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Financial derivatives

NEXT

The Nairobi Securities Exchange Derivatives Market (NEXT), was launched on 4th July 2019, with the aim of facilitating the trading of the futures contract on the Kenyan Market and is regulated by the Capital Markets Authority (CMA).

The Finance Act 2022 introduced taxation of gains accrued or derived from Kenya from financial derivatives by non-resident persons. However the Finance Act has exempted gains arising from transactions in the NSE Derivatives Market.

A financial derivative is an instrument whose value depends on its underlying asset/entity. It is an instrument whose value is derived from the value of one or more underlying asset, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. 

They enable parties to trade specific financial risks (such as interest rate risk, currency, equity and commodity price risk, and credit risk, etc.) to other entities who are more willing, or better suited, to take or manage these risks. Investors use derivatives to hedge a position, increase leverage, or speculate on an asset's movement. Derivatives can be bought or sold over the counter or on an exchange. There are many types of derivative contracts including options, swaps, and futures or forward contracts.

They are discussed below:

Forward contract. These are contracts between two parties to sell or buy an asset in future at an agreed future time and given price. Forwards are traded over the counter and are characterized by the actual delivery of the underlying asset at a predetermined date. The parties exchange the product at the price agreed during the contract irrespective of the prevailing market price. Forwards have a very high risk since they are not regulated and are to meet the needs of the buyer and the seller.

Future contract is an agreement to exchange a pre-specified asset at a pre-specified price on a pre-specified date in the future. One party agrees to sell to the other party on a specified future date, a specified asset at a price agreed at the time of the contract and payable at the maturity date. The agreed price is called “strike price”. Futures are traded on an organized market (e.g. the NEXT) just like any other security. Futures contracts require either physical delivery of the asset or settlement in cash.

  • NB: Futures are usually settled by the payment of the difference between the strike price and the market price on the fixed future date, and there is no physical delivery.

Option contracts give a right, but not an obligation to the buyer or seller to buy or sell an underlying asset on the date of exercising the option. There are two types of options namely:
  • Put option is a right, but not an obligation to sell an asset in future at a predetermined price. 
  • Call option is a right, but not an obligation to buy an asset in future at a predetermined price.
The buyer of an option has to pay a premium for purchasing an option. Therefore, the maximum loss that a buyer of an option may suffer is the amount of premium paid. The seller of an option has unlimited risks because the buyer can by exercising his option insist on performance.

Swap contract refers to a contract whereby parties agree to exchange obligations that each of them have under their respective underlying assets. There are largely two types; interest rate swap and currency swap contracts.