How to trade in derivatives

An employee monitors trading at the Nairobi bourse. PHOTO | SALATON NJAU | NMG
An employee monitors trading at the Nairobi bourse. PHOTO | SALATON NJAU | NMG 

Derivative trading has been among us ever since the ancient times. In 1700 BC, Jacob bought a type of derivative called an ‘‘option’’ by paying seven years’ labour for the right to marry Laban’s daughter, Rachel.

Instead the old man tricked Jacob into marrying his eldest daughter Leah, and Jacob then served another seven years in exchange for the right to marry his initial choice, Rachel, as well.

It was, however, not until 1848 that the Chicago Board of Trade was formed to professionally trade in corn futures derivatives contracts. Closer home in Kenya, people who invest in financial markets are used to trading in shares, bonds and currencies. Most of our citizens will speak gleefully about how they made a killing in the KenGen or Safaricom IPOs.

However, when the stock market starts to dip, the only strategy is either to sell the share or ride the wave. In order to give investors additional options, the Nairobi Securities Exchange (NSE) is developing futures contracts to allow investors to diversify their investment portfolios and to the country, provide a full spectrum of risk management options.

Equity and fixed-income securities are claims on the assets of a company. Currencies are the monetary units issued by a government. Commodities are natural resources and agricultural produce. These underlying assets are said to trade in cash markets and their prices are sometimes referred to as cash prices. Some of these markets exist in Kenya and are relatively familiar.

However, derivatives markets are less familiar. Derivatives are financial instruments that draw their value from the performance of underlying assets such as equities, fixed-income securities, currencies and commodities.

What purpose does a derivative serve if the underlying asset is readily available? Although cash markets can perform reasonably well without derivatives, where derivative products function well they can improve the performance of the markets for the underlying assets through enhancing price discovery and flow of market information in the cash market.

Derivatives can be used to create strategies that cannot be implemented with the underlying assets alone.

In addition, derivatives are characterised by a relatively high degree of leverage, meaning that participants in derivatives transactions have to invest only a small amount of their own capital relative to the value of the underlying.

As such, small movements in the underlying can lead to fairly large movements in the amount of money made or lost on the derivative instruments.

Derivatives generally trade at lower transaction costs than comparable cash market transactions. For example, here at home, the Capital Markets Authority has recently published proposed derivatives fees that NSE wishes to charge on its single stock futures (SSF) and NSE 25-share equity index futures contracts. These fees will be substantially cheaper than the underlying.