"Discuss the role of the futures markets in risk management practice for companies

Transcription

1 "Discuss the role of the futures markets in risk management practice for companies in a country (UK) of your choice with reference to a particular sector/industry." Executive Summary Futures market is an essential tool for effective management of companies effecting the functioning of financial markets, thus various aspects of their impact such on markets, risk management and foreign exchange risk management are considered through the analysis of their functioning in markets, companies, and economy. We examine the role that UK financial markets fulfil and the way they function. We delve into the importance of derivates in risk management while looking at Barcleys and the way it manages its risks. Through the investigation of the way futures benefit markets we unravel economic theoretical as well as practical effects of such market. When delineating various functions that futures market accomplishes, we look at the specific applications of futures in risk management, such as various types of hedging. This paper also looks at the reasons behind engaging futures in foreign exchange management by examining some effects of unmanaged foreign exchange exposure effects. The implications of currency exchange point to the ways of managing different 1

2 risks and the reasons behind such choices. Introduction While looking at the UK futures market various, issues and practices that involve financial markets are examined. In particular, we follow Barcley s management practices as an example of the banking industry that manages various risks using various control mechanisms. Barcleys is part of the lending and investment sector, thus being the type of business that pays particular attention in ensureing diversification of exposures, managing risks, as well as having the largest sectoral exposure to home loans, personal loans, and other business services. In its business Barcleys relies on derivates and their sale as risk management products. The Group manages its own exposure to fluctuations in interest and exchange rates through derivates. This involves foreign exchange, interest rate, equity, commodity and credit derivatives. The Group s income and liabilities are managed through derivative instruments, which are swaps, forward rate agreement, futures, and options ( p. 79). The Group is engaged in buying and selling financial instruments that are traded or cleared on an exchange. They involve interest rate swaps, futures and options on futures as well as over the counter instruments ranging from commoditised transactions in derivative markets to trades with specific terms tailored to the requirements of the 2

3 Group s customers. Principle exchange rate related contracts include foreign exchange contracts, currency swaps and currency options ( p. 84). 1. UK financial market other things to discuss, consider how much daily trading takes place 1 page The UK financial markets characterize a wide range of trading arrangements, made to locate investors with whom to carry transactions. There are three major investment exchanges such as the London Stock Exchange, LIFFE (The London International Financial Futures and Options Exchange) and the commodity markets. Financial markets allow for transferring funds from savers to borrowers through intermediation, where a financial intermediary, such as a bank borrows from the original savers and on-lends the funds to the ultimate borrowers. They allow trading money for securities and commodities. Commodity markets delay or accelerating consumption over time. Financial markets operate through supply and demand. Various mechanisms, such as interest rates allocate resources. Interest payments, dividends, and other gains or losses in the value of the asset make a yield also related to liquidity and maturity as well as to the level of risk involved. Through financial markets capital is raised, risk transferred, while international allows for matching those who have financial capital with those who want it. Securities are issued and interest or dividends are expected in return. 3

4 The greater the level of risk of a financial instrument, the greater the required yield by investors, as shown in the graph below (Pawley et. al 1991, p. 7) Bonds Equities Preference shares Treasury bills The risk/return trade-off Investors manage risks through maximizing profits or minimizing the risk for the level of return. Financial markets change through the way financial intermediation is conducted. This is achieved through changes in the volume of demand, portfolio preference of customers, changes in the financial market environment, and changes in financial institutions own objectives, constraints, and portfolio behaviour. The role of the UK financial institutions and markets involves running the payment system, providing funds for borrowers, instruments for lenders, creating assets and liabilities, supply non-intermediation financial services. They also assign resources amongst competing uses, transfer risk and supply instruments for portfolio allocation (Pawley et. al 1991, p. 9). 4

5 It is essential for the financial markets to be financially efficient as they channel savings into the most profitable businesses, innovate customer needs, and with their lowest possible cost they are operationally efficient. their performance is thus beneficial to economy (Pawley et. al 1991, p. 9). The impact of financial markets is evident in our everyday life through splitting financial functions and risks. It allows banks selling a mortgage not to be the bearer of the mortgage while insurance company, in the same way, is not the bearer of accident risks. Financial markets enable the sharing of risks and permit diversifiable risk to be widely shared. Such risk vanishes when it is widely shared while nondiversifiable risk does not vanish when shared and is held by those most willing to hold it (McDonald 2003, P.9). The UK financial markets experienced various benefits through advances in risk management. Such changes as well as changes in accounting and regulatory frameworks allowed, for example, pension funds and insurance companies to reduce disparity between their assets and liabilities. The composition of portfolios shifted towards longerdating assets while minimum funding requirements and accounting standards effected long-term bonds buying by UK pension funds ( p. 102). 5

6 BIS 76 th Annual report p. 103 Financial markets make financial institutions that facilitate trade, such as Stock exchanges, allow buyers and sellers trade stocks and shares. Some financial markets include capital markets, stock markets, commodity markets, money markets, derivates markets, or futures markets. 3,6 0 0, ,2 0 0, ,8 0 0, ,4 0 0, ,0 0 0, ,6 0 0, ,2 0 0, , , EURONEXT LIFFE Options Futures 2 7 / / 2 3 / 3 4 / 3 5 / 3 6 / 3 7 / 3 10 / 3 11/ 3 12 / 3 13 / 3 Number of contracts traded daily on London International Financial Futures and Options Exchange ( The increased role of derivatives in transferring risks and synthesizing exposure to asset prices has promoted a focus on risk management and Barcleys engages guidance for risk control mechanisms as well as guidance for managing most significant areas of risk that is based on new research developments through shareholder value based principle, fostering culture that allows monitoring of risks, ensuring that risk management systems are adequate, and reviewing such risks through annual review. As Barcleys also needs to manage market risk it uses a common metric to make sure that returns are appropriate to 6

7 risks. This is achieved through allocating economic capital to businesses based on risks ( p. 55) 2. Use of futures in UK financial markets 1 page Futures are traded at the London International Financial Futures Exchange. Futures and options allow for the protection of financial assets and opportunities through the protection against adverse movement of values. Trading with futures can be utilized to engage various strategies, including risk management and trading chances in fixed income, treasure and equity products employing short and long yields (Ibid, p. 3). Futures contract market involves trading with commitments of transactions that are made at a later date without exchanging money when the contract is initiated. The trade is unified and the liquidity and depth of the market are maximized. Future contracts are standardized and market liquidity in this way enhanced (Merrick, 1990 p. 14). Future market liquidity is assured through the large number of transaction volume and volatile prices. Future positions close before maturity. Their creditworthiness is guaranteed by either party. Risk management is crucial and futures market can significantly reduce these risks. Financial institutions face risks such as liquidity, involving problems with changes in asset prices or credit withdrawals, investment risks, incorporating investment loss, credit risk when there are delays with debt payments, earning risks, involving reduction in earnings that is connected with operating costs, and operating risks that result from various looses due to inefficiency or poor management. As the assessment of risks is crucial, especially for banks, most UK institutions charge loans on a floating rate basis to 7

8 match floating rate liabilities. These practices may increase credit risk as interest rate risk passes to the customer. To limit risk, financial institutions use instruments such as swaps, options, and financial futures. These devices may also have risks as it was the case with the Midland Bank that hedged its interest rates in 1990 (Pawley et al. 1991, p. 238). There are direct and indirect benefits of futures markets, such as direct users and speculators. For commercial firms a futures market reduces the cost of hedging and promotes their use of the market. Lower hedging costs foster the expansion of output and facilitate the carrying of inventories, thus promoting specialization and attendant economies of scale in such activities. Futures markets can increase hedging benefits thus enhancing the volume of inventories. In this way, futures market also assists hedging benefits. The development of futures markets make also related markets more efficient due to fostering transactions and better information. In the result, other markets become more liquid and efficiently priced which boosts their use as well as larger output and lower prices of the related goods are achieved. As futures markets have also related markets, such as spot, forward, and option markets for the underlying asset, a similar set of markets, and futures they improve the efficiency of the underlying spot market due to the close relationship between the futures and spot markets. Other benefits influence transactions, liquidity and pricing efficiency. 8

9 Through the reduction of bid-asked price spreads that indicate liquidity, leading to larger inventory holdings, the futures market also reduces the variability and uncertainty of prices (Burns 1983, p. 67). Futures markets can allow for better price expectations, better transaction and decision making in the given and related markets as well as maturities. Better price expectations about non-market factors can foster new markets. Such improvements also benefit firms in terms of long-term planning, debt securities, foreign exchange, while also affect the development of economy (Burns 1983, p. 72). 3. Futures as a method of risk management in UK 1 page Risk management is crucial for both market intermediaries and producers who use derivatives in business practice. Market intermediaries manage risk by charging a bid-ask spread, managing specific risk in their individual asset inventories, and the headgeable market risk component of their core business risk. Dealers use futures markets to hedge especially when the volatility of the bond market is higher. The pressures of capital requirements are greater when the magnitude of spot exposure is high while the change in spot exposure increases this exposure. Producers in various countries can take advantage of futures market to spread their risks, but developed market economies, such as UK, involve lower risk than poorer countries. The World Bank s examination of the nature of price risk in internationally traded commodity markets has led to the findings that the risk that producers face in poor countries can be averted through commodity futures markets. Higher risk for producers in 9

10 poorer countries is caused by price volatility. Futures market have two main social functions of future markets prices discovery and hedging, thus producers that trade future contracts can reduce price risk through hedging. Some risks, such as quantity risk cannot be hedged. Hedging with futures involves taking a position in the future market opposite to the position that is held in a cash market. To protect against downward price exposure in the cash market, a short hedge is employed. It occurs when a long cash position is held and then futures contracts are sold. A long hedge is part of a short cash position when futures contracts are bought to protect against upward price exposure in the cash market. The following can be applied in the risk minimizing hedge ratio: ΔVH=(ΔS)(QS) (ΔF)NFQF ΔVH= the value of the hedged portfolio QS=the quantitiy of the spot/cash position being hedged QF= the number of unites of the underlying asset in one futures contract that is used to hedge (on the opposite side of the cash market position) NF= the number of futures contracts ΔS= change in the spot price of the good ΔF= change in the futures price 10

11 If ΔVH=0 then (ΔS)(QS)=( ΔF)NFQF, and the risk-minimizing number of futures contracts to trade, NF is the fractional term, ΔS/ΔF is the hedge ratio. Banks use products such as futures and options contracts for their clients as riskmitigation products. The needs of various corporations involving borrowing money, financial transactions, investments, hedging price volatility also involve currency risk and interest rate risks. Various insurance liabilities necessitate that hard commodities and insurance companies invest in equity and bond portfolios. Pension funds have investments similar to those of insurance companies and thus they face even bigger risk to meet their future pension funds liabilities. Other risks involve foreign currency exposures due to overseas investments (Hyman 2006, p.2). Barcleys use derivatives to manage exposure to fluctuations in interest and exchange rates as part of asset and liability management activities. It thus buys and sells financial instruments traded or cleared on an exchange, such as interest rate swaps, futures, and options on futures. These derivative instruments affect the net interest income, such as profits, commissions as well as other assets and liabilities. It also buys and sells financial instruments traded over the counter which involves commoditised transactions in derivative markets. Through industry standard documentation the Group protects itself against outstanding balances. Equity related contracts involve equity and stock index swap and options, such as warrants being options listed on an exchange. Equity swap involves an agreement of exchanging periodic payments that are based upon an estimated amount between two parties where one pays fixed or floating interest and the other pays 11

12 money based on the stock return ( p. 79). 4. Futures as a method of foreign exchange risk management 1 page Management of foreign exchange exposure can affect a company s earnings and value. Firms may be unaware that by avoiding to use instruments such as forwards or futures may expose them to speculative risks. It may appear that exposure cannot be measured and currency exposure can be difficult follow with precision, many transactions are not completed, revenues are influenced by currency changes, and thus the management of foreign exchange exposure is important. Unmanaged exchange rate risk can lead to strong fluctuations in earnings as well as market value of companies, especially in the case of large exchange rate movements. The currency change may threaten the firm s viability and bring the costs of bankruptcy to bear. Hence, such tools as out-of-the-money options can secure against currency risks (Giddy & Dufey). Financial investment or a foreign currency liability leads to exchange risk. Financial assets and liabilities are fixed in nominal terms and can be protected from losses through various means, such as cash payments or forward exchange contracts. The effect of exchange rate changes on operational cash flows depends on volume effects, pricing flexibility, diversification, production and sales flexibility. There is thus economic exposure that involves the currency of determination of revenue and costs. Currency of determination affects the currency in which competitors denominate prices. It is essential for corporations to predict currencies to be able to hedge. As exchange rates exhibit behaviour that is similar to speculative asset markets, rates are more volatile, moved by 12

13 changing expectations, and difficult to forecast (Giddy & Dufey). There are different ways to manage foreign exchange risks that involve forward exchange contracts, futures, or currency swaps. Their cost is the same only default risk or transaction costs may differ. These tools differ in relation to different risks involved. In this way, futures do not hedge contingent cash flows and options are better equipped to do that.forward contracts are most common ways of hedging transactions in foreign currencies. Forward contracts require future performance and it may be the case that a party is unable to perform the contract which may lead to the disappearance of the hedge. It also requires access to the forward market in the appropriate quantity to hedge the exchange exposure(giddy & Dufey). The currency futures market is the best market for exchange rate risk hedging. Currency futures are also contracts for delivery at a future date and agreed price but they differ due to their standardization in terms of amounts and delivery date. The most essential feature of this trade is the time pattern of the cash flows between parties. While forward contracts are effected at maturity, futures involve cash changing during the contract when there is a change in the price of the contract thus eliminating default risk. Due to such use most big companies use forwards while futures are used when there is a credit risk problem (Giddy & Dufey). While forward contracts can lock an exchange rate, there are circumstances such as different ways of realizing currencies, where forward or futures are inappropriate and a foreign exchange option is better suited because it is the right and not the obligation to 13

14 exchange currency at a certain established rate. A foreign exchange option is a contract where a future currency delivery is exchanged for another while those who dispose options have the right to purchase the currency at a determined price although there is no requirement to do that. The right to buy or sell is called the option premium. The seller who gets the premium has to deliver at the established price upon the buyer s exercise of such option. Some options delivered are the currency itself (Giddy & Dufey). Barcleys engage in trading with interest rate swaps, futures and options on futures on an exchange. The holders of exchange traded instruments supply margin with cash for final settlement. The Group also manages exchange rate risks, such as adverse effects of market interest rates involved in the UK banking operations. Various aspects of these operations are managed through interest rate swaps and derivatives. Its international banking operations involve market interest rate risks that are managed through policies involving interest rate gap limits or value at risk limits( p.79). Barcleys carries out its foreign exchange risk management in the view that its corporate and retail banking businesses experience foreign exchange risk when supplying its services. The Group transfers part of this risk in UK to Barclays Capital. Group Market Risks assigns foreign exchange open position limits to better manage customer flows in its international operations ( p.84). Conclusion 1 page 14

15 Futures are an effective way to spread financial risk both for financial institutions and producers. They are essential in risk management, where risks such as liquidity, investments, earnings, and operating costs require additional management efficiency. Although derivatives also have risks they can limit risks that financial institutions face. Futures markets increase hedging benefits and fosters efficiency of markets, leading to the creation of new markets, benefiting firms and economy. They are beneficial for both intermediaries and producers in hedging and spreading risks. They also allow to alleviate their risks and meet insurance liabilities especially when risks are high. Such risks are useful in particular when interest rates and exchange rates fluctuate. As in the case of Barcleys derivates allow managing exposure and affect profits, commissions and liabilities. Futures can prevent from the exposure to speculative risks, and manage exchange risks. They are useful due to the effect of exchange rate changes on operational cash flows. Thus foreign exchange risks can be managed through forward exchange contracts, futures, and currency swaps depending on the type of risk involved. These tools are necessary as currency changes influence profits also leading to fluctuations in earnings as well as market values of companies. 15

16 References Bank for International Settlements, th Annual Report. BARCLEYS PLC ANNUAL REPORT Available from: BURNS B. J Futures markets and market efficiency. In STREIT, M., E., Futures Markets Modelling, managing and monitoring futures trading. Oxford: Basil Blackwell GIDDY, I., H., DUFEY G.. The management of foreign exchange risk. New York University and University of Michigan. 16

17 Available from: HYMAN, M., New ways for managing global financial risks. West Sussex: John Wiley & Sons Ltd. International bibliography, information, documentation (Ibid). New York: Bowker and Unipub. MCDONALD R., L., Derivatives markets. USA: Pearson Education. MERRICK, J.J Financial futures markets. Structure, pricing and practice. New York: Harper and Row Publishers. STIGLITZ, J. E. Futures markets and risk: a general equilibrium approach. In Futures markets. Modelling, managing and monitoring futures trading Oxford: Basil Blackwell PAWLEY M., WINSTONE D., BENTLEY P., UK financial institutions and markets. Houndmills, Basinstoke, Hampshire and London: MacMillan 17