PSE mulls sale of more derivatives

The Philippine Stock Exchange (PSE) is studying the possibility of launching more derivatives in the equities market to boost trading activity.

Derivatives are financial contracts designed to create pure price exposure to an underlying commodity, asset, rate, index or event. Examples of derivatives are futures, forwards, options and swaps, and these can be combined with each other or traditional securities and loans in order to create hybrid instruments.

Derivative products help investors in mitigating their risks and in maximizing their gains even when the market is moving down.

“The study’s scope will include the technical aspects of derivatives and a review of the regulatory environment needed for the smooth conduct of derivatives trading in the stock market. It will likewise identify areas that require closer coordination between the PSE and various government agencies whose functions or existing rules will affect derivatives trading in the stock market,” said PSE president Francis Lim.

These agencies include the Securities and Exchange Commission (SEC), Bureau of Internal Revenue and the Bangko Sentral ng Pilipinas.

Lim noted that the PSE is already trading warrants which are a form of derivatives.

The PSE’s decision to study more derivatives trading was an offshoot of an earlier decision to introduce its securities borrowing and lending (SBL) program and to come up with its own revised rules on short selling.

The exchange’s proposed set of rules on short selling is now pending approval before the SEC, while the SBL program was introduced early this year.

“We believe the local availability of all these complex stock market instruments will attract more investors, especially those who prefer markets that offer a wider range and a more sophisticated variety of products and services. The presence of knowledgeable investors who trade on these sophisticated instruments hopefully will create a significant increase in value turnover,” Lim said.

Lim said the PSE will focus on stocks and indices as underlying securities for derivative products.

Based on PSE’s initial study, derivatives trading accounts for a sizable share of total volume in some stock markets abroad. In Hong Kong, for instance, derivatives trading at times represents half of total turnover. “I hope we can generate as much turnover as other markets do from the introduction of more derivative products,” Lim said.

A popular form of stock market derivative is an option or option contract, which is a form of security that gives an investor the right – but not the obligation – to either buy (known also as the call option) or to sell (also known as the put option). The put or call option often involves a specific amount of a given stock, commodity, currency, index or debt at a specified price (the strike price) during a specified period of time.

Each option has a buyer, called the holder, and a seller, known as the writer. If the option contract on a certain security is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party. Ordinarily, a put option allows an investor to make money when the stock goes down. When the market is up, a call option allows an investor to enjoy a gain at a rate faster than the actual increase of the stock. Warrants are call options.

In the case of a security that cannot be delivered such as an index, the contract is settled in cash. For the holder, the potential loss is limited to the price paid to acquire the option or the right to buy the security. When an option is not exercised, it expires; no shares change hands and the money spent to purchase the option is lost. But for the buyer, the upside is unlimited.

Options are most frequently used as either a leverage or protection. As leverage, options allow the holder to control equity in a limited capacity for a fraction of what the shares would cost. The difference can be invested elsewhere until the option is exercised. As protection, options can guard against price fluctuations in the near term, because they provide the right to acquire the underlying stock at a fixed price for a limited time. Thus, risk is limited to the option premium, except when writing options for a security that is not already owned.