Guide to derivatives as Risk Management Mechanisms (2)

Business+Process+pic+ShutterstockFOR example, a flight ticket presents an option and by using the ticket, a passenger has an option to travel. In case he decides not to travel, he can cancel the ticket and get a refund but he has to pay a cancellation fee, which is analogous to the premium paid in an option contract. The airline, on the other hand, has an obligation to carry the passenger if he decides to travel and refund his money if he decides not to travel. Where the passenger decides to travel, the airline gets the ticket fare, and where he does not, they get the cancellation fee. The passenger on the other hand, by booking a ticket, has hedged his position in case he has to travel as anticipated. In the event the trip becomes unnecessary or unachievable, he can get out of the position by canceling the ticket at a cost, which is the cancellation fee.

A Swap is an agreement by two parties to exchange a series of cash flow in the future. It allows parties to exchange a series of payments (whether currency or interest rate payments) without exchanging the underlying debt. For instance, a swap may involve one party exchanging a portion of its floating interest rate payment on a debt for a portion of the fixed rate interest payments on another party’s debt. The swap of the interest rate payments (floating for fixed and vice versa) does not involve an exchange of the underlying debt between the parties.

For example, Company A is a borrower and its bank has given it a loan of N100, 000,000 at a floating rate of 7%. Company B on the other hand has been granted a N100, 000,000 loan at a fixed rate of 9%. Company A thinks rates will go up, but Company B believes they are about to drop. In order to mitigate the risks Companies A and B have identified with their respective loan transactions, they can have an interest rate swap so that Company A ends up with a fixed interest rate of 9%, and Company B with a floating interest rate of 7%. Each party now has the borrowing profile which they require, and each is better off as a result of swapping their interest rate. And of course, the Companies’ underlying debt obligation of N100, 000,000 each remain ‘unswapped’. In essence, swaps offer a means of exchanging interest rates without exchanging the underlying principal obligation.

In light of the foregoing, there is no doubt that the derivatives market effectively fulfills the economic functions of price efficiency and risk allocation. However, a number of factors have been identified as militating against the development of a derivatives market in Nigeria. They are dearth of capacity, scarcity of derivatives products in the local market, the absence of an organized market, the uncertainty of the tax regime to regulate the market and an absence of regulations for mainstreaming these products in the Nigerian capital market.

Having regard to the immense benefits of these products for the financial market particularly the level of activities it portends for the capital market, it is perhaps imperative that a legal framework for the use of these products is developed in the shortest possible time. Whilst the Central Bank of Nigeria’s guidelines for foreign exchange derivatives in the Nigerian financial market is quite commendable, it still does not suffice as a regulatory framework for the purposes of derivatives in the financial market. It is expected that a more comprehensive and detailed framework would be developed and implemented to give practical effect to the objectives of the guidelines and ensure a fully operative derivatives market in Nigeria.

Finally, notwithstanding the innumerable gains associated with the use of derivatives, prudence should be employed to mitigate the risks that are usually associated with using these mechanisms, where not adequately regulated. However such regulations should be drafted such that there is an imposition of unnecessary limitations on the potentials of derivatives in the economy.

Ikeh is of the Perchstone & Graeys legal practitioners, Lagos

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