Despite their unpredictable nature, financial markets have become one of the most dynamic and popular investment arenas in the world today. The Economist, in "Mapping the Markets", mentioned that the global markets churn out a combined volume of billions of dollars during daily tradings. This is a major factor why investing in equities, currencies or commodities has stirred the interest not only of veteran private investors, but also of individual neophytes.
While the markets arguably hold huge economic potential, investors can only achieve actual success through careful assessment of their financial goals and the proper use of instruments designed to address their needs.
Thanks to the availability of a wide array of multimedia information resources, investors these days have the opportunity to become more sophisticated and aware of the possible investment risks and gains.
Financial derivatives are some of the investment tools that allow investors to use the market more efficiently. Aside from acting as an insurance that shields portfolios from the eventualities of a fall-off, derivatives can also be used to hedge the risks associated with market investing. As the name suggests, derivatives derive their monetary value from the value of the underlying asset (equities or commodities) they are structured upon.
Its intricacy had raised a few eyebrows in the financial community over the years. The nagging question on whether derivatives are good or bad, however, may even be considered out of context if we look at this tool in a deeper perspective.
For investors, the rule of thumb that should always apply is: decide first the risks you want to mitigate and the investment strategy you want to apply before you consider using derivatives. The risk in using derivatives products lies in the possibility of using a particular tool for the wrong reason. Simply put, if you hit your hand with a hammer, don't blame the hammer!
When should an investor consider derivatives?
A good illustration of appropriate uses of derivatives could be demonstrated in the following examples, which are based on commodities and equities:
If a transportation company, which is heavily dependent on fuel for the day-to-day operation of its business, is concerned about the rise of oil prices, it can shield itself from possible fluctuations by buying a "futures". A type of commodity derivatives, "futures" would allow the company to be guaranteed a fixed price for a fixed amount of oil on an agreed-upon delivery date.
If the price of oil goes up, the transport company gets compensated for the loss of profit due to price hike. But, if the oil price goes down, the company does not enjoy profit increase. In summary the transport company profits are immune from the oil price fluctuation.
Another approach that the transport company could take would be to pay in advance an agreed or predetermined premium. This is also known as a "call option". With this product, the company is covered from losses if fuel costs go up. In contrary to the strategy based on "futures", the company would also earn additional profit if oil prices go down.
If a professional investor anticipates that the price of certain stocks will rise, instead of buying the actual stock, the investor can use derivatives to optimize returns by either:
Buying futures so that if the shares do rise, the profit is multiplied but if the reverse occurs, the losses would be multiplied as well.
For instance, supposed an investor buys notional futures for the cost of "zero" which give him exposure to $3m worth of a certain stocks. Depending on its market performance, the stocks could either rise by 10% or drop by 10%, meaning the investor could earn $300,000 or lose $300,000.
The investor can buy a call option which gives him an exposure to $3m worth of a certain stocks that has a predetermined guarantee of 5 percent for a cost of $150,000, in the event of the market moving 10% in either direction, the investor could either lose $150,000 (the premium paid by the investor) or earn $300,000 (minus the premium of $150,000 the investor already paid). The maximum loss being the premium paid while the upside is unlimited.
financial derivatives becoming popular
Derivatives have been generating a growing interest in the investment community mainly because of four reasons: accessibility, efficiency, standardization, and general awareness.
Accessibility. Investing in physical commodities (such as oil) requires a lot more infrastructure than investing in derivatives that are linked to the commodities. Take into consideration the transportation company.
Even though it has the money right now to buy $1 million worth of crude oil, it cannot be expected to physically buy and store say 7,400 barrels of oil (with each barrel containing 159 liters of fuel). Instead, it may opt to buy futures or call options of oil, which is more logical and convenient.
Efficiency. As earlier mentioned, with derivatives, investors have the opportunity to get exposed to certain volume of shares at a fraction of the actual stock price. For example, investors could buy exposure to $1m worth of stocks by paying only $100,000, whereas direct equity investment would mean they have to pay the actual equivalent of those stocks, which is $1m.
Standardization. Because derivatives are traded in exchanges, standards are maintained, regulated and ensured by financial houses. Thus, investors are assured that contracts and volumes of derivatives traded follow a set of governed standards, further eliminating disparity or inconsistency in the market.
General awareness. The number of published articles, both in print and online, about derivatives is an indication of the growing public interest about those particular investment tools.
current status of equity derivatives in Gulf
The GCC is in the initial stages of developing a derivatives market. Few countries have developed regulatory frameworks to allow the development and trading of derivatives products, examples are Kuwait and UAE (the Dubai International Financial Exchange and the Abu Dhabi Securities Exchange have recently announced their plan to introduce a derivatives platform).
The financial community is hoping that the regulatory body overseeing the Economic City in Riyadh would put forward the necessary framework to allow structuring and trading of equity derivatives. All eyes are on the oldest financial market in the region, Bahrain, and the newest financial center, Qatar, as they introduce the necessary regulations and continue to participate in the evolution of the Gulf's financial sector.
Although there are regulatory challenges, there has also been an active but private derivatives market (as opposed to public trading through exchanges) taking place in the GCC in the form of over-the-counter (OTC) trading of derivatives products. This is a tailored derivatives contract between two parties who agree to the terms and conditions of the contract.
It has been difficult to accurately estimate the size of the OTC market given the fact that transactions are private in nature. Their existence, meanwhile, is proof of the market's appetite for this kind of financial product and the investment requirements that they want to satisfy. The golden rule is: as a professional investor, you must define your investment objective then select the most appropriate investment tool.
By Dr Laurent Dambly, Executive Director and Head of Capital Markets, Arqaam Capital
© The Peninsula 2008
