Why are we discussing Derivatives? I noticed that lots of investors are aware of assets like stocks, bonds, and even crypto currencies so I just wanted to give a small introduction to some investment vehicles that are available in so many parts of the world and potentially coming to the Nigeria Financial markets in the nearest future. They are called Derivatives.
A Derivative is a financial security in which its value is derived from an underlying asset or groups of asset. It comes in the form of a contract between two or more parties (buyer and seller) which gives the parties certain rights and obligations either during the contract period or at the maturity date of the contract.
During the life of this contract, the price of the derivative fluctuates based on the fluctuation/volatility of the price of the underlying asset. Example of common underlying assets for derivatives are stocks, bonds, commodities, forex and interest rates etc.
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Derivatives can be trade over-the-counter (OTC) or on an exchange. Most derivatives are traded OTC therefore open to counterparty risk as they are largely unregulated. On the other hand, exchange traded derivatives like Futures are very highly regulated and the counterparty risk in many cases are almost nonexistent as transaction completion are mostly guaranteed by the exchange itself.
Counterparty risk is the risk that one of the parties to the contract, either the buyer or the seller will not uphold his/her part of the deal due to factors like bankruptcy. This usually bring about unwanted costs of litigation.
Derivatives are used to hedge transactions/positions or speculate on the directional movement of an underlying asset. It also enables an investor to achieve his aim of maintaining a diversified portfolio and the flexibility to manage his risk levels. Derivatives at first were used mostly to hedge in cross border transaction but now there is the speculation aim as there are even derivatives for betting on weather and social events.
Using Nigerian as an example, Imagine a US investor with portfolio in dollars who is afraid that the rapid devaluation of the naira could make his investment in a Nigerian company (in naira) more risky. If he purchases shares on the NSE (Nigerian Stock Exchange), he is exposed to exchange rate risk while holding the stock because the more the naira is devalued, he will be recouping less amount in dollars when he sells his shares.
So to hedge (protect against) this risk, the investor could purchase a currency derivative like Currency Swap and Futures to lock in a specific exchange rate; meaning that when he sells his shares and gets back his naira he can reconvert to dollars at the locked in rate instead of the prevailing exchange rate in the market. This same instance can be used in trading on grains like wheat. Its just about locking in a future price in the present.
Without going into details, the most popular derivatives available in the market are:
Swaps, Forwards, Futures and Options. We have more products like CDS and exotic options which are a bit more complex in nature.
An option is a contract that gives the holder the RIGHT to buy or sell an asset (underlying asset) at a given price and within a given time. An investor buys this right by paying a premium to the seller. Once the buyer exercises his right, the seller of the option has an OBLIGATION to honor the terms of the contract. If the buyer doesn’t exercise his right (he can decide not to), the seller goes home with the premium.
Forwards and Futures are similar to Options but the buyer and seller both have an OBLIGATION to honor the terms of the contract. The major difference between forwards and futures is that forwards are mostly OTC while futures are exchange traded.
The European Derivatives markets were valued at €735trillion as at 2018. This is extra value created from “traditional instruments”. Having derivative markets could help SMEs and investors to perform cross-border transactions at lower risk and also deepen the financial markets of the economy. The NSE for some years now have been working on introducing a derivative exchange in Nigeria; recently organizing capacity building sessions, workshops and trainings. However, some large institutions do have some access to OTC traded instruments. India introduced derivatives about 9 years ago and are currently witnessing trading activity at 25 times pre-derivative years.
Except counter-party risks there are still cons to derivative trading like high volatility since the price of the contract is based on the market sentiment of the future value of an asset. Also, there is the big issue of complexity to understand and value properly. Over-valued derivatives were a big cause of the 2008 financial crises that rocked America’s economy. The roles of banks as market maker and not a speculator had to be redefined by the Dodd Frank act as an aftermath of the crises.
This topic is really vast. We have not even scratched the tip of the iceberg with this article. However, it could be interesting for investors in Nigeria who are mostly conversant with stock, treasury bills, currency and even crypto trading to realize that they could buy lending interest rates as a product.
By; Chibueze Nwosu
Chibueze Nwosu has a Masters in Finance and currently works as a Business Analyst in the banking sector.