A vibrant financial market is a key pillar of any strong economy. It is a market with breadth in terms of having a wide variety of products available to investors and depth in terms of having sufficient liquidity for each of those products.
A strong financial market contributes to the well-being of the overall economy by attracting a variety of participants and allowing for the efficient flow of capital across different sectors.
The Kenyan financial market has long been dominated by two types of products; shares and bonds. The Nairobi Securities Exchange (NSE) has recently introduced Exchange Traded Funds and Real Estate Investment Trusts.
It is also in the process of rolling out a derivatives market which can play a big part in contributing to the government’s Big Four agenda as well as the overall wellbeing of our financial market and economy.
A simple definition of a derivative, perhaps, is a contract between two parties. Like any contract, it sets out the rights and obligations of the counter-parties to a transaction or any particular undertaking.
The Exchange will be rolling out a derivatives market featuring futures contracts as the first products on the market. Futures are among the simplest derivatives products in existence.
A futures contract is an agreement between a buyer and a seller to exchange a particular quantity of an underlying asset on a future date at a price agreed today.
The main distinguishing feature between different types of futures contracts is the underlying asset. A commodity future would therefore be based on a particular commodity while an equity future would be based on an equity instrument.
More specifically, a maize future would represent an agreement to buy or sell a particular quantity of maize on a future date at a price agreed today, while a single stock (share) future would represent an agreement to buy or sell a particular quantity of shares on a future date at a price agreed today.
So how could these futures contracts and other derivatives possibly contribute to the Big Four agenda? Let us look at how futures contracts can be used. The oldest and most basic use for futures contracts is risk management or hedging, which simply means eliminating or reducing risk.
A farmer is exposed to the risk of the price of their maize falling before harvest. The farmer would therefore want to eliminate or reduce the financial risk of lower profits due to the fall in price.
The farmer could hedge their position by selling a maize futures contract. This means the farmer enters a pact to sell his or her maize at harvest or on any future date at a price agreed today.
The farmer locks in a price for the maize today and should the market price of maize fall in the future, the farmer has protection against lower prices while other farmers would make losses if they had not hedged themselves.
This also allows the farmer more certainty about the price they will receive for their produce so they can plan more efficiently. This ease of planning also accrues to users of the produce such as millers who can plan around guaranteed prices and delivery times for produce they use as inputs.
Interaction between commodity buyers and sellers on an organised derivatives market will also help stabilise food prices ensuring buyers and sellers get a fairer price that is not distorted by middlemen. The derivatives market therefore has a part to play in achieving the food security pillar of the Big Four agenda. The writer is Equity Derivatives Specialist