Free Custom «Use of Derivative in the Investments, Portfolio Management, and Corporate Finance with a Specific Focus on the UAE» Essay Paper

A derivative is a security whose price depends on the underlying asset. A derivative is in itself a financial contract whose value and price are based on the fluctuations in the price or prices of another asset or assets. These may include commodities or equities as the underlying assets. In the capital markets arena, the derivatives are a common form of investment, especially in the United States where the capital markets are deeper than in the UAE. Therefore, it is common to hear of such terms as exchange traded funds, futures, forwards, and options, all of which are types of derivatives. Other than the derivatives being of interest to the capital markets investors, these financial securities are also an important element in the corporate finance and in the portfolio management by companies. In such a setting, the derivatives are used mainly as the tools of risk mitigation and less often as investment opportunities. Particularly, the derivatives may be used in hedging against the foreign exchange risk, interest rate risk, or even in hedging against the prices fluctuations of such commodities as oil. Owing to the importance of derivatives in the procedural practices of risk management by corporations and the investment interest of various capital markets investors, it would be easy to assume that capital markets such as the Abu Dhabi Securities Exchange (ADX) and the Dubai Mercantile Exchange (DME) in the UAE already have platforms for the trading of derivatives. However, the analysis of data and information on the derivatives investments in the UAE paints a different picture of the region. This pertains mainly to the fact that the introduction of derivatives in the ADX and the DME is still under consideration, although it may come to fruition within the next 6-12 months (Al Sayegh, 2015). This research paper focuses on the use of derivative in the investments, portfolio management, and corporate finance with a specific focus on the UAE.

 

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The UAE, like all other GCC countries except Kuwait, does not have a working derivatives market. However, the information from Nasdaq indicates that the UAE has been working on the establishment of derivatives into the market since 2005 (Nasdaq Dubai, 2016). However, the process was halted in the wake of the latest global financial crisis when the derivatives gone wrong resulted to the meltdown of the financial markets in the USA, Europe. Moreover, in the process, the crisis touched all other countries across the world, including the UAE. At the time of the crisis, the UAE had started trading in derivatives through the Dubai Mercantile Exchange. However, all the derivatives traded in the exchange at the time were only registered in Kuwait. Therefore, the Dubai Mercantile Exchange only provided the platform, on which traders were able to access derivative products that enabled the authorities to test the possibility of introducing locally registered derivatives in the UAE (Nasdaq Dubai, 2016).

Testing the waters in the derivatives market involved the use of forward contracts. The parties involved in the derivatives transactions included the buyer, the market maker, and the DME. The derivative deals were structured in such a way that the buyer would pay a premium and 40% of the value of the underlying stock to the market maker. Then, the market maker would give shares to the DME. If the buyer determined that they would suffer a loss from engaging in the transaction by paying the remaining 60%, the buyer would refuse to pay the remaining 60% and then DME would return the shares to the market maker. Owing to the global financial crisis, the trading of derivatives took place for only for three years between 2008 and 2011, and it only involved forward contracts on commodities and oil in particular. This development would later provide the platform, upon which the UAE continues to consider the reintroduction of derivatives in the region (Hunter, 2013).

Unlike the USA, where the markets for derivatives have both depth and breadth, the derivatives market in the UAE operates under special conditions pursuant to the sharia laws. Firstly, the contracts have only been on commodities. Secondly, trading in currency futures, forwards, and options has been considered almost impossible in the UAE because of the sharia law limitations that include the prohibition of interest otherwise known as riba. Secondly, the sharia laws do not provide for the speculative trading that characterizes the trading of derivatives in the USA. This is a way of dealing with uncertainties and this is why short selling has not yet been allowed. Thirdly, the market has not yet allowed the trading in the derivatives whose underlying assets are equities. However, the issue of having the derivatives based on equities is still under consideration, and moving forward, there is a high likelihood that this will also be introduced to the market. However, this may depend on how well the market will accept the derivatives as investment vehicles (Diaa, 2015).

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While derivatives are not publicly traded in the UAE, the use of derivatives in hedging practices as well as in the management of investment portfolios takes place through the over the counter markets as well as through bilateral transactions between the interested parties. Most notably, the use of derivatives takes place among the banks. The problem with the use of derivatives by the banking sector is that derivatives are highly unregulated and secondly, derivatives increase the risk absorbed by the banking sector either through the investment risk or through the balance sheet. Considering the high risk associated with trading over the counter, the risk is higher in the unregulated market than it would be in the regulated trading environment for derivatives. Consequently, this necessitates the needs for the creation of a derivatives market in the UAE (Hassan, 2009).

The second major observation is that corporations and investors in the UAE do approach the international investment baking for the structuring of custom derivatives. Firstly, this observation indicates that there exists a strong demand for derivatives in the UAE. Secondly, the observation underscores the need for the creation of a derivatives market to create liquidity for such investors and corporations. A derivatives market would ensure that the corporations have access to a variety of derivative products in the UAE. This would ensure that the investors are able to plan their investment portfolios efficiently. Secondly, the transaction and other costs charged in the structuring of derivative products would be lower and easily determined through the market forces. This would help in dealing with the information asymmetry that currently bothers the derivatives market in the UAE (Khedhiri & Muhammad, 2008).

Several corporations in the UAE use derivatives for hedging and investment purposes. In the banking sector, for instance, the inter-bank derivatives on currencies are used to hedge against the fluctuations in foreign exchange rates. The currency that the banks majorly hedge against is the USD followed by the Sterling Pound and the Euro. The banking sector hedges against the fluctuations in the foreign exchange rates using forward contracts. In some instances, the use of options also takes place, especially with those banks that have cross-border transactions (Hassan, 2009).

The second major industry that uses the derivatives for hedging and investment purposes is the air travel industry with the two major carriers Etihad and Emirates airlines engaging in hedging practices. The two companies majorly use the forward contracts on oil and currencies to hedge against the fluctuations in oil prices and the movements in the currency exchange rates. While derivatives are not yet publicly traded in the region, the analysis of data indicated that hedging costs are among the highest costs for both Etihad and Emirates. The application and use of derivatives by the two largest carriers in the UAE helps in explaining the importance of derivatives in the economy, particularly in the management of risk as well as investment vehicles for both individuals and corporations. Consequently, this helps in explaining why the government in the country ought to consider the objective of having a derivatives market in the UAE more attentively (Khedhiri & Muhammad, 2008).

In conclusion, the above analysis of the use of derivatives in the investments, portfolio management, and corporate finance with a specific focus on the UAE indicates that the UAE still does not have a formal platform where derivatives are traded. However, the Dubai Mercantile Exchange has an existing regulatory framework for the trading of derivatives, hence having made an appropriate step towards the introduction of derivatives into the capital markets. Secondly, the analysis indicates that while a formal market does not exist, over the counter transaction and bilateral transactions for derivatives do exist. Inter-bank transactions in currency derivatives are common in the banking sector, while oil and currency derivatives are common among several corporations, including Etihad and Emirates. Other investors engage the international investment banks to structure and design derivatives, and this indicates how important the derivatives are for the market. Consequently, this paper recommends a faster introduction of the derivatives market in the UAE. This would reduce the risk associated with over the counter transactions on derivatives.