DERIVATIVE AS A CAPITAL MARKET INSTRUMENT

INTRODUCTION
A derivative is a financial contract which derives its value from the performance of another entity such as an asset, index, or interest rate, called the "underlying” Its price is dependent upon or derived from the underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. They are essentially called derivatives because the value of the derivative contract is at every point determined 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) and the actual market price of the item on the relevant maturity date.
Derivatives are one of the three main categories of financial instruments, the other two being equities (i.e. stocks) and debt (i.e. bonds and mortgages).
INVESTORS AND INVESTMENTS
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 exposure.
THE RISKS IN DERIVATIVES
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:  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.

 COMMON DERIVATIVE CONTRACT TYPES

Some of the common variants of derivative contracts are as follows:

1. Forwards: A tailored contract between two parties, where payment takes place at a specific time in the future at today's pre-determined price.
2. Futures: are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold; the forward contract is a non-standardized contract written by the parties themselves.
3. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction. Options are of two types: call option and put option. The buyer of a Call option has a right to buy a certain quantity of the underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right. Similarly, the buyer of a Put option has the right to sell a certain quantity of an underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right.
4. Binary options are contracts that provide the owner with an all-or-nothing profit profile.
5. Warrants: Apart from the commonly used short-dated options which have a maximum maturity period of 1 year, there exists certain long-dated options as well, known as Warrant (finance). These are generally traded over-the-counter.
6. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies exchange rates, bonds/interest rates, commodities exchange, stocks or other assets. Another term which is commonly associated to Swap is Swaption which is basically an option on the forward Swap. Similar to a Call and Put option, a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on one hand, in case of a receiver Swaption there is an option wherein you can receive fixed and pay floating, a payer swaption on the other hand is an option to pay fixed and receive floating

Swaps can basically be categorized into two types:

·         Interest rate swap: These basically necessitate swapping only interest associated cash flows in the same currency, between two parties.

·         Currency swap: In this kind of swapping, the cash flow between the two parties includes both principal and interest. Also, the money which is being swapped is in different currency for both parties

Types of Derivatives

OTC and exchange-traded

In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market:

1         Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options – and other exotic derivatives – are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts is difficult because trades can occur in private, without activity being visible on any exchange.

2         Exchange-traded derivatives (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange.A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.

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). Derivative 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 transaction cost would typically be the premium paid by the buyer at the time the option is purchased.

Economic function of the derivative market

Some of the salient economic functions of the derivative market include:

1. Prices in a structured derivative market not only replicate the discernment of the market participants about the future but also lead the prices of underlying to the professed future level. On the expiration of the derivative contract, the prices of derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools to determine both current and future prices.
2. The derivatives market reallocates risk from the people who prefer risk aversion to the people who have an appetite for risk.
3. The intrinsic nature of derivatives market associates them to the underlying Spot market. Due to derivatives there is a considerable increase in trade volumes of the underlying Spot market. The dominant factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure to transfer risk.
4. As supervision, reconnaissance of the activities of various participants becomes tremendously difficult in assorted markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the presence of an organized derivatives market, speculation can be controlled, resulting in a more meticulous environment.
5. Third parties can use publicly available derivative prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts.

In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative Market participant.
 DERIVATIVE IN NIGERIA CAPITAL MARKET
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 end June, 2012, derivatives is yet to be embraced in its fullest capacity in Nigeria. Its presence is however slowly creeping into the financial system in Nigeria. Very 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. Mr. Oscar Onyema, 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.

The multifaceted impact of derivatives in the financial sector in Nigeria will also come to bear in securitization transactions upon the passage by the National Assembly of the Securitization Bill. Various forms of derivatives will without doubt be employed to credit enhance the structures and to hedge against interest rate and currency exchange rate risks that may have an impact on the transactions. This will evidently have a huge effect on the Capital Market and in readiness for transactions of this nature, the Securities and Exchange Commission, the apex regulator of the Capital Market in Nigeria, has in furtherance of its goal to develop the market taken steps to enhance the capacity of its officers on securitization, mortgage backed securities, and other exotic financing mechanisms
Conclusion

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 becomes 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.

YinkaOlaiya