2021’s game-changing market deal
IN August, Finance and Economic Development minister, Mthuli Ncube, launched the Zimbabwe Mercantile Exchange (ZMX), the first such commodities exchange since the other commodities exchange known as Zimbabwe Agriculture Commodity Exchange, shut down in 2001.
Currently, the ZMX has active trades in red and white sorghum while commodities like barley, cow peas, wheat, soya beans, tea, among others, are eligible for trade in March 2022. It was announced by Ncube that ZMX will provide derivatives trade such as options, futures and swaps in addition to the normal buying and selling of commodities.
e introduction of ZMX provides the much-needed price discovery and transparency in commodities pricing.
e proper commodities pricing and trade of derivatives presents an opportunity for financial institutions and other market makers to be innovative and engineer financial products that have ZMX traded commodities as the underlying assets.
Synthetic financial products derived from the ZMX can be created based on the desired cash flows, returns and risk appetite of both local and international investors, traders, arbitrageurs and speculators.
e engineering and synthesis of financial products play a comprehensive role in product diversification, liquidity creation, risk management as well as assets and liability management.
Let’s have a look at some of the financial product simulations that can be derived from the ZMX based on financial instruments that have been set to be traded.
In the presence of traceable commodity prices and market trends from the ZMX, financial institutions as market makers, can synthetically create an agro loan by selling a credit default swap (CDS) on a farmer or farming entity.
Income received from CDS premiums replicates interest income on lending.
e advantage of synthetic agro lending through CDS is that income is earned without committing capital plus it requires less credit monitoring and less due diligence.
e ZMX provides a platform for price discovery and traceable commodity prices, which makes it an ideal platform for exchange traded agro bonds.
e exchange traded agro bonds bring in a host of other simulated products replicating both capital and money market financial instruments.
For instance, in the absence of a forward loan facility in the market, a borrower can engineer one by taking a long position on an agro bond that matures on the desired start date of the forward loan, financed by a short position of the present value of the total forward loan repayment on the maturity date.
e cash inflows on maturity on the long position agro bond replicates the cash received on the desired start date of the forward loan.
e cash outflow on maturity of the short position on the agro loan replicates the forward loan repayment on the maturity date.
e advantage of such a synthetic forward loan is that, from the short position perspective, the price paid for the bond maturing is lower and, the price received on the long position for the bond maturing is higher.
Banks can also synthetically sell their non-marketable financial assets such as loans advanced to farmers that are secured by commodities with traceable ZMX prices, held under the warehouse receipt financing system.
Under a special purpose vehicle the commodities backed loans can be converted into tradeable capital and money market financial instruments through securitisation.
Using the same securitisation approach, banks can also synthetically raise their capitalisation by selling part of their risk weighted assets (RWA) emanating from commodities backed loans from acquiring the true market value from the ZMX.
e cash received on the new securitisation products can be used to invest in riskless assets such as government Treasury Bills.
e banks will basically be manipulating the inverse relationship between capitalisation and RWA plus taking advantage of the presence of transparent commodities prices from the ZMX.
As an investor who is bullish about the price of a certain commodity traded on the ZMX, but with limited capital for an outright purchase, it is ideal to synthetically purchase the commodity using options.
is is achieved through the investor buying a call option and selling a put option at the same strike price for the same underlying ZMX commodity with the same expiration. e payoff characteristics are similar to holding the commodity but have the benefit of being much cheaper than buying the underlying commodity outright.
In the absence of actively traded futures contracts on the ZMX, the same approach can be used because the payoff characteristics are similar.
e opposite can be done for a bearish investor who is expecting the prices for a ZMX commodity to fall.
e investor can sell a call option and buy a put option at the same strike price, underlying commodity and expiration.
However the synthetic commodity purchase will be the most ideal when trading or investing on the ZMX because Zimbabwe is characterised by ever rising prices due to constant rise in inflation.
e Zimbabwean economy is characterised by constant and overnight changes in monetary policies that may result in abrupt exponential change in either direction in the value of a commodity trading on the ZMX.
A farmer or any holder of the commodity can engineer a hedge to cushion themselves through a long straddle in which they buy both a call and a put option for the same underlying commodity with the same maturity and strike price.
Profits are made in either direction, that is, a soaring or plummeting value that will cover the cost of the trade, while losses are limited to premiums paid in buying the options.
Banks, insurance companies and other market makers can introduce weather derivatives for trading on the ZMX.
Weather derivatives are financial instruments that can be used by farmers as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions.
Revenue for a farmer is driven by weather conditions that can’t be controlled hence the need to hedge the risk through weather derivatives such as options, futures and swaps.
For example, a farmer can use weather derivatives to hedge against a poor harvest due to insufficient precipitation.
e weather derivative structure is made up of an underlying asset based on a measurable weather index such as rainfall or temperature.
Unlike traditional farming insurance that requires a farmer to file a claim and prove damage, is non-tradable in the market and serviced through premiums, weather derivatives do not require filing for a claim and prove damage, the instruments are exchange trade and only the strike price is settled.
e introduction of weather derivatives on the ZMX can attract other economic players such as utility and energy companies, beverage manufacturers and retailers, leisure and tourism operators as well as mining and construction companies with projects that can be affected by weather conditions.
is can significantly grow participation on ZMX.
For the financial engineering and the synthesis of financial instruments to be a success, authorities may need to revisit the ZMX price protection limits which in their view, is meant to ensure market stability.
e price movement limits will hinder derivatives trading as there is a need for prices to be purely determined by market forces.
In addition, it is key that monetary and fiscal authorities ensure that macroeconomic fundamentals are favourable to nourish trade activities of the ZMX.
Nhete is a member of the South Africa Institute of Financial Markets and holds a Master’s of Science Degree in Finance and Investments as well as Bachelor of Commerce Honours Degree in Banking and Finance. — +263 773 778 826 or michaelnhete@gmail.com