Complex vs Simple Financial Products – Which To Choose? – Nairametry
The world of financial products is full of jargon and most of it can be very confusing, even for experienced investors.
Many investors in Nigeria, especially newbies, make the mistake of choosing a complex product that they don’t really understand because it is marketed to them by their suppliers as a way to make money.
The suppliers of these financial products market the complex products with promises of guaranteed and huge returns, but hide the built-in fees and risks inherent to the client.
Complex financial products can be a combination of one or more simple financial products. For newbie investors, it is safer to stick with simple financial products.
We will break down complex and simple financial products as we go.,
What are Simple Financial Instruments?
First of all, a financial instrument is a monetary contract between two parties that can be negotiated.
Simply put, simple financial products are those that present a clear breakdown of what you are getting. Examples are stocks, cash, bonds, term deposits, demand deposits. Their value is derived directly from the market.
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 funds for a specific purpose, it can 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 principal is returned to you.
Bond maturities vary from one to three years for short-term bonds and three years or more for long-term bonds. Interest paid for bonds is generally low compared to term deposits and other straightforward financial products.
You can only access your capital at the end of the period. The risk associated with bonds is low because the risk of a government default is minimal, but it may depend on the government. Government bonds in Nigeria are called FGN bonds and are issued by the Debt Management Office (DMO) on behalf of the Federal Government of Nigeria. FGN Bonds are auctioned monthly and are available from Principal Broker Market Makers (PDMMs).
Once issued, these bonds can be traded (bought and sold) daily through approved brokers in the secondary debt market on the NGX and FMDQ stock exchanges by retail and wholesale investors respectively.
2. Term deposits
This is a short term deposit or long term investment with a duration usually between a month and a few years where you deposit money in the bank and interest is paid to you at predetermined periods. .
With term deposits, interest is usually paid to you at the end of the period with your principal. You can also receive quarterly interest.
The minimum deposit is usually N 100,000 and you can get access to your money before the end of the period, but with penalties because the contract would have been broken.
The contract would be terminated so that you could access your funds and you forfeit any interest earned during the period. Interest rates for term deposits fluctuate and must be negotiated before signing the contract with the bank.
Typically, your bank will tell you its available fixed deposit systems, along with the interest rates, and you can choose which system 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 range from 4% to 10%.
3. Treasury bills
These are similar to government bonds and are issued by the government. The minimum deposit is higher than the fixed deposit and the term is usually 364 days.
Your interest is paid to you immediately and that is the reason why investors like it, and it is generally considered low risk. You can only access your capital at the end of the term of the contract. Your capital is reimbursed at the end of the term of the contract.
You can invest in treasury bills through 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 collect the money and give it to a fund manager who invests in portfolios like real estate programs etc.
The investment is broken down into individual units and each group member is assigned a number of units based on the amount they have invested.
This is particularly advantageous as most of the investors may be from rural areas and have no knowledge of how the financial markets work and the fund manager helps them in this part and in doing so even the villagers are able to benefit from the capital market.
There are several unitary trust systems in Nigeria.
5. Venture capital
Most new businesses are not creditworthy and do not have access to bank loans, so what do they do?
They approach venture capitalists who provide capital to new businesses.
Where do venture capitalists get their own money? Well, investors put money into a pool and invest in venture capital to give these startups money in exchange for equity.
When the company begins to make a profit, venture capitalists also make profits by being the shareholders of the company. An agreed percentage of the company’s profit that might depend on the contract is paid to the venture capitalist.
What are complex financial products?
These are financial products made up of derivatives. They are a combination of various financial instruments put together and are generally high risk and difficult to value. Derivatives are generally traded with the use of leverage.
Let’s talk about derivatives. These are financial products which cannot exist on their own but derive from an underlying asset. An underlying asset can 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 on the FMDQ stock exchange in the form of OTC FX futures contracts to hedge against currency risks.
Derivatives are the building blocks of complex financial products. Derivatives can be of four main types, namely futures contracts, futures contracts, options and swaps. There are also complex over-the-counter derivative instruments such as CFDs and NDFs (a form of futures 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 and international securities.
We will discuss futures and options below and how they can be used to speculate and hedge against risk.
1. Futures contract
It is a kind of contract in which two parties come to an agreement to buy or sell an asset at an agreed price at a future date. Both parties have an obligation to comply.
Take the example of a soybean farmer in Bauchi state who plans to invest N1M in growing two tonnes of beans and sell it after a year, but is concerned that there will be no has an epidemic that could affect the quality of the beans harvested, thus affecting its sales in the market. .
He approaches a broker who arranges for him a future contract with an investor.
Suppose the investor agrees to pay 1.5 million naira for two tons of beans in a year, regardless of the market price at which the contract is signed and both parties go home. Fast forward in a year, suppose the price of beans goes up to N2M for two tons and there has been no outbreak.
The farmer, on the other hand, had reduced his risk of an outbreak (blanket) by agreeing to sell for 1.5M N.
An options contract is a contract that gives its holder the right but not the obligation to buy or sell an asset at a known price (called an exercise price) and on a known date.
After this date, the option loses its legality.
Before an option is delivered to the holder, the holder must pay a premium to the seller of the option. This is so because the assets of the options contract will be out of the market during this period.
Options that can be exercised at any time within the period are called American options while those that can only be exercised at the end of the period are called European options.
The right to buy is also called the call option while the right to sell is also called the put option.
If at the end of the period the option holder chooses not to trade with it, he could simply walk away but will lose the premium he paid to the prospective seller of the option.
Here is an example. If Ngozi owns a house and Hassan asks for the right to buy the house from him for, say, 500,000 N at any time during the next two months, Ngozi offers Hassan a put option and Hassan pays him a premium of, say. , 5,000 N.
Hassan leaves with the put or put option while Ngozi takes the N5000 premium which is more like an inconvenience indemnity since during the next two months, his house is closed to other investors.
Fast forward in two months and Hassan approaches Ngozi with the put option (although he may choose to change his mind and forfeit the premium paid) and pays her 500,000 N and she gives up ownership of the house. .
For a call or call option, suppose an investor agrees to buy 10,000 units of xyz shares at N5 per unit, or 50,000 N over the next two months, he could ask his broker to prepare a call or call option and sell to another investor at a premium say N1000.
Once the period has elapsed, the holder of the call option can choose to cash it by paying 50,000 N to the seller and taking possession of the xyz share.
If the unit price of xyz stock has increased to N10 per unit at the time the call option holder can choose to resell and make a profit after subtracting the amount paid as a premium.
It will be 100,000 – 50,000 – 1,000 = N49,000 profit. If the unit price of xyz stock had fallen by the end of the period, the holder of the call option suffers a loss.
Complex financial products are not for ordinary investors
Complex financial products are not for everyone. New investors should navigate safe waters as they can still make money with simple financial products.
Regulators have asked vendors of these products to make them as simple as possible, without compromising functionality.
Complex financial products incorporate a variety of products, may have hidden fees, and may not be liquid when you need to access money and you may end up trading at a loss. It is safer to invest in simple financial instruments.