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What are financial derivative products?

There is a serious discussion going on about financial derivatives (a kind of financial instruments) in the media, political circles and other sections of the general public after the disclosure of the Ceylon Petroleum Corporation’s hedging activities and the alleged losses suffered by the CPC due to these transactions. It seems, quite understandably, that only a few in the general public has any understanding about theses financial instruments.

Our objective here is to provide a basic introduction to a highly technical area in finance. These instruments are being used for speculative and risk management purposes by highly sophisticated and experienced professionals. We will not discuss any of the C PC’s alleged activities relating to hedging transactions. It is purely an educational discussion to make the general public aware of what these instruments are and to explain how they work. We will stick to the risk management aspects of the contracts for simplicity. We will not discuss the pricing of the derivative, because it is highly technical and mathematical in nature.

There are two kinds of financial instruments, fundamental and derivative. Stocks and bonds are fundamental instruments. Anybody with money can invest in stocks and bonds. A coupon bond holder’s income will be the interest earned if it was purchased in the primary market and held it till maturity. If a coupon bond is bought in the secondary market, income will be the interest received plus any capital gain realised. Income of a stock will be the dividends you receive, if any plus any capital appreciation at the time of the sale of the asset. Instead of buying stocks or bonds, the investor can buy derivative products for the same purpose, to make money or to hedge any long or short positions.

A derivative instrument is a contract whose value depends on something else, commodity, security or an index. The value of the derivative instrument depends on the value of the underlying asset. Derivatives are bought and sold for speculative and risk management purposes as mentioned earlier.

Financial derivatives are forward contracts, futures contracts, options, options on futures, swaps and options on swaps. We will explain the very basics of them.

Forward contracts

Forward contracts sometimes are very simple arrangements we all use at times. For example, one agrees to buy a piece of land at one point in time but requiring the parties to execute the terms of the contract at a future point in time. A person who has a small plot of rubber might agree to sell the next crop to a trader at an agreed price but the rubber to be delivered and to receive payment on a future date. The buyer and the seller secure the terms of the contracts at the time of the agreement. But most forward contracts are not that simple.

There are two groups of people who deal with forward contracts, speculators and hedgers. For example, a builder may need timber in three months time. He expects timber prices to go up in the near future and does not want to buy and store it. There is a timber dealer who has timber and expects the prices to go down. Both of them can come to a contract today to hedge their perceived exposure to the market volatility.

There is another group of people who assume risks for profit, called speculators, who bring liquidity to the market. For instance a person who wants timber in three months does not have to find a person who has timber to sell in three months because speculators come forward and assume the risk for a price. Both parties hedge their perceived exposure. The contracts are negotiated by the parties involved (there are brokers to bring the parties together) and there is no structural arrangement to support the parties, which is a drawback of forward contracts. Biggest advantage of forward (OTC ) contracts over futures contracts (discussed later) is the flexibility, and they can be structured according to the requirements of the parties. The biggest drawback for hedgers in developing countries like Sri Lanka is also the same flexibility. The party who has more information, knowledge or any other influence over the counterparty, can take advantage by structuring the contract to their benefit at the expense of the other party. According to economic theory, market system fails in a situation like this due to asymmetric information and moral hazard.

Futures contracts

Futures contracts are special forms of forward contracts that are designed to reduce the disadvantages associated with forward contracts. They are nothing more than forward contracts whose terms have been standardised so that they can be traded (much like securities) in the marketplace. Standardisation makes futures contracts less flexible than forward agreements, but it makes it more liquid.

There is no futures exchange operating in Sri Lanka. In a futures market, like Chicago Mercantile Exchange, all contracts are standardised as to the quantity, price, delivery date, settlement and the other major terms of the contract. Participants do not have to find counterparties and contracts are transparent because they are created by the exchange. The exchange is the clearing house and parties are dealing directly with the exchange which takes the responsibility of the performance of the contract. This is a very efficient market and futures contract prices are indicative of the future spot prices; and this feature is known as price discovery.

The parties who enter into a forward contract are on their own, and they have to take all precautions to safeguard their interests. If the participants are not experienced professionals, it is advisable for them to deal with an exchange rather than getting involved in forward contracts. In case the participants cannot find exactly what they want in a futures market, still they can find something very close to their requirements because markets are nearly complete in economic sense. Futures contracts can be closed out by entering into an offsetting transaction, making physical delivery or cash settlement. Compared to futures contracts, forward contracts are illiquid, have credit risk and are unregulated.

Options

Options are available for fundamental instruments like stocks and bonds and derivatives like futures and swap contracts. Here we will discuss a few very basic option strategies.

Options are traded in exchanges and they are standardised contracts. European type options are different from American type options that American type options can be exercised at any time before they expire. European type can be exercised at the expiration only.

There are two kinds of options, call and put. One can buy either a call or a put option and also sell (write) a call or a put option. An investor can enter into any combination of strategies too, of different maturities and strike prices, which mean that there are many strategies available to an investor or a hedger. Call option gives the investor the right to buy the underlying asset and there is no obligation on the part of the buyer. The seller of the option called the writer is obligated to sell (call option) or buy (put option) the asset whenever the buyer exercises the option. The buyer (call or put) has to pay a price for this right which is called the premium. A call option gives the buyer the right to purchase the underlying asset at the strike price no matter what the market price is. And a put option gives the buyer the right to sell the underlying asset at the strike price at any time before the expiry.

The following hypothetical case explains the mechanics of an option transaction:

The market price of a stock is Rs. 50 and there is a call option priced at Rs. 5. The strike price is Rs. 55 and expires in three months. For the same stock there may be several options with different expiry dates, strike prices and premiums. One can buy or sell this option and does not have to have a long or a short position in the stock to do so. If you expect the price of the stock to increase within three months you can buy a call option by paying Rs. 5 per share. If the price goes up before the expiry say to Rs. 65, call buyer can exercise the option. He pays Rs. 55 to purchase the underlying stock and sells at Rs. 65. He will make a profit of Rs. 5, selling price minus the exercise price and the premium.

He does not have to exercise the option but simply can sell the option; the profit will almost be the same because the market value of the option will increase with price of the underlying stock. Due to arbitrage activities, there will be no arbitrage opportunities to take advantage of due to price difference in the commodities market and the options market. The writer of the call option will lose Rs.5 and it is a zero sum game. If the price comes down below Rs. 60 the buyer will not exercise and allow the option to lapse. His loss is Rs. 5 and the gain of the writer is Rs.5. if the investor is of the opinion that the price of the stock will come down, he can buy a put option to make a profit. If the price goes below Rs. 55 he will buy the stock in the market at the market price and sell at strike price Rs. 55.

Options are very complicated and call and put options can be combined to create many complicated strategies depending on the requirements of the parties concerned. Some strategies available for speculators and hedgers are, buy a naked (without a short position in the stock)call , write a naked call, buy a naked put, writing covered calls, buy the stock and the put, bull and bear spread strategy, box spread, straddles, butterfly spreads, condor spreads, ratio and calendar spreads.

Swaps

At your birthday party you have received many presents. When you open them in the presence of your friends you noticed that two identical saris of the same colour were given by two friends. After noticing this, one of your friends tells you, "don’t worry I have the same sari of a different colour and we can exchange." Basic principle of swap is the same. In finance one exchanges one stream of cash flow for another stream of cash flow, swap cash flows. But in finance, swaps are unbelievably complicated; only highly sophisticated and very large corporations with knowledgeable and experienced people should get involved in these transactions. Futures contracts tend to be short term instruments and are available only for certain commodities. To avoid this and other shortcomings of futures contracts, corporations have developed swap transactions. The first swap transaction was created by the World Bank and IBM when they swapped cash flows denominated in Swiss francs and deutschemarks. There are many kinds of swaps, some of them are equity index, interest rate and currency swaps.

Hypothetical example

Bank of Sri Lanka has invested a large sum of money in Treasury securities with an average yield say 12%. Bank of Sri Lanka would like to participate in the Colombo Stock Exchange activities but it has no correct infrastructure or the expertise. There is a brokerage house, which has a large inventory of equities and wants to diversify into fixed income securities. Both do not want to part with their stock and bond portfolios. They can come to a swap contract for mutual benefit. They can agree to swap the cash flows of a nominal principal, say of Rs.100, 000,000, for a period of five years. Bank of Sri Lanka will get an income related to the appreciation of the Colombo all share price index. The broker will get a 12 percent income. The contract day index is 100. On the first settlement day after six months, the index is 110. Nothing happens to the portfolios of each participant.

On the settlement day after six months, Bank of Sri Lanka will get an income of Rs. 10,000,000 and Bank of Sri Lanka will have to pay Rs. 6,000,000 to the dealer. But the settlement is the net difference, 4,000,000 Bank of Sri Lanka receives from the broker. This settlement will take place every six months for five years. This is a very basic, plain vanilla swap contract. But real contracts are very complicated and depend only on the parties’ requirements and the imagination of the parties.

We will now take a practical example where we can combine some of the derivative strategies to hedge a position. Lanka Energy (imaginary company) wants 10,000,000 barrels of crude oil in three months for the generation of electricity. Currently the price is $120 and it expects the price to go up. If the price goes down the company will be happy and it is exposed only to upward price movement. What can you do? One option is to do nothing and buy at the market rate and absorb the risk. Optionally, the company can sign a derivative contract to hedge the exposure too. Company can have a forward contract or an exchange traded futures contract to cover the upside exposure. Company can sign an agreement to a forward or a futures contract to buy crude at say 125 in three months. If the prices go up to 150, the company pays 125. But now you are exposed to downward price movements because of the contract. If the price goes down to 50 you are exposed to a loss of 75. This exposure can also be covered easily by buying put option. Purchaser has the right to sell at the strike price. If the strike price is 120 the company can sell the crude you have to buy in the futures contract at 125. The company is now free to buy at the market price which is now 50. So you have covered both upside and downside exposures.

Derivatives are financial instruments that companies can use for hedging or speculative purposes. These objectives can be achieved if carried out diligently by experienced and knowledgeable people. Otherwise it might give disastrous results.

 

The writer is a former Financial Analyst on Wall Street, New York

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