Derivative - Is it Lucrative ???

I as a novice in this world of finance, with dreams to study and understand such a great product of finance which lures trillions of dollars every year in to the financial markets look at things in a completely different way. To begin with I understand derivatives to be instruments to HEDGE an underlying exposure a company/individual has interest in and fears the loss of value in the future. So to avoid/minimize this loss the company/individual undertakes Futures/Options route to mitigate or minimize the potential risk.

As per my understanding derivatives and related markets (futures and options) were introduced to address the following issues

- To have a platform or meeting place for the two ends to meet, and to minimize the substantial part played by middlemen in trade of commodities and other assets.
- To have a better method of price discovery through such exchanges where the demand and supply in sync with other factors will lead to appropriate price of the asset.
- To help the parties involved to mitigate or minimize the risk of value erosion, supply/demand and other risks in reference to their interest.

But so far of what ever I have learnt and seen in this short tenure, I haven’t yet been convinced with the working of the whole system as such. The issues I confront everyday while I deal with the subject are as follows

- If this concept was to make the 2 ends meet and minimize the role played by middlemen, then why are the exchanges allowing parties not involved in that particular trade or having exposure in the underlying allowed to trade in the commodity (Speculate) and make things even more complex (I know the first response to this will be for liquidity, would come to it later!).

- If these exchanges/ markets are for better price discovery, then again how can speculators in such markets help for the same, I believe only the parties having interest/ exposure in the underlying can help in a better price discovery and not novices like me, who don’t know a thing about the underlying at the first place.

- If all the above is done for the sake of liquidity and opening up of the financial markets and the economy in the world in a big way, my question is where are we answering the real issues for which such innovative financial products were developed.

To be able to explain the above concerns I would like to share certain examples I have come across so far which have provoked me to delve deeper into this subject and understand it better.

The case of MGMR (Metallgesellschaft), which clearly shows how the derivative contracts led to its risk in the underlying quadruple, I believe if it was not hedged the losses would have been far lesser than it were due to the hedged position. I simply think that when MGRM was already locked with the underlying contracts its only fear was that its underlying should not be affected in value or other ways, so it undertook several other derivative contracts and locked itself further more, which only led to increase in the number of ways it was locked than the number of ways it should have been able to come out of the losses (risks). And we see the result of it, a reputed company owned by several financial giants (German banks) had to liquidate due to the risk management techniques which infact increased the risk not only of the underlying but of the company as a whole leading to an uncalled liquidation with losses not just from the underlying but from various other ends including the derivatives, liquidity and many more ways.

I have studied 12 ethanol producing companies of US during my summer training (April – June 2008) and have found that most of them have huge losses (unrealized) on their derivative transactions which have reduced their profitability in an industry where there are various other factors which are already making life difficult for the companies, over which such derivative contracts are not making life any easier. Ethanol companies generally undertake derivatives contract in two underlying commodities namely Corn and Ethanol, the dynamics of the industry have changed a lot in the last 2 years and again as mentioned earlier I feel these companies would have faired better even without such contracts. The more time they spend looking after the risk management, the more they loose their time to concentrate on their underlying business itself (to me it seems like loosing from both ends).

Another important example to support the view is of the Crude oil prices which have soared to the level of $147 in July08 from about $70 in a year’s time. According to various research reports 60% of the increase in crude prices is due to speculation by various big players who are throwing money in crude to make money, which is leading to notional increase in demand of crude which subsequently resulted in increased price due to high demand (notional). Today the crude price again is at about $113(August 15 2008); the volatility of such an important commodity to the whole world is uncalled for, as it is leading to such levels of inflation in the world making food, travel to be even a rich mans dream. The main reason for such volatility in Crude prices as mentioned earlier is speculation, where in parties who do not have any exposure of the same playing dirty games in the exchange and leading to such worse condition of the world. Now again I feel the same question raises, where has the availability of such contracts helped to hedge the risk or even in price discovery. It has infact done things the other way round, the risk increased even more in the world level, prices were not discovered but infact were (are) being dictated by giants with huge liquidity who are moving the market the way they want (why should millions of people in the world get affected, just because several giants want to make money from such activities). I don’t think anyone can convince me in this context (at least no one has been able to so far).

I am not questioning the ability of this product (derivatives) to help minimize the risk but my only concern is that it’s not able to safeguard your interests always (most of the times). One must realize that such contracts are taken to limit the down side, while we must also remember and understand the fact that it’s a zero sum game, if one party earns, the other looses. Infact as seen in various situations such contracts are even leading to limit the upside and the company remains exposed to the downside i.e. in case the company was not hedged it would have made much more money when the price increased, while in case the company is hedged it earns only a limited predetermined profit because of the so called derivative contract, while in the downside also the same applies, as in when the company is not hedged it looses only the value of the asset to that extent, while when it is hedged it looses in terms of the value of the asset plus also on the investments or upfront expenses it had done to undertake the derivative contract.

One important thing one must remember in all these arguments is that one takes a derivative or any other contract after making certain assumptions about the movement of the price of the asset, what I want to say is, if you already have a view of the movement and your derivative contract is also to augment that view then what’s the need of it at the first place, as you can just follow your view and you can make money. The problem only comes when your assumptions turn out to be wrong and then neither does your view help nor does the augmenting derivative contract. I believe a contract can only help me, if and only if it is able to take away any possibility where my view goes wrong because I would anyways make money in other ways without the contract through my view and actions following the same.

To sum it all up, I am not game for these lullabies that this financial product was started with such and such intention and it is the best way to mitigate risk and so on, yes I like the concept and the innovation but still its not able to address the main issue which it was supposed to address so I don’t think its worth a thing to boast about or at least in that context (context that it helps to mitigate risk, price discovery bla bla). I think I need some more time to understand it better, need to do some more R&D before I come to any final conclusion but this whole write up was to sum up my initial relationship with such a novel concept.

Do feel free to comment, criticize or rectify me where ever I am wrong, as mentioned in the start I am a novice trying to understand and learn and I believe there is no better way of learning than to express your thoughts and build on it with guidance from other stalwarts.