Uses for Derivatives and Hedging Finance Essay

In finance, a derivative is a financial instrument (or, more simply, an agreement between two parties) that has a value, based on the expected future price movements of the asset to which it is linked-called the underlying asset such as a share or a currency. There are many kinds of derivatives, with the most common being swaps, futures, and options. Derivatives are a form of alternative investment. For example, a cotton farmer and a miller could sign a futures contract to exchange a definite amount of cash for a certain amount of cotton in the future. Now by doing this both the parties have reduced their risk. The cotton farmer was saved from the price uncertainty and the miller got saved from the unavailability of cotton. However, there are certain situations where still risk is present. There would be no availability of cotton due to vague reasons or the miller couldn't pay the quantified amount. For these reasons a third party is formed which is called as 'Clearing House'. Although it sloves most of the future contract but not all the derivated that are insured against counter-party risk. From another perspective, both the farmer and the miller have obtained certain amount of risk and also have lessened certain amount of risk. From the farmers perspective he has lessen the risk that the price of the cotton may drop down and has simultaneously gained the risk if the cotton prices go high.

Thinking from the millers' perspective it has gained the risk if the prices fall down because he might have paid extra from the current prices and it has reduced the risk if the prices go up. Concluding from this situation is that both the parties are under certain type of risk. Speculation and arbitrage Derivatives can be used to obtain risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will get into a derivative contract to gamble on the value of the fundamental asset, betting that the party seeking insurance will be wrong about the future value of the fundamental asset. Speculators will want to buy an asset in the future at a low price according to a contract when the future market price is high, or to sell an asset in the future at a high price according to a contract when the future market price is low. Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.

Derivatives Market

The Derivatives Market is meant as the market where exchange of derivatives takes place. Derivatives are one type of securities whose price is derived from the underlying assets. And value of these derivatives is determined by the fluctuations in the underlying assets. These underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and market indices. As Derivatives are merely contracts between two or more parties, anything like weather data or amount of rain can be used as underlying assets. The Derivatives can be classified as Future Contracts, Forward Contracts, Options, Swaps and Credit Derivatives.

Types of Derivatives Market

OTC Exchange-traded In broad terms, there are two groups of derivative contracts, which are distinguished on the way they are traded in the market: Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary during the trade. Products such as swaps, forward rate agreements, and exotic options are almost always traded through OTC. The OTC derivative market is the largest market for derivatives, and is largely free from revelation of information to other parties except the parties trading with each other, since the OTC market is made up of banks and other highly cultured parties, such as hedge funds. Revealing of OTC amounts is difficult because trades can occur in private where the transaction is not visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is US$684 trillion (as of June 2008).

Because OTC derivatives are not traded on an exchange, there is no intermediary counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each party relies on the other to perform. Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via dedicated derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals' trade pre-defined contracts that have been standardized by the exchange. In the Exchange Traded Derivatives Market or Future Market, exchange acts as the main party and by trading of derivatives actually risk is traded between two parties. One party who purchases future contract is said to go "long" and the person who sells the future contract is said to go "short". The holder of the "long" position owns the future contract and earns profit from it if the price of the underlying asset goes up in the future. On the contrary, holder of the "short" position is in a profitable position if the price of the underlying asset goes down, as he has already sold the future contract. A derivatives exchange acts as a middle person to all related transactions, and takes Initial margin from both the parties to act as a guarantee.

Common derivative contract types

There are three major classes of derivatives: Forwards Futures Options Swaps Illustration Consider 2 parties (X and Y) settle into a contract on 1st June, 2010 where, X agrees to give 10000 stocks of Hindalco to Y, at a price of Rs. 10 per share, on 29th June, 2010 (expiry date). In this contract, X, who has committed to sell 10000 shares of Hindalco at Rs. 10 per share on 29th June, 2010 has a short position and Y, who has committed to buy 10000 shares at Rs. 10 per share is said to have a long position.

In scenario of physical settlement, on 29th June, 2010 (expiry date), X has to actually give delivery of 10000 Hindalco shares to Y and Y has to pay the price (10000 * Rs. 10 = Rs. 1, 00, 000) to X. In case X does not have 10000 shares to deliver on 29th June, 2010, he/she has to acquire it from the market and then deliver the stocks to Y. On the expiry date the profit/loss for each party depends on the settlement price, that is, the end closing price in the market on 29th June, 2010. Depending on the closing price, three different scenarios of profit/loss can be concluded for each party.

They are as follows: Scenario I. Closing price on 29 June, 2010 is greater than the Forward price. We assume that the closing price of Hindalco on 29th June, 2010 is Rs. 10.5 Since the short investor has sold Hindalco at Rs. 10 in the Forward market on 1 June, 2010, he can get 10000 Hindalco shares at Rs. 10.5 from the market and then can be delivered them to the long investor. Therefore the person with a short position makes a loss of (10 - 10.5) X 10000 = Rs. 5000. If the long investor tends to sell the shares in the market immediately after getting them, he would make a profit of (10.5 - 10) X 10000 = Rs. 5000.

Scenario II. Closing price on 29th June, 2010 is the same as the Forward price. The short seller will get the stock from the market at Rs. 10 and give it to the long investor. As the settlement price is same as the Forward price, no contractor will gain or lose anything. Scenario III. Closing Spot price on 29th June is less than the forward price. Assume that the closing price of Hindalco on 29th June, 2010 is Rs. 9.5 The contractor who has short the shares, who has sold Hindalco at Rs. 10 in the Forward market on 1st June, 2010, will buy the share from the market at Rs. 9.5 and give it to the long investor. Therefore the contractor with a short position would make a profit of (10 - 9.5) X 10000 = Rs. 5000 and the contractor with a long position in the contract will lose an amount of Rs. 5000, if he sells the shares in the market immediately after getting them. The major shortcoming of physical settlement is that it results in massive transaction costs in terms of actual purchase of securities by the contractor holding a short position (in this case X) and transfer of the security to the contractor in the long position (in this case Y).

Further, if the contractor in the long position is actually not interested in holding the security, then he/she will have to incur further transaction cost in disposing off the security. A different way of settlement, which helps in reducing this cost, is through cash settlement. Cash Settlement Cash settlement doesn't include actual delivery of the security. Each contractor either pays (receives) cash equal to the net loss (profit) emerging out of their respective position in the contract. So, in case of Scenario I, where the price at the expiry date (ST) was greater than the forward price (FT), the contractor with the short position will have to compensate an amount equal to the net loss to the contractor at the long position. In the illustration above, X will simply pay Rs. 5000 to Y on the expiry date. The reverse case is in the Scenario (III), when expiry date is less than forward price. The long contractor will be at a loss and have to pay an amount equal to the net loss to the short contractor. In the illustration above, Y will have to pay Rs. 5000 to X on the expiry date. In case of Scenario (II) where expiry date equals forward price, neither X nor Y will pay anything to anyone. In case of the physical settlement and cash settlement, the overall loss and profit position is same except for the transaction cost which is involved in physical settlement. Default risk in forward contracts A major drawback of forward contracts is that they are subject to default risk.

Irrespective of whether the contract is for physical or cash settlement, there is always a possibility for one party to dishonor the contract. It could either be the seller or the seller. This ultimately results in the other contractor suffering a loss. The risk of making losses to any of the contractor due to the other contractor dishonoring the contract is called as counter party risk. The major cause behind such risk is the lack of any negotiator between the parties, who could have taken the job of striking a contract properly between the two contractors. Default risk is also known to as counter party risk or credit risk. Forwards Futures Privately negotiated contracts Traded on an exchange Not standardized Standardized contracts Settlement dates can be set by the parties Fixed settlement dates as declared by the exchange High counter party risk Almost no counter party risk Illustration Suppose X has "bought a call option" of 1000 shares of Tata Steel at a price of Rs 200 per share at a premium of Rs 10. This option gives X, the buyer, the right to buy 1000 shares of Tata Steel from the seller of the option, on or before June 27th, 2010 (expiry date of the option).

The seller has the obligation to sell 1000 shares of Tata Steel at Rs 200 per share on or before June 27th, 2010 (i.e. whenever asked by the buyer). Suppose instead of buying a call, X has "sold a put option" on 1000 HUL shares at a price of Rs 1000 at a premium of Rs 10. This option is an obligation to X to buy 1000 shares of HUL at a price of Rs 1000 per share on or before June 27th (expiry date of the option) i.e., as and when asked by the buyer of the put option. It depends on the option buyer as to when he exercises the option. As stated earlier, the buyer does not have the obligation to exercise the option.

Futures Options

Both the buyer and the seller are under an obligation to fulfill the contract The buyer of the option has the right and not an obligation whereas the seller is under obligation to fulfill the contract if and when the buyer exercises his right. The buyer and the seller are subject to unlimited risk of loss The seller is subjected to unlimited risk of losing whereas the buyer has limited potential to lose (which is the option premium). The buyer and the seller have potential to make unlimited gain or loss The buyer has potential to make unlimited gain while the seller has a potential to make unlimited gain.

On the other hand the buyer has a limited loss potential and the seller has an unlimited loss potential. SwapsA Swaps are contracts to exchange cash (flows) on or before a stated future date based on the fundamental value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date. Just like trading of equity-linked contracts or commodity contracts; the trading of foreign exchange traded derivatives or the future contracts has evolved as very important financial activity all over the world. The derivatives whose fundamental assets are credit, energy or metal, have shown a considerable growth rate over the years around the world. Interest rate is the only factor which influences the global trading of derivatives, the most.

Derivative Market and Financial Risk Derivatives play a vital role in risk management of both financial and non-financial institutions. But, in the present world, it has become an intensifying concern that derivative market operations may destabilize the productivity of financial markets. To manage risk and to increase returns, the companies, the financial and non-financial firms are using forward contracts, future contracts, options, swaps and other various combinations of derivatives. It is true that in today's competitive world derivatives market is used an instrument for risk management. But, the major concern over here is the main components of Over the Counter (OTC) derivatives that are interest rates and currency swaps. So, the economy of the country is bound to suffer surely if the derivative market instruments are misused and if a major fault takes place in derivatives market.

For example: The bubble that bursts during the phase of Harshad Mehta and Ketan Parikh. They used derivatives instrument to arbitrarily increase the rates of some commodity which helped up to certain extend but in the end the bubble burst and the whole country's economy tumbled.

Determining the arbitrage-free price

The arbitrage-free price for a derivatives contract is multifaceted, and there are many different variables to consider. The main topic of financial marketing is Arbitrage-free pricing. The stochastic process of the price of the underlying asset is very crucial; so a simplified version of the valuation technique is developed - the binomial options model. OTC represents the biggest task in using models as these contracts are not publicly traded and, therefore, no market price is available to authenticate the theoretical valuation. The results i.e. the final price of the most of the models depend heavily on how we have derived our input variables. It is, therefore, common that OTC derivatives are priced by Independent Agents and that both counterparties taking part in the deal should upfront when signing the contract. Criticism Derivatives are often subject to the following criticisms: Possible large losses The use of derivatives can result in increasing use of leverage, or borrowing. The problem doesn't occur in borrowing the money but when the individual or organization is unable to repay the debt.

A to earn large profits with a little movement in the prices. However, investors could lose large amounts if the price of the underlying moves in an unfavour condition. Counter-party risk Some derivatives (especially swaps) expose investors to counter-party risk. For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the first business may be adversely affected, because it may not be prepared to pay the higher variable rate. Large notional value derivatives typically have a large notional value. There is a risk of the investor unable to compensate for the losses that he has incurred. Now as the losses has occurred once then the investor would enter into the market to bid come out of those losses but he enters more in to losses. Buffett called them 'financial weapons of mass destruction.' 

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