Derivative is an
instrument whereby two or more parties whose value is depending on agreed upon
underlying financial assets, which can be commodities, bonds, currency, stocks
indices, etc. There are few types of derivative instruments such as forwards,
futures, options and swaps. Each of derivative instruments encompassed with its
own functions and characteristics.

Under the
leadership of Mr.Kuan, Hartalega has growth prosper and known as a public
listed company, namely Hartalega Holdings Berhad. As mentioned, Hartalega has
expanded its business to myriad countries around the world. In order to manage
the exposure of foreign exchange rate, Hartalega Group’s has entered into
foreign exchange forward contracts. The purpose of the use of forward currency
contracts by Hartalega’s Group is to manage sales transaction exposure. Foreign
currency forward contract is one of the common types of derivative instruments
used by a company to lock the currency exchange rate for a currency’s purchase
or sale at a specific price for settlement at a predetermined time in the future.
By using of this contract, it enables investors to protect the cost and profit
margins of products and services purchased and sold overseas. It also enables
investors to lock-in exchange rate as much as a year in advance.

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             Besides, foreign
exchange forward contract is a hedging instrument without upfront payment.
Hence, it includes binding contract which cannot be broken when one party
stands to lose. There are few risk associated foreign exchange forward contract
which are credit risk, exchange rate risk and interest rate risk. Credit risk
usually occur in FX forward contract when either one of the parties is unable
to fulfil the obligation, while the other party will required to sign another
contract with a third party, hence being exposed to market risk. However, FX
forward contract is potentially unfavourable movement of exchange rate. By
locking in the exchange rate at the purchased currency, the party lose the chance
of profit from favourable exchange rate movement. In contrast, the unfavourable
exchange rate may withdraw further opportunity of party for profit. In term of
interest rate risk, the price of forward contract is rely on differential between
interest rate which can be gained by the two currencies, variation in those
rates can alter the price of the contracts. If the party has signed forward
contract it no longer have the opportunity to enter at a lower rate if there a
favourable change in interest rate.

Hartalega’s
Group enters into foreign currency forward contract for less than one year to
hedge the Group’s trade receivables and sales denominated in United States
Dollar (“USD”). By this, if USD strengthens against MYR, it will increase the
cash flow of the company. While USD weaken against MYR will lead to a decrease
of the company’s cash flow.  Besides, the
used of foreign currency forward contract likely depend on the economic factor
which could cause of a company loss. Hartalega company has announced of lower
profit in its third quarter ended Dec 31, 2016 due to the revaluation of USD
denominated and a loss of foreign- exchange forward contract. This has brought
significant impact to the company performance due to the unrealised forex loss
arising from the revaluation of US denominated loan. Hartalega has predicted there
will be rise of cost raw material in the future. Currently, Hartalega is
worried about strengthen of MYR which will lower the company’s profit.

Apart from that,
the used forward currency contracts by Hartalega are valued using a valuation
technique with market observation inputs. The fair value of the forward foreign
currency contracts is identified by reference to discounting the difference
between the contracted rate and the current forward price at the reporting date
for the residual maturity of the contracts using risk-free interest rate (based
on government bonds). Since foreign currencies contracts are hedged with
creditworthy financial institutions according Hartalega Group’s policy, Hartalega’s
Group does not expect or anticipate any significant credit risk. Besides, there
are no cash requirement risks as Hartalega Group’s only employed foreign
currencies contracts as its hedging instruments.      

            As Hartalega’s Group only emphasized on the use foreign
currency forward contract, I would like to suggest on other types of
derivatives which are useful in managing the exposure of financial risk such as
swap, future contract and option.

Swap is a
derivative contract whereby two parties exchange its financial instrument. Swaps
usually involve cash flows that are depending on a notional principal amount
that both parties have agreed. Swap has classifies into several types which are
interest rate swap, currency swaps, commodity swaps, debt-equity swaps and
total return swaps. It is recommended Hartalega to enter into interest rate
swap as it provided high liquidity in major currencies. Interest rate swaps is
the most common type of swap. Interest rate swap happen when two parties agree
to enter interest rate arrangement, a borrower that carried a loan with a
variable interest arranges with counterparty for example, U.S. Bank to swap the
loan term, exchanging the variable rate at a fixed rate. Subsequently, the
borrower entitles to pay a fixed rate and any spread which is applied to the
proxy used to identify the variable rate. In return, the counterparty offers
payment of the lending rate which is excluded of any spread; in that case that
portion of interest is removed for the borrower. The borrower is not entitles risk
for changes in variable rate loan. It is encouraged Hartalega to take in the
consideration to carry out interest rate swap as one of its derivatives
instrument as this exchange involve with only interest cash flow over and
without principal involved. Each party in the contract is simply swapping its
existing obligation for desired obligation. The fixed rate is depending on an
average of expected future floating rate.   

            Besides that, it is also recommended Hartalega to enter
option contract as one of their derivatives. Options contract is a contract
between a purchaser and seller which gives the buyer of the option the right to
either buy or sell a particular asset at a specified date at an agreed upon
price. Options contracts are usually use in commodities, securities and real
estate transactions. There are two type of options are recommended to Hartalega
which are call option and put option. Call option is an agreement that gives
the buyer the right to buy at a predetermined price for a specified period of
time. The call option’s seller is obligated to sell the underlying security if
call buyer exercise his or her option to buy on or before the option expiration
date. Therefore, put option is an agreement that gives the buyer the right to
sell shares of an underlying stock at predetermined price at specified period
of time. The put option’s seller is obligated to buy the underlying security if
put buyer exercises his or her option to sell or before the expiration date of
option.  

            Instead of options, foreign currency future contract also
one of the derivative instruments where Hartalega can take into consideration. Foreign
currency future contract is a contract where the price is specifies at which a
currency can either be purchased or sold at a future date. The differences
between future and forward contracts is that future contract are traded on
exchanges and standardized contracts while forward contract which is currently
used by Hartalega is a private contract between two parties to buy and sell an
asset at an agreed price in the future. Additionally, forward contract involved
the chance of one party to default while future contract involved with clearing
houses which function to guarantee the transaction. By entering into foreign
currency future contracts, it provide more flexibility and allowing traders
access to high leverage as well as trading in specific position sizes.    

            As a conclusion, Hartalega is recommended to undertake or
enter into different type of derivatives instrument to manage its financial
risk. Hartalega can take several advantage by enter into more derivative
instrument. A company can predict future price trend, stabilizing expenses and
maximizing profits by enter into derivatives instruments. However, when a
company is emphasized on its derivative market, the option and commodity price
can easily enable a company to predict the future price trend of its raw
material. Hence, it enables company to make wise decision on instant large
purchases or future purchase. If estimation made by the company proved correct,
it can prevent unnecessary expense on raw materials at the same time cost
saving to the company. Derivatives instruments are a useful in managing risk
and if applied judiciously it can generate good results and advantage.