The Need for a Derivatives Exchange in Zimbabwe

Categories: BusinessChange

The preconditions of establishing such an exchange and the risks associated with the use of derivative securities in the Zimbabwean economy.

Abstract

This report seeks to highlight the need for a derivatives exchange market in the Zimbabwean economy as a panacea to strengthen its financial sector. It is believed that use of derivatives can help stabilize the economy and also enhance its growth.

Introduction

The corporate use of derivative financial instruments such as forwards ,futures, options and swaps has been subject to rapid growth in terms of the extend use and complexity of the instruments used, Barnes (2001).

It is said that there is a common relationship between the financial market and economic growth, Bonga (2010). Thus asset manager need to be in a market where they are able to actively manage and devise mechanisms that promote fund growth and also manage the risks they are exposed to, Njanike (2015).

Derivatives are defined as financial instruments whose value is derived from the value of one or more underlying things like commodities, precious metals, currency bonds etc.

, since the value of these is linked to various other securities in the market, they are considered to be risky.

Examples of derivatives include Futures, Forwards, Options and Swaps.

Before taking the above different derivatives into account we firstly need to understand how they work, especially in an economy of Zimbabwe since it is still a growing economy.

Let us consider a sweet shop that produces sweets on large scale having various operations around cities in Zimbabwe. Most of materials they use in their production are jiggery, sugar edible oils, colouring, flavouring, chocolate, coconut etc, The prices of these materials continuously change due to various economic and natural factors such as production of sugarcane, coconut etc.

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so in order for the Sweet shop to manage risk of high prices should enter into agreement with those who produce sugarcane and other materials at certain agreed price at a point in time. In future if the prices of these items rise above that price agreed in the contract the Sweet shop will benefit from differences between market prices and agreed prices. Hence if there are to be such derivatives exchange in Zimbabwe it will benefit sunshine industries and other SME’s in our economy.

Preconditions for establishing derivatives exchange in Zimbabwe

The following conditions are necessary for derivative market to function effectively and efficiently derivatives markets, conditions may include: stable inflation, free floating exchange rates, stable interest, a ready and consistent supply of commodities in case of commodities exchange.

There should also be legal and regulatory framework frameworks conductive to build liquidity in both primary and secondary markets of derivatives uncertainties in law can be a deterrent to investors. Without regulations derivative activity will be flourishing and by the time regulations are created, it might hinder development of these instruments. Clear taxation and accounting rules must govern derivative trading.

Types of derivatives

Forward Contracts

Forward contracts can be defined as customised bilateral contracts between counterparts where settlement takes place in future on specific date at a price agreed today, these types of contracts are less liquid than future.

For example, a maize farmer who enters into a forward contract with a food processor to deliver 100 000 tonnes of maize for $250/tonne on September 2019. With an assumption that cost of growing maize is $200 per tonne. Contract like this will benefit both sides, the farmer is assured of a buyer at an accepted price also the processor because he/she now knows the price in advance this helps the processor to reduce uncertainty in planning. If the spot price increases on delivery the farmer will miss profit opportunity. Where spot price refers to the cash price of the same commodity or financial asset presently. On the other hand, if price declines the processor will be paying more than what would be. Thus, forward contract limits risk and potential rewards ideal for hedging purpose.

Forward contracts involve a specific seller delivering an asset to a specific buyer at a fixed future on specific future date, problem only arises when one fails to perform their obligation. For example, when we take into account the above example the processor may become bankrupt or the might bust by failing to harvest 100 000 tonnes. Either way the price moves the farmer or the food processor has an incentive to default.

Futures

A futures contract is a contract between two parties with an intermediary involved, the futures exchange. The contract requires one of the parties to agree to make delivery of a commodity or financial asset and the other party to take or accept delivery of the same commodity or financial asset. To be more precise, a futures contract allows a trader to undertake a contract to either make (deliver) or take (accept) delivery of a commodity or some kind of financial asset in the future on a known date, under specified conditions, also effectively for a price contracted today. (Evans, 2013)

The party to the contract who is agreeing to take delivery of the commodity or underlying asset is long in the position, whereas the party who is agreeing to deliver the commodity or underlying asset is short in the position. A speculator will benefit when she is long if the price rises, short if the price falls.

Difference between Futures and Forwards

Futures contracts they differ from forwards in numerous ways, firstly there are traded on clearing house rather than over the counter market, leading to more exact price determination secondly establishment of clearinghouse means sellers and buyers no longer trade face to face. Instead as an option market, the clearing house acts as a seller to buyers and as a buyer to all sellers, thus credit risk inherent in forward contracts is minimised and investors can concentrate on price movements. Thirdly futures are standardised instruments they lay down quantity of a commodity to be delivered, and that the commodity meets the quality standards at predetermined places and dates. This is totally different with forward contracts where the only requirement is consensus. Also, future contract gains and losses are marked to market daily based on settlement price to indicate investors gain or loss. Settlement price is the mean of prices at which the contract traded immediately before the bell signalling the end of trading for the day.

A position can be closed off/set off by entering into reversing trade to the original one. An investor who is long on futures contract can close out the position by reducing a contract. The ease of offsetting a position is one benefit of having a clearinghouse which will simply cancel offsetting position from its books, majority of futures contracts are closed out this way rather than having the underlying asset delivered. In contrast forward contracts are meant for delivering.

For example, considering a farmer who sold short maize futures and later noticed that maize growing cost has escalated. He can offset his short futures position to reduce losses. Let’s say another farmer faces a setback that the maize crop harvest is going to differ from anticipation of 100 000 tonnes. Since the maize futures trade let’s say in a standard quantity of 5000 tonnes, 20 contacts would have been sold to cover the anticipated tonnes. If now 80 000 tonnes appear to be available then the farmer can offset (20 000 tonnes) 4 contracts. This flexibility is not available in forward contracts.

Hedging a forward and futures

Hedging with a forward is simple because the contract can be tailor made to match maturity and size of the position to be hedged. For example, suppose you the manager of an oil exploration firm, you have just discovered oil. You can have expectations that in six months’ time you will have one million barrels of oil but you are not sure about the future price of oil and you would like to hedge your position using a forward contract by selling forward one million barrels of oil. Thus, in this case you are aware of what you will receive months from now.

On the other hand, hedging a forward contract has one problem, this type of a contract is less liquid. Hence if after a month you discover that there is no oil there you no longer need the forward contract, in fact if you just hold the contract you will be exposed to risk of oil prices. In this case you would want to unwind your position by buying back the contract, given the illiquidity of forward contracts this may be difficult and expensive. To prevent illiquid problems with forward market one may prefer to use futures contracts.E.g from the above example you can sell one million barrels worth of futures, suppose the size of one futures contract is one thousand barrels then the number of contracts to sell will be one thousand. Since the futures are standardised, they may not match your hedging need perfectly. When hedging with futures contract there might be discrepancies in maturity, contract size and in the asset. Thus, a perfect hedge is available only when the maturity of futures matches that of the cashflow, when the contract is of the same size as the position to be hedged and also when cashflow being hedged is related linearly to the futures. In the event of a mismatch between the position to be hedged and futures contract, the hedge might not be perfect.

OPTIONS

According to ASX limited an option is a contract between counterparts giving the taker (buyer) the right, but not the obligation, to buy or sell a security at a predetermined price on or before a future date. To acquire this right the buyer pays a premium to the seller of the contract.

Call option

Call options give the buyer the right, but not the obligation, to buy the underlying shares at a future price, on or before a predetermined date. For example, Saints Limited (STO) shares have a last sale price of $6.00. An available three-month option would be an STO three-month $6.00 call. A taker of this contract has the right, but not the obligation, to buy 100 STO shares for $6.00 per share at any time until the expiry*. For this right, the taker pays a premium (or purchase price) to the writer of the option. In order to take up this right to buy the STO shares at the specified price, the taker must exercise the option on or before expiry. On the other hand, the writer of this call option is obliged to deliver 100 STO shares at $6.00 per share if the taker exercises the option. For accepting this obligation, the writer receives and keeps the option premium whether the option is exercised or not.

Put Option

Put options give the seller the right but not the obligation to sell the underlying shares at a predetermined price on or before future date. The seller of a put is only required to deliver the underlying shares if they exercise the option. Example, an available option would be an STO three month $6.00 put. This gives the taker the right, but not the obligation, to sell 100 STO shares for $6.00 per share at any time until expiry. For this right, the taker pays a premium (or purchase price) to the writer of the put option. In order to take up this right to sell the STO shares at a specified price the taker must exercise the option on or before expiry. The writer of the put option is obliged to buy the STO shares for $6.00 per share if the option is exercised. As with call options, the writer of a put option receives and keeps the option premium whether the option is exercised or not.

If the call option or put option is exercised, the shares are then traded at specified price. This price is called the exercise or strike price. The closing or last date when an option can be exercised is called expiry day. There are two different exercise styles, American style and European style. American style means the option can be exercised at any time before the expiryand European stylemeans the option can only be exercised on the expiry day.

Advantages of option trading

Risk and tome to decide

Put options help manage risk, because they allow you to hedge against a possible decrease in the value of shares you hold. On the other handtaking call options gives you time to decide, in the sense that the purchase price is fixed. This gives call options holder until expiry to choose whether or not to exercise the option and purchase shares. Likewise, the buyerof the put option also has time to decide whether or not to sell the stock.

Speculation

Options can be traded without intentions of ever exercising due to its ease of trading in and out of an option position. In option trading you may decide to buy call option if you expect the price to increase or you can decide to buy put option if you expect the price to fall. Either way you can sell options before expiry to take a profit or to limit a loss.

Leverage

Leverage provides the potential to make high profits from a smaller initial outlay than investing directly. Usually leverage involves more risk than investment in underlying shares. Trading in options can allow you to benefit from price changes of shares without having to pay the full share price.

Diversification and income generation

Options can allow you to build a diversified portfolio for lower initial outlay than purchasing equity directly.

SWAPS

Swaps contracts are financial derivatives that allow two transacting agents to swap revenue streams arising from some underlying assets held by each party. For example if Datlabs borrowed money from Ecobank (ZWL) but wants to do business in South Africa (SA). Datlabs revenue and costs are in different currencies. It needs to make interest payments in ZWL whilst it generates revenue in ZAR. However, it is exposed to risk emanating from the fluctuation of the ZWL/ZAR exchange rate.

Datlabs can use ZWL/ZAR currency swap to hedge against the risk. In order to complete the transaction, the Datlabs need to find someone who is willing to take other side of the swap, e.g. it can look for SA company that sales its products in Zimbabwe. It should be clear from the structure of the currency swap that the two transacting parties must have different views on the market movement of the ZWL/ZAR exchange rate.

These swaps can be interest rate swaps, currency swaps and hybrid swaps.

Advantage of Derivatives

Leverage

This is the ability to make abnormal profits in derivatives than in case of primary securities or mutual funds.

Manages Risk

Derivative contracts help to hedge the risk of high prices in the future. A hedge is an investment position intended to offset potential losses / gains that may be incurred by a companion investment. It is also used for protecting ones capital from the effects of inflation through investing in bonds and shares which are high yielding financial instruments

Increase market liquidity

One of the major strengths of derivatives is their nature of liquidity, which means their ability to be converted to ready cash. Futures contracts can be an answer to the long liquidity crisis the Zimbabwe financial system has been facing as buyers and sellers can agree to trade an underlying asset at a future date at a certain price.

Disadvantage of derivatives

High Volatility

Since prices of derivatives are based on certain underlying assets like commodities and stocks, they are exposed to high risk. Majority of these derivatives are traded on open markets, and the prices of the underlying assets will be continuously changing in nature, hence making then very risky that they can lose their value.

Requires Expertise

Unlike mutual funds or shares where one could manage them with limited knowledge relating to his sector of trading, derivatives are challenging to sustain in the market without expert knowledge in the market.

Contract life

Derivative contracts have a limited life, as time passes they deplete in value, so one may even have chances of losing completely within that agreed time frame.

Conclusion

The Zimbabwean financial sector is still not trading in derivatives security, yet Zimbabwe Stock Exchange is among the oldest and largest in Africa. The Johannesburg Stock Exchange is the only one in Africa that offers derivatives. This shows that a lot has to be done in the continent to boost investment and help firms manage market risk and all other risks that needs derivatives for efficient management. (Wellington G. Bonga, Jul. – Aug. 2015)

References

  1. Bojan, L., 2015. ReasearchLeap. [Online] Available at: www.researchleap.com/necessity-of-the-establishment-of-a-financial-derivatives-market-in-bangladesh/amp/[Accessed 21 August 2019].
  2. Chikoko, L., 2007. Are derivatives better dead or alive in Zimbabwe?. The Dyke, Volume 3.1, pp. 48-49.
  3. Evans, G. R., 2013. Chapter 10 Futures Contracts. First ed. s.l.:s.n.
  4. Evans, G. R., 2015. Future Contracts. In: Economcs 104 Financial Economics. s.l.:s.n., pp. 1-21.
  5. Limited, A., 2018. Understanding Option Trading, Sydney: ASN limited.
  6. Ritchken, P., 1999. Option markets. [Online] [Accessed 13 August 2019].
  7. Shapiro, A., n.d. Foundation of Finance. [Online] [Accessed 21 August 2019].
  8. Tsetsekos, G. & Varangis, P., 2000. Lessons in Structuring deerivative exchange. The world Research Observer, Volume 15, pp. 85 – 97.

Cite this page

The Need for a Derivatives Exchange in Zimbabwe. (2019, Dec 09). Retrieved from http://studymoose.com/the-need-for-a-derivatives-exchange-in-zimbabwe-essay

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