All businesses face a market risk when some increase in their cost cannot be transmitted into the selling price. The costs they bear could be due to commodities, currencies or interest rates. In such cases, a forward contract allows an entity to fix a price for a future date. Thus, by entering into forward contracts for fixing costs during the period when the selling price cannot be changed, the entity protects itself from market risks. There are other derivatives that could mitigate risk better, most notably options.
Though the forward contract is useful in mitigating market risks, it does introduce a new problem: credit risk. The entity which gets a favourable price out of the forward contract (favourable when compared with the change in price later) bears a credit risk on its counterparty. This is because the counterparty may default. The reverse can also be true.
One way of mitigating credit risk is to have an exchange-traded version of the forward contract: a futures contract. This contract also offers price transparency—all entities have the same price information. However, the futures contract involves setting aside or receiving margins in the form of cash or collateral, for payment or receipt on a daily basis (and at times even more frequently). Thus, there would be cash inflows if the price change is favourable, and cash outflows if the change is unfavourable. The frequent cash inflows or outflows will require the company to borrow or lend. Now, most companies do not have the competency to deal with the sudden surge of cash inflows or outflows because of these margins. Besides, they often cannot access the market at interbank interest rates. The trouble is: the pricing of the futures contract implicitly requires the firm to have the ability to borrow or lend at these rates.
Thus, despite the higher price transparency, futures may not be suitable for most companies.
Would exchange-traded options, where the contract seller agrees to buy or sell an underlying asset to the buyer (who has the right or “option” of exercising this contract, but not the obligation) at a predetermined price, be suitable instead? If corporations are allowed to buy options on commodities, currency and interest rates, they will not face the problem of margins. This is because the buyer of an option never has to make any payment beyond the initial premium paid at the time of the purchase. It’s the option seller who is affected by margin requirements—it’s the seller who bears the risk whenever the option buyer exercises the “option”—if the price moves favourably. So, corporations can easily use options as a hedging tool without credit risk.
But aren’t options expensive compared with forwards? In the case of a bank, over a long period of time, all hedging instruments ought to deliver a similar performance. So, while forward contracts do not entail an upfront cash outflow (unlike the purchase of an option, in the form of the premium), their performance will be similar to that of an option contract over the long term. This is because, unlike the option contract, the forward contract could have an opportunity cost because it’s obligatory.
This is a good time to note that, currently, options are not permitted on commodities and interest rates; although currency options are permitted, they can’t be traded on exchanges. However, all forwards are allowed. This is strange: At its fundamental level, each forward contract combines a purchased option (where the buyer gets a right) and a sold option (where the seller has an obligation towards the buyer). Thus, it is not meaningful to permit forward or futures contracts, but disallow exchange-traded options.
A.M. Godbole is an adviser with AV Rajwade & Co. Pvt. Ltd, a risk management consulting firm. These are his personal views. Comments are welcome at firstname.lastname@example.org