So a few years ago I was doing my bachelors degree and I got obsessed with derivatives, mostly futures so I wrote a little something, thought about it today and decided to share, take it as something from a momentarily obsessed fan.
Futures’ trading is used in several parts of the world to hedge against interest rate and foreign exchange risks. In Kenya however, it is simply an emerging concept and this study seeks to explore the reasons why it has taken Kenya such a long time to come up with this great idea and its benefits to various sectors of the economy should it become operational in the near future.
The futures market in Kenya is one of the most disused risk management methods especially with regard to managing foreign exchange risk. In 2007-2008 Kenya experienced political unrest that lead to economic instability in many aspects such as increase in interest rates, and constant fluctuations in the currency exchange rates. Kenya being a net importer, the effect was adverse since imports became very expensive leading to high inflation rates and low standards of living. In developed countries futures markets are used to hedge against losses due to unpredictable currency fluctuations. Since the 2007-2008 instability several other factors including the weakening of the dollar, which is the main international trading currency. There has been a need to find ways that will enable stability of imports as well as exports.
In the early 2000’s the Nairobi Securities Exchange (NSE), by then called the Nairobi Stock Exchange (NSE), and the market regulator, the Capital Markets Authority (CMA), wanted to reform the market. As part of the market reform agenda, the authority initiated market reforms in 2001 which led to the reorganization of the NSE into four distinct segments: The Main Investments Market Segment (MIMS), Alternative Investments Market Segment (AIMS), Fixed Income Securities Market Segment (FISMS), and the Futures and Options Market Segments (FOMS). Currently, all these departments but the FOMS are operational. This would have been the department that would have housed and operated Kenya’s futures market.
Each and every day, the world is becoming more and more of a global village. The need to transact with other countries, in the region, the continent and the rest of the world has a whole has increased substantially. We need to import commodities, technology, specialized labour, diversify our investment portfolios, and we also need to export our own produce, labour and sell our own companies out there. For these reasons, now more than ever, we need to maintain our currency’s strength to ensure that we always get the better part of the deal when transacting with other countries and regions. This, however, is only actionable in theory where factors can be held constant to create favorable conditions. In practice, however, it is very difficult, in fact, it is impossible to hold conditions constant. We therefore need to implement measures to curb the occurrence of losses due to the volatility of changes in foreign exchange rates.
Trading in futures is one such way as it enables the parties to hold one of the most important factors in transactions constant, the price. Trading in futures, especially currency futures might be one of the most effective ways of helping Kenya maintain its economic stability and still import and export as usual.
To demonstrate how we came up with the idea of finding out how best the futures market can work to help in dealing with our foreign exchange problem, we will give a very common Kenyan problem with an imported good, oil. Kenya imports oil mainly from the United States of America (USA). The price of oil per barrel averages $96 as of the third of November 2013. Let’s say that Kenya plans to import say, 100,000 barrels of oil and intends to pay for it February of 2014. This will cost Kenya $9,600,000 worth of oil in 2014. The amount paid is not readily available and Kenya will have to purchase the dollar. The current value of the shilling to the dollar is sh.85.50.
Therefore as of today we owe USA ($9,600,000 *85.50) = Ksh. 820,800,000. However, there are risks associated with the future. The exchange rate may or may not remain constant. If the exchange rate is expected to increase, it would be prudent for Kenya to enter into a futures contract if it is possible to reduce its future losses.
This is how it works, a futures contract by definition is a contract entered into by two parties, a buyer and a seller for the purchase of a commodity or a financial instrument, at a predetermined price and date in the future. This gives the buyer (seller) the right and obligation to buy (sell) an asset at a predetermined price. In our case, Kenya will be the buyer in person of say, the Energy Ministry. We will assume the Energy Ministry will purchase currency from the Central Bank of Kenya. The ministry will therefore approach the central bank to enter into a futures contract for the purchase of US$ 9,600,000 in February 2014 at a price of 85.50. In case the rates go up to say 1$ exchanges for Ksh. 90, the ministry will still purchase the dollars at 85.5 and will therefore incur Ksh. 820,800,000. If, however, there had been no futures contract, the ministry would have had to pay Ksh. ($9,600,000*90) = 864,000,000. This would have been a loss of Ksh. 43,200,000. This would have trickled down to the ordinary Kenyan’s budget. The price of everything goes up because; most of our manufactures use electricity whose production is dependent on oil. The fuel levy in electricity will go up, the manufacturers’ costs of production will increase, the manufacturers will transfer costs to consumers by increasing prices which will increase the cost of living and consequently the unions will be on the streets demanding increase in pay for workers, which then goes back to increasing labour costs.
All this will stem out of a budget deficit of Ksh. 43,200,000 which wouldn’t have been a necessary expense had there been a futures trading system in place. These losses occur every day in our country in many sectors and cause harm that we may not even be aware of. This is why I am are exploring the importance of futures market in Kenya, why it failed and the past and how it can be improved so that it can last.
Futures’ trading has many dynamics but in a nutshell, that is basically how it works.
Where are we now?
The futures market in Kenya is highly underdeveloped due to the low level of investor sophistication and awareness, lack of commodities in large scale, high frictional costs in the market structure, inadequate risk management and inadequate liquidity among other factors. In the early 2000’s the futures and Options Market Segment (FOMS) was formed but to date remains inactive. This study has been brought about by the Kenyan government’s policy pronouncement in 2010 by the then minister of finance in his budget speech, in which he announced that steps would be made towards developing institutional and legal framework to introduce a commodity and futures exchange in Kenya. I seek to find out how best this can be done.
Futures– Is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument at a predetermined future date and price.
Derivatives- Are financial products having a value derived from an underlying variable.
Options– they give the buyer (or seller) an option but not an obligation to buy (or sell) an underlying asset at a future date at a predetermined price.