Wednesday,
June 09, 2021 / 05:50 PM/ Saurav Sharma / Header Image Credit: Skilling
Derivatives
are financial market instruments that involve a contract between two parties
for an agreed-upon event, outcome, or price movement of an asset. Derivative
instruments derive their value from the value or return of another asset or
security.
In
simple words, derivatives are a synthetic market that is derived from another
capital market. Based on supervision of the contract terms, derivatives are
mainly divided into Over the Counter (independent contract between two parties)
and exchange-traded (traded via an exchange like NGX). The derivative dealers
or clearinghouses offer different types of contracts mainly on bonds,
commodities, currencies, interest rates, stocks, and indices.
According
to BIS, the Notional amounts outstanding of all global OTC derivatives market (which
is the value held by a derivatives position in the market) was around $1188 trillion USD in 2020 which
makes the derivative market cap more than $1 quadrillion i.e., nearly 10 times
the GDP of the world. While the gross market value of these contracts was only
a fraction of that i.e.: $31.26 trillion denoting risk position held by
participants based on leverage on these positions.
But
the Derivatives carry a lot of risks that traders & participants must be
aware of.
In
past two decades, OTC derivatives have become so much popular among retail
customers, raising concerns among regulators. Some regulators have even
highlighted the role of OTC derivatives in financial crisis of 2008 and huge losses
they cause to retail customers. Due to this many harsher restrictions were
placed on the derivatives in recent years by many regulators worldwide which
include Counterparty restrictions, leverage/margin restrictions, stricter
reporting requirements, stricter onboarding requirements etc.
Here,
we look at the basics of derivatives and the risks they carry.
Types
of Derivatives
Worldwide
traders can trade on 5 different types of following derivative instruments.
Each type of instrument has different conditions, risks, obligations, etc.
Forward
It
is a contract in which one party agrees to buy while the counterparty agrees to
sell a physical or financial asset at a predefined rate and date in the future.
It is an agreement to buy and sell at a future date at a fixed price. These
contracts are self-regulated and are traded over the counter. The counterparty
and credit risk are high in a forward contract.
In
general, there are no fees involved to enter into an agreement for both the
counterparties. If the strike price of the asset increases above the
agreed-upon price at the time of delivery, the buyer will gain. If the strike
price of the underlying asset is below the stated forward price on maturity,
the seller will have the profit.
Futures
Future
contracts are like a forward contract, but these are traded through an
exchange. This mitigates the counterparty and credit risk but both parties are
required to pay an initial margin as collateral to the exchange which acts as a
clearinghouse. Both the parties have the right and obligation to meet the terms
of the contract at the time of maturity.
Futures
are standardized contracts with specific future dates and prices. The quality
and quantity of the underlying asset are also predefined by the exchange. The
settlement can either be deliverable (buying or selling of underlying asset) or
cash settlement (only the price difference between the agreed-upon price is
paid).
Options
The
option contract differs slightly from forward and futures contracts as traders
have the right but no obligations to exercise the terms of the contract. The
expiry date and the price at which the buyer or seller has the right to buy or
sell are stated by the exchange. But the contract holder can choose whether to
exercise the contract or not before the expiry.
It
is an exchange-traded derivative. Holder of the option contract has an
advantage over futures contract holder. Hence, the premium required to enter
into an agreement is much higher.
The
option contract in which the holder has the right to buy at the stated price is
called the call option while the option with the right to sell is called the
put option. Traders can either go long or short with both types of options
contracts. The American option contracts can be exercised at any point before
the expiry while the European options can only be exercised at the expiry date.
Going
short on both the options means you are selling the contracts and will only
gain the premium amount in case the long option holder does not exercise the
contract before expiry.
Swaps
Swap
contracts are self-regulated private exchange agreements in which two parties
exchange the cash flow or liabilities. The two parties agree to make a series
of payments on specified periodic dates over a certain time horizon. The
payments are made based on predefined terms concerning underlying assets like
interest rates, currency, etc. The payment amount can differ on each settlement
date. The party with higher liability will pay the netted amount to the
counterparty.
CFDs
Contract
for Difference (CFD) is a derivative arrangement in which the difference
between the opening and closing trade price of the underlying asset is settled
by cash. CFDs are used to speculate on price movements of financial instruments
without owning any asset.
According
to Trade Forex Nigeria, CFD is
commonly used OTC instrument worldwide to trade assets & securities in
short term like Forex, Commodities & Indices. CFD instruments are
over-the-counter derivative instruments and carry a huge leverage &
counterparty risk which are suited to advance investors. Due to its nature, CFDs
are highly regulated in European countries like UK, Germany, Italy etc; in APAC
countries like Australia, Singapore, Malaysia and African countries like South
Africa & Kenya. But the regulation
is not yet uniform as there are many countries where it is still not regulated including
Nigeria.
Role
of Derivatives in Financial Markets
Derivative
instruments play an important role in financial markets as they can be used for
multiple purposes.
- Hedging: Derivatives are
largely used for hedging the risk factor in various financial markets. Suppose
if you have a long position on a large quantity of stocks you can reduce the
risk by selling a futures contract or buying a put option. Hedging the
financial markets through derivatives is like buying insurance on your
positions. If things go against the expectations, the derivatives will cover up
your losses. - Speculation: Traders can
take advantage of price movements in various capital markets through
derivatives without owning any asset. This allows them to speculate on
financial markets that may not be feasible to access without derivatives. Some
stocks, commodities, etc can be too expensive or have lesser liquidity to buy
or sell without derivatives. Speculating through derivatives involves risk but
can allow traders to make a quick profit through price movement of the underlying
asset. - Portfolio Diversification: Involving
multiple capital markets in your portfolio reduces the risk factor. Hence,
derivative instruments can be crucial to diversify the portfolio by
participating in multiple financial markets.
How
can you Trade Derivatives in Nigeria?
In
December, 2019, new derivatives framework
was implemented by SEC governing Central Counterparty and Derivatives
trading; making way for recognised exchanges like NGX to launch their own
derivatives exchange. According to these rules, regulated exchanges have been
allowed to offer Exchange traded derivatives & standardised OTC derivatives;
and clearing shall only be done by registered Derivatives Clearing Members. All
participants shall have registered Legal Entity Identifier.
- NGX Derivative Exchange: The Nigerian
Stock Exchange NGX, formerly known as NSE, is planning to launch the
exchange-traded derivatives market in Nigeria. The exchange will be following
the regulatory framework issued by the Securities and Exchange Commission (SEC)
of Nigeria and the Central Bank of Nigeria (CBN). The NGX derivative market
will include derivatives on equities, commodities, interest rates, and
currencies. - FMDQ Exchange: In
collaboration with FMDQ, CBN offers long term OTC Naira settled FX futures
contract to hedge against forex risk. The contract can be 1 month to 60 months
period. And are settled on maturity date at differential of contract rate and
NAFEX rate. This instrument is currently only available to CBN Authorized
dealers or Banks who offer to their clients. - Commodity Derivative Exchange: Commodities
like Grains, Liquids, Tubers, Powders, Metals, Minerals, Oil, Gas can be traded
in Nigeria through forward contracts which are offered by SEC licensed commodity
exchanges like AFEX and LCFE. - CFD and Forex Brokers:
Although
CFDs are currently unregulated in Nigeria. But there are few CFD & forex
brokers in Nigeria that are regulated with foreign financial regulators like
FCA, CySEC that offer CFDs on various instruments to Nigerian traders. These
CFD brokers allow traders to speculate the price movements on forex, commodities,
indices, stocks, cryptocurrencies, etc. Traders must approach CFDs with caution
as it is an advanced trading strategy and is not suited for beginners.
What
are the Risks Involved in Derivative Trading?
Derivative
market may reduce your overall risk by hedging your investments and
diversifying the portfolio. But they carry multiple types of risk that the
traders in Nigeria must be aware of.
1. Market Risk
Almost every capital
market in the world involves market risk. Any position in the capital/financial
markets are taken based on analysis, research, or assumption. However, the
actual price movement of the asset may or may not move as anticipated. Since
the derivative market is created out of other capital markets, the market risk
of the underlying asset also affects the derivatives. The derivative contracts
have no value after expiry and hence can be even riskier than the market from
which it is derived.
2. Counterparty
Risk
It is the risk that
evolves when any of the counterparty (buyer or seller) fails to make the obliged
payment. The counterparty risk is more prevalent with the derivatives that are
traded over the counter (OTC). Since the exchange-traded derivatives are
managed by the clearinghouse and are regulated, there is a lesser probability
of facing counterparty risk. Choosing trustworthy and renowned dealers can
mitigate the counterparty risk.
3. Liquidity Risk
It is the risk of not
finding the counterparty or enough traders in the market to close out the trade
order. In capital markets with fewer participants or low liquidity, traders
might not be able to liquidate their holdings.
4. Price Risk
The initial margin or
premium which is also regarded as the price of the derivative contract is
difficult to calculate even for the most experienced financial firms. It is an
evolving market, and each contract can have a different price at different
points in time. Hence, traders might buy or sell the contracts at different
prices. The risk of mispricing the derivative instruments is called price risk.
5.
Leverage Risk
Leverage is the borrowed
capital to trade or invest in a capital market. In derivative markets, leverage
plays an important role as the margin requirement is generally low and leverage
is high. A higher leverage ratio can enable traders to earn more with a small
deposit amount but can also increase the loss if the outcome is against the
anticipation. Trading with a low or safe leverage ratio can mitigate the
leverage risk in derivative markets.
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