Derivatives are financial tools used to hedge against price fluctuations of assets such as government and corporate bonds, raw materials, currencies and shares. Unfortunately, however, derivatives don’t always work as planned.
Mortgage-backed securities were intended to transfer risk between businesses that needed financing and lenders – yet this wasn’t always achieved during the global financial crisis.
1. Options
By taking advantage of derivatives’ leverage, small initial capital can be leveraged into riskier assets, fuelling speculation and market instability while leading to more bankruptcies as participants take positions that surpass their financial capabilities.
Derivative financial instruments used for hedging purposes are an integral component of any company’s risk management strategy – this is especially relevant for emerging countries like Bosnia and Herzegovina (B&H).
Unfortunately, B&H’s derivatives markets account for only 10% of global turnover due to both a lack of knowledge and expertise within the market as well as regulatory restrictions. Overcoming these hurdles can be achieved – all it takes is understanding six classes of risk associated with EM debt allocation in order to create successful strategies.
2. Futures
Traders can utilize derivatives to hedge positions, add leverage or speculate on asset movements. Depending on their use, derivatives may increase risk while providing opportunities for quick profits – both appealing features of trading for those seeking high returns.
Credit derivatives have long been seen as a means to transfer credit risk; however, as evidenced during the 2008 financial crisis they can sometimes act as a source of increased exposure rather than helping manage it.
Even with its challenges, an emerging markets derivatives market presents investors with the chance to effectively manage exposure to various economic and market factors in various ways. Managed futures have historically shown low to negative correlation results under most conditions and may serve as key component of an institutional portfolio’s allocation towards alternative investments.
3. Swaps
Swaps offer two parties the ability to exchange an asset’s cash flows with each other; typically exchange-traded swaps settle regularly while forward contracts only at maturity.
Emerging credit derivatives markets have experienced an uptick in activity recently; however, their size remains relatively small in relation to bond and equity markets (see Table 4.1).
Financial derivatives allow investors to reduce the risks associated with foreign exchange, interest rate, market, and default risk by unbundling and redistribution of these risks–foreign exchange, interest rate, market, and default risk–into more manageable chunks, thus streamlining cross-border capital flows and providing opportunities for portfolio diversification. Unfortunately, however, they may also be used by market participants to bypass prudential safeguards and take on excessive leverage; to protect market integrity it is therefore crucial that markets for these instruments be well designed with robust prudential regulation governing them properly.
4. Credit Default Swaps
Credit default swaps (CDSs) allow investors to transfer the credit risk associated with fixed-income products, similar to insurance policies. They were key elements in both the 2008 Great Recession and 2010 European sovereign debt crisis.
CDS sellers tend to take an optimistic view of an issuer’s creditworthiness; investors purchasing protection often adopt more cautious assessments. Either way, premiums paid to CDS sellers indicate how exposed the buyer may be. The lower their premiums are, the lesser exposure there will be for the issuer’s financial condition.
CDS spreads and bond market measures both provide information; however, we have evidence to show that between January 2016 and February 2020 (pre-COVID crisis), bond market measures provided more timely insight than CDS spreads in many EM countries.
5. Credit Spreads
Debt trading terminology can be complex and sometimes obscure to those without extensive financial training; yet understanding concepts such as credit spreads is integral to successful investing outcomes.
Credit spreads refer to the yield differential between risky corporate junk bonds and Treasury bills of similar maturity; this represents investors’ compensation for taking on additional default risk associated with emerging market corporate bonds.
As an asset class that helps diversify portfolios, emerging market debt deserves careful examination of its risk-return and correlation characteristics within an asset allocation framework. Sizing positions based solely on valuation metrics (such as rich/cheap valuation or high yield), should also be avoided to better manage idiosyncratic volatility and risk in this asset class.
