Investments
Introduction
An equity instrument is a document that is legal evidence of ownership of a business premise. It is issued to shareholders of the company, and it is the one that is used to fund the company.
Various categories include:
- Common stocks are issued by a public company to consolidate funds.
- Also similar to common bonds is the convertible debenture, but the slight difference is that common debenture can be converted into common stocks at certain prices
iii. A preferred stock involves the participation of the shareholder as an owner of the company.
- Depository receipt entitles shareholders the rights to common bonds.
v.Lastly, we have a transferable subscription right, which is an instrument issued to all shareholders by companies instead of their shareholdings.
A bond instrument refers to the obligation of a bond agent to the holders. Various types of bonds include corporate bonds and municipal bonds. The bond is like a measure the issuer owes the holders for an obligation. Further bonds can be a form of a loan.
Derivative instruments are financial agreements which have their worth connected to the price of an original asset (Kota & Charumanthi, 2018). Derivatives are classified as composite financial instruments with various uses. Some of these purposes are hedging and having more access to extra markets and assets.
Increasing globalization has stimulated most organizations to expand their businesses beyond their physical boundaries to gain as a result of being competitively advantaged and the economy of scale. New markets have penetrated the economy, thus affecting the economy in two ways. One has increased profitability and, on the other hand, unpredictability in net income because of the prevailing risks (Ojo, O.V, 2015). This has resulted in many finance managers of various multinational companies to focus on the importance of managing risks to lessen the inconsistency in their liquidity flows from procedures in foreign countries and fluctuations in foreign exchange rates.
Most scholars believe that higher exchange rate fluctuations and volatility of overseas sales affect the firm’s profitability levels. Therefore, finance managers with corporations abroad are on the view that various trade agreements and minimal capital flow restrictions have increased exchange rates exposure. Further, most countries are using the system of floating exchange rates because the exchange rate from foreign countries is exposed to complex exchange rates Risk, and this justifies the need to employ different risk management methods.
Types of Derivative
Forwards and Futures
These refer to financial pacts that compel purchasers to obtain an asset at an earlier agreed price at a date in the future. Forwards and futures are fundamentally similar (Shamsher. M, 2020). Nevertheless, forwards are substantially flexible pacts since the agents can customize the fundamental product and the transaction date. On the other side, futures are consistent pacts operated on the exchanges.
Options
Options give the taker of an arrangement to rights and not an obligation to trade on the given a set at a pre-set value. Regarding now the kind of option, the purchaser can exercise that option on the day it matures or on any other day before it matures.
Swaps
These are derivative contracts that permit cash flow exchange that is floating. Some of the common include interest rate swaps, currency swaps, and commodity swaps.
When to Use Derivative Instruments
Most scholars believe that shareholders can mitigate risks via a well-built portfolio. Most available readings on managing risks indicate that most firms use derivatives instruments in risk mitigation. Under normal conditions of the market, it is not useful for an organization to use the derivative instruments method to reduce risks (Manrai D.R, 2011). Nevertheless, some theoretical evidence shows that under some market frictions, firms with operational trends like tax convexity, distressed financial costs, opportunities of growth, managerial assets, and liquidity restraints stand a better chance to enhance the corporation value by utilizing the hedging techniques. (Ojo, O.V, 2015)
Derivatives will help the firm under the following conditions: the first one is when the opportunity cost is more than the inside funding and then when venture expenses and firms cashflow has a negative correlation. Further, the corporate risk management program, through the use of derivative instruments, gives corporations an inducement for them to reduce financial crisis costs by reducing the conduct of the holders of equity who are opportunistic. However, the leverage levels influence to what extent derivatives will be used. Highly leveraged companies, those that are vastly growth-driven and those with low debt proportion, should be more motivated to use the derivatives in their risk management. Studies have shown that for non-financial firms, using derivative instruments for calculating tax incentives is almost four times beneficial than using tax convexity (Shamsher. M, 2020).
Also, using derivative usage and debt has an optimistic consequence on each other. Companies with many outsiders’ holdings should be more inclined to derivative instruments to manage risks. The ability of different firms to finance their growth gives them the justification to use derivative instruments. If firms are not in a position to finance their projects, they turn to the usage of derivatives. The structure of company ownership also influences the firm’s management of the usage of derivatives in risk management. If, for example, the owners feel that the operations of the firms are uncertain, they may appeal to the management to turn to derivatives as their risk management style. With so many firms globally facing the uncertainty of operations, it is preferred that the usage of derivative instruments other than the portfolio of equities and debt instruments. For the firms to ease financial distress and also reduce financial constraints, they have to incline to the usage of derivatives
Advantages of Derivatives
Derivatives have so many advantages to the financial market. Some of these include:
- Hedging Risk Exposure – since the derivative values are connected to original asset values, the pacts are applied for evading risks. For instance, if an investor buys a derivative contract that has a price that moves alternately to the worth of the underlying asset the investor possesses, the earnings in the derivative agreement will counterweight the original asset.
- Underlying asset price determination – Derivatives are mostly used in the determination of the price of the underlying asset
iii. Market efficiency – It has been proved that derivatives upsurge the efficacy of monetary markets. Using the derivatives pacts, finance managers can duplicate the asset payout.
iv.Admittance to inaccessible resources – Using derivatives organizations gain entree to the earlier unobtainable markets and possessions. For example, using interest swaps, companies attain a more appealing rate of interest, which are offered from direct borrowing.
Derivative Risk
Derivative comes with some substantial drawbacks despite the designated benefits. Scholars believe that these drawbacks resulted in the financial crisis experienced in 2007-2008.
- High risk – the inherent risks of the instruments exposes firms to potential very big fatalities. The complexity of the contract design makes the assessment complex hence they bear very high risks (Kota et al., 2018)
- Speculative features – These instruments are regarded as speculation tools. Since they are so risky, unrealistic speculation may lead to adverse losses.
iii. Counterparty risks – Some contract that is traded over-the-counter does not go through the due diligence process, and thus there are chances for counterparty default.
Recommendation to investors and Finance Managers
I would recommend finance managers and investors to use derivative instruments as part of their portfolio management strategies to improve investor outcomes by hedging risk, cash flow management, and transactional cost minimization. Regulated use of derivatives markets has been proved as a tool that effectively serves investment needs. Some of the reasons for recommending the use of derivative by financials include:
The derivative instruments can be very good at hedging risk exposures. Since the price of the derivative is merged with the worth of the original asset, profits from derivatives can easily offset any losses from the underlying asset. More so derivatives are very accurate when defining the value of the given assets.
Derivatives also increase the efficiency of the financial markets since they can replicate the pay off assets by both values of the fundamental asset and the derivative being at equilibrium. Lastly, derivatives help firms access unavailable markets and assets. Organizations can achieve this by making use of interest rate swaps.
References
Kota, H. B., & Charumathi, B. (2018). Determinants of financial derivative disclosures in an emerging economy: a stewardship theory perspective. Australasian Accounting, Business and Finance Journal, 12(3), 62-86.
Kuzman, B., Ercegovac, D., & Momčilović, M. (2018). Development of derivative trading on the financial market and agribusiness sector in Serbia. Economics of Agriculture, 65(2), 601-616.
Manrai, D. R. (2015). Investor Behavior towards Derivative Markets in Indian Context. IOSR Journal of Business and Management (IOSR-JBM), 10-14.
Novak, O., Osadcha, T., & Petruk, O. (2019). Concept and Classification of Derivative Financial Instruments as a Methodological Precision on Their Regulation in the Financial Services Market. Baltic Journal of Economic Studies, 5(3), 135-144.
Ojo, O. V. (2015). TAX TREATMENT OF DERIVATIVE INSTRUMENTS.
Shamsher, M. (2020). Asian derivative markets: Research issues. International Journal of Banking and Finance, 5(1), 1-25.