Benel Lagua l April 5, 2024 l The Manila Times
THIS author had a chance, in the late 1990s, to enroll in a Finance class by Robert Merton at Harvard. Merton is well known for his continuous-time finance contribution that led to the Black-Scholes-Merton model in derivative pricing. Together with Myron Scholes, Merton won the Nobel Prize for this model.
That was my first exposure to the use of derivative instruments. It was not a seamless experience because, at that time, and until today, more than two decades after, the Philippine economy has no options and futures markets. It was a struggle grappling with instruments only read about in business papers.
In today’s volatile world, we are all continually exposed to uncertainty. Uncertainty exists because one does not know for sure what will occur in the future. Risk is uncertainty that matters because it affects people’s welfare. And one needs to formulate a benefit-cost trade-off analysis of risk reduction to decide on the proper course of action.
Confronted with risk, one can avoid it, control it or absorb it out of our resources. However, the financial systems can be useful in a fourth track, risk transfer. The most basic method of transferring risk to others is to simply sell the asset that is the source of the risk. However, at times, one either cannot or does not wish to sell. Here is where three methods of transferring risk come into play: hedging, insuring or diversifying. And derivative instruments play a key role.
A derivative is an instrument whose value depends on the values of other more basic underlying variable. Examples of derivatives are futures contracts, forward contracts, swaps, call options and put options. There are many underlying assets for which derivatives are created: stocks, currencies, interest rates, commodities, debt instruments, etc. So instead of buying the asset directly, an investor can trade contracts that represent rights and obligations tied to the underlying asset.
Many financial transactions have embedded derivatives. Real options analysis, for example, is a strategic decision-making tool to assess capital investment decisions, such as building a new manufacturing plant or entering a new market. Assessment of the options embedded in investments uses derivatives theory. It helps in assessing the flexibility to expand, delay or abandon the market based on future market condition.
One is said to hedge a risk when the action taken to reduce one’s exposure to a loss also causes one to give up the possibility of a gain. The farmer who sell their future crops at a fixed price in order to eliminate the risk of a low price at harvest time gives up the possibility of profiting from higher price at harvest time. This is a forward contract. And when it is a standardized forward contract that is traded on some organized exchange, it becomes a futures contract.
Another contract that facilitates hedging is a swap contract, where two parties exchange (or swap) a series of cash flows at specified intervals over a specified period. The swap payments are based on an agreed principal amount or notional. The swap contract, in effect, is equivalent to a series of forward contracts.
A second technique of risk transfer is insuring, which entails paying a premium (the price paid for the insured) to avoid losses. One substitutes a sure loss (the premium paid) for the possibility of a larger loss without the insurance. When one insures, the premium eliminates the risk of a loss, but the owner retains the potential for a gain.
Options are the financial derivative form of insurance. An option is the right to either purchase (call option) or sell (put option) something at a predetermined price in the future, called the strike price. An option gives the right but not the obligation to purchase or sell the underlying. In contrast, a forward contrast is an obligation for the two parties involved.
The final form of risk transfer is diversifying, which means holding a similar amount of many risky assets instead of concentrating all of your exposures in only one. This author has devoted several other columns on this subject but suffice it to say that for diversification to reduce risk exposure, the risks must be less than perfectly correlated with each other.
Derivatives help in risk management so that parties can reduce exposure to volatile market conditions and protect against potential losses. For the risk-takers, derivatives provide opportunities to speculate on the future price movements of underlying assets without buying them outright. This is the power of leverage. Derivatives can also be used to diversify an investment portfolio, manage risk-return profiles, and optimize investment strategies. They offer flexibility and customization to meet specific objectives and address constraints. Finally, by exploiting price differences between related markets or assets, arbitrageurs can benefit from inefficiencies in pricing.
We may not have the market or exchange in our country for options and futures, but a conceptual understanding of derivatives can have practical applications. There are simple forward contracts, commodity swaps and customized over-the-counter derivatives that can be tailored to specific needs. And understanding of derivatives can open the analyst’s eyes to real options, which will enhance strategic decision-making and risk management.
*** Benel dela Paz Lagua was previously EVP and chief development officer at the Development Bank of the Philippines. He is an active Finex member and an advocate of risk-based lending for SMEs. Today, he is the independent director in progressive banks and some NGOs. The views expressed herein are his own and do not necessarily reflect the opinion of his office as well as Finex. Photo from Pinterest.