Use of Derivatives as a Risk Management Tool - Essay Example

Use of Derivatives as a Risk Management Tool Student’s Name Subject Professor University/Institution Location Date Declaration I affirm that this paper is my personal work. It has never been presented before for any examination or degree in another university. Table of Contents Declaration ii Table of Contents iii Types of derivatives 1 Forward contract 1 Future contract 2 Options Contract 2 Swaps contract 2 Derivatives that are used in India 3 Use of derivatives by a risk manager 5 Credit Risk 5 Market Risk 6 Liquidity risk 7 Operations risk 9 Legal risk 9 Conclusion 10 List of References 12 Introduction Derivatives refer to financial tools whose values are dependent on the worth of the basic financial tools as well as any fundamental asset such as stock price, exchange rates, price index, interest rates and commodity prices. They play a vital role by helping firms to control business risks and they have a likelihood of taking an increasingly important place in companies which are looking for a refuge from the unpredictability of financial markets. Augmented financial risk results in financial losses to a firm which has a great success potential. This emphasizes the significance of managing risk by firms in order to hedge uncertainty. Derivatives present companies with an effective technique for dealing with risk which results from uncertainty and instability in fundamental asset (Bartram & Brown 2011:964). This paper will discuss how a risk manager can use derivatives to protect his firm which is located in India. Types of derivatives Forward contract According to Junxun (2008 :3), this is a contract between two people or entities to acquire or dispose property at a given time in the near future. In such a case, the amount that is received or paid by either party is determined when the parties enter into the contract. This is the easiest type of derivative that is being used by majority of individuals or companies in the business environment in India. Forward contracts are transactions that are carried out in the Indian money market whereby the instrument’s delivery is postponed until the time the contract is signed. One party to the contract takes on a long-term position of a buyer and accepts to purchase the asset at a given date in the future for a specific price. The remaining party takes a short term position of a seller and accepts to vend the asset at the same price on a similar date. The parties are not expected to pay any margins to one another. Counter party non-payment risk and liquidity deficiency are the major shortcomings that are associated with forward contracts. Future contract This is a forward contract which is standardized and provides for the buying or selling of an asset at a given future date at a given price through a particular exchange. It is traded through exchanges which function as a seller or buyer instead of the counterparty in forward contracts. Futures have the following features. First, they are bought and sold in a controlled exchange like NSE. Additionally, they are connected to a clearing house as a way of ensuring a smooth running of the financial market. Futures also have daily settlement and margin requirements which function as an additional safeguard. Moreover, they provide for monitoring and supervision of the contract which is done by a regulatory body (Chan 2010 :87). Options Contract Jain & Rastogi (2009 :91) maintain that, an option is a privilege but not an obligation, to sell or buy an asset at a specified price and date. There are two types of options namely, put option and call option. Put option gives a person a right to vend an item while call option gives a person a right to purchase something. Options are further categorized as exchange traded and Over the Counter (OTC) options. The former are standardized and are sold in recognized exchanges while the latter are customized agreements which are traded privately amid the parties involved. Call options present the holder with a right to purchase a given quantity of an asset at the stated price before or on expiration date. On the other hand, the seller nonetheless, is obligated to sell the asset if the purchaser exercises his choice to purchase. Swaps contract Gibson (2007 :26) defines a swap as a form of barter exchange. It is an agreement whereby parties consent to exchange a sequence of cash flows within a given time period in future. The parties that take part in a swap are referred to as counter parties. There are two common types of swaps which include interest rate and currency swaps. Interest rate exchanges involve swapping just the interest linked cash flows amid the parties under a similar currency. Currency swaps entail exchanging both the principal amount as well as the interest between parties, with cash flows on one side being different from those being given by the other party. Derivatives that are used in India Derivatives markets were introduced in India in the 1900s. Recently, Indian government policies have changed, facilitating enhanced role of market-oriented pricing as well as less doubt of trading in derivatives. Trading in futures for several commodities was previously banned, but it was re-introduced at the start of the 20th century and state electronic good exchanges were formed. OTC derivatives were prohibited in India with some exemptions which related to the derivatives which were particularly permitted by Reserve Bank in India or when it comes to goods, those which were controlled by the Commission of Forward Markets but this is a thing of the past. There are two exchanges which provide derivatives trading and which are National Stock Exchange (NSE) and Bombay Stock Exchange (Vashishtha & Kumar 2010 :19). Vashishtha & Kumar (2010 :20) further assert that, derivatives on equities have been the most successful in India. Index futures started trading in mid 2000 while index options began a year later. Moreover, futures and options of private securities were introduced in July and November in 2001. By 2005, NSE traded options and futures on 118 private stocks as well as three stock indices. These derivative agreements are conducted on cash basis and there are no physical deliveries of underlying commodities that are involved because deliveries may be expensive. Derivatives on security indices and private securities have undergone a rapid growth following their inception. Single security futures are particularly becoming highly popular forming close to half of the valued traded by NSE. According to Weinberger & Tufano (2005 :33), NSE introduced futures on interest rate in 2003, but trading in them has been low as compared to equity derivatives. The problem with such instruments was defective contract requirements, leading to erratic deviation of related interest rate from the original rate which was being used by the market contestants. At the present, institutional investors prefer to take part in Over the Counter markets, whereby instruments like forward contracts and interest rate exchanges are thriving. With India’s fall in interest rates, firms are swapping their flat rate borrowings with floating rate ones in efforts to lessen funding costs. Derivatives on foreign exchange are becoming less active as compared to interest rate ones, though the former have been in India for a longer time. Banks, importers and exporters are using Indian rupee forward bazaar to evade exposure of their foreign currencies. Liquidity as well as turnover in the bazaar has been on the increase, even though trading is mostly being done in contracts with a shorter maturity of not more than one year. The application of derivatives as a risk management instrument in India differs according to the type of organization that wants to use them. This means that, different derivatives work differently for different businesses. Financial institutions like banks have liabilities as well as assets with different maturities along with diverse currencies and are thus exposed to various risks of non-payment from their clients. Therefore, they have a likelihood of using derivatives on currencies and interest rates and also derivatives which control credit risk. Non-financial institutions operate differently and thus they use different set of derivatives from those used by financial institutions (Weinberger & Tufano 2005 :38). Use of derivatives by a risk manager Drawing from Selvam & Rita (2011 :20), an effective risk manager is expected to have knowledge of the several financial instruments that are available for controlling financial risks in the market in which a company operates. Various derivatives activities are associated with different risks and thus a company’s choice of derivatives and their application in management of risk will depend on the prevailing risk. For a risk manager who plans to acquire safeguard for his firm which operates in India, he will have to deal with different risks and choose the kind of derivatives to use. Credit Risk This is a risk which relates to counterparty’s failure to carry out an obligation for a company when it comes to swaps (Selvam & Rita 2011 :21). In this case, the risk manager should ensure that, both pre-payment as well as payment credit risk is evaluated at the consumer level in all the products of the company. On the payment day, exposure to default by the counterparty may be equal to the total value of all securities or cash flows that the company was to receive. Before the payment date, the risk manager measure credit risk as the summation of the cost of replacing the position, in addition to an approximation of the company’s potential exposure in the future from the swap due to changes in the market. Selvam & Rita (2011 :21) further stipulates that, replacement cost must be ascertained using present market prices or commonly accepted techniques for approximating the present worth of future settlements that are required under every contract, based on prevailing market conditions. Accoridng to Selvam & Rita (2011 :22), prospective exposure to credit risk is determined more subjectively as compared to current exposure and it is mainly a sub-set of the remaining time to maturity along with the expected instability of the rate, price or index that underlies the contract. Big derivatives participants and companies in India should evaluate the likely exposure by simulation analysis or use of other sophisticated methods which, when correctly designed and adopted can generate estimates of likely exposure that integrate both portfolio-specific aspects and present market conditions. The risk manager should establish credit limits, which consider both pre-settlement and settlement exposures for counterparties with who the company conducts business activities. Selvam & Rita (2011 :23) further claim that, just like bank loans, Over the Counter derivatives may have existing credit exposures for a long period. Due to these potentially lasting exposures as well as the complexity related to a number of derivatives in India, the risk manager should take into account the general financial stability of the company’s counterparties along with their capacity to carry out their obligations. This will help the risk manager to minimize the extent of credit risk that the company may face. Market Risk Madhumathi (2011 :69) says that, this is a risk to the financial position of a company caused by unfavorable shifts in volatility or the market price level. The market risk that is created by a swap or a future is familiar, even though not necessarily simple to manage. It is an exposure to price changes of the primary cash instrument as well as interest rate changes. In comparison, an option’s value is also influenced by other aspects such as the instability of underlying instrument’s price and time passage. Additionally, all trading operations are influenced by the liquidity of the market and also by local and global economic and political events. Market risk in India is increasingly being ascertained by market contestants through a value-at-risk technique, which determines the prospective benefit or loss in any position, institution or portfolio which is linked to a price shift of a particular probability in a given time scope. The risk manager should thus revalue every trading portfolio and determine its exposures. Although the manager may apply risk measures different from value-at-risk, the kind of measure that is used must be sufficiently correct and precise, and the risk manager should make sure that the measure is adequately integrated into the risk management method of the company. Moreover, the manager should set up margins for market risk, which are connected with the derivatives that are being used by the company and, which are compatible with utmost exposures approved by its top management. These limits must be distributed to business functions and personal decision-makers and must be clearly comprehended by all pertinent parties. If a company’s derivatives operations are narrow in quantity and restricted to end-user undertakings, it will need simple risk measurement approaches than those needed by a merchant (Madhumathi 2011 :71). The risk manager should thus make sure that every significant risk emerging from derivatives related activities can be monitored, quantified and controlled. The risk manager should at least assess the possible effect on the company’s earnings as well as capital that may emerge from adverse fluctuations in rate of interest and other conditions, which are related to risk level and efficiency of derivatives in the company’s general risk management. Liquidity risk According to Varma (2008 :4), a company faces two liquidity risk types in its derivatives transactions. One relates to particular commodities or markets while the other risk relates to the overall financial support for the company’s derivatives transactions. The first one refers to the risk which a company cannot be able to easily offset a given condition at or close to the earlier market price due to insufficient market depth or interruptions in the market. Financial liquidity risk denotes the risk, which a company will be incapable to discharge its settlement obligations on payment dates or during margin calls. Since neither of liquidity risks is essentially exclusive to derivatives transactions, the risk manager should assess both risks in a broader perspective of the company’s general liquidity. When setting up limits, the manager should know the size, liquidity and depth of the specific market and set up guidelines accordingly. A company which takes part in the markets of OTC derivatives should evaluate the likely liquidity risks related to untimely expiry of derivatives agreements. Several forms of regulated agreements for derivatives operations permit counterparties to ask for security or to end their contracts prematurely if the company experiences an unfavorable credit happening or decline in its financial state. Moreover, during cases of market tension, customers might request the early ending of various contracts in the dealer’s market-making operations’ context. In such cases, a company which owes cash on derivatives activities may be demanded to deliver security or pay a contract before due date and probably at times when it may face additional liquidity and funding pressures. Early termination of contracts may also bring in additional, unplanned, market positions (Varma 2008 :5). The risk manager must thus know about these likely liquidity risks that relate to derivatives must include them in the company’s liquidity plan so that the use of derivatives can fully benefit the company. Operations risk Drawing from Pathak (2011 :294), this is a risk that relates to information systems or in-house controls’ deficiencies and which in turn lead to an unexpected loss. It is allied to system failures, human error and insufficient controls and procedures. The risk may be aggravated by the use of particular derivatives like swaps due to the intricate temperament of their compensation structures as well as computation of their worth. Segregation of functional duties, risk monitoring and exposure reporting from the company’s functions is vital to accurate internal control. Accurate internal control ought to be given over the recording of transactions in the database, transaction numbering, time and date details and the verification and payment procedures. In this case, the risk manager must make sure that transactions are verified as fast as possible. He should check the consistency amid requisites of a derivative transaction as earlier agreed and the requisites as they were consequently confirmed. Moreover, the risk manager should evaluate the systems requirements for derivatives transactions during tactical planning process. Present and estimated volumes must be considered alongside the nature of derivatives transactions as well as the expectations of the users. The risk manager should put in place, a documented derivatives products’ contingency plan which is in harmony with other plans in the company. Moreover, the risk manager ought to make sure that, a system exists in which derivatives contract recording is confirmed, retained and safeguarded. Legal risk This is a risk which results from incorrect documentation and illegal enforcement of contracts. According to the company laws in India, legal risks ought to be controlled and managed by the use of policies set up by a company’s legal counsel normally in collaboration with the company’s risk management department. At least, there must be processes and guidelines for ensuring the implementation of counterparty contracts (Bhole & Mahakud 2009 :808). Therefore, before participating in derivatives activities, the risk manager should rationally confirm whether its counterparties possess the legal and obligatory regulatory right to take part in derivatives trading. Besides determining the right of counterparties to take part in derivatives transactions, the manager should also logically ensure that the provisions of all contracts administering its derivatives transactions with counterparties are lawfully sound. Additionally, the risk manager should sufficiently evaluate its derivatives contracts’ enforceability before completion of individual transactions. According to Bhole & Mahakud (2009 :810), recently, participants in India’s derivatives bazaars have suffered significant losses due to their inability to reclaim losses from defaulting counterparties when the court ruled out that the counterparties operated outside their rights in participating in such transactions. Therefore, the risk manager should make sure that, counterparties have the authority and power to take part in derivatives transactions. Also, that the obligations attached to the transactions are enforceable. This will help the company in avoiding lawsuits which may ruin its reputation and hinder its business success. Conclusion The worth of derivatives depends on the worth of fundamental assets that are attached to the derivatives. There are four main types of derivatives which are forward contract, future contract, options and swap. The use of derivatives was introduced in India in 1900s. The exchanges that deal in derivatives in India are National Stock Exchange (NSE) and Bombay Stock Exchange. Derivatives on equity are the most effective risk management tools in India while trading in futures on interest rates has been low. The choice of derivatives in India depends on the type of organization. For a risk manager who aims at protecting his company in India, he will use derivatives to manage risks such as credit risk, market risk, liquidity risk, operations risk and legal risk. List of References Bartram, S. and Brown, G. (2011) 'The Effects of Derivatives on Firm Risk and Value', Journal of Financial & Quantitative Analysis , 46 (4) : 967-999. Bhole, L. M and Mahakud, J. 2009 Financial institutions and markets : structure, growth and innovations, New Delhi: Tata McGraw-Hill. Chan, L. (2010) 'The Risk That Wasn't There: Understanding the Role of Derivatives on Reducing and Creating Risk', Journal of the Utah Academy of Sciences, Arts & Letters , 87 (2): 57-67. Gibson, M. S. (2007) 'Credit Derivatives and Risk Management', Federal Reserve Bank of Atlanta Economic Review , 92 (4): 25-41. Jain, P. and Rastogi, A. K. (2009) 'Risk Management Practices of Corporate Firms in India: A Comparative Study of Public Sector, Private Sector Business Houses and Foreign Controlled Firms', Decision , 36 (2): 73-97. Junxun, D. (2008) 'Credit Derivatives and Risk Management In Banking', Management Science & Engineering , 2 (4): 1-9. Madhumathi, R. (2011) Derivatives and Risk Management, New Delhi : Pearson Education India. Pathak, B. V. (2011) Indian financial system Markets, institutions and services, Delhi: Pearson . Selvam, V. and Rita, S. (2011) 'Financial Derivatives -- Real Challenges in India', Advances in Management , 4 (1): 20-23. Varma, J. R. (2008) Derivatives and risk management, New Delhi: Tata Mcgraw-Hill. Vashishtha, A. and Kumar, S. (2010) 'Development of Financial Derivatives Market in India', International Research Journal of Finance & Economics , 37 (1): 15-29. Weinberger, D. B. and Tufano, P. (2005) 'Using Derivatives: What Senior Managers Must Know', Harvard Business Review , 73 (1): 33-41. Read More