using Options Contracts
An option is a right (privilege), but not an obligation. To hedge with the option contracts, the one need to buy either put or call option to sell or buy the underlying asset of the company at the exercise price before the expiry date. If the option is in the money or at the money then the option holder will be protected against the risk in prices.
The Group 6 Company October 30 call option is quoted at TZS 500/-, the Group 6 Company October 30 put option is quoted at TZS 1,500/-, while the Group 6 Company spot price is quoted at TZS 28,000/-. The call option is said to be out of the money since its immediate exercise (if possible) has no value. Conversely, the put option is in the money. Suppose the Group 6 Company spot price rises to TZS 31,000/- on October 16, which is the option maturity date. Then, the call holder is better of exercising his right and making a profit of TZS 1,000/-. The call expires in the money, while the put expires out of the money.
Hedging with Swaps
To hedge with currency swap , the two parties agree to enter into agreement of exchanging both periodic interest payments and principal denominated in one currency into another currency at the agreed upon rate of exchange for the specific period of time. However, on the maturity date, each party is required to return the swapped principal sum (Watson & Head, 2010).
A company agrees to pay its bank semi- annual interest over 20 years, based on a fixed nominal interest rate of 5.5% (per year), and to receive interest payments based on a floating interest rate, say, the 6 month LIBOR rate. Both interest payments assume a principal amount of TZS 1 million. No payment is exchanged up front. Several swaps are traded over the counter, namely, interest rate swaps, currency swaps, equity swaps, and the more recently introduced and controversial credit default swaps. There are several combinations of derivative contracts, such as options on swaps or swaptions, options on futures contracts, and options embedded in bonds, among others.
Arguments for and against the use of derivatives in hedging risk
Argument for the use of derivatives in hedging risk
Derivatives help to gain the certainty concerning a future outcome; Under the strong fluctuating currency market, neither of parties is able to predict accurately what actual exchange rate in the future will be. Therefore derivatives for example forward contract assists in the protection of unfavorable exchange rate movement which causes fluctuation that can lead to loss of large amounts of money in firms from the decrease in over sale price or from the sudden rise in imported material cost (Stephens, 2003).
Derivatives allow firms to set accurate budget and stick to the financial plan; This is because the exact values of future transaction are calculated. This also means that derivatives enable firms to focus on their business activities in order to reap the huge profit instead of wasting time, capital and resources on keeping a constant track of fluctuation of exchange rate (Stephens, 2003).
Futures and options contract can be used for altering the risk of investing in spot market. For instance, consider an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He can protect himself by selling a futures contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in the futures market and similarly, if the spot price falls below the exercise price, the put option can always be exercised.
Derivatives markets help to reallocate risk among investors. A person who wants to reduce risk, can transfer some of that risk to a person who wants to take more risk. Consider a risk-averse individual; he can obviously reduce risk by hedging. When he does so, the opposite position in the market may be taken by a speculator who wishes to take more risk.
Derivatives markets help in the raising of capital. As an investor, you can always invest in an asset and then change its risk to a level that is more acceptable to you by using derivatives.
Options and futures help in price discovery by providing information about the volatility or risk of the underlying asset. Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen, futures markets provide a low cost trading mechanism. Thus information pertaining to supply and demand easily percolates into such markets.
Operational Advantages; as opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to significant price changes. However, futures markets tend to be more liquid than spot markets, because herein you can take large positions by depositing relatively small margins.
Market Efficiency; The availability of derivatives makes markets more efficient; spot, futures and options markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence these markets help to ensure that prices reflect true values.
Ease of Speculation; Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions. Also, the amount of capital required to take a comparable position is less in this case. Speculators always take calculated risks. A speculator will accept a level of risk only if he is convinced that the associated expected return, is commensurate with the risk that he is taking.
Argument against the use of derivatives in hedging risk
Unable to withdraw from the contract; Once the two parties enter the derivative contracts for example forward contract, they are legally obliged to carry it out up to the maturity date even if the business circumstance changes. However, (Stephens, 2003) argue that if one party seeks to withdraw from the contract will certainly suffer from the relatively high cost of cancellation. This means that when it comes to the situation in which the exchange rate in the market moves against one party’s interest, the firm is not allowed to withdraw from its contracted position in order to grab profit from such a profitable movement (Watson ; Head, 2010).
High degree of credit risk arising from two sources; Firstly, there is no initial cost or deposit requirement when undertaking the contracts. Secondly, the gains and losses between two parties are figured out at the time the contract becomes mature and related currency are delivered at the pre-determined price. Consequently, it is quite an inducement to the party going to suffer from the loss, or to the party which no longer need to trade the contractual currency, to default on the forward contract (Hutchninson ; Thornes, 1995).
Leverage is a double edged sword and therefore if you do not get it right chances are you wound end up losing huge amount of money because these contracts have specific maturities and on that date they get expired unlike cash market where you can hold on to stocks for long period of time.
Since its inception many critics have been blaming derivatives for huge fall which keeps happening frequently after the introduction of derivatives and many people say that it increases unnecessary speculation in the market which is not good for the small retail investors who are the backbone of stock market.
It is quite complex and various strategies of derivatives can be implemented only by an expert and therefore for a layman it is difficult to use this and therefore it limits its usefulness.
Lifespan; Derivatives are “time-wasting” assets. As each day passes and the expiration date approaches, you lose more and more “time” premium and the option’s value decreases.
Direction and Market Timing; In order to make money with many derivatives, investors must accurately predict the direction in which the market or index will move (up or down) and the minimum magnitude of the move during a set period of time. A mistake here almost guarantees a substantial investment loss.
Costs; the bid/ask spreads of more common derivatives such as options can be daunting. An option with a bid of 5.25 and an ask of 5.875 means an investor could buy a round lot (100 units) for $587.50 but could only sell them for $525, resulting in an immediate loss of $61.50 before factoring in commissions.
The costs of hedging can be explicit when we use insurance or put options that protect against downside risk while still providing upside potential and implicit when using futures and forwards, where we give up profit potential if prices move favorably in return for savings when there are adverse price movements. There are five possible benefits from hedging: tax savings either from smoother earnings or favorable tax treatment of hedging costs and payoffs, a reduced likelihood of distress and the resulting costs, higher debt capacity and the resulting tax benefits, better investment decisions and more informational financial statements. While there are potential benefits to hedging and plenty of evidence that firms hedge, there is surprisingly little empirical support for the proposition that hedging adds value. The firms that hedge do not seem to be motivated by tax savings or reduce distress costs, but more by managerial interests – compensation systems and job protection are often tied to maintaining more stable earnings. As the tools to hedge risk – options, futures, swaps and insurance – all multiple, the purveyors of these tools also have become more skilled at selling them to firms that often do not need them or should not be using them.
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