A Survey on the Usage of Derivatives and Their Effect
on Cost of Equity Capital

Abstract

Despite familiar concerns about “excessive” speculation, as well as occasional financial blowups involving derivatives, their acknowledged value for hedging and managing financial risks has led to continuing expansion around the world. Derivatives trading exists in most countries with developed financial markets, and new derivatives markets have opened in many emerging market countries as well. In this article, the authors report on a survey of derivatives usage in Malaysia. They document why firms do or do not use derivatives, what kinds of firms and instruments are involved, and how they are handled with regard to governance and accounting within the firm. The most common derivatives in use are foreign exchange and interest rate products.

In addition to the inherent difficulty of establishing well-functioning markets in unfamiliar and often complex types of financial instruments that any emerging market country faces, Malaysia has a special challenge because it is a largely Muslim country whose regulatory authorities must take into account the constraints imposed by Shariah law. The authors explain how the main principles of Shariah apply to derivatives and discuss some ways the system gets around them. They also test whether derivatives usage allows a firm to lower its cost of capital, as one might expect if it is managing its risk exposure more effectively, but the survey evidence does not support the hypothesis.

TOPICS: Derivatives, emerging markets, exchanges/markets/clearinghouses