Use of derivatives as essential risk management tools
Risk has been identified as an inevitable phenomenon that threatens the “smooth-sailing” of any organisational “ship.” Here, organisational ship refers to the day-to-day operations, medium-term and long-term development and growth strategies of an institution.
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As noted earlier, the perceived threats to the success of an organisation can be prevented or minimised through the use of effective risk management techniques. Risk management relates to managements’ careful identification of activities with negative effects and taking proactive steps to avert or reduce the undesirable effects on their respective organisations.
In order to mitigate their strategic exposure to risk, managers of risk in various institutions recommend and use derivatives. A derivative, as the name implies, obtains its value from the value of another product. Stated differently, a derivative refers to a product whose value is predicated on or derived from the value of an underlying product or asset. Examples of an underlying product in this case include currency, security and commodity. Examples of derivatives include options, swaps, futures and forwards. The value of each of these derivatives depends on the value of its underlying asset – currency, security or commodity. The contractual arrangement of each of the identified derivatives is explained in the following section.
Option contracts
Options have been identified as one of the ways in which organisations can effectively manage risk. An understanding of options helps managers to cope with the ever-changing market conditions. The term option is used to describe a contractual arrangement in which the holder has the right to purchase or sell an asset within a stated period of time at a predetermined price. Thus, option holders have a right, not an obligation, to exercise their options at a later date.
Types of option and markets
There are different types of options and option markets. Examples of options include call option, put option, American option, European option, covered option, and naked option. A call option gives the holder the right to purchase an asset at a specified future date at a predetermined price. To illustrate, assume Mr Bee owns 500 shares in RitchSean Company, which sold for ¢10.50 per share on July 10, 2016. Mr Bee could sell the right to buy his 500 shares to Mr Cee on December 14, 2016, at a predetermined price of say, ¢12.70 per share. Mr Cee’s right to buy the 500 shares is known as a call option. The contract allows Mr Cee to exercise his right only on December 14, 2016, and this is called European option. European option is the type of option that can only be exercised on the expiration date. An expiration date is the final day on which the option can be exercised. In our illustration, the GH¢12.70 is known as the strike price or exercise price. However, if the contract allows Mr Cee to buy the 500 shares at any time until December 14, 2016, there is an American option. Thus, an American option permits the holder to exercise his or her right on, or before the expiration date. Mr Bee, the seller of the option, is called an option writer.
Sometimes, investors sell covered options by writing call options against stocks held in their investment portfolios. In some cases, investors sell naked options. That is, they sell the options directly, not against their stocks. Suppose the organisation’s stock price on the date Mr Cee decided to exercise his right or call his option was GH¢11.60 per share. This means the call option is out-of-the-money because the exercise price (GH¢12.70) is more than the prevailing price per share (GH¢11.60).
On the contrary, the call option would be in-the-money if it was exercised when the organisation’s market price per share was ¢14.80. This is because the current price per share (GH¢14.80) exceeds the exercise price (GH¢12.70). Even though a buyer in a call option is at liberty to exercise his or her right, the seller is obligated to do so. In our illustration, Mr Bee, the seller, is obligated to sell when Mr Cee, the buyer, calls for the option.
A put option exists when an individual purchases an option today that allows him or her to sell an asset at a predetermined price at a later date. Assume Mr Bee’s analysis reveals a decrease in the market price per share of RitchSean Company in the next five months. Mr Bee can decide to buy an option today that would give him the right to sell each share at say, GH¢11.60, at a future date. Mr Bee could buy the company’s shares at the reduced price, and sell at the strike price to make a profit.
Transactions related to options are traded on several exchanges, the Chicago Board Options Exchange (CBOE). They are also available on individual stocks, and on stock indexes such as the Standard and Poor’s (S&Ps) 100 Index and the New York Stock Exchange (NYSE) Index. An Index option refers to an investor’s ability to place a bet or hedge on the rising and falling prices of assets in the market and individual shares.
Most option contracts are written for six months with an exception called the Long-Term Equity AnticiPation Security (LEAPS). The LEAPS are also traded on the major exchanges, and are available on stock indexes and individual stocks. Unlike regular options, the LEAPS are long-term in nature; the maturity date of LEAPS could be extended to two-and-half years.
The cost of one year LEAPS is about twice the value of matching three-month option. Although the one-year LEAPS are relatively expensive, the extended contract period makes it possible for buyers to record gains, and to secure their investment portfolios over a considerable period of time. It is believed effective utilisation of the option technique would help businesses record significant gains, and increase their market value. Option trading is one of the fastest-growing financial activities in the advanced and emerging economies across the globe.
Swap contracts
A swap contract occurs when two parties are obligated to swap or exchange something, such as specified cash payments at specified time periods. Currently, the most common types include interest rate swap, credit spread swap, commodity swap, currency swap and equity swap.
The interest rate swap refers to the obligations of two parties to exchange interest rate payments (variable and fixed interest payments) at specified intervals. As an illustration, assume Company D has a GH¢20 million, 10-year fixed interest rate loan outstanding while Firm E has a 10-year, GH¢20 million variable interest rate loan outstanding. The implication is that both firms have interest payment obligations, but one (Firm D) is fixed while the other (Firm E) varies with changes in future market interest rates. Even though Firm E has a variable rate, its stream of cash flow from investment is stable and would therefore prefer fixed to variable interest payments. Contrarily, Firm D experiences fluctuations in its economic fortunes, it has unstable stream of cash flows. After careful analysis, Firm D has decided to settle for variable interest payments over the life of the loan. To resolve this financial impasse, Firm D could swap its interest payments obligation with Firm E. When this occurs, there is an interest rate swap. Firm D would now have the opportunity to make variable interest payments to commensurate with the variations in its cash flows while Firm E would make fixed interest payments to commensurate with the stability in its cash flows. Through interest rate swaps, firms are able to prevent or minimise risks associated with debt and the effective cost of debt.
In currency swap, two parties are obligated to exchange foreign currency payments at specified intervals. As an illustration, assume Firm Q, an American company, has secured $20 million loan in the United States of America (USA) to finance its investments in Ghana. However, Firm H, a Ghanaian company, has secured GH¢20 million loan to finance its investments in USA. Firm Q’s cash flow from operations would be in cedis, but required to make loan payments in dollars. Conversely, Firm H’s cash flow would be in dollars, but required to make loan payments in cedis. The nature of the investments exposes both firms (Firm Q and Firm H) to foreign exchange rate risk.
The writer is the Dean/Senior Lecturer. Regent Univ. College of Science and Technology Consultant
Eben Consultancy
Email: [email protected]; [email protected].Website: www.ebenezerashley.com