Complex or simple financial products – which one to choose?

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

Many investors in Nigeria, especially beginners, make the mistake of choosing a complex product that they don’t really understand because it is marketed to them by their vendors as a way to make money.

The providers of these financial products market the complex products with promises of guaranteed and huge returns, but hide the embedded fees and inherent risk from the customer.

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

We’ll 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 exchanged.

Simply put, simple financial products are those that have a clear breakdown of what you get. Examples are stocks, cash, bonds, fixed deposits, demand deposits. Their value comes 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 may choose to issue bonds to the public.

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

Bond maturity periods range from one to three years for short-term bonds and three years and longer for long-term bonds. The interest paid for bonds is generally low compared to fixed deposits and other simple financial products.

You cannot access your capital until the end of the period. The risk associated with bonds is low because the risk of default by a government is minimal, but it can 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 through primary market makers (PDMM).

Once issued, these bonds can be traded (bought and sold) daily through approved brokers on Secondary Debt Market at NGX and FMDQ Scholarship respectively by retail and wholesale investors.

2. Fixed deposits

It is a short-term deposit or a long-term investment with a duration usually between a month and a few years, where you deposit money with 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 together with your principal. You may also receive quarterly interest.

The minimum deposit is usually N100,000, and you can access your money before the end of the period, but with penalties because the contract would have been breached.

The contract would be terminated so that you can access your funds and 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 their available fixed deposit schemes, along with the interest rates, and you can choose the scheme 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% 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’s the only reason investors love it, and these are generally considered low risk. You can only access your capital at the end of the contract term. Your capital is repaid at the end of the contract term.

You can invest in T-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 such as real estate projects etc.

The investment is divided into individual units and each member of the group is allocated a certain number of units depending on the amount they have invested.

This is particularly advantageous because most of the investors may come from rural areas without any knowledge of how the financial markets work and the fund manager helps them in this part and by doing so even the villagers can profit from the capital market.

There are several trust unit schemes in Nigeria.

5. Venture capital

Most new businesses are not creditworthy and cannot access bank loans, so what do they do?

They are aimed at venture capitalists whose business is to provide capital to new businesses.

Where do venture capitalists get their own money from? Well, investors bring funds into a pool and invest in venture capital to give money to these startups in exchange for equity.

When the company starts making a profit, the venture capitalists also make a profit 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 bundled together and are generally high risk and difficult to value. Derivatives are generally traded using leverage.

Let’s talk about derivatives. These are financial products that cannot exist on their own but derive their existence 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 Exchange in the form of forward contracts to hedge against currency risks.

Derivatives are the building blocks of complex financial products. Derivatives can be of four main types, namely futures, forwards, options and swaps. There are also complex OTC derivative instruments such as CFDs and NDFs (a form of futures or futures contracts) used in the 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 where two parties come to an agreement to buy or sell an asset at an agreed price at a later date. There is an obligation for both parties to comply.

Take for example a soybean grower in Bauchi State who plans to invest N1M in growing two tons of beans and selling after one year, but fears that there will be an epidemic which may affect the quality of the beans harvested, thus affecting its sales on the market. .

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

Suppose the investor agrees to pay N1.5 million for two tons of beans in a year, regardless of the market price, the contract is signed and both parties go home. Now in a year, suppose the price of beans rises to N2M for two tons and there was no outbreak, the investor now pays N1.5M for the beans and resells them for N2M and realizes a profit of N500,000.

The farmer, on the other hand, had reduced his outbreak risk (hedge) by agreeing to sell for N1.5 million.

2. Choice

The options contract is one that gives its holder the right but not the obligation to buy or sell an asset at a known price (called strike 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 asset of the options contract will be out of the market during this period.

Options that can be exercised at any time within the time limit 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 known as a call option while the right to sell is also known as a 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 potential 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 at, say, 500,000 naira anytime within the next two months, Ngozi offers Hassan an option to sell and Hassan pays him a bonus of, say, 5 000 naira.

Hassan walks away with the option to sell or sell while Ngozi takes the N5000 bonus which is more like inconvenience pay since for the next two months his house is off limits to other investors.

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

For a call or call option, suppose an investor agrees to buy 10,000 units of xyz stock at N5 per unit, or N50,000 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.

After the period has elapsed, the call option holder can choose to cash it out by paying N50,000 to the seller and taking ownership of the xyz shares.

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

This will be 100,000 – 50,000 – 1,000 = profit of N49,000. If the unit price of xyz stock had fallen at the end of the period, the call option holder makes a loss.

Complex financial products are not intended for ordinary investors

Complex financial products are not for everyone. New investors should sail in safe waters because they can still make money with simple financial products.

Regulators have asked vendors of these products to simplify them as much as possible, without compromising functionality.

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

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