Question

In 500 words, indicate companies in Malaysia that would use derivative instruments in order to avoid loss due to the current declining state of Malaysian currency.

Answer 1

Answer of the above question is given below.

The Determinants of Derivative Usage: A study on Malaysian firms

Derivatives became a hot topic during that period and a lot of researchers started to conduct studies to further investigate the factors and impacts of the derivatives in the market of developed countries. Derivatives are securities where price is derived from one or more underlying assets, it serves as a contract between two or more parties. The most common types of derivatives are future contracts, forward contracts, options and swaps.
Derivatives play an important role in helping companies to manage risk of the interest rates, currency exchange rates, and equity markets. For example, a company that owes a large amount of debt at a variable and the interest rate will be locked in its debt at a fixed rate, the company may enter a derivative contract that will allow it to swap interest rates with those companies that are seeking to switch from a fixed to a variable rate. Derivatives also can also be used for speculative purposes to earn profits. The use of derivatives and the cost of equity is closely related. The researchers evidences that firms used derivatives to reduce their financial distress in the
market and they use derivatives to hedge rather than to speculate in the foreign exchange market (Gay, 2011).
According to World Federation of Exchanges (2012), the exchange trade derivative contracts hits 25 billion at the year 2011 which consist of 13 billion options and 12 billion futures. It shows a 12% growth compared to 2010 which is higher in growth rate than on cash market. Besides, according to the information by ISDA regarding the use of derivative by the companies appears to be widespread, some of the companies are facing losses due to not hedging or misuse of derivatives instrument such as Metallgeselschaft loss from Oil future with
the amount of $1800 million in 1993, Sumitomo Corporation loss from Copper future with the amount of $3500 million in 1996, Kashima Oil loss from Foreign Exchange derivative with the amount of $1500 million in 1994 (Karpinsky, 1998). Therefore, companies should have well defined their risk management policy in order to benefit from the use of derivatives. Thus, this study would like to determine the motive that sways the firm to hedging in Malaysian corporate.
Starting from 2008, the Financial Accounting Standards Board had been announced as a more comprehensive derivatives disclosure requirement. This ensures that all listed firms are required to disclosure their derivatives contract in the financial reporting. Thus, lead to another hot topic in derivatives among the finance researcher.
Debt
A firm with a higher debt means that the firm is facing the risk of financial distress. In other words, the
firms would be likely to default on loan when borrowing more from creditors. Therefore, derivatives
could play a very important part in helping the firm to deal with its competitive financial environment.
In most of the previous research work, debt is proxy by leverage and debt to equity.

Proxy Variable: Leverage
Leverage is the proxy to measure the corporate’s debt. While, some of the companies might be using
debt to finance operations by increase the leverage without increase its equity to make an investment.
However, corporate with a higher leverage might face the risk of bankruptcy during the economic
downturn if they are unable to settle the payment. Below are the empirical results that were carried out
by many previous researchers in different industries and countries.

Proxy Variable: Debt to equity ratio
The debt to equity ratio is the proxy of corporate debt. It is a very simple and popular of debt valuation
indicator to measure the ability of the company to repay its debt obligation over its equity. However, the
company might have a tendency towards bankruptcy if it uses debt in access than its own financial
sources to finance its business due to the cost of debt financing and thus, end up leave nothing to the
shareholder. Below are the empirical results that were carried out by many previous researchers in
different industries and countries.

Investment growth
Shortfall cash may cause the firm to decrease the investment opportunity. Firms may engage in
derivatives to avoid underinvestment problems and earning fluctuation by minimizing the risk in order
to enhance the investment opportunity. Most of the previous research work, investment growth is proxy
by capital expenditure and dividend payout. Thus, below are the conceptual papers that had been
observed by previous researchers between the investment growth and derivatives on their finding.