FINANCE - 24 JUL 2015

Parachutes - Companies Embrace Derivatives

Parachutes - Companies Embrace Derivatives
Parachutes

Derivatives are that funky part of the 2007/08 Financial Crisis that are said to increase company valuations. Nigeria's latest on establishing a derivatives market has been a “Bi-Monthly Breakfast Meeting of Chief Executive Officers of Dealing Member Firms” that took place in September 2014. A Derivatives Feasibility Study was part of the agenda, with no further information on its progress.

Parachutes vs. Derivatives

I was looking for a joke about derivatives. Then it occurred to me that since derivatives can be considered a form of insurance, insurance jokes should apply, so here goes – "Needing insurance (derivatives) is like needing a parachute. If it isn't there the first time, chances are you won't be needing it again." Attempting a less than perfect adaptation - Derivatives act as parachutes for business downsides, in order that actual business success can come about. If you thought you didn’t need them during market upsides, chances are you won’t in a downside. Nigerian efforts at creating these parachutes started in 2013, when the Nigerian Stock Exchange (NSE) launched a Derivatives Feasibility Study (DFS) as part of the re-launch of its Alternative Securities Market (ASeM). The country stands to benefit greatly from successful completion of its derivatives projects.

We can further illustrate the parachute analogy with a classic example – We have an oil producing company and a bank. The company churns out 100,000 barrels of oil per month. If the price of oil in a given month is $70 per barrel, the producer can sell its output and receive revenue of $7 million. If the price is $90 per barrel, the producer can sell for $9 million. But, if the price falls to $50, the oil producer is only receives $5 million. This is where derivatives, like insurance become useful. The oil producer, noticing the uncertainty in price movements, can enter into an arrangement with a bank, where the bank agrees to pay the producer $69 per barrel for 100,000 barrels - $6.9 million. If the price increases to $90 per barrel that month, the oil producer still receives $6.9 million and does away with the benefits of a higher price (the oil producer could have received $9 million instead of $6.9 million).

Have your parachute

Here is the parachute in the above scenario – If the price of oil falls below $50, the company still receives $6.9 million, as opposed to the $5 million (or less) that its oil would have brought in. The company is protected against downward movements, which would make it a loss but at the same time, it gives up the potential benefit from upward movements. This scenario gives the reader some context concerning price movements in a world of constant change (aka “volatility”). The demand for transactions similar to the one described above is strong. The Bank for International Settlements estimates the size of the global OTC (over the counter) derivatives market at approximately $639 trillion, with respect to notional amounts outstanding. Over 90% of this amount is governed by contracts published by ISDA (International Swaps and Derivatives Association). To conclude, derivatives are a globally regulated affair, with enormous amounts at stake.

Derivatives and company value

This section explains the benefits to company value, derived from a successful derivatives market. “Volatility” is a word thrown around in many spheres of business and economics. This author will replace it with “change”. Managing risks reduces exposure to volatility (sorry, I meant change). What change are we talking about? Constant change in foreign exchange rates, stock prices, interest rates and commodity prices (the example above uses a commodity - oil). Even within these primary financial market changes, there are secondary changes. Interest rates are sometimes subject to central bank policies and commodity prices can be subject to the influence of producer cartels (think OPEC). Risk management is the study of how these changes impact business activity, and companies that manage this are necessarily better investment prospects.

Studies have shown that companies which actively manage the risks described above, tend to be higher valued in the stock markets. This should not come as a shock, as surveys by ISDA have shown that 90% of the Global Fortune 500 companies are using the instrument. In additional surveys by academics - Charles Smithson and Betty Simkins concluded that there is evidence that rigorous risk management increases firm value. They also noted the positive correlation between higher share values and the use of derivatives to manage foreign exchange rate risk and interest rate risk.

Derivatives in Nigeria – Fact or Fiction?

Considering the benefits outlined above, establishing a well-regulated Nigerian market in derivatives is essential for the growth of its capital markets due to their ability to efficiently allocate and diversify financial risks. Are derivatives in Nigeria a case of fact or fiction? The answer is somewhere in between - In a 2013 NSE paper, on the Listing Of Nigerian Telecommunications Companies, the NSE outlined a scorecard of how far it has achieved its initiatives. It gives a tick for completed initiatives. The Derivatives Feasibility Study was mentioned, but without a tick. This indicates that it is still ongoing. However, the study is located in the 2013/14 time frame. This suggests that it may be discontinued sometime in 2015. With no further publications in this respect, due in no small part to recent elections, establishing a derivatives market in Nigeria is still only a matter of fiction.

 

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Omotola Ariyo

Omotola Ariyo

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