Financial Derivatives and Strategies for Hedging and Risk Management - Essay Example

Financial Derivatives Theoretical Framework Derivatives are the financial tools whose values are largely determined by the of currencies, the securities, stock capital and market indices. Their value changes as a result of the alterations variables like rates and exchange rates. They are mostly used in risk management and in hedging risks of financial nature. In the process of trading, the fact exchanges is on another side of the trading becomes very essential in removing risks of counterparty nature in the event the partner in the trade fails to honour their obligations as regards to what you are trading. When contrasting the commodity clearance as well as exchange traded derivatives, the CCPs have been doing well in doing away with the mess. They have been able to clear the instruments of cash, particularly equity. The CCPs have come out as very good in simplifying risk exposures of counterparties. In the same process, they happen to facilitate even a multilateral network. The CCPs have one big way of ensuring that risk is avoided as much as possible. If the other party fails to pay, they have other free markets risks options and they can use them to regain normalcy. Banks having enough capital to take in the transmitted losses will not go bankrupt, but will be weak, and therefore they can’t cascade (Kaufman and Scott, 2003). The traded exchange scenario has the merit of having trades flowing through a common central place. The price is easily determined for a given instrument without much difficulty. This is notwithstanding the size and or party making the transactions. The theory however should a more level playfield so that the smaller and less difficult businesspeople can be advantaged as well. Given that most firms offering exchange trade commodities must register, it will be good for the purpose of regulations. This is aimed at making the trading environments even safer. The cost of exchange traded products is usually floated as a challenge. This is because of the tight regulations required. In exchange trade, products must flow through the exchange. The profit entity is thus able to set the pay and therefore hike the cost of transactions. Over the counter have only one big merit. There is little regulation and the exchange is not centralized. The competition is however higher since the trader must attract many customers for more profit. That will mean that the transaction costs are usually lower than that of the exchange traded markets. Hedging is considered an integral part of a competitive market. Owing to the heightened competition globally, large companies cannot compete on the premise of scale and scope economy exploitation. Neither can they do it by capitalizing on imperfections in the capital market. They rely on risk mitigation methods. These are the elimination of cost inefficiency, product price hedging on financial derivatives and also horizon hedging. Corporate Executive Board Procurement Strategy Council (2003) study showed that 42% of risks managers believed that most risks can be controlled well by the procurement teams. For instance, hedging in the metal market increased from 21% to 32% for aluminium only. As Aluminium demand was believed to grow by 9.5%in 2007, they were to reduce in 2008 by 1%. This is due to lack of choices and dropped profits. Differences Between Over the Counter and Exchange Trading We have two types of financial markets, Over the Counter (OTC) and exchange trade. The two have a number of differences and as thus discussed. Trading on an exchange These are transactions that have to adhere to set regulations that control the trading processes. The information is usually centralized and this makes it possible for the price to be determined easily for all participants of the market. Initially, they used to happen physically but the technological advancements have removed the need for the physical presence. For instance, London and NASDAQ Stock Market exchanges are digitalised, as is Eurex, the global second-biggest future exchange. The exchange markets are tightly regulated and the traders do not have an option of deciding on their own prices as the OTCs may be able to. The competition is usually low and the prices are very high. This is due to the costs that are experienced in the course of control and regulation. In the exchange markets, one cannot enter and leave the market freely. They have a number of rules that control this. This may contrast with the OTCs where the traders can opt when to leave the market. They do not have many restrictions. Trading over the counter Contrary to the exchange markets, the Over the Counter is not based somewhere specific. They are never a “place.” They are normally not very formal thought they have a great deal of organization. The traders here are the ones who decide the price of the commodities on sale. Therefore, they may not quote the same price to every customer. The traders have the freedom of leaving the market as they wish something not similar to the exchange markets. Generally, they are less open and have fewer rules and regulation to control them. The regulation is therefore not as tight as the case is with the exchange markets. This is the reason why the financial difficulties experienced in the 2007 US Mortgages originated from the loosely regulated OTCs. OTC markets have two segments, the interdealer and customer markets. This is not the case with the exchange markets. In the customer market, the dealers are the ones who trade with each other as well as their customers. They initiate contacts and the securities and derivatives they want to sell or buy and at how much. The interdealer markets has a system where the dealers say prices and sometimes lay off their risks to colleague traders having the same risk and in the process get the bigger position. Dealers have direct contacts to others which they can exploit whenever they want to trade. The normal customers cannot penetrate the market. Hedging This is a risk management strategy where the stock is protected from picking a certain risk. There are a number of reasons why a firm can decide to hedge or not. The main issue is the cost that will be incurred in the hedging process. This must be revealed against the risk being managed. There are explicit and implicit costs. Explicit costs are those that take the form of premiums in insurance. A business will be remitting some money periodically so that it is shielded from the risks covered. A bigger risk will attract bigger premiums. For instance, a Florida based business will incur more in risk protection that a Mid-West located business because of the prevalence of floods and hurricanes. Implicit Costs on the other hand are usually incurred by the firms that hedge their risks against debts. The cost therein will be implicit in nature. The Benefits of Hedging On the contrary, there are reasons why companies will go for hedging. It has its fair share of advantages. The benefits can be financial to qualitative and managerial. Tax Benefits A firm that hedges risks may receive tax benefits of significant amount in relation to one that does not. When engaging in hedging, the income will automatically be lower than when there is no hedging in place. Higher income will be taxed at higher rates which the company will avoid. The table below explains it all. Table showing the tax paid when hedging and without hedging WITHOUT HEDGING WITH HEDGING Year Taxable Income ($) Tax Paid($) Taxable Income($) Taxes($) 1 66 180 800 240 2 1500 550 1200 400 3 400 120 900 270 4 1600 600 1200 400 Total 4100 1450 4100 1310 Better investment decisions Good decisions can also arise due to hedging. Managers have considerations on the investments depending on the amount of cash they are having. The firm will be able to avoid the risks that come with investments since it will not be influenced by risks that can be waved away. The managerial risk aversion will have managers turn down diversifiable risks. According to the Sam Langfield and Tomohiro Ota‘s paper, Mapping the UK inter back systems, it explains how core banking institutions can be the ‘fire stops’ when there is a default by the peripheral banks. This is because are capable of diversifying risks from counterparties risks. The main banks have linkages to the peripheral banks. Capital market frictions A company with good investment that has taken all it money will have to raise more from capital and equity issue. Jensen and Meckling’s paper says that firms dependent on new capital for investments will not invest much and will issue the shares on discount. The problem is worse for risky firms since they cannot differentiate when they are making money for good or poor investments. Distress Costs Distress is so common in businesses, no matter how large. Customers may fail to buy your products if the word says that the company is bankrupt. Even employees may decide to run away for fear of payment hitches; therefore, 20% to 40% of the company value may be affected. A study of bank failures from 1865 to 1936, just after insurance was introduced in 1993, reported that the most cited cause of failure was local financial distress, of all 4,449 causes listed for the 2,955 failures surveyed (Kaufman&Scott,2003). For instance, Large companies like Coca Cola that have very little debt can easily cover the costs of firms with big debt obligations can be in trouble for extending their financial capabilities to the extremes. It thus becomes essential to hedge risks. Capital Structure Companies that think they have little debt will most probably be tempted to borrow more. They will thus have the tax advantage of being in debt. This means that since hedging increases debt, the firms will have more tax advantage. The evidence if debt can be increased b hedging is not precisely known. However in a study that examined 698 firms from 1998 up to 2003 showed that firms that hedge buy buying property insurance were able to borrow more and their debt costs were lower. Informational Benefits Financial data prepared when non business related risks are hedged can give room for precision in their preparation. The figures will be good and the investors will easily be attracted. The changes in income for large firms that hedge rate risks will show the operating performance of the firm better than otherwise. In DeMarzo and Duffie’s 1995 paper, the informational advantage is explored incisively and how it influences the behaviour of investors. Hedging makes investors able to know the management strengths. Strategies for hedging and risk management In the literature of hedging, the strategy employed to address a certain motive should be delved into at first. The literature can be indeed vast. The selection of the best strategies must take into consideration the risk to be maximized. When interested in future markets and price mechanisms, futures are preferred. There are four complexities specific to financial networks, directed links; weighted links; multiple links; and node heterogeneity. Derivatives have been used extensively in the management of risks since 1970s. Risk in banks for instance, if not mitigated can cause adverse shock that generates losses at one bank large enough to drive it into insolvency may transmit the shock to other banks along the transmission chain. . The range that is covered grows annually since there are very limited markets where one cannot go for hedging. Some of the strategies that have been employed by many firms are briefly discussed below. Futures and Forwards A forward is a contract where a buyer opts to purchase a commodity at a given specific price for a given duration. Since the price of the commodity may change with time, the buyer will not bear the risks associated with the changes. The process will go on till the contract period expires. For instance, assume a refinery that plans on purchasing 2,000 barrels of crude oil in September for a price equal to the price of the time. The company can hedge by use of NYMEX futures for crude oil prices. The oil is purchased at $60 per barrel. Spot prices are currently $62.What if the September prices drops to $54? The Company will gain $6 per purchased barrel. The seller loses $6 through the futures contract for $60. What if the price hikes to $66? The buyer will lose $6. All in all, the seller will have effectively mitigated the risks that come with the fluctuation in the prices. It will be easier for budgeting and matters of financial management. The gains and losses will have been offset. The diagram below gives an illustration. Buyer payoffs Future prices Spot price on underlying assets Seller Payoffs Swaps A set of cash flows are swapped with other sets or equal market significance at the time of the transaction. For instance, Euros can be swapped with dollars so that the risk involving such currencies is managed. Considering an airline company that wants curb the risk of fuel price changes, a swap can done and the company receives a floating price respect to the fuel used during a certain period. The planes can be fuelled but the swap ensures it makes up of the differences that may occur. If the float price is $1 and a fixed price of $0.75, the rate payer will easily make $0.25 per unit sold. Options These give the freedom to purchase a certain good at a specified price before the expiry date. Put options on the other hand will give the buyer a freedom to sell a commodity at a fixed specified price. Pay off on put Payoff on call Exercise price Value underlying asset at expiration Self-Insurance A company may decide to have a provision that takes care of its risks of buy a product that covers the third party risks associated with its business. If the company is able to the merits of pooling of risks solely and therefore does not need to insure itself in the process. Though sometimes it is very costly, it is essential since the risk is mitigated. References Alkeback, P., & Hagelin, N. (1999). Derivatives usage by non-financial firms in Sweden with an international comparison. Journal of International Financial Management and Accounting, 10(2), 105-120. Saramaki, J, Kivela, M, Onnela, J-P, Kaski, K and Kertesz, J (2007), ‘Generalizations of the clustering coefficient to weighted complex networks’, Physical Review E, 75, 027105 Soromaki, K, Bech, M, Arnold, J, Glass, R and Beyeler, W (2007), The topology of interbank payment flows, Physica A 379 317-333. Kaufman, George G. (1994) Bank Contagion: A Review of the Theory and Evidence. Journal of Financial Services Research (April): 123–50. U.S. Shadow Financial Regulatory Committee (2000) Reforming Bank Capital Regulation. AEI Press, Washington, D.C. Read More