What are Financial Derivative Products?

By A. D. D. Akmeemana

There is a serious discussion going on about financial derivatives (a kind of financial instruments) in the media, political circles and other sections of the general public after the disclosure of the Ceylon Petroleum Corporation's (CPC) hedging activities and the alleged losses suffered by the CPC due to these transactions. It seems, quite understandably, that only a few in the general public has any understanding about theses financial instruments.

Our objective here is to provide a basic introduction to a highly technical area in finance. These instruments are being used for speculative and risk management purposes by highly sophisticated and experienced professionals. We will not discuss any of the CPC's alleged activities relating to hedging transactions. It is purely an educational discussion to make the public aware of what these instruments are and to explain how they work. We will stick to the risk management aspects of the contracts for simplicity. We will not discuss about the pricing of the derivative, because it is a highly technical and mathematical in nature.

There are two kinds of financial instruments, fundamental and derivative. Stocks and bonds are fundamental instruments. Anybody with money can invest in stocks and bonds.

A coupon bond holder's income will be the interest earned if it was purchased in the primary market and held till maturity. If a coupon bond is bought in the secondary market, income will be the interest received plus any capital gain realised. Income of a stock will be the dividends you receive, if any plus any capital appreciation at the time of the sale of the asset.

Instead of buying stocks or bonds, the investor can buy derivative products for the same purpose, to make money or to hedge any long or short positions.

A derivative instrument is a contract whose value depends on something else, commodity, security or an index. The value of the derivative instrument depends on the value of the underlying asset.

Forward contracts

Derivatives are bought and sold for speculative and risk management purposes as mentioned earlier.

Financial derivatives are forward contracts, futures contracts, options, options on futures, swaps and options on swaps. We will explain the very basics of them. Forward contracts sometimes are very simple arrangements we all use at times. For example, one agrees to buy a piece of land at one point in time but requiring the parties to execute the terms of the contract at a future point in time.

A person who has a small plot of rubber might agree to sell the next crop to a trader at an agreed price at present but the rubber to be delivered and to receive payment on a future date. The buyer and the seller secure the terms of the contracts at the time of the agreement. But most forward contracts are not that simple.

There are two groups of people who deal with forward contracts, speculators and hedgers. For example a builder may need timber in three months time. He expects timber prices to go up in the near future and does not want to buy and store it. There is a timber dealer who has timber and expects the prices to go down. Both of them can come to a contract today to hedge their perceived exposure to market volatility.

There is another group of people who assume risks for profit called speculators who bring liquidity to the market. For instance a person who wants timber in three months does not have to find a person who has timber to sell in three months because speculators come forward and assume the risk for a price. Both parties hedge their perceived exposure.

The contracts are negotiated by the parties involved (there are brokers to bring the parties together) and there is no structural arrangement to support the parties, which is a drawback of the forward contracts. The biggest advantage of forward (OTC ) contracts over futures contracts (discussed later) is the flexibility, and they can be structured according to the requirements of the parties. The biggest drawback for hedgers in developing countries like Sri Lanka is also the same flexibility.

Futures contracts

The party who has more information, knowledge or any other influence over the counterparts, can take advantage by structuring the contract to their benefit at the expense of the other party. According to economic theory, the market system fails in a situation like this due to asymmetric information and moral hazard.

Futures contracts are special forms of forward contracts that are designed to reduce the disadvantages associated with forward contracts. They are nothing more than forward contracts whose terms have been standardised so that they can be traded (much like securities) in the marketplace.

Standardisation makes futures contracts less flexible than forward agreements, but it makes it more liquid.

There is no futures exchange operating in Sri Lanka. In a futures market like Chicago Mercantile Exchange all contracts are standardised as to the quantity, price, delivery date, settlement and the other major terms of the contract. Participants do not have to find counterparties and contracts are transparent because they are created by the exchange.

The exchange is the clearing house and parties are dealing directly with the exchange which takes the responsibility of the performance of the contract. This is a very efficient market and futures contract prices are indicative of the future spot prices; and this feature is known as price discovery.

The parties who enter into a forward contract are on their own, and they have to take all precautions to safeguard their interests. If the participants are not experienced professionals, it is advisable for them to deal with an exchange rather than getting involved in forward contracts.

In case the participants cannot find exactly what they want in a futures market, still they can find something very close to their requirements because markets are nearly complete in economic sense. Futures contracts can be closed out by entering in to an offsetting transaction, making physical delivery or cash settlement. Compared to futures contracts, forward contracts are illiquid, have credit risk and are unregulated.