Why derivatives market is misunderstood

Nairobi Securities Exchange staff monitors trading. FILE PHOTO | NMG
Nairobi Securities Exchange staff monitors trading. FILE PHOTO | NMG 

You might have heard others talk about derivatives. What are derivatives and how do they work? Derivatives are one of the most important financial innovations in history, but they are often misunderstood.

They are securities whose value is determined by or derived from other underlying assets like shares, land among others.

Derivatives can help stabilise the economy or bring the economic system to its knees in a catastrophic implosion due to an inability to identify the real risks, properly protect against them, and anticipate so-called “daisy-chain” events where interconnected corporations, institutions, and organizations find themselves instantaneously bankrupted as a result of a poorly written or structured derivative position with another firm that failed; a domino effect.

Most derivatives are based upon the person or institution on the other side of the trade being able to live up to the deal that was struck.

If society allows people to use borrowed money to enter into all sorts of complex derivative arrangements, we could find ourselves in a scenario where everybody carries these derivative positions on their books at large values only to find that, when it’s all unraveled, there’s very little money there because a single failure or two along the way wipes everybody out with it.

The crash of 2008 in the stock market and the real estate market was largely the result of a derivatives market run amok.

The problem becomes exacerbated because many privately written derivative contracts have built-in collateral calls that require a counterparty to put up more cash or collateral at the very time they are likely to need all the money they can get, accelerating the risk of bankruptcy.

It could very well evaporate on you no matter what you’re carrying on your balance sheet.

Call options and put options, which can be used conservatively or as extraordinarily risky gambling mechanisms are an enormous market.

For example, you can get other people to pay you to buy a stock you wanted to buy (loaning shares), not a popular product in the Kenyan market.

Exchange traded options are, from a system-wide standpoint, among the most stable because the derivative trader doesn’t have to worry about so-called counterparty risk.

While they can be extremely risky for the individual trader, from a system-wide stability standpoint, exchange traded derivatives such as this are among the least worrisome because the buyer and seller of each option contract enters into a transaction with the options exchange, which becomes the counterparty.

Granted, as part of compensation for working for a company, employee stock options are a type of derivative that allow the employee to buy the stock at a specified price before a certain deadline.

The hope of the employee is that the stock increases in value substantially before the derivative expires so he or she can exercise the option and, commonly, sell the stock on the open market at a higher price, pocketing the difference as a bonus.

More rarely, the employee may opt to come up with all of the exercise cost out of pocket and retain his or her ownership, accumulating a large stake in the employer.

While futures contracts exist on all sorts of things, including stock market, commodities, futures are predominately used in the commodities markets. Imagine you own a farm in Molo. You grow a lot of potatoes.

You need to be able to estimate your total cost structure, profit, and risk. You can go to the futures market and sell a contract to deliver your potatoes, on a certain date and a pre-agreed upon price.

The other party can buy that futures contract and, in many cases, require you to physically deliver the potatoes. Laikipia ranchers or Kimalel goat auction can sell futures for their cattle.

All of these derivative contracts keep the real economy going when prudently used as they permit the transfer of risk between willing parties to lead to greater efficiency and desirable outcomes relative to what a person or institution is willing and able to expose to a chance of loss or volatility.

Companies, banks, financial institutions, and other organisations routinely enter into derivative contracts known as interest rate swaps or currency swaps. These are meant to reduce risk.