As a result of the novel coronavirus (COVID-19) and the Russia-Saudi oil price war, businesses are now continually reviewing their risk position as:
- supply chains are disrupted due to lock-downs and the imposition of travel restrictions;
- governments enact interim regulations on a public policy basis to shield citizens which regulations have been onerous or disruptive to businesses;
- contractual counterparties breach or default on existing contracts for delayed performance or non-performance;
- commodity prices fluctuate; and
- stock markets contract as share values in exchange markets continues to drop amid negative market sentiments.
To minimize exposure from such factors affecting price movement, an investor or business can hedge against the risk by entering into a transaction to compensate or balance an investment or a contractual obligation.
Before a business decides on a hedging arrangement, it needs to determine the risks associated with it. The areas where businesses mainly have hedgeable risk are in commodities (agricultural products, metals, oil and oil-related product etc), securities (shares, equities and equity indices), real estate, currencies and interest rates. To mitigate the risk inherent in these areas, businesses can enter various types of hedging arrangements.
Hedging arrangements typically involve derivatives which are financial contracts that derive their value from the underlying asset or assets which can be commodities, securities, currencies, interest rates, amongst others. The types of derivates available in the financial markets are forwards, futures, options, swaps, equity and credit derivatives with businesses electing one or more derivatives depending on the risked hedged. In this article, we will touch upon forwards and futures.
Forward contracts are customized contracts entered into by two parties to buy or sell an asset at a specified price on a certain future date. The terms of the contract vary from one party to another and are therefore unregulated. An example would be a business that needs to purchase petroleum. The buyer can enter into a forward contract with a producer or importer (seller) to purchase a specific volume of petroleum at a fixed price set on the contract with delivery of the petroleum being made at a future pre-determined date. In this instance, the risk mitigated by the buyer is an increment on the sale price. Conversely, the producer or importer mitigates the risk that can result in the drop in petroleum prices as was witnessed in the Russia-Saudi oil price war.
Forwards: Legal considerations
Forwards are private bilateral contracts and as unregulated contracts, careful consideration should be given to the following issues and contract provisions by a business before entering into a forward:
1. Counterparty Default – Unlike futures, which are guaranteed (see below), the parties to a forward contract are at risk of the other party defaulting. A seller may fail to deliver, and a buyer can default on payment or a party may even elect to terminate the forward contract. To mitigate risk, a seller can request the buyer to provide them with a payment guarantee to guarantee payment and similarly, a seller can incorporate breakage cost provisions in the futures contract to penalize a buyer for early termination.
2. Contractual Terms – Forward contracts are non-standardized, therefore parties should carefully review their positions and the terms of the forward contract, more particularly:
a.force majeure provisions - The disruptions to the supply chain and the ability of a party to meet its obligations such as a result of COVID-19 should be taken into consideration. With governments imposing measures, a forward contract should incorporate provisions that anticipate events or actions that limit or hinder the seller’s or buyer’s ability to meet its obligations due to disruptive directives.
b. default provisions – It needs to be considered whether a default in the forward contract will trigger cross-default provisions in other contractual arrangements and what the implications are for a business. Likewise, the default provisions should be carefully considered together with a business’s financial position. Disruptions resulting in liquidity issues may require a business to negotiate with its creditors and in doing so result in the party triggering default provisions in the forward contract.
c. terms of delivery and payment - COVID-19 has caused delays in delivery as a result of lock-downs and travel restrictions. Therefore, delivery terms should anticipate such disruptions with contracts by providing for an extension of delivery. Similarly, payments may be delayed as a result of a change in business hours due to complying with government directives and with financial institutions working with limited personnel.
d.notices and remedial periods – Parties may wish to consider longer notice and remedial periods to facilitate timely response notification once facts have been ascertained and with a longer remedial period to allow a party an opportunity take remedial action. However, this will be dependent on the nature of the commodity and the bargaining position of each party to the forward.
Futures are standardized contracts that specify (i) the asset underlying the contract (generally commodities, currencies, equities and equity indices), (ii) the quantity of the asset being traded, (iii) the price of the contract which is tied to the price of the underlying commodity under a specific currency, and (iv) the expiration date of the futures contract after which date the contract must be settled. Because futures are standardized contracts, they are traded through an investment market (futures exchange) and consequently are subject to market regulations.
As with any contract, there is a risk of a party defaulting - in the case of a seller, failing to deliver and of a buyer failing to pay. In a futures exchange, once a futures contract is entered into by the buyer and seller (through their appointed broker), a clearing house guarantees both parties by (i) purchasing the commodity on behalf of the buyer if a seller defaults on the delivery of the commodity and (ii) paying a seller if a buyer defaults on paying for the commodity.
How do futures contract work? The example of an Oil Producer
An oil producer can agree to sell a specific quantity of barrels at a set future date at a pre-determined price under a future contract. Conversely, a buyer can agree to purchase the oil subject to the terms of the futures contract. If:
a. the market price of a barrel rises, the oil producer losses the margin under the futures contract from the fixed price set out therein with the buyer making a saving as they will have bought the barrels at a price lower than the market price.
b. the market price of a barrel drops, the oil producer gains from selling the barrels at a price higher than the market price under the futures contract thereby shielding them from the loss made when selling at the market price with the buyer making a loss as they will have bought the barrels at a price higher than the market price.
The foregoing example works across the range of futures commodities but varies depending on the combination of financial instruments relating to the underlying asset and the terms of the futures contract.
Futures contracts in Kenya
In Kenya, futures are traded on the Nairobi Stock Exchange (NSE) NEXT derivatives market with the NSE Clearing Limited being the clearing house and guarantor of futures. The NSE NEXT derivatives market facilitates the trading of:
a. single stock futures, where parties agree on the day to a predetermined price on the shares of a specific company to be paid on a future specific date – presently, a settlement is made 3 months period from the contract date; and
b. equity index futures, which futures contracts are based on the share index of selected companies measured on the daily price variation of shares NSE selected companies.
In advanced exchange markets offering a variety of futures, producers of agriculture and extractive industry related commodities and investors holding portfolios of shares and bonds, use futures to hedge against price movement and to maximize the value of the assets from the price changes.
The benefits of futures contracts noted in sophisticated and well-developed exchanges are that
- market brokers can easily enter and exit positions taken on behalf of their clients. Consequently, they can minimize the exposure of their client by changing their position (buying or selling) or even exiting the market.
- a business can protect itself from price fluctuations from a variety of factors related to contracts such as interest rate and currency fluctuations.
- investors have access to markets not usually available to them to speculate. Globalization and information technology have made it possible for an investor to open a foreign brokerage account to invest in foreign markets; and
- as a regulated market, the cost of trading on exchanges is set out with a party being able to select and negotiate the level of commissions with a market broker.
Like any other trading activity, futures contracts do have their disadvantages, such as:
- it is possible to incur heavy losses particularly if the underlying asset is performing poorly in relation to the futures contract position and more so if it is leveraged against a loan with a business incurring a loss while still obliged to make repayments under the loan; and
- a business missing out on a profit opportunity due to a favourable price movement.
Risk is inherent in any business and the strategies to mitigate them each have their pros and cons. Forwards are well appreciated by Kenyan businesses but it is now more important for them to also orient themselves with futures contracts with the introduction of the NSE NEXT derivatives market and the potential it holds when it expands the financial products on offer.
Article by Christopher Kiragu
Principal Associate, MMAN Advocates