The establishment of a second similar modeled derivatives exchange market in Sub Saharan Africa to that of the Johannesburg Stock Exchange (JSE) Derivatives Market, is likely to give the Nairobi Bourse a much needed liquidity boost, with market capitalization expected to hit Kenya Shillings 1 billion over the next three years.
The highly anticipated launch of a derivatives exchange on the Bourse is expected to strengthen the product portfolio of the Nairobi Securities Exchange (NSE) by allowing listings of instruments like future contracts and options letting investors cushion themselves against interest rate fluctuations, exchange rate volatility and commodity price changes.
The trading of such complex instruments like futures contracts and options which hedge against risk, require proper guidelines and stringent monitoring to avoid financial crisis as seen in more developed countries in the recent past. The NSE had delayed an earlier launch of the derivatives market as it conducted benchmark studies of other countries with successful derivatives markets to ensure that the regulatory framework was aligned with international standards. It has also attempted to achieve a seamless transition by conducting a simulation of the current trading system with all concerned stakeholders as well as providing training for all members, dealers and clearing banks as per international standards.
So with all the fuss being made on the launch of the Derivatives Exchange, what can investors expect to gain out of these complex instruments?
Large scale losses associated with the use of derivatives on other global derivatives exchanges has led to fear among local investors and analysts alike, that derivatives trading is a very risky activity that could lead to widespread disruption of the Kenyan financial system.
What sometimes gets lost in these prevalent discussions about derivatives related losses are the benefits that derivatives instruments provide to investors and the economy as a whole.
Derivatives instruments such as options, forwards and futures will provide both local and foreign investors with opportunities that are currently not available in the Kenyan financial market. These instruments will aid in the allocation of risk for investors and will lower the costs of their diversifying portfolios, as derivative pricing will reveal information to investors that will make the financial market more stable.
At first glance, the economic benefits of a derivatives market might not be apparent, as derivatives are zero-sum monetary transactions – the amount paid by one side of the contract is the amount received by the other side. When a contract expires, the gains and losses completely offset each other. But even though these derivatives represent zero-sum monetary transactions, they need not represent zero-sum economic gain. Investors who will use derivatives instruments will do so to hedge, speculate or leverage.
Investors who will hedge risks with derivatives instruments will also be able to transfer risks from themselves, if they are unwilling to bear the risks, to other investors better able or more willing to bear them. In this regard, derivatives will help allocate risks efficiently between different individuals and groups within the local economy.
Investors will also be able to use the derivatives instruments to engage in speculative activity. Speculators who want to take a position in the market will be betting that the price of the underlying asset or commodity will move in a particular direction over the life of the contract.
The use of forward contracts for speculation will provide investors with an advantage over actually buying an asset and holding it because neither party will put any money up-front when entering into the forward contract. Thus, the forward contract will give investors much more leverage than buying the underlying asset in the cash market.
While speculation may seem to be no more than gambling on future price movements, speculators will play an important role in the Kenyan economy because they will provide liquidity. This liquidity will enable other investors, who may be using derivatives to hedge risks, to more easily buy and sell derivatives contracts.
Lastly, derivatives contracts such as options also aid in risk allocation because of the cheap leverage opportunities they provide to an investor. I have already hinted at the leverage obtained by using forward contracts. Leverage will come about because no cash will be put up at the time the parties enter into the contract.
Is leverage a good thing for Kenya’s financial markets? Generally, yes, because leveraged positions will give investors access to risk-return exchanges they otherwise would not have. Broadening the available choices on the Kenyan financial market will help local investors especially, to curb risk per their own investment portfolios while leveraging relatively small amounts of funds over a wide class of assets and thus diversify their portfolios.
The introduction of derivatives on the Nairobi Securities Exchange (NSE) will deepen the equities market and is likely to attract higher foreign inflows into the Kenyan market. The NSE is expected to roll out the derivatives exchange based on cash settlements which will be easier to run. The derivatives exchange will eventually move on to an asset-based settlement in the future and is expected to show tremendous growth over the next three years.
While much has been made of derivatives losses globally, the economic benefits expected to be provided by derivatives instruments for the Kenyan financial markets are much more significant. Derivatives will provide information to financial market participants and may help reduce overall market volatility. Hedging, speculation and leveraging will also help the economy achieve an efficient allocation of risk while assisting in boosting the liquidity of the market, providing local investors with exciting new investment opportunities in the years ahead.
Written by Shazmir Dhanji
Disclaimer: The views and opinions expressed in this article are my own and do not necessarily reflect those of the publication for which I write.