EXPLAINER: How Nigeria’s newly launched exchange-traded derivatives market can profit stock investors – Premium Times

Now that the liquidity in the Nigerian stock market is worrisomely low when set beside January’s and daily size of trade is miles apart from its pre-pandemic level, capital market authorities have launched the first exchange-traded derivatives market in West Africa, marked by Thursday’s introduction of two futures contract, NGX 30 Index and NGX Pension Index.

The combined value of the transactions executed on the bourse last year stood at N1.9 trillion, according to NGX Domestic and Foreign Portfolio Investment Report issued January.

That suggests a 12.4 per cent contraction compared to that of the preceding year.

The trend has regressed further this year, with the first quarter transaction value summing up N591.8 billion compared to N676.5 billion a year earlier and a vast portion of smart money deserting stocks for safer havens particularly fixed income securities.

The Nigerian Exchange Limited (NGX) has lined up seven derivative contracts for the first phase, all of which have gained the consent of the industry watchdog, the Securities and Exchange Commission.

Aside NGX Pension Index Futures and NGX 30 Index Futures, there are MTN Nigeria Communications Plc Stock Futures, Dangote Cement Plc Stock Futures, Zenith Bank Plc Stock Futures, Access Bank Plc Stock Futures and Guaranty Trust Bank Plc Stock Futures.

The last five are yet to debut.

By the move, the exchange hopes to deepen “Africa’s position in the global financial markets through ETDs, as well as enhancing liquidity and mitigating against price, duration, and other financial risks that may arise from sophisticated financial transactional activities,” said Temi Popoola, the chief executive officer.

Understanding derivatives and stock futures

Derivatives are a class of securities, whose value is dependent on the performance of an underlying asset or a set of assets unlike individual stocks, for instance, whose value come directly from activity on their shares in the market.

“You can gain exposure to the NGX Pension Index, the NGX 30 Index without necessarily, for instance, paying the full amount that you would have needed (were you to buy the individual stocks making up the contract),” Ahmed Jinad who heads investment research at broker Meristem Securities Limited told PREMIUM TIMES.

In this way, derivatives’ value is subject to fluctuations in the prices of the financial instrument or the basket of assets making them up. The component securities could be bonds, stocks or currency.

They come in the form of a contract executed between two parties who have come into the understanding to either buy or sell an asset at an agreed date and time among other terms and conditions.

Futures, a type of derivative, require the buyer and the seller to fulfil their obligations under the contract at a future date based on the price set at the time of entering the agreement, not considering whether the market price of the asset has changed when the contract expires. The buyer takes delivery of the asset when settlement is made at the point the contract matures.

“Essentially, what you’ll do with derivatives generally is to hedge risk depending on what kind of forecast you have about the market or the strength of the index and where you expect it to be at a future date,” Mr Jinad said.

“So there are different kinds of position that you can take apart from the long-only option that we have had for a very long time,” he added, referring to the buy-hold-and-sell mode the market had operated for years before the launch.

Portfolio managers use futures to gain a speculative advantage like taking a position in shares offering strong prospects of price appreciation by purchasing them ahead of time to sell when the time is right.

Futures can also be used for hedging purposes, enabling traders and investors to take action aimed at averting possible swings of prices in an unfavourable direction, thereby mitigating risks.

It is possible to use futures to lock in gains in instances where a stock has appreciated to a point where a drop could possibly follow.

“One problem with thinking of hedging transactions strictly as insurance is that, unlike insurance, there exists a third possibility often unaccounted for by inexperienced investors, namely, that the investment rises in value, but by only a small amount,” said James Chen, analyst at financial literacy website Investopedia.

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“In that scenario, the investor may find that the small gain has become a loss when the cost of the hedging transaction is taken into account.”

Futures are pretty similar to forwards, a major distinguishing feature lying in the fact that the former are traded on an exchange through brokers while trading in the latter is conducted over-the-counter.

Types of stock futures

Stock futures can be single stock futures or stock index futures.

Single stock futures have just one underlying security linked to the contract, with each contract typically controlling 100 shares of stock.

Five of the derivatives proposed by the NGX including Access Bank Plc Stock Futures, Guaranty Trust Bank Plc Stock Futures, MTN Nigeria Communications Plc Stock Futures, Dangote Cement Plc Stock Futures and Zenith Bank Plc Stock Futures fall into this category.

Holders of stock futures contract do not enjoy dividends or voting rights unlike investors in everyday equities.

Single stock futures ease both the asset and risk management process of the underlying security by concentrating on only one stock rather than a mixed bag of equities.

Stock index futures are contracts derived from an index, which itself tracks the prices of diverse stocks under it. NGX Pension Index Futures and NGX 30 Index Futures, which have just being introduced, are notable examples.

Index futures help investors with holdings in many stocks to hedge against the risk of equities prices falling by selling equity index futures.

According to Investopedia, “in the event of a market downturn, the stocks within the portfolio would fall in value, but the sold index futures contracts would gain in value, offsetting the losses from the stocks.”

The NGX authority has set the third Friday of every month as the expiration date of all the seven contracts, while the Monday prior to the expiration day will be the listing day.

“Certain Equity Index futures strategies can be applied by risk managers to efficiently create a long equity position,” the NGX said at a workshop for market participants in August

“This way, they can gain the equity market exposure they want, while only using a fraction of the capital.”

Mr Jinad feels bringing in stock futures to dilute the mix of investment options may not ramp up interest in equities, at least for now, considering that participation in the trading of the new securities is likely to tend towards testing the waters at this stage.

“For things like that, you want to give it time for the market to embrace it. People are not going to invest because something is new, they are going to invest based on the potential upside that they think they can get from it,” he said.

“The underlying components for the contracts that will be available are still the same stocks that have been in the market, that sentiment on them seems to be dampened at the moment.”

Institutional investors and investment managers, according to the analyst, are the class of market participants that will be most inclined to trade in futures for now and will need to leverage strategy for it to be productive.