By Akash Joshi
The old adage of not putting all ones eggs in one basket still holds good. Investment pundits prescribe diversification as an effective way to reduce the risk element. Futures, options, swaps and warrants are some such instruments derived to tackle the risks attached with investing. These allow an investor to hedge or reduce asset-related risks. However, they also tend to confound investors due to their esoteric nature.
But then what exactly are derivative instruments? At a ground level, they are contracts to buy or sell at specific assets at a future date at a predetermined or conditional price.
Futures
Usually, a ‘Futures’ contract contains an agreement to buy or sell a specific commodity, asset or security at a pre-decided price. The contract is legally binding on both the parties.
The generic contract involves two parties: the investor, who may want to buy or sell gold or any other commodity, and the broker who is willing to take an opposite position.
An investor, for example, may want to buy gold for his jewellery business or for investment purposes. If he feels that the price of gold at $380 per ounce (oz) on that particular day, say January 1, is on the rise and wishes to take advantage of any further rise, he could lock in to a specific price say $390 per oz for delivery by April.
The investor then approaches the broker (commonly known as the futures commission merchant in the US). The broker and the investor enter into a futures contract offered by the commodity exchange, say at $390 per oz with the delivery slated for April 1 and the quantity being 100 oz.
The investor has to pay up the margin money of 10 to 20 per cent, depending on the prevalent interest rates and the exchange rules. The exchange decides whether the margins would be in percentage points of the contract value or on a flat per ounce basis.
Thus initially, the investor has to only pay the margin money, in this case $3,900 (assuming it is 10%), to the broker. The investor could invest his balance money in other assets for the period. But, if on the delivery date the price of gold has touched $410, the investor needn’t feel stupid. As, he could take delivery by paying the balance amount and sell the gold in the spot market if he is an investor.
Alternatively, he could use the relatively cheaply acquired gold for business purposes. Conversely, if the price falls to $375 per oz, the investor could still enter into a similar contract with the broker, this time around for selling the same quantity. All he loses is the margin money. He can still buy the required amount of gold at a lower cost from the spot market. This offers him tremendous leverage.
A similar scenario crops up when an investor or businessman plans to sell an asset without owning it, or go short.
This is just the basic framework of futures trading. The different exchanges where the futures are traded have various regulations and specifications of trade quantities, to effect fair trades.
Flashback
The concept of futures originated in Chicago way back in 1830 with an intention to provide the wheat and soya farmers with an instrument to hedge their harvest. Formal futures trading began at the Chicago Board of Trade only after the American civil war.
Gold futures debuted at the Winnipeg Commodity Exchange in Canada. The exchange started out in November 1972 with a 400 oz contract in US dollars. Delivery was also available in gold certificates issued by Bank of Nova Scotia and the Canadian Imperial Bank of Commerce. The first trade was effected at $62.50 per oz. By 1974, the price had reached $200 per oz.
These contracts were so popular that by 1974 there were as many as 1,00,000 contracts floating in the market. This, mainly because neighbouring USA was deprived of bullion trading. But when in 1974 USA lifted restrictions on trading in bullion, popularity of the Winnipeg Comex started waning and by 1988 disappeared into oblivion.
The futures fever slowly caught up in other countries too, some with success but with lot of casualties, which included:
the London gold futures exchange which started operations in the early 1980’s and closed shop soon after three years. the Sydney futures exchange in Australia. This exchange began with a 50 oz contract in1978 but wound up by 1989. This exchange had a relationship with the Comex where participants could take open positions in one exchange and liquidate them in the other. However, such deals failed to buoy up volumes. the Singapore International Monetary Exchange (Simex) was set up in 1983 by way of an alliance between the Gold Exchange of Singapore and the International Monetary Market (IMM) of Chicago. 100 oz contracts were to be traded. However, the idea fell through as it did not do well. The Tokyo Commodity Exchange (Tocom) which launched a 1 kg contract in 1982, was one of the few commodity exchanges to successfully launch gold futures. Trading volume on the Tocom peaked with a seven million contract.Timothy Green, well-known author of World of Gold, attributes failure of these commodity exchanges to a lack of natural teams of domestic traders, an over-reliance on foreigners for volumes and the sickness of gold futures on many exchanges.
Options
‘Options’, as the term suggests, offer better leverage to investors, traders and speculators. The parties to an options contract are the same, with a basic variation. An potential buyer is said to ‘call’ and when he wants to sell he is said to ‘put’ in option jargon.
An investor who wants to purchase any option, that is a call or a put, approaches a broker who sells the contract. Thus the investor is a buyer of an option contract and the broker a seller.
Under an options contract, an investor can lock into a future price known as the strike price. He has to then pay a premium upfront to the writer. The premium is decided on various variables such as the strike price, the current price, current interest rates, duration of the contract and anticipated volatility of the asset. Once the premium is paid, the investor (buyer) has the option to honour the contract. Which means, the buyer could call (buy) or put (sell) the decided quantity at the strike price, if he so wishes. However, the broker (writer/seller) has to honour his commitment.
For example, if the investor expects the gold price at $390 on a particular day to rise further, he could buy a call option for 100 oz for a period of three months at a premium of 5 per cent (assumed) and at a strike price of $400 per oz. He has to pay a premium $2,000 instead of $40,000. The investor till such time could put his resources in other assets by way of diversifying. The exchange again tends to fix the band of the strike prices available and their requisite premiums.
If during maturity the gold price touches $420 per oz, the investor breaks even and the option is said to be at the money. If the price crosses $420 the investor profits, the contract is said to be in the money, the investor could present the money and, take delivery.
But, if at that time he does not have the requisite cash, then too no problem. There exists a liquid market, which trades in such option contracts where the investor could trade the option and get the difference between the ruling price and the strike price under prevailing market conditions.
On the other hand, if the price slips to $360 per oz, the option is said to be out of money and the investor could buy the required gold from the open market to meet his requirement. Alternatively, he could forego the contract thereby limiting his downside risk to the premium paid upfront.
This is straight or ‘vanilla’ option trading. There are other flavours available to suit the palate. They include down and out, knockouts and mini-maxes, to name a few. The terms are exotic too like strips, straddles, butterfly spreads, etc. The advantage of options is that they can be engineered to meet specific investor requirements.
Trading in options was initiated and popularised by Mocatta Metals Corporation of USA and Valuers White Weld (later Credit Suisse First Boston Futures Trading) of Geneva, in the 1970s.
Utility
The utility of derivatives in risk management and portfolio diversification is generally short-term. The need for gold derivatives is for a variety of reasons. The modern portfolio theory rightly holds that diversification leads to risk reduction and higher returns. To diversify, an investor must hold a wide variety of assets. Gold is certainly an asset, which could adorn a portfolio effectively. But, due to the large transaction costs involved, storage costs and importantly due to its ill-liquidity gold is not a very popular investment vehicle.
The cost thus tends to segment the market. Such segmentation means that investors are forced to hold assets of a particular kind. It deprives the investors to enhance the quality of returns. Derivatives enable the investors to overcome the cost barriers.
For instance, holding physical quantities of gold would be an onerous task for a mutual fund, exposing it to further risks like that of theft. Gold storage itself is a separate business, and is certainly not that of a mutual fund. By trading in derivative contracts, the storage costs and the burden could be done away with .
The leverage that derivatives offer to any trader, investor or speculator is tremendous. With a small sum an investor could participate in the bullion market. There is an exit route as well. Volatility of the market also gets neutralised. However, analysts have diverse opinions about this, with some claiming that derivatives make the market more volatile and some swearing otherwise. But it has been observed that the cumulative effect of derivatives is more stabilising than otherwise.
Finally, the derivative instrument can be likened to fire. While the discerning ones stand to gain from it, a person who fails to read it right could land up burning his fingers.