Development of Energy Derivatives in Risk Management - Coursework Example

Topic: Development of Energy Derivatives in Risk Management The financial markets function in a vicinity that is prone to an array of stakes and risks which are liable for the high instability of the prices of products and merchandise. The need to regulate this price fluctuation has fostered the development of valuation as well as risk management approaches for assets and their derivatives which are similar to those extensively brought into use in the fixed income, equity and foreign exchange market-places. The recent developments in the field of financial risk management efficaciously stress on the quantitative methods along with their application in reducing financial risks has made way for many insightful analyses. Market deregulation, advances in global trade, and perpetual technological developments has transfigured the financial market-place throughout the past two decades (Comptroller's Handbook, 1997). An off-shoot of this transfiguration is augmented market fluctuation which has resulted in an equivalent increase in demand for risk management products. This requirement is mirrored in the development of financial derivatives ranging from the harmonized futures and options products to the wide spectrum of over-the-counter or OTC products as offered. Introduction Financial risks may be construed as the risks to an organization which crop up as a result of price vacillations, either directly or indirectly, influencing the value of a company (Sprcic, 2007). A fusion of greater deregulation, international competition, interest rates, and foreign exchange rate fluctuation, along with commodity price suspensions, and hoisted corporate concerns, have resulted in increased significance of financial risk management in the years that trailed. Be it a multinational corporation and its revelation with to exchange rate vacillations, a transportation company with the price of its fuel, or a tremendously prevaricated corporation and its interest rate confrontation, the way and limit of managing such risks has frequently witnessed a major role in the success or failure of a business. As a result, we can discuss that financial risk management is one of the most significant corporate operations for the reason that it contributes to the actualization of the primary target of the company, which is stock-holder wealth maximization (Sprcic, 2007). It is possible to conduct financial risk management in two unique manners. On one hand, the first approach can be the employment of a diversification approach in the assortment of businesses that are operated by the corporation. On the other hand, the second approach can be the corporation's involvement in financial transactions. In the case of such diversification, which has been one of the most prominent tools of risk management, firms which are basically concerned about the fluctuations of their earnings, have switched to the financial markets. This is solely because of the reason that the financial markets have embellished more straight approaches to risk management which excel the requirement to straightway invest in actions which help in the alleviation of instabilities. The errand of financial risk management has been provided by the increasing accessibility of an assortment of derivative implements in order to shift financial price risks to other worthy parties which are capable of benefiting from it. 2. Literature Review 2.1 Introduction to Derivatives Prior to the accurate development of derivatives markets, the resources for dealing with financial risks were few and were hugely outside managerial regulation. Even though, a few of the exchange-traded derivatives were existent, but they enabled corporate users to prevaricate merely against particular financial risks, in restrained manners and over short span horizons (Sprcic, 2007). Corporations were frequently fostered to resort to functional options such as establishing plans over-seas, so as to alleviate the exchange-rate risks, or also, to the natural prevaricating with the help of attempting to match currency anatomies of their assets and liabilities (Santomero, 1995). As suggested by Allen and Santomero, throughout the conclusion of the twentieth century, commercial as well as investment banks gave rise to a widened selection of innovative commodities that were proposed to assist corporate managers in dealing with financial risks (Allen and Santomero, 1998). Simultaneously, the derivatives exchanges, which prosperously gave way to the interest rate and currency derivatives, have embellished into vigorous innovators, perpetually supplementing new products, thereby, refining the existent, and locating innovative methods to increase their liquidity. Since that time, the markets for derivative implements such as forwards and futures, swaps and options, and novel amalgamation of all these fundamental financial instruments have been establishing and developing at a striking pace. The range as well as quality of both exchange-traded and over-the-counter derivatives, collaboratively with the depth of the market for such implements, has spread themselves tremendously. As a result, the corporate usage of derivatives in prevaricating interest rate, currency, and merchandise price risks is extensive and ever-increasing. It can also be marked as the commencement of derivatives insurgency (Sprcic, 2007). The reports from Bloomberg suggest that a derivative can be referred to as a financial obligation whose value is obtained from interest rates, the results of particular occurrences or the prices of outlined assets such as debt, equities and commodities (Risk, 2007). Moreover, companies and investors bring them into efficient use in order to hedge or speculate against price alterations. According to Hu, the materialization of the contemporary as well as novel derivative market enables corporations to cut-off themselves from the financial stakes and customizing them (Hu, 1995). As a result, under such new circumstances, the share-holders and stake-holders growingly anticipate the management of the company to be efficient enough in recognizing and managing exposures to financial risks. The outcomes of the empirical analyses put forward the fact that the use of derivatives as well as risk management activities is extensively constant with the prophecy from the theoretical literature which is based on the value-maximising conduct (Sprcic, 2007). By prevarication or hedging of the financial risks such as currency, interest rate and commodity stake, it is possible for corporations to decrease cash flow instability. Moreover, with the help of alleviation of the cash flow instability, it is likely for corporations to lessen the anticipated financial agony as well as agency costs, thus, improvising the current value of expected future cash flows. More to it, the reduction of cash flow instability can lead to the improvisation of the likeliness of possessing adequate internal funds for investments that are planned (Stulz, 1984), thereby, eradicating the requirement to either cut beneficial projects or confront the transaction costs of extrinsic funding. The key theory behind it is that, id the access to extrinsic financing, that is debt or equity, is expensive, the corporations with investment projects calling for funding will tend to prevaricate their cash flows so as to shun short-fall in own funds, which may happen to precipitate a pricey visit to the capital market-places. A striking empirical approach based on such a principle is that corporations which are in possession of substantial investment opportunities that are confronted with high costs or hoisting up funds under financial agony will tend to get comparatively more inspired to hedge against risk exposure than the firms that are next to average in their performances (Sprcic, 2007). 2.2 Energy Derivatives and Financial Risk Management Derivatives are often considered as financial contracts which, although, do not delineate ownership rights in any asset, but obtain their worth from the value of some other outlined commodity or asset. With cautious usage, derivatives are efficacious and influential implements for secluding financial risk, and prevaricating so as to lessen the exposure to risks. In particular, derivative contracts shift price risk to the parties that are capable and wilful for bear it. However, the way of transferring risk is somewhat intricate and often misconstrued. Also, derivatives have been related to some striking financial break-downs with doubtful financial reporting. There is nothing new and innovative in the derivative theory of managing particular risks. However, innovative is the global competence, flexible exchange rates, price distortion, and the development of spot or cash markets which have confronted more market contributors to substantial financial menaces. At the same time, development and advancement in information technology as well as calculation have enabled traders to allocate a value to the risk with the help of using formulas that have been developed by the academics (Scholes, 1998). Commencing from the latter half of the twentieth century, the business of secluding, packaging, and selling particular risks has developed into a multi-trillion dollar industry. Corporations involved in the buying, selling, marketing, distribution, or designing hedges for energy markets such as those of natural gas and oil are entities which have exposure to a number of risks. Firstly, they have to bear exposure of price risk, which we will discuss further. The macro-economic conditions, domestic distortions, weather, supply and demand instability, and strikes at the energy development facilities are some of the aspects which have tremendously impact the price of oil as well as gas (McCann and Nordstrom, 1995). More to it, corporations that attempt to lessen the price risk by prevaricating or hedging, and liaisons that take the opposite stand of a hedge trade, may be prone to basis risk which is the risk of a movement in the pricing of natural gas or oil associative to the price of the hedge vehicle (McCann and Nordstrom, 1995). Another risk which has an adverse influence on all the hedged stands in energy products is the instability risk. The associatively high price of oil as well as natural gas interprets into tremendous ambiguity, and leads to a greater risk. Lastly, a supplementary risk which is quite prominent in commodity products is the risk that is risen by a 'stack and roll' hedging strategy. This type of risk has consequently deranged the hedging approach of 'Metallgesellschaft' during the conclusion of the year 1993 (McCann and Nordstrom, 1995). Price risk management is associatively novel to the local petroleum, natural gas, and electricity corporations, or the energy arena. Electricity has not been a rigorously competent industry, whereas, natural gas and oil pipelines as well as residential natural gas costs are still controlled skilfully. Functioning under government security, the energy industries have had little requirement for risk management prior to the whiff of distortion which commenced somewhere around 1980, which was the same time that contemporary risk management implements came into existence and were practised proficiently by investors (Report, 2002). The businesses that function in the petroleum, natural gas, and electricity domain are meticulously vulnerable to market risk as a result of the extreme instability of energy commodity costs. To a considerable extent, energy company managers as well as investors can make exact approximations of the probable success of exploration ventures, the possibilities of break-downs, or the performance of electricity equipments. Derivatives have proven to be of immense use in the petroleum as well as natural gas industries, and they are still brought into us in the energy industries regardless of all the setbacks faced by them in the history. Perhaps, they would be used more widely, if at all, the financial market statistics would be more lucid. Moreover, managers may happen to restrain the use of derivatives for the reason that their presence in the company accounts can be troublesome for some classes of investors. Also, the scarcity of occasionally, dependable spot costs along with the quantity statistics in most of the markets makes it next to impossible and pricey for traders to provide derivatives in order to manage domestic risks. The vistas for the development of an active energy derivatives market are entangled to the course of the restructuring of industry. It can, thus, be summed up that the prospects for energy derivatives are limited until and unless the energy spot markets work healthily (Report, 2002). To a great extent, company managers as well as investors are able to make exact estimates of the probable success of exploration ventures, along with the possibilities of refinery break-downs, or the performance of energy machinery. Diversification, long-term contracts, and insurance can be referred to as efficacious tools for managing such risks. Such conventional approaches, however, do not work properly for the management of price risk. In case of a considerable fall in the energy prices, the equity values of producing companies also witness a slump down, and ready cash becomes inadequate. As a result, it is more possible that contract compulsions for the energy sales or consumptions may not be acknowledged. We can conclude that commodity price risk plays an overriding role in the energy industries, and the use of energy derivatives has developed into a common source of aiding energy firms, investors, and consumers so as to manage the risks that crop up from the high instability of energy prices. Now that we have argued about the variability in prices as a result of the swift alterations in supply and demand, frequently in association with critical weather or global political occurrences, the energy price instability is the confirmation that markets function in order to assign scarce supplies to their peak value uses. Nevertheless, swiftly transforming prices terrorize the household budgets and financial plans. More to it, price alteration makes investments in the energy conservation as well as production somewhat pricey and risky. Investors, whether they are individuals who consider fuel-efficient hybrid automobiles, or organizations that analyze new energy production opportunities, face difficulty in adjudicating whether the present prices signal long-term values or transient events (Report, 2002). Unfavourable timing can spell wreck, and even good investments are capable of generating large temporary cash losses that ought to be funded. The businesses in the energy industries have made use of derivatives in order to reduce their exposure to instable prices, restrain their requirement for cask-cushions, and finance investment for more than two decades (Report, 2002). Even though, derivatives have been of great use in the energy market, much of their development in usage terms over the past several years has been in financial markets as a straight response to the risen instability in credit as well as foreign exchange markets. Post the decision made to enable the exchange rates to float, they've become unstable. The futures exchanges have responded by producing derivative products which could be used to alleviate financial risks associated with this instability. 3. Conclusion The new developments in the energy market are being driven by the reform and restructuring of the outlined physical markets. As a result of such competition, and meticulously retail competition, the value of derivative implementations as well as risk management strategies increases in significance (Fusaro and Wilcox, 2000). With the financial world setting about recovering from the perpetually turbulent market circumstances, risk management will witness an essential role in the success of recovery. Consistent challenges are required to be confronted skilfully and tremendous opportunities are also arising within the market domain. As a matter of fact, with this consistent and ever-increasing globalization, it is critically necessary than ever to keep up with the transforming environment, thereby, making sure that we are in touch with the cutting edge approaches, theories, and fashions. Developments in the market are capable of altering the value of a corporation's holding of derivatives soon before their stated settlement date. A corporation is responsible for outlays in order to settle its derivative stand in the market. However, on the other hand, a company along with its share-holders can also avail the advantages from an increase in their value. Hence, it is essential for shareholders to be cognizant of these developments, and it is necessary for the corporations to notify the transformations in the value of their derivative holdings on an occasional basis. Transformations in the value of derivatives ought to be mirrored both on the balance sheet as well as in the earnings. It is preferable if mark-to-market is the basis for the valuation of the derivatives. References Allen, F. and Santomero, A. M. 1998, The Theory of Financial Intermediation. Journal of Banking & Finance, 21 (11), 1461-1485. Comptroller's Handbook. 1997, Risk Management of Financial Derivatives. Comptroller of the Currency, Administrator of National Banks. Fusaro, P. C. and Wilcox, J. 2000, Energy Derivatives: Trading Emerging Markets, New York: Energy Publishing Enterprises. Hu, H. T. C. 1995, Hedging expectations: Derivatives reality and the law and finance of corporate objectives. Texas Law Review, 73 (3), 985-1040. McCann, K. and Nordstrom, M. 1995, Energy Derivatives: Crude Oil and Natural Gas. Product Summary prepared by: The Financial Markets Unit Supervision and Regulation, Federal Reserve Bank of Chicago. Risk, H. 2007, Derivative Trades Jump 27% to Record $681 Trillion (Update1). Press Release, Bloomberg. Santomero, A. M. 1995. Financial Risk Management: The Whys and Hows. Financial Markets, Institutions and Instruments, 4 (5), 1-14. Scholes, M.S. 1998, Derivatives in a Dynamic Environment, American Economic Review, Vol. 88. No. 3. Report. 2002, Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries. Energy Information Administration, Official Energy Statistics from the US Government. Sprcic, D. M. 2007, The Use of Derivatives as Financial Risk Management Instruments: The case of Croatian and Slovenian non-financial Companies, Financial Theory and Practice 31 (4). Stulz, R. 1984. Optimal Hedging Policies. Journal of Financial and Quantitative Analysis, 19 (2), 127-140. Read More