The first ever derivatives were traded on olive oil and grains as far back as 1750 BC. Sellers of these commodities were interested in protecting themselves from unpredictable market fluctuations and would enter into agreements with their counterparts to either set a fixed buying or selling price for these commodities in the future.
The reason for implementing this price-fixing was clear at the time and still holds true today: fixing the prices helped minimise the potential fluctuations in prices for both buyers and sellers of the commodities. This reduced the variability in commodity prices over time and ensured a predictable cash flow.
Today, there are a wide variety of derivative products that cover not only olive oil and grains but also a diverse range of other commodities, such as oil, gold, aluminium, cotton, cocoa, and more. These derivatives cover a wide range of asset classes, including foreign exchange, interest rates, and credit.
The Role of Derivatives in Modern Financial Markets
The mention of ‘Derivatives’ frequently brings to mind the image of Einstein-esque scientists, hunched over grand mainframe computers, engaged in complex financial calculations, processing an immense number of permutations every second. This portrayal may not be an exaggeration: financial markets in various locations worldwide have perpetuated this stereotype by restricting job opportunities in derivatives and structuring to a privileged few.
These opportunities were offered only to ultra-wealthy clients who had to meet minimum transaction sizes. This restricted access to derivative instruments. Given the volatility observed in different asset classes, it is imperative to acknowledge the significance of these instruments, especially considering the increasing popularity and accessibility of derivative instruments. As part of Absa Bank’s commitment to promoting financial education and inclusion, this article aims to clarify the misconceptions surrounding derivatives, which we will refer to as Risk Management Products (RMPs) – and for good reason!
Understanding Risk Management Products (RMPs)
To unravel the ‘mysteries’ around RMPs, it is important to first define what these instruments are. Risk management products are financial instruments that derive their value from an underlying asset, index, or rate. They are instruments which allow business owners to hedge against price movements in an underlying security or asset.
Consider a client who is interested in the performance of a commodity like gold and wishes to hedge against the movement of gold prices with the view that gold prices will go up. To execute the strategy, they have two options. They have the option to hold on to the physical gold at its current value, intending to sell it when gold prices increase. Alternatively, they have the option to enter a contract where they make a profit if their prediction comes true, with no need to own the physical gold. By using this derivative instrument, the client can have exposure to the commodity without owning it.
The same holds true for a gold consumer, such as a refinery, who wants to avoid an increase in gold prices. To take advantage of potential savings during a gold rally, they might consider locking in lower prices now for future purchases. To put it simply, both producers and consumers of this type of commodity can leverage RMP solutions that will benefit them, considering macroeconomic conditions and their market outlook.
Futures and Over-The-Counter Derivatives
With this foundational understanding of how we can take advantage of market movements in our desired asset class using an RMP, we can now delve into the basic RMP solutions that are accessible in the market. But before that, let us first tackle the misnomer around Futures and Over-The-Counter Derivatives (such as Forwards). The Futures market can be traced back to the 17th century, beginning with the rice market in Osaka. I
n the 19th century, the first Futures market for agricultural commodities, such as wheat and corn, came into existence. In 1972 financial futures contracts on currencies were introduced on the Chicago Mercantile exchange (CME) and from then on various exchanges, including the London International Financial Futures Exchange (LIFFE), London and Marche a Terme Internationale de France (MATIF), also opened. Currently, we have the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange, the London Metal Exchange, and the Ghana Commodity Exchange amongst several others, each serving their unique purpose.
The importance of futures markets and their distinguishing features to forwards.
More important to appreciate, however, is the role of the Futures market in managing market risk. In essence, Futures markets facilitate the transfer of price fluctuations in commodities, along with their associated risks, from a risk-averse party to a risk-tolerant party. Furthermore, they enable the establishment of a single price, embody the primary source of public information for decision-making, and ensure payment and delivery through designated administrative procedures and obligations imposed on the parties involved in the contracts.
Although this market is very liquid, and one can enter and exit risk almost immediately, the disadvantage with these efficient markets is that the contracts and dates on which clients want to trade are standardised and thus limit flexibility for businesses that require it. This is why Over the Counter (OTC) derivatives, like Forwards, are useful for establishing flexible contractual relationships between buyers and sellers, unlike the Futures market where contracts are standardised and regulated by the exchange.
Parties involved in these OTC contracts have the flexibility to determine the size, date, and other parameters based on mutual agreement. This is much more flexible for the parties involved, and this is where financial institutions like Absa Bank can step in to play the role of the counterparty, honouring whatever obligations the buyer or seller need.
Regardless of whether businesses opt for futures contracts or OTC transactions (which are more common in our part of the world), it is wise for them to explore risk management products (RMPs). This is essential, as they will invariably be exposed to foreign exchange, interest rate, commodities, or credit while operating.
Part II of this article will analyse four notable risks that businesses encounter: foreign exchange risk, interest rate risk, commodity price risk, and credit risk. We will also discuss RMPs that can be implemented to mitigate these risks.
Gerald is the Head of Institutional Sales and Structuring at Absa Bank Ghana and Jacob is the Head of CIB Markets at Absa Bank Ghana .
