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How derivatives help businesses to manage a set of financial risks

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A trader at the Nairobi Securities Exchange.
A trader at the Nairobi Securities Exchange. FILE PHOTO | NMG 

As volatility in equity markets this year demonstrate, the world continues to be a risky place. Fast-moving changes in foreign exchange and commodity markets have real impacts on stock markets, business confidence and economies.

These developments illustrate the continuing need for financial tools that can mitigate an escalation of the kind of uncertainty that can freeze investment and hiring plans. However, in the aftermath of the Great Recession, many people perceive derivatives in a negative light. My research and others demonstrates how the use of derivatives can improve economic performance.

Derivatives are specific types of instruments that derive their value over time from the performance of an underlying asset: eg equities, bonds, commodities. There are three main families of derivative contracts: options, futures, and swaps. They all have the ability to reduce risk; thus, are widely used for hedging purposes.

A derivative is traded between two parties – who are referred to as the counterparties. These counterparties are subject to a pre-agreed set of terms and conditions that determine their rights and obligations.

Derivatives are developed to meet a variety of financial market participants’ needs, the predominant one being the unbundling and efficient management of financial risks. Although derivatives seem complicated, their premise is really very simple: They allow users to pass on an unwanted risk to another party and assume a different risk, or pay cash, in exchange.

If you were to sell a call option, however, you would be giving someone else the right to buy the underlying security from you at the strike price.

If you sold a call option on a position you did not own, this could mean you’d be forced to go out and buy that security for a higher price in the market so you can sell it to the holder of the call option at the strike price. In this case, you have unlimited risk because the underlying security could rise to any price and you would still have to purchase it to resell it at the lower strike price. What’s more, you would have to purchase not just one share of the underlying security, but 100 shares to fulfil your obligation to the contract holder.

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Companies can lower funding costs and diversify funding sources through derivatives. A Kenyan company, for example, may decide to issue debt in Japan rather than in the Britain because of a slight difference in Japan and Britain interest rates; by arbitraging the difference in interest rates and using a currency swap (an agreement to exchange one currency for another) to obtain the funding in Japan Yen, the company lowers its costs.

Another major use of derivatives is to hedge interest rate or exchange rate risk. An issuer of fixed-rate debt who anticipates a general increase in interest rates can enter into a forward swap (an agreement to swap sometime in the future) to lock in the level of interest rates at the time the funding decision is made.

Similarly an issuer of floating-rate debt can eliminate the risk of rising interest rates by purchasing a cap, essentially fixing an upper bound on the rate the borrower will have to pay, no matter what market rates do.

Importers, exporters and companies that have significant overseas operations may find derivatives an ideal tool to manage exchange rate risk. A Kenyan exporter to EU who is expecting a fixed payment in euros could see profits disappear if the euro severely depreciates before the exporter gets paid.

Companies facing exchange rate risk can use currency swaps and foreign exchange forwards or options to hedge expected future cash flows from foreign transactions.

Although thousands of firms have successfully used derivatives to protect themselves from adverse shocks, others have made foolish bets that have cost them dearly such Kenya Airways. At the least, policymakers want to be sure that investors and regulatory authorities know when firms are using derivatives to speculate rather than to hedge.

For those wishing to speculate with derivatives, the message from investors and policymakers is pretty clear: We’ll be watching you. Derivatives have a stabilising effect on the economy by reducing the number of businesses that go under due to volatile market forces.

Hedgers use derivatives to reduce risk; however, their counterparts, called speculators, use them to increase risk. This is the dark side of derivatives, as they are sometimes considered legalised gambling tools.

Next, derivatives provide investors with signs and valuable information about spot markets. For example, the convergence of the forward price to the spot price at maturity provides useful information to market participants.

In addition, derivative markets over some operational advantages. Transaction costs are often lower and short-selling positions are usually easier than in cash markets. Economic and financial crises have had great impact on derivatives markets. Examples include the major stock-market crash in 1987, and the recent credit-risk crisis.

Consequently, derivatives markets suffered; however, investors’ confidence and growth were usually back. In sum, derivative markets contribute to making financial markets more complete and efficient. This suggests that firms do reduce cash flow risk and market risk significantly by managing with derivatives

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World Bank pushes G-20 to extend debt relief to 2021

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World Bank Group President David Malpass has urged the Group of 20 rich countries to extend the time frame of the Debt Service Suspension Initiative(DSSI) through the end of 2021, calling it one of the key factors in strengthening global recovery.

“I urge you to extend the time frame of the DSSI through the end of 2021 and commit to giving the initiative as broad a scope as possible,” said Malpass.

He made these remarks at last week’s virtual G20 Finance Ministers and Central Bank Governors Meeting.

The World Bank Chief said the COVID-19 pandemic has triggered the deepest global recession in decades and what may turn out to be one of the most unequal in terms of impact.

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People in developing countries are particularly hard hit by capital outflows, declines in remittances, the collapse of informal labor markets, and social safety nets that are much less robust than in the advanced economies.

For the poorest countries, poverty is rising rapidly, median incomes are falling and growth is deeply negative.

Debt burdens, already unsustainable for many countries, are rising to crisis levels.

“The situation in developing countries is increasingly desperate. Time is short. We need to take action quickly on debt suspension, debt reduction, debt resolution mechanisms and debt transparency,” said Malpass.

ALSO READ:Global Economy Plunges into Worst Recession – World Bank

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Kenya’s Central Bank Drafts New Laws to Regulate Non-Bank Digital Loans

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The Central Bank of Kenya (CBK) will regulate interest rates charged on mobile loans by digital lending platforms if amendments on the Central bank of Kenya Act pass to law. The amendments will require digital lenders to seek approval from CBK before launching new products or changing interest rates on loans among other charges, just like commercial banks.

“The principal objective of this bill is to amend the Central bank of Kenya Act to regulate the conduct of providers of digital financial products and services,” reads a notice on the bill. “CBK will have an obligation of ensuring that there is fair and non-discriminatory marketplace access to credit.”

According to Business Daily, the legislation will also enable the Central Bank to monitor non-performing loans, capping the limit at not twice the amount of the defaulted loan while protecting consumers from predatory lending by digital loan platforms.

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Tighter Reins on Platforms for Mobile Loans

The legislation will boost efforts to protect customers, building upon a previous gazette notice that blocked lenders from blacklisting non-performing loans below Ksh 1000. The CBK also withdrew submissions of unregulated mobile loan platforms into Credit Reference Bureau. The withdrawal came after complaints of misuse over data in the Credit Information Sharing (CIS) System available for lenders.

Last year, Kenya had over 49 platforms providing mobile loans, taking advantage of regulation gaps to charge obscene rates as high as 150% a year. While most platforms allow borrowers to prepay within a month, creditors still pay the full amount plus interest.

Amendments in the CBK Act will help shield consumers from high-interest rates as well as offer transparency on terms of digital loans.

SEE ALSO: Central Bank Unveils Measures to Tame Unregulated Digital Lenders

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Scope Markets Kenya customers to have instant access to global financial markets

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NAIROBI, Kenya, Jul 20 – Clients trading through the Scope Markets Kenya trading platform will get instant access to global financial markets and wider investment options. 

This follows the launch of a new Scope Markets app, available on both the Google PlayStore and IOS Apple Store.

The Scope Markets app offers clients over 500 investment opportunities across global financial markets.

The Scope Markets app has a brand new user interface that is very user friendly, following feedback from customers.

The application offers real-time quotes; newsfeeds; research facilities, and a chat feature which enables a customer to make direct contact with the Customer Service Team during trading days (Monday to Friday).

The platform also offers an enhanced client interface including catering for those who trade at night.

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The client will get instant access to several asset classes in the global financial markets including; Single Stocks CFDs (US, UK, EU) such as Facebook, Amazon, Apple, Netflix and Google, BP, Carrefour;  Indices (Nasdaq, FTSE UK), Metals (Gold, Silver); Currencies (60+ Pairs), Commodities (Oil, Natural Gas).

The launch is part of Scope Markets Kenya strategy of enriching the customer experience while offering clients access to global trading opportunities.

Scope Markets Kenya CEO, Kevin Ng’ang’a observed, “the Sope Markets app is very easy to use especially when executing trades. Customers are at the heart of everything we do. We designed the Scope Markets app with the customer experience in mind as we seek to respond to feedback from our customers.”

He added that enhancing the client experience builds upon the robust trading platform, Meta Trader 5, unveiled in 2019, enabling Scope Markets Kenya to broaden the asset classes available on the trading platform.

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