Types Of Traders

A reason for the success of the derivatives market is that they have attracted an array of different traders. The three broad categories of investors can be identified as:

• Hedgers - Hedgers use derivatives to reduce the risk that they face from potential future movements in a market variable.

• Speculators - Speculators use derivatives to bet on the future direction of a market variable.

• Arbitrageurs - Arbitrageurs take offsetting positions in two or more instruments to lock in a profit.

Below are examples to better understand how the three types of traders use derivatives.

1. Hedgers

Company X knows that in six months it will have to buy 50,000 kilograms of beef to fulfil an order. Assume the spot price for beef is KES 500/kg and the six-month futures price is KES 450/kg. By buying the futures contract, Company X can lock in a price of KES 450/kg. This reduces the company's risk because it will be able close its futures position and buy 50,000 kilograms of beef for KES 450/kg in six months. In the above case Company X has hedged against the risk of the price of beef going up in the next 6 months.

2. Speculators

A speculator believes that a stock in Company Y is overvalued and will decline in price in the

coming months. He/she will short sell the stock now and wait for the prices to decline then buy

back the stock therefore making a profit. Speculators make bets or guesses on where they believe the market is headed. They are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risky.

3. Arbitrageurs

On exchange R EABL shares are trading at KES 300 and on exchange S EABL shares are trading at KES 312. If you buy 1000 EABL shares on exchange R and simultaneously sell them on exchange S, you can net a profit of KES 12,000 without any risk or any outlay of cash. So the arbitrageur has taken advantage of the price difference in the two markets.

Risks Associated With Derivatives

1. Lack of transparency - This is a key risk in the OTC derivatives market. A trade can be executed between two participants in an OTC market without others being aware of the price at which the transaction was effected. In general, OTC markets are therefore less transparent than exchanges and are also subject to fewer regulations.

2. Counterparty risk - This is the risk that a counterparty in a derivatives contract will not satisfy its obligations under the contract. It is also known as default risk.

3. Operational risks - This are the risks that occur from human error or the failure of control systems.

4. Systemic risk to the financial system posed by the default of a major player e.g. the mere size of the OTCD market , its global dimension, and its lack of adequate collateral have created significant systemic risk to the overall financial system.

Risk Managemenet Sructure And Tools

The risk management structure is that each member will carry its client’s losses if the client defaults. Likewise each clearing member will carry its members (for whom it clears) losses if the member defaults.

Risk is also mitigated by the clearing member and the member through the following:

1. Initial Margin - This is the initial amount of cash that must be deposited in the account to start trading contracts. It acts as a down payment for the delivery of the contract and ensures that the parties honour their obligations. Both buyers and sellers must put up payments.

2. Maintenance Margin - This is the balance a trader must maintain in his or her account as the balance changes due to price fluctuations. It is some fraction - perhaps 75% - of initial margin for a position. If the balance in the trader's account drops below this margin, the trader is required to deposit enough funds or securities to bring the account back up to the initial margin Such a demand is referred to as a margin call. The trader can close his position in this case but he is still responsible for the loss incurred. However, if he closes his position, he is no longer at risk of the position losing additional funds.

3. Variation Margin - This is the amount of cash or collateral that brings the account up to the initial margin amount once it drops below the maintenance margin.

4. Guarantee fund - This is a fund that is set up by a clearing house and is funded by its clearing firms. In the event of a settlement failure, the clearing house may draw on its guarantee fund in order to settle the trades on behalf of the failed clearing firm.

Clearing And Settlement Procedures

What is a Clearing House?

A Clearing House is defined as an agency or separate corporation of a derivatives exchange that is responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data. Clearing houses act as third parties to all futures and options contracts acting as a buyer to every clearing member seller and a seller to every clearing member buyer.

Rationale behind a Clearing House

In order for a derivatives exchange to function efficiently it is very important that an efficient clearing house is able to clear all transactions reported to or traded on the exchange.

A clearing house stands between two clearing members and its purpose is to reduce the risk of one or more clearing members failing to honour its trading settlement obligations. A clearing house reduces the settlement risk by netting offsetting transactions between multiple counterparties, by requiring margin deposits, by providing independent valuation of trades and collateral, by monitoring the credit worthiness of clearing firms, and in many cases, by providing a guarantee fund that can be used to cover losses that exceed a defaulting clearing members collateral on deposit.

Once a trade has been executed between two counterparties either on as exchange, or in the OTC environment, the trade is handed over to the clearing house which then steps between the two original traders clearing firms and assumes the legal counterparty risk for the trade. This process of transferring the trade title to the clearing house is called novation. As the clearing house concentrates the risk of settlement failure into itself and is able to isolate the effects of a failure of a market participant, it also needs to be properly managed and well capitalised in order to ensure its survival in the event of a significant adverse event, such as a market crash or a large clearing member defaulting.

Advantages And Criticisms Of Derivatives

Advantages

1. Enable price  discovery: Derivatives  encourage  more  and  more  people  with  objectives  of hedging, speculation, arbitrage to take  part in the market thus increasing competition. There are  therefore  more  and  more  people  who  keep  track  of  prices  and  trade  on  the  slightest of reasons.  Individuals  with  better  information  and  judgment  are  inclined  to participate  in  the markets  to  take  advantage  of  such  Active  participation  in  the market  in  large numbers  of  both  buyers  and  sellers  ensures  a  fair  price. The  increased  number  of  participants, more  trades,  more  volumes,  and  greater  sensitivity  to  smallest  of  price  changes  facilitates correct and efficient price discovery of assets.

2. Facilitates transfer  of  risk: They  redistribute  risk  between  the  various  market    In this  sense, derivatives  can be compared to insurance as it provides  means to hedge against unfavourable market  movements  in  return  for  a  premium,  and  provides  opportunities  to  those  who  are willing to take risks and make profits in the process.

3. Completion of market/efficient market : A market is efficient or said to be a complete market (theoretically  possible)  when  the  available  instruments  can  by  themselves  or  jointly  provide cover against any possible adverse outcomes. It is a theoretical concept, which is not seen in practice  though  with  the  presence  of  derivatives,  there  is  a  greater  degree  of  market completeness.

4. Lower transaction costs: Derivatives are a form of insurance or risk management, the cost of  trading  in  them  has  to  be  low  or  investors  will  not  find it  economically  sound  to purchase such "insurance" for their positions.

Criticisms

Options offer the potential for huge gains and huge losses. While the potential for gains is alluring, their complexity makes them appropriate for only sophisticated investors with a high tolerance for risk.

1. When a derivative fails to help investors achieve their objectives, the derivative itself is blamed for the ensuing losses when, in fact, it's often the investor who did not fully understand how it should be used, its inherent risk, etc.

2. Some view derivatives as a form of legalized gambling enabling users to make bets on the market. However, derivatives offer benefits that extend beyond those of gambling by making markets more efficient, helping to manage risk and helping investors to discover asset prices. While professional traders and money managers can use derivatives effectively, the chances that a casual investor will be able to generate profits by trading in derivatives are mitigated by the fundamental characteristics of the instrument:

3. Costs - Derivatives are considered quite expensive compared to trading in the traditional investments.