All You Need To Know About Financial Derivatives in Singapore
What are Derivatives?
A derivative is a financial contract between two or more parties and whose value is derived from one or more underlying assets. The value of the contract is dependent on fluctuations of underlying assets. The most common underlying assets used in this type of financial contract include stocks, bonds commodities, currencies and market indexes.
Derivatives can be traded over the counter or on an exchange. OTC derivatives carry the biggest risk given that they are unregulated. Exchange derivatives, on the other hand, are standardised and come with obligations and requirements that both parties must adhere to.
How Derivatives Work
Simply put, derivatives are contracts between two parties that come with specified conditions under which payments are to be made once the conditions are met. They are often used as an instrument to hedge risk for one party of a contract, while offering high returns for another party.
For example, if company A is in the business of producing pre-packaged goods, it is destined to be a large consumer of flour and other commodities needed to produce the products. Given that the raw materials are subject to volatile price movements, the company may be forced to hedge against the risk by entering into a derivative contract.
A derivative contract will allow the company to enter into an agreement with a supplier of raw materials to be able to purchase the products at a predictable and market-friendly price. In this case, company A might enter into an options contract to buy a certain raw material at a certain price at an agreed period.
Should the price go above the agreed price, Company A will be able to exercise the contract and buy the product at the agreed strike price. If the company decides against buying the commodity at the agreed price then the seller will be able to sell the product at the high market price.
The derivative contract, in this case, helps protect the two parties either way. Company A is guaranteed a competitive price regardless of market conditions, while the producer is assured a fair value for his goods.
Financial Derivatives are essentially cash flows that are discounted at present value. Given that, the underlying asset does not have to be acquired. They allow the breakup of ownership and participation in the market value of an asset. The contractual freedom allows modification in the performance of an underlying asset.
What Types of Derivatives Are There?
While there can be hundreds of derivatives variation in the market all of them can be traced to either the following categories.
Forward contracts are the most common and simplest forms of financial derivatives. Simply put, they are contracts between two parties- a buyer and a seller, for the purchase or sale of something at a future date.
Any type of contract that calls for the acquisition of a good or service at a price agreed upon today without the right for cancellation is called a forward contract. There are instances where the contracts can be reversed before their expiration. However, the terms might not be favorable as they are set that way to prevent such occurrences.
There are hundreds or even thousands of such contacts available in the market today. Traded over the counter, these type of contracts don’t carry any credit risk as the clearinghouse acts as the guarantor to both parties in the contract.
Futures contract are in all aspect similar to forward contracts as they call for the sale of a product at a future date while the price is determined at the present. However, unlike forwarding contracts, futures contracts are listed in popular trading exchanges.
The exchange, in this case, acts as an intermediary, which means a buyer and seller don’t enter into an agreement with each other. Rather, they enter into an agreement with the exchange.
Unlike Forward contracts, futures contracts cannot be reversed’ or modified under any circumstance. Future contracts also come in a predefined format, size and have a predefined expiration.
Given that they are traded in exchanges, future contracts follow certain daily settlement procedure which means losses realized have to be settled every single day.
While Futures and Forward derivatives contracts bind two parties, Options derivatives are asymmetrical. In Options derivatives, only one party is tied to the contract while the other party is given the option of deciding what to do later i.e. the expiration of the option. What this means is that one party has the obligation to buy or sell later, where’s the other party can make a choice.
In most option contracts, the party that has the privilege to make a choice ends up paying a premium for the privilege.
There are two types of option contracts:
- Call option: accords one the right but not the obligation to buy something at a future date.
- Put Option: accords one the right but not the obligation to sell an asset later.
This is arguably the most complicated form of derivative as it is designed to enable people change their streams of cash flow. These are simply private contracts and are not traded on the exchange. Instead, they are negotiated between two parties with investment bankers acting as the middlemen in the contracts.
Swaps enable companies to avoid risks posed by foreign exchange fluctuations. The most common type of swap is interest rate swap that allows parties to swap only the interest related cash flows. Currency swaps, on the other hand, involve the swapping of both principal and interest between parties involved.
What Are Derivatives Used For?
Derivatives were initially developed with the aim of ensuring balanced exchange rates when it comes to trading goods on the international scene. Over there years, they have evolved and are now based on a variety of transactions.
For Price Discovery
Market prices for goods and service are constantly changing, given the continuous flow of information around the world. Unforeseen events such climatic conditions, political situations also play a role in the determination of the actual price of such assets.
That said, the way people absorb this information directly affects the actual price of an asset in a process called price discovery. It is for this reason that derivatives come into being in the form of futures markets.
Derivatives allow market participants to set the price of a product they wish to buy in future. By doing so, they are able to obtain a price that is not affected by interpretation of events that may occur in future.
Derivatives can also be used for speculation, in betting what the price of an asset will be in future. It also allows buyers to avoid the pressures of interest rates, which are known to affect prices.
The most important purpose for derivatives in the market nowadays is hedging against risk. Hedging is the process of reducing the risk in holding a market position while speculation is rife. For instance, traders buy Put options to protect against the share price of a stock, which they are long, from dropping leading to losses.
If a share price of a stock rises in this case, a trader stands to gain and if they drop there is no loss incurred given the put option in place. In this case, the potential loss is hedged with the options position.
Derivatives being a form of insurance or risk management come with the low cost of trading, which makes them lucrative when it comes to overall returns.
What Are The Risks of Derivatives?
Determining Real Value
Given that derivatives try to speculate the value of an asset in future, getting to know the actual value is usually a big problem. Their complexity makes it extremely impossible to know their actual value. The financial crisis of 2009 was mostly triggered by mortgaged-backed securities that were wrongly priced.
Most derivatives are based on underlying assets such as commodities, metals, and stock. Given that most of these assets are traded in the open market, their prices are constantly changing, which increases the risk a trader is exposed to, thus increasing the risk of losing money.
The fact that derivatives require traders to put 2-10% of their contract into margin account poses one of the biggest risks to novice traders A drop in the value of an asset close to the margin level requires traders to add more money to their account to boost the margin account. A persistent drop in the price of an asset could drain a trader depending on the expiry of a contract.
The fact that derivatives are time-based means the chances of losing money is also high. As time passes on, the value of most derivatives tends to drop further increasing the chances of losing invested capital.
Derivatives in Singapore
Corporates in Singapore use derivatives to manage risks around business and financial activities. The most popular type of product, in this case, has to be foreign exchange derivatives for hedging against the risks of fluctuating foreign exchange.
Companies in the manufacturing business also use commodity derivatives to hedge against the risk that may arise because of an increase in prices of raw materials.
Singapore Stock Exchange (SGX) has also benefited a great deal from an increase in derivatives trading in the country. Derivatives trading is a key part of the exchange accounting for nearly 40% of the total income.
In 2015, the stock listing agency upgraded its derivatives trading and clearing platforms as it sought to strengthen risk control and system safeguards. In response to growing activities around derivatives, the country’s Singapore stock exchange SGX has increased fees by as much as 10 fold for derivative trading members.
Annual fees for derivative trading for big global banks with direct access to the market now stands at S$25,000, up from S$2, 000. Large international banks will see the biggest change as individual traders contend with smaller increases.
There is already concern that the fee increase could prompt some institutions to drop their membership.
Michael Syn, head of derivatives at SGX, told the Financial Times: “As we’ve seen peak globalisation over the past few years, it’s become even more important for us as an international financial center to make sure that we offer those risk management and access products that meet international clients’ needs.”
In a bid to further strengthen derivative trading and snare a bigger share of the $540 trillion global derivative business. Singapore is working on taking advantage of rough new European banking rules that seem to be affecting derivatives trading in the region.
Regulators in the country have held talks with their counterparts in Hong Kong as they seek to come up with new regulatory measures that will help attract more derivatives business from Europe.
If successful, Hong Kong Monetary Authority and Monetary Authority of Singapore (MAS) would be able to lure billions of dollars of the banking business. The derivatives under considerations include interest rate swaps and foreign exchange derivatives that would allow companies and investors to hedge their exposure to interest rates swings.
Asia currently accounts for less than 10% of the global over the counter derivatives market. Global banks hold the majority of Asia related trades with London being the booking center for such deals.
Derivatives Providers In Singapore
Singapore Exchange Derivatives, a subsidiary of the Singapore Exchange, is the leading provider of derivatives contracts in the country. The firm provides interest rate futures contracts trading, as well as hedging services for loans deposits and interest rate swaps.
DBS Bank offers a wide array of derivatives. The MAS regulated financial institution offers trade execution and clearing services for derivatives as well as clearing and online future trading. Some of the derivatives it offers include commodity derivatives, FX derivatives, and interest rate swaps derivatives.
The bank offers a wide array of interest rate structured products that allow investors to hedge against interest rate risk. One of the products on offer is interest rate swap for converting fixed rate assets and liabilities into floating rate and vice versa.