Introduction of Derivatives to the Kenyan Market. What are derivatives?

Last week, the Nairobi Stock Exchange announced the launch of its derivatives market.

NEXT is the Nairobi Securities Exchange (NSE) derivatives market that facilitates the trading of futures contracts in the Kenyan market. NEXT is regulated by the Capital Markets Authority (CMA).

NEXT was established as a result of:

• Increased integration of the Kenyan financial markets with international markets;
• Increased volatility in asset prices in local and international financial markets;
• The need for more sophisticated risk management tools and strategies;
• The need to broaden and deepen Kenyan financial markets.

Source: NSE Website

This post seeks to define derivatives and how they work.

First, derivatives are a type of asset class that derives its value from another class of asset. This is why they are called derivatives. The underlying asset can be shares in the stock market, commodities (such as gold, wheat, oil, copper etc), or even currencies.

Derivatives are typically used by individuals who want to protect themselves against price movements of the underlying asset on one hand, and by an investor looking to profit from the price movement on the other hand.

A derivative contract is a contract entered into by both parties, based on a certain set of assumptions (or educated views) of how the price is likely to move. There are four main types of derivatives:

1. Forwards: This is an agreement to exchange an underlying asset at a pre-agreed price at a future date. Forwards typically do not trade in an exchange, but over the counter between one party and another.
2. Futures: Futures are a form of a forward contract that trades over an exchange. Unlike forwards, futures contracts are standardised.
3. Options: Forwards give the buyer the right but not the obligation to buy or sell the underlying asset at a pre-agreed price. These can be traded on an exchange or over the counter.
4. Swaps: These are agreements to exchange currencies or interest rates in the future.

The NSE launched a futures market, which allows traders to get into contracts that allow them to exchange shares or stocks at a pre-agreed price at a future date. Let us use an example. Say investor A holds 1 million shillings worth of BCD Limited and believes that the stock will go down. Instead of selling off their shares, the investor may choose to get into a futures contract by selling BCD Limited futures. The investor would pay the futures price (as per the market), and should the price fall, the futures price would rise to compensate them for the loss in price.

Derivatives may not be a financial instrument for the non-sophisticated investor, but they do offer some benefits towards developing the market.