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Guide to derivatives as risk management mechanisms

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Business+Process+pic+ShutterstockA growing trend in very developed economies is a paradigm shift from diversifying risk exposures into varying portfolio of assets to treating such risks exposures as assets eligible for trading in the financial market. Effectively, in these economies the risk exposures associated with various assets are packaged into financial products and transferred by investors unwilling to retain same to those willing to bear them in an organized market.

Typically, some of the risks usually transferred are credit risks, interest rate risks and currency exchange risks, all of which are almost always encountered in business transactions ranging from the simple sale and purchase agreement to the very complex financial transactions.

It is however interesting to note that in spite of the immense benefits of these risk mitigating mechanisms in business transactions, there is still some level of apathy to using them in Nigeria. And this is undoubtedly because; there is still a dearth of knowledge in how they are created and their role in risk management.

It is against this background that this article seeks to demystify the mechanisms collectively known as derivatives. In simple terms, derivatives are financial instruments which are utilized for effective mitigation of risk exposures in any business transaction. A simple analogy of how derivatives operate can be achieved with this example: A farmer grows corn, but if the price go down at the time of the harvest, he could go bankrupt. So he buys an insurance policy – a derivative – that guarantees him a fixed price. The farmer plants his crop knowing he will not lose money.

In more technical terms, derivatives are financial contracts that are linked to and obtain their value from another asset. In other words, as a standalone contract, a derivative does not have any value. However, its value is derived from the assets from which it is created, which mostly include stocks, bonds, commodities, currencies, interest rates and market indexes. A brief explanation of the most common types of derivatives would perhaps assist with proper appreciation of this risk management mechanism.

Forwards Contract
A financial market is almost always volatile, thus a promising deal can quickly turn sour if unforeseen economic and political developments trigger fluctuations in exchange rates or commodity prices. Over the years, one of the instruments developed to deal with these uncertainties is the Forward contract. A Forward contract is an agreement that commits one party to buy and another to sell a given quantity of asset for a fixed price on a specified future date. For instance, a Nigerian Company might agree today to buy a certain product from an American manufacturer. The deal will be priced in dollars, and payments will be made when the product is delivered in three months. Both companies will normally base their business calculation on a certain naira/dollar exchange rate, but for the next three months they will face the uncertainty that a sharp fluctuation in the exchange rate could make their deal less profitable than anticipated. To protect themselves against exchange rate uncertainty, companies (as in the instant scenario) would enter into a forward agreement i.e. an agreement that guarantee a specified exchange rate on a given date in future for the purpose of the transaction.

Future contract
A Future contract is basically an agreement to deliver a set quantity of a particular commodity at a pre-agreed price on a date in the future. For example, a farmer can produces 10,000 tons of grain at production costs of N100 per ton and the current price is N120 per ton. At the end of the harvest (all things being equal), he is expected to be in profit to the tune of N20 a ton. However, it is also possible that at the end of the harvest, the price of grain in the market may drop to N70 per ton (perhaps owing to an abundant supply of same in the market). It is clear that the farmer will incur considerable loss in this event. Thus, to hedge against the risk of possible loss, the farmer may enter a future contract to deliver the 10,000 tons of grain at the end of the harvest at the current price of N120 per ton. Future contracts are generally traded on an organized exchange. Buying and selling of futures contracts in Nigeria would take place on the platform of the Nigerian Stock Exchange (NSE).

Options
Options, as the name indicate, gives one party the option to take or make delivery of some assets. But this option is given to only one party in the transaction while the other party has an obligation to take or make delivery. The asset involved can be a stock, bond, or currency but since the other party has an obligation and a risk associated with making good the obligation, he receives payment for that known as premium. The party that had the option or the right to buy/sell enjoys minimum risk and the cost of this minuscule risk is the premium that is paid to the other party.
Thus, an option is a derivative that gives one party a right and the other party an obligation to buy/sell a given asset at a specified price for a specified quantity. The buyer of the right is called the option holder; the seller of the right (and buyer of the obligation) is called the option writer; the specified price is called the exercise or strike price whilst the cost of the transaction is the premium.
Ikeh is of the Perchstone & Graeys legal practitioners, Lagos


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