What is a derivative?
A derivative is a contract between two or more parties that derives its value from one or more underlying assets. Its value is determined by fluctuations in the underlying asset.
Kenya is set to launch the derivatives market soon (fingers crossed) which will be exchange traded (like in the stock market) and pre-funded futures market.
How can it be used?
A participant in a derivatives market can use a derivatives contract either to hedge or speculate.
Hedging involves mitigating the risk of economic loss arising from changes in the value of the underlying.
Speculating involves increasing the profit arising if the value of the underlying moves in the expected direction.
Who are the participants in a derivatives market?
These are basically the hedgers and the speculators.
A hedger uses a derivatives contract to hedge against adverse movements in an underlying asset especially a cash asset. The rationale for this is that cash prices and futures prices move in tandem.
Speculators constitute roughly 85% of the participants in the derivatives market. They participate in the market so as to make a ‘killing’ in both the spot and derivatives market. The participants do not necessarily have the underlying asset in which they are trading the derivatives contract on but they are trading with a profit motive.
What are the advantages for a speculator? (most of us will fall into this category)
- A good judgment on the futures price movement can make the speculator earn good and fast money as on average the futures price changes much faster than prices on the underlying asset in the spot market.
- Futures contracts are highly levered investments meaning that an investor would only need to put up a small fraction of the contract value as margin so as to trade and yet they can ride on the full value of the contract when it makes either a profit or loss. This small fraction is not a deposit on the contract value but it is a measure of ‘good faith’ that the investor can fulfill his obligations as and when they are on a losing streak.
- Unlike in the stock market, futures contracts don’t incur interest on the difference between the margin amount and the contract value.
- Commissions on futures contracts are small as compared to other investments and the investor only pays the commissions once a position is liquidated.
Are derivatives inherently evil?
No. The real issue lies with the overexposure of banks and other large institutions and uninformed investors. Derivatives can add substantial value to companies if used conservatively and with restraint.
They can be beneficial to investors who use them appropriately and in moderation. Again, information is key as it is useful to know and understand the risks and benefits of investing in the derivatives market.