Trade in derivatives one way to secure future returns

What you need to know:

Derivatives refer to a class of financial instruments whose value is derived (hence the name) from a different class of assets.
Most derivatives involve the purchase or sale of the underlying at an agreed date in the future for a price agreed upon today.

Towards the end of 2016, the NSE launched a new platform to facilitate the trade of derivative contracts. The Nairobi Securities Exchange Derivatives Market (NEXT) was started after a series of delays, being initially announced in 2014. Currently, NEXT only allows you to trade in two types of derivatives contracts, Single Stock Futures and Equity Index Futures.

Derivatives refer to a class of financial instruments whose value is derived (hence the name) from a different class of assets. These assets could be shares, bonds, currencies or even commodities such as wheat or gold and so on. These assets from which derivatives obtain their value are referred to as the underlying assets, or, more commonly, simply as the underlying. Most derivatives involve the purchase or sale of the underlying at an agreed date in the future for a price agreed upon today. This may all seem a bit complex, but consider the following Biblical example:

In approximately 1920 BC, Laban and Jacob entered into a form of derivative contract. Jacob was to work for Laban for seven years for the right to marry Laban’s daughter, Rachel. In this scenario, the underlying was Rachel and the price of the contract was the seven years of labour that Jacob had to give.

Let’s now try a more modern example:

Suppose you were purchasing 90 kilogramme bags from a maize farmer to sell in the market. Assume the current market price is Sh4,500. Suppose further that you expected prices to go up to Sh5,000 per bag in a year’s time due to inflation. You could enter into a contract with the farmer today to purchase the bags in one year at Sh4,500 per bag. If the prices do go up to Sh5,000, you would purchase the bags at a lower rate than the price at the time and therefore you would make a gain of Sh500 per bag if you sold the bags immediately. Alternatively, the price could go down to, say, Sh4,000 in which case you would make a Sh500 loss per bag. This example shows a type of derivatives called forward contracts where the underlying is a commodity (maize).

The idea of speculation can be seen in the above example where an investor expects the price of the underlying (maize) to rise or fall and therefore enters a contract so as to gain from such a movement.

The writer is a student from the Strathmore Institute of Mathematical Sciences.