Introduction To Financial Derivatives

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DAVID ADONRI Managing Director HIGHCAP SECURITIES

Financial engineering at it’s peak has just taken off in the Nigerian Capital Market. The feat was achieved recently when Nigeria Exchange Limited (NGX) received SEC’s approval to trade in the following seven derivative contracts:

1) Access Bank PLC Stock Futures.

2) GTCO PLC Stock Futures.

3) Zenith Bank PLC Stock Futures.

4) Dangote Cement PLC Stock Futures.

5) MTN Nigeria PLC Stock Futures.

6) NGX 30 Index Stock Futures.

7) NGX Pension Index Stock Futures.

Translation of the age long dream of trading in derivatives into reality, is a watershed in history of the Nigerian Capital Market. This is the highest product level a Capital Market can attain. Although the plan to introduce derivatives predate the demutualization of the defunct Nigerian Stock Exchange, now NGX, the absence of a financial market infrastructure, called Central Counter Party (CCP), delayed it’s take off. Derivatives are financially engineered instruments that can magnify  profits and losses hence, basic necessity for infrastructure like the CCP for novation and attendant risk management. The establishment of NG Clearing Ltd as Nigeria’s CCP put derivatives trading on NGX at a safer and efficient level.

Now that NGX is poised to launching West Africa’s Exchange traded derivatives, and Market Operators are also ready, time has come for the investing public to be sensitized on how to key into this new Capital Market window of opportunity. This introduction is very rudimentary. As a result, prospective investors still need to contact their stockbrokers who specialize in Futures, for necessary guidance because derivative is a specialty and niche financial product.

Derivatives have a reputation for being obscure but they are created and traded in large numbers all over the world. They have become increasingly popular in recent decades, with total value outstanding estimated at over $600 trillion. Derivatives have become a convenient way to achieving financial goals in terms of income maximization or protection against losses.

In the world of economics and finance, prices rise and fall according to the whims of Markets. Due to incessant price volatility, uncertainty becomes a thought provoking element that can make or mar returns on investment. Derivatives have emerged as financial tools to engineer contracts with values and timelines solidified to be solutions to multiple economic challenges.

In the most basic form, a derivative is a mutual agreement between two parties to perform some kind of financial transaction at a specified time and at a predetermined price. This in general term, make derivatives futuristic. However, in precise term, a financial derivative can be defined as a type of financial instrument or contract whose price or value is dependent on the value of another underlying asset(s) or variable (s).

The underlying assets or variables can be Common Stocks, Bonds, Commodities, Currencies, Stock or Market Indexes, Credit, Interest Rate, Energy and even weather. Price of derivatives derive from fluctuations in value of the underlying assets or variables.

A derivative contract is set between two (bilateral) or more (multilateral) parties. They are tradable on an Exchange platform or Over – The – Counter (OTC). Exchange traded derivatives have standardized contract terms, with guaranteed clearing and settlement of transactions and deivery of assets. CCP, which is a critical part of the Exchange traded derivatives ecosystem carries out the clearing, settlement and delivery functions through novation (Buyer to Seller and Seller to Buyer), also risk and collateral management. Exchange traded derivatives involve many parties and are hence, multilateral contracts.

In contrast, OTC traded derivatives are generally bilateral contracts involving only two parties. They are non standardized privately negotiated contracts which are tailored to meet the need of the parties.

OTC derivatives are unregulated and not traded on any Exchange. As a result, they generally have greater possibility of counter party risk, which is the danger that one of the parties involved in the transaction might default.

Many derivative instruments are leveraged, which means a small amount of capital is required to have an interest in a large amount of value in the underlying asset. This increases their potential risks and rewards. In spite of it’s risk, the derivatives market is one that continues to grow, offering products to fit nearly any need or risk tolerance.

There are many different types of financial derivatives that can be used for risk management or hedging, to speculate on the directional movement of an underlying asset and to leverage a position.

Hedging is a trading strategy that during the life of a derivative contract, neutralizes the exposure of the resulting portfolio to changes in the price of the underlying assets while, speculation is geered towards maximization of investment returns.

Common derivative contracts include Forwards, Futures, Options and Swaps.

1) FORWARDS Contract is the simplest example of a financial derivative. It is an agreement today for a future transaction. Forwards are usually bilateral contract agreements where the parties (Buyer and Seller) may customize the terms, size and settlement process of the transaction. Forwards are unregulated contracts that are traded OTC.

Once created, the parties in a Forward contract can offset their position with other counter parties which can increase the potential for counterparty risks as more traders become involved in the same contract. However, due to their simplicity and flexibility, Forwards are quite popular in commodities and currency transactions, to guaranty supply or uptake and also risk management.

For example, to guaranty supply of agricultural produce, an Aggregator (Produce buyer) can go into a Forward contract with the Farmer for uptake of a specified volume of produce at a price on a future date. Also, an importer can enter into a Forward contract with a Forex Dealer to buy foreign currency at a future date to guaranty supply and to hedge against exchange risk.

2) FUTURES Contract or FUTURES, is an agreement today between parties for the purchase or sale of an asset at an agreed price on a future date. Futures and Forwards are similar except in the fact that Futures are multilateral standardized contracts that are traded on an Exchange while, Forwards are not.

Futures are marginable financial instruments, as the CCP, in course of managing the collaterals, marks to market everyday. This may warrant maintenance margins and margin calls. The parties in a Futures contract are under obligation to fulfill their commitment to buy or sell the underlying asset.

However, a speculator can end his obligation to purchase or deliver the underlying asset by closing or unwinding the contract before expiration with an offsetting contract. Hence, not all Futures contracts are settled at expiration by delivering the underlying asset. Many derivatives are in fact cash settled, which means that the gain or loss in the transaction is simply an accounting cash flow to the parties brokerage account.

Futures contracts that are cash – settled include many Interest Rate Futures, Stock Index Futures and more unusual instruments like Volatility Futures e.g Weather Futures. Futures are mainly hedging instruments. For example, they can be used to mitigate exchange rate risk when the investor purchase a Currency Futures to lock in a specific exchange rate.

3) OPTIONS Contract is similar to Futures in that it is an agreement today between parties to buy or to sell an asset at a predetermined strike price on a specified date. While an Options contract is a right to exercise the transaction agreement, there is no obligation to do so, unlike in Futures contract. It is an opportunity only, not an obligation. Futures are obligations.

There are two basic forms of Options, which are, Call Option and Put Option. A Call Option gives the buyer the right but not the obligation to buy an underlying asset of a contract size at a specified price, on or before a future expiration date.

A Put Option gives the buyer the right but not the obligation to sell an underlying asset of a contract size at a specified price, on or before the expiration date. Buying or selling an Option comes at a price called Premium, which the investor can forfeit if the right is not exercised.

A Long Call means buying a Call Option while a Short Call means selling a Call Option. On the other hand, a Long Put means buying a Put Option while a Short Put means selling a Put Option. Options can also be described based on when exercisable.

An American Option can be exercised at anytime from initiation date to the expiration date whereas, a European Option can only be exercised at expiration. Bermuda Option is in between.

4) SWAPS, are derivative contracts used to exchange one kind of cash flow with another. For example, a trader might use an Interest Rate Swap to switch from a variable Interest Rate to a Fixed Interest Rate loan.

A Currency Swap is another type of contract wherein foreign currency exchange rate risk is exchanged. Credit default Swap is also another popular derivative where the risk of default on a loan is exchanged.

Financial derivatives are potent risk management tools to minimize exposure to market risks. They enable producers and consumers to lock in prices while guaranteeing stable supply and demand.

They can be used by investors and enterprises to hedge against adverse events, making changes in macroeconomic variables to be less harmful. Derivatives can be purchased on margin, which means that investors can use borrowed funds to purchase them, making them less expensive.

The buying or selling of derivatives in isolation is risky business. They are better used for hedging purposes. Derivatives have no intrinsic value of their own as their value comes from the underlying assets.

They are vulnerable to market sentiment and market risk. Also, supply and demand factors can cause a derivative’s price and it’s liquidity to rise and fall, regardless of what is happening with the price of the underlying asset. Derivatives are leveraged instruments which can increase the rate of returns or make losses mount more quickly.

Although derivatives carry some risks, they are very potent tools to manage risks. The benefits are overwhelming while the opportunities they offer are countless. Through the NGX, these exotic products are now available locally. Investors can now approach their Stockbrokers to reap the benefits from this new window of opportunities.

DAVID ADONRI

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