NEXT⚡

Hey there dear reader😊,

You’ve always wanted to buy that dream house that gives you a breathtaking view of your children playing chako chako from the balcony, with a sizeable parking area for your spouse’s car, your car, the family car and the visitor’s car. You do your research and observe that the price of this dream house continues to escalate year by year. You become afraid that 5 years years down the line, it will be too expensive which means settling for a much smaller garage or a playground that doesn’t have green grass for selfies and rolling around with your kids doing abujubujubuju. Scary right?

Because of this forecastable “nightmare”, you inquire the professional financial services of Mr. Derivative. He tells you that it’s possible for you to buy your dream house 5 years down the line at the current market prices. How? By getting into a contract that locks in a certain price that you’ll buy the house in the future. Fantastic right? All you have to do is pay an amount to enter this contract and save up money to buy your house at a not so expensive price. Voila!

The above scenario is a simplistic view of the financial product referred to as derivatives which forms our blog discussion today.

Last month, the Capital Markets Authority gave approval to the Nairobi Securities Exchange to launch the derivatives market, which has been a dream for many investors. The approval sparked excitement across the investment platform for many reasons which we’ll try to demystify today. Let’s get to it.

Recall the above example of the dream-house? This type of transaction in the derivatives world would be known as a forward contract; one party in the contract agrees to buy an item in the future at a pre-determined price while the other party in the contract agrees to sell/deliver the “contract item” at the agreed upon price. This transaction is beneficial to both parties; the party that buys the contract is going to buy their dream house at an affordable price regardless of high future prices since they locked in a price, today, with the seller. The seller gets to avoid a scenario where they may not sell the houses at the hiked prices. Win win for both of them. (Again, a very simplistic view of the advantages)

Let’s sink our feet further and imagine of another case whereby, you speculate that the prices of Safaricom shares will surge in three months time to shs. 40 per share. Therefore, you’d want to buy now @ shs. 27 and sell later at shs. 40. But remember this is a speculation; the price could as well plummet to shs. 10. In this case, there is a possibility of a gain, if your predictive instincts are right or a loss, if wrong. To protect yourself from exposure to severe losses in case of a price nosedive, you buy a derivative contract known as an option. This contract gives you the right, but not the obligation, to sell the safaricom share at shs. 40 in the future to the other party in the contract in case of a price increase. In case the price drops to shs. 10, you can choose not to exercise your right to sell by simply not selling the share. Therefore, you protect yourself from price risk.

I think with those examples so far, we get the groove of what this term derivative means; a contract that helps you in your investment (simply put).Essentially, there are three main types of derivatives; futures, swaps and options. Each of them can be used by investors for different reasons; some use them for speculative purposes (it’s like you’re gambling), others to protect themselves for severe risk exposures and others can use them to profit from certain price anomalies in the market.

But before we go on you may be asking yourself, so what exactly is the exact definition of a derivative? To answer this question, allow me, dear reader, to use a rather “far-fetched” example😁;

Hapo zama za kale, during wedding ceremonies, a man’s family would have to pay some dowry to the woman’s family so that the girl could “legally” leave her home. This dowry would, in most cases, be in form of cattle. So the cows would represent the value of the girl…ehe. The more educated and beautiful and only child the girl was, the more the cows had to be exchanged for this dime of a girl😍. Controversially, we could conclude that the value of this girl was derived from the value of the cows (bare with me here😂). However, the man’s family and the bridegroom were not getting cows…they were getting the bride!🎉Even though they were getting the girl, they paid the price of cows. Here comes the definition; a derivative is a contract or financial security that derives its value from its relationship with another asset (call an underlying asset); underlying in this example being the cows and the girl= derivative.

So when the Kenyan capital market gets all excited about this derivative market, its because it comes with several trading benefits. One is that there is hope that more investors will now participate in the securities market which will deepen our market and increase liquidity. Second, for you as an investor, you can leverage on speculative advantages to buy stocks at lower prices today and sell at higher prices.

However, the derivatives market can be and actually is quite complex. In our blog we have tried to understand what we can do with these products and what they are, just scratched the surface. It gets sophisticated with the pricing concepts and the many products that can be formed from derivatives; instances of swaptions.

Derivatives and derivative markets are very interesting. With wise and smart investments, they reward with good margins. Hopefully when NEXT (name of the Kenya derivatives market) begins to operate (most likely next month July), you and i can become participants of this phenomena and make good profits while trading.

That’s all for today. I hope you’ve gotten the feel of this derivatives buzz.

Thank you for reading through dear reader😊. Enjoy your weekend and see you in the next blog.