Takeaways
- Derivatives derive their value from underlying assets such as stocks, commodities, currencies, and interest rates.
- They are used for hedging (risk management) and speculation (profit-seeking).
- The four primary types of derivatives are forwards, futures, options, and swaps.
- Hedgers (businesses, investors) use derivatives to stabilize prices and reduce risk, while speculators use them to bet on price changes for profit.
- While derivatives offer financial benefits, they also carry risks, including market volatility and potential losses.
Financial derivatives are complex financial instruments whose value is derived from another asset. These underlying assets can be stocks, bonds, commodities, currencies, interest rates, or market indexes. Derivatives play a significant role in global financial markets, providing opportunities for risk management and profit generation.
Derivatives serve two main purposes: hedging and speculation.
Related articles
Hedging: Reducing Risk in the Market
Hedging involves using derivatives to mitigate the risk of adverse price movements in the physical market. It is widely used by businesses and investors who wish to protect themselves against financial losses caused by market volatility.
Hedging in Ethiopia’s Agricultural Sector
Ethiopia is one of the world’s top coffee producers. A coffee farmer in Ethiopia worried about international coffee price fluctuations can enter into a futures contract to sell coffee at a fixed price. If global coffee prices fall, the contract ensures that the farmer still sells at the predetermined price, avoiding financial loss.
On the other hand, an Ethiopian coffee exporter, expecting prices to rise, may enter a similar contract to buy coffee at a fixed price, ensuring they avoid paying higher market prices later.
This type of agreement provides financial stability, although one party may benefit more depending on market movements.
Hedging in Ethiopia’s Airlines Industry
Ethiopian Airlines, as Africa’s largest carrier, heavily relies on jet fuel. To manage fuel cost fluctuations, it can use commodity futures contracts to lock in fuel prices. If global fuel prices rise, the airline benefits by paying the pre-agreed rate, ensuring cost predictability. However, if prices drop, they may end up paying more than the market rate.
Speculation: Profit-Seeking in the Market
Unlike hedging, which is used to reduce risk, speculation involves taking on risk with the hope of making a profit. Speculators use derivatives to bet on price movements of assets without necessarily owning them.
Speculating in Ethiopia’s Emerging Stock Market
With Ethiopia establishing its own securities exchange, an investor anticipates that the stock price of a major Ethiopian bank will rise. Instead of purchasing the stock outright, they buy a call option, which gives them the right to purchase the stock at a fixed price before a specific date. If the stock price increases, they can buy at the lower price and sell at a profit.
If the stock price falls, the trader is not obligated to buy, and they only lose the premium paid for the option.
Currency Speculation in Ethiopia
Due to Ethiopia’s floated exchange rate system, currency traders speculate on potential devaluations of the Ethiopian Birr. A trader expects the Ethiopian Birr to depreciate against the U.S. dollar. The trader enters a currency futures contract to buy U.S. dollars at the current rate. If the Birr depreciates, the trader profits by exchanging at a higher rate later. If the Birr strengthens, they suffer a loss.
Types of Derivatives
There are four main types of derivatives: forwards, futures, options, and swaps. Each serves different financial purposes and is used by various market participants.
1. Forwards: Customized Risk Management
A forward contract is a private agreement between two parties to buy or sell an asset at a future date for a predetermined price. Forwards are not traded on an exchange, meaning they can be tailored to specific needs.
Example: Ethiopian Coffee Exporter
A coffee exporter in Ethiopia agrees to sell 1,000 kilograms of coffee to a European importer at $4 per kilogram, deliverable in six months. This forward contract protects both parties from unexpected price swings. However, if coffee prices rise to $5 per kilogram, the exporter misses the chance to sell at a higher price, while the importer benefits.
2. Futures: Standardized Market Instruments
A futures contract is similar to a forward contract but is standardized and traded on exchanges like the Ethiopian Securities Exchange (once operational). These contracts are subject to strict regulations and require daily settlements.
Example: Investing in Teff Futures
An Ethiopian investor anticipates that teff prices will increase. They buy a teff futures contract that allows them to purchase teff at a fixed price. If teff prices rise, they can sell the contract at a profit. If prices fall, they incur a loss.
3. Options: The Right, But Not the Obligation
Options give buyers the right—but not the obligation—to buy (call option) or sell (put option) an asset at a specific price before a set date. Unlike forwards and futures, options provide flexibility.
Example: Call and Put Options in Ethiopia’s Stock Market
- Call Option: An investor buys a call option for the stock of an Ethiopian telecom company at 500 ETB per share, expiring in two months. If the stock price rises to 600 ETB, they can buy at 500 ETB and sell at 600 ETB, making a profit. If the price drops, they simply let the option expire, losing only the premium paid.
- Put Option: A trader expects an Ethiopian insurance company’s stock to drop and buys a put option at 200 ETB per share. If the stock falls to 170 ETB, they can sell at 200 ETB and buy at 170 ETB, making a profit.
4. Swaps: Exchanging Cash Flows
A swap is a contract where two parties exchange cash flows based on different financial instruments. Swaps are mainly used by large institutions to manage financial risk.
Example: Interest Rate Swap for Ethiopian Banks
An Ethiopian bank with a variable interest rate loan fears that rates will rise, increasing its costs. Another Ethiopian company has a fixed interest rate loan but prefers a variable rate. They agree to swap interest payments—one paying fixed rates and the other paying variable rates—helping both manage financial risk.
Financial derivatives are a vital component of modern markets, helping businesses, investors, and institutions manage risk and seize financial opportunities. As Ethiopia’s capital market grows, understanding derivatives will be crucial for navigating investment opportunities and financial risk management.
