Derivatives and Their Effect on Cost of Equity Capital
Summary
Corporations face several types of risks in the market where some of these dangers can be controlled, and others cannot. Market risks are those risks of loss arising due to adverse changes in rates and price, as well as equity prices. Nevertheless, derivative instruments offer ways in which organizations manage their financial risks. These instruments are off-balance sheet items, and their associated rights evade financial statement disclosure. Additionally, derivative value is derived from the underlying instrument, such as interest rates and indexes. Derivatives have demonstrated a fruitful way of providing elasticity in a climate of variable market rates. Firms differ in their approach to which they use derivatives, and in the absence of these items, it can as well be argued that stakeholders are unaware of the market risks facing an organization. Changes in exchange rates have been the main risk to firms involved in exports and imports, and it is not a surprise that most scholars have focused mostly on foreign currency risk. Market risks such as a commodity, technology, and leadership risks, have in recent years developed to be the centre of attention. This paper will discuss questions and issues arising from a survey conducted in Malaysia from several companies regarding risk management. They include; what type of market risks are evaded? Why are companies avoiding? How is the widespread of derivatives? Which derivatives are used and their purpose? How is risk management reported? These questions are worth studying to understand the outcome of derivatives on the cost of equity capital in Malaysian firms (Ameer, Mohd Isa & Abdullah, 2011). Some of the methods used include survey questionnaires to collect data, and which covered a brief report of the firms and critical areas where derivatives are used. Secondary information was also obtained to test the hypothesis and analyze statistics.
Contribution and Insight
Malaysia inhabits a subjective middle position in the Asian derivatives markets, and the regulatory environment has a considerable influence on derivative usage. More so, the Sariah Advisory Council curtains proposed tools to prevent them from interests and gambling as well as extreme uncertainty. Some of the instruments used include: commodities must be permissible and exist in physical form, and sellers should have legal ownership of assets in the final form. Derivative instruments may contain features such as Salam, joala, and istisna contracts. In a salam, the agreement stipulates that payment of items must be paid in cash. This contract cannot be based on a uniquely identified underlying, meaning that commodities cannot be based on a product from a particular file. Also, the Malaysian derivatives market has gone through a series of structural and operational changes. Study with different organizational setup has shaped scopes of derivative instruments in the Malaysian market. Sharia restrictions do not apply in the index options and futures, as well as oil futures and swaps. In Malaysia, hedging of foreign exchange experience is associated to trade activities not exceeding one year. More so, foreigners’ access to onshore markets only to buy securities on the stock exchange.
In Malaysia, to be eligible for hedging accounting, chosen risks and portions must be identified discretely as gears of monetary tools. Since stakeholders are aware of the usage of derivatives to hedge imminent currency flow, less than expected earnings generate lack of assurance in executive capability to run the business, therefore not disclosing derivatives could benefit risk-averse managers. Nevertheless, the growing economy requires foreign capital flow and investors rely on corporate risk disclosure for investment decisions. More so, hedging affects firms’ value through changes in tax reliabilities or even changes in stakeholder contracting costs. For this reason, hedging increases the companies’ worth by reducing outward privileges such as bankruptcy costs (Ameer, Mohd Isa & Abdullah, 2011). According to the paper, findings and results cannot be used in practice, since there is uncertainty, such that collection of data is like a bet on chances of getting feedback from the companies, for example, out of all the responses only a quarter were termed useful. The feedback from the study is too small to be taken for real practice. More so, types of risks and instruments found are limited, for instance, commodity risk is found less hedged, and most firms prefer swaps, which could limit other firms from different regions.
Strengths and Weaknesses
One of the strength of this paper is that even though the responses were few, the exactness and quality of cost calculation on equity capital seems correct. Forecast for future earnings is well determined. The use of genetic algorithms to determine the value of the total assets in corporations has shown the effects of the rate of equity on investment. Additionally, the use of data collection techniques in this study has resulted in the required information by the researchers, from the turnover to purchase of derivatives. The paper also tackles on both sides of derivative usage to cover those firms not using the technique. Issues arising as to why some firms do not use derivatives is that they are not much exposed and lack of expertise. More so, the researchers were able to come up with various recommendations for firms not using derivatives such as training of managers with difficulties of understanding the complexity of derivatives. Also, approvals are given that leaders of a firm should be responsible for the financial standards, as well as open-minded to risk supervision functions to create value to stakeholders. However, the paper has several shortcomings from data collection throughout. Besides, the research is only able to get meagre response rates. As a result, limited data made it challenging to identify crucial links between key variables and the estimated number of derivatives. Also, the method of collecting data was limited to only one; questionnaire. Instead, a technique such as use case which a direct way of observation would have best worked in collecting information on derivative usage. Besides, direct interviews would have given almost correct and absolute data rather than mailing the questionnaires to firms. As a result of the used methods of data collection, it is easy to replicate the results of this study as one can guess random figures and reasons to get similar outcomes.
Concluding remarks
Study on the utilization of derivatives and their effects on the cost of equity capital has shown both sides as to why some organizations use derivatives while others do not. This research cannot be used for practice as some results show that in Malaysia, no link among the rate of equity and the notional quantity of derivatives was found. What I learn from this papers’ research is that the usage of derivative instruments varies across industries. Moreover, lack of knowledge in handling derivatives is a primary concern for managers hence the need for overall training. Furthermore, there is a need to explore global markets to clarify the usage of derivatives worldwide.
References
Ameer, R., Mohd Isa, R., & Abdullah, A. (2011). A Survey on the Usage of Derivatives and Their Effect on Cost of Equity Capital. The Journal of Derivatives, 19(1). doi: 10.3905/jod.2011.19.1.056