Financial derivatives are potent risk management tools for minimizing exposure to market risks. They enable producers and consumers to lock in prices while guaranteeing stable supply and demand in various markets.
They can also be used by investors and enterprises to hedge against adverse events, thus making changes in macroeconomic variables to be less harmful. The buying or selling of derivatives is risky business. They are better used for hedging purposes. Hedging is a trading strategy such that, during the life of a derivative contract, neutralizes the exposure of the portfolio to changes in price of the underlying assets.
From rudimentary perspective, a derivative is a mutual agreement between two parties to perform some kind of financial transaction at a specific time and at a predetermined price. Consequently, derivatives are futuristic. 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 asset(s) or variable(s) can be ordinary shares, bonds, commodities, currencies, indexes, credit, interest rate, warrants, energy, weather and several others. 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 traded on an exchange platform or over-the-counter (OTC). Exchange traded derivatives have standardized contract terms with guaranteed clearing and settlement of transactions, and delivery of instruments. 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 and privately negotiated contracts which are tailored to meet the needs of the parties. OTC derivatives are unregulated, as a result, they generally have greater possibility of counterparty risk which is the danger that one of the parties involved in the transaction might default.
Common derivative contracts include Forwards, Futures, Options and Swaps. Each can be used to create products that fits any need or risk tolerance.
1) FORWARD CONTRACT (FORWARDS)
Forward 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 positions with other counterparties which can increase the potential for counterparty risk as more traders become involved in the same contract.
However, due to their simplicity and flexibility, Forwards are quite popular in commodity and currency transactions to guaranty supply or uptake at predetermined price and volume, thus managing the attendant risks. For instance, an importer can enter into a forward contract with a forex dealer to buy foreign currency at a future date to guaranty supply at a predetermined price in order to hedge against exchange rate risk. FMDQ Exchange trades currency Forwards.
2) FUTURES CONTRACT (FUTURES)
This 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. The parties in a Futures contract are under obligation to fulfill their commitments to buy or sell the underlying asset through novation administered by a Central Counter Party (CCP). Not all contracts are settled at expiration by delivering the underlying asset. Many Futures are cash settled which means that the gain or loss in the transaction is simply an accounting cash flow to the parties’ brokerage account. Futures 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, it can be used to mitigate foreign exchange risk when the investor purchase a currency futures to lock in a specific exchange rate. Two stock index futures namely, NGX 30 Index Futures and NGX Pensions Index Futures are currently traded on Nigerian Exchange (NGX) platform.
The underlying assets for these indexes are ordinary shares of listed companies which have been selected to meet certain parameters. The indexes measure the aggregate change in performance of the underlying stocks from time to time. For instance, a passive investor who bought an Exchange Traded Fund (ETF) based on NGX 30 Index when it was 150 points at unit price of N100, he can hedge against price diminution by simultaneously buying appropriate number of NGX 30 Index Futures expiring on a future date at a higher NGX 30 Index points of say 165 that will preserve the value of his investment.
3) OPTIONS CONTRACT (OPTIONS)
Options contract is a right to exercise the transaction agreement but not an obligation to do so. Options are similar to Futures except that Options contract is an opportunity whereas, a Futures contract is an obligation. There are two types of Options. These are Call Options which is the right to buy the underlying asset and Put Options which is the right to sell the underlying asset.
SWAPS CONTRACT (SWAPS)
This is a derivative contract used to exchange one kind of cash flow with another.
Options and Swaps have been sparingly dealt with in this tutorial. Next edition of Money Digest will give further insights to them with illustrations. Meanwhile, investors can contact their respective Stockbrokers to open Derivatives Brokerage / Margin Accounts through which hedging transactions are conducted.
