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Derivatives: Vital tools for hedging and curbing risks

Kshama Fernandes

Imagine you are a 'stock-picker' in the Indian market. You identify a scrip, which you believe is undervalued and that the only way it can go is up. But you could still lose on two grounds: the stock may really not be worth more than the market price and the entire market could move against you even though your underlying assessments of the worth of that particular stock were right (a fall in the index).

In short, every 'buy' position on a stock is simultaneously a buy position on the market index. So how would you remove this 'market risk' from your portfolio?

In India, there isn't much one can do at the moment. In a few weeks, however, when index futures start trading, we will finally have a way to hedge the index risk and begin concentrating on pure stock-picking (if we believe that is where our core competency lies).

This is just one example of how index futures could be useful to an investor. After much debate and apprehensions, exchange-traded financial derivatives seem set to take-off in India.

Although we still await the launch of the first derivative product, namely index futures, there is no doubt that once launched, derivative products such as futures and options will have a significant impact on resource allocation and investments in India.

Hence, there arises a need to understand the working of these instruments and markets.

Derivatives, like futures and options, are products that derive value from the value of an underlying asset, index or reference rate. Futures and options markets have become increasingly important in the arena of finance and investments globally.

The origin of the futures markets can be traced back to the Middle Ages. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose of his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too would face a price risk: that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into a contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be a futures-type contract, which would enable both parties to eliminate the price risk.

In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the 'to-arrive' contract that permitted farmers to lock in the price and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. These were eventually standardised and, in 1925, the first futures clearing house came into existence.

Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. Although all these contracts enable hedging and speculation, the size of the futures markets in commodities is limited by the level of production.

The real boost to the futures industry came after the launch of financial futures. These are financial contracts which derive their value off a spot-price time-series called the 'underlying'. The first financial futures contract -- a contract for trading currency futures -- was launched by the International Monetary Market, or IMM, a division of the Chicago Mercantile Exchange, or CME, in 1972.

The treasury bill futures contract in 1975 followed this. Since then, a large number of futures contracts have been developed. Of these the most successful contracts are index futures, treasury bill futures, and foreign exchange futures.

However, a forward contract is distinct from a futures contract. Both, forwards and futures, aid the same purpose -- that of locking on to a stated price for future delivery. However, they are different characteristically. The most popular forward contracts are those on foreign exchange. In India, we have a strong dollar-rupee forward market with contracts being traded for one, two and six-month expiration.

Importers and exporters hedge their currency risks using these forward contracts. For example, an importer expecting a consignment in three months could hedge his exchange risk by entering into a three-month forward contract to buy dollars in the dollar-rupee forward market.

Forward markets, however, are plagued with several problems. Basically being private agreements between two financial institutions or between a financial institution and its corporate client, forward contracts do not trade on an exchange. Hence, they face problems of illiquidity and counter-party risk.

Illiquidity comes from the fact that forward contracts do not have to conform to the standards of an exchange. Both, the quantity and the delivery dates, are set as per the mutual convenience of the parties involved. Hence, they are specifically tailored to the needs of these parties, making the contracts non-tradable.

Counterparty risk comes from the possibility that one of the parties could fail to fulfill its leg of the transaction. For instance, if one of the parties to the contract declares bankruptcy, the other suffers. The greater the time period over which the forward contract is open, the more are the potential price movements, and hence larger is the counter-party risk.

The futures markets efficiently solve the above problems. Futures trade on organised exchanges with standardised contract terms enabling a liquid market in these contracts. Futures trading requires margin payments and daily settlement. Clearing houses associated with these exchanges guarantee fulfillment of futures contract obligations doing away with the counter-party risk.

Hence, futures markets could be thought of as a special kind of forward contracting, with characters such as organised exchanges, clearing houses, financial safeguards and standardised contracts.

Yet another interesting derivative contract is an 'option'. An option gives one the right, but not the obligation, to buy or sell something on a stated date at a stated price in the future. Options are fundamentally different from forward and futures contracts. They give the holder the right to do something along with the option to exercise this right. In a forward or futures contract, however, the two parties are committed to the terms of the contract, and have to fulfil them.

It costs nothing to enter into a forward or futures contract (except for the margin requirements), but the purchase of an option requires an up-front payment called the option premium. Since the setting up of the Chicago Board of Options Exchange, or CBOE, in 1973, option markets have become increasingly popular with investors.

What economic needs do derivatives such as options and futures fulfill? The prime function they perform is the reallocation of risk, either across time or among individuals with different risk-bearing preferences.

Risk can be reduced either by (a) entering into a contract with another party facing opposite risk, or (b) by the risk-averse party entering into a contract with a risk-tolerant one. Take, for example, an Indian exporter who faces losses when the rupee appreciates, and an Indian importer who faces losses when the rupee depreciates. They are exposed to opposite risks in the same market and can reduce the same by entering into a forward contract in the rupee-dollar market.

Where currency futures contracts are available, the exporter would short futures and the importer would go long. In the second case, the risk-averse investor, with exposure to the equity market, would hedge by buying 'put' options on the index sold to him by a risk-taking investor.

The ultimate importance of the derivatives markets hinges on the extent to which they allow investors to reduce their financial risks. Some of the largest derivative markets in the world are contracts on the market index. Some help control risks associated with market fluctuations (S&P Futures that trade on the CME). Others contracts are on treasury bills to help control interest rate risks (Treasury Bill Futures on the IMM), and on exchange rates to help control currency risks (Eurodollar Futures on the IMM).

Used appropriately, derivatives help develop convenient mechanisms for hedging and risk-reduction. With index futures being launched by the NSE shortly, investors in India will at last have a smart means of hedging their risk.

The author is a faculty member at the Department of Management Studies, Goa University. She handles capital markets and derivatives.

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