Question

Describe And Distinguish Among Alternative Derivative Instruments, Including The Different Types Of Exposures Multinational Corporations Face When Using Derivative Instruments.

Answer 1

Derivatives :

Derivatives are financial instrument whose value is derived from another underlying asset. The underlying asset can be equity, forex or any other asset. The price of the derivative is determined by the spot price of the underlying asset. Since financial asset prices are never stable so through the use of derivatives it is possible to mitigate the price risks by locking in the asset prices.

A derivative financial product's value depends indirectly on the price of the cash instrument which is refer to as the "underlying" price. Example of cash instruments are actual share of the company, physical stocks of commodities, cash foreign exchange etc.

The most commonly used derivative instruments are options, forwards and futures. Others are like swaps, swaptions, structured notes etc. Derivatives can be traded over the counter or on an exchange. OTC derivatives constitute a large proportion of the derivatives market. However, the OTC derivatives suffer from counterparty risks. Since these derivatives are traded between two private parties, and they are not regulated, any one of them can default anytime. Exchange traded derivatives are more standardized and heavily regulated.

Pros and Cons of derivatives :-

Pros - 1) Lock in asset prices, 2) helps to hedge against risk, 3) helps to diversify the portfolio, 4) Can be used to leverage the capital structure.

Cons :- 1) Hard to make the valuation of the instrument, 2) complex to understand, #) Subject to counterparty risk, 4)It gets affected by supply and demand factors of the underlying assets.

Different types of derivatives :

Forward contract : A forward contract is an agreement to exchange an asset for cash, at a predetermined future date specified today.

A forward contract is a bilateral contract in which both the buyer and seller agree upon the delivery of a specified quality and quantity of assets at a specified future date at a predetermined price. Forwards are typically OTC derivatives, the dtails of which are settled privately between two parties

The underlying assets of forward contracts are : metal, energy products, interest rates, foreign exchange.

Since, the forwards are subject to credit risk so they are entered between 2 parties having good credit standing.

The forward price of an asset equal to the spot or the transaction and the cost of carry. The cost of carry includes all the cost of carrying the asset forward like storage, transport,cost, interest payment, dividend receipts.

Future Contract :

Futures have evolved out of forwards and are exchange traded version of forwards. A future contract can be defined as an agreement to buy or sell an asset at a certain price.It is firm's financial agreement to deliver or take delivery of a standardized quality of an underlying asset at a pre established price agreed on a regulated exchange at aspecified future date.

The credit risk of futures are eliminated through the system of margin requirement by the clearing houses established by the future exchanges.

Types of future contracts : Commodity future (underlying asset is some sort of commodity like soyabean sugar ,gold, silver.
Financial futures ( money market paper, t bills. note, bonds.
currency futures (US dollar, euro, pound etc.) Index future (Underlying asset is the hare indices nifty, tokyo's nikkei, New york stock exchange.

SWAPS : they are another type of derivatives used to exchange one kind of cash flow with another. For example a trader might use interest rate swap to switch from a variable interest loan to a fixed interest rate loan.

OPTIONS : There are two main reason why an investor use option . one is to hedge risk and another is to speculate. Options are similar to futures that is they are future agreement to buy or sell an asset at pre determined price on a future date. but the difference here is the its an opportunity not an obligation to exercise the agreement. Imagine an investor has 100 shares of $ 50 each.He believes the share price will rise in the future however to hedge the risk he decides to buy a put option that gives the right to sell the 100 shares at $50 at a future date and the price is called the strike price.

There are 2 types of options : American options (can be exercised anytime any time between the date of purchase and the expiration date). European option (they can be exercised only at the end of their lives).

Difference between futures and options :

Futures : 1) Exchange traded, with narration, 2) Exchange defines the product, 3) Price is zero, strike price moves, 4) Price is zero, 5) Linear pay off, 5) Both long and short at risk.
Option : 1) Exchange traded, 2) Exchange defines the product, 3) Price moves, strike price fixed, 4) Price always positive, 5)non linear pay off 6) only short at risk.

Different types of exposures an MNC faces

1) Transaction exposure : When a co. has assets and liabilities the value of which is contractually fixed in foreign currency and these items and these items are to be liquidated in the near future. For example, the value of assets in the form of foreign currency receivables or liabilities in the form of foreign currency payables will be sensitive to the exchange rate. Like wise, currency rate fluctuations would impact loans, interest, dividend,etc to be paid to the foreign entities or received from them. The transaction exposure affect the operating cash flows during the current financial year and are short term in nature.

Example a company buys raw material from abroad at $100. The payment will be settled after 6 months. Hence till date the co has transaction exposure of $ 100.If dollar apreciates during these 6 months the co have to pay more conversely the depreciation of dollar will reduce his bill in terms of his home currency.

2) Translation exposure : It arises when the value of assets & liabilities as they appear in the balance sheet and are not to be liquidated in the near future. Translation of the balance sheet items from their value in foreign currency to that in domestic currency is done to consolidate the accounts of various subsidiaries. Hence translation exposure is known as consolidation exposure .

For example, let an Indian co having a subsidiary in US . In the begining the US subsidiary has capital equipment , inventory and cash valued at $200000, $100000, $200000 respectively. The exchange rate is Rs 45 per dollar Therefore the translated value of these assets is Rs. 14400000 . At the end of the year the assets are $ 210000, $ 105000, $ 100000. At the exchange rate of Rs 46 per dollar the translated value is Rs 14950000. thus there is a translation gain of Rs 550000. on asset side of balance sheet. There must have been a translated loss on the liabilities side of the subsidiary such as debts denominated in dollar.

Her it must be noted that there is no movement of cash since these assets and liabilities are not liquidated. simply their values are worked out by the parent co. thus translation gains and losses are notional and there is no tax implication.

Operating Exposure ; It results from those items which have an effect on cash flows but the value of which is not contractually defined as is the case of the transaction exposure.

For example tender submitted for a contract remain an item of operating exposure until the award of contract. Once the contract is awarded it becomes an transaction exposure. Interest cost on working capital requirements may increase if money supply is tightened following a depreciation of the home currency. Exchange rates will affect future revenues as well as costs and hence operating profits. since these effects are of long term nature & impact the competitiveness of the firm the operating exposure is also called strategic exposure . IT influences the long term business decisions such as product, market sources of supply and location of production facilities etc. Fluctuation in the exchange rates has an impact on the customers suppliers competitors. A firm selling only in domestic market with inputs denominated in home currency is still exposed to competition from importing firms. an appreciation in home currency will put it in disadvantage form the imported product