Derivatives are financial contracts that have their valuation based on another asset, commonly known in finance as the underlying asset. Consequently, derivative is not something one can touch. However, it is the asset, upon which it is derived from, that can be tangible. Notably, derivatives can be of various types of assets, with the most common assets including equities as in the case with the exchange-traded funds. They can also be commodities such as gold and oil futures (Engdahl, 2008). Additionally, derivatives can be on currencies such as options and forward contracts on major currencies like the US dollar, the Euro, or the Sterling pound against the AED (Taylor, 2011). Breaking down the various types of derivatives requires focused deliberations, which is why this paper narrows the scope of the analysis to the use of derivatives in investment, portfolio management, and in corporate finance within the UAE. To start with, the paper attempts to contextualize the use of derivatives in the UAE by introducing to the reader the state of affairs in the trading and the use of derivatives in the UAE now.
The UAE has two registered exchanges - the Abu Dhabi Exchange (ADX) and the Dubai Mercantile Exchange (DMX) (Fagan & Ringshaw, 2002). However, none of the two exchanges currently trades the derivatives. The authorities in the nation still consider the idea of establishing a derivatives trading platform in the UAE. The deliberations began in earnest in 2005. In 2008, the authorities established the trading of derivatives through the DMX. It provided for the creation of the trading policies in the UAE, and trading began in the same year. However, this coincided with the 2008/2009 global financial crises that started with the failed subprime mortgages in the USA (Global Capital, 2011). Particularly, the global financial crises caused the failure of the newly established derivatives trading platform in the UAE not only because of the financial implications. Rather, one of the problems was the fact that derivatives on the subprime mortgages resulted in massive defaults. Since many investors had bet against the subprime mortgages through the derivatives, the meltdown in the mortgages resulted in the massive losses, affecting utterly all the financial institutions, including the investment banks, the insurance companies, and the commercial banks. As a result, an investor in Dubai and the UAE, in general, feared the derivatives, which led to the collapse of trading in 2011 (Gulf News, 2014).
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However, derivatives are completely bad, and the best indicator of this fact is the observation that many firms in the UAE do apply the use of derivatives in corporate finance policies. Particularly, the application of derivatives in corporate finance revolves around the issue of risk management practices. It should be noted that derivatives provide one of the most efficient ways of hedging against financial risks. For instance, the derivatives are applied by the UAE banks in locking interest rates, foreign exchange rates, and even the prices of commodities, especially when they consider that adverse movement of the prices of the mentioned instruments is quite likely. However, the UAE does not have a derivatives market, and as a result, corporate deal origination and structuring are done through bilateral agreements with the investment banks in the UAE. If a firm considers that the oil prices are likely to move upwards, as expected in the current market conditions, the business firms in the UAE may attempt to lock the prices of the commodity by taking futures contracts on oil prices. The futures contract gives the buyer the right and not the obligation to exercise the contract at the specified future date or let the same to expire, considering their views on the movement of the oil prices (Taylor, 2011). In the UAE, locking of oil prices happens commonly with airlines business as Emirates Airlines and Etihad Airlines have such derivatives as key elements of their financial reports. In other instances, a corporation expecting to receive money in the form of foreign currencies may want to lock the exchange rates by taking a currency forward contract, and in the process, it ensures that it protects itself against the possibility of adverse movements in the currency exchange rates. Such transactions are in wide application across the UAE, especially in the commercial banking sector of the economy. However, the nation lacks a trading platform for the derivatives. Consequently, they often approach the investment banks to structure deals on derivatives, making it expensive for the corporations. The problem could be solved by having a regulated and centralized trading platform for the derivatives, and this would ease the deal origination as well as the deal execution process (Taylor, 2011).
The second major use of derivatives in the UAE is portfolio management. Research indicates that as compared to corporate finance and risk management, the UAE does not have a wide use of derivatives in portfolio management. The most efficient example for the illustration of how derivatives come into portfolio management is the use of exchange-traded funds. These funds track a particular index. In the USA, for instance, it is common to hear of the ETFs that track the S&P 500 among other indices (Taylor, 2011). If there were such an ETF in the UAE, then it would track the Abu Dhabi Exchange indices (Advantage Futures, n.d.). Such ETFs become important portfolio management vehicles for investors, meaning that investors do not have to go through the trouble of deciding what particular financial assets to include in the investment portfolio. The investor can easily buy a fund that is well managed by professionals, track its performance through the comparison with the index, and then determine whether to continue holding the portfolio or not. The ETFs are similar to mutual funds with the only advantage of the ETF over the mutual fund being the fact that the investor can easily buy or sell this derivative through the exchange. Now, the UAE has not had any ETF, and the reason for this is the speculative nature associated with equities. Sharia laws prohibit trading in speculative assets, and considering that the UAE is a sharia compliant nation, the highest possibility is that the ETFs may be the last thing to be introduced in the UAE (Mohamad & Tabatabaei, 2008).
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The third major use of derivatives is investments. Derivatives are used as an important investment vehicle with terms, such as long selling and short selling, coming into play. The latter is prohibited under the sharia laws and as such, it is expected that short selling will not be in the application in the UAE once the derivatives market comes live (Mohamad & Tabatabaei, 2008). However, it is highly likely that one of the possible elements of derivatives will be applied. As an investment vehicle, long selling does not involve the levels of speculative behavior associated with short selling. Considering that the trading in derivatives in the UAE was halted in 2011 due to the negative implications of short selling and other speculative means of investing in derivatives before 2008/2011 global financial crises, the application of derivatives as investment vehicles may take time before adoption in the UAE. Notably, Kuwait, which was the first and the only nation in the UAE to have a derivatives market, has not yet allowed the introduction of speculative derivative commodities in the market. Since Kuwait helped in the formation of the Dubai Mercantile Exchange, it is expected that the nation will not introduce the same derivatives anytime soon (Saidi, Scacciavillani &Ali, 2011).
To conclude, to deal with the issues of investing in derivatives effectively, there is the need for the UAE to re-establish the derivatives market at the DMX before moving to the ADX. It would provide the investors with liquidity required by a properly functioning capital market. Secondly, opening a derivatives market in the UAE would help in dealing with the issues of transaction costs in deal origination. Thirdly, this would also ensure that information asymmetry concerning the derivatives in the UAE is eliminated. However, most important is the fact that the establishment of a derivatives market in the UAE would ensure that investment risk would be reduced effectively by the presence of a regulated trading platform. Therefore, this paper concludes by recommending the establishment of a regulated derivatives market in the UAE.