The immense development of the financial derivatives market and reports of major losses associated with derivative products have resulted in a great deal of confusion about these complex instruments. Are derivatives a cancerous growth that slowly but surely destroying global financial markets? Are people irresponsible if they use financial derivatives as part of their over-all risk-management strategy? Are financial derivatives the source of the next financial fiasco?

Those who oppose financial derivatives fear a financial disaster of tremendous proportions, one that could paralyze the world’s financial markets and force governments to intervene to restore stability and prevent massive economic collapse. Critics believe that derivatives create risks that are uncontrollable and not well understood. Some liken derivatives to gene implanted, potentially useful, but certainly very dangerous, especially if used by a new believer without proper safeguards.

Derivatives, as their name implies, are contracts that are based on or derived from some underlying asset, reference rate, or index. Most common financial derivatives can be classified as one, or a combination of four types: swaps. forwards, futures, and options that are based on interest rates, currencies, commodities or any other assets.

On March 15, the Governor of the State Bank of Pakistan, Dr. Ishrat Hussain, announced at a seminar organized by the Pakistan Banking Association that he is in favour of gradually involving the country progressively in the derivative market in accordance with the Malaysian regulatory model. Malaysia? Out of all the ?????countries in the world probably because it was a sanctuary for him as it follows a dual economic system being an Islamic State.

The value of financial futures is not an imaginary notion. These instruments are not a selective luxury that can be done without. Indeed, if the use of financial derivatives as a hedge mechanism is excessively restricted, the consequences to the world’s financial fabric may be much harsher than anyone realizes. It is this reality that is imperative for Asian developing governments to recognize. In our global market environment, driven by constant and changing market risks, instantaneous information flows, and sophisticated technology, financial derivatives are an essential instrument of finance, indispensable in the management of risk.

Why is there indeed a need for a futures market? In other words, might this not merely be the invention of a legalized form of gambling, another unnecessary evil? Certainly that has been suggested by many, on more than one occasion. One might even ask why Futures market in anything?

The fact of the matter is that, whether we like it or not, we deal in futures all the time. The housewife who buys more than she immediately needs because a given product is on sale; the butcher who contracts for delivery of, at an agreed price, months in advance of his anticipated sales; the weaver who agrees to deliver his cloth at a future date long before the product is ready; the wholesaler who builds inventory in advance of anticipated demand.

Isn’t the investor in real estate speculating in futures? Isn’t the farmer doing the same when he plants his crop? Surely a securities analyst is speculating in futures when he gives a buy recommendation on a particular stock on the basis of his projection of future earnings. Doesn’t the buyer for a department store take into consideration the same elements that go into futures market trade?

What is the supply, what is the demand, what is the trend? Indeed, there are thousands of everyday examples in business and social life that inherently include the elements of futures trade and futures speculation. Dealing in futures is an ordinary, daily occurrence.

Nevertheless, financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage financial risks. Ultimately, they offer organizations the opportunity to break financial risks into smaller components and then to buy and sell those components to meet specific risk-management objectives.

Moreover, derivatives allow for the free trading of individual risk components, thereby improving market efficiency. Using financial derivatives should be considered a part of any business’ risk-management strategy to ensure that value-enhancing investment opportunities can be pursued.

Derivatives are complex, high-tech financial products created by the Wall Street but their history lies behind decades, especially financial derivatives.

Economists are steadily fabricating new, complex, sophisticated financial derivative products. However, all these are built on a foundation of the four basic types. Most of the effective innovations are designed to hedge complex risks in an effort to reduce future and manage risks more skillfully.

The newest innovations require a firm understanding of the trade-off of risks and rewards. Users should constitute a guiding set of principles to provide a frame-work for effectively managing and controlling financial derivative activities. These principles should focus on the role of senior management, valuation and market risk management, credit risk measurement and management, enforceability, operating systems and controls, and accounting and disclosure of risk-management positions.

The fact is that some derivatives are highly complex, but others are quite simple. Some are ‘exotic’ others are ‘plain vanilla”. But more often than not, derivatives are effective instruments for managing financial risk.

Forward agreements: There are no sure things in the global marketplace. Deals that looked good six months ago can quickly turn if unforeseen economic and political developments encourage fluctuations in exchange rates or commodity prices. For example, an American company might agree today to buy a certain product from a Pakistani manufacturer. The deal will be priced in rupees and payment will be made when the product is delivered in six months.

Both companies will base their calculations on a certain dollar-rupee exchange rate, but for next six months they will face the uncertainly that a sharp fluctuations in the rate could make their deal less profitable than anticipated. To protect themselves against exchange rate uncertainty, companies, sometimes use forward agreements. Forward agreements are a form of derivative, and they are usually arranged through large, money-central banks.

A more sophisticated transaction is called a ‘forward’ swap. For example, a cotton exporter could sell euro 200,000 forward for dollars for delivery of in 2 months at $1.0870 and simultaneously purchases back $ worth 200,000 forward for delivery in 3 months at $1.0617. The difference between his buying and selling price is equivalent to the interest rate differential between borrowing costs of the two currencies.

The word ‘Futures’ refers instead to such things as foreign exchange futures and stock index futures. Futures contracts are forward agreements with an important difference. Whereas the terms of a forward agreement are generally customized to the needs of the counterparties and sold through over-the-counter (OTC) dealers, futures contracts are standardized agreements traded on organized exchanges.

As the name implies, trading in options involves choice. Someone who invests in an option is purchasing the right, but not the obligation, to buy or sell a specified underlying item at an agreed upon price, known as the exercise, or strike, price. There are two basic types of options- calls and puts. A call option gives an investor the right to buy the underlying item during a specified period of time at an agreed upon price, while a put option confers the right to sell it.

Interest rate swaps allow two parties to exchange or ‘swap’ a series of interest payments without exchanging the underlying debt. The least complicated interest rate swaps are commonly referred to as “Plain vanilla”.

A manufacturing company is hedging risk when it uses forward agreement to limit the impact that exchange rate fluctuations might have on an international trade deal. But it’s probably fair to say that the same company would be speculating if it were to invest heavily in a foreign currency forward agreement solely on the assumption that a certain currency will move sharply in one direction or the other.

Exporters for hedging purpose can use derivatives. For instance, an exporter of cotton may want to lock the current forward price by entering a forward contract on cotton futures. This would eliminate the downside risk and also the upside potential. Better still; the exporter may want to enter into a put option on cotton futures. The latter would allow the exporter to hedge away the downside risk alone while leaving the upside potential to the exporter.

There are times when treasurers or portfolio managers might feel as if they are under pressure to increase the return on their money by investing heavily in “exotic” derivatives ‘no guts no glory’ approach to investing. Hedging can easily become speculation through greed or ignorance or carelessness.

In every business a trader is involved with the basic risk of a profit or loss this is the definition of every craft, whether a derivative is “plain vanilla” or “exotic” there are points that investors ought to consider before entering into the deal:

Market risk: Investors tend to base their decisions on certain assumptions: Interest rates will go up or down; stock market will move higher or lower, the dollar will be stronger or weaker.

Liquidity risk: Investors who plan to sell a derivative before maturity need to consider at least two major points: l) How easy or difficult will it be to sell before maturity, and 2) how much will it cost.

Credit risk: Counterparty credit risk is a much greater concern in the OTC derivatives market. If one of the counterparties (buyer, seller, or dealer) defaults on an agreement- just walks away after the market takes an unfavourable turn- there’s no mechanism for dealing with the fallout.

Interconnection risk: Interconnection risk, also known as ‘systemic risk’, is the danger that difficulties experienced by participating players in the derivatives market could trigger a chain reaction that might ultimately affect the entire banking and financial system.

The value of financial futures is not an imaginary notion. These instruments are not a selective luxury that can be done without. Indeed, if the use of financial derivatives as a hedge mechanism is excessively restricted, the consequences to the world’s financial fabric may be much harsher than anyone realizes. It is this reality that is imperative for Asian developing governments to recognize.