Trading in instrument set to be unveiled at NSE savvy investors to avoid losses. PHOTO | FILE
What you need to know:
The derivative has no direct value in and of itself. Their value is based on the expected future movements in the price of the underlying asset.
Financial markets are growing, especially in Kenya. However, the pace of growth is not something to cheer about.
But all the same, growth is growth. Here in Kenya, there have been two recent developments in the financial markets worth noting. The forthcoming futures market and the real estate investment trusts schemes, which provide an alternative to direct investment in traditional mortgage securities.
So what are these new products in the financial markets especially special financial instruments known as derivatives?
In markets such as South Africa, derivatives are no longer a new phenomena. The market is much more developed and sophisticated than the Kenyan or the East African market.
But what are derivatives? A derivative is a financial contract with a value that is derived from another (underlying) asset. The derivative has no direct value in and of itself. Their value is based on the expected future movements in the price of the underlying asset.
The three broad uses of derivative instruments are hedging against potential risk due price movements, speculation and taking advantage of mispricing in financial and commodities market. The act of taking advantage of market discrepancies is known as arbitrage.
Derivatives can be traded in organised bourses such as the Nairobi Securities Exchange or simply over the counter involving two parties.
The main derivatives used in financial markets are options, futures, forwards, and swaps. The only instrument out of all these four so far being developed in our securities exchange is futures.
Forwards are ordinarily traded over the counter and involve two parties and have been used by individuals and corporations in Kenya over time.
Options
As the name suggests, an option is a contract which gives one counterparty, the right to either exercise or let the option expire.
The one who has the right to either exercise or not is known as the buyer and the other counterparty is the writer. The decision on what action to take depends on the prevailing price in the market.
For example, if one enters into an option contract to buy $100,000 in three months’ time, at Sh90 per dollar, this is known as a call option — and the opposite would be a put option. The Sh90 is the strike price also known as the contract price.
If at the end of three months the prevailing exchange rate in the market is Sh100 to the dollar, there is a potential gain of Sh1 million before other costs are considered. The speculator buys $100,000 at a unit price of Sh90.
The sum used is Sh9,000,000. The speculator then turns to the open market and sells the $100,000 at the prevailing market price of Sh100. The sum received will be Sh10 million hence a gross profit of Sh1 million. But what Sh85 per dollar. There is potential loss of Sh500,000. The speculator will let the option expire without exercising.
The practice, however, is that the buyer will ordinarily pay the other counterparty (writer) a fee known as premium, agreed upon during the contract. Premium is paid whether the option is exercised or not.
They are a means of locking in, by way of contract, future prices or rates to be used in a transaction. A company or individual expecting foreign currency and who may fear fluctuation in exchange rate may want to enter into a forward contract with a financial institution to sell the foreign currency at an agreed rate in future.
For instance if a Kenyan exporter expects receivables worth £10,000 and is fearing that the sterling pound may depreciate over time, one may decide to enter into a forward contract with a bank to say sell the £10,000 at Sh150. If the sterling pound depreciates to say Sh140, the exporter will be happy to have locked in a rate of Sh150.
If, however, the pound appreciates to Sh160, one will still be satisfied that there was at least a hedging, though in effect the loss will be Sh100,000 — the difference between the market rate and the contracted rate.
Some Kenyan companies have incurred losses due to inaccurate prediction of future exchange rates, resulting in under hedging or over hedging. Forwards may also be used for speculative and arbitrage purposes.
Futures
They operate more or less like forwards but with some distinguishing characteristics, the main one being that they are traded in organised security exchanges.
Further, futures are traded in standardised sizes. For instance, one contract may be worth 30,000 Canadian dollars. One could choose to buy three contracts worth 90,000 Canadian dollars to either sell or buy the dollars at a future date depending on need and availability of the currency.
If, for instance, a speculator envisages a situation where the Canadian dollar will appreciate in value over a period, a speculator will enter into a contract in the futures market to buy the dollars at a cost lower than the speculated price.
If it so happens that the Canadian dollar appreciates in value, the speculator buys the Canadian dollar at the contract price of say Sh90 and sells in the market at the prevailing exchange rate of say Sh100, the gain will be Sh10 times 90,000 Canadian dollars, that is, Sh900,000.
If the speculator was wrong on exchange rate prediction and the Canadian dollar depreciates in value, there will be loss. And this should not surprise because speculation is about taking risks.
They are another form of derivative that involves swapping responsibilities. The difference between swaps and other derivatives is that a company needs counterparty with similar needs but from the opposite side.
For example, if a Kenyan firm borrows £4,000,000 payable over five years from UK bank at an interest rate of 10 per cent per year, the fear is that the firm will experience foreign exchange risk exposure in that the pound will fluctuate over the term of the loan hence the firm ends up paying more in Kenya shillings equivalent.
The remedy is to get a UK firm which has a loan (equal in the amount), payable over five years and the debt must have been acquired from a Kenyan bank. The two firms swap loan repayment responsibilities.
The Kenyan firm will pay on behalf of the UK firm the loan obtained in Kenya and on the other hand the UK firm settles the Kenyan firm’s debt obtained in UK. In both instances, the two firms will avoid foreign exchange risk exposure and also save on currency conversion costs.
This is a simplified explanation of how swaps work because often times there will be differences in interest rates and amounts of loan.
Often times, the loans obtained though equal in amount will have different interest rates, consequently refunds or compensation for excess remittances by one of the parties will be facilitated by swap banks who act as middlemen.
Good financial practice, if one chooses to use debt financing is to go for floating rate debt for projects whose revenue streams are variable and finance fixed income projects with fixed rate loans.
Sometimes a business with fixed income project may not be able to obtain a fixed rate loan. The task is get another business with a similar problem from the opposite side and swap repayment responsibilities.
Mr Were is a financial and business adviser at Anchorage Ltd.
