Use of Derivatives by Risk Manager for Protection of Company Based in Thailand - Case Study Example

Use of Derivatives by Risk Manager for Protection of Company Based in Thailand Introduction The crucial importance of developing risk management as an inherent part of existing organisational practices is seen from the failure of large companies, uncertainties in global markets, and concerns about the effectiveness of corporate governance (Ward, 2003). Derivatives have a vital role in risk management. They are instruments that are derived from other instruments. The class of instruments termed Derivatives is composed of options, futures, fowards, and swaps and various complex combinations of these basic types (Doherty, 2000). The kingdom of Thailand is centrally located within South East Asia, and has a long history of sovereign independence. In order to promote economic development the Thai government liberalised the previously stringent controls on foreign investment and created the Board of Investment for added investment and currency. A generally accommodating environment has been created for foreign investment, with some restrictions applied. Bangkok, the capital of the country, is home to 10% of the population. With a predominantly rural economy, agriculture is the backbone of Thailand’s economy (Campbell, 2006). Thesis Statement: The purpose of this paper is to investigate how the well-established risk management tool of derivatives can be used by a risk manager to obtain protection for his company based in Thailand. Discussion “The region-wide financial crisis wrought considerable negative economic and social consequences in Thailand” (Campbell, 2006: 373). The country experienced a considerable devaluation in its currency which had previously been linked to the United States dollar. Due to the resultant crisis caused by non-performing loans and bankruptcies, the government took over or closed down a number of failing financial institutions. Almost all real assets involve risk. Financial markets and the diverse financial instruments traded in those markets allow investors who take risk, to bear the risk; while other less risk-tolerant individuals can to a greater extent remain away from the main trading. The stockholders bear most of the business risk along with potentially higher rewards. In this way capital markets allow the risk that is inherent to all investments to be borne by the investors most willing to bear that risk. The allocation of risk also benefits the firms for acquiring the capital to finance their investments. “When investors can self-select into security types with risk-return characteristics that best suit their preferences, each security can be sold for the best possible price” (Bodie et al, 2004: 5-6). This enables the process of constructing the economy’s stock of real assets. The Economic Situation in Thailand The government has shown a strong commitment to resolve the problems faced by Thailand. Several economic measures were introduced to re-establish fiscal stability, to bring down interest rates and inflation and to restore Thailand’s resources. Restructuring the financial sector and increasing liquidity in the private sector have also been implemented. Critical changes to the legal system in the last seven years include important new legislation dealing with finance, bankruptcy, competition and property, and revision to the laws controlling foreigners’ economic activities (Campbell, 2006). The economic situation in Thailand is now believed to be on the road to recovery. Even so, the International Monetary fund continues to endorse the need for certain structural reforms in Thailand. Foreign investment is encouraged, and industries other than key, sensitive ones, are free to undertake investment participation without any intrusive regulation. By the investment promotion Act administered by the Board of Investment, investment is actively promoted by making certain privileges available to foreign companies. The Board of Investment’s role is to facilitate the flow of investment into Thailand and to investigate the appropriateness of investment proposals. Since the time of the economic crisis, the Board of Investments’ requirements have been further revised, to promote overseas investment, specifically in “those industries that bring new technology to Thailand and create local jobs” (Campbell, 2006: 374). Derivatives Used in Risk Management for Company Based in Thailand The significance of Risk Management as an intrinsic part of organisational management has been acknowledged. It should be applied naturally in all organisational activity because every member of an organisation needs to make decisions, plan, and manage uncertainty to varying extents (Ward, 2003). Options: a form of derivatives, and insurance form the two most important forms of hedging products. Hedging tools form the most apparent risk management devices, and include insurance and options. All these derivatives are essential in risk management. Options are choices, futures and forwards are devices for trading some asset in the future, and swaps are the exchange of one thing for another (Doherty, 2000). Thailand introduced the Derivatives Act 2003 on 7th January, 2004. The Act is intended to “remove uncertainties created by undertaking derivative transactions in the absence of specific laws and regulations and to regulate and encourage development of the derivatives market” (Campbell, 2006: 374). The Act applies to those managers, dealers and others who provide services in respect of futures and options, or an integration of both, on exchange rates, interest rates, financial indices, securities, securities indices, gold, and crude oil. Operators will be regulated by the Securities and Exchange Commission, and any new self-regulatory organisations that are set up under the Act. Specifically, operators dealing with public investors will require a license to operate and must operate under a company set up under Thai law. On the other hand, operators dealing with institutional investors must also operate under a company set up under Thai law, but will need to be registered only, and not licensed (Campbell, 2006). Besides requiring licensing and registration, the Act contains provisions regarding “reporting, operator shareholding and personnel requirements, operational restrictions, sales practices, unfair practices, risk management and disclosure, advertisements, client asset manageement and protection, financial integrity, and audit control, together with civil and criminal sanctions for breach of the Act or any regulations issued under it” (Campbell, 2006: 375). Since new kinds of financial transactions are developing, there is a concurrent increase in the awareness of credit risk. Financial derivatives such as interest rate or currency swaps denote the “unbundling of market risk and credit risk” (Caoette et al, 1998: 17). An interest rate swap is usually a transaction between the following two parties: a highly-rated issuer that prefers floating rate obligations but can raise fixed rate debt at a relatively low rate; and a lower-rated issuer that prefers fixed rate obligations but can raise only floating rate funds. Thus, the main part of the more innovative swap deals actually turns on credit risk, and it is by accepting credit risk that swap sellers derive a great proportion of their revenues. Derivates enlarge the notion of credit risk to include counter-party risk. Companies now have exposure to third parties with whom they never entered into formal credit relationships. Counter-party risk expands simultaneously with society becoming increasingly inter-dependent (Caoette et al, 1998). However, derivative transactions being zero-sum, total financial risk in the economy has not increased because of derivative transactions. But, derivatives require additional financial contracting, with additional exposure to be managed and monitored by the contracting parties. Adequate standards for disclosure regarding credit worthiness have become increasingly important and investments have had to be made in credit evaluation and monitoring structures. There are also additional risks in the interpretation and enforcement of financial contracts. “Default by a counterparty with a substantial aggregate exposure could lead to a chain reaction affecting many other institutions” (Caoette et al, 1998: 17). However, it is worth noting that these systemic risks have always been inherent to financial transactions. The one distinctive advantage of derivatives transactions as compared to more traditional financial interactions is that they are not represented on the balance sheet. Due to this their true risks are not visible to outsiders, and sometimes even to insiders. While derivatives may pose no incremental risk to the financial system as a whole, they pose extensive risks to participants who have not made adequate investments in people, analytics and technology (Caoette et al, 1998). The risk manager who wishes to obtain protection for his company based in Thailand, can ensure beneficial outcomes by using derivatives as the risk management tool. The use of derivatives by investment managers is important because funds that use derivatives to cashequitise are able to achieve returns as if they did not experience any investor flows at all. Moreover, it is essential to examine the interaction between fund flows and concurrent or subsequent performance; as well as fund performance as fund flow varies, and to draw inferences from this analysis (Frino et al, 2009). Frino et al (2009: 926) conduct a study to investigate derivative use, fund flows and investment manager performance; examining “the scenario where two funds experience large, material fund flows but one fund uses index futures to mitigate the costs of these flows while the other does not”. If index futures are an effective means of alleviating the costs associated with increased fund flow and performance, and the hypothesis contained in Ferson & Warther (1996) study is true, that fund flows cause negative market timing by diluting fund betas at periods of higher expected returns by regressing changes in fund flows against changes in mutual fund betas, then, the manager that trades index futures under these conditions should experience superior performance relative to another manager who does not. The authors’ (Frino et al, 2009) study provides additional insight into the relationship between fund flow and performance. By studying the return differential associated with the use of index futures, with a fixed level of fund flow, they present additional evidence relating to whether fund flows effect negative fund performance or merely co-vary with it. The evidence reveals that fund flow significantly affects the alpha and market timing performance of managers who do not trade derivatives. A statistically significant value of 1.5% of all new flow is lost in trading. Also, the market timing performance of these managers is negative in the presence of flow. The average non-user’s fund’s market timing ability is neutral, and the average non-user’s fund’s alpha is not significantly different from zero. On the other hand, managers who undertake derivative based management of new cash appear to be unaffected by investor flows. “In fact, the unconditional performance of the average user fund is statistically equivalent to the performance of the average non-user fund conditional on zero fund flow” (Frino et al, 2009: 926). That is, funds that use derivatives to cashequitise, achieve returns as if they did not experience any investor flows at all. Thus, the research study found that index futures are an important mechanism for enhancing performance, particularly when a fund provides substantial liquidity services to its investors. Investment in derivatives for the purposes of cash-equitisation has secondary benefits for fund holders beyond enhancing returns. Since index futures are able to eliminate the costs of investment flows, funds that engage in this strategy may have less need to impose restrictive conditions, such as minimum holding periods or redemption fees, to impede costly redemptions. The Financial Accounting Standards Board (FASB, 1998) resolved unanimously that derivatives should be represented as assets or liabilities on the financial statements of users, and should be carried on the Balance Sheet at fair value as either assets or liabilities. Particular special treatment would be given to derivatives that constitute bona fide hedges of other exposures. Due to opposition encountered to this decision, the FASB stated that the public had a right to know the company thoroughly, in which they invested. Regarding international accounting risk, the FASB announced that “the United States is home to the broadest, deepest and most liquid capital markets in the world” mainly because the country has the best financial reporting in the world. When the U.S. is contrasted with countries like Thailand and Indonesia whose markets are in turmoil right now, the transparency and thoroughness of U.S. financial reporting is evident. Part of the problem in these countries is that the investors are wary that the company may be withholding critical information about losses, which are hidden under the country’s accounting and reporting systems (Johnson, 1999). Conclusion This paper has highlighted the use of derivatives by a risk manager, to obtain protection for his company based in Thailand. The developing economic situation in Thailand is appropriate for the use of the risk management tool. Legislation also supports the use of the instrument. Derivatives are complex fiancial instruments that can be effective risk management tools. However, they can also expose the company that trades in derivatives to potential ruin. Derivatives usually need not be accounted for in a company’s financial statements; hence investors are unable to know the true financial condition of the company (Johnson, 1999). If the potential risk to investors can be eliminated by transparency on the part of the company, along with comprehensive financial reporting, public interest towards investments can be promoted. References Bodie, Z., Kane, A. & Marcus, A.J. (2004). Investments. New York: McGraw-Hill Higher Education. Campbell, D. (2006). International protection of foreign investment – Volume II. The United States of America: Yorkhill Law Publishing. Caouette, J.B., Altman, E. & Narayanan, P. (1998). Managing credit risk: the next great financial challenge. New York: John Wiley and Sons. Doherty, N.A. (2000). Integrated risk management: techniques and strategies for managing corporate risk. New York: McGraw-Hill Professional. Ferson, W.E. & Warther, V.A. (1996). Evaluating fund performance in a dynamic market. Financial Analysts Journal, 52: 20-28. Financial Accounting Standards Board (FSB). (1998). Statement No.133, Accounting for derivative instruments and hedging activities. FASB, Norwalk, Connecticut. Retrieved on 24th March, 2009 from: http://www.fasb.org/pdf/fas133.pdf Frino, A., Lipone, A. & Wong, B. (2009). Derivative use, fund flows and investment manager performance. Journal of Banking & Finance, 33: 925-933. Johnson, P.M. (1999). Derivatives: a managers guide to the worlds most powerful financial instruments. The United States of America: McGraw-Hill Professional. Ward, S. (2003). Approaches to integrated risk management: a multi-dimensional framework. 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