NSE gets nod to pilot Derivatives Market

Futures contracts, swaps, credit derivatives and mortgage-backed security arerepresentative of existing derivatives

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By David Onjili

In line with attaining Kenya’s long term investment needs’, there have been efforts – such as the establishment of the Nairobi International Finance Centre Authority – to align the economy to Vision 20130. The main goal here is to increase the level of activity at the bourse, increase market capitalisation and also increases liquidity to make Nairobi a financial hub.

Thus, news of the introduction of a Derivatives Markets has been met with enthusiasm because the bourse currently does not meet the threshold to make Nairobi a financial hub continentally. These are exciting times for those in the financial world.

In line with the Capital Markets Authority’s (CMA) 2015-2019 strategic plan, which aims at increasing the listings in the Exchange while capitalising on product innovation, the CMA gave the Nairobi Stock Exchange (NSE) the nod to pilot the Derivatives Market.

While investors are drawn to it mostly for speculative purposes, a key component of the derivatives market is its ability to remove transaction risks. Michael Mulei, an investor based in South Africa admits that it is a fairly sophisticated product and if it gains poor reception it may not take off, which is why the pilot phase has to be controlled.

Controlling it generally means that specific players can be allowed to trade it to see how well it works.

This is generally done to avoid creating a financial crisis. Mulei exudes confidence that it would work out in Kenya and also provide investors with diversified portfolios.

The Central Bank of Kenya has in the meantime granted both Stanbic and Cooperative Banks licences to participate as clearing and settlement members during this pilot testing phase.

What’s a derivative?

It’s a financial security whose value is derived from an underlying asset or group of assets and their prices determined by fluctuations in the underlying assets. Thus a derivative is a contract between two or more parties based on the assets which include bonds, currencies, interest rates and stocks.

They can either be traded on an exchange where they are standardized or over the counter (OTC). Standardization of derivatives traded on the exchange makes them less risky as opposed to those unregulated and traded OTC.

They also assist international traders to account for the difference in value of their respective currencies, thus creating balanced exchange rates for their internationally traded goods. Since they’re a category of security and not a specific kind, derivatives have unlimited functions based on the type one invests in.

With derivatives now here, a complete understanding of the same is key to any would be investor to be aware of the risks and impact of the investment.

Futures contracts, swaps, credit derivatives and mortgage-backed security are just but a number of existing derivatives. For now the NSE will focus on Equity Index and Single stock derivatives.

Perspective

A futures contract, which is a type of derivative, is quite useful. Imagine signing today a contract to purchase a thousand bags of maize at KSh2,800 for each Kg 90 bag and never caring about price increases when you finally pay for your bags of maize.

Even if the Kg 90 bag will be retailing at KSh3,500, when purchasing, since you signed a futures contract that will not lead to a price hike. While the seller might run at a loss of KSh700 per Kg 90 bag, they will in turn increase their liquidity and be able to purchase other needed commodities. This kind of scenario can be replicated in other industries like aviation for purchase of jet fuel.

While a Derivatives market is exciting news, there have been continuous efforts by the regulator to increase activity and turnover at the NSE, including enabling direct access to investors to the bourse, enabling of short selling and borrowing of securities, as well as the introduction of the Exchange Traded Fund (ETF).(

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