Hedging and its potential for economic development

W. A. UPANANDA

Senior Lecturer, Department of Banking and Finance, Wayamba University

Oxford Dictionary defines hedge as a row of bushes closely planted together as a boundary to a field. The above meaning connotes avoiding and protection against losses or damage that will incur in the future.The same meaning implies in financial markets as well, particularly, in market for derivatives.

The word derivative is defined in the Oxford Dictionary ' as derive from something else'. Something else connotes involvement in indirectly.

In financial markets, derivatives are financial contracts whose values are determined by the underlying assets. In other words assets are not directly traded but things that change the values of these assets (interest rates, prices, exchange rates) are used to develop financial contracts to hedge against risk.

Financial markets, similar to other common markets, are places where surpluses are traded to deficit buyers. In a market there are three types of traders - risk takers (speculators) and risk avertors (hedgers) while the third category is arbitrageurs (profiting from mispricing). Hedging is a means of protection from future risk on existing investment.

Therefore 'hedge' in financial markets can be defined as a transaction in which an investor seeks to protect a position in the spot market by using an opposite direction in derivatives.

In other words, you have to take a reverse decision in derivatives to insulate against possible adverse effects on underlying asset.

Financial instruments are means by which people invest their money (bonds, stocks, and currencies). Also they can invest on financial contracts, such as futures, options, and swaps which will be explained later.

These are made on the basis of the values of bonds, stocks, and currencies (fundamental instruments) and termed derivatives.

Risk aversion is the common feature of these derivatives. Other terms used in option contracts (right either to use or not to use buy or sell at a specific price and date) are cap and collars. Cap is the upper limit setout by a seller and assures payment over that cap price.

Floor is the price setout by the buyer (Government of Sri Lanka) as the lowest price which the Government wants to maintain.

Collar is the band of prices that the government of Sri Lanka anticipates and simultaneously buy the cap and sell the floor).

Strip hedge is a similar term which describes a series of rates or prices that will be held for short-terms covering the entire contracted period (four three-month periods to cover twelve months).

Risk arises from future uncertainty of the outcome and no merely on the uncertainty. For example risk is associated with almost all the events of a life including life itself. Life insurance policies are there to transfer your risk in monetary terms to mitigate the impact of sudden death or permanent disability(death is certain but not known the date).

Insurance company charges a premium for taking your risk. Likewise risk bearers in the market for derivatives charge a premium for taking others' risk.

Market for derivatives

The financial instability arisen in 1970s as a result of collapsing fixed exchange rate regime and the market for derivatives emerged. Financial derivatives are evolved as a vehicle for two economic activities: reducing risk of uncertain future and creating opportunities for speculation.

Although derivatives are mainly concerned about financial instability, it could be used for many situations and commodities where price fluctuations occur. Derivatives in financial markets are forwards, futures, options, and swaps.

More importantly, there are methods of combining several derivatives and or non-derivatives to make a tool, which is not existing, in the market to adverse risk but match the investors' interest.

This is called financial engineering and it is the responsibility of financial institutions including the Treasury to make tools which are not available in the market to match requirement of the country. Basic rule in financial management is 'innovation, doing something creative, has a profit while imitation has a cost.

Futures and forwards, derivative products, are involved in determining prices and rates now for future cash flows. Option, another derivative product, provides right but not an obligation.

For example if the prices or rates of the underlying assets (stocks, bonds etc..) are less attractive than the rates stipulated by the option , the holder can ignore it.

However, that liberty also has a price. That is called 'option premium'. The buyer has to pay value of the stock and the option premium. Forwards, futures, and swaps have no premium since they were obligations.

Forwards, has the longest history in literature. It traces back to Shakespeare's 'The Merchant of Venice'. Antonio signed a forward contract with Shylock for a specified amount of money to be paid in future date in exchange of one pound of flesh from the chest. When the obligation was not met, the value of the contract went up by several folds but Shylock refused to accept any bid other than the pound of flesh.

It was settled only before the courts where Potia (fiance of Antonio) was able to convince the court that the contract cannot be executed without harming her client (Antonio). That is, pound of flesh cannot be extracted without dropping blood. In this example pound of flesh was not traded but the contract. Similarly forward contracts are sellable if they are conformed to the assets traded in the financial market. This is very important for Sri Lanka to develop a market for derivatives and it should not necessarily a financial instrument but could be one which has similar characteristics of money.

Minimising losses due to hedging

This is not an easy task since hedging itself is a device for reducing risk. As explained earlier, market for derivatives evolved through the act of attempt in reducing risk or hedging.

Minimising losses due to hedging have to be viewed from several perspectives:

(1) extent of protection received from hedging.

(2) How prudent in selection of an alternative from several options.

(3) Value base used to compare the alternatives

(4) Time taken to flow benefits (expected cash flow)

(5) Risk premium (advantage of taking the risk).

The extent of protection received has to be measured on the value base used to compare the worth of alternatives. The spread (difference between the lowest and highest value), time value of money, and financial environment is also important to minimise losses in the event of reducing risk.

To understand the alternative derivative products available for hedging is needed to make a financial decision. As explained above, forwards and futures are agreeing on a quantity of financial instrument (stocks, bonds or oil) at a price determined now on a future rate or price at a specific date. Financial options are derivative products which are consisted of two sub products - put option and call option.

These are rights either to buy or sell specified quantity of stock or bonds at a specified rate in a future date or within a period of time.

The option holder has a right not obligation to buy or sell the as agreed or to ignore it if things are unfavorable. But this option can be gained by paying a premium. Usually portfolio management is a common way to reduce the future risk. That is to invest in several options to spread the risk.

Falling prices could be a gain or another form of investment. Hedge strip is also a way of spreading strip. Because one has to break down total time span into shorter time periods (two or three-month periods) to cover the total contracted period. Forecasting the spread is another thing used in hedging - the range between lowest and highest prices. There are sophisticated tools to forecast the spread taking all factors related to demand and supply into consideration.

However, the most important way of reducing hedging risk is through financial engineering. Financial engineering is the method of making appropriate financial tools, which are not currently available in the market, in conjunction with other instruments derivatives or otherwise).

Risk-reward portfolio is a means of getting closer to the requirement of the country rather than selecting one strategy available in the market for derivatives.

It is also a main responsibility of state-owned financial institutions develop such tools.

The next part of this article is devote to how derivatives market could be use for capital market development and economic development.

Using market for derivatives for economic development

In Sri Lanka, no exchange is developed to trade derivatives. Therefore hands-on experience in trading derivatives is lacking among our financial institutions. However, there are forward sales contracts where one can develop further to make a market for derivatives. The factors involved in the evolution of market for derivative in the West is important for one to develop a derivative market.

The collapse of fixed exchange rate regime was the starting point of market for derivatives.

Then the basic requirements for a derivative market would be: price fluctuation, ability to develop freely tradable instruments, presence of speculators and hedgers, feasibility to develop an exchange which takes the responsibility of executing the contracts.

Most of the above requirements are embodied in agricultural commodities particularly in paddy and cereal grains, potato, and onion. Prices of these commodities fluctuate seasonally (vary with the rainfall). Farmers do not get all the information before allocating resources for production.

There are four basic questions to be answered when allocating resources:

1. What to produce?

2. When to produce,

3. How much to produce?

4. How to produce?

Market provides information for first three questions while technology answers for the fourth.

Emulating characteristics of money would help develop derivatives to determine the type ( commodity), time, and quantity required to a reasonable degree of accuracy.

It also can signal the technology to be adopted, the varieties to be used, and the quality of product. Providing training and assist in establishing forward contracts will pursue producers allocate their resources rationally.

Intervention of the Government is needed at the initial stage to monitor the execution of contracts as in Chicago Mercantile Exchange (CME) or Chicago Board of Trade (CBOT), the biggest futures exchange in the world. Silver lines are rare in non-monsoon clouds.

Hedging is a rare silver line that emerged from the petroleum cloud to enlighten the gloomy state of the farming community in the country.

It is up to the policy makers to use capital market instruments in stimulating the allocation of resources rationally.