The Use of Derivatives Markets and Products by a Company - Essay Example

Choosing a company for which information is available and will comprise analysis and comment on the derivatives activities Financial derivatives andcommodity derivatives are the means of hedging risks that corporations face as part of their risk management strategy. (Stutz 1996, pp23-24) Derivatives are defined as agreements value of which is determined by underlying assets without having to be invested with as much amount. (BIS 1995) In this type of contract a place. This feature signifies semblance of derivatives as financial instruments. (Oldani p 1) Derivatives are presented in five forms of contracts namely swaps, forward, future, option, and repo. The fact that five varieties can be combined to give wide flexibility and freedom has led to an astonishing growth of derivatives in financial markets. Derivatives serve as ideal substitutes for complex investment strategies at a minimal cost. (Haugh and Lo 2001) Firms using derivatives have lesser risk exposure than which do not use.(Hentschel and Kothari, 2001) The banks who have used interest rate derivatives have shown higher growth in lending than those banks who do not use derivatives. (Brewer, Minton, and Moser 2000) From Micro-economic point of view, derivatives in different forms have the following functions. Swaps: These are mostly OTC contracts having longer period than options and futures and serve the purpose of meeting needs single client of a Bank or any institution. They afford firms to have new investment opportunities to hedge against any risks in currency rates, interest rates, and credit default etc. It is the periodical payments that represent the risks undertaken by these contracts and not their notional value. Forward: These are OTC future contracts but not designed to serve individual client needs, having some attributes of futures. Futures: These are capable of increasing market efficiency and liquidity. Depending on national and international laws, this type of derivatives display very high transparency and are used to hedge and speculate in financial and commodity segments. Options: These are similar to futures but do not reflect clearly the underlying assets and do not give unique empirical results unlike options. The notional value does not represent the risk undertaken but the premium paid for opening and closing signify the extent of investment. Repos: These are unique to inter-banking transactions between RCB and European inter-bank system and are meant for finance liquidity rather than to hedge or speculate. The use of derivatives by a company is proposed to be demonstrated in this paper by the example of Glaxo Smithkline (GSK), world's one of the largest pharmaceutical giants. GSK uses derivatives among various finance instruments to finance its operations and manage market risks. The company's derivatives are mainly foreign currency contracts, interest rates and currency swaps. It uses them for swapping of its borrowings and liquid assets into currencies needed for the entire group of the plc. It uses derivatives to guard against changes in foreign exchange currency rates and interest rates. The derivatives are not used for speculation but only used to hedge against its own risks stemming from targeted business operations. It neither issues nor holds derivative financial instruments for trading purposes as a company policy. They are initially shown at cost in the Balance Sheet and revalued subsequently on the relevant reporting dates at fair value. The ones that are treated as hedges are designated as fair value hedges, cash flow hedges or net investment hedges. Changes in fair value of derivatives designated as fair value hedges are shown in the income statement with corresponding entries in the hedged asset or liability. Those designated as cash flow hedges are reflected in equity to the extent they are effective. The remaining portion that is not effective is reflected in profit and loss account at the same time. Those deferred in equity are later taken to income statement when the hedged asset results in loss or gain. Investment in foreign entities in the form of hedges are treated in the similar manner as cash flow hedges are treated. Any change in the fair value of a derivative that does not require hedge accounting are immediately reflected in the income statement. The company's annual report 2006 states that since inception its derivative contracts are utilized as an economic hedge of the related financial instrument reflected in accounts and cash flows. Not named as hedges, they are shown in market value and fluctuations in the said values are credited or debited to profit and loss account directly trough out the contract duration. While profit or loss from the hedged transactions in foreign exchange are deferred and added to relative foreign currency transaction at the time of their occurrence, results of balance sheet hedges are accumulated and carried over to reserves except for forward premiums or discounts which are treated as interest over the contract duration. Interest swap contracts have interest differentials and they are adjusted against interest expenditure in the profit and loss account for the life duration of the derivative agreements. The total assets as in 2006 show an amount of m 25,553 inclusive of m 193 represented by Derivative financial instruments as against m 179 as in 2005. On the liabilities side Derivative financial instruments are valued at m (100) & m (150) respectively. Page 143 of GSK's Annual report for 2006 states as follows as regards valuation of derivatives. Valuation of derivative instruments The fair value of derivative instruments is sensitive to movements in the underlying market rates and variables. The Group monitors the fair value of derivative instruments on at least a quarterly basis. Derivatives, including interest rate swaps and cross-currency swaps, are valued using standard valuation models, counterparty valuations, or third party valuations. Standard valuation models used by the Group consider relevant discount rates, the market yield curve on the valuation date, forward currency exchange rates and counterparty risk. All significant rates and variables are obtained from market sources. All valuations are based on the remaining term to maturity of the instrument. Foreign exchange contracts are valued using forward rates observed from quoted prices in the relevant markets when possible. The Group assumes parties to long-term contracts are economically viable but reserves the right to exercise early termination rights if economically beneficial when such rights exist in the contract. ((Annual Report 2006) The disclosures relating to Derivative financial instruments are as follows. (Annual Report 2006) The GSK PLC being mainly concerned with risks of foreign exchange rate and interest fluctuations, it is desirable to know how currency risks and interest rate risks are tackled through derivative instruments. Currency risk When receivables, liabilities, cash and cash equivalents or forecasted transactions are in foreign currencies, a firm stands exposed to currency rate fluctuation risks. The main currency risks to which the GSK PLC is exposed involve all major world currencies except Pound Sterling which is the local currency. Therefore currency fluctuations are monitored and analyzed systematically by its finance department. During the process the scope of hedging is evaluated regularly and defined. Recorded foreign currency operating items and financial items are normally fully exchange-hedged. The anticipated foreign currency exposure from forecasted transactions in the next twelve months is hedged on a basis of understanding by the management officials. As a result a significant proportion of contractual and foreseeable currency risks are hedged through forward exchange contracts, currency options and currency swaps. (Bayer Financial Statements) Interest rate risk An interest rate risk - the possibility that the value of a financial instrument (fair value risk) or future cash flows from a financial instrument (cash flow risk) will change due to movement in market interest rates - applies mainly to assets and liabilities with maturities of more than one year. Such long maturities are only of material significance in the case of financial assets and liabilities. Interest rate risk is analyzed centrally in the GSK PLC and managed by the central finance department using a mix of fixed and variable interest rates defined by the management and subject to regular review. Derivatives- mainly interest rate swaps, cross-currency interest-rate swaps and interest options - are employed to preserve the target structure of the portfolio. (Bayer Financial Statements) The Derivatives concept is almost like insurance premium concept in that when the risk takes place, the derivative premium paid compensates the instrument holder and in the event of no risk taking place, the holder has to contend with the premium paid as an expense. "The key to understanding derivatives is the notion of a premium. Some derivatives are compared to insurance. Just as you pay an insurance company a premium in order to obtain some protection against a specific event, there are derivative products that have a payoff contingent upon the occurrence of some event for which you must pay a premium in advance."(Derivatives explained) In order to promote the use of derivatives as a financial innovation, myths about derivatives should be clarified. 1) That derivatives are new and involve high tech financial products developed by financial experts: It appears that even in times of Aristotle, option contracts had been in use. Aristotle had written story of a poor philosopher by name Thales who had proposed a financial device by which future possibilities of olive harvest could be estimated by his forecasting skills and accordingly he made agreement with olive press owners by depositing a token money he had in order to keep their presses reserved for him for oil extraction when harvest took place. At the time of actual harvest, because of plentiful harvest demand for presses was unprecedented and the Philosopher Thales who had booked the presses let to the harvesters the presses at a very high price. This story of Aristotle written 2500 years ago evidences that the concept of Derivatives is not new. Vanilla variety of derivative instrument is the simplest form available. Variants have since been introduced with more sophisticated and complex structures which are more difficult to measure and manage. Even though there have been continuous innovations, there are still four basic types of derivatives. 2) That derivatives are speculative and highly leveraged. In other words the general impression is derivative are nothing but gambling. The derivatives are not just to hedge against future direction of exchange rates and interest rates but they have come to be used for more volatile markets, deregulation, and new technologies. It was in 1970 when the fixed-rate currency exchange system established in 1944 at Bretton woods conference collapsed, currencies started floating freely. Since then Governmental restrictions on interest rates also were also phased out. This led to unprecedented volatility of financial market since the Great depression necessitating banks to develop risk management measures. First one was foreign exchange forwards enabling parties to a contract agree to buy and sell at a fixed exchange rate at a future date. This eliminated risk in upward and downward fluctuations in exchange rates. This ensured economic viability of projects overseas. This was how derivatives started developing to hedge against certain risks and triggered further development in an explosive manner. Thus around 1980 SWAP contracts were introduced. A swap is a forward looking derivative that renders parties to agree to a series of cash flows on certain appointed future dates. There are interest-rate swaps and currency swaps arranged through private negotiations designed to meet each firm's specific objectives. 3) The present day enormous size of derivatives market overtakes the size of bank's capital considered an unsafe banking practice. The financial derivative market size in the U.S. is now more than $ 20 trillion and is far greater than all banks' capital put together and also is greater than the nation's (US) GDP of $ 7 trillion. The figures quoted for derivatives are only notional and does not involve change from one another. The derivatives credit exposure for 10 largest banks in the U.S. works out to only 15 percent of total assets whereas average exposure is 49 percent of assets for the said banks' loan portfolios. In the absence of derivatives, the loss would be three times more in case of loss of 100 percent of the loans for those banks. Thus derivatives improve economic efficiencies by isolation of risks and distributed to those willing to accept at the least cost. The use of derivatives enables risks to be broken down and managed independently. Viability of financial derivative therefore depends on the notion of comparative advantage. 4) Only large companies and banks have the use derivatives: Though very large companies make use of the derivatives, small firms also can benefit from the derivatives as can be seen from the following hypothetical example of a small bank having $ 5 million total assets. (see annexure 1) Conclusion As stated in the annual report for 2006, GSK employs derivatives among others to finance operations and manage market risks. It does not however use derivatives for speculative purposes. The derivative instruments are mainly forward foreign currency contracts, interest are and currency swaps in order to swap borrowings and liquid assets in foreign currencies and thus manages risks in changes in exchange rates and interest rates. As on 31st December 2006, GSK held total contracts in foreign exchange for maximum one year or less to buy or sell for a total notional sum of 14,687 million. It says that based on the total net debt as on 31st December 2006, a 10% appreciation in the exchange rate of sterling would result in reduction of 210 million and 10% weakening in the sterling currency exchange rate would increase the net debt by 256 million. Similarly, with regards to interest rates, for every one percentage point decrease in the average interest rates, GSK says that it would experience an increase in the annual net interest charge of 5 million. Note 39 to the Annual report of GSK reveals that there had been sizeable underlying assets for their corresponding assets and liabilities shown in the balance sheet below as in 2005 and 2006 It will be clear from the foregoing that derivatives are here to stay and will be the forerunner for many more innovations to come in the segment of Financial Engineering. "Financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage risks. Ultimately, financial derivatives should be considered part of any firm's risk-management strategy to ensure that value-enhancing investment opportunities are pursued. The freedom to manage risk effectively must not be taken away." (Siems F 1997) However the time tested and non speculative alternative strategies like Forward exchange contracts to hedge against future exchange rate fluctuations are still available as alternative strategies to derivatives. While derivatives can serve the financial markets if handled carefully like the GSK without using them for speculative transactions, derivative will always be viable alternative to hedge against risks. The GSK has evidently hedged a sizeable amount of underlying contacts as in note 39 above for small sums of derivative premium with its operations in as many as 117 countries of different currencies. References Annual Report 2006 Glaxo Smithkline PLC accessed January 6, 2008 www.gsk.com Bayer Financial Statements 2006 BIS (1995), Issues of measurement related to market size and macro-prudential risks in derivatives markets, Basle. Brewer, E. - Minton, B.A. - Moser, J.T. (2000), "Interest rate derivatives and bank lending", Journal of Banking and Finance, Vol. 24, No. 3, pp. 353-379. Siems F Thomas 1997 10 Myths about Financial Derivatives CATO Institute. Accessed January 7 2008 Derivatives explained, accessed January 7, 2008< http://www.finpipe.com/derivatives2.htm> Hentschel, L and Kothari, S.P. (2001), "Are Corporations Reducing or Taking Risks with Derivatives", Journal of Financial and Quantitative Analysis, March, Volume 36, No1, pp.93-118. Oldani Chiara p1 "an overview of the literature about derivatives" Stulz, R., 1996, Rethinking risk management, Journal of Applied Corporate Finance 9(3), 8-24. Annexure 1 However, firms of all sizes can benefit from using them. For example, consider a small regional bank (SRB) with total assets of $5 million (Figure 1). The SRB has a loan portfolio composed primarily of fixed-rate mortgages, a portfolio of government securities, and interest-bearing deposits that are often repriced. Two illustrations of how Serbs can use derivatives to hedge risks follow. First, rising interest rates will negatively affect prices in the SRB's $1 million securities portfolio. But by selling short a $1 million Treasury-bond futures contract, the SRB can effectively hedge against that interest-rate risk and smooth its earnings stream in a volatile market. If interest rates went higher, the SRB would be hurt by a drop in value of its securities portfolio, but that loss would be offset by a gain from its derivative contract. Similarly, if interest rates fell, the bank would gain from the increase in value of its securities portfolio but would record a loss from its derivative contract. By entering into derivatives contracts, the SRB can lock in a guaranteed rate of return on its securities portfolio and not be as concerned about interest-rate volatility (Figure 2). The second illustration involves a swap contract. As in the first illustration, rising interest rates will harm the SRB because it receives fixed cash flows on its loan portfolio and must pay variable cash flows for its deposits. Once again, the SRB can hedge against interest-rate risk by entering into a swap contract with a dealer to pay fixed and receive floating payments. Figure 1 Sample Balance Sheet of a Small Regional Bank Assets Liabilities Loans $3 million Deposits Securities $1 million - Interest-bearing $3 million Cash and premises $1 million - Noninterest-bearing $1 million Equity $1 million Total assets $5 million Total liabilities and equity $5 million Figure 2 Effect of Interest Rates on Securities Earnings of a Small Regional Bank Figure 3 Effect of Interest Rates on Net Interest Margin of a Small Regional Bank Rates Drop 300 bps No Change in Rates Rates Rise 300 bps Asset Yield (Loans) 7.00% 7.00% 7.00% Liability Yield (Deposits) -1.00% -4.00% -7.00% Net Margin (w/o Swap) 6.00% 3.00% 0.00% Fixed Swap Outflow -4.50% -4.50% -4.50% Floating Swap Inflow 0.50% 3.50% 6.50% Net Swap Flow -4.00% -1.00% 2.00% Net Margin (w/Swap) 2.00% 2.00% 2.00% Say the SRB currently receives a 7 percent fixed rate from its loan portfolio and pays a variable rate for its deposits that approximates the three-month T-bill rate. The top portion of Figure 3 shows the SRB's net interest margin under three scenarios, all of which assume that the T-bill rate is currently at 4 percent: (1) rates falling 300 basis points, (2) rates unchanged, and (3) rates rising 300 basis points The SRB's net interest margin would decline with rising rates and increase with falling rates. To hedge that interest-rate risk, the SRB can negotiate with a swaps dealer to pay 4.5 percent fixed interest in exchange for T-bill minus 0.5 percent (Figure 4). The net swap flow is shown in Figure 3 under the same three scenarios. In this case, the value of the swap increases with rising rates because the SRB receives floating-rate cash flows and pays fixed rates. As shown on the bottom of Figure 3, the swap provides an effective hedge against interest-rate risk. With the swap, the bank has a guaranteed 200-basis-point spread, no matter what happens to interest rates. Without the swap, the SRB could get badly burned by rising interest rates. Figure 4 Effect of Interest-Rate Swap on a Small Regional Bank The economic benefits of derivatives are not dependent on the size of the institution trading them. The decision about whether to use derivatives should be driven, not by the company's size, but by its strategic objectives. The role of any risk-management strategy should be to ensure that the necessary funds are available to pursue value-enhancing investment opportunities. However, it is important that all users of derivatives, regardless of size, understand how their contracts are structured, the unique price and risk characteristics of those instruments, and how they will perform under stressful and volatile economic conditions. A prudent risk-management strategy that conforms to corporate goals and is complete with market simulations and stress tests is the most crucial prerequisite for using financial derivative products. (Siems F 1997) Read More