Derivatives as protection for Thai financial markets (29-03-07)
By Jon Fernquest[Introduction|Vocabulary|Article]
[Reading Questions|Answers]
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Today's article discusses derivatives and how they can be used to help Thai financial markets work more efficiently.
The article stresses that speculators are as essential as hedgers for the proper functioning of markets.
It's also worth rereading a article published last year in the Bangkok Post "Do derivatives make economic policy more difficult?" written by Dr. Chodechai Suwanaporn of the Fiscal Policy Office who recently contributed an insightful Op-Ed piece on international best practice in exchange rate management.
Reading Questions
Here are some questions to guide your reading (See answers at end):1. What does the value of a derivative depend on?
What is the value of a derivative derived from?
2. What are the three most common types of derivatives?
3. What kind of underlying assets are derivatives based on?
4. Do derivatives have to be based on the price of an underyling asset? Explain.
5. Are derivatives always used to reduce risk?
6. How do hedgers and speculators make different uses of derivatives?
What benefits does each side derive from derivatives?
7. What advantages do derivatives have for adjusting the risk of a portfolio, over directly buying and selling the securities in a portfolio to adjust risk?
8. Does the general public have a positive or negative image of "speculators" ? Why?
9. Is the publics' image of speculators really justified?
10. Do speculators usually hold the securities they are trading for a long or a short time?
11. What are speculators trying to do when they trade?
12. Does the media usually write positive or negative stories about derivatives?
13. How long has Thailand been deregulating its capital markets?
14. What laws and exchanges are important for derivatives in Thailand?
Bangkok Post Article March 29, 2007
Derivatives 101: valuable tools for liquidity
BRIAN HOEGEEThe word "derivative" conjures up thoughts of sophisticated mathematical formulas such as Black-Scholes and black-box algorithmic trading strategies right from the start. Derivatives also seem to receive the majority of the blame, unfairly at times, for market events causing global investors to panic and run for the exits. These two associations may be true, but derivatives are actually very simple to understand and also help the complicated financial system we all live in run smoothly.
Derivatives are financial instruments that derive their value from an underlying asset. The underlying asset is used as a common reference point by market participants to enter into an agreement to exchange money, assets or some other value at a future date based on the price of the asset.
There are several types of financial instruments that are considered derivatives; futures, options and swaps are just a few. All of these can be traded over-the-counter (OTC) or via an exchange. Futures and options are probably the most common types of derivatives, yet swaps are also an integral part of global finance. They can be based on different types of assets such as commodities, equities, bonds, interest rates, exchange rates, or indices such as the SET50 Index. Investors can even trade weather conditions, housing prices or percentage chances that the US Federal Reserve will lower interest rates.
Depending if one is a hedger or a speculator, the main use of derivatives is to either minimise or reduce risk or actually take on additional risk. Buying futures and hedging a stock portfolio against adverse price fluctuations is a very common use of derivatives. Anticipating a downward turn in stock prices, fund managers will sell index futures (e.g. SET50 Index futures) and capture profits when prices fall.
It is not realistic for a manager to sell 15-20% of a portfolio, let alone 50% or 100% anticipating a fall in prices. Due to the leverage and liquidity in today's index futures markets, fund managers can hedge their entire portfolios fairly easily and more importantly, pay commissions that are substantially lower than on traditional equity trading.
Speculators, on the other hand, are doing just that - speculating on the price movement. Although many view speculators as reckless and excessive risk-takers, these traders actually provide the necessary liquidity the futures markets need to operate efficiently and far outnumber the hedgers.
The speculators frequently are trying to capture arbitrage opportunities through abnormal short-term price discrepancies. By no means are they long-term traders, unless a sophisticated strategy has been applied which yields a small profit.
Of course, the media never write about the benefits of derivatives and usually only attack the industry after noteworthy cases involving derivatives jolt global markets; Long-Term Capital Management (LTCM) and Nick Leeson come to mind.
LTCM used a complex strategy that included derivatives and other types of investments, to make bets on the relationships between different bonds and interest rates around the world. In ordinary times, that strategy worked fine. But the collapse of markets in Asia and Russia in 1998 changed all that.
As soon as LTCM's underlying investments began to go sour, brokers began making margin calls that the highly leveraged hedge fund was eventually unable to meet. Nick Leeson, the infamous trader at Barings Futures in Singapore, on the other hand, used unauthorised firm capital to bet on the Nikkei. The Kobe earthquake in January 1995 put him and his firm out of business as massively leveraged Nikkei futures positions went against the company.
Derivatives aren't for the faint of heart, but really should they be getting such a bad rap? Thailand doesn't seem to think so. The Securities Exchange Commission of Thailand has deregulated its capital markets dramatically over the past four years. The Derivatives Act of 2004 paved the way for the Thailand Futures Exchange (TFEX) along with allowing other derivatives participants and products to enter the market.
Currently, there are several derivatives products available to sophisticated Thai investors. Exchange-traded derivatives include: SET50 Index Futures (TFEX). OTC derivatives offered by brokers include: equity options, equity-linked notes and index guarantees. A fairly new product, which has been extremely successful in London and South Africa, is called a contract-for-difference or CFD. Major benefits to using CFDs are leverage (only 30% margin required) and short-selling - an opportunity to make money when stock prices fall. This allows sophisticated investors with 10 million baht to trade 33 million baht in nominal value with leverage. Finally, gone are the days when sophisticated Thai investors were disadvantaged and not allowed to go short.
Globally, the daily use of derivatives by investors, small and large, private and institutional is a good thing that provides sorely needed liquidity to the world marketplace. Derivatives aren't so bad after all, are they?
Brian Hoegee is Managing Director, Asia, of Global Trader, a leading London-based derivatives provider registered with the Thai SEC. Contact him in Bangkok at or visit www.gt247.com
Vocabulary (in discussion above)
derivatives - futures, options, swaps, etc (a financial asset that "derives" it value from other financial assets such as stocks, bonds, commodities, interest rates, exchange rates, and stock price indices; See Economist Glossary and Wikipedia)
liquidity, market liquidity - how easy an asset can be sold and converted into cash (liquidated) (See Wikipedia on Market Liquidity and Ec Economist Glossary)
conjures up thoughts of - makes you think about
Black-Scholes model - A mathmatical formula the gives the correct price of a future option to buy an asset (See Economist Glossary and Wikipedia)
x is a black-box - you know what x produces, but you don't know why (you don't know what is inside the box)
algorithm - a series of steps in a computer program (to calculate the solution to a problem)
black-box algorithmic trading strategies -
panic and run for the exits - for example a fire in a movie theater with everyone trying to run outside in fright
a common reference point - a value used for comparison by everyone
financial instruments - a contract for the payment of future, examples include stocks, bonds, derivatives, checks, drafts, notes (See Wikipedia's list)
futures - a contract to buy something in the future, a contract that is traded on a public exchange, so the price reflects current expectations about the value of the underlying asset (See Economist Glossary on derivatives)
options - the right to buy an asset before a given date (See Economist Glossary on derivatives)
swaps - "a contract by which two parties exchange the cashflow linked to a liability or an asset" (See Economist Glossary on derivatives and Wikipedia)
traded over-the-counter (OTC) - not traded on a public exchange (See Wikipedia on over-counter in finance and Economist Glossary on derivatives)
an integral part of - an essential part of
equities - stocks
the SET50 Index - indices are calculated from the stock prices of the top 50 and 100 listed companies in the SET Index in terms of large market capitalization, high liquidity and comply with the requirement regarding the distribution of shares to minor shareholders, and etc. (See Wikipedia on SET50 and SET125 stock indices)
SET50 Index Futures - futures on the stock index traded on TFEX
Thailand Futures Exchange (TFEX) - Thailand's futures exchange, a subsidiary of the Stock Exchange of Thailand (See website)
a hedger - someone who buys derivatives for protection, to reduce risks (for example a farmer who wants a guaranteed future price or a stock trader who wants to reduce the risk of the portfolio that he holds)
a speculator - someone who risks losses for the possibility of considerable gains (Source)
hedging a stock portfolio against adverse price fluctuations - protecting against losses when the value of stocks changes
leverage, leveraged - "the financial advantage of an investment that controls property of greater value than the cash invested. Leverage is usually achieved through the use of borrowed money." (Source) default or insolvency risk increases with leverage (See Wikipedia on Capital Assets Pricing Model (CAPM) and Beta Coefficient)
highly leveraged - borrowed a lot of money to purchase the securities or assets that you hold
reckless - acting like you don't care about danger (or the negative effects of what you are doing on other people)
arbitrage, capture arbitrage opportunities - buy in one market and sell in another for a profit
discrepancies - a difference between two values that should be the same
noteworthy - interesting, remarkable, significant
Long-Term Capital Management (LTCM) - a hedge fund that lost $4.6 billion in 1998 and had to be bailed out by the government Federal Reserve Bank of New York to avoid a wider collapse in the financial markets, the hedge fund failed despite having the help of two Nobel prize economists on its board of directors (See Wikipedia)
Nick Leeson - a former derivatives trader whose unsupervised speculative trading in Singapore caused the collapse of Barings Bank, the United Kingdom's oldest investment bank (See Wikipedia and the movie Rogue Trader)
the collapse of markets in Asia and Russia in 1998 - During the global recession of 1998, which started with the Asian financial crisis in July 1997, oil prices collapsed and since oil was 80% of Russia's exports Russia was severely affected.
(See Wikipedia on the Russian financial crisis)
buy on margin - buy securities, borrowing money to pay for part of it
margin - an investor's equity in the securities in his or her account. The margin purchaser puts up a portion of the value of the securities, borrowing the remainder from the investment dealer.
making margin calls - if the value of a security falls, the investor must pay money to the investment dealer who lent money to cover the loss
the Nikkei - the Nikkei 225 stock index (See Wikipedia)
aren't for the faint of heart - with risky investments, you can suddenly lose a lot of money
get a bad rap, take the rap - be criticised and blamed for something bad
Securities Exchange Commission of Thailand - the government agency regulating securities trading in Thailand (See website)
Derivatives Act of 2004 - Thailand's laws derivatives trading (Read the act)
equity options - (See Wikipedia on equity options)
index guarantees -
contract-for-difference or CFD - the seller will pay the buyer the difference between the current value of an asset and its value on a future date.
If the difference is negative, then the buyer pays instead to the seller. This allows investors to speculate on share price movements without owning the stock (See Wikipedia and also)
short-selling, go short, short position - selling a security that you do not own yet, for delivery to a buyer in the future, if the price falls then you make a profit
(See Economist Glossary and Wikipedia)
nominal value vs. real value - real values are reduced by inflation so they can be compared over several years, nominal values are not, so comparisons are meaningless
Answer Key:
1. What does the value of a derivative depend on?
What is the value of a derivative derived from?
The value of a derivative depends on (or is tied to, based on, derived from) the value of
an underlying asset.
2. What are the three most common types of derivatives?
Futures, options, and swaps.
3. What kind of underlying assets are derivatives based on?
Commodities, equities, bonds, interest rates, exchange rates, and stock price indices.
4. Do derivatives have to be based on the price of an underyling asset? Explain.
No, they can be based on events in the future too, such as weather conditions or the chance that that the US Federal Reserve will lower interest rates.
5. Are derivatives always used to reduce risk?
No, derivatives can be used to both decrease and increase risk.
6. How do hedgers and speculators make different uses of derivatives?
What benefits does each side derive from derivatives?
Hedgers use derivatives to reduce risk, for example, by reducing the impact of price fluctuations on their stock portfolio or to ensure a future price for rice that is not yet harvested.
Speculators use derivatives to "take on additional risk" and "speculate on price movement" because they feel that they have some information or knowledge that others don't and can beat the market.
7. What advantages do derivatives have for adjusting the risk of a portfolio, over directly buying and selling the securities in a portfolio to adjust risk?
a. It is difficult ("not realistic") to sell a large percentage of the securities in a portfolio.
b. Commissions are lower than directly trading securities.
8. Does the general public have a positive or negative image of "speculators" ? Why?
The general public has a negative image of speculators.
Many people see speculators as "reckless" and "excessive risk-takers"
9. Is the public's image of speculators really justified?
No, it is not really justified. Without speculators markets would not exist. They provide liquidity to a market and make it possible for people to buy and sell.
Derivatives and speculators are essential to controlling risk and exposure to price volatility in a market.
("...these traders actually provide the necessary liquidity the futures markets need to operate efficiently and far outnumber the hedgers.")
10. Do speculators usually hold the securities they are trading for a long or a short time?
They usually hold securities for a short time.
11. What are speculators trying to do when they trade?
They are looking for price discrepancies that they can profit from through arbitrage.
("The speculators frequently are trying to capture arbitrage opportunities through abnormal short-term price discrepancies. By no means are they long-term traders, unless a sophisticated strategy has been applied which yields a small profit.")
12. Does the media usually write positive or negative stories about derivatives?
The media usually writes negative stories about derivatives.
13. How long has Thailand been deregulating its capital markets?
"The Securities Exchange Commission of Thailand has deregulated its capital markets dramatically over the past four years."
14. What laws and exchanges are important for derivatives in Thailand?
"The Derivatives Act of 2004 paved the way for the Thailand Futures Exchange (TFEX) along with allowing other derivatives participants and products to enter the market."
TFEX is a subsidiary of the Thai stock exchange.
