How options and futures can mitigate price risk
Before injecting cash into any project, investors tend to focus on time, returns and risk associated or inherent in an investment.
Investors who are in most cases informed and rational tend to raise questions about assets before giving out their resources. These questions include: What will I benefit?
What are the chances that I will get that return (risk)? When will that benefit be realised (time)? No rational investor will take a risk if he or she is not adequately compensated.
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This is why Options and Futures are used to manage risks and enhance returns from employed assets. Their trading at the Nairobi Securities Exchange(NSE) next year is thus welcome.
Every market has its players in the Option and Futures market, namely hedgers, speculators, and arbitrageurs.
An authority in Options, Hull, tells us that these three groups use Option and Futures reducing assets’ risks to speculate (take a view on the future direction of the market); to lock in an arbitrage profit; to change the nature of a liability as well as the nature of an investment without incurring the costs of selling one portfolio and buying another.
A hedger insures his trade to reduce the risk. This explains why we need a vibrant Futures and Option’s market.
Assume you are a farmer and your crop will be ready in three months. Your biggest worry would be the price of the crop in December. That price can either be favourable or unfavourable.
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You can manage the risk of unfavourable price by hedging, which requires one to enter into a contract to sell the crop at an agreed price in December. A future contract is a legal agreement to buy or sell something at a predetermined price at a specified time in the future.
It is an agreement to buy or sell an asset for a certain price at a given time and form a contract that will be traded at the NSE. It means you can reduce that risk with a Futures contract.
You stand to gain when the price decreases and lose when it increases because the extra cash will not come to your pocket., then buy a Futures contract to hedge the risk.
Thus you can either buy or sell a Futures contract to reduce your risk exposure. The farmer above can have contracts three months to maturity. If the price of the crop falls, the gain on the Futures contract will offset the loss from the sale of the crop. If the price rises, then the trader in the market profits.
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Using Futures contracts, can at no cost reduce the risk to almost zero. Thus firms such as Kenya Airways, whose key input is fuel should not expose shareholders to risks associated with the future price of oil when there are contracts available to eliminate price fluctuations.
It is not only those who own assets that trade in Futures.
You can speculate on prices of assets that you do not own, but whose Futures contracts are trading in a Futures market. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell the asset for is known as the forward price.
The specified time in the future—which is when delivery and payment occur—is known as the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.
Speculators are key because they bring liquidity to the market. If as a speculator, you contract to buy the asset in the future and profit when the asset’s price increases.
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Suppose that there are no storage costs for crude oil and the interest rate for borrowing or lending is five per cent per annum. How could you make money if the June and December Futures contract for a particular year trade at Sh60 and Sh66, respectively?
You could go long one June oil contract and short one December contract. In June, you take delivery of the oil borrowing Sh60 per barrel at five per cent to meet cash outflows.
The interest accumulated in six months is about 60×0.05×0.5 or Sh1.50. In December, the oil is sold for Sh66 per barrel and Sh61.50 is repaid on the loan.
The strategy leads to a profit of Sh4.50 independent of the actual price of oil in June or December. It will be affected by the daily settlement procedures.
Trading Futures and Options are delicate and risky, more so if the market is dominated by speculators than hedgers.
Speculators in most cases do not hold the assets subjected to future’s contracts and might find it hard closing their positions. Should that happen, the Futures market collapses. So tread carefully or involve well trained or experienced staff.
Trading options and future is complex and the CMA and NSE must closely monitor to avoid a financial crisis.
-The writer teaches at the University of Nairobi