The Finance Derivatives Function
The only thing uncertain in finance is certainty itself. The stock market, interest rates, and the value of currencies fluctuate every millisecond. These fluctuations create opportunities for investors, however, they can easily become risks. For both investors and companies, managing these risks is fundamental to profitability.
Derivatives go beyond speculative tools, they are the most effective tools in the stabilization of profits, the locking in of prices, and the safekeeping of portfolios against unforeseen market movements. This is where derivatives come in. This paper explains how derivatives can be used as tools for risk management, the strategies involved, and how they can be used by investors, traders, and corporations for effective hedging.
What are Derivatives?
A derivative is a financial instrument and contract whose value is determined by an underlying asset, which may be a stock, commodity, currency, bond, or market index. The four most common derivatives are:
Futures- These are standard contracts that have been finalized and agree to buy or sell an asset at a determined price by a future, determined date.
Options- These are contracts that give the right, but NOT the requirement, to buy or sell the underlying asset at a determined price at, or prior, to the date of expiration.
Forwards – The contracts between two entities that resemble futures but are arranged over-the-counter (OTC) are known as forwards.
Swaps – These are contracts to trade cash flows to eliminate the vulnerability to rate or price changes, for example, interest rate or currency swaps.
In spite of the common view that derivatives are largely for speculation, at their core, derivatives are intended for hedging, which is the safeguarding of current assets or future cash flows from losing value when prices change adversely.
Risk Management Using Derivatives
Risk management is all about spotting the possible financial risks and determining the right approach to counter them.
Some of the common categories of market risks are as follows:
Price risk: The risk that the price of an asset (such as stock or commodity) will change.
Interest rate risk: The risk of changes in the rate of interest charged/ earned.
Currency risk: The risk of fluctuations in currency exchange rates.
Volatility risk: The risk of changes in expected future market conditions, or the changes in market sentiment.
By providing a way to transfer risk from those wanting protection to those willing to take the risk for a potential reward, derivatives lower all of these market risks.
The Role of Derivatives in Hedging
Like an insurance policy, hedging reduces the adverse consequences of negative price changes but, of course, does not eliminate risk.
Let us consider how different sectors integrate strategies to mitigate risk.
1. Equity Portfolio Index Future Hedging
Let’s say an Investor forecasts short-term market volatility due to geopolitical factors. The investor owns a set of Nifty 50 stocks valued at around ₹10 lakh. Instead of liquidating the value, the investor shorts Nifty Futures contracts.
If the market declines by 5%, the value of the portfolio declines, however, the short futures position gains approximately the same amount, offsetting the loss.
This is a prime example of an index futures hedge, allowing the investor to keep their long-term position while mitigating the risk of downside loss.
2. Futures to Secure Prices for Commodity Producers
Consider a wheat farmer who is apprehensive that prices may decrease before the harvest is ready. By selling wheat futures, the farmer is able to lock in a selling price.
If the futures price is lower when the spot price is harvested, the farmer can offset the loss as the futures gains. On the other hand, if the futures price is higher, the farmer is left with a loss in profit, however, the price stability compensates for that loss in profit.
This is a prime example of commodity futures mitigating the risk of price volatility for commodity producers.
3. Investors Using Options for Protection
Options are one of the most adaptable risk mitigating strategies available.
An investor from Infosys can purchase a put option with a strike price proximal to the market price. If the stock rapidly depreciates, the put option counterbalances the decline in the stock values.
Likewise, companies can also utilize put and call options to gain the advantages from the positive price movements to insure themselves against negative price movements in the foreign currency market.
When a premium is paid to hedge with asymmetric protection, the buyer is not obligated to exercise, which is akin to paying an insurance premium.
Most large companies borrow affordably through floating rate loans. If the interest rate increases, the borrowing cost increases as well.
With an interest rate swap, the firm can change variable interest payment obligations to fixed to ensure predictable costs in the payment of interest obligations.
This mechanism helps companies in planning their finances with a greater degree of certainty.
Derivatives are pivotal to treasury functions of the corporations.
Companies use derivatives to:
Hedge the exposure of foreign exchange: With currency futures and options exporters can set the exchange rate, while importers can hedge against the drop in the currency.
Mitigate the changes in interest rates: With interest rate swaps and forward rate agreements.
Hedge Commodity Price Increases. Buyers of commodities like fuel, oil, copper, or steel can stabilize input costs by using futures.
For instance, to manage costs, airlines purchase crude oil futures or swaps to hedge against jet fuel price increases. In the same vain, IT companies hedge by converting $ revenues to avoid losses due to appreciation of the INR.
Therefore, companies can retain some degree of margin predictability in the face of global market volatility through the effective use of derivatives.
Derivatives and Institutional Portfolio Management
Mutual funds, pension funds, and insurance companies as institutional investors utilize derivatives for portfolio risk management.
Typical institutional approaches entail:
Portfolio insurance, or protection, against market downturns using index futures or options.
Earning a premium through covered calls for yield addition.
Using futures to modify exposure instead of trading the underlying assets for enhanced asset allocation.
Smoothing changes to portfolio returns using VIX or other volatility derivatives for return volatility management.
These approaches help maintain institutional portfolios in good shape through market downturns.
Hedging with Derivatives
Lower Cost: Derivatives involve less capital outlay for transactions than buying or selling the underlying assets.
More Flexibility: Investors can adjust the extent of exposure to risk, hedging a partial position or the entire position in the underlying asset.
More Liquidity: Price transparency and liquidity is enhanced by trading of derivatives on exchanges.
More Accuracy: Other risk management techniques are less effective than the use of options for tailoring risk management to specific scenarios.
To summarise, derivatives aid in maintaining a balance of risk and reward without disturbing the fundamentals of the investment portfolio.
The Double Edge of Derivative Instruments
Derivatives are a double edged sword in that they are of great strength, and yet require a great deal of discipline and mastery. If not handled properly, they can magnify instead of mitigate risk.
Some of the risks are as follows:
Leverage Risk: Because of the small margin requirements, there can be great losses if the trading market moves in an unfavorable direction.
Complexity: If a derivative is built with sophisticated structures, it can contain other hidden risks.
Counterpart Risk: In an Over-The-Counter (OTC) derivative trading position, the financial distress of one trading party can affect the other.
As such the direction of a derivative trading position must always maintain its hedging techniques within clearly defined risk parameters. Derivatives are not a line of loss prevention, but a line of risk transfer.
Regulatory Legislation and Transparency
In India, the trading of derivatives is under the jurisdiction of the Securities and Exchange Board of India (SEBI).
All derivatives traded on the BSE, NSE, and MCX are required to have block trading arrangements, daily MTM (Mark to Market) arrangements, and position limits to maintain the stability of the market.
There are now systems in place to improve the transparency of the derivatives market on a global scale, and of the Dodd-Frank Act in the United States of America and EMIR in Europe, both of which were enacted in response to the crisis of 2008.
These systems are aimed to improve the primary focus of derivatives to be risk mitigation not allow speculation of the market.Conclusion
No one can argue that derivatives are essential to the functioning of today's marketplace. Whether it's a farmer hedging against a decline in crop prices, a foreign currency manager worried about an exporter's forex exposure, or an investor worried about a downturn in their portfolio, derivatives facilitate more efficient risk management.
When used correctly, they help in the stabilisation of uncertain returns and the protection of capital, but more importantly, they enhance the performance of the user in uncertain situations. Unfortunately, their primary purpose is to eliminate risk, but when misused, they create the kind of risk and uncertainty that the user is trying to eliminate.
Ultimately, the most important part of the process is knowing what and how much to hedge, when to leave things as they are and, most importantly, strategy, understanding and control.
In an uncertain and volatile world, derivatives do not eliminate the uncertainty but rather give you the tools to measure and act on the internally consistent uncertain risk.
