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Exploring derivatives as instrument for market expansion

Developing derivatives will help reduce the current problem of shallowness and lack of breadth in the capital market

 

On account of the economy’s radically changing financing needs, including recourse to public private partnership (PPP) arrangement as a solution to the nation’s infrastructure dearth, finance experts are of the opinion that opportunities should now abound for a broadening of the exchange’s product offerings to include key derivative categories, expansion of listed mutual funds, index funds, among others.

 

According to reports, the derivatives market continues to be the largest single segment of the global financial market and has been estimated to be more than five times larger than global equities and bond markets. Local and international players in the derivatives market space, therefore, continue to anticipate the launch of ETDs in the market and are keeping a keen eye on the activities of NGX in this regard.

 

In an effort to strengthen the Nigeria capital market and make it compete favourably with other exchanges across the globe, some experts have in various fora called on the regulators to create more products that will broaden deepen and inject liquidity to the market. In pursuit of its drive to deepen the stock market, the regulators have said it will intensify efforts to create more products like derivatives to offer investors other alternative investment platforms.

 

Following this avowed commitment, the Nigerian Exchange Limited, last week, inaugurated first Exchange Traded Derivatives Market.

What is derivative?

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index or security. Common underlying instruments include: bonds, commodities, currencies, interest rates, market indexes and stocks, according to Invetopedia. Futures contracts, forward contracts, options, swaps and warrants are common derivatives.

 

A futures contract, for example, is a derivative because its value is affected by the performance of the underlying contract. Similarly, a stock option is a derivative because its value is “derived” from that of the underlying stock. Derivatives are used for speculating and hedging purposes. Speculators seek to profit from changing prices in the underlying asset, index or security.

 

For example, a trader may attempt to profit from an anticipated drop in an index’s price by selling (or going “short”) the related futures contract. Derivatives used as a hedge allow the risks associated with the underlying asset’s price to be transferred between the parties involved in the contract.

 

Again, commodity derivatives are used by farmers and millers to provide a degree of “insurance.” The farmer enters the contract to lock in an acceptable price for the commodity; the miller enters the contract to lock in a guaranteed supply of the commodity.

 

Although both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change. For instance, while the farmer locks in a specified price for the commodity, prices could rise (due to, for instance, reduced supply because of weather-related events) and the farmer will end up losing any additional income that could have been earned. Likewise, prices for the commodity could drop and the miller will have to pay more for the commodity than he otherwise would have.

 

The basic principle behind a derivative contract is to earn profits by speculating on the value of the underlying asset at a future date.

 

As such, derivatives are used as a risk management instrument, and are suited to both professional and private investors who wish to hedge an open position or gain exposure to assets and markets without necessarily holding the underlying assets.

 

ETDs are variants of derivatives traded on an organised securities exchange as against those other derivatives traded through informal over-the-counter (OTC) market.

 

The derivatives market, however, is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives.

 

NGX’s exchange traded market

Nigerian Exchange Limited (NGX) recently announced the launch of West Africa’s first Exchange Traded Derivatives (ETD) Market with Equity Index Futures Contracts. This is consistent with the Exchange’s commitment to develop the Nigerian capital market by providing a market that thrives on innovation and responds to the needs of stakeholders in accessing and using capital.

 

The launch of NGX ETD Market saw the listing of two Equity Index Futures Contracts, NGX 30 Index Futures and NGX Pension Index Futures, with more securities to be added in the future.

 

To promote clearing efficiency, stability and confidence, the Exchange has collaborated with a premier Central Counterparty (CCP) in Nigeria, NG Clearing Limited, to provide the clearing infrastructure for NGX Derivatives Market and its clearing members, Access Bank and Zenith Bank.

 

The ETDs Market will commence with trading activities by the first three Trading License Holders – Cardinal Stone Securities Limited, Meristem Securities Limited and APT Securities and Funds Limited – who have been cleared by NGX Regulation Limited to facilitate transactions on behalf of investors on NGX Derivatives Market. Commenting on the launch, the Chief Executive Officer (CEO), NGX, Mr. Temi Popoola, commended the efforts of stakeholders who have successfully driven the completion of the Derivatives Market since 2014.

 

“I would like to specially acknowledge the work that was done under the previous management of the Exchange, led by Mr. Oscar Onyema, whose contributions have formed the foundation of our present gains and accomplishments made manifest through the launch of NGX ETDs market.

 

“NGX remains committed to building an exchange that can cater to the increasingly sophisticated needs of domestic and foreign investors. “A strong pillar in our strategy is to enhance liquidity and expand market capitalisation to the end that we create value for stakeholders, and the introduction of ETDs is a critical step in the right direction.

 

“The platform will play an essential role in broadening and deepening the market, adding new impetus to NGX’s leading position as Africa’s preferred exchange hub. “Our partnership with best in class Central Counterparty, NG Clearing Limited, further engenders confidence in the ETDs market segment amongst market participants, as the clearing infrastructure is capable of reducing systemic risk and enhancing market transparency,” he added.

 

Mr Tapas Das, Chief Executive Officer of NG Clearing, said: “The launch of the derivatives market in Nigeria is a testament to the maturity of our market, a sign that the market has come of age and is ready to transition into a new era.

 

“The risks that come with the derivatives market will be managed through NG Clearings’ robust technology- enabled Clearing and Settlement, Collateral Management, and Risk Management offerings as a critical Central Counter Party (CCP) Financial Market infrastructure (FMI).”

 

ETDs are standardised, highly regulated, and transparent financial contracts listed and traded on a securities exchange, and guaranteed against  default through the clearing house of the derivatives exchange. NGX ETDs market will complement existing asset classes, provide investors and other market players with the necessary tools for tactical asset allocation, as well as improve risk and cost management for effective portfolio management. It will further enhance the participation of domestic and international investors in Nigeria’s financial markets, which will positively impact the performance of the economy.

 

Derivatives to enhance stock market

The Group Chairman of Nigerian Exchange Group Plc, Mr. Abimbola Ogunbanjo, had said that Nigeria’s Exchange Traded Derivatives (ETDs) would boost the nation’s stock market.

Ogunbanjo in a keynote address he delivered in Lagos during training themed; ‘Legal & Risk Aspect of Derivatives and Central Counterparty Clearing (CCP) Transactions,’ said: We believe that Nigeria’s ETD initiative will eventually develop into a robust market place that can support our growth ambitions as a nation, using South Africa as an example of Africa’s first derivative market.”

 

He noted that South Africa’s derivatives market had grown rapidly in recent years, which has supported capital inflows and helped market participants to price, unbundle and transfer risk.

“Their market comprises two broad categories of derivatives, namely options and futures. Within these two categories, a wide range of instruments may be identified: warrants, equity futures and options, the agricultural commodity futures and options, interest rate futures and options, currency futures and fixed income derivatives.

 

“The fixed income derivatives are made up of bond futures, forward rate agreements (FRAs), vanilla swaps, and standard bond options. Notwithstanding the foregoing, South Africa has had to manage the risks associated with misuse of complex financial products via continuous improvement and enhanced enterprise risk frameworks.

 

“Accordingly, as innovation drives interest in any product, the market will require continuous advancement to risk frameworks, technology and critical thinking to bringing about competition which is a basic driver towards development and growth in the market.”

 

Ogunbanjo noted that the concept of derivatives remained relatively novel in the Nigerian financial market space and has only been noticeable within the Over-The-Counter (OTC) segment of the market.

 

“The frontiers of the Nigerian financial market is expected to grow exponentially due to enhanced liquidity arising from the development of new and intricate financial instruments. Given the open and transparent financial market place the NSE offers to a wide range of domestic and international investors,” he said.

 

Last line

 

Derivatives are essential in markets with a significant low product to investor ratio like the Nigerian Stock Exchange. However, the regulators and fund managers have key roles to play in ensuring the right products are introduced to the market and that product proliferation does not lead to investor abuse.

 

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