# Understanding Derivatives – Lies, Lies and Damn Lies -5

Previous Chapter : The Holy Grail – LIES, LIES AND DAMN LIES-4

1 As there are no margin requirements defaults could arise
2 As there is no central place to trade finding counter parties are not easy
3 As there are only two parties involved, agreeing to a mutually agreeable price is not easy.
4 There is no liquidity for such contracts. Bid and ask prices can vary widely increasing the cost of transaction.

These contracts reduce risks as follows.
A US exporter is to receive one million Euros after three months. He has no clue about the Euro/Dollar rate after three months. He is satisfied by the existing rate. He wants to sell his one million Euros in the forward market. He approaches his bank with this request. His banker finds a buyer of dollars (probably an importer from Germany) who requires them after three months. The US exporter sells one million Euros to the German exporter near the then current rates. Both will have the money only after three months. Both parties make a forward contract immediately. Now, suppose Euro goes down with respect to dollar. It means that one needs to pay more Euros to get one dollar. This also means that the US exporter gets fewer dollars if Euro depreciates with respect to dollar. Due to his forward contract the US exporter still gets the same number of contracted dollars after three months. In the case of the German importer, he needs to pay the same contracted dollars to get his 1 million Euros. He could have paid fewer dollars to get his 1 million Euros had he not made a forward contract. It may look that the German importer lost. But it is not so. Exchange rate movement could have been in the reverse too. Then the US exporter would have been a loser. Both these parties have removed the variability of their returns by entering into a forward contract.

By selling their receivables in the forward markets both parties removed their risks..

FUTURES CONTRACTS HAVE A GREAT FUTURE
While forward contracts are traded between two parties or two firms, futures contracts are traded in exchanges with counter parties remaining unknown to each other. Here the term exchange is introduced. Exchanges are independent institutions regulated by Government- appointed bodies with rules and regulations enforceable by law. These are places where stocks, commodities and their derivatives could be bought or sold. Companies that have public share holding must enlist their shares in these exchanges so that shareholders get a chance to trade their shares without the intervention of the companies concerned. These institutions are highly essential because without these shareholders have to find counter parties by themselves or approach directly the companies for selling the shares. Both these methods of trading are time consuming and costly and hence act as inhibiting factors for fund raising and investments.

These exchanges provide a central place to trade. They guarantee trades avoiding defaults by taking margins depending on risk. They design sensible contracts with clear specifications so that the only variable is price and they enable smooth trading. All exchanges have a Clearing House that acts as intermediary between buyers and sellers.

Therefore forward contracts when traded in exchanges have very few drawbacks. In exchanges there will be thousands of participants buying and selling. These traders have information about the assets they are trading on. Therefore they have some idea about the worth of an asset at a future point of time. This creates liquidity and price recovery. Exchanges and clearing houses collect margins I order to prevent default. However there is a problem with exchange-designed contracts. Contracts are stream lined and quantity, quality, expiration and other variables are fixed, except price. Therefore one individual cannot create a contract with a specific quantity to hedge his specific position. (This is not clear to me)

As S&P500 has 500 shares, it is a widely diversified index. Therefore company specific risks are totally eliminated in this index due to negative correlations among various companies. Thus S&P 500 has only risks related to market as a whole. Hence S&P500 derivatives can be used to hedge against systematic risks.

There are serial methods by which futures contracts could be used to hedge risks in stock markets and commodity markets. (The last Part about indices is not easy to understand)

Before discussing these methods it is pertinent to find out the type of participants who operate in these futures markets.

FUTURES CONTRACTS HAVE A GREAT FUTURE

There are four types of traders in futures exchanges.
1.Producers
2.Consumers
3.Speculators
4.Arbitragers

Farmers are producers of farm products. Oil drilling companies are producers of oil. Food product companies are consumers of farm products. Oil refineries are consumers of crude oil. But speculators and arbitragers are two different groups. Among the four groups speculators are in the majority. These people assess the likely prices of assets in the future and take positions on them to buy or sell them at a future date. Suppose crude oil is trading at \$80 per barrel in the spot markets. A group of people having information on oil may feel that oil prices may go up after 3 months. There may be another group who feels that oil prices may fall after three months. The first category might push up the oil prices with huge demands while others might sell oil to this group. One of these groups is definitely in the wrong. As oil does not get transferred immediately and both these two groups have no other interest in oil other than taking profit from their guess work they are called speculators. As transfer of assets does not take place immediately futures exchanges charge the traders only the risk margins. The maximum risk in the positions is determined every day using computer soft ware and margin money collected through brokers. As fluctuations in prices are not a very big risk, margins normally come below 25% of asset prices. Therefore speculators need to raise only a maximum of 25% of asset prices to take positions in the futures exchanges.

When the producer of an asset like wheat wants to sell his future wheat production (produce or product?), there will be plenty of speculators ready to bid for the production (?). Consumers may also bid for the asset. Apart from producers, speculators will also try to buy and sell futures on wheat depending on their perceptions. A speculator who feels that the future prices will fall, will sell future contracts while a speculator who feels that prices will go up, will buy them. Here producers and consumers are transferring their price risks to speculators. Arbitragers are a group of traders who watch the price difference of an asset in different exchanges. Price difference is a rare occurrence due to efficient communicational facilities. However if such a thing happens, this group will buy from where the asset is priced less and sell to where the asset is priced higher. Most often cost of transactions and other levies nullify any advantages in arbitrage trades.

In the case of financial assets like stocks, investors can reduce risk by using futures. Suppose a mutual fund has \$2 billion assets in stocks. Suppose the portfolio has one to one correlation to SPX. This means that if S&P 500 falls by one percent, the portfolio will also lose 1% in value. Asset managers of the mutual fund fear greater volatility in the markets due to political events abroad. As this risk is systemic in nature they will sell \$2 billion worth of SPX in the futures markets. If markets crash by 2%, the portfolio will lose 0.04billion in value. At the same time SPX will also lose \$0.04 billion in value. As the portfolio managers have short positions in SPX any fall in portfolio value will be compensated by the profit from SPX short positions.
Suppose an investor or a mutual fund will receive some funds after three months. However markets had a big crash and price earning ratios fell considerably before the receipt of funds. These investors can then choose the futures market to accumulate their preferred stock by paying margin to stock exchanges. Suppose a mutual fund receive \$2 billion after three months from sale of units. If the price earning ratios fall considerably, the stocks will become very cheap. The mutual fund can buy the required portfolio in the futures market by paying a small margin. If prices go up by the time the fund gets money from sale of units it can sell the futures. It can buy the shares from spot markets at current prices and their sale of futures will provide them profits to compensate for the rise in spot prices.

Speculators in futures markets play altogether a different game. They buy and sell huge quantities with thin spreads paying small amounts of margins. They may not even hold their positions to the next trading day. It is speculators who create most of the volume in the derivative markets. As they are ultimately the carriers of someone else’s risks, most of them end up with huge losses. Broker’s charges and other levies are very heavy for them due to their huge trading volumes. Even though speculators do a useful job of creating volumes, price recovery and liquidity, buying and selling futures as a speculative activity is sheer foolishness. Most often individuals take speculative positions without knowing the direction of the markets. Their risks are unlimited and ultimately Murphy’s Law will catch up with them unless of course they are blessed by the goddess of Luck.

To be continued
CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com

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