Derivatives - Introduction and Strategies

By: James M. Zammit

For many years, derivative instruments have been feared by many in the accountancy and audit professions alike, not only due to their more complex accounting requirements but even more so as a result of the exposure to risk that they can cause. Large organisations such as Barings Bank have been brought down as a result of derivative speculation and derivative related fraud as early as 1995. Later, horror stories amongst them Enron’s massive implosion in 2001, bringing down not only a number of its counterparties but also the big five audit firm Arthur Andersen, have changed accounting professionals’ perception of derivatives worldwide. In the energy sector, derivatives are the most advanced and complex of their sort. With rather loose regulations in the 1990s, it became evident that higher regulation would be required to retain lower leverage, reduce off balance sheet items and keep more simplified and understandable balance sheets. Derivatives proved themselves to be tools to be used only with lots of caution, requiring great attention to detail to ensure that these are properly accounted for and disclosed.

IAS39 Financial Instruments sets out some very precise rules defining derivatives and their accounting treatment when used as hedges. A derivative falling within the scope of IAS39 has to have three main characteristics. Firstly, its value must change in response to a change in a specified interest rate, financial instrument price, commodity price foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided that in the case of a non-financial variable, the variable is not specific to a party to the contract. Secondly, it requires no initial net investment or an initial net investment that is smaller than what would be required for other types of contracts that would be expected to have a similar response to changes in market factors.Thirdly, it is to be settled at a future date.

Working with derivative instruments in a risk management capacity is in itself a challenging and, many a time, a very demanding task especially when more complex structures of physical and paper positions are set up to either curtail risk or benefit from market directionality.

For members of the accountancy and audit profession who have only limited exposure or theoretical knowledge of these instruments, there is a need for more hands on experience to come to grips with the inner workings of each specific instrument, and more importantly, the situations when each of them is to be applied. This experience is hard to come by locally, as there are only a handful of companies who could ever have exposures that require the use of derivative instruments. This article aims to provide some practical literature that will throw more light on some of the specific situations where market exposure can be identified and where derivative instruments may therefore be applied. For the purposes of staying within his area of competence, the author makes reference to the petroleum market in doing so.

Derivative instruments – some basic definitions

Futures: A legally binding contract between two parties in which the seller agrees to sell to the buyer a commodity for a specific price at a specified future date. At the end of the contract the buyer exchanges with the seller, payment for the commodity contractually agreed on. Futures are regulated and traded on exchanges. Although the future has the underlying implications of an exchange of a commodity for cash upon expiry, it is more often than not the case that a future contract position is entered into, and exited from prior to its expiry, thus offsetting any obligations to deliver or receive delivery of the commodity in question.

Swaps: A swap is a private agreement carried out on the over-the-counter (OTC) market consisting of the exchange of cash flows that are dependent on the price of an underlying commodity . The primary use of a swap is that of hedging against the price volatility of a commodity. When two parties enter into a swap, they agree to buy and sell the floating cash flows around the agreed fixed price for the transaction. In return for this, one of the parties will pay the other the difference between the fixed price and the floating price, the former being the agreed OTC price and the latter being the market price for the commodity involved for the duration of the swap contract.

Options: The right but not the obligation to buy or sell an asset within a specific period at a predetermined price. It is similar in nature to a future or swap but, for an additional cost, the option holder has the right to choose whether or not he wants to exercise the option. This gives the holder greater flexibility to benefit from advantageous movements whilst still having the benefits of a hedge. Should the market move favourably to the position, the holder may opt to forgo the option cost. Conversely, should the market move adversely, the holder will exercise the option and will have hedged his position.

Derivative trading strategies - to hedge or to speculate?

Whether one needs to hedge or not derives primarily from the inherent exposure in the business. Should such exposures be frowned upon, then the decision to hedge needs to be taken. If however, there is a more aggressive approach to revenue generation, then it may be more appropriate to bear certain exposures or even go so far as to actively seek them. It is however at its very least a top level strategic decision that should be followed by proper risk management procedures aimed at monitoring and controlling all exposures.

As globalisation sets in and the exchange of information keeps accelerating at such break neck speeds, market volatility becomes ever more the norm of the day. Volatility can be defined as the relative rate at which the price of a commodity (security, share etc) moves up and down. A study carried out by Platts (providers of global energy information and part of the McGraw-Hill Companies), has shown that volatility on the oil market has greatly increased over the last years not only in frequency of daily movements but also in the size of each daily fluctuation. One may try to argue the predictability of the market by analysing trends, charting price movements and attempting to study market fundamentals, but at the end of the day a hard and fast rule to predict market movements remains elusive, and is in fact inexistent as the amount of political, social and economic variables are close to infinite on a global scale. Exposure to market volatility can substantially impair an organisation’s profitability under adverse conditions. On the upside, failure to reduce exposure can also turn risks into profits – however this is no different to a game of roulette or black jack in a casino. When companies choose to bear exposures and generate profits by hoping that the windfalls from favourable market movements exceed the losses that they bear from adverse movements, then they are almost better off avoiding the trading of physical products (commodities such as oil, gold, metals, grains etc) and instead taking paper derivative positions as the bottom line results would ultimately be the same.

The trading of physical commodities such as oil products (starting from crude oil all the way to the heavier extracts such as straight run and cracked fuel oils, and other lighter products such as naphta, jet and gasoline) on today’s volatile markets creates a number of risks which need to be controlled by a risk management team dedicated to identifying and controlling the exposures that arise as a result of the specific activity being undertaken. Using a variety of tools such as swaps, futures and options as well as several other custom-made solutions including the offsetting of physical positions or other hybrid solutions, the risk manager and his team are responsible for entering into derivative positions to hedge these risks. In brief this can be summarised as the risk management team creating paper exposures that are usually equal and opposite to those exposures already arising out of the physical commodity trading. The net effect of these two opposing exposures leads to the elimination of the risks that arise from holding a physical position of a commodity subject to price volatility issues. The properly tailored derivative hedge therefore provides price and pricing stability. What the hedging exercise effectively does to eliminate price and pricing risk is to a) convert floating prices into fixed prices and b) convert uneven pricing periods into similar pricing periods. In both theory and practice, a hedged transaction is no longer at risk of making any sudden losses or gains arising from market movements once the hedges have been set and the position is locked.

Speculation, on the other hand, requires a trader to knowingly take a physical or derivative position aimed specifically at assuming some degree of risk with the intention of making a profit from favourable market movements. The approach to speculation is of course extremely diverse to the hedging approach and the strategy will depend entirely on how much risk a trader is looking at assuming as well as what commodities or products he is choosing to deal with. The trading style itself will also vary in the manner in which trades may be executed. In position trading a derivative portfolio is entered into and held for a short to medium term period with the aim of exiting the position at profit making levels. Shorter term swing trading entails the holding of all positions for a very short time period (ranging from hours to days) with the view of making profits from the various market swings. An even more aggressive style of trading is day trading whereby on a daily basis the trader opens and closes his portfolio and can calculate the actual daily profit without the need of a mark to market approach. Day trading portfolios are always closed before the end of the day. When speculating, risk is therefore a factor of the trading style, the selected instruments and the balance of the portfolio held, as well as the trader’s individual approach, market perception, information network and ultimately, his ‘hold or fold’ decisions. With speculation, there are no two ways about it - the bottom line is that of making profits. However, the risk-return relationship for speculation usually means that higher risks may lead to higher returns but wrong decisions in such volatile, high risk environments could always backfire hurting the net value of your net asset position.

When one is involved in the physical trading of commodities, the usual approach taken is a more conservative one that places emphasis on developing and increasing the physical trading activity whilst protecting it from market exposure. Set-up costs to enter in most commodity businesses are, more often than not, extremely prohibitive and one is hardly likely to risk one’s business venture by taking on unnecessary exposures. A sound physical trading business needs to shelter its activity from ever increasing stormy market movements and although some market shifts may be desirable, others may not. In contrast, speculators often await situations of market volatility and take derivative positions without involving themselves in physical positions so as to try to draw as much advantage as possible from market swings. Having said this, a number of major globalised trading companies dealing in commodities have their own needs to hedge their global exposures. However, their exposures are so wide, and their portfolio so large, that they can enter into a sort of high volume day trading, which is really a spin off the activity they would usually need to carry out, creating market liquidity in the process and also incorporating separate speculative revenue generating positions. This usually takes the form of entering and exiting several trades making only a small marginal contribution on each trade. The higher volume of trades of course makes up for the lower margins per trade, often yielding a return of more than sufficient size.

Irrespective of whether one speculates or merely hedges, accountants and auditors are faced with the often uncomfortable underlying accounting implications that emerge from IAS 39. However, on the practical side, it is unfair to perceive derivatives as being complex without appreciating the added value that they give businesses exposed to volatile markets. Accounting professionals need to start off by understanding the mechanics of the instrument, the situations that specifically necessitate its application, and which of the various instruments or combinations thereof are to be used. It is at this point that one can understand, evaluate, account for, audit and adequately disclose these instruments. As a former derivative trader, I cannot but stress how important it is to understand the mechanics of these instruments, as failure to do so could lead not only to wrong accounting treatment but could also mean that accounting controls may not be properly in place. There are situations where a perfect hedge cannot be applied, for a many number of reasons including lack of liquidity or uneven lot sizes and this means that there may be inherent residual exposures. For the purposes of risk management, it is necessary to be able to quantify and gauge all exposures, whether primary or residual in nature, as cumulative residual exposures can add up and remain un-hedged

Part 2 of this article entitled “The Mechanics of Derivatives – Illustrative Cases” will be published in the next (Spring 2008) issue of the Accountant and will illustrate some specific applications of futures, swaps and options and their mechanics.

James M. Zammit B.Accty (Hons), FIA, MIM, CPA is a certified public accountant, also holding a practicing certificate in auditing. He joined the Maltese office of Deloitte & Touche, also working in Rome and Milan where he was involved in several domestic and multinational audits. He later served as the Group Financial Controller for one of Malta’s group of companies active in the petroleum and other related sectors where he was fundamental in leading a number of local and international projects. His exposure to the local petroleum sector enabled him to join a Swiss based trading company in the capacity of Fuel Oil Trader and Risk Manager. Apart from following various aspects of the company’s business development on the Mediterranean and Far Eastern physical oil and derivative markets, he was entrusted with setting up the company’s risk management function whilst also trading in derivative instruments to maintain the company’s hedges and speculative positions. In 2007 he returned to Malta and is now involved in his own audit, accountancy and advisory practice. He may be contacted by e-mail on jmz@maltanet.net