Equity-based investments simply the best
Introduction PREVIOUSLY, most Zim-babwean investors preferred investing their money in risk-free investments in which they did not bother themselves with the investment’s risk
As the economic situ-ation worsened with inflation rocketing to unprecedented levels, risk-less investments like the money markets became unattractive and returns fail to match inflation.
In light of this scenario we have seen people shifting their attention to equity-linked investments, which though risky are able to match and at times outstrip inflation growth. One such avenue was through derivatives.
These products have generated an insatiable interest among Zimbabweans although most of them still wonder what they really are.
What are derivatives?
A derivative is a fina-ncial instrument whose value depends on the value of some other underlying asset be they commodities or equities.
What makes these instruments unique is that they are agreements between two parties to trade an underlying asset at a date in the future in contrast with most investments, which are issued by a borrower to an investor in order to raise money.
Derivative products, which include forwards, futures, swaps and options, have become a standard risk management tool that enables risk sharing and thus facilitates the efficient allocation of capital to productive sectors.
Types of derivatives
Forward contracts – this is an agreement between two parties under which one agrees to buy from the other a specified amount of an asset at a specified price on a specified future date.
For instance a farmer can enter into a contract with a miller in which the farmer undertakes to sell say 100 tonnes of wheat exactly 60 days from now at $200 000/tonne.
The two have different obligations in the contract where the seller is expected to deliver and the buyer is expected to honour the contract and pay for it.
This applies to any commodity, be they financial or real products.
A futures contract is more like a forward agreement besides that with the former; an organized exchange interposes itself between the buyer and the seller.
More so, futures in-clude a standard qua-ntity of a specified commodity or financial instrument.
The Zimbabwe derivatives market is still in its infancy and products like futures, which require organised exchanges, are not yet tradable.
Some derivatives pro-ducts allow people to exchange a series of payments for example interest payments.
Let’s say X has a fixed interest rate obligation, which he got at a lower rate owing to his good credit rating. Y who cannot secure a similar amount at a rate as low as X’s probably because of a poor rating can take a floating interest rate obligation.
The two can enter into an arrangement where X pay Y’s interest outlays while Y also undertakes to pay X’s fixed interest outlays.
The arrangement is called a swap agreement, which can either be based on interest rate or currency. Please note that the two swap interest payments and not the principle amount. However these are possible where interest rates are not suppressed by the authorities.
Similarly currency swaps require a proper and realistic foreign currency rate policy.
The current Zimbabwean situation cannot adequately support the implementation of these agreements.
An option is a contract, which conveys to its holder the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) part of an underlying security at a specified price (the strike price) on or before a given date (expiration date).
After this given date, the option ceases to exist and the contract is said to have expired. It is worth noting at this stage that unlike swaps only one part is obligated under an option contract, in this case the setter (also known as the writer) who should sell or buy at the specified price upon the buyers request.
Also note that options can be written on an instrument such as a Treasury Bill or Bankers Acceptances for example.
However, the Zimbabwean market is currently dominated by options on shares.
Advanced markets like the London and New York derivatives markets have some complex products like captions and swaptions, which are a combination of, say swap and option or an option on option.
This article is however restricted to more conventional products, which are currently offered in Zimbabwe.
Economic functions and benefits of derivatives
The core function of the financial system is to facilitate the allocation and development of economic resources, both spatially and across time in an uncertain environment. Financial markets, institution and instruments like derivatives constitute the major elements of the financial system.
Derivatives provide probably the most efficient allocation of economic risks. An exporter can hedge his receipts in foreign currency with currency put options or by selling currency forward or futures contracts.
A portfolio manager can hedge against overall stock exposure by selling index futures contracts. Similarly, a financial institution hedges the interest rate gap between assets and liabilities by either buying or selling interest rate swaps.
In order to enhance the full risk return investment spectrum, portfolio management strategies require diversification.
Derivatives significantly reduce the cost of diversification and leverage.
More interestingly de-rivatives in themselv-es facilitate diversification, given that the investment represents only a fraction of the cash instrument, it is easier to diversify a given amount of capital across several assets.
Additionally derivatives often give access to asset classes, which are not available as financial investments otherwise, for example oil, coffee, and wheat.
Derivatives also benefit the economic system in information gathering. Basically risk and uncertainty are a function of information asymmetry.
Derivatives help to reveal new information, which is otherwise unavailable in the cash market, for example information about the volatility expected by individuals.
Successful asset and portfolio management rests on availability of such information.
It thus very clear that derivatives play an important role to individual investors and the economy at large.