Financial derivatives have changed the face of the financial markets by creating new ways of understanding and measuring risks.
Derivatives offer firms the chance to turn financial risks into smaller components then to buy and to sell those components to better meet the specific risk management objectives.
Zimbabwe operates under a market oriented approach thus derivatives allows the free trading of the individual risk components thereby improving market efficiency, although the underlying risk is not completely eliminated, it results in a redistribution of risk which offers greater robustness, if risk takers able to handle risk.
Derivatives should be considered as part of any business risk management strategy so that value enhancing investments opportunities can be exploited.
In Zimbabwe where interest rates are difficult to predict as far as their future direction is concerned, derivatives reduce uncertainties, thus making it possible to initiate productive activities that might not otherwise be pursued.
A case example could be a Zimbabwean farmer who may wish to produce wheat but is concerned about the future prices of the commodity and the whether the market will buy the harvest.
To ensure that such uncertainties do not exist, the farmer in question would devise prudent risk management strategy that goes hand in hand with the broader farm objectives of selling all his produce at a good price.
A part of the strategy could mean the farmer could be entering into futures contract on a commodities market to hedge against the risk of an adverse movement in the future prices of his commodity.
Derivatives enable end-users to manage and reduce their inherent risk exposures effectively, thus permiting them to focus on their core businesses.
The ability to manage and reduce risks ultimately leads to stronger long run economic performance. If derivatives did not exist, economic agents would be more hesitant to make long-term investment and production decision, as they would be unsure of the future price movements.
Zimbabwe is a country blessed with natural resources especially in the form of minerals.
A large proportion of the foreign exchange receipts can be attributed to sale of minerals in foreign markets, as volatility rises on the world markets, prices of such minerals are not stable which poses risks to producers of such commodities.
To hedge against such risks, it is important for Zimbabwean firms to enter into derivatives market where risk is transferred to someone willing to accept it.
This does not mean to shift away the risk from the mining firms but also guarantees the country of a reasonable amount of foreign exchange. Firms would be able to lock in a guaranteed return no matter the price levels of the commodity in the future.
Derivatives markets help to improve the liquidity in the underlying asset markets by bringing hedgers and speculators together. The ability to hedge leads to investors and traders taking bigger positions and be more active in the underlying market.
Derivatives are windows into market expectations, thus could be exploited for information about future price expectations for various types of financial assets and important commodities.
This is useful for regulators and policy makers when assessing the health of the financial system and the appropriateness of a monetary policy stance.
A example being currency and interest rates swaps and futures prices which contain valuable information about the outlook for the economy and the tightness of monetary conditions, which are very useful to central banks when making monetary policy decisions.
In Zimbabwe there is no proper regulation law in fact derivatives securities were banned after the collapse of the banking system in 2003.
Derivatives if left unregulated can pose serious risks challenges such as liquidity risk and counterparty risk which cause substantial losses that can harm the entire economy. Derivatives are off balance sheet items and if left unregulated can result in Zimbabwe suffering another financial crisis.
Derivatives cannot survive in a market where its players are unwilling to take risk as derivatives are risky financial instruments. Implementation of Derivative security exchange can result in failure of the entire banking system and affect the whole financial system. Market makers are risk averse and not willing to bear the risks associated with derivatives.
The Reserve Bank of Zimbabwe was a major player in derivative securities where it traded in derivatives like currency swaps between 2003-2004. The reserve bank would give gold in exchange for foreign currency.
Through the use of the Homelink initiative the RBZ would mortgage loans to citizens in the diaspora who in turn would pay back the loan with foreign currency. The Reserve Bank was not successful in trading in derivative securities and this led to a ripple effect on the banking sector in the form of failure of Trust Bank and Renaissance Bank.
Once these banks closed consumer confidence was at an all-time low and still affects the banking sector to today, this can be seen through the lack of cash deposits from consumers as they were once badly affected by ripple effect of derivative securities.
The banking sector does not have sufficient know-how or knowledge to trade in derivative securities, as they have major risk challenges that can negatively affect the whole economy.
Very few people are qualified and experienced to implement derivatives securities in Zimbabwe. Due to the complexity of derivatives it is required that managers that have the required skills and experience supervise and target the actual risk levels associated with derivative securities, yet few people understand finance and the models involved.
When used properly, derivatives can help organisation to meet their risk management objectives so that funds are available for making worthwhile investments.
In an inflationary and volatile environment like in Zimbabwe where returns on investments by shareholders are to a large extend negative, derivatives can increase shareholder’s value by means to provide a better means to control a firm’s risk exposures and cash flows.
Hedgers and speculators would be brought together which improves liquidity of the underlying asset among other things. All these would have a positive impact on the economic system.
Blessing Nyatanga holds a Bachelors Degree In Banking and Investment Management from NUST. He writes in his own capacity and his views and opinions do not represent the views and opinions of Business Weekly and Zimpapers. Mobile : 0784909184 or Email: [email protected]