Company faces many kinds of risks like unanticipated changes in demand, selling price, costs, taxes, interest rates, technology, exchange risk, etc. As a result of this, profitability of the company is going against the nature.
Risk management is not about the elimination of risk; rather it is about the management of risk. The management can reduce or control their risk exposure by entering into financial contracts.
In the modern world, Derivatives play a pivotal role in finance and risk management. Handling the derivatives requires a thorough knowledge of principles that govern the pricing of the financial derivatives.
A derivative is a financial instrument whose pay-off is derived from an underlying product or commodity. For example, stock option is one of the derivative instruments whose value is dependent on the price of stock. Derivatives include options, forward contracts, futures contracts and swap.
An option is a right to buy or sell an asset at a specified exercise price at a specific point of time. Option is a right and does not constitute any obligation on the part of the buyer or seller to buy or sell the underlying asset.
How does option help reducing risk of a company?
I shall explain the concept with a simple example. One of your relatives is running a cracker shop. He is expecting increase in the price of the crackers during the festival time. To avoid the risk, he approaches a vendor and enters into an optional contract to buy 1000 boxes of crackers at Rs. 500 per box (exercise price) on 31st October 2007. For this, vendor would demand a sum as advance (Option Premium) which is not refundable if he fails to exercise his right on maturity of the contract. (i.e. 0.5% of the contract value).
By incurring a small cost (Opportunity cost), he has bought an insurance against increase in the price of the crackers.
SITUATION 1: Suppose the market price of a box at the time of expiry of the contract is Rs. 550 per box (Spot Price). Since the market price is higher than the agreed contract price of Rs. 500, he will gain by exercising the optional contract. He will be able to buy at Rs. 500 while the actual market price is Rs. 550.
With the help of optional contract he reduces the price of crackers by Rs. 47500. (i.e. [1000 x (550-500)] – [(1000 x 500) x 0.5%])
SITUATION 2: Please think and tell me. At the time of maturity, if the price of box is below the agreed price (say Rs. 475), will the option contract come to an end with the loss of Rs. 25000 [(500-475) x 1000]? The answer is “No”. Because the buyer of the option contract holds the right to buy the underlying asset, not the obligation to buy the same. His loss is limited to the extent of Rs. 2500 (Option premium) only
We may observe from this example that buying an option shields a company from increases in the prices while the company can continue benefiting from the decrease in the prices. Thus, option creates an opportunities to guard against risk and benefit from changes in the prices.
- It’s an agreement between two parties to buy / sell an asset at a future date at an agreed price.
- There is no initial cash flow (like Option premium)
- Cash is paid or received on the due date.
- Forward contracts are obligations not optional.
- It is an Over-the-counter contract.
To do a project, you plan to buy a laptop. You approach a DELL Laptop Dealer. When you go to his showroom, you find that choice of yours is not available for immediate delivery. The shop keeper offers to deliver it to you after 15 days for Rs. 50000 and also states that if you don’t accept the offer, and if you want to buy laptop after the specified period, you will have to pay the actual market price on that day which could be more than Rs. 50000. If you accept his offer, you will be a party to the forward contract. Now you are under an obligation to buy the laptop and pay to the shopkeeper Rs. 50000 after 15 days and he is obliged to deliver laptop to you.
You would notice that a forward contract is similar to an option in hedging risk, but there is a significant difference.
- Under forward contract, both the parties are bound by the contract whereas under option contract, the party has the choice to exercise or not to exercise his right to buy or sell.
- Buyer must take the delivery and seller must make the delivery, But under option, the buyer has a right to decide whether or not he would exercise the option.
A futures contract is like a forward contract. Nevertheless, unlike forward contracts, futures contracts are traded in organized exchanges. Thus, they are liquid. Yet another feature is that they are marked to market. Price differences are settled through the exchange clearing house everyday. The clearing house pays to the buyer if the price of a futures contract increases on a particular day. The seller pays money to the clearing house. The reverse will happen if the prices decrease.
The future contracts are traded on organized exchanges in standardized contract size. For example, the standard contract size of barley in the barley international exchange is 20 metric ton. You can enter into barley futures contracts for 20 metric ton or its multiples. If your requirement is less than 20 metric ton, then you should enter into a forward contract as it can be custom made for your specific requirement.
In the future contracts one partly would lose and another will gain. The profit and loss will depend on the agreed futures prices and the actual price at the time of contract maturity. Suppose the future price of cotton is Rs. 50000/lbs and the market price on that date turns out to be Rs. 55000 /lbs. The cotter seller will receive Rs. 5000 /lbs lesser than market price which is his loss. His loss is the buyer’s gain; he will pay Rs. 5000 per ibs less.
Thus, the seller of the contract gains when the contract price is more than the actual market price on the due date. The buyer of the contract will gain when the contract price is less than the actual market price.
FORWARD CONTRACT VS. FUTURE CONTRACTS
- ORGANIZED FUTURES EXCHANGES: Forward contracts are not traded in any exchange. Future contracts are traded in the organized futures exchanges.
- STANDARDIZED CONTRACTS: Futures contracts are standardized contracts in terms of the amount or quantity as well as the quality of the product. Forward contract are non-standard. They are custom-made depending on the requirements of the parties.
- MARGIN: The buyers and sellers of the futures contracts are required to deposit some cash or securities as margin. This is done to ensure that the buyers and sellers honour the deal. In case of forward contracts, there is no formal requirement of margin.
- DELIVERY: A seller of the futures contract may wait for the contract to mature and then make the delivery. In practice, the seller of the futures contracts buys back the futures just before delivery. Most forward contracts are made to give and take delivery.
It is an agreement between two parties to trade cash flows over a period of time. Swaps arrangements are quite flexible and are useful in many financial situations. Two most popular swaps are Currency Swaps and Interest-rate Swaps.
- CURRENCY SWAPS involves an exchange of cash payments in one currency for cash payments in another currency. Most international companies require foreign currency for making investments abroad. These firms find difficulties in entering new markets and raising capital at convenient terms. Currency swap is an easy alternative for these companies to overcome this problem.
- INTEREST RATE SWAPS allows a company to borrow capital at fixed (or floating rate) and exchange its interest payments with interest payments at floating rate (or fixed rate).
These two swaps can be combined when interest on loans in two currencies are swapped.