Introduction to Financial Derivatives – Vanguard News

Introduction to Financial Derivatives – Vanguard News

This introduction is very rudimentary. As a result, prospective investors still need to contact their stockbrokers who specialize in Futures, for necessary guidance because derivatives are a specialty and niche financial product. Now that NGX is poised to launch West Africa’s Exchange traded derivatives, the market operators are also ready. Time has come for the investing public to be sensitized on how to key into this new capital market window of opportunity. Derivatives have a reputation for being obscure but they are created and traded in large numbers all over the world. They have become increasingly popular in recent decades, with total value outstanding estimated at over $600 trillion. Derivatives have become a convenient way to achieve financial goals in terms of income maximization or protection against losses.

READ ALSO:Nigeria stock market resumes week with N4bn loss Translation of the age long dream of trading in derivatives into reality is a watershed in the history of the Nigerian capital market. This is the highest product level a capital market can attain.

Although the plan to introduce derivatives predated the demutualization of the defunct Nigerian Stock Exchange, now NGX, the absence of a financial market infrastructure, called Central Counter Party (CCP), delayed it’s take off. Derivatives are financially engineered instruments that can magnify profits and losses hence, basic necessity for infrastructure like the CCP for novation and attendant risk management. The establishment of NG Clearing Ltd as Nigeria’s CCP puts derivatives trading on NGX at a safer and efficient level. Financial engineering at its peak has just taken off in the Nigerian capital market. The feat was achieved recently when Nigeria Exchange Limited (NGX) received the Securities and Exchange Commission (SEC) approval to trade in the following seven derivative contracts:1) Access Bank Plc Stock Futures.2) GTCO Plc Stock Futures.3) Zenith Bank Plc Stock Futures.4) Dangote Cement Plc Stock Futures.5) MTN Nigeria Plc Stock Futures.6) NGX 30 Index Stock Futures.7) NGX Pension Index Stock Futures.

Many derivative instruments are leveraged, which means a small amount of capital is required to have an interest in a large amount of value in the underlying asset. This increases their potential risks and rewards. In spite of it’s risk, the derivatives market is one that continues to grow, offering products to fit nearly any need or risk tolerance. There are many different types of financial derivatives that can be used for risk management or hedging, to speculate on the directional movement of an underlying asset and to leverage a position. Hedging is a trading strategy that during the life of a derivative contract, neutralizes the exposure of the resulting portfolio to changes in the price of the underlying assets while speculation is geared towards maximization of investment returns. Common derivative contracts include Forwards, Futures, Options and Swaps.   A derivative contract is set between two (bilateral) or more (multilateral) parties. They are tradable on an Exchange platform or Over-the-Counter (OTC). Exchange Traded Derivatives have standardized contract terms, with guaranteed clearing and settlement of transactions and delivery of assets. CCP, which is a critical part of the Exchange Traded Derivatives ecosystem carries out the clearing, settlement and delivery functions through novation (Buyer to Seller and Seller to Buyer), also risk and collateral management. Exchange Traded Derivatives involve many parties and are hence, multilateral contracts. In contrast, OTC Traded Derivatives are generally bilateral contracts involving only two parties. They are non standardized privately negotiated contracts which are tailored to meet the needs of the parties. OTC derivatives are unregulated and not traded on any Exchange. As a result, they generally have greater possibility of counterparty risk, which is the danger that one of the parties involved in the transaction might default.

In the most basic form, a derivative is a mutual agreement between two parties to perform some kind of financial transaction at a specified time and at a predetermined price. This, in general terms, makes derivatives futuristic. However, in precise terms, a financial derivative can be defined as a type of financial instrument or contract whose price or value is dependent on the value of another underlying asset(s) or variable (s). The underlying assets or variables can be common stocks, bonds, commodities, currencies, stock or market indexes, credit, interest rate, energy and even weather. Price of derivatives derive from fluctuations in value of the underlying assets or variables. In the world of economics and finance, prices rise and fall according to the whims of markets. Due to incessant price volatility, uncertainty becomes a thought provoking element that can make or mar returns-on-investment. Derivatives have emerged as financial tools to engineer contracts with values and timelines solidified to be solutions to multiple economic challenges.

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