‘Futures’ and ‘options’ – is the investment secure or risky
“Most of the sad experiences with derivatives have occurred not from their use as instruments for hedging and offsetting risk, but rather, from speculation “ observes Stephen A. Ross, Randolph W. Westerfield and Jeffrey Jaffe (2004). As the name signifies is a financial instrument whose pay offs and values are derived from or depend on something else. For example an option is derivative and the value of call option depending on the value of the underlying stock on which it is written. Call options are a complicated version of derivatives. It may be observed that most of the derivatives are forward or future contracts which are otherwise known as swaps. Derivatives are generally used by the firms as effective tools for changing the risk exposure of the firm. The derivatives help the firm to getaway with the unwanted risk elements in their financial transactions. The firms may also adapt themselves to the practice of using the derivatives for transforming some of their risks into different forms and meet the challenges posed by the changing circumstances in the financial arena.
This paper attempts to bring the salient features of two forms of derivatives ‘Futures’ and ‘Options’ and also analyse the characteristics and nature of both of these financial instruments and determine how safe they are as investments. The paper also aims to discuss the associated risks with each of this derivative and how does it affect the investment decision of a firm.
2.0 HEDGING AND SPECULATION:
Before we proceed to analyse the nature of the two derivatives which are our subjects for the paper, we should acquire a basic knowledge about the two important activities associated with such derivatives being “Hedging’ and “Speculation”. These two transactions narrate the use of any form of the derivatives by the firm, be it is futures or options.
Risk is always an unwanted guest in the financial discipline. However individuals would like to face risks if the rewards are more. That is an individual would invest in risky securities if he feels that he may get an enhanced return for his investments in the future. By a similar analogy, a business firm would engage itself in a risky project if there are concrete indications that the project will benefit the growth of the firm by offering enhanced returns in the future. So when the firms take such kind of risky proposals for execution, they are forced to look into ways of protecting themselves from the risks against unforeseen political or economic developments that may affect the future of the project and thereby substantially reduce the expected returns from the project to the detriment of the firm. When the firms reduce their risk by way of derivatives we call it as ‘Hedging’. Hedging offsets the risk of the firm such as the risk in a project by one or more transactions in the financial market.
Another form transaction which merely changes or even increases the risk of the firms are also usually entered into which are known as ‘Speculating’ – on the movement of some economic variables. Speculation is done with respect to the certain underlying financial instruments. To illustrate suppose a firm purchases a financial instrument as a derivative with the idea that the interest rate would go up in the near future and the firm have not made any arrangements for offsetting the risk of expected changes in the interest charges, then the firm is said have entered into a speculative transaction. Speculation since depends on the future change of economic conditions is a risk enhancer as opposed to Hedging where the firm gets its risk reduced or transformed into any other form. If it so happens that the opinions or predictions about the changes in the economic conditions proved wrong then the consequences will be very dear and will cost the firm huge financial losses. There are examples in the financial history of firms losing billions of dollars on these kinds of transactions. We can cite the example of the US firm MG Refining and Marketing (MGRM) and its German Counterpart Metallgescelschaft (MGAG) who were reported to have lost more than $ one billion in their oil futures transactions.
“Speculators – these are the risk takers. They buy or sell futures contacts to try and make a profit and have no interest in price protection because they do not use the actual good. Speculators look at chart patters, fundamentals, demand, supply, and other factors about an individual commodity and make a buy/sell decision based on where they feel the price will be in several days, weeks, or months.” (O’Brien, 1989)
The above explanation on the two terms was necessary to make an analysis of the nature of futures and option contracts and to determine how far they take the characteristics of Hedging or speculation, based on which some conclusion may be drawn on the risk element involved in entering into these derivative transactions.
“Futures are a financial contract that includes the vending of monetary mechanisms or physical products for upcoming (future) deliverance. Trading is done on a commodity exchange. Futures contracts strive to predict as to what will be the worth of an index or product in the future. A person is fundamentally assenting to acquire something that a vendor has not produced so far. The futures contract will state the price that will be paid and the date of delivery – more on this later”. (Zigler, 2003)
As we discussed, the Derivatives may take the form of a forward contract or a future contract. In order to understand the meaning of the terms associated with the derivatives we can consider the following example: On April 1st person ‘A’ goes to a book shop and asks for a certain title by a specific author. The shop owner expresses his inability to supply immediately as that particular book was out of stock and he promises to reorder the book and deliver on May 1st at the actual price of the book at $25. A’s acceptance to pick up the book as per the offer from the shopkeeper, on the May 1st signifies the following:
· A has entered into and buying a ‘Forward Contract’ with the Book shop owner.
· In commodity parlance A will be ‘Taking Delivery’ when he picks up the book on May 1st.
· The book may be termed as ‘Deliverable Instrument’.
· The book shop owner is ‘Selling a Forward Contract’.
· When the book is delivered on May 1st, it is called ‘Making Delivery’.
· No cash changes hand on April 1st when the contract is entered but only when the book arrived and delivered.
Thus from the foregoing example it may be observed that the forward contract is nothing special but one which happens in the ordinary course of business, as every time a firm orders for certain goods which are not available for immediate delivery and accepted for a future delivery a forward contract is entered into. Usually for larger contract written agreements are entered into. It may be noted that unlike options, in forward contracts both the buyer and seller are under obligation to perform under the contract, the seller has to make delivery and the buyer has to take delivery by honoring the contract. Forward contracts are different from cash transactions where the exchange of cash and commodity takes place at the same time.
The above discussion as a detour from ‘futures’ was necessary because ‘Futures’ are kind of forward contracts which takes place in financial exchange. Contracts in financial exchanges are usually known futures. Although basically futures are forward contracts there are some fundamental differences. They are:
Unlike other forward contracts, a futures contract can be delivered by the seller in any day during the delivery month. This gives the liberty and choice to the seller to select the day on which the commodity is to be delivered. When the seller decides to deliver, he intimates the exchange clearing house concerned which in turn will intimate the buyer. As there will be many buyers for the same commodity, the exchange will decide any buyer at random and intimate the buyer so selected. At this instance the buyer should be ready to take delivery in a few days. Obviously since there are many buyers and the ultimate buyer is selected by the exchange clearing house, there is every chance that the original buyer who contracted with the seller may not take delivery
Futures contracts are usually transacted though exchanges. Since the transactions are carried through the exchange the buyer and seller are given the option of netting out their contracts. They buyer can net his futures position with a sale and similarly the seller can net his futures position by a purchase. If a buyer does not sell his contract he may have to take delivery of the commodity.
The prices of futures contract are ‘marked to the market’ on a daily basis and the transactions completed everyday. The buyer and seller both are required to keep some deposit with the exchange as ‘Margin’. The details of how the transactions take place in the commodity exchange and how the settlements are made between the buyers, sellers and the intermediaries as well as the exchange are beyond the scope of this paper. Hence the discussion stops here with the remark that ‘mark-to-the-market’ is an important aspect in the futures contract and although there will be so many intermediate cash transactions, the buyer will ultimately pay the price at which the buying of the futures was contracted.
Futures contracts are discernible to market every day at their settlement prices which is determined at the end of the day, and ensuing daily profits and losses which are conceded by means of gaining or losing financial records. Futures contracts can be terminated via counterbalancing the transaction carried out at some time before the contracts expires. The immeasurable popularity of futures contracts are concluded by counterbalancing or by means of a final cash disbursement rather than by deliverance. (Black, and Scholes. 1973)
Options are quite contrasting in nature to the Futures contracts. An ‘Option’ is a contract giving its owner a right to buy or sell an asset at a fixed price on or before a given date. Option contracts are unique in the sense that they give the ‘right’; but not the ‘obligation’ to do something. It also gives the choice to the buyer to use the option only when it works out to his advantage. Otherwise he may disregard it. Just as in the case of futures, options are also having certain terms to describe the underlying transactions: They are:
‘Exercising the Option’ – This term describes the act of buying or selling the underlying asset via the option contract.
‘Striking or Exercise price’ – This is the price in the option contract at which the option holder can buy or sell the underlying asset.
‘Expiration Date’ – The maturity date of the option is the expiration date and after which the contract will become invalid.
‘American and European Options’ – American option can be exercised any day till the expiration date. Whereas the European option can be exercised only on the maturity date.
4.1 TYPES OF OPTIONS:
“A call option gives the holder the right to buy the underlying asset by a certain date for a specific price. A put option gives the holder the entitlement to sell the underlying asset by a specific date for a specific price. The price in the contract is known as the exercise price or strike price; the date in the contract is known as the expiration date, exercise date or maturity. American options can be exercised at any time up to the expiration date. European options can be exercised only on the expiration date itself. Most of the options that are traded on exchanges are American. Though, European options are commonly easier to analyse than American options, and some of the characteristics of an American option are often deduced from those of its European equivalent.” (Roll, 1977)
The most common type of option is ‘Call option’. A call option gives the owner the right to buy an asset at a fixed price during a particular time period. Similarly there are no restrictions on the kind of assets that can be transacted, but the most common transactions are entered into on stocks and bonds. As opposed to Call option a ‘Put option’ gives the holder the right to sell the stock or other commodity for a fixed exercise price. It is possible to evolve more complex option contracts combining call and put options. The call and put options have definite values and there are various models and ways of finding out the values during the option period. However, the value of a call option at the expiration will be decided by the price of the underlying stock at the expiration date and the value of the put option will be decided by the ruling market prices of the underlying stock. It may be noted that the call option is valuable whenever the stock is above the exercise price and the put option is valuable when the stock price is below the exercise price.
5.0 FUTURES – HOW SECURE THESE CONTRACTS ARE:
Having studied the fundamental aspects of the two types of derivatives under our consideration, we can move on to the discussion on the nature of these contracts with respect to the risks involved in such type of contracts. A peculiar nature which is associated with the futures contract is the ‘mark-to-the-market’ provision. Since the transactions are settled on a day to day basis this factor gives rise to the following two situations:
· Differences in the net present value: – This signifies that, though the net outflow under the contract is the same for buyer, the present value of cash flows will make a huge difference in the cases where there is a large drop immediately following the purchases and the buyer has to make an immediate settlement. The converse will be true when the price of the commodity increases immediately after the purchase. Even though there is no practical significance of the net present values, this is especially true in the case of contracts with large values.
· The firm must have extra liquidity to handle a sudden outflow of prior to expiration. This added risk and the cost of keeping the liquid funds makes these contracts less attractive and riskier.
The futures contracts are riskier to some extent. To illustrate let us consider the following situations of our previous example of the contract by A to buy the book on May 1st.
In the intervening period if the price of the particular book is slashed and is available in the market at $ 15 A may not be interested in taking delivery on the date agreed. Similarly if the price of the book is increased in the meantime to $ 40 then the shop owner may not be interested in calling A to take delivery. This illustration clearly explains the risks associated with the futures contract. Thus forward contracts are characterised with a big shortcoming that whatever way the prices of the commodities move, either the buyer or seller will have the tendency to make a default.
However by the adoption to mark-to-the-market method, the risk element is reduced to some extent as the transactions are initiated through exchange clearing houses where the payments are settled though the exchange. Since the exchange is involved in the settlements the seller or buyer will not have the tendency to default. Moreover the buyer or seller will have to meet their commitments only for the difference in the contracted and market prices of the transaction.
Another factor which needs to be considered in favour of the futures contract is that the settlements are made in the clearing house on a day to day basis which leaves no chance for any accumulation of losses either to the buyer or the seller or to the intermediaries.
“The only substandard item of a futures indenture is the value of an essential entity, which is decided in the trading ground.” (Zigler, 2003)
Because of the quality of defaults associated with the futures contract, usually such contracts are entered into by individuals and organizations who know each other and who can trust the other one. However thanks to the genius of the ‘mark-to-the-market’ provision which has enabled the meeting of the unknown investors in varied kinds of futures business transactions with chances for default kept at a very low level. Hence it can be said that the commodity exchanges have never experienced any major defaults.
Because of the wide acceptability, among other commodities, agricultural commodities, metal and petroleum and financial assets are the major ones where large futures contracts are entered into involving billions of dollars being transacted in a day worldwide. This explains the secure nature of futures contracts.
There are different types of futures contracts like long hedging contract, short hedging contracts, interest rate futures contracts – the most popular of this type being the Treasury Bonds. Each type of futures has different characteristics and the discussion of this type does not come within the purview of our paper.
6.0 NATURE OF OPTION CONTRACTS:
The public has often viewed the futures and options as exotic and risky instruments that individuals enter into at their discretion. Although these derivatives can increase risk, they also do have an important role in the financial managements of the organizations. With the recent advances in the area, futures and options can be easily priced. Options are frequently embedded in the every day activities of corporations. When used diligently firms are sure to profit from these kinds of transactions. Now let us examine how secure or risky are the option contracts.
6.1 VALUATION OF OPTIONS:
Options, on the other hand, regularly exhibit non-linear behaviour with respect to time, price, and volatility. Many options traders can attest to seeing options prices sometimes head in a counterintuitive direction, or not move at all, in response to activity in the underlying stock or fund. Simply put, options pricing counts on a complex mathematical model, rather than the simple arithmetic used for security futures. (Estrella, Hendricks, Kambhu, Shin, and Walter, 1994)
In the case of option contracts the critical factor is the valuation of the options which normally determines the suitability or otherwise of the contracts.
Call and Put option values are determined by:
· The Current price of the underlying asset ( for stock options it is the price of a share of common stock)
· The Exercise price
· The time to expiration date.
· The variance of the underlying asset
· The risk free interest rate.
The ability to delay payments is more valuable when interest rates are high and less valuable when the interest rates are low. Thus the value of a call is positively related to interest rates.
6.2 OPTIONS – HOW RISKY THEY ARE:
An analysis of the above factors which go in the valuation reveal that out of the five components which determine the value of the options, the Exercise price and the time to expiration date are the only two factors which are known and controllable. The other three factors are completely variable and are not controllable. This phenomenon makes the options contract riskier than the futures where although the prices are variable, the transactions are controlled through exchanges which factor gives a better feeling of confidence.
However with the advent of time several theories have been evolved around the valuation of options and several quantitative techniques have been developed in this direction, which have made the valuation of options more or less accurate and thereby have reduced the element of risks involved. Now the firms for eliminating or reducing the risks involved in their high risk projects may enter into option contracts by precisely calculating the values of options. This enables the firms to take calculated risks and enhance the value of their assets. One of the important mathematical tools developed for the valuation of options is the Black Scholes method which provides a more reliable method of calculating the option values. Even though the key factor in the valuation of options is the volatility of the market in the case of stock options, this method of valuation has put in more acceptability to the options as a source of transforming the risks of a company.
7.0 USAGE OF DERIVATIVES:
Normally, financial advisers have turned away from options. “They are expensive to trade and can be difficult to manage,” says Howard Simons, a consultant for FTSE-Liffe Markets, a Birmingham-based electronic exchange for trading single-stock futures. (Brady, 1989) Futures may also face resistance, according to Larry Klein, an RIA and marketing consultant in Birmingham. “Most financial advisers tend toward packaged products,” says Klein. “They like the idea of raising money and handing it over to a money manager or a fund. Using futures on individual stocks is way too much work for them.”
However, the veracity of the above statements cannot be checked due to the fact that the use of the derivatives like futures and options by firms cannot be quantified precisely due to the fact that they do not appear in the financial statements unlike the bank debt or external debt. Several studies and surveys have been conducted in this respect and the results of such surveys indicate that the usage of the derivatives is very widely prevalent in the publicly traded firms. The prevailing view is that the derivatives are very helpful in reducing the variability of cash flows, which in turn reduces the various costs associated with the financial distress. Survey reports indicate that large firms make more use of the derivatives than smaller firms. Most of the evidences available conclude that the derivatives are most frequently used by firms where financial distress costs are high and access to the capital market is constrained.
“We have only scratched the surface of what is available in the world of derivatives. Derivatives are designed to meet the market place needs and the only binding limitation is the human imagination. Nowhere should the buyer’s warning caveat emptor be taken more seriously than in the derivatives market…” Stephen A. Ross, Randolph W. Westerfield and Jeffrey Jaffe (2004).
Managing financial and other risks is critical to successful corporate finance. In this connection we saw earlier that a derivative security is one that derives the value from an underlying primary security and examples of such derivatives are forward contracts, future contracts, options and swap. To hedge risk the financial manager must first identify the relevant risk. To the extent possible it should be quantified. Hedging simply involves taking a position opposite to the risk exposure involved. In the light of these statements, to conclude the paper let us consider the factors relating to futures:
Ø A futures contract is standardized and traded on an exchange; it calls for delivery of a specific instrument, one out of a basket of approved instruments, or a cash settlement based on some index, all of which pertains to a specific future date. Both the buyer and seller of a contract must maintain margin as a security deposit. Each day their positions are marked to the market, with the losing party required to settle.
Similarly in respect of options we saw that:
Ø A call option gives the holder the right to buy a share of stock at a specified price, the exercise price. A European option can be exercised only at the expiration date; an American option can be exercised anytime up to and including the expiration date. The value of the option at the expiration date is the value of stock minus the exercise price, or it may be zero. It cannot be a negative value. The most important factor affecting the value of the option is the price volatility of the stock; the greater the volatility the more valuable the option, all other things remaining the same. In addition, the longer the time to expiration date and the higher the interest rate, the greater is the value of the option, all the other things remaining the same. With a stock and an option on the stock, it is possible to establish a risk-less hedged position by buying the stock and by writing options or selling them short. We also saw that quantitative techniques have been evolved over the time for a precise valuation, the important of them being the Black Scholes method.
Having analysed the various factors associated with both the derivatives futures and options we may conclude as below:
Since futures contracts are governed by commodity Exchanges and clearing houses there is no big risk element involved in futures contract. Also since settlements are made on a daily basis it does not throw any trader out of gear as there will be no accumulated losses. Another factor which reduces the risk factor is both the seller and buyer are allowed netting out their contracts either by buying or selling according to their contracts. Hence it may be concluded that the Futures contracts are secure.
In the case of options contracts, although the valuation depends on a completely variable element of volatility in the market, since there are well defined valuation models available now the firms can take advantage of the stock options to a limited extent. Here also there is the insurance of opting out of the contracts if the prices are not moving in the desired directions with a minimal loss. Thus it may be concluded that the options are a little more risky than the futures.
However a comment on the derivatives is worth noting; “Derivatives are to finance what scalpels are to surgery”. Hence the risk and security are in the hands of the people who make use of these very important financial tools.
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