The attitude of investors in developed economies towards risk has evolved from the initial position of diversifying risk exposures between varying portfolios of assets into the treatment of risk as an asset eligible for trading on regulated markets. The extent to which an investor is willing to take up risk is now being given particular attention in the form of risk packaging such that various risks associated with an item or asset is separated and the risk packages are sold to investors willing to take up such risks in accordance with their risk appetite.
Simply put, in a credit transaction, the creditor is ordinarily accustomed to seek a guarantee to protect itself from any risk of default; In effect, if the debtor defaults, the guarantor owes an obligation to the principal to make up the default to the extent of the guaranty. It is almost often a tripartite contract. However, with a derivative, the creditor may simply enter into a separate and independent contract with the aim of mitigating or hedging his risk exposure. Some of the risks which will typically be transferred include credit risks, interest rate risks and currency exchange risks. Credit risk is the risk that a debtor may not repay principal and pay interest to the creditor at the agreed date. Interest rate risk is the risk that changes may fluctuate negatively with respect to the interest rate to be paid on an agreed principal sum particularly where the interest rate is calculated on a floating rate basis. Currency risk on the other hand is the risk that fluctuations may occur negatively as regards the exchange rate of a relevant currency used in a transaction. These risks are very often encountered in daily contracts starting from the basic sale and purchase agreements to the extremely complex financing transactions. A party to a contract may then decide to protect itself from the relevant risk associated with the transaction to which it is involved by entering into a derivative contract.
Derivatives are transactions whose values are determined by the value of an underlying asset such as a commodity, security, rate or index. They are essentially called derivatives because the value of the derivative contract is at every point deter-mined by the difference between the agreed value placed on the item at the time of entering into the contract but to be performed at a future date (the notional value). Variants of derivatives include options, swaps and for-wards (futures when traded on an exchange). An option is a right and not an obligation to buy or sell an item at an agreed price in the future. This form of derivative is very often purchased by travelers without realizing it. A traveler may visit a bureau de change for the purpose of buying £100 at the rate of N250 to a Pound. Upon the conclusion of the transaction, the dealer may then offer to re-purchase the sum of £50 from the traveler upon his arrival at the same rate of exchange (N250 to a Pound) for a fee. The buyer obviously has entered into an options contract and may exercise his right to repurchase Naira at the rate of N250 to a Pound upon his arrival at a future date. Whether or not he exercises his right will be dependent upon the prevailing exchange rate on the relevant date of his arrival.
A forwards derivative on the other hand is a contract where a party agrees to deliver a specified asset to another party on a specified date in the future (the maturity date) and at a specified price, agreed at the time of the con-tract but to be paid on the relevant date of maturity. What will normally happen is that parties would agree on a price to be paid for an asset in the future. On the date of payment, almost inevitably, the price agreed upon will be different from the market value of the asset. The difference between that agreed price and the market price is an asset that becomes tradable. The asset will only become significant where there is a decision to trade on it and the benefit to either of the parties will be determined by the market value of the asset on the maturity date. The Central Bank of Nigeria (CBN), under the leadership of Mallam Sanusi Lamido Sanusi, has only just made the decision to permit trading in this regard. The main reason for entering into derivative contracts is to facilitate risk management (hedging) and to create price discovery (such that the pricing for an item is based on supply and demand factors). Derivative contracts can also be used in various sectors to transfer risk which an entity or investor is not willing to retain. On the converse, the purchase of a derivative can serve as an opportunity to invest in a sector which a party will otherwise not be open to invest. In the banking sector for example, the risks imminent in loan agreements between the bank and its customers can be offloaded to investors willing to take up such risks. This will have the attendant resultant effect of helping the bank avoid costly liquidations.
Investors in derivative contracts also stand the chance of benefiting from minimal transaction costs as opposed to parting with the full value of the item in the event of an outright purchase. With investments in options contract for example (where the buyer of the option has a right and not an obligation to purchase the underlying item on the maturity date), the trans-action cost would typically be the premium paid by the buyer at the time the option is purchased. Whereas the growth of derivatives has increased tremendously over the last decade with a record of about US$638,923 billion as the notional value of derivatives as at the end of June, 2012, derivatives are yet to be embraced in its fullest capacity in Nigeria. Its presence is however slowly creeping into the financial system in Nigeria. Quite recently, the CBN issued guidelines for the introduction of FX derivatives which essentially permitted certain variants of derivatives to be employed as hedging tools in the foreign exchange market by authorized dealers and investors alike on a strictly regulated basis. Mr. Oscar Onyeama, CEO, Nigerian Stock Exchange has also indicated commitment to expand product offering on the Nigerian Stock Exchange with the creation of an options market by 2013/2014 which will essentially trade stock options, bond options and index options. A futures market is also proposed to be created in 2016 comprising of currency futures and interest rate futures. These developments are no doubt a step in the right direction towards liberalizing the Nigerian Capital Market and ensuring that the much clamored diversification of investments be-comes a reality in Nigeria. However, given the vulnerability that derivatives may pose where it is left unregulated, it is important that care is taken to ensure that adequate regulation is introduced to protect the market. It may also be instructive to ensure that the regulation so introduced is not such that will limit the potential of derivative transactions in Nigeria.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.