Page 4087 - Week 13 - Wednesday, 24 November 1993
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sell market securities at a set price by a fixed date. Investors pay an initial premium to obtain an agreed future trading price for selected market securities. Most corporations, government entities and financial institutions regularly use derivatives to protect their borrowing and investment exposures.
This practice is known as hedging. Hedging of investments involves using derivative transactions to lock in a future sale price to protect against possible price falls. This effectively guarantees a minimum future rate of return on certain market securities irrespective of general market trends. However, investors can still obtain higher returns if, in the meantime, the actual market price were to rise. By reducing exposure to possible losses, this form of strategic investment is less speculative than relying solely on market expectations.
For example, Madam Speaker, an investor could consider that the price of particular shares may fall in the near future. Rather than selling the shares at the current market price, the investor could pay a premium for the right to choose to sell the underlying security at an agreed price by a future date. This right would be exercised if the share price did fall, or would be allowed to lapse if prices rose or remained steady. If prices happen to fall the loss is confined to the cost of the premium rather than the entire reduction in the share price. Of course, any profits made when the share prices rise are partly offset by the relatively small cost of the premium. In this instance the premium can be regarded in the same way as an insurance premium.
This strategy effectively enables the minimum value of the portfolio to be maintained at a predetermined level. Without this type of cover the investment manager would have to rely more on predicting exact market turning points to maximise returns, which is considered a more speculative form of investing. A speculator, on the other hand, seeks to use derivatives to make large profits with minimum outlay by gambling on future market changes and usually does not hold the underlying securities. Whereas the hedger is concerned with protecting existing investments against significant falls in their value, speculators will take deliberate risks and, if their forecasts are wrong, they can incur significant losses.
In terms of the Government's own use of derivatives, I should point out that the Audit Act 1989 requires that derivatives must relate to an existing borrowing or investment, thus guarding against speculation. It is not the intention of this Government to use derivatives for speculative purposes. The committee's report recommends that external fund managers should be able to use financial derivatives only up to a maximum limit of 5 per cent of the total value of investments. This proposal is intended to limit the use of derivatives, but would also have the effect of limiting the extent to which the fund manager could control market risk. Investments could thus be exposed to unnecessary risk, thereby defeating the intended purpose of the recommendation. An investment portfolio that does not have sufficient capacity to use derivatives for hedging purposes will require the funds manager to rely heavily on market timing decisions for the sale and the purchase of physical securities. This can be a high cost activity.
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