Title: Hedging, Speculation and Regulation
Executive Summary:
Report:
Brief Introduction to Derivatives
Derivatives are financial contracts that transfer risks between two parties, i.e. from firms that are seek to reduce risk (hedgers) to those that have excess risk bearing capacity and are after a profit (speculators). The price of the derivatives are derived from the future price or prices of the underlying assets such as currencies, commodities, interest rates and stock market indices.
There are several kinds of derivatives, that can be loosely divided into two categories: forward based instruments and options. In the former, the rights and obligations of both parties are symmetrical and lock in a price or rate of exchange that will take place on a future date. The following are examples of forward derivative instruments
Forwards
A forward is a customised contract between two parties to buy and sell an asset at a specified price on a future date. Usually, forwards are not traded on a centralised exchange and are regarded as an over-the-counter (OTC) instrument. They also expose the signatories to counter party risk i.e. that the other party may default on its obligations.
Futures
Futures are financial contracts obligating the buyer to buy or the seller to sell an asset at a predetermined future price. However, they differ from forwards in that they are standardised contracts, traded on a futures exchange (e.g. Chicago Mercantile Exchange) with no counterparty risk as any contract holder will be required to post a margin to ensure fulfilment of the contract at all times.
Swaps
Swaps are derivative contracts through which two parties exchange financial instruments. Most swaps involve exchanging cash flow for a notional principal amount that usually doesn't change hands. Due their complex nature, swaps are OTC contracts between business or financial institutions.
Options
Options are asymmetrical in nature, with the option holder either having the right to sell (put) the option within a period of time or the right to buy the underlying right or interest over a period of time, or at a particular point in the future (call option).
Commonly in derivative transfers, hedgers look to absolve risk, whilst speculators look to incur that risk, with the ultimate aim of profiting. Whilst in theory, derivatives lead to effective transfers of wealth, the recent financial crisis, with its high profile bailouts, led to the transfer of wealth from governments to those who had irresponsibly incurred risk and almost destroyed the financial system. Moreover, given that the current, notional amount of outstanding derivatives is $553 trillion, about 7 times more than estimated global GDP, they truly appear to be Warren Buffet’s weapons of mass destruction that can cause the financial system to implode in the future. Their mass destruction potential remains, but that risk can be mitigated through careful management by firms and proposed regulatory changes that will be dealt with below.
Hedging Function of Derivatives
Brief Overview
Hedging is a technique used to achieve a desired risk level where an organisation takes on a negatively correlated position to a currently held asset or liability. Primarily a loss limiting strategy, effective hedges can lead to tax benefits, protect against extreme events or stabilise cash flows. It is important to note that successful hedging will not completely eliminate risk, as to do so would significantly reduce profits, rather its aim is to reduce risks to manageable levels.
Speculative Function of Derivatives
Brief Overview
However, through derivatives, a party can speculate on the price of an asset, without actually owning or acquiring the asset. Unlike hedging, the objective of speculation is to maximise profit rather than reduce risk. In essence, as derivatives are a zero sum game, there can only be one winner. Moreover, under the secondary market, these complex financial instruments could be notated or even transferred to third parties.
Benefits of Derivatives
The following examples are ways in which derivatives can be used to effectively hedge a fictional Company A’s liabilities.
Mitigation of Currency Risk
Company A (incorporated in the UK) sells widgets in Europe but manufactures them in Taiwan. Its liabilities are therefore in Taiwanese dollars. Within a short period of time, the next batch of product will need to be acquired. Therefore, rather than waiting for a spot currency exchange just before purchase, Taiwanese dollars can be acquired by a forward/future contract. This has the effect of fixing the exchange price at a pre-determined price today. In doing so, Company A is reducing exposure to the volatility of exchange rates and and obtaining certainty with its future commitments. However, as mentioned above, this is a legally binding contract, which means that the company is obliged to purchase Taiwanese dollars, notwithstanding the disadvantageous depreciation the Taiwanese Dollar relative to the forward.
Options can also be used to mitigate Currency Risk. Instead of being obligated to purchase the currency in the future, a call option would allow Company A to purchase Taiwanese Dollars, only if the
Commodity risk
Interest Rate Risk (Examples)
Insert example (Option/Forward) dealing with input costs
Swaps- converting fixed to floating rates for fixed income investments See Khan academy video
Mass Destruction Potential
When both combine
Basis risk- offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. Example of acquiring copper prices on futures market being 10p higher than at future date.
Quantity Risk- Risk of over or under hedging- example of farmer fluctuating crop and being able to adjust. See Gen Re and trouble Buffett had to get rid of it. 2002 shareholders letter. Also AIG.
Southwest airlines oil hedge.
How to mitigate
See Mckinsey Article. Whilst potential to be mass destructive, can be successfully mitigated against by firms themselves. See regulation of OTC markets below as well. Example of it being a controlled fire….
Mass Destruction Potential
Arguably where more mass destruction potential comes in as profit driven. Complex financial models can be tricked (Amaranth) and with improper systems in place.
AIG Pre-financial crisis, OTC market unregulated. As Buffett said in the article…introducing speculation into the system easily with brokers failing to realise that there was no free lunch.
Analyse role of CDS+ securitisation.
Mainly tackled by regulation.
Regulation
G20 speech and reform to derivatives…
Analyse preceding regulation in UK. Basel II and Basel III, MiFID II. Analyse impact and then clearing houses.
In effect agree with Buffett, risks are being mitigated against slowly, but no real solution to one off disruption