Monday, January 17

Complex vs Simple Financial Products – which should you choose?


The world of financial products is full of jargon and most of it can be really confusing for even experienced investors.

A lot of investors in Nigeria, especially the beginners, make the mistake of choosing a complex product which they don’t really understand as it is marketed to them by their providers as ways to make money.

Providers of these financial products market the complex ones with promises of guaranteed, and huge returns but hide the embedded fees and inherent risk involved from the client.

Complex financial products can be a combination of one or more simple financial products. For beginner investors it is safer to stick to simple financial products.

We shall breakdown complex and simple financial products as we proceed.,

What are Simple Financial Instruments?

First of all, a financial instrument is a monetary contract between two parties that can be traded.

Simply put, simple financial products are those which have a clear breakdown of what you are getting. Examples are stocks, cash, Bonds, Fixed deposit, call deposits. Their value is derived from the market directly.

Let us discuss some of them below.

1. Government Bonds

When you buy this, you are simply lending money to a government. When a government needs to raise money for a purpose, they may choose to issue bonds to the public.

When you buy a bond, interest is paid to you and at the end of the period your capital is refunded to you.

Maturity periods for bonds vary from one to three years for short term bonds and three years and above for long term bonds. The interest paid for bonds is usually small as compared to fixed deposits and other simple financial products.

You cannot access your capital till the end of the period. The risk associated with bonds is small because the risk of a government defaulting is minimal, but this can depend on the Government. Government Bonds in Nigeria are called FGN Bonds and are issued by Debt Management Office (DMO) on behalf of Federal Government of Nigeria. FGN bonds are auctioned monthly and are available through Primary Dealer Market Makers (PDMMs).

These bonds once issued can be traded (bought & sold) daily through licensed brokers on Secondary Debt Market at NGX and FMDQ Exchange by retail and wholesale investors respectively.

2. Fixed deposits

This is a Short-term deposit or Long-Term investment with tenor usually between one month to a few years where you deposit money with the bank and interest is paid to you at pre-determined periods.

With fixed deposits the interest is usually paid to you at the end of the period along with your capital. You may also receive quarterly interest.

Minimum deposit is usually N100,000, and you can have access to your money before the end of the period albeit with penalties since the contract would have been breached.

Contract would be terminated for you to access your funds and you forgo any interest earned during the period. Interest rates for fixed deposits fluctuate and should be negotiated before contract is signed with the bank.

Generally, your bank will tell you their available Fixed Deposit Schemes, along with the Interest Rates, and you can choose the scheme that you want.

All major banks in Nigeria like UBA Bank, GT Bank, Access Bank etc. offer Fixed Deposit Bank accounts, and their Interest Rates can vary from 4%-10%.

3. Treasury bills

These are similar to Government Bonds & are issued by the Government. The minimum deposit is higher than that of fixed deposit and the tenor is usually 364 days.

Your interest is paid to you immediately and this one reason investors like it, and these are generally considered low risk. You cannot access your capital until the end of the contract period. Your capital is refunded at the end of the contract period.

You can invest in T-Bills via your bank, as banks like UBA offer this instrument.

4. Unit Trust

This is when a group of people come together to pool resources and invest in a particular product. They gather the money and give it to a fund manager who invests in portfolios like Real Estate schemes etc.

The investment is broken down into single units and each member of the group is allotted a number of units depending on how much he or she invested.

This is particularly beneficial as most of the investors maybe from rural areas with no knowledge of financial market workings and the fund manager helps them with that part and by so doing even villagers are able to take advantage of the capital market.

There are multiple Unit Trust Schemes in Nigeria.

5. Venture Capital

Most new businesses are not credit worthy and cannot access bank loans so what do they do?

They approach venture capitalists who are in the business of providing capital to new companies.

Where do the venture capitalists get their own money from? Well investors contribute funds in a pool and invest in venture capital to give money to these startups in return for equity.

When the business starts making a profit, the venture capitalists also make profits by being the equity holder in the company. An agreed percentage of the company’s profit which could depend on the contract is paid to the venture capitalist.

What are Complex Financial Products?

These are financial products that are made up of derivatives. They are a combination of various financial instruments lumped together and are usually high risk and difficult to value. Derivatives are usually traded with the use of leverage.

Let us discuss derivatives. These are financial products that cannot exist on their own but derive their being from an underlying asset. An underlying asset could be a stock, a commodity like gold, interest rates etc.

They can be used either to speculate or to hedge against risk. For example, Currency Derivatives can be traded FMDQ Exchange in the form of OTC FX Futures to hedge against currency risks.

Derivatives are the building blocks of complex financial products. Derivatives can be of four major types namely are Futures, Forwards, Options and Swaps. There are also complex OTC derivative instruments like CFDs and NDFs (a form of forward or futures contracts) used in financial markets. CFDs and NDFs are commonly used in Forex Trading and most online forex brokers in Nigeria offer CFDs on Currencies, Commodities, Metals & International Securities.

We will discuss futures and options below and how they can be used to speculate and to hedge against risk.

1. Futures Contract

This is a kind of contract where two parties reach an agreement to either buy or sell an asset at an agreed price at a future date. There is an obligation on both parties to comply.

Take for example a soya beans farmer in Bauchi state plans to invest N1M in cultivating two Tons of beans and sell after one year but is afraid that there might be a disease outbreak which might affect the quality of beans harvested thus affecting his sales in the market.

He approaches a broker who arranges for him a future contract with an investor.

Let us say the investor agrees to pay N1.5M for two tons of beans one year from now irrespective of the market price the contract is signed and both parties go home. Now fast forward to one year from now let’s assumes the price of beans rises to N2M for two tons and there was no disease outbreak the investor now pays N1.5M for the beans and resells it for N2M and makes a profit of N500, 000.

The farmer on the other hand had reduced his risk of disease outbreak (hedging) by agreeing to sell for N1.5M.

2. Options

Options Contract is one that gives the holder the right but not the obligation to buy or sell an asset at a known price (called the strike price) and at a known date.

After that date the option loses its legality.

Before an option is handed over to the holder, he must pay a premium to the option seller. This is so because the asset in the options contract will be off the market for that period.

Options that are exercisable within the time frame at any time are called American options while those exercisable only at the end of the period are referred to as European options.

The right to buy is also called a call option while the right to sell is also called a put option.

If at the end of the period, the holder of the option chooses not to transact with it he could simply walk away but will lose the premium he paid to the intending seller of the option.

Here’s an example. If Ngozi owns a house and Hassan requests for the right to buy the house from her at say N500,000 anytime within the next two months, Ngozi offers Hassan a sell option and Hassan pays her a premium of say N5000.

Hassan walks away with the sell or put option while Ngozi takes the N5000 premium which is more like an inconvenience allowance since for the next two months her house is off limits to other investors.

Fast forward to two months from now and Hassan approaches Ngozi with the sell option (though he might choose to change his mind and forgo the premium paid) and pays her N500,000 and she relinquishes ownership of the house.

For a call or buy option let’s assume an investor agrees to buy 10,000 units of stock xyz at N5 per unit which is N50,000 in the next two months, he could ask his broker to prepare a call or buy option and sell to another investor at a premium say N1000.

When the time period elapses, the holder of the call option may choose to cash it in by paying N50,000 to the seller and taking ownership of stock xyz.

If the unit price of the stock xyz has risen to say N10 per unit at the time the holder of the call option can choose to resell and make a profit after subtracting the amount paid as premium.

This will be 100,000 – 50,000 – 1000 = N49,000 profit. If the unit price of stock xyz had fallen at the end of the period the holder of the call option makes a loss.

Complex Financial Products are not for Common Investors

Complex financial products aren’t for everyone. New investors should navigate safe waters as they can still make money from simple financial products.

Regulatory bodies have asked providers of these products to simplify them where possible, without compromising functionality.

Complex financial embed various products, may contain hidden fees and may not be liquid when you need to access the money and you may end up trading at a loss. It is safer to invest in simple financial instruments.



nairametrics.com

Leave a Reply

Your email address will not be published. Required fields are marked *