Comparative Analysis of Forwards and Futures Contracts
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A Mauritian Perspective
This research compares the OTC derivatives market with the exchange-traded derivatives market. Forwards contracts have been used as a representative for OTC markets and Futures for organised exchanges and the costs and benefits of each one have been analysed. This research has been done being with regard to the GBOT setting up in Mauritius.
Forwards are frequently used contracts relative to others, in Mauritius. Hence, it is assumed that if the users have to shift to the GBOT, they will use futures contracts as a substitute for forwards since both have similar characteristics except that futures are more sophisticated than forwards. A survey has been done on the top one hundred and twenty companies in Mauritius out of which, only 70 have responded. The questionnaire aimed at determining the current derivatives position in Mauritius and a glance at the perception of the financial officers with respect to GBOT.
Even though they believe that GBOT will benefit the country, they are unwilling to enter the market; while most of the respondents are unaware of GBOT and uncertain about the futures market and trade mechanism. Unexpectedly, it was found that some firms use futures for risk management.
The results have been used to conclude whether it is viable for Mauritius to introduce an exchange and what measures can be taken to ensure that GBOT is successful. With respect to this research, it seems that the Mauritian market is not ready yet, to conceive this new development in its financial system but there are some measures that can be adopted to combat the inhibitors and there are much lessons to be learned from the record of derivatives mismanagement.
List of Abbreviations
AML Air Mauritius Company Limited CDS Central Depository and Settlement Company Limited CBOT Chicago Board of Trade CME Chicago Mercantile Exchange CFTC Commodity Futures Trading Commission EFP Exchange of Futures for Physical FSC Financial Services Commission FX Foreign Exchange GBOT Global Board Of Trade HSBC Hongkong and Shanghai Banking Corporation Limited MTM Mark-To-Market OTC Over-The-Counter SEM Stock Exchange of Mauritius STC State Trading Corporation S0 Spot price today ST Spot price at maturity USA United States of America
"The presence of derivatives market has undoubtedly improved national productivity growth and standards of living." Alan Greenspan (Chairman of the US Federal Reserve System, 2005)
Derivatives have gained prominence in the past few decades and are today a vital element in finance. Although they are the latest addition to the financial world, they have been witnessing a high rate of success. They have undergone constant innovation and active trade, notwithstanding the fact that they have led to a more complex form of hedging. Electronic trading and settlement facility has revolutionised the global financial and commodity markets by attracting international investors and increasing liquidity.
1.2 Background Theory
Hedging is a form of insurance that uses derivatives to absorb financial risk by locking in a price for a particular good. Its essence pertains to the uncertainties associated in prices of goods. Since prices of goods cannot be predicted with certainty, people speculate.
Gol (1980) states that "when everyone expects a price rise, all opinions seem to converge over a price rise, such that, if speculators enter the futures market, they would also be buyers rather than sellers and their buying activity may further aggravate the price rise".
Speculation helps in effective risk management but sometimes backfires; for instance, many airlines speculated a rise in fuel prices and hedged their exposure with derivatives. Unfortunately, the financial crisis 2007-2008 caused fuel prices to decrease considerably in the spot market, but the airlines had the obligation to honour their derivative contracts at relatively higher prices.
1.2.2 Derivatives market
Derivatives are financial instruments that derive their value from one or more underlying assets such as stocks, bonds, currencies, interest rates, commodities and market indices; for example, an oil futures contract derives its value from the price of oil- oil being the underlying asset.
Derivatives are used extensively in financial and non-financial institutions. Forward contracts are the basic derivatives that stemmed from the goods market, and have thereupon paved the way for other derivatives. Some goods traded through derivatives are base metals, precious metals, agricultural products, energy products, foreign currencies, interest rate, and stock indices among others.
Other includes contracts based on carbon, commodity indices, credit, fertilizer, housing, inflation, and weather.
Source: Futures Industry Magazine 2009
For this research, commodities, assets, and goods are used interchangeably, irrespective of whether they are used in the financial, commodities or foreign exchange markets.
1.2.3 Types of derivatives
There are two distinct groups of derivative instruments: forward-based products and option-based products. Forward-based products are termed linear derivatives as they offer a linear payoff and include futures, forwards, and swaps.
Conversely, option-based products are non-linear derivatives since they offer a non-linear payoff and include puts, calls, caps, floors, and collars. Other derivatives, such as options on futures, swaptions, and forward caps, combine the features of both forward and option contracts.
Derivatives trade in over-the-counter (OTC) markets or in organised exchanges. OTC trading occurs among a few dealers via phone or electronic messages. OTC contracts are mutual agreements made through private negotiations and transacted outside a trading platform. However, some OTC derivatives are cleared via exchanges (e.g. in the Chicago Mercantile Exchange). Swaps, forwards, and customised options are OTC contracts.
Exchange-traded derivatives are standardised in terms of quantity and quality (the amount and quality of the good is fixed) and negotiation is not possible. Organised exchanges employ both open outcry system and electronic order matching systems and share similar purposes to securities exchanges. They design the contract terms and operate a clearinghouse, which acts as a guarantor, settles all contracts, and regulates trading. Large securities firms and commercial banks act as derivatives dealers. Futures and standardised options are traded on exchanges.
The three broad categories of traders in the derivatives market are hedgers, speculators, and arbitrageurs. Hedgers use derivatives to reduce the risks that they face from adverse movements in prices of goods while speculators take a position to realise gains with a relatively small initial outlay. Arbitrageurs enter the market to realise gains without risking their own capital. Conclusively, hedgers transfer their risk to speculators and arbitrageurs and thus, boost liquidity on the market.
1.3 Objective of Study
A well-regulated organised derivatives market encourages a sustainable financial development and increases savings and investment in the long-run, thereby promoting economic growth. However, the concern is how and when to discern the time for its implementation in small economies.
This dissertation aims at analysing the benefits and drawbacks of using forwards and futures contracts. Forwards contracts can be used by minority users, without major procedures and regulation. Contrarily, futures require significant concern and assistance of the government to support and ensure a good operating system. The research is carried out with regard to the commodities market being set up in Mauritius.
"Forwards laid the groundwork for futures", hence, both are treated simultaneously throughout this study. Futures (exchange-traded) are enhanced forms of forwards (OTC) but differing somewhat in the way they are traded. The costs and benefits of the two instruments are analysed and compared. This will indicate whether it is viable for Mauritius to introduce a derivatives exchange and suggests the measures that can be adopted to ensure that its objectives are attained.
Swaps and options are excluded from the study because they operate differently and due to word constraint. Forwards and futures are relatively simpler and typically alike, thus, rendering comparison easier.
1.4 Overview of Remaining Chapters
Chapter 2 deals with the literature review while Chapter 3 is an overview of the derivatives market in Mauritius. Chapter 4 covers the research methodology section. Chapter 5 presents the analysis and findings of the research, followed by Chapter 6, which concludes this study and includes some recommendations.
chapter two: literature review
2.1 Importance of Derivatives Market
Several factors such as size, leverage, asset-liability duration, and taxes amongst others, affect the hedging decision of a firm. The Miller and Modigliani theory posits that hedging is fruitless in perfect financial markets. In reality though, markets are imperfect and hedging alters a firm's value by influencing its investment decisions.
Bessembinder (1991) distinguishes that hedging corporate risk with forward contracts increases firms' value by reducing incentives to under-invest. He also advocates that large institutions are more likely to use derivatives due to informational economies of scale. Likewise, Haushalter (2000) finds a positive correlation between hedging decision and total assets and characterises it as the economies of scale in information and transaction costs of hedging. Hedging also enables a firm to negotiate with its customers, creditors, and managers, which improves contract terms.
A research on African countries suggests that "volatile international capital flows have the tendency to destabilise shallow markets and precipitate a crisis if there is a change in investors' appetite" and urges adoption of stronger domestic policies and local derivatives markets for financial risk management purposes (Adelegan, 2009).
Hedging is a zero-sum game; one does not gain from trade unless another faces a loss. The gain to the buyer will be exactly equal to the loss to the seller of the forward contract, whilst the gain to the seller will be exactly equal to the loss to the buyer. Hieronymus (1971) defines hedging as "taking a position in a futures market that is equal in size and opposite to a predetermined position in the cash market". Hence, a loss in one market is offset by a gain in the other market. This principle works since cash prices and futures prices of a commodity are expected to converge as the contract reaches expiry.
Anderson and Danthine ( 1981) define a pure hedge term "equal to the risk-minimising futures position corresponding to a predetermined cash position". A hedger, thus, uses the possibilities offered by futures markets to minimise his risk.
2.2 Forwards Market
A forward contract is a bilateral binding agreement to buy or sell a specific quantity and quality of an asset, at a pre-determined price and pre-determined future time. Normally, contracts specifying settlement in excess of 30 days after the trade date are forward contracts.
Forwards are the first and simplest derivatives that sprouted in the sixteenth century in the agricultural markets, wherein they were used primarily to resist adverse price movements. Dong and Liu (2005) advocate that the equilibrium forward reduces commodity price risk; the buyer and seller will transact at the price specified in the contract, whatever the price of the underlying asset in the spot market at maturity.
A forward agreement is somewhat like a legal contract, customised with respect to the needs of the particular buyers and sellers, obligating delivery of the underlying asset under the conditions specified in the contract. The buyers and sellers negotiate over the contract terms. Anderson and Danthine (1981) claim that, "in the forwards market, speculators are assumed to be risk-neutral, bidding competitively to exercise arbitrage opportunities".
2.2.1 Benefits of Forward Contracts
126.96.36.199 Risk Management
Typically, a forward contract alleviates financial risks, thereby protecting traders. There is no initial investment in the forwards market since cash changes hand only on settlement of the contract at maturity. This causes less volatility in cash transactions, rendering cash flows easy to manage.
188.8.131.52 Settlement Facility
Cases wherein the seller defaults for some reason, contracts may be mutually settled in cash. Duffie (1989) finds that in practice, only a small fraction of forward positions are actually delivered while most are closed out before delivery by a cash settlement. Sometimes, initial traders are able to transfer their contracts to someone willing to take their obligation. Per se, it offers a certain degree of flexibility.
184.108.40.206 Trade Linkages and other benefits
Forwards allows negotiation on the contracting terms, which benefits traders, builds up trust, and strengthens trade links between parties. Wolak (2007) analyses an electricity company and concludes that forward contracts reduce the cost of production as well as its volatility, and increase pro?t. Likewise, Dong and Liu (2005) show that forward contracts in non-storable goods benefit both producers and suppliers.
2.2.2 Costs of Forward Contracts
220.127.116.11 Counterparty Default Risk
Forward contracts mitigate financial risks but give rise to counterparty risk (risk of default), which is one of the prominent risks in OTC derivatives. Counterparty risk can cause huge losses.
18.104.22.168 Transaction Costs
In order to ensure guaranteed deals, parties with good credit ratings should be identified, which is a very costly task. Nevertheless, these firms do have a possibility to default for reasons such as insolvency or bankruptcy. An ideal illustration is the collapse of the Lehman Brothers investment bank that has created the biggest turmoil in the world's history; following which, more concern has shifted to the OTC market.
22.214.171.124 Legal procedures
Once the terms and conditions of the contract are accepted, they must be adhered to otherwise legal procedures may entail. Forwards market is an unorganised form of trade with no ability to deal with conflicts other than seeking legal recourse that may be too costly. Influential and wealthy parties only may recourse to such practices. Besides, it causes damage to the dealer's reputation.
126.96.36.199 Liquidity and Transparency issues
There is no possibility of closing out or reversing a forward contract. Thus, forwards lack flexibility and liquidity and forward delivery is not guaranteed in the absence of a regulator. Additionally, since the contract involves only two entities, there is reduced transparency and possibility of mispricing the goods since not all the forces are at work.
188.8.131.52 Market Power and Bargaining Power
Market power and bargaining power affect the capacity for negotiation along with the forward equilibrium price. As such, small investors with lesser power may suffer. Dong and Liu (2005) show that the forward equilibrium moves in favour of the participant with high market power, such that he gains from the contract. However, when negotiation costs are very high, both producers and buyers face a loss regardless of market power and use forward contracts for risk management rather than for gains.
184.108.40.206 Informational Inefficiency
A study by Mahenc and Meunier ( 1983) stipulates that there is no proper information dissemination in the forward market but under conditions of imperfect information, forward trading indirectly creates efficiency in the spot market.
The necessity to deal with the shortcomings of forward contracts led to the emergence of the futures market.
2.3 Futures Market
A futures contract is an agreement between two parties to buy or sell a fixed amount of an asset at a pre-decided price and date. In this respect, futures share the same characteristics as forwards; for instance, they help buyers and sellers with long term planning by locking in a price. However, futures are more sophisticated than forwards.
Financial futures were traded on shares of the Dutch East India Company in the seventeenth century, but modern futures markets originated in Japanese rice futures, which were traded in Osaka in the eighteenth century. Futures emerged with the grading system, which purported to ensure that at maturity, the quality of goods delivered was as specified in the contract, which eventually led to standardisation of futures contracts.
Futures are standardised contracts in respect of quantity, quality, delivery date, and location. They trade on organised exchanges, which are responsible for setting the quantity, quality of the underlying asset in the contract. Moreover, the exchange sets the terms and conditions of the contract, which are non-negotiable by the traders. All investors are treated equally; small investors are also able to hedge without difficulty.
2.3.1 Structure of the Futures Market
Futures exchanges share the same purpose as securities exchanges. They usually have an integrated clearinghouse for clearing and settlement facility. Brokers, who are also members of the exchange, are responsible to match the buy and sell orders without buyers meeting sellers and vice-versa. Only members are allowed to trade on the platform, thus, a non-member wishing to deal in futures, should trade through a broker.
The exchange connects buyers and sellers worldwide, communicates and keeps parties joint and ensures compliance with the terms and conditions of the contracts. Exchanges use open outcry in "pits" or electronic order matching systems or some use both, such as The Chicago Mercantile Exchange. Some authors argue that the open outcry system is more liquid and transparent than the automated system.
Traders need to deposit a margin with the exchange prior to trade. The demand for margin (a percentage of the value of the contract) is referred as collateral or as a good faith deposit (Gay, Hunter, and Kolb 1986). All traders are required to have a minimum stated sum of money in their accounts. Contracts are settled on a daily basis: the mark-to-market system (MTM) which affects the contract price. If price of contract increases on a particular day, the holder makes a profit, which he can withdraw from his account, whereas if price decreases, he makes a loss and the amount is deducted from his account. As such, he is required to deposit a margin, referred as a call margin, to replenish his account to the threshold level, known as the variation margining system.
Futures contract protect the value of inventories and partly finances the cost of storage since the future price of a commodity is dependent upon its cost of carry (Future price = cash price +cost of carry). This helps to improve marketing policies, financial planning, and long-term forecasting of prices. If ST is expected to be higher than current S0, then the current futures price will be set at a high level relative to the current S0. Likewise, if ST is expected to be lower at maturity, current futures price is set low.
2.3.2 Benefits of Futures Contracts
Fundamentally, futures market confers two main purposes: price discovery and price risk management. The market provides protection against default, manipulation, and abuse.
220.127.116.11 Risk Management and Settlement Guarantee
Moser (1998) reckons that futures contracts counteract default risk and protect traders through a set of rules. Firstly, standardisation protects traders as it ensures that the quality of the goods delivered is as specified in the contract. Moreover, the exchange can order its members to produce their financial accounts for inspection if their solvency is doubted. In 1873, the CBOT decided to expel any member who refused to abide by this rule (Andreas 1894). The margining and MTM system also contribute to curtail counterparty default risk as traders are called to supplement their account for the losses incurred on their contracts within 24hours; failure to do so causes their positions to be liquidated. There is a settlement guarantee in case of default while a tight regulation ensures that manipulation and abuse is virtually absent.
18.104.22.168 Price Discovery
Futures market is transparent; pricing of commodities are fair and manipulations very difficult. Electronic trading on the exchange platform pools together all forces affecting the price of a commodity, leading to price discovery mechanism, which improves efficiency and lowers costs. Technology renders the exchange highly competitive since the market reacts very fast; prices and transactions are monitored constantly while information is captured continuously and incorporated in the intrinsic value of a good. Telser and Higinbotham (1977) concur that, "futures market pools trade from diverse area into a central market, thereby increasing the heterogeneity of potential transactions". They proclaim that futures are liquid as transaction occurs readily at mutually acceptable prices and that homogenisation and clarity of the terms and conditions boost liquidity.
One need not possess the underlying asset to sell futures while one may not be in need of a commodity to buy futures. Speculators and arbitrageurs enter the futures market without possessing or the intention of buying the commodity. Thus, the transfer of risks to different players in the market increases liquidity and maintains the equilibrium in demand and supply. Telser and Higinbotham (1977) statistically demonstrate that as the number of traders in the market increases, the market clearing prices become normal. Futures can be squared-off (reverse a position) without negotiation, thus making delivery non-mandatory.
Positions can also be rolled-over. If period for hedge is later than the expiry date of the current futures contract, the hedger can rollover the hedge position by closing the existing position in a futures contract and simultaneously taking a new position in another futures contract with a latter expiry date.
22.214.171.124 Transactional and Informational Efficiency
Futures market increases the informational efficiency of cash market and promotes import and export competitiveness. Cox (1976) empirically demonstrates that futures trading increases traders' information about forces affecting supply and demand. His analysis rejects the claim that futures trading impose costs on producers, consumers, and others who handle the physical commodity. Additionally, evidences from more fully informed traders suggest that futures trade increases efficiency in spot markets.
126.96.36.199 Increase Export Competitiveness
When entering forward contracts, exporters do not, usually, possess the entire stocks for export. Futures market enables them to hedge their projected purchase, until they have to buy in the physical market for exporting. Taking a position in the futures market will help to offset the gain/loss in the physical market; that is, at maturity the net loss/gain in futures market offsets the gain/loss in the physical market. Thus, exporters can accept contracts with longer duration and increase their competitiveness.
188.8.131.52 Offsetting gains and losses in the physical market
Futures market also allows a hedger to take a position in the futures market opposite to the position he takes in an over-the-counter market. Such a transaction is termed: exchange of futures for physical (EFP). The OTC and futures positions should be for the same underlying assets or at least similar in terms of value and quantity. This results in the flexibility of customising the physical market with respect to the needs of traders, parallel to the OTC market and at the same time enjoying settlement guarantee in an exchange.
Usually, margin requirements for EFP transactions are lower. EFP may seem appealing but is inefficient in fair pricing. Exchange Officials apprehend that EFPs would harm the futures market by reducing volume and liquidity and inhibit fair price discovery.
184.108.40.206 Diversification of portfolios
Futures on commodities serve to diversify portfolios, since they are less volatile than financial securities. Bodie and Rosansky (1980) report an average excess return of 9.5% per annum for an equally weighted portfolio of commodity futures between 1950 and 1976. Their analysis reveals that equities are riskier than commodity futures. Furthermore, total return of the equally weighted commodity futures was negatively correlated with the return on long-term bonds, suggesting that commodity futures are effective in diversifying equity and bond portfolios. The benefits of diversification from commodity futures tend to be larger for longer holding. A similar analysis carried out by Gorton and Rouwenhorst (2005) confirms that commodity futures returns have been effective in providing diversification of both stock and bond portfolios.
Weiser (2003), on the other hand, contends that commodity futures returns vary with the stage of the business cycle. He finds that commodity futures usually perform well in the early stages of a recession while stock returns are generally disappointing and in later stages of recessions, commodity returns fall while equities perform well.
2.3.3 Costs of Futures Contracts
Despite appealing benefits, futures contracts inherit some costs and the prime one is the complexity of handling them. Futures were generated to deal with the limitations of forwards but, in so doing, they brought a more complex form of hedging. Proper knowledge of the market is crucial; otherwise, hedgers may face unwanted losses.
220.127.116.11 Basis Risk
Basis risk (the difference between spot and futures price) is inbuilt in futures market. Hedge positions are usually not perfect due to this difference. Working (1962) emphasises that the existence of basis risk prevents the elimination of all risks. Brorsen (1995) finds that changes in basis can cause forwards to be cheapest in some periods and futures to be cheapest in others.
Therefore, the benefits of hedging can be enjoyed when the market is well understood.
Advanced futures concepts about hedge positions, hedge ratios, and types of hedges should also be mastered as they benefit hedgers differently in different markets.
18.104.22.168 Mark-to-Market System (MTM)-cash drain out
The transaction costs involved, such as, initial margin and variation margin in the MTM system freezes up working capital that could have yielded interest. Furthermore, the margin call should be paid before next opening of the market- a very short delay. These daily settlements make transactions volatile and cash flows cumbersome to maintain. Margin costs and brokerage commission discourage some investors, especially small traders, to enter the market. Williams (1986, 1987) shows that risk-neutral firms will hedge if transaction costs are lower in the futures market than in the cash market. Moreover, instances of dual trading exist, whereby brokers trade on behalf of their clients to earn a commission, without improving the customers' position.
22.214.171.124 Large Number of Participants needed
Futures contracts fail for lack of interest by market participants, that is, a low trading volume. Telser and Higinbotham (1977) statistically demonstrate that the benefit of an organised market is an increasing function of the number of potential participants and hence, an increasing function of the turnover of the potential participants in that market. They conclude that an organised futures market survive only if it is perfectly competitive, which is achieved when there are many participants. If the open interest (number of contracts outstanding) in the futures market declines, the volume of trade falls relative to the open interest. The commission and the margin are raised consequently. They even assert that there is a cost to the emergence and survival of an organised exchange.
126.96.36.199 Standardisation issues
Standardised nature of contracts may cause over-hedging or under-hedging. For example, a contract specifies £1000 to be sold while a hedger may need only £800. Therefore, he over-hedges by £200. Conversely, say a hedger needs £1100, he under-hedges by £100.
188.8.131.52 Uninformed Investors Increase Volatility
Uninformed investors may increase price volatility in the futures market. If the market is inefficient in information, futures prices become biased predictors of future spot prices and causes cash prices and future prices to diverge rather than converge.
Usually, futures contracts with longer maturity are closer to spot prices since time is required to assimilate unanticipated shocks. However, Kaminsky and Manmohan (1990) suggest that it is impractical to make any generalisations about the short-term and long-term horizons in commodity futures market. They find that for longer periods several markets are not fully efficient. In addition, Chernenko et al. (2004) study a wide range of futures and forward rates from financial markets and conclude that "forward and futures prices are not generally pure measures of market expectations"; per se, they may not be an efficient forecast of the future prices of assets.
184.108.40.206 Losses Faced By Investors
Other studies indicate that large scale, professional speculators can profitably forecast commodity prices, but small traders cannot. Stewart (1949) considers futures-trading accounts for small-scale speculators and discovers that they face huge losses. Moreover, Houthakker (1957) and Rockwell (1967) find that large speculators earned profits and small speculators incurred losses for a particular set of data. Similarly, Working (1931) estimated that speculators in wheat futures, incurred losses.
Empirical research shows that, for cattle and wheat producers, futures markets have lower transaction costs than forward contracts, while for small firms like farmers, the contracting costs might be higher because of opportunity cost of time in learning about futures, setting up a brokerage account, and managing margin calls. It would be unnecessary for small groups of traders, well acquainted with each other to transact among themselves than use futures.
2.3 Derivatives Mishaps
The history of derivatives has witnessed some spectacular losses in the derivatives markets, which includes losses made by both financial (e.g. Amaranth hedge fund, Barings Bank) and non-financial institutions (e.g. Orange country, Shell, Metallgesellschaft).
The Metallgesellschaft (MG) is a German oil company, which used futures to hedge its exposure in its early 1990s. MG hedged its position with long positions in short-dated futures contracts that were rolled forward. However, the price of oil fell and then came the margin requirements, which caused short-term cash flow pressures.
Members of MG claimed that these were short-term cash outflows and in the long-run, there would be a cash inflow. However, this led to a serious issue as huge cash was drained out of the system. Consequently, MG executives closed out all their hedged positions. Therefore, one lesson to be learned is to be alert at all times and constantly review the hedging strategies and pricing models to avoid mispricing goods.
Table 1: A Comparison between Forwards and Futures
Futures Forwards Traded on exchange Traded on OTC markets Several traders- international participants through the electronic trading system Private contracts-usually between two entities; few dealers Standardised-small lot size Customised to the needs of traders Delivery is mandatory but taking delivery is optional- Contract usually closed out Delivery mandatory and contracts are rarely mutually settled Can be rolled forward if good is not needed Delivery occurs at specified date Regulated market Unregulated market Daily settlement- MTM Settlement at maturity Trade and settlement guarantee-clearing house No guaranteed trade and settlement No credit and default risk - margining system Credit and default risk present Transparent-all forces used to price the contract Not transparent-not all forces present Speculation and arbitrage possible Speculation and arbitrage may be risky Risk transfer to different players is efficient Risk not transferred efficiently Liquid- many traders Illiquid- few traders, usually two parties Small traders are free to participate Suitable for firms with good credit ratings and market power Trade match are anonymous Counterparties are identified for guarantee Transactional and informational efficiency Inefficient in information and transaction costs Cash flows cumbersome to maintain No cash flow problems Complex Relatively simpler
3.1 Financial Structure of Mauritius
"The launch of the first Pan-African Derivatives Exchange, the Global Board Of Trade (GBOT), in Mauritius marks a milestone in the development of our financial sector."
(R. Bheenick, Governor of the Bank of Mauritius, July 2009).
Over the last decade, Mauritius has been concentrating on the banking sector, capital markets, insurance sector, and global business to shape a robust financial services sector, which is one of the four pillars of the Mauritian economy. It is now taking a stance in the derivatives market by launching a futures and options exchange (GBOT) to boost its financial system, and render it more solid and attractive.
Despite massive evolution in the global derivatives market, Mauritius still lags behind for various reasons, such as, the absence of liquid markets for the underlying assets, and other pre-requisites. Likewise, proper knowledge and expertise in handling these instruments were absent thus far, but the motivation and commitment of private organisations and the government have lead to the conception of several campaigns in creating public awareness, education, and training through workshops to uphold the derivatives market.
3.2 OTC Derivatives Market in Mauritius
Past studies reveal that Mauritius deals mainly in OTC derivatives such as forwards, swaps, and options. Nevertheless, OTC derivatives market is still at a premature stage since hedging activities is concentrated among a few particular groups of companies only namely textile, transport and construction companies, hotels, parastatal bodies, financial firms, banks among others. Credit derivatives, introduced lately, are widely used by Banks to minimise the risk of default on loans.
Various institutions are now attuning to the importance of hedging through derivatives. For instance, the Hongkong and Shanghai Banking Corporation Limited (HSBC) has established the HSBC Financial Products Institute to provide training programmes on derivatives and risk management and constitutes of globally synchronised officers to provide clients with access to international derivative markets. HSBC derivatives products include forwards, FX options and currency swaps.
3.2.1 The Air Mauritius Hedging Failure
The Air Mauritius hedging failure has ushered misconceptions about the effectiveness of derivatives products in mitigating risks. Nonetheless, the derivatives market is slowly gaining prominence and acceptance through public awareness campaigns.
The Air Mauritius Company Limited (AML) hedged fuel prices with forwards contracts in 2007, anticipating that fuel prices would be shooting up. The financial crisis, however, caused the AML to face huge losses since spot prices of the hedged fuel were lower than the contract price and unfortunately, the contract could not be withdrawn. The losses incurred nearly lead the AML on the verge of bankruptcy.
Unaudited figures show that the Company has realised a net loss of EUR 20.5m on its hedging contracts during the 9 months period ended 31st December 2008. Unrealised losses (Mark-to-market) as at 31st December 2008 on unexpired hedge contracts maturing up to August 2010 stood at EUR 129.5m.
(AML Board communiqué, 12 January 2009).
The risk management committee of the AML is responsible for hedging activities and regularly revises the credit ratings of its counterparties to manage default risk. Air Mauritius has a fuel price hedging strategy on crude oil, gas oil and jet fuel with a maximum time horizon of 24 months (2 years) with a policy to hedge between 30 to 70% of exposure. Contrary to this policy, the company hedged 80% of the fuel requirements for a period of 3 years, ending in August 2010. This strategy has been severely criticised. The forward contract was handled similar to futures with daily settlements (MTM), but with no possibility of exiting the contract or reverting its position. It can be reasonably questioned whether the use of futures contract would have been more advantageous, or the forward contract is the better choice provided it included an exit clause. Anyhow, this mishap has alerted risk managers to structure their hedging strategies carefully henceforth.
3.3 Prospects for Exchange-Traded Derivatives Market
Mauritius opportunities are limited only to OTC derivatives market; the introduction of a futures exchange will undoubtedly broaden the alternatives for derivative products. Importers, exporters, small traders, large firms, and other traders will be benefited largely.
The Global Board Of Trade (GBOT) has already been set up in Mauritius in November 2009 but is expected to launch its electronic trading activities in January 2010. Several workshops and seminars have been organised in this context. GBOT will introduce an array of commodities and currency derivatives and plans to trade in debt and equity products. Several conferences have been carried out amongst larger nations with greater financial stability, and success. Mauritius is enjoying the support of other countries in promoting the local derivatives exchange, and diversifying its products and services.
The commencement of a futures exchange in Mauritius is anticipated to increase efficiency and liquidity in the markets for underlying assets. Mauritius, being a small economy and export-oriented country will be able to manage its risks efficiently and eventually be more competitive and financially attractive. Exchanges offer better price dissemination, thus, prices of commodities will be less controlled and more market-determined and stable with lower volatilities, which may lead to the phasing out of subsidies and benefit Mauritius largely.
The derivatives market will uplift the stability and success of our financial system by facilitating risk management and price discovery. Indisputably, it will occupy a very significant position in our small economy. As literature puts forth, the derivatives market will strengthen cross-border economic ties, encourage international trade, and induce a regional integration process in the long-run to benefit all African countries.
In addition, the Stock Exchange of Mauritius (SEM) is initialising trade in Index Futures, expectantly in 2010. It plans to commercialise futures contracts on the SEM-7 index and on some of the most liquid stocks traded on the Official Market for better management of portfolios. In this respect, the SEM has organised extension programmes to outline the aims, characteristics, potential benefits and risks of the futures trade, as well as the trade mechanism and the settlement facility provided by the Central Depository and Settlement Company Limited (CDS).
Furthermore, the SEM, in collaboration with the National Stock Exchange of India, provides online courses about financial and derivatives markets to market participants, investors and the public at large. The supervisory and regulating body of the derivatives market is the Financial Services Commission (FSC).
Chapter 4: Research Methodology
4.1 Definition of Problem
The derivatives market is, yet, another backbone for a sustainable financial development in an economy besides the banking and non-banking financial services sector. The authorities concerned with the development of a sound and stable financial system in Mauritius claim that time is ripe to integrate a derivatives exchange. However, absence of real demand for futures contracts may cause this new venture to fail.
As seen previously, one of the factors affecting the effectiveness of exchange-traded derivatives is the volume of contracts traded on the market. Many participants are needed to increase the volume, boost liquidity and efficiency of the futures market. Thus, even if economic and social conditions favour the opening of a futures exchange, it is futile if the number of players is insignificant.
Forward contracts are relatively easier to manage and understand compared to futures. In this respect, an investigation is carried out to acknowledge the current frequency of the use of forward agreements but, more importantly, to acknowledge the opinions of potential hedgers on the futures market and distinguish whether there is significant demand and willingness to trade in it. This will help to determine whether liquidity and efficiency will prevail on the market and thus, signify the probable success of the GBOT. Even though, some firms are not currently involved in hedging activities, their willingness, and interest in learning about the futures market may induce them to do so at a later stage.
This survey purports to analyse:
- Whether firms in Mauritius hedge
- The current instruments used for hedging and their frequency
- The feedback on the efficiency of derivatives as well as their drawbacks
- The vigilance of officers in the development of the derivatives market
- The extent to which they are acquainted to the mechanism of the futures market
- The way they perceive the derivatives exchange and its importance on our economy
- The opinions of the management in regard to the futures market
- The outlook of futures contracts in comparison with forward agreements
- The willingness of firms to trade in futures
- The purpose of the firms in entering the futures market
- Willingness of responsible parties to attend related courses or workshops and acquire the knowledge and expertise to deal in futures
4.3 Sources of Data and Research Approach
Both primary and secondary data have been used in this study. However, this analysis is dependent mainly on primary data since it seeks direct responses on the opinions and perception of potential hedgers, which will designate whether there is an actual need for a local futures exchange at present. To this effect, a survey is the most appropriate research approach to gather such information. Primary data obtained from the survey is analysed using SPSS, a user-friendly software. Some data are exported to and worked in excel for illustrative purposes. Secondary data have been gathered from existing articles, financial statements, websites, and other sources.
4.4 Sampling Design
The sample frame chosen for this study is top hundred and twenty companies (ranked on assets) from Mauritius. This sample includes both financial (banks, insurance, investment banks, offshore companies and so forth) and non-financial firms (manufacturers, traders, importers/exporters, hotels, oil companies, textile companies among others). Firms ranked on assets are selected since evidences suggest that firms with larger assets are more likely to hedge. Per se, in this research, it is assumed that the top hundred companies in Mauritius are potential hedgers; they hedge through derivatives and/or will hedge once GBOT starts operation. In this respect, they qualify as a supportive source of information for this survey.
4.4.2 Target Population
The survey targets individuals with proper knowledge, skills, and expertise in derivatives. They should be the one responsible to inform and counsel the firms on risk management decisions. As such, risk managers, financial managers, treasury managers, accountants, or individuals sharing similar responsibilities are best-suited respondents.
4.5 Research Instrument
A questionnaire or an interview was deemed the appropriate tool. However, since the sample size is large (120), interviewing the sample would be too cumbersome and time-consuming. In addition, it seemed doubtful that the targeted population would be willing to answer to an interview. Alternatively, a questionnaire was sent, which was quicker to administer and more practicable to seek information about the behaviours and outlooks of the specific group. The questionnaires were administered by post and emails, but most of the time personally, to address any problem faced by respondents and to ensure that the questionnaire was filled in.
4.6 Questionnaire Design
The questionnaire was designed with regard to the respondents. Since the respondents are at the top management level, they are rather busy and thus, would be reluctant to fill in a questionnaire, which is bombarded with complex and heavy questions. Hence, the questions were set simple, light, and precise to induce responses.
The questionnaire is divided into three parts: Hedging activities in Mauritius, Awareness of GBOT and futures trade and Willingness to trade in futures.
Question1 aims at distinguishing the number of financial and non-financial companies in the selected sample of top hundred companies in Mauritius.
Question 2 determines whether the selected firms hedge or not. This helps to assess whether firms with large assets in Mauritius hedge, like the theories stipulate.
Questions 3 and 4 determine the products used and their frequency of use.
Question 5 rates the efficiency of derivatives as a tool for risk management.
Question 6 describes the costs with using derivatives.
Question 7 aims at analysing the alertness of the respondents and the extent to which they are attuned to the financial arena.
Questions 8 and 9 aim at determining whether respondents are aware of the mechanism and hedging strategies of the futures market. The knowledge of the respondents in the relative field will suggest what can be done to increase awareness and expertise.
Question 10 compares forwards and futures and assesses the perceptions and preferences of the respondents. As such, it can be determined whether they are likely to trade in futures.
Question 11. An overall opinion that summarises the preference and importance of the two markets.
Question 12 allows respondents to have their say about the effect of futures market on the economy.
Question 13 assesses how respondents perceive the introduction of a derivatives exchange in Mauritius. This will relate the degree of importance of the exchange in Mauritius.
Question 14 seeks information about the number of respondents willing to take a position in the futures market, hence, demand for a local derivatives market.
Question 15. Since the futures market is open to all types of traders, it is imperative to acknowledge the motives of participants in entering the market.
Question 16 is hypothetical, meant to assess the likely percentage of risk to be hedged with futures. It is assumed that the greater the range, the greater the demand for futures.
Question 17 (a) seeks to know whether respondents have attended related courses. This indicates that having attended the workshops, they have an overview of the mechanism of the futures and that they are ready to implement whatever they have learned.
Question 17(b). If respondents have attended such courses, then the extent to which they derived satisfaction signifies whether the course was productive and helpful indeed. This can help to frame further suitable training programme to meet the requirements of those interested.
Question 18(b) seeks to know whether respondents are interested in learning about the futures market. Thus, even if there is no significant demand now, learning about the market may induce the respondents to use futures at a later stage.
Overall, this survey assesses whether there is a demand for futures contracts and whether training programmes should be widely and frequently administered to increase awareness and minimise the possibility of mismanagement. Thus, all the responses are used to analyse the current situation and provide some recommendations.
4.7 Limitations of the Survey
The largely known limitation of carrying out a survey is non-response from the target population. Indeed, the same was witnessed in this research. Since the sample size is quite large, the rate of non-response has been larger as well. It was very difficult to contact the respondents and convince them to fill in the questionnaire. Most of the time the respondents claimed to be busy; others suggested to respond later without any promising certainty. Furthermore, some responses may be biased since they depend on the respondents' honesty and integrity when filling the questionnaire.
Also, administering the questionnaire was costly in terms of printing, transport and posting costs. The research also proved to be time-consuming since the sample is large. Additionally, when carrying out the survey, several companies claimed that they were not involved in hedging activities and refused to fill in the questionnaire.
Although the selected sample size is large, it may not fully represent the whole population actually hedging. Some companies, which are potential hedgers, may have been left out since they did not appear in the top hundred and twenty companies list.
5.1 Analysis and Findings
Out of the 120 respondents targeted, only 70 actually responded to this survey. This accounts for 58.3% of the sample and since it is greater than 30%, it can be used effectively to represent the whole population of concern and to infer relevant conclusion for this analysis.
It should be remembered that Mauritius is a very small, developing country, still struggling to boost its economy to higher level of growth and thus, the results obtained for this survey may contradict theory.
All the raw data obtained in SPSS are in the appendix section.
5.2 Hedging in Mauritius
The sample consists of both financial and non-financial firms. As such, it is important to determine the frequency of each variable as they may insight several considerable implications. The diagram below shows that the top 120 companies constitutes mainly of non-financial firms (63%) while financial firms consist of 37% of the sample.
Theoretically, it is known that financial firms are the market makers and, usually, take a position in the derivatives market as investors rather than hedgers. Contrarily, non-financial firms are mostly hedgers that are exposed to risks.
The non-financial firms were not subdivided according to the nature of their business for simplicity purposes and since it was deemed unimportant with regard to the fact that we are analysing the likelihood of the respondents to hedge in the futures market.
The sample was selected on the assumption that firms with larger assets are more likely to hedge. However, literature generalises theories, which may not necessarily apply to all countries. For instance, large firms in the USA are likely to hedge since they have the facilities of a well-developed derivatives market. Conversely, Mauritius still has an under-developed derivatives market.
The percentage of firms that hedge is greater than the percentage of firms that do not hedge as depicted in the diagram below. However, the difference is so small that it seems insignificant.
It is even more interesting to know which of the firms, financial or non-financial, are more likely to hedge.
From the diagram, for non-financial firms the hedging decision has a probability of 0.5 while financial firms have a probability of 0.53.
The values do not differ significantly. Hence, to measure the significance the association between type of firm and decision to hedge statistically, we perform a chi-square test at 5% significance level.
Let us assume two hypotheses:
Ho: There is no association between type of company and decision to hedge
H1: There is an association between type of company and decision to hedge
If p-value is > 0.05, then we accept Ho; otherwise, we accept H1. The result obtained is as follows:
Table 2: Cross-tabulation of type of company and hedging decision
Value df Asymp. Sig. (2-sided) Pearson Chi-Square .097(b) 1 .756 N of Valid Cases 70
The p-value of the chi-square test is 0.756, i.e. >0.05. Hence, we accept Ho and conclude that at 5% significance level there is no evidence of a relationship between type of firm and hedging decision.
From the 51% firms that hedge, 50% use forwards contracts, 30% use swaps, 11.4% use options, and 4.3% use futures. This is represented in the diagram below.
The use of futures in Mauritius was unexpected but upon questioning, the respondents claimed that they hedged in the foreign market to benefit from the array of instruments available. In addition, some are firms have their parent company abroad whereby hedging decisions are managed.
As gathered and expected from most articles, forwards are used mostly in Mauritius. The reasons for using forwards are that they are simple and there is an absence of exchange-traded derivatives market in Mauritius. The options used are OTC contracts, which are quite expensive compared to forwards, hence used rarely. Options require a lump sum to be paid up, known as the premium, upon entering the contract. Some firms resort to options due to the added flexibility over the decision to exercise the option.
The benefits of derivatives are enjoyed mostly when they significantly attain their objectives of minimising risks. Hence, respondents were asked to rate the derivatives that they use.
As it can be seen, 20% of the hedgers perceive derivatives as an excellent tool for risk management while only 2.9% perceive them as poor risk management tools. Most rate derivatives as fair and good risk management tools. Hence, those who rate derivatives as poor tools for risk management can be seem to be very insignificant.
Table 3: Rating derivatives as an efficient tool for risk management
N Valid 70 Missing 0 Skewness .319 Std. Error of Skewness .287
A positive skewness (0.319) indicates that the distribution is positively skewed towards the right, which conforms to the conclusion that very few respondents rate the derivatives they use as inefficient tools for risk management.
Theory stipulates that derivatives have some drawbacks, which explain the losses and closing down of several large firms. Below are the opinions of the respondents with regard to the derivatives that they actually use.
14.3% of the respondents strongly agree that the derivatives are costly but 15.7% disagree. Very few strongly disagree that derivatives are costly, difficult to manage and time-consuming. The opinions of the respondents vary largely, which render it difficult to draw conclusions. However, from what can be depicted, for the difficulty to manage property, the highest response goes to uncertain. Whereas for time-consuming, an equal number of responses are uncertain and agreeable.
Mostly respondents are uncertain about the derivatives that they use. Probably, this is because they use derivatives very rarely and do not think about their costs in an attempt to hedge their financial risk, or perhaps they use the expertise of third parties or they use a pre-determined strategy most of the time.
Table 4: Features of derivatives used actually
Derivatives are costly Derivatives are difficult to manage Derivatives are time-consuming N Valid 70 70 70 Missing 0 0 0 Skewness .568 .408 .479 Std. Error of Skewness .287 .287 .287
The table shows that the distribution is positively skewed (twice the standard error) for all the features of the derivatives, which implies that the distribution is asymmetric such that mostly, the derivatives are perceived to be costly, time-consuming and difficult to manage.
5.3 Awareness of GBOT
As depicted in the diagram above, most of the respondents are aware of the GBOT in Mauritius (51.4%). 40% of the respondents are not aware while 8.6% are uncertain. Conclusively, the number of respondents who are aware of the GBOT is small.
It is expected that financial managers or those of similar responsibilities are vigilant in the financial arena, but statistics show otherwise. 51.4% is only half of the population, who are actually aware GBOT. Nonetheless, even though some respondents know about GBOT, they are unaware of the underlying goods meant to be traded. This can be seen as factor, which can disturb the success of the GBOT. The idea of introducing GBOT started long before its setting up in Mauritius, yet, few financial managers are aware of it. This is likely to hinder the trade of futures.
Logically, if the respondents do not even know about the GBOT, they will hardly know about the goods on the market. If the GBOT wants to attract investors, then it should above all create awareness.
A question of concern can be 'which of the firms are more vigilant in the area of derivatives?' In order to get an insight about this, a Chi-square test is carried out.
Assuming the following hypotheses:
H0: There is no relationship between type of firm and vigilance in the finance
H1: There is a relationship between type of firm and vigilance in finance
We would accept Ho if p-value was >0.05. However, the test revealed a p-value of 0.024, which is less than 0.05. Therefore, we accept H1 in favour of H0 and conclude that there is a relationship between the type of company and awareness of GBOT set up. Conclusively, financial firms are more vigilant in the area of derivatives compared to non-financial firms.
Question 8 & 9
Knowing about the GBOT set up is one thing but understanding the futures market is another. In order to benefit from the futures, one should be wholly literate about the market. Compared to forwards, futures are somehow more complex due to the daily settlements and ability to square off a position. Many losses have been faced due to mismanagement of the derivative instruments. Hence, it is important to assess whether the respondents are suitably qualified to deal in futures.
In general, most of the respondents are somewhat aware of the futures trade mechanism and hedging concepts. Very few are actually fully aware. This can be attributed due to the fact that the managers do not have the expertise to trade on derivatives exchange. Furthermore, the strategies involved in futures are quite complicated and require a good understanding of the market to minimise risk effectively.
Even though, the knowledge is quite low, expectantly in a few years, firms will counteract this issue with regular training programmes for their employees.
Since we are in an uncertain venture, it is best to assess what the respondents (potential hedgers) think of futures. Even if they have no practical background, their perception about the features of futures compared to futures will insight whether there is a demand for futures over forwards. Since Mauritius does not trade largely in futures, the responses are purely opinion based and may not reflect fully the true picture of futures, yet, it will induce some measures that can be adopted to counteract every problem which seemingly hinders the success of the organised derivatives market in Mauritius.
As can be seen from the chart, most of the respondents are uncertain about futures contracts. 34.3% of the responses agree that futures are more transparent than forwards while very few strongly agree this attribute. 14.3% responses disagree that futures are transparent compared to forwards.
The liquidity of futures compared to forwards is an issue since there are 25.7% responses agreeable that futures are more liquid than forwards while 21.4% do not agree with this statement. However, when considering the number of responses that strongly agree and simply agree, the percentage responses non-agreeable is outweighed, such that it can be concluded that futures are more transparent and liquid compared to forwards.
Transparency and liquidity are the positive features of futures but as already seen in the literature section, forwards do have some advantage over futures. Indeed, the benefit of one contract is the cost of the other and vice-versa.
The responses are distributed randomly and thus, it is difficult to make inferences. Nonetheless, from what can be retrieved, there is high degree of uncertainty with regard to the futures market. Most respondents are uncertain about the features of futures.
Some responses significantly demonstrate that futures are more complicated in accounting management. There is considerable evidence that futures are more costly and time-consuming but the rate of response is higher for uncertainty. This can be due to the fact that there are no futures trade for the time being and thus, respondents do not have the technical expertise to assert their point of view. In addition, futures are seen to be somewhat bulkier than forwards; i.e. it is not as simple as forwards since there is the margining, mark-to-market system unlike forwards wherein transaction occurs only at maturity.
Unsurprisingly, 34.3% of responses agree that futures are more complex than forwards, which conforms to literature. Nevertheless, 24.3% respondents contend this statement. All investors have different attitudes and preferences. Such attitude may be classified as a bullish and aggressive attitude, which will eventually enhance the efficient risk transfer in the futures market.
Futures and forwards both have specific costs and benefits but there are no 'best derivatives' as such. Some people classify derivatives as 'evil' and disastrous to the economy, yet, many articles debate this statement. Researchers have shown that derivatives themselves have no hand in financial collapses. However, to prevent such crises it is imperative for derivative users to gain sufficient expertise to refrain from committing blunders that may eventually lead to a breakdown in the financial system.
The types of derivatives used depend mainly on the attitude and risk appetite of the investors. Since this study compares forwards with futures, it was de
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