In the present world of complex and highly sophisticated technologies, the market risks namely currency, commodity and interest rate risks have increased enormously. These risks with the potential for high returns have forced the corporate sector to plunge into the world of derivatives. These are financial instruments that derive their value from the underlying assets such as commodity, currency, shares, bonds etc. Forwards, Futures, and Options are the commonly known derivatives that are used by the corporations, institutional investors such as banks, hedge funds, etc. and individual investors through the amalgam of speculation, hedging and arbitrage strategies to counter the risk factor or sometimes to gain high returns in future. These alternative investment options have become popular after the 2008's credit crisis especially for hedging the future potential hazardous risks due to high volatility of the international currency and commodity and credit markets.
This paper highlights forward, future, and options and how different companies are using them to hedge their commodity, currency and interest rate risks or speculate for higher future returns. Further, one section explore advantages and disadvantages of hedge funds for the corporate investors.
Forwards
Forward contracts are the those derivatives that are traded Over the Counter and customized agreement between two parties to fix exchange rate( interest, commodity price, foreign currency exchange rat) at present for a transaction to take place as some future date. These contracts are commonly used by the corporations especially the large MNC's through the combination of various strategies to counter the currency, commodity price and interest rate fluctuations. However they come with the shortcoming of counter party default risk. Here we closely take some example to explore how these contracts are being exploited through hedging and speculative motives (David Harper, 2007).
Hedging
Hedging is historically a proven way to hedge against the currency exchange rate risks through using forward contracts. It is one of the tools of risk management to reduce the exposure of corporations to various market risks to the extent of bearable. As the volatility in the international prices of commodities and foreign currency rate have huge impacts on the business decisions and dealings, responsibilities of the portfolio managers of corporate investors increase to manage these markets risks through strategically using various hedging strategies. They also have to justify the cost of hedge in order to avoid prevailing uncertainty in the market.
Forward contract can effectively be used for hedging the foreign exchange risk, when the companies' cash flows are certain otherwise the future option contract is feasible. Moreover these contracts have the feature of customization. Here we take an example of a corporation that uses forward contract to hedge the currency risks and transaction exposure in the international market (Farhad F., 2004).
For instance, under a sale agreement, a U.S. based multinational sales 50 cases of fine quality wine to a company based in Venezuela, and the payment of 15 million bolivares will be received in 60 days period from the date of the agreement. The U.S. based exporter sells the 15 million bolivares to its bank by entering into a 60-day forward rate of 750 bolivares per dollar in order to eliminate the transaction exposure and exchange rate currency risk. This forward contract gives hedge to the U.S based exporter against the exchange rate fluctuations in the coming months, and he will be able to convert 15 million bolivares into U.S. $20,000. If the company faces the situation of paying rather than receiving, it can buy bolivares at the forward rate to eliminate the risk accordingly.
However, for small export or importer these foreign currency risks are difficult to control as these hedging strategies against the fluctuation of foreign exchange rates cost more then potential benefits. So these small export or import oriented companies go for cross hedging as another alternative option to eliminate the transaction exposure. Cross hedge is the hedge in a currency whose value highly correlates with the value of the currency in which the payments or receipts are denominated.
Speculation:
It is a financial term that refers to the investors who want to gain returns from the fluctuation of market prices of currencies, commodities and interest rates. Speculative investors are not only the small individual traders, but this dimension includes big MNC's, banks and certain other institutional investors. Here we take forward rate agreement that can be speculated over-the-counter however the counter party could be the one that is trying to hedge against the potential interest rate exposure.
One of the tools of forward contracts is forward rate agreement (FRA) that is most commonly used with speculative motives by the big corporations and banks. However, some corporate investors and banks use FRA to hedge against the interest rate risks and exposure. FRA is a derivative instrument that is traded over-the-counter. The essence of FRA is that only the difference in interest rate is exchange between the counter parties without the exchange of principal. That is why FRA has become a global instrument of hedging against the risks in the interest rates.
Here we take an example where FRA is being used with the speculative motives. For example an A bank's treasurer has forecasted the rise in the current market interest rate, the bank decides to go for an FRA with the B bank who is trying to hedge against the interest rate risk. A Bank agrees to pay a fixed return of 2 per cent on o notional sum of $10 million USD in one year's time. That is B bank would owe $200,000 USD on this date. However, B bank agrees to pay a return based on prevailing market rate on the same notional sum of $10 million USD in one year's time. The A bank would owe $100,000 USD, if the prevailing rate at that time would be one percent. Thus, B bank would pay the difference between the two sums that is $100,000 USD. If the prevailing market rate reaches to four percent at that time, A bank would owe $400,000 USD, compared with $200, 000 USD which B owed. Thus A would have to pay the difference that is $200,000 USD.
Futures
In order to overcome the shortcomings of forward market, futures as a one of the form of derivatives came into being. These contracts are standardized agreements between two parties to sell or buy a commodity, currency, or stock at a future date, at a particular price fixed upon today. Future contracts have also removed the difficulty of finding a counter party as well as counter party default risk-credit risk. These contracts are more liquid than forward contracts as they are traded over the organized exchanges (CBOT, NYMEX, COMEX etc.) throughout the world (Atkins, A.B., Basu, S. 2003).
Hedging
Hedging in future contracts is commonly used strategy by the big corporations and MNC's that are heavily dependent commodities or raw material inputs which are sensitive and whose prices highly fluctuate at the international market. This hedging enables them to counter the commodity risks. For instance, Airline industry that is the biggest consumer of jet fuel gives huge consideration to hedge against the fluctuations and uncertainty in crud-oil prices. Although, we have also observed a case of a major airline company that faced heavy loses not availing the option of its crude-oil hedges, ignoring the surge in oil prices in near future.
Here we take an example of big multinational that is a producer of agricultural products, herbicides and biotech-related products. Monsanta (NYSE:MON) is exposed to high risk of fluctuation in the prices of soybean and corn. Its hedging strategy pays as it provides hedge against the future purchase and carrying value of payables to growers for agricultural inventories. We can also observe that the fair value of the futures of $15 million for soybean and $10 million for corn would be negatively affected with just a 5 percent decrease in the prices.
Speculation
Most of trading in futures is taking place in commodities especially crude oil. As per the rough statistics, the future contracts by hedge funds, big corporations and institutional investors create 60% to 70% of the world's total crude oil demand and push the prices up resultantly in the international market. These future contracts are mostly bough and sold speculatively. This speculative buying and selling of crude oil future has enabled the future and spot markets to converge and thus additional demand has also been created. It could be observed in the some big mercantile exchange or at international oil market that crude oil demand created by speculative future contracts is jus as real as the demand created by physical future oil purchases by a real oil consumer or refinery companies. The speculative buying in the crude oil futures has pushed up the oil prices higher and this act has thus provided the oil refineries and oil marketing companies an incentive of getting the benefit of higher future oil prices. They are eager to buy even at higher prices at present huge quantities of crude oil to put in storage, keeping in view the surge in future oil prices (Dooley, M.D., Shafer, J.R. 1983).
Options
Options contracts are such future agreements that give the counter parties rights to buy or sell some commodity, stocks, and currency etc. without creating any obligations and traded over the organized exchanges. These contracts are entered into by paying some premium or some sort of fee that depends upon the underlying assets' notional value. The most of the future option contracts are standardized and are tradable on the exchanges however some types of options are over-the-counter tradable such as interest rate options, currency cross options and options on swaps (Hansen, L.P., Hodrick, R. 1980).
For instance, by paying a fee of $10, you have got an option to buy long-term T-bills having face $200 for a price $210 in a year. This gives you the right to buy at $210 unlike obligations that arise in future contracts. If the price of the T-bills goes up in a year, you have the option to buy up or sell it again and if the price goes below $210, you can go without incurring the losses.
Option Strategies
A future option is one of the tools for hedging against the future losses that could happen due to fluctuation in the prices of commodities, currency exchanges and interest rates.
Example, if you are going for a call option, you are trying to hedge against the future potential losses due to surge in the price of assets you need. Similarly, a former has forecasted that his next year's grain demand is 40 tons; he might use a call option just in case the price of grain goes up in the market. In the same way, he might use a put option insuring against the price falls. The basic motive in both of the cases is to hedge against the potential losses in future.
One of the option strategies that are regularly exploited by corporations is forex(FX) option to hedge against the currency risk arising due to exchange rate fluctuations and certain other contingent cash flows.
For example a European export oriented company has anticipated receiving an order for a value of 2000,000 USD from an American buyer. It is also expected that sell proceeds would be received after two months from the date of receiving order. After two months, the European exporter would have to convert the receipt of the funds from USD into EUR. His expectation is 1,384,083 EUR after 2 months, if the prevailing exchange rate between EUR/USD is 1.445. Now suppose that the actual exchange rate between EUR/USD reaches to 1.600 after two months. Let us take a look below to have a clear picture of this fluctuation on the cash flows of the European exporter:
Expected Cash Flow in EUR= 1,384,083 (2000,000/1.445)
Actual Cash Flow in EUR=1,250,000 (2000,000/1.600)
The effect of appreciation in EUR against USD is the less EUR receipts for the European exporter.
In order to hedge against this exchange rate fluctuation resulting in loss, the exporter buy an FX option to Sell USD 2000,000 and buy EUR after two months with a pre determined rate or strike price of 1.445. Now even if the exchange rate fluctuate and rises to 1.600 at that time, he will be able to sell USD at 1.445 after two months.
Arbitrage and Futures:
Arbitrage as a future trading strategy has got a lot attraction at the international trading platform to mitigate the all types of major market risks namely currency, commodity and interest rate. This is also considered to be a risk free trading in futures as the corporate investors are not just speculating over the price fluctuations (Farhad F., 2004).
Some of the common features of arbitrage are as follow:
Arbitrage is less-risky some times called risk free strategy of earning profits in the future as well as spot market without any outflow of capital.
Inefficiencies prevailing in markets make the possibility of arbitrage
In arbitrage process, a less-risky return is earned by simultaneously buying an undervalued asset (commodity, stock, currency etc.) and selling an equivalent asset economically.
A true picture of arbitrage is evident in triangular currency arbitrage. This means that three currencies are traded in different markets and a real arbitrage opportunity is created, when it is found that the exchange rate of a currency in one market is not consistent with the cross-rate in another market.
Due to fast flow of data and information from one market to another market, it is hard to find a true risk-less arbitrage investment opportunity.
As arbitrage strategies are based upon some assumptions in the valuation model, which may be wrong, this factor creates drawback of arbitrage and makes it risky.
The highly sophisticated pricing models based upon the pricing inefficiencies enable today's arbitrage strategies to generate an abnormal high risk-adjusted profit (Farhad F., 2004).
It is often observed that trading between the cash market and the future market of given index provides an arbitrage investment opportunity to the corporate as well as institutional investors. For instance, the cash FTSE is trading at 6,000 while a future contract is trading at 6,050, with a 2% premium on the cash market. This premium of 2% seems fair based upon the cost of capital at 5% p.a., thus leaving no real arbitrage opportunity. However, an arbitrage opportunity appears for short times as the market prices fluctuations lead the futures to overshoot.
Here we further elaborate the above noted example and assume that a 6% interest rate surge was unexpectedly created by the British government. The 1% fall to 5,040 is witnessed in cash FTSE against the slump of 2% to 5,929 thus giving you the real arbitrage opportunity of buying the future contract and selling the cash simultaneously. As the spread between the two prices is not the true representation of fair value, this spread would become wider because the cash would plummet and the future contract would surge. It also works the other way as the spread gets narrow sooner or later.
It also observed commonly that as the markets become more liquid, the arbitrage opportunities dry up. However, it is clear that arbitrage opportunities come with both low risk and reduced rewards as well.
It needs to be noted that cash versus future contracts is not the only trading option where arbitrage opportunities appear. For instance, suppose on the basis of some market research and information that Nikkei is likely to be on the upside, whereas the Dow is expected to go downside. This situation creates an arbitrage opportunity in the form of hedging to sell the Dow and simultaneously buy the Nikkei (Farhad F., 2004).
However, your risk is amplified and greater when arbitrage strategy is done at two different markets as compared to the risk involved in arbitraging cash futures spread. The cash and futures spread usually converge and return to fair value, whereas it is not true for the Dow and the Nikkei, they could have entirely different direction.
Hedge Funds
Hedge funds are increasingly becoming popular in the future market as they are unregulated and unrestricted. These features enable the institutional investors to apply various strategies such as short-selling and may others in order to reduce market volatility and speed up performance. The institutional investors are able to apply various hedging strategies not only to protect themselves but also to get positive returns even in the declining market using the hedge funds. In the following section we elaborate the advantages and disadvantages of hedge funds and how these funds enable the institutional investors to hedge and get positive returns (Barker, B., Hui, B., (2003).
Advantages:
The investment made in the hedge funds often insures the high returns as the fund mangers are highly paid and thus motivated to better manage portfolios of investments using various aggressive strategies.
Hedge funds flourish and become prosper on the basis of one investment rather then a basket of diversified portfolios of investments.
The attractiveness of hedge funds is increasing as aggressive investments strategies such as short-selling or leverage buying can be legally utilized.
Institutional and corporations can gain high gains keeping in view the potential rewards in hedge funds.
In today's future market, arbitrage opportunities can be availed by applying the short-selling and other complex strategies which are available only in hedge funds. In addition, these resources and strategies cannot be applied using mutual funds.
Disadvantages:
The highly risky factor of hedge funds can make the institutions and companies lose millions of dollars in very short time period.
Hedge funds investments are not much regulated.
Very often hedge fund mangers are motivated to go for risky strategies with your money for getting high performance fees.
Most of the time it is much difficult for an individual, institutional or corporate investor to truly assess the strategies of hedge funds and their diversified portfolios of investment as hedge funds are private concerns not requiring any public disclosure.
As the investors get leverage by investing in hedge funds, this factor can also amplifies the potential losses.
Hedge fund investments often involve short time market volatility such as writing off call or put options, which may enlarge the incurred losses (Anonymous, 2007).
Alpha
The smartness of a hedge fund investor that is comparison of his returns with the riskiness of investment is measured through Alpha, whereas Beta simply represents the riskiness of the portfolio of investments. Increasing Alphas has long been the motive of major hedge fund investors by decreasing beta or getting high returns (Anonymous, 2006).
It must be noted that an actively managed hedge fund' performance or returns are measured through using the two broad constituents:
Beta in fact represents the market volatility along with fund movement and how these movements show passive return or increase in fund's value. It is simply the representation of the riskiness of the fund. And
Alpha measure the fund manager's smartness of generating high returns by utilizing different strategies so that his investments out perform the market.
Alpha is commonly used to assess a manager' performance as his performance is represented by the excess returns generated by an actively managed fund in a particular market index. However, alpha strategy comes with both negative factor as well as positive factor. When an active manger under performs and fails to get returns in excess of the market, he is though to have generated negative alpha. Hence the success or failure of Alpha strategy is highly dependent upon the manager selection (Anonymous, 2006).
Conclusion
In short, we have covered three major derivatives (forward, futures and options) and some common corporate and institutional hedging strategies to fight against the three different risks namely commodity risk, currency risk and interest rate risks. Now-a-days many other derivatives have also appeared on the future market such as swaps, freight forward contracts and weather forward contracts etc. for instance, farmers and companies highly dependent on agricultural raw materials often try to hedge against the unexpected weather conditions by using forward weather forecast contracts. We have also observed that speculative strategies in futures are not generally utilized by corporations. These derivatives serve as a tool or shelter for corporations against the adverse interest-rate fluctuations or foreign exchange rate movements and uncertain increases in raw material prices. On the other side of the derivative transaction is a speculator.
In addition, we have also noted that corporations and institutional investors can also gain some risk free gains finding some arbitraged opportunities in future as well as spot market. Some light has also put on the hedge funds and their risks and advantages for institutional and corporate investor with the concept of alpha.
