Among other things, the derivatives market is essentially about mitigating financial market risk, and derivative contracts are the financial instruments used for that purpose. A derivative contract derives its value or price from an underlying asset such as currency, commodities, stocks, or bonds. Derivative contracts provide opportunities for financial market participants to capture value from anticipated price movements of the underlying assets they may not directly own. In a derivative contract, the parties take positions based on their expectation of future market movements, aiming to take advantage of price fluctuations. The party that contemplates that the price of the underlying asset will rise is described as holding the long position, while the party that contemplates that there will be a decline in the price of the underlying asset is described as holding the short position. The differences in the positions of the parties can either be cash-settled or settled by physical delivery. For cash-settled derivatives, if there is an increase in the price of the underlying asset, the party holding the short position has the obligation to make payment to the party holding the long position. When there is a decrease in the price of the underlying asset, the party holding the long position has the obligation to make payment to the party holding the short position.
As an illustration, company A which trades cross borders and seeks to mitigate the risk relating to foreign currency exposure may do so through a derivative contract. The company needs to import some materials for production from the United States and will procure foreign currency at a rate of ₦750 (Seven Hundred and Fifty Naira) to USD 1. Company A envisages that in some weeks, USD will appreciate against the Naira, and it executes a derivate contract with company B to hedge the risk of fluctuating foreign currency rates. The maturity date of the contract is September 2024. In October 2023, the dollar appreciates, and the exchange rate is ₦1000 (One Thousand Naira) to USD 1. company B therefore has the obligation to pay company A the difference in their positions, that is, the difference between USD 750 and USD 1000. If the US dollar depreciates against the Naira, it is company A that has the obligation to pay Company B the difference in the rates.
The advantage of utilising a derivative is that Company A is assured of access to foreign currency at ₦750 to USD 1, irrespective of whatever fluctuations may occur in the foreign currency market in that period. The obligation to pay the difference between the long and short positions on the derivative contract will be due at maturity. Upon maturity, the obligations can be settled either by cash or by a physical delivery, if the underlying asset is a commodity.
The core components of a derivative contract therefore are: (a) the underlying asset; (b) the positions of the parties involved; and (c) the maturity date of the contract. Derivative contracts are a vital part of the financial markets because they can be used for several purposes such as hedging a position, risk management, and creating easy access to liquidity, etc.
There are four major types of derivatives contracts: forwards, futures, swaps, and options. For forwards and futures, the parties agree to trade an asset and settle at a future date at a pre-agreed price. The main difference between forwards and futures is that forwards are non-standardised contracts traded over-the-counter (“OTC”), while futures are standardised contracts traded on an exchange. Options are contracts that give investors the right but not the obligation to buy or sell an underlying asset at an agreed price and date, while swaps are derivatives where counterparties exchange cash flows or liabilities from two different financial instruments. The most common forms of swap derivatives are currency swaps and interest rate swaps.
This article will consider how derivative contracts are traded and settled in the derivatives market in Nigeria.