While Jamaica’s securities market is still developing, there are classical examples of companies locally which have employed financial derivatives to hedge exposure to specific events. So, in today’s article, we’ll explore some of these examples and how they benefited the various companies.

A derivative is a financial contract between two or more parties which derives its value from the underlying asset being used to value the contract. Examples of derivatives include forwards, futures, swaps and options. These each have their own uses and assist companies in hedging against various forms of risk.

On October 3, 2018, Mayberry Jamaican Equities Limited (MJE) entered into an irrevocable call option agreement to sell 1,000,000 shares of Supreme Ventures Limited (SVL) at a strike price of $16. On October 4, 2020, the call option expired without being exercised. SVL’s stock price was $20.85 the day the option was signed and closed at $14.77 when it expired.

A call option gives the person the right but not obligation to buy a security or asset at a specified (strike) price within a specified time period. A put option has the same features except it is to sell an asset. To initiate an option, the person who buys the call option would pay a premium to the other party while the person who sells a put option would collect a premium for selling it.

SVL’s stock price peaked at $34.32 on August 5, 2019 before hitting a 52-week low of $11.72 on March 20, 2020. Since the premium cannot be identified in MJE’s financials, let’s estimate that the premium for the option was $5. If the novel coronavirus pandemic hadn’t occurred and the price remained above $21, the owner of that option would be in the money and would have been able to purchase SVL below the market price at the time. However, with the market price below the $16, the option was out of the money and exercising it would have cost the owner money since he’d be paying a premium when he could purchase it on the market for less.

By selling this call option, MJE got additional income other than their quarterly dividends and had a person willing to buy a specific volume of the stock at a price they were comfortable with at the time. If the option was exercised when in the money, MJE would have had $16,000,000 gross plus the premium to invest into another asset. Options give you the flexibility to protect yourself in upwards or downward scenarios while locking in a specific price.

Another example of a derivative is the non-deliverable forward (NDF) currency contract between Barita Investments Limited and Cornerstone Financial Holdings Limited (CFHL). This contract was signed on August 24, 2020 with a settlement date of October 1, 2020 for US $63 million. The USD-JMD rate on August 24 was $153.13 with the rate on October 1 being $147.24. In this case, the Jamaican dollar appreciated against the United States dollar which resulted in Barita making a gain of $719.98 million.

A NDF is a cash settled forward contract where the notional amount isn’t exchanged but the difference between the prevailing rate at the start of the contract and spot price at settlement is paid to one of the parties depending on where the rate went. In this case, the JMD appreciated which meant that Barita was paid that gain while CFHL ended up paying the difference which equated to $11.43. This type of derivative basically results in the party which purchased the contract hedging for the possible foreign exchange risk from the moving rate. If the JMD depreciated during the period, Barita would have owed CFHL at settlement since they’d owe more USD.

Forward contracts aren’t popular in Jamaica but are usually reserved for large transactions where the purchaser would want to hedge against the risk where the rate might go against them for a future deal. Instead of someone paying $1.55 million for US $10,000 now, someone could have gotten a forward contract at a rate of $145 – 1 in January where they’d save $100,000 through the use of this contract. Jamaica has used futures contract before to hedge with the price of oil, but it didn’t turn out as desired with it costing the country more since the price of oil didn’t pass the strike price. Derivatives aren’t always going to be perfect for everyone, but it lowers the risk for some persons based on their future expectations of where an asset might be priced at.

— By David Rose