There was palpable excitement in the media or at least on this platform when Finsec announced its plans to launch a derivatives exchange with an automated system to allow for transparency. As promised then an article delving deeper into financial derivatives was necessary to help us understand the excitement, what exactly derivatives are and what they mean to us individually and Zimbabwe at large.
What are derivatives?
Derivatives are financial securities with a value that is reliant upon or derived (as the name suggests) from, an underlying asset or group of assets— we refer to this as the benchmark. A simple example can be drawn of an option. An option is a contract that gives a party the right but not the obligation to purchase or dispose of a particular specified item at a specified price. Imagine a situation where someone offered you an option to buy fuel from them at a price of ZWL$25 per litre. You would pay an amount for this right to buy the fuel, this can be a small amount such as $2 per litre. At current prices, this is not a good deal but with the magic of time ZWL$25 per litre becomes a bargain and the contract becomes valuable. This is one-way derivatives can be used. The example is simplified for your comprehension.
Now there are many benefits that can be presented by the existence of a derivatives market. Drawing examples from the real world I’m going to illustrate a few advantages of having a derivatives market that serves its participants well.
Hedging is a finance term that rather aptly means to protect a position. Say you held or expected to hold a commodity in the future such as gold. Based on your calculations selling the gold at a particular would be profitable for you but the markets are currently very volatile and the price when you can or intend to sell may not be the same. A futures contract would allow you to lock in a gold price and guarantee your profit from the deal.
If you required US dollars in order to finance a capital expenditure purchase in the future but you were unsettled by the volatility of your currency against the US dollar you could agree on a forward rate contract that would allow you to purchase the US dollars at a predetermined price. This is really useful for your planning and I’m sure Zimbabweans can easily relate to this example.
You know speculation has become a dirty word but speculators are a part of functioning markets, a very big part of them. Say you believed that though Econet shares are currently valued at ZWL$2.60 a share (Thursday 19th April) they will soon (within a month to keep it simple) trade for more than ZWL$30 a share. You then enter into an option contract to buy Econet shares at ZWL$30 per share (these are called call options). Within a week the Econet shares rise to ZWL$35 a share. You are free to exercise your call options at a profit of ZWL$5 a share assuming you sold them immediately.
What they mean for us
As described in the examples above derivatives give a variety of alternative uses for people in different positions in the markets. Ideally, they can easily help smooth business operations or make someone some quick cash. Ultimately whether the use of them is good or bad depends on a lot of factors in terms of perspective. What we know for sure is they are a sign of a more developed financial system and developed financial systems correlate with more developed economies. The illustrations above show how many can benefit from derivatives.
Examples of derivatives
While explaining the various benefits of derivatives I used practical examples each specific to a particular derivative instrument. Going through the instruments we can now learn a little more about the different types of derivative instruments.
Futures or Futures contracts are used for commodities. Examples of commodities traded in futures are crude oil, soya beans and pork bellies. Futures are contracts to perform meaning that the performance of the agreed future price is a must. In a futures contract, the buying party will usually pay a fee based on the amount of the contract.
Forwards, used in the second benefit illustration are used for rates such as interest or exchange rates. Currency forwards are very popular for the reasons outlined in the example. Like futures, the buyer generally pays a fee. One thing to note in both these cases is that the fee tends to take into account the volatility of the commodity so someone looking for a forward for say US Dollar to Zimbabwean Dollar will be required to pay heavily for the contract. This obviously impacts on the profitability of the contract
Are the most exciting of the derivative instruments because of just how versatile they can be. As illustrated in the benefit of speculation options are not obligations but rights to buy if you so choose to. Just to expand a little, options a split into call options (options to buy) and put options (options to sell), both at a specified price. So buyers and sellers can both use options to benefit. Options do also come at a fee paid by the option buyer to the option writer. They do also compensate for volatility. Interesting strategies can be entered into that combine call options and put options, one can enter into an option to buy something then write an option to sell the same thing and if things work out well benefit without having bought into the benchmark. A lot depends on the rules and regulations present in a particular exchange. Options are generally limited to 12-month duration. There are long term options that have durations longer than 12 months known as Warrants.
Swaps are contracts to exchange cash flows at different times or in different territories (currency swaps). These should sound familiar to you as Finance Minister Professor Mthuli Ncube announced they would be arranging these for Chinese entities in Zimbabwe or those who had dealings with Chinese entities. Swaps offer opportunities to avoid fees associated with foreign payments as well as the sometimes cumbersome regulation.
Now that you have some grasp on derivatives and their uses you can hopefully participate in the excitement that is associated with Finsec’s announcement of a derivatives exchange. Derivatives are complex financial instruments and trading in them is recommended with the aid of a financial broker.