As volatility in equity markets this year demonstrate, the world continues to be a risky place. Fast-moving changes in foreign exchange and commodity markets have real impacts on stock markets, business confidence and economies.
These developments illustrate the continuing need for financial tools that can mitigate an escalation of the kind of uncertainty that can freeze investment and hiring plans. However, in the aftermath of the Great Recession, many people perceive derivatives in a negative light. My research and others demonstrates how the use of derivatives can improve economic performance.
Derivatives are specific types of instruments that derive their value over time from the performance of an underlying asset: eg equities, bonds, commodities. There are three main families of derivative contracts: options, futures, and swaps. They all have the ability to reduce risk; thus, are widely used for hedging purposes.
A derivative is traded between two parties – who are referred to as the counterparties. These counterparties are subject to a pre-agreed set of terms and conditions that determine their rights and obligations.
Derivatives are developed to meet a variety of financial market participants' needs, the predominant one being the unbundling and efficient management of financial risks. Although derivatives seem complicated, their premise is really very simple: They allow users to pass on an unwanted risk to another party and assume a different risk, or pay cash, in exchange.
If you were to sell a call option, however, you would be giving someone else the right to buy the underlying security from you at the strike price.
If you sold a call option on a position you did not own, this could mean you'd be forced to go out and buy that security for a higher price in the market so you can sell it to the holder of the call option at the strike price. In this case, you have unlimited risk because the underlying security could rise to any price and you would still have to purchase it to resell it at the lower strike price. What's more, you would have to purchase not just one share of the underlying security, but 100 shares to fulfil your obligation to the contract holder.
Companies can lower funding costs and diversify funding sources through derivatives. A Kenyan company, for example, may decide to issue debt in Japan rather than in the Britain because of a slight difference in Japan and Britain interest rates; by arbitraging the difference in interest rates and using a currency swap (an agreement to exchange one currency for another) to obtain the funding in Japan Yen, the company lowers its costs.
Another major use of derivatives is to hedge interest rate or exchange rate risk. An issuer of fixed-rate debt who anticipates a general increase in interest rates can enter into a forward swap (an agreement to swap sometime in the future) to lock in the level of interest rates at the time the funding decision is made.
Similarly an issuer of floating-rate debt can eliminate the risk of rising interest rates by purchasing a cap, essentially fixing an upper bound on the rate the borrower will have to pay, no matter what market rates do.
Importers, exporters and companies that have significant overseas operations may find derivatives an ideal tool to manage exchange rate risk. A Kenyan exporter to EU who is expecting a fixed payment in euros could see profits disappear if the euro severely depreciates before the exporter gets paid.
Companies facing exchange rate risk can use currency swaps and foreign exchange forwards or options to hedge expected future cash flows from foreign transactions.
Although thousands of firms have successfully used derivatives to protect themselves from adverse shocks, others have made foolish bets that have cost them dearly such Kenya Airways. At the least, policymakers want to be sure that investors and regulatory authorities know when firms are using derivatives to speculate rather than to hedge.
For those wishing to speculate with derivatives, the message from investors and policymakers is pretty clear: We'll be watching you. Derivatives have a stabilising effect on the economy by reducing the number of businesses that go under due to volatile market forces.
Hedgers use derivatives to reduce risk; however, their counterparts, called speculators, use them to increase risk. This is the dark side of derivatives, as they are sometimes considered legalised gambling tools.
Next, derivatives provide investors with signs and valuable information about spot markets. For example, the convergence of the forward price to the spot price at maturity provides useful information to market participants.
In addition, derivative markets over some operational advantages. Transaction costs are often lower and short-selling positions are usually easier than in cash markets. Economic and financial crises have had great impact on derivatives markets. Examples include the major stock-market crash in 1987, and the recent credit-risk crisis.
Consequently, derivatives markets suffered; however, investors’ confidence and growth were usually back. In sum, derivative markets contribute to making financial markets more complete and efficient. This suggests that firms do reduce cash flow risk and market risk significantly by managing with derivatives