With rising inflation and high exchange rates, the risks involved in investing in stocks keep increasing. Nigerian investors have found it difficult to hedge risks in the absence of a derivatives market but thankfully, we have one now.
The Nigeria Exchange Limited (NGX) has launched a derivatives market that includes futures contracts. The derivatives contracts received the full backing of the Securities and Exchange Commission (SEC).
With this recent development, you can reduce risk while investing in stocks. There are also other ways of managing risk without using derivatives and we will discuss them both.
Use Futures Contracts
Futures Contracts, or futures, is an agreement between two parties to buy or sell a certain quantity of an underlying asset at a predetermined price at a time in the future. Futures help to lock in prices to avoid losses from unfavorable price changes.
On the expiry date, both parties to the contract fulfill their agreement regardless of the current market price of the asset. Futures are traded on the Nigerian stock exchange (NGX).
The NGX is the first West Africa Exchange to support Equity Index Futures Contracts. The NGX Pension Index Futures and the NGX 30 Index Futures are currently traded on the NGX.
Apart from these, the NGX would soon launch five additional futures contracts which include:
- MTN Nigeria Communications Plc Stock Futures
- Dangote Cement Plc Stock Futures
- Zenith Bank Plc Stock Futures
- Access Bank Plc Stock Futures
- Guaranty Trust Bank Plc Stock Futures.
The NGX CEO, Temi Popoola stated that this development would improve Africa’s position in the global financial markets and mitigate risks associated with complex financial transactions.
With stock futures, you can set a price to buy or sell your portfolio at a future date. As a contract holder, you can either buy or sell assets while the counterparty takes the opposite side of the trade.
Inflation causes the value of stocks to depreciate. This is because higher production costs reduce the earnings and profitability of a company.
For instance, assume you want to manage the risk of inflation on stocks. You have 5,000 units of Zenith Bank shares and want to sell them at a time in the future.
With the current inflation hike, you are not sure of making a profit from the sales. Let’s say you enter a futures contract at N100 per share to be executed after 2 months.
At the expiry date, the contract buyer has to pay N100 per share regardless of the current price. If at that time, the stock price has fallen to N60, you have made a profit of N40 per share. Note that NGX traded equity futures contracts are only settled in cash.
Adequate knowledge is needed especially when it comes to contract specifications. When you look at the NGX 30 equity futures contract specifications you notice the following:
- Daily cash settlement: Meaning if the asset price rises, you are debited for the difference.
- Multiplier of N1,000 per index point
- Tick size 0.25
- Tick value N250: (meaning N1, 000 x 0.25). For every 0.25 market move you lose or gain N250
- Contract lifespan of 2 months only
- Margin requirements to be determined by NGCL
Hedge Currency Risk with Forex Trading
If you have supplied goods to an oversea business partner and you fear the USD/NGN exchange rate will increase by the time your payment voucher is ready, you can trade forex by going long on the US Dollar.
If your speculation is correct and the US Dollar Index rises, you can sell and make a profit. This will offset any loss you could record if your payment voucher comes in when the rates have already increased.
Although retail forex trading is not regulated in Nigeria, if you use a foreign tier-1 regulated broker your risk is somewhat lower compared to an offshore broker.
Forex trading can offer means of combating FX risk but the forex market is very volatile and so adequate knowledge and risk management tools like stop loss orders should be understood first & it is not suitable for inexperienced investors.
Short Selling Stock
Short selling stock is an investment strategy that predicts a fall in the price of a stock or security. To short-sell stock, you need to study the stock market and choose a stock that would fall in price in the future.
After predicting the fall of a particular stock, you go to the broker to borrow a desired quantity of shares. You then sell the shares at the prevailing price.
If your prediction is correct, you buy back the stock at a lower price and settle your broker. You make a profit from the difference in the stock prices.
Short-selling stocks has a high risk, and high reward ratio. It is very risky as there can be no limit to losses made. There is no direct method to short sell a stock, but the popular way is via CFD contract through foreign brokers.
Consider Diversifying in multiple Asset Classes
Diversification refers to buying different classes of assets and securities to reduce risks in your portfolio. Meaning that all your eggs are not placed in one basket.
When you diversify, you have investments with varying risk levels. This is an important way of minimizing risks as you can offset the loss from an investment by making profits from another.
To diversify, you can invest in Exchange Traded Funds (ETFs) and Mutual Funds. ETF is a type of fund that contains several assets and is traded on the stock exchange like other stocks.
ETFs is an effective tool for diversification since it combines bonds, stocks, and commodities in one portfolio. Nigeria has a ETFs market capitalization of N7.48 billion.
Mutual Funds and ETFs are similar; both consist of various assets. A key difference, however, is that the popular open-ended mutual funds don’t trade on the NGX.
It is not enough for you to diversify with ETFs and Mutual Funds, you should also ensure that the stocks in your portfolio have a negative correlation.
By negative correlation, we mean that the prices of stocks move in opposite directions to each other. If the price of one stock falls, the other rises. This way, your risks would be reduced.
Correlation calculators can be found online and they help you calculate the correlation coefficient between two stocks. Negative is good, and positive is bad for diversification.
Stocks and bonds now have a negative correlation coefficient due to the hike in interest rates announced by the CBN, bonds have become more profitable than stocks as the monetary policies are hawkish and new bond holders will enjoy the new interest rates.
Buy Dividend Yielding & Defensive Stock
A defensive stock is a type of stock that offers a steady rate of returns despite market volatility. The global stock market has experienced a downturn since the war between Russia and Ukraine. Nigeria Exchange Group is no exception.
The hike in fuel prices, and food items, coupled with insecurity issues have a negative impact on companies’ profitability, thereby reducing the stock prices.
However, there are some companies with constant demand regardless of harsh economic conditions. This enables them to maintain constant returns amidst economic downtime.
It is advisable to buy stocks from such companies since they guarantee regular returns despite bad times. Defensive stock can be purchased from companies in sectors like utilities, healthcare, consumer products, Real Estate Investment Trusts (REITs), and telecommunications.
Higher Yield Government Bonds
Bonds are debt-based government securities that give you a fixed rate of interest till their maturity date. The government, when in need of funds to finance its projects, issues bonds to the public.
Nigerian bonds are issued at a par value of N1, 000. Bonds are low-risk investments with interest paid every six months.
The recent hike in interest rates has made bonds attractive to investors. Interest accruable to a bondholder is between 10% and 13% per annum depending on the bond tenor according to CBN.
For example, if you purchase N50, 000 bonds, you receive N6, 500 per annum. Since it is paid semi-annually, you receive N3, 250 every six months.
When you have bonds in your portfolio, your risks are minimized because bonds are almost risk-free with a higher rate of returns compared to stocks during inflation.
With inflation and currency risks on the rise, investors need to learn how to reduce their risks involved. Bear in mind that you need to analyze the market carefully before using any risk management approaches.