Why you should invest in derivatives- What You Need to Know about Derivatives

Posted in CategoryTechnical Queries
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    Ebunlomo 3 years ago

    The year 2020 has led to an increase in investment and savings habit and there exists a lot of information explosion on the internet. This article talks about an investment product not popular in Nigeria but has proved to be an extremely important instrument particularly in unpredictable times such as this.

     

    The Securities and Exchange Commission (SEC) issued an amendment to its rules in December 2019 which provided new rules on the regulation of derivatives trading. The introduction of Derivatives to Nigeria is late, however, better than never. Notwithstanding, Derivatives are Financial Securities that you should really consider investing in and I will be telling you why in this article.

     

    Derivatives are Financial Securities that derive their value from the value of the underlying asset (these could be interest rate, security price, commodity price, foreign exchange rate, index of prices/rates etc.). The derivatives market is divided into two categories; the Over the Counter (OTC) which includes derivatives not listed on an exchange and are traded directly between parties and the Exchange Based Derivatives which are derivatives listed on an exchange e.g Nigerian Stock Exchange (NSE)

     

    Derivatives are characterized by a relatively high degree of leverage. They are fundamentally used for hedging against risk and for speculation. The most common types of Derivatives are:

     

    The Option, a contract under which the option owner enjoys the right to buy or sell an asset without the obligation to do so at a fixed price during a specified period of time. The option to buy is known as a CALL OPTION while the option to sell is a PUT OPTION.

     

    Futures are derivatives that obligates the contracts’ buyer to purchase an asset or shares paid for at a later date with a set price. Futures are standardized contracts that are traded on exchanges.

     

    Forwards are very similar to the Futures contracts except they are more informal as they are traded through a broker and Over The Counter (OTC).

     

    Swaps create an opportunity for parties involved to exchange cash flows from different financial instruments. They most common are the Currency, Commodity and Interest Rate swaps.

     

    So, what makes Derivatives special?

    ·      Derivatives are used for risk management, usually to redistribute risk exposure on a transaction.

    ·      They are used for speculation and hedging as mentioned earlier, especially in the case of traders who look for profit from the changing prices of the underlying assets.

    ·      Derivatives are used to determine the price of the underlying asset.

     

    IN SIMPLER TERMS;

    Derivatives are investment products that are primarily used for speculation, hedging against risk and

     

    They are best used when prices are unstable and businesses are high-risked (which is nearly all the time). They can either be equity derivatives, credit derivatives, commodity derivatives, interest rate derivatives etc.

     

    Through a derivative contract, the value of an underlying asset is locked for a future date to protect the risk fluctuations and speculate the future value of the asset.

     

    They are created in form of legal contracts and involve two parties.

     

    The locked price is mostly known as STRIKE PRICE which represents the consideration upon which the contract will be settled and the underlying asset will be transferred from the buyer to the seller on the settlement date. Settlement of derivative is usually the difference between the strike price and the market value of the settlement date.

     

    Traded derivatives are registered and recognized by SEC.

     

    It is important to note that one of the major drawbacks of Derivatives is that they can be risky, ironically, they serve as risk management tools but they are also prone to volatility which may lead to huge losses.

     

     

    Source: Laura Uche 

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