Understanding Derivatives as investment products (1)

In furtherance of its quest to develop the Nigerian capital market and develop a thriving derivatives market in Nigeria, the Nigeria Stock Exchange has engaged the collaboration of JP Morgan Chase, to bridge the knowledge gap on derivative instruments.

According to the NSE, “the introduction of derivatives will expand the market and enhance its liquidity,” while helping to mitigate against some financial risks in the market. The introduction of derivatives products in Nigeria has been in the works for over 5 years. It is on record that the Exchange began its romance with derivatives in 2015 through a market-wide feasibility study.

In one of my recent articles on profiting from a falling market using Dollar (Naira) Cost Averaging, I noted that the Nigerian market lacks the financial instruments or products that could be used to manage risk and profit from whatever direction the market takes.

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In that article, I did mention that in advanced markets, there are such instruments like options, (specifically, calls and puts) and the ability to use short sells to profit from a falling market.  It does look, however, that we will get there sooner or later, with the NSE’s collaboration with JP Morgan on derivatives.

Though derivatives are potent instruments for risk management, they are actually a two-edged sword and can be very dangerous, if misused. Financial history is replete with instances where the use of derivatives has led to the financial demise of many companies and individuals.

To use them properly calls for a proper understanding of what they are, how to use them and when to use them. In this article, I will aim to give readers a basic understanding of simple derivatives. I said simple derivatives because derivatives come in many shapes and sizes, each differing in their complexities, risk management potentials and mismanagement effects.

What are Derivatives?

Derivatives are financial products that derive their behaviour from the behaviours of their underlining instruments.  It is the fact that they do not have a behaviour pattern of their own, rather their behaviour pattern derives from the behaviour pattern of the underlying, that gives them the name, derivatives.

Types of Derivatives

There is a wide array of derivatives being churned out by financial engineers. There are options, comprising of Calls and Puts, Futures which can be equity futures, currency futures, commodity futures, there are Swaps like plain vanilla swaps, currency swaps, total return swaps or even swaptions, which are options on a swap. Credit default swaps are also a form of derivatives.

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Recently, there have been things like catastrophic swaps, volatility swaps and a host of others. Because the Nigerian market will not go into the very complex types of derivatives, at least for a start, I will dwell on options- Calls and Puts, in this article, by looking at what Calls and Puts are, and how they work or should be used by buyers and sellers.