Principles of Islamic banking and finance/PIBF203/Hedging and derivatives/Uses of derivatives in conventional finance

Derivatives are used for several purposes. In this session you will learn three main uses of derivatives.

Uses of Derivatives

(a)Use of conventional derivative instruments for risk management (hedging)

Risk management is the process of identifying, assessing and minimising risk in any commercial operation. Banks, financial institutions, corporate houses and individuals face diverse risks in commercial operations including interest rate risk, currency risk and counterparty credit risk. The process of risk management aims to reduce (or, as the case may be, eliminate) risks by managing cash-flows efficiently, with a view to ensuring that there is no mismatch at any material point of time, between the cash-flows to an entity and the cash-flows from that entity.

Using conventional derivatives for risk management constitutes at least 10% of the OTC derivatives market, and can be illustrated by way of the following example. Let us assume that at the beginning of a crop season (e.g. 11 January 2009 (T1)), a wheat farmer (F) and a miller (M) enter into a contract whereby M agrees to buy and F agrees to sell 100 bushels of wheat at the price of £2 per bushel at the time of harvest (e.g. 11 June 2009 (T2)). By entering into this contract, both F and M have managed (hedged) their respective risks in the following manner:

(i)F knows (on T1) the price at which he will be able to sell the wheat (on T2) and can accordingly (i) make investments in fertilizers, seeds, etc.; and (ii) plan future profits; and

(ii)M knows (on T1) what price he shall be able to buy wheat at (on T2) and can accordingly plan ahead in terms of pricing and marketing activities.

The contract described above is a basic example of a type of derivative contract known as a forward contract. If the same arrangement was mirrored through a clearing house or exchange (C) (whereby C buys the wheat from F and M buys the wheat from C), it would give rise to a futures contract. An exchange minimises the possibility of a default by either party by requiring the payment of an initial ‘margin’ and regular posting of the ‘margin’ based on marked to market calculations . Through this process, losses are recognised as they occur and the party which is out-of-the-money (i.e. the party with the losing position) is required to top-up its existing margin whenever a ‘margin call’ is made by C. Over the years, with increased sophistication among market-players, the concepts of ‘marked to market’ and ‘margin call’ have, along with other related concepts, evolved substantially.

Another type of derivative contract is the options contract. In the example above, if M paid a premium to F on T1 and acquired the right (but not the obligation) to buy 100 bushels of wheat at the price of £2 per bushel on T2, the contract would be regarded as an options contract whereby M has purchased a call option from F. M’s decision whether or not to exercise the option on T2 would depend upon the spot price of wheat in the market on or about T2. For example, M would (i) exercise the option if the spot price was £2.50 on or about T2 (M’s option would then be regarded as being in-the-money); and (ii) not exercise the option if the spot price was £1.50 on or about T2 (M’s option would then be regarded as being out-of-the-money).

In the above example, M knows that he needs to pay £200 to F on T2. Let us assume that M’s income source is in US Dollars (US$). In such a situation, M might want to enter into a contract with a bank (B), whereby on T2, (i) B agrees to pay M £200, and (ii) M agrees to pay B US$ 300. This would be a swap contract, by which M hedges its foreign exchange risk.

(b) Use of derivative instruments for arbitrage

Arbitrage is the practice of taking advantage of a price differential between two or more markets – i.e. striking a combination of matching deals that capitalize upon the imbalance, with the resulting profit being the difference between the market prices. Arbitrageurs closely follow the quoted prices of the same assets / instruments in different markets and if the prices are significantly divergent, to make a profit (taking into account any applicable transaction costs), enter into an arbitrage transaction whereby they buy the asset from the market having the lower quoted price and immediately thereafter, sell the same asset in the market where it has a higher quoted price. This type of use of derivative instruments requires substantial investments in global networking and telecommunication technologies, with a view to exploit potential arbitrage opportunities. Arbitrageurs may also look to take advantage of a market situation where the current buying price of an asset is lower than the sale price of that asset in a futures contract. Unlike speculative transactions (described in paragraph (c) below), arbitrage transactions are not ‘zero sum games’ (as a gain by the arbitrageur is not directly linked to some other market player’s loss) and can be used to harmonise and regulate international prices.

(c) Use of derivative instruments for speculation

In the example in paragraph (a) above, M had a genuine trade interest guiding his decision to enter into derivative contracts. However, the same types of contracts (i.e. forwards, futures, options and swaps) can be entered into purely with an objective of making a speculative gain. For example, a speculator (X) can enter into a forward contract with F to purchase 100 bushels of wheat at £2 per bushel on T2. This would be based on X’s belief (fuelled by market intelligence and investment analysis) that the price of wheat will not be less than £2 per bushel on T2. On T2, (i) if the price of wheat is £1.50 per bushel, X pays £50 to F ((£2 - £1.50) x 100); or (ii) if the price of wheat is £2.50 per bushel, F pays £50 to X ((£2.50 - £2) x 100). Unlike derivative contracts for trade hedging purposes, in derivative instruments used for speculation, there is typically no actual delivery of goods (e.g. wheat, in the above example) from one party to the other, as participants in such contracts take market positions without taking off-setting positions under corresponding derivative contracts.

Benefits of conventional derivative instruments

In today’s sophisticated global financial markets, derivative instruments can, if used prudently, contribute significantly to the welfare of all market participants in the following ways:

(i) The use of derivative instruments for hedging purposes contributes to risk management and enables such users to formulate more accurate business plans by reducing uncertainties;

(ii) Derivatives are crucially important to facilitate price discovery, as futures market prices depend on a continuous flow of information from around the world and require a high degree of transparency. This flow of information reduces distortionary effects of government regulations and other externalities and facilitates the proper re-alignment of prices;

(iii) Increased trading volumes lead to lower transaction costs, leading to an increased ‘value-for-money’ for market participants;

(iv) Derivative instruments help to channelize more institutional money to emerging markets, as such instruments can be effectively used to manage market, credit and interest rate risks in underdeveloped local capital markets;

(v) The availability of derivatives increases liquidity in underlying cash markets, since market makers inject substantial liquidity into (i) the options and warrants markets; and (ii) the underlying stocks that they trade in; to hedge their market making activities in the derivative markets; and (vi) Since the returns generated from derivative instruments are not correlated to more traditional instruments, derivatives contribute significantly to portfolio diversification and effective portfolio management.