Page 4 - MEX Express - Vol 6 Issue 3

www.mexnepal.com MARKET PERSPECTIVE Volume: 6 • Issue: 3 • Year: 2014 A.D

Derivative Instruments in Commercial Banks of Nepal

In giant economies like US and EU commodity become more volatile than before. Futures contracts forward contracts have become the primary trading of respective currencies that they are exchanging.
market is taken as a backbone of success of their are the oldest way of investing in commodities. instruments in commodity markets. Futures are Different use of derivatives instrument is observed in
respective countries. But in Nepal it is a common Futures are secured by physical assets. Commodity traded on regulated commodities exchanges. It our banking sector but banks are not properly using
myth that commodity market is a “Gambling markets can include physical trading and derivatives is common to find financial companies to use it for hedging purposes. So a full-fledge grown up
Center”. Many people believe that one who is an trading using spot prices, forwards, futures, and derivatives, such as forwards, options, futures, swaps market is not seen although almost all commercial
active market player in this market is a gambler. This options on futures. Futures are a great vehicle for to hedge risk. But this scenario is hardly seen in our banks are using different derivatives instrument.
conservative thinking is pulling back the growth of hedging and managing risk; they enhance liquidity country, although our commercial banks are using It is all because of lack of awareness among market
commodity market in Nepal. Unless this behavior and price discovery. However, they are complicated instruments like Forwards, Swaps but excessive use players regarding commodity market; many people
of thinking commodity market as a gambling house is not seen, and banks are using it for their client think that derivatives are ‘time wasting’ assets in
changes, our country can’t taste the success of and one should understand them before starting but not for themselves. Our banking sector is in the sense that their value declines as their maturity
economic development. It will be hard to say that trade. preliminary stage and still much focus is needed in date approaches. Critics also contend that futures
commodity market is not present in Nepal in fact it is Farmers have used a simple form of derivative this particular sector. Since bank is a profit making and other derivatives are used by speculators to bet
in a developing stage. In developed economies like trading in the commodity market for centuries for institution they are always in safe and profitable side. on the market and take on undue risk. Many people
USA, China, Japan, Russia, etc different derivative price risk management. Derivatives such as futures Forward is used as NDF (Non-Delivery Forward), are still unaware about commodity market. Lack of
instruments are used for hedging purposes. They are contracts, Swaps, Exchange-traded Commodities; Swaps is used in FOREX market and some supervision and proper guidance from NRB (Nepal
using it for minimizing the risk associated in futures commercial banks are using Options in our Nepalese Rastra Bank) hinder in progress of commodity
market and they are doing quite well. market. Clients usually come to bank in favor of market. So due to this reason efficient market is
Derivative is a security whose price is dependent asking them to lock the price while they are trading hardly seen. There is a need that policies of NRB
upon or derived from one or more underlying assets. with foreign parties to ensure safe trading and be revised, new plan and policies be formulated and
A derivative itself is merely a contract between minimize loss due to price fluctuation in future, so more action oriented task be taken into accordance
two or more parties. Its value is determined by the this arrangement is facilitated by bank by charging with commodity market and use of derivative
price fluctuations in the underlying asset. The most some premium. instrument.
common underlying assets include stocks, bonds, Overall, it is believed that banks are doing futures
commodities, currencies, interest rates and market agreement but all conditions are pre-set and are Lalbabu Sah
indices. Most derivatives are characterized by exercised at exercise date and order is executed. MBA (5th Trimester)
high leverage. Derivatives are generally used as an While in case of denomination of currency banks Apex College
instrument to hedge risk, but can also be used for are exchanging currency of one type with other
speculative purposes. (let’s say, Dollar is exchanged with Japanese Yen),
In the new millennium, the financial market has so they are earning from the spread of interest rate

What to look for when investing in Gold?

For centuries, the yellow bullion has played a major role in 3. Dollar strength economy) will positively affect gold consumption demand in India and
economies and cultures across the world. Gold is one of the Since the global market of gold is denominated in US dollars, the strength China offsetting the selloff by investors. We can see from the chart
most sought after commodities around the world from an investment and the weakness of the currency has a major influence on the price of below that for now, interest rates and gold prices are still strongly
perspective and is even more significant as an investment asset in the metal. All else equal, whenever the dollar strengthens, it takes lesser correlated.
South Asia and China due to its widespread use in traditional jewelry. amount of dollars to buy the same amount of gold. As the dollar strengthens,
In undeveloped markets like Nepal, where the financial sector is far gold prices decrease and vice-versa. Furthermore, anytime there is risk of 6. Market sentiment, speculation, and investing
from mature, gold presents one of the very few opportunities for an the debasement of the US dollar, both individual and institutional investors Investors and speculator naturally tend to gravitate towards assets
investor to diversify their investment portfolio (other areas being real (including central banks), tend to flock towards gold, driving its price where they are expecting higher returns and when the market sentiment
estate, fixed deposits, and to a certain level public equities). upwards. The inverse relationship between gold prices and dollar strength is at a high, it means they are expecting strong returns in riskier assets
Investing in gold can be nerve wrecking due to its volatility and is depicted in the chart below: such as equity. At such times capital moves from risk free assets
relatively quick reaction to economic and political developments. and safe havens to riskier and potentially more profitable assets like
While there are many benefits of including gold in one’s portfolio, this 4. Economy equities, driving the price of gold down.
article will explore various factors that influence gold price both in the One of the factors affecting gold prices is the overall state of the economy. Gold acts as one of the best hedges against currency devaluations and
short run as well as the long run. When the economy is doing well, most investments provide a healthy inflation as such, speculators in currency investments create massive
1. Demand and Supply return and conversely, when the economic climate is unfavorable most capital swings, driving the price of gold accordingly.
Like any commodity or most other goods and services, the law of investments provide lower or uncertain returns. At such times, investors All of these factors influence gold prices and at times certain factors
supply and demand applies to gold as well. The price is directly tend to move towards safe haven assets such as gold, driving its price up. are moving in opposing directions. As an investor in this commodity,
proportional to the demand and inversely proportional to the supply of Gold’s historical record of performing well in crisis periods supports this it is paramount to thoroughly explore and understand each of these
the metal. The demand and supply itself however varies on numerous theory. factors to determine where the next price swing is going to take place.
factors. Gold is used for jewelry fabrication, for industrial uses in 5. Interest rates While no investor in the world can predict the direction of gold or any
technology, for investment purposes in the form of gold bars and coins As interest rates of risk free assets rise, it is only natural for investors to other asset for that matter, the better ones take well thought through,
or exchange-traded funds (ETFs), and by central banks primarily as a replace gold with such assets, as the opportunity cost for holding gold gets researched, and calculated risks and increase their odds of success.
hedge against currency devaluation. higher. One of the primary reasons for the increase in opportunity cost of
The supply of the metal is determined by mine production, net holding gold is that it offers no yield compared to an interest-bearing risk- Yurop Shrestha
producer hedging, and recycled gold. Both the demand and supply of free asset like a treasury bond. Director
the metal have been steadily declining over the past three years, with It is important to note that as Chinese and Indian gold demand takes up a
the total supply and down 5% in 2013 compared to 2012 and down higher percentage of the overall gold demand share, interest rates will be
7% in the third quarter of 2014 compared to the same period last year.1 less of a factor. The higher interest rates (which would mean a stronger
2. Central banks and mining companies
Central bank’s net purchases constituted almost 10% of the global
demand of gold in 2013 and they currently hold roughly 16% of all
produced gold.2 Central banks often buy gold reserves to hedge against
inflation, devaluation of its currency, and the devaluation of its foreign
reserves. Conversely, when the value of the USD and other foreign
currencies increase, central banks often sell their gold to shore up their
foreign currency reserves. Since these purchases or sales occur in
huge bulk quantities, they have an almost immediate affect on gold
prices.
Gold mining companies control large supplies of gold and it is in their
interest to maintain high prices for the metal (at least enough to recoup
their mining expense and make some profit). When the gold prices
are on a downtrend, mining companies usually hold on to their gold
reserve, which limits the supply in the market, effectively creating an
artificial price floor for the metal. Such artificial ‘hoarding’ is known
as net producer hedging.
1The London Gold Market Fixing Ltd.; GFMS, Thomson Reuters; World Gold Council
2http://goldratefortoday.org/4-important-factors-affect-gold-rate-part-1/

Editorial Board: Mr. Lakshman Pandit / Mrs. Liberty Shakya / Ms. Shubhechchha Mulepati / Mr. Vivek Risal Page 04
Mercantile Exchange Nepal Limited, Alliance Tower, 4th Floor, Charkhal, Dillibazaar, Kathmandu, Nepal
Phone: +977-1-4011542/43/44, Fax: +977-1-4011545/6 | e-mail: editor@mexnepal.com