Treasury Risk Management - Derivatives - Essay Example

1. Derivatives—an Introduction Derivatives are financial instrument that do not have a value of their own. Derivatives have no intrinsic value (Davies, 2007). They derive their value from that of the underlying assets in future. Underlying assets can be forwards, futures, swaps, caps, ceilings, floors, commodities, equities and bonds. Derivatives are contracts to buy or sell an asset or exchange rate based on specified condition, event, occurrence or another contract. According to Johnson (1999), only four generic types of derivatives, future contracts, options, swaps, and hybrid instruments are heavily used in business these days. The two parties make a contract to make and receive payment linked to the cost of the underlying asset s being traded. Thus they are contractual promises for ownerships and not ownership. The Long and Short of Futures Contract Here it is important to define futures contract, perhaps, the most important derivative related term. A contract within a long (buyer) and a short (seller) is the futures contract. (Johnson, 1999). In the simple farmer and trader analogy, the farmer who promises to provide a commodity in future for a fixed price is the ‘short’ and the trader who opts to buy the commodity, in future, is ‘long’. The contract reached between them is a futures contract. Derivatives result from such futures contacts. Stock Options as Derivatives Stock options are underlying assets that are traded as derivatives on the stock exchanges. Stock options give the investor the option of owning a stock in future while keeping the options of not owning them open, in case of volatile downswing. Thus stock options give the right to buy shares in future. In case of a downswing in prices, the investor can always decide to not use the option and thus survive a stocks crash. The word option in financial parlance means the right of a person or a party to buy or sell an underlying asset in future. However, stock options are only used as an incentive for the company’s employees and are not available to the public. This makes trading in shares and stocks more popular and rampant than stock derivatives. Importance Derivatives are indispensable to a robust economy. In the simplest form derivatives have been used since times immemorial by farmers and producers. Derivatives have been traded in the Amsterdam exchange despite a Dutch government ban since 1600. The Dutch ‘tulip crash’ is the oldest example of a derivative boom going bust. At the time the crash occurred tulip contracts were being sold 20 times their value. Their popularity can be gauged from the fact that they find a mention in Aristotle’s work dating back to 2500 years and as recently as 1997, two economists, Myron S. Scholes and Robert Merton have been conferred Nobel prize for their work on derivatives. The findings of Scholes and Merton will help to prevent risk better. Derivatives have affected fields as diverse as flower growing and song writing. Derivative Exchanges The first exchange to start trading in derivatives, the Chicago Board of Trade went operational in 1848. Chicago Mercantile Exchange was the other largest derivative exchange market in the world. Derivates in Copper, Cotton, and Tea were largely traded in these exchanges. The two Chicago-based exchanges have now merged with the New York Stock Mercantile Exchange to create the CME Group. The International Swaps and Derivation Association is the body that regulates derivative trade in the world today. These exchanges guarantee the performance of contracts which is not possible under over the over the counter trading. Many countries are in process of development of derivative exchanges. Some More Features Though derivative contracts are derived from another contract they are independent of them. In other words, they are used to preserve the value of these underlying assets against swings in market prices. . Their use, in speculation, is precipitated when gains in trading outweigh the transaction costs of the contract. An upward movement in the prices of underlying assets is a speculators heaven. Institutional investors use commodities, currencies, equities, and energy and currency notes for trading. The use of derivatives as hedging instruments is as old as civilization. In earlier times, they ensured a fixed price for a producer at a future date irrespective of the rise and fall in prices due to gaps in demand and supply. The purchaser entered into a formal contract with the seller to buy the produced goods in future. Generally used in case of agricultural produce it was the first form of forward contracting. This secured the producers against the vulnerabilities of the market forces, rising and falling rates of the goods ensuring a fixed price. Even today traders of cash crops enter into contract with farmers to purchase crops in future. Weather derivatives, for example, are used by farmers to cover the risk poor harvests due to vagaries of weather. This ensures that the buyers get the crop in time and sellers have the satisfaction of getting a fixed price. Similarly international companies use currency futures to protect themselves against fluctuations in the international currencies against one other. The ‘put’ option gives the ‘short’ the right and not the obligation to sell crop at the desired cost to the ‘long’. OTC and ETD With boom in trade, commerce, and transactions derivatives have created associated complexities that cannot be explained in the simple over the counter farmer-trader model. It is due to these complexities that derivative trading in exchange is preferred over private transactions. However, derivatives are traded over-the-counter trading (OTC) and exchange regulated traded options (ETD) by brokers and investors. The seller (the farmer in this model) is the short and the buyer is long in derivative parlance. The long to profits in the event of price hike and in the event of price decrease the short profits the price of the underlying commodity. Derivative Misuse Today derivatives are so misused a financial instrument that delving into any financial scandal reveal derivatives misuse at work. (Callahan and Kaza, 2002). Investment wizard Warren Buffet goes to the extent of calling them weapons of mass destruction, and potential financial time bombs. The misuse of derivatives has created many financial catastrophes. Many bestselling novels and blockbusters are based on ‘derivative plots’. The last two decades are replete with such examples of financial mismanagement in derivative funds. In 1996, Amaranth Advisors, a hedge fund, went bankrupt after losing $6 billion in the US market. Commodity Futures Trading Commission charged its CEO of entering into manipulative practices by selling natural gas derivatives rapidly just before the bankruptcy of the company. Three of the biggest financial catastrophes in the US history, WorldCom, Enron, and Global Crossing had misappropriations of derivatives as the common denominator. Enron, for example, did not lose money because of its failure in trading derivatives, but because it used the money raked through energy derivatives by hiding its losses (Partnoy cited by Kaza and Callahan, 2004). Proliferation of derivative induced financial scandals made Sir Julian Hodge, a renowned economist, remark that they have the potential to bring world’s financial system to a collapse (Hodge quoted at projects.exeter.ac.uk). In the first quarter of the current fiscal, the Lehman Brothers and AIG meltdown is attributed to derivatives. The US Government stepped in to check the proliferation of meltdown to the derivative market. Earlier in March, 2008, the Federal Reserve Bank hedging came to the rescue of Bear Stearns, preventing the triggering of what was to be ‘derivatives Chernobyl’. It had the potential to evaporate $516 trillion derivatives system (telegraph.co.uk, 2008). In the new deal JP Morgan will take over its $13.4 trillion contracts totaling 90 trillion on its book, a sixth of the world economy. (telegraph.co.uk, 2008). It is like hedging, the hedging instruments out of trouble. The Long-Term Capital Management, a hedge fund of the government of Orange County rocked the County with overnight evaporation of $1.6billion of tax payers’ money from County’s fund of $ 7.6 Billion reserves. Fiascos such as in Orange County municipality have made tax payers raise their voice for tighter regulations to prevent misuse of public money. Actually, the Orange County government never ran short of funds but it was inappropriate handling of derivatives that led to the crisis. Orange County treasurer used the municipal income of the county as well as that of 200 other municipalities, to bet on a interest rate sensitive fund. The Orange County case is an example of lack of transparency in financial apparatus of government. It shows the chinks in the system as the county treasurer was behind this infamous scandal. (Callahan and Kaza, 2006). The governments of Orange County and in Arkansas scandals abetted by public functionaries are suggestive of a greater malaise, as to how derivatives can be misused right under nose of law. Callahan and Kaza (2006) suggest that since the derivatives are new fangled financial instruments their use and misuse is made easy by lack of their understanding even by financial experts. More Controls Intended for risk mitigation, derivatives are often used as for trading and speculation by speculators. As is the case for any instrument, it is the use they are put to, that creates their worth or spells their drawback. Derivatives by the way they have been used by have served their intended purpose of assurance against risk as well as have been misused by traders and broker to carry out speculations. Speculation over derivatives have often invited severe measures like their banning as has recently been done by the Chinese government in 2006 over the use of foreign exchange derivatives. However an exception has been made in case of banks allowing them to use the derivatives in a non-speculative to mitigate foreign exchange trading risks (Xinhua, 2006). Callahan and Kaza (2006) stress that derivatives are indispensable to world economy. Like other financial instruments, they too carry a certain amount of risk and no amount of government checks can fully regulate the derivative environment. (Callahan and Kaza, 2004). Excessive government controls are also unwarranted in free market economies where an informed investor, aware public and active media can play a real monitoring role. Stricter controls motivate misappropriation experts to find more ruses to circumvent them. We will have to agree with Atkins that every decade is marred by a new financial crisis despite the preventive measures. Conclusion Derivatives, an instrument for risk mitigation have been in use since ancient times. Centuries later as trade and commerce grew manifold the intricacies and complexities associated with them too grew many times over. Now it requires the vision of a financial genius to leverage their potential usage. Many times such a ‘genius’ tries to gain unlimited profits by usurping this potential. In last decades such derivative related scandals have occurred with increasing frequency. Managements have woken up to the disaster when all was lost. Ignorance here certainly is not bliss but a risk. It is important to understand that not everyone including the ones who misappropriate them fully understand their working. As regulators try to develop new models for prevention of misuse of hedging devices and unscrupulous look for new ways to fox them, ordinary mortals should always be on the safe side of the road. 2. Introduction Derivatives, as such, are not investment instruments but contractual obligations for exchange of a payment for an asset in future. In their inception, they were instruments to hedge risks of small time farmers and producers against downslides in prices. They kept the mood of the manufacturer upbeat by assuring him a fixed income thus helping promote sustainable living where the right commodity was available at the right time. Till recent times, derivatives were not even considered as an investment option. As they are tools for risk management, the value of underlying assets is not easily influenced by fluctuations in market price. Due to this price safeguard feature, derivatives became an investor’s choice. Today, it is hard to make out what percentage of the hundreds of trillions dollar derivatives turnover comes from speculation or hedging. Thus the use of derivatives for investment option grew not due to their intended function, but due to an inherent trait that was made use of by, modern financial wizards, to reap profits. Thus due to their risk protection qualities, derivatives became an investment option for traders and brokers. The number of derivative exchanges is growing in number all over the world because of increasing interest of investors in derivative investments. Hedging or Speculation Speculation of derivatives escapes the eyes of the managements and, regulating authorities most of the time as they mistake it for hedging. Derivatives provide the complete investment strategy of speculation, hedging, arbitrage and all possible combinations of the three. (derivativesportal.org). Investing in derivatives for speculative purposes is thus deemed to be its misuse as the speculator tries to gain even in times of a downslide. Some financial experts view derivatives as nothing more than gambling instruments. A small movement in the cost of underlying assets makes the investor earn or lose large amounts. Going by the profits they rake, it makes sense to invest in the derivative market especially when compared to high volatility of shares and commodity market that puts a lot of capital of the investor at risk. But share and stocks are fairly standardized and governed under the securities laws of the country. Derivatives allow heavy return on the investment as the buyer of a derivative contract makes a profit due to increase in prices in future by advancing small marginal money only. Investment options cannot be studied from profit-making view only. There is a spectrum of issues that involve a much wider perspective. One of the enticing features of derivatives is their property of hedging risk by keeping the asset value locked-in for a particular period. The credit protected derivatives make for an interesting investment option. In credit protected derivatives, investment is secured by a third party against liquidity. The third party could be an insurance company, a bank or any other financial instrument. In case, the short is unavailable to provide the underlying asset or the long is unable to make payment due to downswing in the commodity prices, the third party makes up the loss with its protection cover. The State of Evolution Since the derivative market is in a growth stage, proper legal and financial framework to control their trade is in a state of evolution. Most of the financial accidents occur due to lack of regulatory mechanism. In the absence of suitable international and national laws even arbitration at times becomes difficult. The problem is more acute in the Mid-east where the courts and the law find it difficult to differentiate speculation from hedging, speculation being banned in the Middle-east. Countries like Qatar, regularly issue oil-bonds to generate money to finance their oilfield development operations. These, besides, lack of competitive pricing, difficult understanding of its structures and its intricate use are cited as prominent reasons against derivative investment. (stablevalue.org). Low Investment, High Growth With derivatives an investor can make a high profit without actually buying the product, which entails heavy investment. Similarly, if a downswing in prices occurs, a derivative investor will tend to lose only a percentage of losses that were to occur if the investor had bought the commodity. Thus the risk associated with investments in derivatives is far less than that involved in trading of shares, stocks, and commodities while the profits can be far more. An investor can gain a large percentage of profits on investment without actually buying the commodity. The buyer or the investor can base his calculations on the Black-Scholes formula or the Greeks to determine the price of the future contracted asset. Superior and expensive computing made derivatives a domain of the few in 80s and 90s. The complexity of these calculations along with fluctuations in market due to unforeseen variables, undefined rules and lack of regulation, and the fast pace of life makes speculative earning a daunting task for small and inexperienced investor. Losses The overall market losses incurred in derivative crash are voluminous. Investments evaporate into thin air as values of derivatives dry in face of crashing funds, as it happened in the case of AIG, Lehman, LCTM and Enron. Losses in commodity and share market are never so abrupt and so great in magnitude. Though all investments require keeping a vigilant eye on the upward and downward movement of stocks but wariness of the investor may not be sufficient to make out an impending loss in case of derivatives. Derivates are too dependant upon imponderables, the chief being their exposure to manipulation. Off-the-balance sheet transactions of derivatives make them highly vulnerable to manipulation. The forces driving the derivatives market are always a step ahead and extremely complex and beyond comprehension of an ordinary investor. ETD versus OTC It is less risky to bet on Exchange Trade Derivatives (ETD) as they have exchange related guarantees. Both the buyer and seller have to register at the exchange and deposit certain fees as trading fees. On the other hand, Over-the-Counter (OTC) derivatives are privately managed transactions and more vulnerable to risk. More Investment Advantages The derivatives investments are made by open market investors who do not have a direct interest in the sale and purchase of a commodity. Derivatives provide the investor with an option to directly invest in a commodity of choice rather than investing in a company that trades in the commodity. This option of directly trading in a commodity and availing profits from an upswing in the market makes investments in derivatives an interesting option. Derivatives provide short-term, medium-term, and long-term trading options depending upon the commodity that is being traded. Stocks and shares can be traded to reap benefits on long-term basis only. It makes a lot more sense to trade in a product derivative than to trade in the shares of a company that deal in the trading or manufacture of that commodity. Derivatives as financial instruments have found entrepreneurial usage in as unlikely a field as rock singing. David Bowie, the rock icon, sold ‘Bowie Bonds’ to diversify his investments. The purchasers of Bowie Bonds were able to encash the royalties that flowed from Bowie’s songs. By selling these song derivatives Bowie earned a fixed income and secured his future against the ups and downs of his popularity (Kaza and Callahan, 2004). Thus a thinking mind can explore any number of uses of derivatives. The Buffet Way Use of derivatives as an investment instrument; however is, definitely on the rise. There is no harm in using derivatives as an investment option as long as the investor understands the associated risks and is aware of the fact that they are not, per se, investment instruments but risk mitigation tools to provide security to those trading in commodity against market volatility. Warren Buffet cited by Kathryn (2004) suggests that small time investors should stay away from derivatives as they fall in the domain of a privileged few who know the tricks of the trade. Buffet (2004) by this one-sided suggestion closes the door of enterprise and innovation in derivative market as entrepreneurs are borne of a common man taking risks at a big game. With this approach we may never get many more Warren Buffets in future. Conclusion Less investment, more profits make derivatives trade an extremely risky and tedious game. Moreover the rules of the game in derivative markets are still in the defining stage, and little is known of the complexities with which derivative trading is carried out. Most of the time the advantages of derivatives can be made use only by the institutional investor. Amongst individuals only those who can take risks and have the will and patience to carry out fuzzy market calculations should enter the arena. Since not all are endowed with the will, stamina, and sense of adventure for a spacewalk or scuba diving. For them easy and viable option of traditional trading is the easy way to make a living or, perhaps, a fortune. References: Callahan, G., and Kaza, G., (2004), In Defense of Derivatives, “Reason Magazine Website” www.reason.com, Retrieved September 25th 2008, http://www.reason.com/news/show/29033.html Davies, Linda (2007), Into the Fire, Twenty First Century Publishers Limited Johnson, P.M., (1999), Derivatives: A Manager’s Guide to The World’s Most Powerful Financial Instruments, McGraw-Hill Professional, New York Kathryn, N.d (2004), Financial WMD, “The University of MichiganWebsite” http://www-personal.umich.edu/ Retrieved September 24th 2008, http://www-personal.umich.edu/~kathrynd/FinancialWMD.Jan04.pdf Partnoy, F., ( 2002)(Abstract) Enron and Derivatives, University of San Diego - School of Law, , “The Social Science Network Library” Website, www.ssrn.com Retrieved September 23rd 2008 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=302332 Anon (2008), Gambling on Derivatives, “University of Exeter Website”, http://projects.exeter.ac.uk/ Retrieved September 24th 2008, http://projects.exeter.ac.uk/RDavies/arian/scandals/derivatives.html Anon (2008), Feds Rescue Halted a Derivatives Chernobyl, “The Telegraph Media Website” www.telegraph.co.uk, Retrieved September 23rd 2008, http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/2786816/Fed%27s-rescue-halted-a-derivatives-Chernobyl.html Xinhua, (2006) Foreign Exchange Derivatives Banned for Speculation, “The China Daily Website,” www.chinadaily.com.cn, Retrieved September 25th, 2008, Anon(n.d) Structural Investment Contracts (SIC), “The Stable Value Association” www.stablevalue.org/, Retrieved September 25th 2008, http://www.stablevalue.org/library/monographs/monograph-021.pdf Anon(2003), Basics - Learn More About Derivatives, “ Derivatives Portal Website” www.derivativesportal.org Retrieved September 24th 2008, http://www.derivativesportal.org/Misc/?Id=basics Anon (2008) Basics of Options (Derivatives) - Speculation and Hedging, “Free Finance Tutorials Website”, www.financescholar.com, Accessed September 22nd 2008, http://www.financescholar.com/speculation-hedging.html Nike Sweat Shop Nike forayed into Southeast Asian countries like Indonesia, China, and Vietnam long before long before they became hot destinations for the manufacturing industry. Nike’s manufacturing facilities opened a sea of opportunity for the unemployed, introduced them to quality manufacturing techniques, new technologies, while setting basic of employment, remuneration and ushering in a paradigm change in work environment. 700 such contract factories employ 800,000 workers globally. Nike’s CSR describes it as an equal opportunity employer. In a vastly improved CSR policy by 2006, the company has developed a mission code of conduct that is equally responsive to Nike management, employees and sub-contracting parties, and the communities it operates in, spread all over the world. The catch, however, is that Nike basis it’s paying policy on the cost of living in the country of operation and conforms to the minimum wage standards of the country. The company thus earns cost advantage while opening new vistas of multi national enterprise (MNEs) employments in developing countries. Child labor and labor exploitation issues, according to Nike, occurred in the initial days of its landing in Asian countries. Enough checks are in place now as has been verified by third party audits done by Global Alliance. In an age of increased global awareness, misuse of labor laws in any part of the world cannot go unreported especially, in the case of MNEs. Companies like Nike are always subject to public scrutiny. Any such occurrence of the past that is used against Nike as propaganda today, is not justified. Locating the manufacturing facilities in the developing world is not a ‘sin’ in flattened world especially when the labor and work related rules are being complied with. The disparity of $20 dollars of hourly wage in the US and that of $1 in Indonesia is a myth generated by anti-MNE organizations and the media. If it were so, no amount of barriers could check the flow of manufacturing trade from the US to other countries. Such disparities are hard to practice in an age of the Internet, increased communication, transparency, and people to people interaction. Spurred by Nike’s success in eastern countries other countries too scampered to set up their base in Southeast Asian countries to leverage less manufacturing cost thus making a win-win situation both for the multi-nationals and the host countries. 2. Nike should have been more watchful of its activities when it started subcontracting in developing countries in the 80s and 90s. Labor exploitation, as has been admitted by the company, shouldn’t have been allowed to occur in the first place. The company shouldn’t have exited out of Cambodia, in face of these accusations. Rather it should have taken immediate remedial measures allowing third party auditors to conduct regular audits. Now Nike should fully commit itself to development of holistic, socially and morally responsible integrated supply chains through innovation and compliance. The suppliers of Nike should have been sensitized to the company’s CSR and introduced to tailored human resource management programs through vigorous training. Nike’s initiative for development of metrics for social impact of its CSR and business in different parts of the world is a timely decision. 3. Corporate Social Responsibility is a ‘must’ and ‘should’ in the corporate obligations. In the era of globalization, its implementation is as important as investment itself. CSR is no longer a peripheral check but is a source of innovation (Parker, 2005 quoted at www.socialfunds.com) and growth. It is not an end but a means to staying in business. CSR is not remedy against rights violations, a means for reputation management but a better way of doing business. Bringing transparency to operations, sensitivity to the community and environment, designing out root causes at the source and thus making a healthy supply chain are the new building blocks of global business operations for Nike. References 1. The Nike Business Site, http://nikebiz.com/ 2. Baker, M., (2008) Corporate Social Responsibility - Companies in the News, Nike, “The Mallen Baker Website Business Centre Website” www.mallenbaker.net Retrieved 24th September, 2008, 3. Corporate Report (2005-06), Corporate Social Responsibility, “The Social Funds Website” www.socialfunds.com Retrieved September 24th 2008 http://www.socialfunds.com/csr/reports/Nike_FY05-06_Corporate_Responsibility_Report.pdf Read More