Contract Is King in International Finance - Essay Example

Running Head: CONTRACT IS KING IN INTERNATIONAL FINANCE Contract is King in International Finance [Author’s Name] [Institution’s Name] As the world is moving towards the globalization, the importance of International Finance is increasing as the time passed on. Finance managers tend to seek the cheapest sources of finance around the world and this will certainly involve the element of risk as well. The emphasize of international finance is to use the different hedging tools and techniques to tackle the risk. All these tools are based on the contract between tow parties which is very important and the base of any international financial instrument. The major tools are used to minimize the risk are Future, Forwards, options and swaps etc. These tools are also called derivative securities. All these tools are related to contract activities. By highlighting the activities related to these tools, we will actually prove “contract is the king in international finance” and all the intentions of these derivates are actually the efforts of managing contract. Futures: King contract is present in this tool and it is purely based on the contract between two parties. Future is a type of contract in which one party offer an asset or commodity to the other party for a specific price on a certain future date. Future fixed date can be said as off set date of the transaction and price of the asset on that day will be called future price. Both parties are involved in the agreement through a middle man called broker who charged commission from both parties on the transaction. Future contract is used to hedge the exchange rate risk, price risk etc. Forward: Forward is also a kind of future contract in which one party sell commodity to other on specific price on specified date. In this type of contract both parties directly interact with other to make such transaction. Price of this contract is compared with the prevailing price and determine accordingly. As the both parties involved directly without any third party, the chance of default of losing party is more. The actual cash payment is made only when the transaction is executed in that future date and both parties are available. On the date of maturity commodity will be handed over to buyer and he will pay the agreed price to seller. Here in this instrument both parties have no legal obligations, the only binding is the contract which again proves itself as king in international finance. Futures vs. Forwards Both contracts (Future and Forward) are involved buyer and seller, who transact for a certain commodity at an agreed price on some future date. But still there are some differences can be found between these, which are as follows; When buyer purchase the specified commodity on the future date at agreed price, only then Forward contract will be executed. While in Future the price is marked to the market. In forward both parties directly involved in a contract with each other, while in future middleman (broker) also involved in transaction. Futures are based on certain rules and obligations while in Forward contract parties have liberty to set the term and conditions The seller himself searches the buyer for his forwards contract while in Future broker on the behalf of seller will search buyer for him. Risk is high in the case of forward while in case of future risk is less because both parties have to deposit certain some of money to the broker so that the party who is expected to face the lose can not be avoid the contract without incuring any cost. For example Mr. A enter into a forwards contract with for the purchase of a commodity @ $1000 after 6 months from the date. While spot rate is $900 that time. On contrary to the prediction of Mr. A the price of that commodity is $800 after 6 months in the market while he entered in to the contract to purchase that for $1000. So in this case chance of default on the behalf on buyer in expected and if the price will go up to $120 then default may be occur on the counter party side to avoid that big lose. So in this way, forwards are more risky as compared to the futures. Transaction cost is less in case of forward while high in case future because parties have to pay the commission to the broker or clearing house. While in forwards no such type of payment is made by any of the party. (Pilbeam 2006) Options: While we come towards the options, it is also a kind of future contract in which buyer or seller has option to revoke the contract before maturity. How contract play vital part in case of options can be judge through the following passage. There is a stated option where “the contract buyer has a right to exercise a feature of the contract (the option) on or before a future date (the exercise date). The 'writer' (seller) has the obligation to honour the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium. This option premium and all conditions to exercise option is mentioned in that master contract between the parties”(Keith, 2006) “Most often the term "options" refers to a derivative security, an option which gives the holder of the option the right to purchase or sell a security within a predefined time span in the future, for a predetermined amount. (Specific features of options on securities differ by the type of the underlying instrument involved.) However real options are another common types. A real option may be something as simple as the opportunity to buy or sell a house at a given price at some period in the future. The writer has the obligation to sell the house to the option buyer for the price agreed in the option while the option buyer does not have to purchase the house at all, so again the buyer has received something of value. Real options are an increasingly influential tool in corporate finance.” (Keith, 2006) Swaps: Unlike the other international finance instrument, swap is not available in the market. Means you can not buy swap through a broker or clearing house rather it is a direct contract between two parties in which terms of exchange is already defined by both parties and then contract agreement is prepared. It can be defined as “Swap is a contract between two parties to exchange sequences of cash flows after a fixed period of time. While determining these series of cash flows, at least one should be determined by a random or uncertain variable, like an interest rate, foreign exchange rate, commodity price, commodity price etc. SWAPs are not traded in market but these are traded Over-The-Counter (OTC) between two private parties and in such type of contract, there is always a risk of default.” (Hallwood and MacDonald 2000) The market for derivative securities has become very large in recent years. Worldwide these securities provide "hedge" on an estimated $16 trillion approximately of financial securities. Their basic function is to transfer risk from one party who do not want to bear that risk to those who are willing to take risk for a specific fee. All this transfer of risk is done through the contract which is no undoubted king of international finance, without it one can not perform the basic functions of international finance. In this respect the derivatives market is almost the same as the insurance industry. For example, a put option is an insurance against the price of a commodity or stock falling. And, like the insurance industry, both the beneficiary and insurer are better off as the result of such transaction. However it is not called the insurance in international finance context rather it is called hedging. (Madura 2008) Whenever we listen the word International finance, list of derivative securities comes in our minds. All these securities have a feature of contract in them, so the contract is main element we can say use in international finance in order to avoid from the risk. Now the question arises; “How derivatives (forward contracts, futures, options and swaps) can be used to hedge risk associated with these?” The answer to this question can be given with the help of examples as follows; Options Suppose Mr. John want to purchase the 1000 shares of ABC & Co @ $50 each. John is expecting that the price of the shares will go up. At the same time, he don’t want to bear the big loss in case of price will come down. He estimated that, he can bear the loss of $4 per share not more than this. For that he can purchase the put option to sell 1000 shares for $46 each. Now if price will increase in future, he will get profit and that option automatically ended because price dose not fall down to that level. But if the price of the share will be decreased below $46 per share, even then, he has the option to sell that those shares for $46 and can restrict his loss to only $4 per share. (Keith, 2006) Futures and forward contracts Let’s suppose that Mr. Smith is a manufacturer of furniture of high quality. For that he purchases the large quantities of different types of wood for his business. He has received a big order from a corporate customer to manufacture the high quality furniture for its newly established new head office building. He has to start his work on this project after 3 months. To fulfill that order, he will have to purchase the 20 tons of high quality wood for which he don’t have the fund right now. That wood costs $400 per ton now, and it is expected to rise in the future. So he decided to enter in future or forward contract with any other party and will purchase 20 tons of high quality wood from him at $410 per ton after 3 months. Now even if the price will go up to the $450 per ton, he has secured himself from that increase by entering into the future contract. Swaps Assume XYZ & Co issued coupon bond in the market which contain the variable coupon rate attached with the LIBOR. Ms. Julia is working as finance manger in the firm and firm has to pay 60bp plus LIBOR to the bond holder as yearly interest. Now the LIBOR rates are expected to increase in the future and Ms. Julia want to reduce the risk as much as possible. As a result of this, she decided to enter into the swap contract with any other party who will pay LIBOR plus 60bp to the bond holder of XYZ & Co and in return charged a fixed rate of interest from XYZ & Co. If the LIBOR rise in the future then Ms. Julia will have already hedge against swap contract and have to pay only the fix rate of interest to the third party. (Hallwood and MacDonald 2000) Conclusion: From all above discussion, we can conclude the “Contract is King in international finance” as the main focus of international finance manager is to minimize the risk and derivative securities are the main tools used to do so. All these securities are based on contract, which confirm the statement mentioned above. Especially the options given as buyer or seller help the managers to restrict the risk to a specific level and by using forward or future contract perfect or imperfect hedging is widely used in the international financial market. If one says that he/she can do effective international financial management without contract, his/her statement is not more than a fantasy. All of the above concepts are related to contract management. Contract management is vast field showing the importance of contract in international finance. Contract has vital importance in international finance and thus it is right to say “contract is the king in international finance”. References Hallwood, C. Paul and MacDonald, Ronald, 2000, International Money and Finance, Wiley-Blackwell; 3 edition, California. Madura, Jeff, 2008, International Corporate Finance, International Edition, South Western College; International Student Ed edition, New York. Pilbeam, Keith, 2006, International Finance: Third Edition, Palgrave Macmillan, New Jersey. Read More