BY KOSMAS NJANIKE
Risk management is a broad subject that can be applied to a number of activities. It can simply be defined as reducing uncertainty which could be upside or downside. A standard risk management process can be understood as a four-stage process centred on identification, quantification, management and reporting.
Each of these elements is a vital link in the chain and has to be implemented correctly in order to be effective. The development of risk management in recent years has been driven by the rapid advance in the state of information technology (IT). Improvements in IT have made possible huge increases in both computational power and the speed with which calculations can be carried out. Improvements in computing power mean that new techniques can be used in creating platforms for international trade. The developments have brought improvements in computing power, increases in computing speed and reductions in some transaction costs.
Decision makers are no longer tied down to the simple ‘back of the envelope’ techniques that they had to use earlier when they were confined to their local financial markets and products. Previously, they lacked the means to carry out more complex calculations and access to international financial markets. In this era, sophisticated algorithms programmed into computers to carry out real-time calculations and online trading on the international commodities market is possible. Access to international financial markets and the ability to carry out such calculations then creates a whole new range of risk measurement and risk management possibilities. This article looks at one way risk can be hedged against using derivatives. It is unfortunate that we do not have an organised market for derivatives in Zimbabwe with the vast opportunities they bring.
Derivatives contracts get their name from the fact that they are “derived from” some other underlying claim, financial instrument or assets. For example, a gold forward contract is “derived from” the underlying physical asset- gold. Derivatives are also known as “contingent claims” reflecting the fact that their payoff is contingent upon the price of something else. In the gold contract example, the payoff to gold forward contract is contingent upon the price of gold at the expiration of the contract. Hedgers, arbitrageurs and speculators use derivatives instruments for different purposes. Hedgers use derivatives to reduce uncertainty by transferring the risk they face from potential future price movements of the underlying asset. In such cases, derivatives serve as an insurance or risk management tool against uncertainty in price movements. Speculators use derivatives to make profits by betting on the future direction of market prices of the underlying asset. Therefore, derivatives can be used as an alternative to investing directly in the asset without buying and holding the asset itself. Arbitrageurs use derivatives to take offsetting positions in two or more instruments to lock in a profit.
There are four major types of derivatives and these can be regarded as building blocks which are Forwards, Futures, Swaps and Options. In the last decades, the world of finance and capital markets has experienced quite a remarkable transformation in the derivatives markets. Futures, options and swaps, as well as other structured financial products are now actively traded on many exchanges and over the counter (OTC) markets throughout the world, not only by professional traders but also by retail investors and ordinary individuals as long as there is knowledge and passion.
Derivatives contracts play a crucial role in managing the risk of an underlying security such as commodities, equities and equity indices, bonds currencies, liability positions or interest rates. Commodity derivatives are traded in agricultural products such as wheat, livestock, beans, etc; industrial metals such as copper, zinc, tin, etc; forest products and many other products. However, financial derivatives where in many cases no delivery of physical security is involved are traded in stocks, government bonds, interest rates, foreign exchanges and stock indices.
Why then talk about it when our financial markets have nothing to offer, interest rates depressed and ZSE not performing? In recent years, new derivatives instruments have been devised, different from the traditional instruments and tailor made to meet the demands of the market. From Zimbabwe, one can be trading on the world markets through an international broker of course as a Binary Options Trader.
Binary options are estimates of underlying assets performance during a given time frame. All you need to do is predict either “Put or “Call” that is sale or buy respectively. Binary Options trading has only two investment possibilities for one to predict and then choose between. From anywhere as long one is online, option trading through brokers is very possible. Minimum deposits differ from one firm to the other but from as little as $10 one can trade. Some firms can offer free lessons online to registered traders and others have gone to the extent of offering auto-trade facilities that assist those without trading experience. It is also important to have knowledge on the level of risk involved in binary option trade. Some are making a living out of it but there are a number of things to be considered before embarking on it. Thanks to the advances in IT. – Newsday
Kosmas Njanike is a business management consultant, investment analyst, author and a University lecturer. Can be contacted on email@example.com