By David Adonri, Vice Chairman, Highcap Securities
In the last edition of Money Digest, the use of Forwards and Futures to manage investment risks was discussed. Now our focus is on managing investment risks using Options and Swaps. As reminder, Forwards, Futures, Options and Swaps are basic derivative contracts from which several hedging products can be created. Hedging is a method of neutralizing the exposure of investment portfolios in the capital market to changes in price of the underlying assets. Also recall that a financial derivative was defined as a financial contract agreement between parties now, to perform a financial transaction in future at a predetermined price or value, where the outcome is dependent on the value of another underlying asset or variable. Against the above background, let us proceed to shedding light on Options and Swaps which are other potent risk management tools.
Unlike Forwards, Futures and Swaps which are forward claims that must be delivered at maturity, Options contract is a contingent claim where delivery is only contingent on exercising a right. Options contract (Options) is an agreement between parties, giving the bearer the right but not the obligation to buy (in the case of a Call) or sell (in the case of a Put), the underlying asset, at a specific price called Strike Price, on or before a specified future date. A premium is paid by the holder or investor to secure the right. Buyer of Option is called a Holder while the seller of Option is called a Writer. The risk of a holder of Options is limited to the premium paid which is forfeited if at expiration of the contract, the Option is not exercised. The Options writer is exposed to unlimited risk if the Options contract is in the money I.e not expired and underlying asset is appreciating or depreciating. When writing an Options contract, your risk is potentially unlimited. So, an effective risk management strategy is important. The three most essential characteristics of Options are: (1)The Strike Price which is the price at which the buyer of the Option can buy or sell the underlying security or asset if he chooses to exercise the Option.
(2) The Expiration Date which is the specific date at which an Option expires and becomes worthless. (3) The Options Premium which is the price at which an Options contract is purchased.
Options are traded on an Exchange and can be cash settled. Majority of time, Option holders choose to take their profit by trading out (closing out) their positions i.e selling in the market while writers buy their positions back to close. Only about 10% of Options are exercised, 60% are closed out while 30% expire worthlessly.
“Call Option” which is the right to buy the underlying assets and “Put Option” which is the right to sell the underlying assets, are the two types of Options contracts traded. A Long Call means buying a Call Option while a Short Call means selling a Call Option. On the other hand, a Long Put means buying a Put Option while a Short Put means selling a Put Option. Options can also be described based on when exercisable. An American Option can be exercised at any time from initiation to the expiration date, whereas a European Option can only be exercised at expiration date. The Bermuda Option is in between.
Options can enhance an investor’s portfolio through added income, protection and even leverage. Depending on the situation, there is usually an Options scenario appropriate for an investor’s goal. Options were basically invented for hedging purposes. They can be used as an effective hedge against a declining stock market to limit downside losses. Hedging with Options is meant to reduce risk at a reasonable cost. Thus, Options can be used to insure your investment against a downturn. Options are leveraged products which allow you to speculate on the movement of a market without owning the underlying assets.
Unlike Options and Futures which are traded publicly on an Exchange, Swaps are customized contracts traded over-the-counter (OTC) privately. As a result, there is always a risk of counterparty default in Swap deals. In finance, a Swap is an agreement between two parties to exchange financial instruments, cash flows or payments for a certain period of time. Swaps have two legs. In practice, one leg is generally fixed while the other leg of cash flows is determined by a random or uncertain variable, such as interest rate, foreign exchange rate, equity price or commodity price. Most Swaps involve cash flows based on a notional principal amount which usually does not change hands during or at the end of the contract.
The most common and simplest Swap contract is a plain vanilla interest rate Swap. In this Swap, one party agrees to pay the other party a predetermined fixed rate of interest on a notional principal on specific settlement dates for a specified period of time. Concurrently, the second party agrees to make payments based on a floating interest rate to the first party on the same notional principal at the same specific dates for the same specified time period. Here, the two cash flows are paid in the same currency. The reason for this kind of Swap is to hedge interest rate risk or to better match maturities of liabilities and assets. For example, a bank which pays a floating rate of interest on it’s deposits (liabilities) and earns a fixed rate of interest on loans advanced (assets), can take a Swap in opposite direction to redress the mismatch.
The second common Swap is the plain vanilla currency Swap which involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payment on a similar loan in another currency. The major reason for this kind of Swap deal is to satisfy each party’s need for funds denominated in another currency and hedge against foreign exchange risk.
Swaps can be structured in several ways which are limited only by the imagination of financial engineers. In the capital market, Swaps can be used in converting equity – based cash flows such as the performance of a stock asset or index into fixed income cash flows such as a benchmark interest rate. This can eliminate the uncertainties in cash flows associated with equities and replace them with the safety of fixed income while still holding the underlying equity assets.
Just like Futures and Options, a Swap has a calculable market value. So, one party may terminate the contract by paying the other, the market value. Buy out is not automatic, it has to be specified in the contract or by mutual consent. Other methods of exiting a Swap contract includes entering an offsetting Swap with a third party, selling the Swap to someone else or using a Swaption which is an Option on the Swap.
While Forwards and Futures are traded on FMDQ Securities Exchange and the Nigerian Exchange Limited (NGX) in Nigeria, Options are yet to debut but plans are underway. Several unreported Swap deals occur over the counter in the country. Their formalization is only a matter of time because Swaps are the most popular financial derivatives in the global economy. Any investor who understands how to use Swaps, Options, Futures and Forwards to hedge against adverse exposure, stands at a vantage position in the capital market to better manage investment risks.