1 May 2012

Zimbabwe: How Derivatives Can Help Revive Agriculture

DERIVATIVES are financial instruments (contracts) that do not represent ownership rights in any asset but, rather, derive their value from the value of some other underlying commodity or other asset. When used prudently, derivatives are efficient and effective tools for isolating financial risk and "hedging" to reduce exposure to risk.

Derivatives increase the financial markets' depth and encourage innovation that reduces reliance on cash.

Zimbabwe's current liquidity crisis is worsened by the almost universal demand for cash for every transaction that could be reduced by the use of proxy assets created through the use of derivatives.

The use of derivatives allows financial market players to systematically manage and reduce risk that allows participants to be more receptive to new ideas and innovations since such risk can be reduced via use of derivatives.

Futures contracts, which are part of the derivative family, can be an answer to the long liquidity crisis the Zimbabwe financial system has been facing seriously of late since February 2009 after the economy was dollarised.

A major strength of derivatives is their nature of liquidity, which means their ability to be converted to ready cash.

In a futures contract, buyers and sellers agree to trade an underlying asset at a future date at a certain price.

When the Zimbabwe Commodities Exchange starts to operate, it will be a critical platform of exercising the futures contract and benefit from its advantages.

The exchange will be a market place where sellers and buyers of the futures contract will meet for trades.

Trading in these contracts improves market transparency and liquidity since there are flexible instruments with a ready market.

Futures contracts are standardised contracts that are traded on a standardised stock market like SAFEX (South African Futures Exchange).

Derivatives can revive agriculture sector

Zimbabwe's economy depends largely on the agricultural sector, that means if this sector is rejuvenated again back to its feet of 90s the whole economy will recover.

Promotion of agribusiness can be a genesis to a better financial system that is sound and strong. Futures contracts will give farmers strong and stable financial planning and ease of acquisition of inputs.

If a farmer is guaranteed of selling maize at a future date on a fixed price it will be easier for the farmer to plan for the next season.

This will encourage production and attract more farmers into products, which are traded via derivatives.

Maize growers in the country have not been producing enough maize for consumption due to lack of sound market and guaranteed buyers.

If a farmer can plant maize knowing that there is a buyer in the contract to buy the grain then that can boost the yield of grain that has been seen produced less since lack of a customised market. Reduce over-reliance on bank loans. Another cause of the current liquidity crisis is the over-reliance on bank credit by most Zimbabweans.

When the multi-currency system was introduced in February 2009, most banks attracted deposits through issuing of loans.

This resulted in overdependence on bank loans, micro-finance loans and shark loans especially by households and resulted in non- performing loans and then liquidity crisis.

Futures contracts can come in as a rescue to this problem as a source of generating liquidity other than bank loans.

In this situation a futures contract will represent an asset that the holder can sell or use as security to raise cash thereby improving market liquidity just by the increase in tradable financial instruments.

Increase market liquidity on the ZSE

The Zimbabwe stock market is currently volatile, which makes it riskier to invest in stocks hence an exchange traded derivative, is an answer to the problem.

The introduction of derivatives will increase the market size of tradable therefore liquid financial instruments, which in turn will serve to reduce the current credit and liquidity crunch.

There is quite a long list of derivatives contracts that include option contracts, forwards, swaps that can be subdivided into a long list of these contracts.

Derivative contracts can result in huge losses as witnessed in 2007 global financial crisis where these contracts were partially blamed for causing the credit crisis.

Derivatives contracts can be very complex hence need a strong base in simulation and financial modelling and financial engineering expertise in trading them.

l Portia Mawire is a Financial Engineering student at the Harare Institute of Technology and also vice president of the Financial Engineering Society (FES). She is currently attached at GMRI Capital.

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