Ideas & Debate

Why derivatives market is better way to cut risks

Derivatives offer a simple, effective, and low-cost way to transfer risk. file photo | nmg
Stockbrokers at the NSE. Derivatives offer a simple, effective, and low-cost way to transfer risk. file photo | nmg 

Derivative trading has been amongst us ever since the ancient times. Circa 1700 BC, Jacob purchased a type of derivative called an ‘option’ by paying seven year’s labour for the right to marry Laban’s daughter, Rachel.

Instead the old man tricked Jacob into marrying his eldest daughter Leah, and Jacob then served another seven years in exchange for the right to marry his initial choice, Rachel, as well, probably because there was no ‘central counterparty’ to handle the ‘credit risk’.

It was, however, not until 1848 when the Chicago Board of Trade was formed to commercially and professionally trade in corn futures derivatives contracts.

Closer home in Kenya people who invest in the financial markets are used to trading in shares, bonds and currencies. Most of citizens will speak gleefully about how they made a killing in the KenGen or Safaricom IPOs.

However, when the stock market starts to dip, the only strategy is either to sell the share or ride the wave. In order to give investors additional options, the Nairobi Securities Exchange (NSE) is developing futures contracts to allow investors to diversify their investment portfolios and to the country, provide a full spectrum of risk management options.

Equity and fixed-income securities are claims on the assets of a company. Currencies are the monetary units issued by a government.

Commodities are natural resources (minerals, metals and energy) and agricultural produce such as maize, coffee and tea. These underlying assets are said to trade in cash markets or spot markets and their prices are sometimes referred to as cash or spot prices.

Some of these markets exist in Kenya and receive much attention in our mainstream media. Hence, they are relatively familiar not only to financial experts but also to the general population.

However, somewhat less familiar, but potentially more fascinating, are the markets for derivatives. Do you need to be a financial experts to know what they are? Are the risks outweighed by the rewards and opportunities?

Derivatives are financial instruments that draw their value from the performance of underlying assets such as equities, fixed-income securities, currencies and commodities.

What purpose does a derivative serve if the underlying asset is readily available? Market trends have answered this by showing that although spot or cash markets exist and can perform reasonably well without derivatives, where derivative products function well they can actually improve the performance of the markets for the underlying assets through enhancing price discovery (ensuring cash markets are not under or over-priced) and enhancing flow of market information in the spot market (through highlighting perceptions on future trends).

Derivatives can be used to create strategies that cannot be implemented with the underlying assets alone. For example, derivatives make it easier to go short, thereby benefiting from a subsequent decline in the value of the underlying assets.

In addition, derivatives are characterised by a relatively high degree of leverage, meaning that participants in derivatives transactions usually have to invest only a small amount of their own capital relative to the value of the underlying assets.

As such, small movements in the underlying assets can lead to fairly large movements in the amount of money made or lost on the derivative instruments.

Derivatives generally trade at lower transaction costs than comparable spot market transactions. For example, the Capital Markets Authority (CMA) has recently published on its website for public consultation and input, proposed derivatives fees that NSE wishes to charge on its single stock futures and NSE 25-share equity index futures contracts.

These fees will be substantially cheaper than the underlying. Due to the affordability of the product, derivatives end up being more liquid than their corresponding underlying assets.

For example, turnover of derivatives trading at the Johannesburg Stock Exchange and more recently on the Bombay Stock Exchange are three to four times higher than their respective equities markets.

Derivatives also offer a simple, effective, and low-cost way to transfer risk. For example, a shareholder of a company can reduce or even completely eliminate the market exposure to price changes by trading a derivative on the equity.

Holders of corporate bonds or any other fixed-income securities can use derivatives to reduce or completely eliminate interest rate risk, allowing them to focus on the credit risk.

Alternatively, holders of fixed-income securities can reduce or eliminate the credit risk, focusing more on the interest rate risk. Derivatives permit such adjustments easily and quickly.