Why derivatives trading on the bourse is long overdue

Nairobi Securities Exchange (NSE)trading floor.

The Nairobi Securities Exchange (NSE) is taking too long to start trading in derivatives - financial instruments whose value depends on the price of another asset. Derivatives are useful in reducing the risk exposure associated with trading in securities.

They offer investors additional investment opportunities. For instance, instead of buying the asset, the investor can just buy the right to buy that asset.

For example, if you plan to invest in the BAT share now and sell the same six months later, two choices are open to you. If you are certain that the price will go up, you buy the share now, wait for six months and then sell it at a profit.

However, that kind of certainty does not exist at the stock market. It is the uncertainty associated with changes in asset prices that creates room for trading in these type securities called derivatives.

Thus, instead of the outright purchase of an asset, just find another investor to sell you the right to buy the BAT shares from the seller six months from now.

 The advantage is that by then, you will enjoy some degree of flexibility because you will only buy those shares when it is favourable to you. This will be less costly than purchasing the BAT shares now. However, this option works better when derivatives are traded at the NSE. Currently, they are not trading.

Derivatives are important to financial market players because they are a form of insurance to investors and specifically reduce risk associated with trading in securities.

The popular derivatives that investors use to prevent risks are futures and options. The risk managed through derivatives include stock market risk, commodities risk, and foreign currency risk.

It is not surprising that firms and even non-profit institutions find derivatives a powerful management tool.

Apart from firms using derivatives as instruments to reduce the risks associated with the corporate cash flows, a class of financial market players use derivatives to take a position in the expectation of profit. In other words, they use derivatives to speculate.

CASH FLOWS

In finance literature, the benefits from trading derivatives at a securities exchange include enabling firms to achieve cash flows that they could not achieve or can only obtain at a higher cost.

Those who trade derivatives generate a lot of information about the assets associated with it that drive the securities’ market to a higher level of efficiency and predictability.

To some extent, firms use derivatives to reduce tax liabilities. In nearly all developed capital markets, trading in derivatives is a must.

How do options reduce risk and enable speculators to make money? This is to reduce risk and not eliminate it because, in financial markets, it is the unpredictable new information that propels asset prices. For example, BAT shares are currently selling at around Sh779 per share. However, a characteristic of the stock market, you cannot be certain about the price of the share, say six months from now.

If you pay Sh779 for the share now, in six months’ time, there are two possibilities - the price can be above or below the initial share price. If in six months it is above Sh779, say at Sh894.88, you will sell it at that price making a profit of Sh95.88 per share or a return of 12 per cent. If, however, the price goes down to say Sh703.12, the loss is 12 per cent or Sh95.88 per share.

If options are traded at the NSE, Investors can use options to minimise the loss of Sh93.48 per share. In this case, the investor reduces the loss by buying a derivative, better known as a call option.

A call option will give the holder the right to buy the BAT shares at an agreed price six months from now.

The agreed price is the exercise price, say Sh849.11. This means the investor will not buy the share for Sh779.00 now but will decide whether to buy it or not at Sh849.11 six months from now.

If in six months the price moves from Sh779 to Sh894.88, then the investor will exercise their right to buy the BAT share because it is profitable to do so. The investor will buy the share at Sh849.11 from the option seller and immediately sell it in the market for Sh894.88, making a profit of Sh45.77 per share.

If the price drops down to Sh703.12, then buying the share at Sh849.11 does not make sense because the investor can buy the BAT share at a lower price of Sh685.52. Whenever the BAT price drops below the agreed price, the option will not be exercised. 

Investors must be aware that options are meant to reduce risk and that they have a cost. The advantage is that the capital outlay required to buy a derivative such as an option much lower than the amount to be invested in the purchase of a security.

However, unlike shares, not everybody can be a trader or dealer in options as this requires continuous specialised training.