Treasury Today Country Profiles in association with Citi

Exercising options: getting back to basics with derivatives

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Revered and reviled perhaps in equal measures, derivatives have been traded for many years as both a risk mitigation tool in their simplest form, and as an instrument of profit generation in their more exotic incarnation. Treasury Today goes back to basics on this multifaceted topic.

Mention derivatives and thoughts often turn to the financial crisis of 2008. Whilst it is hardly fair to blame these admittedly potentially unwieldy financial products for all of the ensuing woes, their misuse by people who either failed to grasp what they were buying into, or worse, knew exactly what they were doing, will resonate throughout the years. Not for nothing did Warren Buffett called derivatives “financial time bombs”.

So, what are they that they can cause so much interest, misunderstanding and chaos? In essence, they are financial instruments where the value is generated over time on the back of the performance of an underlying asset or set of assets (commonly referred to just as the underlying) such as equities, bonds or commodities. Derivatives trade typically involves two parties – counterparties – who submit to a set of pre-agreed terms and conditions that determine individual rights and obligations.

Unless collateralised (guaranteed), the value of a derivative is dependent upon on the credit status of the counterparty. Earnings, said Buffet, are often “wildly overstated” because they are “based on estimates whose inaccuracy may not be exposed for many years”.

Using derivatives to speculate on price movements gives price exposure to an underlying asset such as a commodity, index or exchange rate or even something ‘exotic’ such as weather conditions in a region.

Although sometimes highly leveraged instruments (where investment is through borrowed money – a high-risk strategy), it is important to know that derivatives can be either vanilla or exotic. There is no precise definition of either but vanilla instruments are traditionally the simplest form. These are typically used for basic risk mitigation, especially hedging, and are usually based on standard calls and puts found on major exchanges. Exotics are relatively more complex, often using non-standard underlying assets. Although they are generally used to mitigate and manage risk, derivative contracts can also be used to speculate on the price fluctuations of the underlying asset.

Using derivatives to speculate on price movements gives price exposure to an underlying asset such as a commodity, index or exchange rate or even something ‘exotic’ such as weather conditions in a region. Such derivative contracts – especially futures and options – are often settled in cash. Cash is just a more convenient method of executing these contracts. In a commodities deal, cash is used to pay the difference between the spot and futures price, rather than taking ownership of the physical commodity.

Corporate use of derivatives

If using derivatives to mitigate risk of future price movements in the underlying commodity, currency or interest rate, treasurers can achieve more accurate budgeting and forecasting. Fixing prices for a period also means monitoring price fluctuations of the underlying is redundant, allowing treasury to focus on more value-added tasks. Of course, derivatives are eminently tradable so treasurers are not tied in to them unnecessarily.

Trading options

Derivatives can be traded either on or off exchange. Exchange-traded derivatives (ETDs), traded through exchanges such as the Chicago Mercantile Exchange and the New York Mercantile Exchange, offer publicly available pricing. Contract terms, using standardised contracts, are non-negotiable.

However, off-exchange derivatives trades made over-the-counter (OTC) use tailored contracts with specific terms and conditions pre-agreed by the counterparties. The lack of standardisation means OTC derivatives are less liquid (because terms may not suit other buyers).

Today, most buying and selling is conducted over electronic trading networks.

Frequently used derivatives

The most common types of derivatives are options, swaps and swaptions, forwards and futures.

Options

Exchange-traded options are based on standardised contracts whereby one party has a right to purchase an agreed quantity and class of underlying at a future date at a pre-agreed ‘strike’ price. The right, however, is not an obligation as the buyer can allow the contract to simply expire. There are two types of option contracts that can be either bought or sold:

  • Call options give the right but not the obligation to buy the asset at the strike price either before or on the future date. The seller is obliged to sell the asset at the strike price if the buyer exercises the option.

  • Put options give buyers the right but not the obligation to sell the asset at the strike price either on or before the agreed expiration date. Sellers are obliged to repurchase at the strike price if the buyer exercises their option.

The nature of options means the greatest loss a treasurer will face is the cost of the premium paid to buy that option: if the market goes against them, the option is not exercised.

Swaps

Swaps allow treasurers to exchange one series of future cash flows for another. The value of underlying assets, which do not need to be the same, will usually be sourced from publicly available data. Swaps are often used by treasurers to hedge against movements in interest rates. A company with a fixed interest rate may wish to swap it for a floating rate if it believes the reference rate will fall. It may also seek to fix an interest rate of a payment to eliminate some uncertainty around its cash outflows, or to hedge against an anticipated interest rate rise.

Swaptions

A non-standard method of protecting against interest movements is through a swaption. In exchange for an option premium, the buyer secures the right but not the obligation to enter into an underlying swap. A buyer securing the right to pay fixed rate and receive floating rate takes a ‘payers swaption’. The right to exercise a swap where the buyer receives fixed and pays floating has a ‘receivers swaption’.

Forwards

Another non-standardised derivative contract is the forward. Here, counterparties agree privately to buy or sell an asset at a specified future data at a price agreed at the time the deal is transacted. Popular types of forward contracts are currency forwards and commodity forwards. The former may be used to hedge an FX exposure when the company has a known future payable or receivable in a foreign currency.

The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.

Futures

Futures are similar to forwards. Both give the holder the right to buy or sell an asset/commodity at a future date, although futures are exchange-traded not private agreements as per forwards. A futures contract may also require physical delivery of the underlying asset or be settled in cash. Either way, futures can be risk-laden because both counterparties are gambling on winning (when clearly only one can). At least counterparty risk is reduced because the clearing house of the exchange used to trade acts as the third party to the deal.

If using derivatives to mitigate risk of future price movements in the underlying commodity, currency or interest rate, treasurers can achieve more accurate budgeting and forecasting.

An account with a brokerage firm is required to buy and sell futures contracts. Having agreed a futures contract, the buyer and seller must deliver an initial margin (typically 1% to 5%) of the total purchase price of the futures contract. The profit or loss of the contract for each party is calculated on a daily basis, this being added to or subtracted from the relevant margin account. This reduces counterparty default risk.

The key regulations

Dodd-Frank Act

The Dodd-Frank Act was signed into US law in 2010. This established a new framework for regulatory and supervisory framework for the OTC derivatives market. Derivatives subject to regulation under Title VII of the Dodd-Frank Act include interest rate, credit default and equity swaps.

In meeting G20 objectives of increasing transparency and reducing systemic risk in the derivative markets, Dodd-Frank has moved all OTC derivatives onto exchanges and swap execution facilities (SEFs). This ensures most derivatives are processed through clearing houses and central counterparties.

The main requirements include reporting swap transactions to a swap data repository, clearing sufficiently liquid and standardised swaps on central counterparties, trading standardised swaps on trading platforms, and establishing higher capital and minimum margin requirements for uncleared swaps.

EMIR

The EU’s European Markets and Infrastructure Regulation (EMIR) came into force in August 2012. The European Securities and Markets Authority (ESMA) drafted its Regulatory Technical Standards (RTS). These provide the detailed specifications of the regulation. EMIR applies to all OTC derivatives even when an EEA-based company is trading with a non-EEA counterparty.

The main objective of EMIR is to reduce the risks and large credit exposures seen in OTC derivative transactions. Other than some additional reporting requirements, exchange traded derivatives are less of a focus as these are already subject to rules around central clearing.

EMIR’s headline requirements are for central clearing and margining of standardised OTC derivatives, the reporting of all derivative transactions to a trade repository, and risk mitigation measures for all uncleared derivatives (including collateral exchange and confirmation and reconciliation procedures).

Given their heightened importance under EMIR, firms providing central clearing services (known as central counterparties or CCPs) were subject to additional requirements around their structures and procedures.

Most non-financial companies using derivatives for hedging purposes are not expected to put their OTC derivative transactions through central clearing. This means they will not have to put up margin to cover the daily mark-to-market valuation (the most recent market price) of their derivatives.

FRS 102

For many years, derivatives non-balance sheet items. Organisations entering into OTC products recorded the impact of these instruments in their books only when settlements occurred or when they reached maturity. FRS 102, applicable to accounting periods commencing on or after 1st January 2015, changes all that.

Derivatives now have to be presented on the balance sheet at their fair value, and the credit risk to both counterparties in the transaction needs to be reflected in the calculation. This usually requires a valuation, provided by the counterparty bank, or external advisors, deploying relatively complex derivative valuation models. Additionally, changes in the derivatives’ fair value now have to be recorded in the income statement.

Under FRS 102 the derivative is accounted for independently from the hedged transaction, which can be an unrecognised cash flow – for instance, a highly probable forecast transaction, sale, or purchase in foreign currency, or future variable interest rate payments.

This means the impact of the derivative on the income statement may not occur at the same time as the underlying hedged transaction, nor in fact be represented in the same line item (that is, it not being part of EBITDA or interest expense).

Organisations can reduce or eliminate income statement volatility arising from derivatives by applying hedge accounting. But they can only do so providing they can meet certain requirements, and then actively elect to do so. These requirements are:

  • To document the existence of a hedging relationship between derivative and hedged transactions.

  • To demonstrate an economic relationship (that derivative and hedged transactions are expected to move in opposite ways), usually by the coincidence of the critical terms of both transactions or by undertaking a quantitative analysis of their correlation.

  • To specify and quantify causes of ineffectiveness – possible mismatches between the derivative and the hedged transaction – by modelling the hedged transaction, usually using a ‘hypothetical derivative’ (the best possible hedge, being a proxy for the hedged risk and transaction).

Margin rules

On 1st September 2016, new initial margin (IM) and variation margin (VM) rules for non-centrally cleared OTC derivatives were introduced globally. The rules ensure appropriate collateral (such as cash, various debt securities and corporate bonds) is available to offset losses caused by the default of a counterparty.

Although only financial firms and systemically important non-financial entities are covered, each jurisdiction is able to set out its own definition of in-scope, out-of-scope and exempt entities. Most jurisdictions’ rules do not yet require the exchange of margin with certain types of non-financial entity, such as those trading below the EMIR clearing threshold (ranging between €1bn and €3bn, depending on class of OTC derivative). For now, at least, threshold value alone will exclude corporate contracts.

Asia expanding derivatives

Exchange-traded equity and commodity derivatives trading is a developing market in Asia. Hong Kong and Singapore are of course the leading trading hubs, being fourth and fifth largest globally in turnover of OTC interest rate derivatives (behind the US, the UK and France).

China is now opening up overseas investors access to its foreign-exchange derivatives market. Access is limited to the hedging needs of private-sector investors’ onshore bond positions. According to the State Administration of Foreign Exchange, the move in early 2017 enables hedging of bond positions and is seen as a means of driving greater investment inflow. China’s interbank bond market was opened up in 2016 and can trade products including forwards, swaps, cross-currency swaps and options using domestic settlement agents. Whilst there are no specific restrictions on the notional amount of FX exposure, steps such as market access, liquidity, reporting rules, settlement dates are anticipated a future point to bring the market in line with international access.

The key to securing the investment of international institutions in any new jurisdiction is the establishment of rules around close-out netting (the payment of a final sum in the event of insolvency). In this respect, Malaysia is a prime example how a framework can be used to good effect. In March 2015, the Netting of Financial Agreements Act 2015 came into force, providing legal enforceability of close-out netting provisions under Malaysian law.

In seeking to encourage derivatives market trading, Indonesia has sought to improve local banking knowledge and is now allowing international institutions to establish operations in the country in exchange for market training and guidance.

The Securities and Exchange Board of India (SEBI) also allows foreign portfolio investors to trade commodity options and equity derivatives through International Financial Services Centres. SEBI has also set up a risk-based supervision framework for brokers.

At the start of the year, Pakistan’s Securities and Exchange Commission talked about developing new regulations to allow the country’s stock exchange (and supported by Chinese investor cash) to issue a wider range of derivatives. This could open up the market to hedge fund trading. Cash-settled futures and single stock options were on the starting list. And in April this year, Vietnam’s Hanoi Stock Exchange published listing, trading, settlement and membership rules for derivatives trade.

Global acceptance

Asia Pacific jurisdictions seem not to be diverging too far from existing international standards and have notably been establishing processes, including confirmations timings and reporting fields, that are mostly aligned with more established trading hubs in other regions. This should serve to make market development a more cost-effective process.

But it also demonstrates that whilst emerging markets see the value of derivatives, they also heed the lessons from previous errors of judgement. The market, despite what the likes of Buffett say, is here to stay.

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