Should Nepal be limited to only stock market? What is a derivative market? Is it required in Nepal?

-Krishna Khatiwada

What is a derivative market?

Financial Instrument which is derived from the underlying asset value is called derivative. For example, Rice is the derivative product of paddy and the changes in paddy prices will fluctuate the rice price. Similarly, in the stock market, the derivative instruments change their price correspondingly with the underlying assets (stock, currency, commodity etc.). Additionally, there are other factors which affect the derivative instrument's price.

Types of derivative instruments

There are different kinds of derivative instruments. However, the article will discuss the Futures and options contracts. Future and Options are the most traded derivative instruments around the globe.

Futures contracts

It is an agreement between the investors to buy and sell the stock (or any other instruments) at a predefined price in future. For simplification, one investor wants to buy onions at current price, let's say at Rs 50 per kg, in the hope that the onion price will increase in the future and another investor will sell it with the expectation that its price will decrease. So, they will do the agreement to buy and sell the onions after three months at the predefined price of Rs 50 per kg. On the expiry date (after three months) if onion price is more than the Rs 50/kg then buyer will be profitable as the sellers have to sell it as according to the agreement even though the current market price is more than Rs 50/kg. In short, in futures contract, an investor have right and obligation to buy trading instruments in future. Future instrument's price fluctuates in a similar way as the parent asset.

Options contract

Option contract offers a right but not the obligation for the option buyers. For example, if an investor wants to buy 100 stocks of ABC of worth Rs 1 lakhs in future then he can do that by giving some advance, let's say Rs 1000 to the sellers. Now buyers have the right to buy that stocks in future but if the stock price goes down by 5% then buyers will have a loss of Rs 5000 but option trading provides an opportunity to walk off the agreement, however, investor has to pay the advance amount to sellers for walking off. However in practical cases, trading in option is complicated as we have to choose right strike price, volatility will play an important role, and we should have the clear idea about Greeks of options. However, in reality option is traded differently.

Difference between the futures and option contract

The main difference between the futures and options contracts is that in futures buyers have the obligation and right to buy shares whereas, in option trading buyers have the right but no obligation to buy that stocks.

In the derivative market, an investor can sell the stock first and can buy it later and we are interested in this feature of derivatives.

Derivative as the risk management instrument

There are three kinds of risk associated with the investment in the stock market

1. Company risk: It is associated with the particular stock. If company management found guilty of fraud or insiders trading etc., this will affect the stock price that is solely associated with that company only.
2. Industries Risk: If the product of that sectors are less demanding or the substitution for the product is trending then that involves industry risk.
3. Market Risk: It is associated with the whole market trend and it is the most dangerous kind of risk because as the investor we choose good companies but still the price of those stock will decrease as the trend will be bearish.

Industry risk and company risk can be minimized easily by diversifying the investment portfolio in different stocks in different sectors but we can't save ourselves from market risk in Nepal. Now consider this example, if we have invested in a diversified portfolio by choosing selective stocks and no matter how good our portfolio looks, if the trend is bearish then we will lose capital. To survive this bearish trend, we have to exit all our portfolio which creates another problem of charges and commission and to re-enter the market we need to pay charges and commission. So in the process to survive the bearish trend in the Nepalese Stock Market we have to pay double charges. But if the derivative market gets introduced in the Nepalese capital market then we can survive market risk by hedging.

What is hedging? How can we hedge our investment portfolio for managing the market risk?  

The process of buying and selling a financial instrument at the same with the same amount is called hedging.

Consider this example, if an investor has a total investment portfolio of worth Rs 10 lakhs and if he is expecting a sharp fall in the market then he can sell NEPSE index futures or options contract. To hedge with futures contract we need to find the beta value (market sensitivity) of the total portfolio and we need to invest "the product of beta value and investment capital" in a future contract.

Hedging with option is bit tricky and it requires a sound knowledge in the subject while hedging with futures is relatively easier. Many hedge fund managers prefer options for hedging.

Where else can we hedge?

If we are expecting a below average monetary policy or country's GDP growth or any big events then with that expectation market may fluctuate heavily. So, in those cases, we could lose a huge amount in a few days. To survive those fluctuations, we can hedge our capital by selling derivative contracts.

Besides hedging, there are other advantages of a derivative market:

In the capital market, there are two types of investor: one who thinks the stock price will increase while other think it will decrease. Mainly, one type of investor dominates the situation while other type remains passive. If the derivative market gets introduced in Nepal then both type of investor can take active participants in the market and as a result, the volume will increase.

Commodity derivative market was introduced in Nepal as a Nepal Derivative Exchange (NDEX) but it hasn't flourished and it is less popular among the investors. In Nepal, we are limited to equity trading in the capital market. But if the commodity market gets flourished then we will have two alternatives for investment. If equity market is not performing well then we can shift our investment in the commodity market and vice-versa. By investing in different instruments we will minimize our risk.  we can make a huge profit with the limited risk by effectively investing in the derivative market.Derivative market is the best instrument for risk management.