2. HOW DERIVATIVES CAN BE USED FOR HEDGING RISKS.
Hedging with Options Contracts
Option contract is an agreement that give a holder the right to purchase or sell currency for an agreed price and at a certain amount of currency at a specified time in the future. However, the option holder is not obligated to exercise the contract. Therefore, the holder has to pay premium to the broker, a firm or individual who carry out the orders to buy or sell currency option contracts on the behalf of holder (Pike & Neale, 2009)
Classification of option contract according to (Bodie & Kane & Marcus, 1999)
Call option, this gives the holder the right to buy a certain quantity of currency at the exercise/strike price in a specified period of time.
Put option, this gives the holder the right to sell a certain quantity of currency at the exercise/strike price in a specified period of time.
Two types of option contract basing on the terms on exercise in the contract according to (Bodie & Kane & Marcus, 1999)
European style options, this allow the holders to exercise the option only on the expiration date.
American style options, this allow the holders to exercise the contract at any time up to the expiration date.
The Group 6 Company October 30 call option is quoted at TZS 500/-, the Group 6 Company October 30 put option is quoted at TZS 1,500/-, while the Group 6 Company spot price is quoted at TZS 28,000/-. The call option is said to be out of the money since its immediate exercise (if possible) has no value. Conversely, the put option is in the money. Suppose the Group 6 Company spot price rises to TZS 31,000/- on October 16, which is the option maturity date. Then, the call holder is better of exercising his right and making a profit of TZS 1,000/-. The call expires in the money, while the put expires out of the money.
According to (Nguyen, 2012), there are two parties engaged in the option contract which are option holder and option writer.
Figure1. Participants in option contract
Option holder/option buyer/option taker is the party which grants another one the option but not an obligation to do or not to do something. In addition, this party has a right to choose to purchase or sell currency at specified price within a certain period of time.
Option writer/option seller/ option granter is the party who is obliged to fulfill that choice in accordance with the terms of contractual option.
Premium is the non-refundable cost for which holder is required to pay to gain the possession of option at the outset regardless of whether option will be exercised or not (Wilmott, 2000).
Hedging with Forward Contracts
Bodie & Kane & Marcus (1999) defined forward contract as a non-standardized contract entered by two parties or more with the intention of exchanging one currency for another at an agreed rate and at a certain quantity on a specified future date. According to (Wilmott, 2000, p 26) in forward contract, strike price is the rate on which one currency is based to be converted to another currency as the contract is exercised. The certain date at which the contract is due to be exercised is called expiration date and also the action to perform the obligation to deliver currency under the terms of contract is called exercise.
Assume that a US construction company, Group 6 ltd just won a contract to build a stretch of road in Tanzania. The contract is signed for TZS 10,000,000 and would be paid for after the completion of the work. This amount is consistent with Group 6 ltd minimum revenue of TZS 1,000,000 at the exchange rate of $0.10 per TZS. However, since the exchange rate could fluctuate and end with a possible depreciation of TZS, Group 6 ltd enters into a forward agreement with CRDB to fix the exchange rate.
Hedging with Futures Contracts
Future contract is a standardized contractual agreement in which two parties promise to exchange one currency for another at a pre-determined rate and at a certain quantity on a specified future date (Arnold, 2010).
As for hedging with futures, if the risk is an appreciation of value one needs to buy futures and if the risk is depreciation then one needs to sell futures. Let’s assume accordingly that Group 6 ltd sold Rupee futures at the rate RM0.10 per Rupee. Hence the size of the contract is RM1, 000,000. Now say that Rupee depreciates to RM0.07 per Rupee – the very thing Group 6 ltd was afraid of. Group 6 ltd would then close the futures contract by buying back the contract at this new rate.
Hedgers are parties at risk with an underlying asset and they decide to take out (buy or sell) derivative instruments to offset their risks. There are 2 hedge positions which are;
This is maintained by the party who commits to purchasing the currency in the future. This is because this party is currently not holding any contractual currency and expects to possess it sometime in the future. Since the party is seen to be short on the cash position therefore, the party wishes to lock in purchase prices and use a long hedge, which reduces the risk of a short position (Jones, 2002).
This is maintained by the party who commit to selling the currency in the future. This is because the party is currently holding the contractual currency. Since the party is seen to be long on the cash position so the party needs to protect themselves against a decrease in prices. Hence, a short hedge mitigate the risk taken in a long position (Hull, 2011)
Figure2. Hedge positions in future or forward contracts (Nguyan, 2012).Hedging with Swaps
Currency swap is the agreement between two parties to swap both the periodic interest payments and principal denominated in one currency into another currency at the agreed upon rate of exchange for the specific period of time. However, on the maturity date, each party is required to return the other the swapped principal sum (Watson ; Head, 2010).
A company agrees to pay its bank semi- annual interest over 20 years, based on a fixed nominal interest rate of 5.5% (per year), and to receive interest payments based on a floating interest rate, say, the 6 month LIBOR rate. Both interest payments assume a principal amount of TZS 1 million. No payment is exchanged up front. Several swaps are traded over the counter, namely, interest rate swaps, currency swaps, equity swaps, and the more recently introduced and controversial credit default swaps. There are several combinations of derivative contracts, such as options on swaps or swaptions, options on futures contracts, and options embedded in bonds, among others.
3. ARGUMENT FOR AND AGAINST THESE OF DERIVATIVES IN HEDGING RISK.
Arguments for (Benefits):
Derivatives help to gain the certainty concerning a future outcome
Under the strong fluctuating currency market, neither of parties is able to predict accurately what actual exchange rate in the future will be. Therefore derivatives for example forward contract assists in the protection of unfavorable exchange rate movement which causes fluctuation that can lead to loss of large amounts of money in firms from the decrease in over sale price or from the sudden rise in imported material cost (Stephens, 2003).
Derivatives allow firms to set accurate budget and stick to the financial plan
This is because the exact values of future transaction are calculated. This also means that derivatives enable firms to focus on their business activities in order to reap the huge profit instead of wasting time, capital and resources on keeping a constant track of fluctuation of exchange rate (Stephens, 2003).
Unable to withdraw from the contract
Once the two parties enter the derivative contracts for example forward contract, they are legally obliged to carry it out up to the maturity date even if the business circumstance changes. However, (Stephens, 2003) argue that if one party seeks to withdraw from the contract will certainly suffer from the relatively high cost of cancellation. This means that when it comes to the situation in which the exchange rate in the market moves against one party’s interest, the firm is not allowed to withdraw from its contracted position in order to grab profit from such a profitable movement (Watson & Head, 2010).
High degree of credit risk arising from two sources
Firstly, there is no initial cost or deposit requirement when undertaking the contracts. Secondly, the gains and losses between two parties are figured out at the time the contract becomes mature and related currency are delivered at the pre-determined price. Consequently, it is quite an inducement to the party going to suffer from the loss, or to the party which no longer need to trade the contractual currency, to default on the forward contract (Hutchninson & Thornes, 1995).
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