What are Derivatives in Financial Markets Trading? Understanding the Basics and Risks

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Wednesday, June 09, 2021 / 05:50 PM/ Saurav Sharma / Header Image Credit: Skilling



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Derivatives are financial market instruments that involve a contract between two parties for an agreed-upon event, outcome, or price movement of an asset. Derivative instruments derive their value from the value or return of another asset or security.


In simple words, derivatives are a synthetic market that is derived from another capital market. Based on supervision of the contract terms, derivatives are mainly divided into Over the Counter (independent contract between two parties) and exchange-traded (traded via an exchange like NGX). The derivative dealers or clearinghouses offer different types of contracts mainly on bonds, commodities, currencies, interest rates, stocks, and indices.

 

According to BIS, the Notional amounts outstanding of all global OTC derivatives market (which is the value held by a derivatives position in the market) was around $1188 trillion USD in 2020 which makes the derivative market cap more than $1 quadrillion i.e., nearly 10 times the GDP of the world. While the gross market value of these contracts was only a fraction of that i.e.: $31.26 trillion denoting risk position held by participants based on leverage on these positions.

 

But the Derivatives carry a lot of risks that traders & participants must be aware of.

 

In past two decades, OTC derivatives have become so much popular among retail customers, raising concerns among regulators. Some regulators have even highlighted the role of OTC derivatives in financial crisis of 2008 and huge losses they cause to retail customers. Due to this many harsher restrictions were placed on the derivatives in recent years by many regulators worldwide which include Counterparty restrictions, leverage/margin restrictions, stricter reporting requirements, stricter onboarding requirements etc.

 

Here, we look at the basics of derivatives and the risks they carry.

 

Types of Derivatives

Worldwide traders can trade on 5 different types of following derivative instruments. Each type of instrument has different conditions, risks, obligations, etc.

 

Forward

It is a contract in which one party agrees to buy while the counterparty agrees to sell a physical or financial asset at a predefined rate and date in the future. It is an agreement to buy and sell at a future date at a fixed price. These contracts are self-regulated and are traded over the counter. The counterparty and credit risk are high in a forward contract. 

 

In general, there are no fees involved to enter into an agreement for both the counterparties. If the strike price of the asset increases above the agreed-upon price at the time of delivery, the buyer will gain. If the strike price of the underlying asset is below the stated forward price on maturity, the seller will have the profit.

 

 

Futures

Future contracts are like a forward contract, but these are traded through an exchange. This mitigates the counterparty and credit risk but both parties are required to pay an initial margin as collateral to the exchange which acts as a clearinghouse. Both the parties have the right and obligation to meet the terms of the contract at the time of maturity.

 

Futures are standardized contracts with specific future dates and prices. The quality and quantity of the underlying asset are also predefined by the exchange. The settlement can either be deliverable (buying or selling of underlying asset) or cash settlement (only the price difference between the agreed-upon price is paid).

 

Options

The option contract differs slightly from forward and futures contracts as traders have the right but no obligations to exercise the terms of the contract. The expiry date and the price at which the buyer or seller has the right to buy or sell are stated by the exchange. But the contract holder can choose whether to exercise the contract or not before the expiry.

 

It is an exchange-traded derivative. Holder of the option contract has an advantage over futures contract holder. Hence, the premium required to enter into an agreement is much higher.

 

The option contract in which the holder has the right to buy at the stated price is called the call option while the option with the right to sell is called the put option. Traders can either go long or short with both types of options contracts. The American option contracts can be exercised at any point before the expiry while the European options can only be exercised at the expiry date.

 

Going short on both the options means you are selling the contracts and will only gain the premium amount in case the long option holder does not exercise the contract before expiry.



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Swaps

Swap contracts are self-regulated private exchange agreements in which two parties exchange the cash flow or liabilities. The two parties agree to make a series of payments on specified periodic dates over a certain time horizon. The payments are made based on predefined terms concerning underlying assets like interest rates, currency, etc. The payment amount can differ on each settlement date. The party with higher liability will pay the netted amount to the counterparty.

 

CFDs

Contract for Difference (CFD) is a derivative arrangement in which the difference between the opening and closing trade price of the underlying asset is settled by cash. CFDs are used to speculate on price movements of financial instruments without owning any asset.

 

According to Trade Forex Nigeria, CFD is commonly used OTC instrument worldwide to trade assets & securities in short term like Forex, Commodities & Indices. CFD instruments are over-the-counter derivative instruments and carry a huge leverage & counterparty risk which are suited to advance investors. Due to its nature, CFDs are highly regulated in European countries like UK, Germany, Italy etc; in APAC countries like Australia, Singapore, Malaysia and African countries like South Africa & Kenya.  But the regulation is not yet uniform as there are many countries where it is still not regulated including Nigeria.

 

Role of Derivatives in Financial Markets

Derivative instruments play an important role in financial markets as they can be used for multiple purposes.


  • Hedging: Derivatives are largely used for hedging the risk factor in various financial markets. Suppose if you have a long position on a large quantity of stocks you can reduce the risk by selling a futures contract or buying a put option. Hedging the financial markets through derivatives is like buying insurance on your positions. If things go against the expectations, the derivatives will cover up your losses.
  • Speculation: Traders can take advantage of price movements in various capital markets through derivatives without owning any asset. This allows them to speculate on financial markets that may not be feasible to access without derivatives. Some stocks, commodities, etc can be too expensive or have lesser liquidity to buy or sell without derivatives. Speculating through derivatives involves risk but can allow traders to make a quick profit through price movement of the underlying asset.
  • Portfolio Diversification: Involving multiple capital markets in your portfolio reduces the risk factor. Hence, derivative instruments can be crucial to diversify the portfolio by participating in multiple financial markets.

 

How can you Trade Derivatives in Nigeria?

In December, 2019, new derivatives framework was implemented by SEC governing Central Counterparty and Derivatives trading; making way for recognised exchanges like NGX to launch their own derivatives exchange. According to these rules, regulated exchanges have been allowed to offer Exchange traded derivatives & standardised OTC derivatives; and clearing shall only be done by registered Derivatives Clearing Members. All participants shall have registered Legal Entity Identifier.


  • NGX Derivative Exchange: The Nigerian Stock Exchange NGX, formerly known as NSE, is planning to launch the exchange-traded derivatives market in Nigeria. The exchange will be following the regulatory framework issued by the Securities and Exchange Commission (SEC) of Nigeria and the Central Bank of Nigeria (CBN). The NGX derivative market will include derivatives on equities, commodities, interest rates, and currencies.
  • FMDQ Exchange: In collaboration with FMDQ, CBN offers long term OTC Naira settled FX futures contract to hedge against forex risk. The contract can be 1 month to 60 months period. And are settled on maturity date at differential of contract rate and NAFEX rate. This instrument is currently only available to CBN Authorized dealers or Banks who offer to their clients.
  • Commodity Derivative Exchange: Commodities like Grains, Liquids, Tubers, Powders, Metals, Minerals, Oil, Gas can be traded in Nigeria through forward contracts which are offered by SEC licensed commodity exchanges like AFEX and LCFE.
  • CFD and Forex Brokers: Although CFDs are currently unregulated in Nigeria. But there are few CFD & forex brokers in Nigeria that are regulated with foreign financial regulators like FCA, CySEC that offer CFDs on various instruments to Nigerian traders. These CFD brokers allow traders to speculate the price movements on forex, commodities, indices, stocks, cryptocurrencies, etc. Traders must approach CFDs with caution as it is an advanced trading strategy and is not suited for beginners.


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What are the Risks Involved in Derivative Trading?

Derivative market may reduce your overall risk by hedging your investments and diversifying the portfolio. But they carry multiple types of risk that the traders in Nigeria must be aware of.

 

1.      Market Risk

Almost every capital market in the world involves market risk. Any position in the capital/financial markets are taken based on analysis, research, or assumption. However, the actual price movement of the asset may or may not move as anticipated. Since the derivative market is created out of other capital markets, the market risk of the underlying asset also affects the derivatives. The derivative contracts have no value after expiry and hence can be even riskier than the market from which it is derived.

 

2.     Counterparty Risk

It is the risk that evolves when any of the counterparty (buyer or seller) fails to make the obliged payment. The counterparty risk is more prevalent with the derivatives that are traded over the counter (OTC). Since the exchange-traded derivatives are managed by the clearinghouse and are regulated, there is a lesser probability of facing counterparty risk. Choosing trustworthy and renowned dealers can mitigate the counterparty risk.

 

3.     Liquidity Risk

It is the risk of not finding the counterparty or enough traders in the market to close out the trade order. In capital markets with fewer participants or low liquidity, traders might not be able to liquidate their holdings.

 

4.    Price Risk

The initial margin or premium which is also regarded as the price of the derivative contract is difficult to calculate even for the most experienced financial firms. It is an evolving market, and each contract can have a different price at different points in time. Hence, traders might buy or sell the contracts at different prices. The risk of mispricing the derivative instruments is called price risk.

 

5.     Leverage Risk

Leverage is the borrowed capital to trade or invest in a capital market. In derivative markets, leverage plays an important role as the margin requirement is generally low and leverage is high. A higher leverage ratio can enable traders to earn more with a small deposit amount but can also increase the loss if the outcome is against the anticipation. Trading with a low or safe leverage ratio can mitigate the leverage risk in derivative markets.

 

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