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
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.
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).
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.
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.