Currency futures signal big growth for Africa forex market

The forex markets were pretty volatile since the start of the week beginning September 6 soon after the Labour Day holiday.

The key reason was the Wall Street Journal’s story that claimed some European banks involved in the summer’s “stress tests” had understated their exposure to sovereign debt.

As a result, the Japanese Yen rose to 83.52 per dollar in New York, its strongest level since May 1995.

The Swiss Franc rose to a record SFri 1.2840 against the Euro.

Rising Yen had sent jitters to the financial markets and the Nikkei 225, Japanese benchmark index started tumbling down on September 8 as the rising Yen threatened Japanese corporate earnings.

Analysts have already started revising the sales and profit forecasts.

The ripple effect was felt in the commodities market as well; crude oil and metals were down, gold was near record high (due to haven appeal) at US$ 1259 per ounce.

In the globalised world, any impact in the currency market is ultimately having a direct impact on the economy.

According to Bank for International Settlements latest statistics, the Global foreign exchange market average daily turnover was around US$ 4.0 trillion in April 2010 compared to US$ 3.3 trillion in April 2007.

Forex market is the most liquid market in the World; in fact the average daily turnover is slightly more than the combined annual GDP of emerging economies like India, Brazil and Russia. The market participants are the central banks, commercial banks, other financial institutions, corporate houses, government bodies, currency speculators and individuals.

Going forward, the daily turnover is more likely to increase due to rise in currency fluctuations.

Last month, President Nicolas Sarkozy (G 20 Leadership Agenda) had mentioned about proposing measures to curb currency fluctuations.

In his annual speech to French diplomats at the Elysée palace the President said “Who could challenge the fact that exchange rate instability poses a vital threat to global growth?”

According to World Trade Organisation, world trade is set to rebound in 2010 by growing at about 9.5 per cent.

Foreign exchange market activity became more global with cross–border transactions representing 65 per cent of trading activity.

The trade between countries involves the mutual exchange of different currencies.

The US dollar dominates about 85 per cent of the share of foreign exchange transactions and in terms of market turnover by currency pair, the EUR/USD remained by far the leading pair followed by USD/JPY and USD/GBP.

In the forex markets, there are two kinds of exchange rate transactions.

The predominant one, called spot transaction involves immediate exchange of currencies, the average daily spot turnover rose to about $1.5 trillion in April 2010 compared to $1.0 trillion in April 2007.

The other option is a forward transaction or a forward contract, which is the simplest type of derivative.

Trading activity in these instruments continued to expand, average daily turnover stood at about $2.5 trillion in April 2010.

Forward contract

In a forward contract, two parties undertake to complete a transaction at a future date but at a predetermined price fixed today.

The two parties could be an exporter who promises to supply US$ (underlying asset) and a bank who needs the US$ or can be an oil company or a multi national corporation.

To simplify, let us say a horticulture exporter in Kenya expects to receive US$50 million from US in three months.

On the other hand, a local private bank needs US$ 50 million to finance their offshore clients.

Both the parties are exposed to currency fluctuations, while the exporter’s Economic Research head feels US$ could appreciate, the treasury head from the bank feels that US$ could depreciate.

Since both parties face risk in the opposite direction, it would be logical for both the parties to meet, negotiate and agree on a price at which the transaction can be carried out in three months.

Once they meet up and agree upon (for example, formalised and documented) we have a Forward Contract.

In fact, the benefits for both the parties are that they have eliminated all price risks.

The exporter now knows the exchange rate which he will receive for his US$ regardless of what happens to USD/KES exchange rate, the same is the case with the banker.

He has eliminated the exchange rate volatility since he will only have to pay the agreed rate regardless of spot prices in the next three months.

There is an added benefit: since both parties have “locked-in” their exchange rates, they would be in a better position to plan their business activities.

In view of these shortcomings, markets developed a new instrument that would provide the risk management benefit of forwards while simultaneously overcoming its problems.

The resulting innovation was the Futures Contract.

A Futures Contract is essentially a standardised Forward Contract.

The standardisation is with respect to the contract size, maturity period, delivery etc.

With standardisation, it was possible to trade them on an exchange-which in turn increases liquidity and therefore reduces transaction costs.

In addition, since all buyers and sellers transact through the exchange, the problem of double coincidence of wants is easily overcome.

One would transact in futures contract maturity closest to needed maturity and in as many contracts as needed to fit the underlying asset size.

With exchange trading, the second problem with forward contracts, that of being possibly locked into an unfair price would not exist.

This is because each party is a price taker with futures price being that which prevails in the market at the time of contract initiations.

As exchange quoted prices are market clearing prices arrived at by the interaction of many buyers and sellers who are anonymous, the prices would be by and large ‘fair ’.

The problem of counterparty risk does not arise in futures contract because the exchange being the intermediary, guarantees each trade by being the buyer to each seller and seller to each buyer.

What this means is that each party transfers the counterparty risk of forwards on to the exchange in case of futures contracts.

The transfer of risk to the exchange by parties to the futures contact has to be managed by the exchange, which now bears the risk.

The exchange minimises the potential default risk by means of the margining process and by daily marking the position to the market.

The basic idea behind the margining and marking to market process is to reduce the incentive to default by requiring initial deposits (initial margins), recognising losses as they occur and requiring the party whose position is losing to pay up as the losses accrue (margin calls).

Changing dynamics

In the past couple of years, the changing dynamics of global forex markets have taken its toll on the Kenyan shilling as well.

The shilling had experienced a great deal of volatility vis –a vis the US dollar as well other major currencies.

Rising volatility will make short term as well as long term planning difficult.

However, one should also keep in mind that the scenario (volatility) is not going to change immediately.

To mitigate the risk one needs to hedge his currency risk using currency derivatives and for that you need a currency futures market.

Across the world all advanced countries as well as most of the emerging economies have catered futures market to its market participants.

So far the currency futures markets were not available in African continent except South Africa.

But all this is set to change; the Global Board of Trade based out of Mauritius will start operations in October and enable importers, exporters, banks, corporate houses, government organisations and individuals to hedge their currency risks at low transaction costs through its proposed offerings in various African currency futures.

Perhaps, the dawn of currency futures could be a momentous development in the foreign exchange market in Africa.

It represents a massive stride ahead in the continuing globalisation of the Africa’s financial markets.

But one should also keep in mind that financial derivatives are powerful tools; it should be handled by careful and competent financial managers.

They are not mechanism or tools to make profits; rather they could curtail losses.

Profits may be a byproduct at best. Futures market if used recklessly can also be very destructive devices.

Africa is, thus set for a landmark development which will stimulate further foreign trade and investments while ensuring good risk mitigation.

Dr Narayanan is an Economist, Global Board of Trade and Mr Khapre is CEO, BDO East Africa. The views expressed in this paper are solely those of the authors and do not necessarily reflect those of the organisations for which they are working.