This market is not well developed in this country
By CPA Justus Musila
A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic, underlying variables. The underlying variables are financial assets such as bonds, equities, monetary exchange rates and interest rates. Derivatives include forward and future contracts, swaps, and options.
Derivatives are tools at the disposal of a finance manager to manage a wide range of financial risks. There is an argument that derivatives date as far back as 1700 B.C during bible times at the period when Jacob had to purchase a 7 year option to marry Laban’s daughter, Rachel. Laban, however defaulted on the derivative and Jacob had to purchase another 7 year option and he eventually married Rachel (Chance, 1995).
Derivatives are traded in either an over the counter (OTC) market or an exchange market. The derivatives
exchange is one where there is trade of standardized contracts as defined by the exchange while in OTC markets, the participants ink the deals as mutually agreed. Derivatives markets started off in 1848 with Chicago Board of Traders, established to bring farmers and merchants together.
Since then, derivative markets which are diverse and robust and trading in a wide range of underlying variables currently including credit derivatives, electricity derivatives and weather derivatives are spawned across the globe. Globally trading volumes (number of contracts traded) in OTC derivatives have increased to over 46 billion contracts in 2020 as reported by World Federation of Exchanges.
According to International Swaps and Derivatives Association, ISDA (2022), the notional value (the number of contracts multiplied by the contract’s underlying value) of OTC derivatives traded is $606 trillion at the end of 2021 while the Bank of International Settlements, BIS reported that a gross value (absolute value of all outstanding derivatives values) of $12 trillion OTC derivatives were traded by close of 2021.
In 2020, the Americas region accounted for 42.8% of all exchange traded derivatives volumes, the Asia Pacific (APAC) region 41.5% and the remaining 15.7% was traded in Europe, Middle East and Africa (EMEA) region. It is noteworthy to state that World Federation of Exchanges has only one African exchange participating – the Johannesburg Stock Exchange.
Several African countries require to integrate their derivative exchanges with both regional and global
derivatives exchanges to benefit from both economies of scale and capital inflows. The derivatives markets are yet to be developed in Africa despite a 2018 declaration in Arusha for African countries to develop mechanisms to cushion farmers from commodity price risks.
The Arusha declaration inclined towards commodity derivatives because most African economies are agriculture based. A large proportion of investors in South Africa use derivatives to hedge against Equity, foreign exchange and interest rate risks as evidenced by $500,000 notional value of equity, currency and interest rate derivatives traded in 2020 according to World Federation of Exchanges 2020.
It was reported that some countries like Botswana and Zimbabwe have attempted to develop both commodity and financial derivatives markets but they have failed after a few years of operations
In Kenya the Nairobi Securities Exchange Derivatives market, NEXT, the second in Africa after JSE was launched in 2019 and has two derivatives trading. These are; equity index futures and single stock futures. The derivatives market registered a turnover of KES 24.9 million in 2021 an impressive growth of 621% since inception in 2019. There is evidence of OTC derivatives in Kenya, but the trading volumes andtrading values are not public.
There is a demonstration of the existence of over the counter derivatives for hedging financial risks inKenya for some time now. The OTC instruments in Kenya include forwards and swaps for hedging interest rates, currency and equity risks. A few companies also use commodity derivatives for hedging, for example, Kenya airways is reported to have been hedging on jet fuel prices.
Finance theory affirms that financial risk is mitigated by use of financial derivatives. The use of financial derivatives to mitigate financial risks has been extensively exploited in the Americas region, Asia Pacific region, Europe and Middle East Regions. Africa region is lagging in the use financial derivatives for hedging financial risks.
There are two derivatives markets in Africa and only the South African JSE has considerable trading volumes since the Kenyan NEXT is relatively young with low trading volumes. Kenyan firms and investors face financial risks which include foreign exchange rate risk, interest rate risks, equity risks liquidity and credit risks.The Kenyan economy is more open to international trade exposing Kenyan firms to foreign exchange rate variations, and interest rate fluctuations which require mitigation mechanisms.
Although both firms listed on NSE and those not listed have extensively and at varying proportions utilized financial derivatives for several years, the opportunities presented by derivatives markets are yet to be fully tapped. Kenya is an agriculture based economy and therefore various commodity derivatives should be available to help farmers and traders hedge against the inherent risks in the agricultural trade chain.
The derivatives market in Kenya is not properly developed and the players in the market are not well skilled in the operations of derivatives as evidenced by market skepticism and challenges in pricing and valuation of derivatives. The awareness about derivatives operations in the financial market in Kenya is also another factor hindering wide use of derivatives.
Further, some firms use derivatives in the short term for hedging due to costs associated with use of
derivatives. It has also been observed that some firms prefer to use other hedging tools like insurance for risk management.
Derivatives market in Kenya is on an impressive growth trajectory, but it needs to be nurtured andsupported. The development of this market should be promoted and awareness of derivatives operations should be availed to investors both individual and institutional. Training and skills development around derivatives operations will also be a key driver, enabling valuation of derivatives and unbundling of the full scale of derivatives operations.
The resultant increase in trade volumes is likely to push down the attendant costs. The NSE should integrate with larger securities exchanges in the region like South Africa’s JSE and other internationalexchanges to tap into capital flows and benefit from economies of scale. The full range of derivatives available globally should be rolled out gradually by additionally introducing commodities derivatives to take care of risks in the vibrant agricultural sector.