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What You Need to Know About Derivatives

A derivative is an instrument that derives value from its underlying asset(s) which can be bonds, shares, currencies, or market indices.

Image I Courtesy NSE

NSE NEXT which is the Nairobi Securities Exchange (NSE) derivatives market trades single stock futures and index future contracts.

What is a Derivative?

A derivative is an instrument that derives value from its underlying asset(s) which can be bonds, shares, currencies, or market indices; by itself, it is simply a contract between parties.

Types of Derivatives

Derivative contracts are traded on an organized exchange or over-the-counter (OTC). Derivatives are further categorized as Forward contracts, Future contracts, options, and swaps

Forward contracts

Involves the buyer agreeing with the seller to acquire an underlying Asset at a future date, and at a price agreed upon by both parties. Forward foreign exchange contracts are popular forward contracts that require a  buyer to buy a specific amount of currency at an agreed spot rate.

Future contracts

Future contracts are simply forward contracts that trade on an organized exchange hence are more marketable and have less counterparty risk compared to forward contracts which trade in the OTC. The OTC has one major advantage in that it allows parties to customize their contracts, a feature not available in an organized exchange.

An exchange-traded future contract requires the buyer to place an initial margin and an additional margin that settles the Investors’ account depending on the price movement of the underlying asset on a daily basis instead of waiting for the contract to mature. The next effect is the same whether the contract is settled daily or at the end.

Options

The holder( buyer) must pay an option premium when they get into an option contract.

An option contract gives the buyer the right and not obligation to buy(call option) or sell(put option) an underlying asset at a specified price.

American Options can be exercised at any time prior to their expiration. European options can only be exercised on the expiration date. 

For put options, the seller is obligated to buy the underlying asset if the buyer chooses to exercise her put option. The buyer’s maximum loss is only limited to the cost of the put option (premium) yet he can make endless gains making them quite attractive to Investors.

For instance, assuming Safaricom is trading at KES 35 today, if I feel Safaricom’s price will increase I buy a Call option. At expiration, if my assumption is correct and the price jumps to 38, I will have the right to buy Safaricom at KES 35 and I can sell it immediately at 38 making 3 shillings. If the price had dropped or remained at 35, I would decide to not exercise my right and the contract expires.

Assuming Safaricom is trading at KES 35 today, if I feel Safaricom’s price will fall, I buy a Put option. At expiration, if my assumption is correct and the price falls to 32, I will have the right to sell Safaricom at KES 35 and make 3 shillings. If the price had increased or remained at 35, I would decide to not exercise my right and the contract expires worthless.

Swaps 

A swap is a contract between 2 parties to exchange a predetermined cash flow or a financial instrument at a future date. Swaps are important tools for large portfolio managers and international business operators. They are literally tools of barter trade.

Assuming I have bonds in my portfolio but want to sell them to buy shares in Centum but can’t find a buyer I look for someone who has Centum shares who is also looking for the bonds I have, and we exchange either the assets or the returns of the assets. I can keep the bonds, but I am earning a return on the Centum shares, the other party pays me the return on the Centum shares as I give him the interest earned from my bonds. This allows big portfolio managers to rebalance their portfolios without making big sales which affect the market price of shares and bonds.

International businesses use them in swapping currencies or currency returns.

They are mostly used by financial institutions and not individuals; the rate of default is high.

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Purpose of derivatives

Price Discovery

When future contracts and options trading in exchange it leads to price discovery of the underlying assets and provides information on their value. This is achieved by comparing the different spot prices of the underlying assets.

Hedging and diversification

In forward contracts producers can lock in predetermined commodity prices and buyers can secure a purchase price which reduces their exposure to fluctuation in security prices.  For exchange-traded future contracts, taking positions in the opposite direction without abandoning their position the investor incurs less stock-selection risk(because of diversification) and less market risk. 

Speculation

The art of speculation is to develop one insight that others have overlooked and then trade big on small advantage. Speculators try to cash in from the price fluctuation of the underlying asset in the short- term.

Derivatives at the NSE

Single stock futures and index futures ( 25 share index) are traded at the NSE. It includes derivative contracts of KCB, Safaricom, EQTY, ABSA, East Africa Breweries, British American Tobacco, and the NSE 25 index.

Illustration 

Investor A purchasing 1000 shares of ABSA trading at Ksh.9 will only make a gain if the share prices rise, and their exposure is Ksh.9000.

Investor B is bullish about ABSA and buys a single contract of ABSA.

The initial margin is set at 10% of the transaction ( 1000*10%*9)= 900.

If the share price rises to Ksh. 13, the total gain will be;

((13-9)*1000)= Ksh 4000

Total settlement = Ksh 900+ Ksh.4000 = Ksh.4900

Should the market go against the investor’s position, the Initial margin is used to compensate the counterparty. The losses in the future contracts can wipe out the Investor’s initial margin therefore they’re not an investment instrument for novice investors.

Agriculture is a source of income for many households not just in Kenya, but in the rest of Africa. Seasonal risk can be managed by the introduction of agricultural futures and options that serve to Spread risk and obtain price insurance. A well-developed derivatives market is also a source of funding in local currency to supplement Foreign direct investment.

The NSE and other players organize seminars and conferences to educate Investors on the new financial products and how they function in order to enhance market participation. Do check out the NSE website.

First published on People Pennies. Ms. Kasiva Mutisya is  Finance and Investment Analyst. Follow on Twitter 


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