The New Year’s gift from our exchange is trading derivatives since less risk would mean more safe investment. And the Nairobi Securities Exchange (NSE) are introducing new securities this year (2019). These new securities - Options and Futures is what academics and practitioners call derivatives.
The NSE defines derivative as a financial instrument whose characteristic and value of the underlying asset is typically a commodity, bond equity or currency. Whereas the issuer receives cash for financing projects for the case of securities such as bonds and equities, the that is not so in the case of derivatives.
However, because derivatives are meant to address risk in primary securities, they make equity and bond issue successful. The risk is feared by investors, and the advice them is: Do not take risks that you are not adequately be compensated for.
That derivatives like Options and Futures will improve risk management across securities listed at NSE is not in doubt.
This means that derivatives gravitate around risk. But risk gravitates around all of us all the time. When you buy goods and services, you are risk exposed. When you run a large, medium or small business, then the risk is all over you because you have risked your money as capital in the business.
All assets we hold face risk exposure because there is always the possibility that the market price of your asset or assets might decline.
What you pay a million shillings for an asset today, the same might be selling for a half a million tomorrow, a fifty per cent loss in your wealth.
This makes risk management concern to all of us. Derivatives enable you to take care of such a loss, though it is impossible eliminating all the risks.
Derivatives allow an investor to lock in a future price through a binding contract, such that you do not have to worry about future price changes.
Again, the derivatives enable you to buy or sell for an amount something at a fixed price at a future date. A derivative is in a way, an incentive for investors to take risks; and it is risk-taking by investors that propel economic growth and create jobs for citizens. Therefore, Futures and Options by reducing risk, create profitable opportunities.
Real-world examples are always visible. For example, if you are importing spare parts for Motorcycles from India, then you worry would be that the Indian Rupee will rise, and your imports will become expensive, but you might find it difficult passing this additional cost to your Kenyan customers.
You are the manager of an airline, and you realise that rising fuel prices increase your operational costs and impact and adversely on the bottom line. Even when you sell ‘ladies’ spare parts,’ which include imported hair, nails, etc. you face a risk. In any case, nearly all financial transactions are risk infested. Risks in the preceding examples are manageable through futures and options.
Therefore, a significant portion of market players transacting options and futures are marking an attempt to remove risk from their businesses.
Those players are aware that even at financial markets, many times the future is unknown and that unknown future scares, but are aware that derivatives help protect against the unknown future. When we buy bread we tend to think of wheat, but that is being superficial.
There is water, there are interest rates, there is baking flour and the cost of all those must be managed if a bakery is to make profits. And as mentioned above, hedging involves buying or selling a Futures contract in order to lock in the price of an underlying commodity such as wheat and all other ingredients required to make bread.
If you need the wheat three months from now and you agree today about the price at which that wheat is to be delivered, then you are hedging because your concern is controllably your cost as to remain competitive. There is a group in Futures and Options markets that make the market complete by bringing liquidity in the market.
This group is known as speculators. If you do not grow wheat, or you are not a baker but buy or sell wheat futures, you are a speculator. Speculator’s intention is to make a profit by buying and selling future and options contracts; they have no interest in the underlying.
However, be warned. Trading in Options and Futures is not like trading bonds and equity; it is not for simple minds.
Remember options on equities derive them value from equities, and the terminology is purely mathematical and unless the current brokers are retrained to handle derivatives, there will be red light ahead.