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NEWS INSIGHT
DERIVATIVES: The ancestors' new request by Ely Obasi In 6 months a 21-year-old student turns $2,400 into $240,000, and buys a new BMW. In a few weeks, Barings Bank loses $980 million, and goes burst. Is there anything in these financial instruments for Africa?
If his dream holds out, this young Jacksonville, Fla.-based physician will be home in Nigeria next December, his sizable end-of-year bonus in his wallet, to build the new family house he promised his father on the latter's deathbed. Back in the ancestral village, the kin await him. His relevance depends on this time-honored ritual. But the naira may not stay still. If the government goes ahead, as it has said it might, and merges the two rates of exchange that currently exist, the value of Mosheshe's anticipated bonus of $25,000 may drop from N2 million to one million, or even less, as the autonomous exchange rate appreciates. That amount will not pay for the building project. In Africa, one does not renege on a pledge made to dead forebears. Ken Mosheshe wishes there was a way he could secure the sale of his dollars at today's rate, but wait until December, when his bonus would be paid, to make delivery. Mosheshe does not know he could easily have done that with a forward contract. Nobody has pointed him to any bank in Nigeria that deals in forwards. But perhaps even if someone had, the man would not have cared to find out how they work. Forwards are also called derivatives, and from some of what he has seen in the media, the name "derivatives" is the kiss of financial death. Across the Atlantic, Ibrahim Mohammed runs an extensive car importation business in Lagos, Nigeria. Mohammed is pretty convinced that the much-talked-about merging of exchange rates will not happen before the proposed general elections due around August, 1998. He believes, in fact, that the political tension that will build up as the preparation for that election gets under way might drive up the demand for the dollar, thereby lowering the exchange rate of the naira(that is, increasing the number of naira he needs to buy a dollar). Ibrahim Mohammed is certain his business plans for 1998 would be on solid ground if anyone would offer him dollars at today's exchange rate, but hold off the delivery till early December when the customary pre-Christmas buying spree would have cleared out his inventory, and brought him a good stock of naira. But Ibrahim Mohammed cannot do this deal. In the financial arena that he does business, nobody talks about forward contracts. And derivatives, until a few weeks ago, was an unknown word. Had there been such a forward market, both men would sleep easy the rest of the year; Mosheshe confident he has the resources to honor his ancestors, and Mohammed certain he would replenish his inventory in 1998, no matter what happens to the naira. Used in this fashion derivatives are perfectly safe financial instruments. Such strategies for managing future risk are the reasons why derivatives are badly needed in African financial markets. A decade ago, such financial products were not in demand, because most African currencies were pegged at some arbitrary values. But currency liberalization came. And volatility in exchange rates followed, bringing along their own peculiar headaches. Forwards are only one type of derivatives. Far better known are their close cousins known as futures. Futures are actually standardized forwards which trade on exchanges. Another popular derivative is the option contract. There is an endless variety of variations and configurations to which derivatives can be put to achieve all kinds of effects, from risk management to very sophisticated high-risk speculation. Nigeria's first encounter with derivatives happened with the inauguration, early February, of the Nigeria International Debt Fund. Just like the contracts which would give Ibrahim Mohammed the freedom to arrange his business plans with greater certainty, the International Debt Fund will serve businesses that have payments due in the future in foreign currencies. "It is about protecting your purchasing power in dollar terms," said Phillip Iheanacho of U. K.-based Afrinvest Securities Ltd., "Investors mostly interested are institutional investors who know they are going to be able to make payments in dollars in the future." The Nigeria International Debt Fund which aims to trade up to $100 million, is offered to investors who are keen on the government's dollar-denominated par bonds and promissory notes. Developed by the local subsidiary of Citibank, Nigeria International Bank (NIB) and United Bank for Africa (UBA), the Nigerian International Debt Fund trades on the Nigerian Stock Exchange, and offers investors a yield of not less than eight percent, which is higher than current US money market rates. The Nigeria International Debt Fund becomes, instantly, an important instrument for managing future exchange risk. And for earning good returns while waiting for that future. There are several other such uses of derivatives for managing financial risk. Foreign exchange instability, as stated above, is not the only risk for which derivatives are deployed. The management of fluctuating commodity prices and changing interest rates have also been revolutionized by derivatives. For a continent like Africa, with many countries primary commodity producers, serious losses have been suffered over the years resulting from commodity production not hedged against risk. "The debt problems of many African and other Third World countries would not have been so severe," says Phil Clark, a London-based financial consultant, "if appropriate risk management strategies had been adopted right from the onset, strategies that would have used the financial instruments called derivatives." The OECD estimates that during the first half of 1993, $4 billion raised on international capital markets by developing country borrowers had some risk management built into them. And even though the African scene has been slow to pick up, the developing country share of the outstanding global volume of derivatives more than doubled between 1988 and 1989 (the most recent year for which data has been published. With the growing integration of global trade and finance markets, firms and individuals from developing countries have found themselves less insulated from the volatility that is characteristic of international business. The more nimble ones have been hurrying to develop markets that copy the risk management instruments used in New York, London, Tokyo, Paris and Singapore. In spite of this, developing countries' share of the derivatives market has remained at only 3 percent of the total. Much of the blame for this slow growth can be laid at the doorsteps of governments and economic circumstances that put bottlenecks in the way of innovation. But in many parts of the Third world firms are swiftly learning the new ways to manage risk, and the mystery that has surrounded the reputation of derivatives cannot hold up. "Any time governments loosen their grip," Clark says, "local markets for derivatives develop. Initially developing countries' firms' ability to use some of the more sophisticated financial instruments is limited. But the learning curve is usually step, and as financial liberalization goes on, the expertise of the market increases. When that does not cut it, access to international market is explored." Whenever the international market is ventured into, for international trade or financing, the crisis of fluctuating exchange rates arrives at the doorstep of the venturing firm. A Nigerian air transporter that finances its seasonal aircraft maintenance with a dollar loan, places itself at great risk if the naira gets suddenly devalued, as happened in March 1992, when government fiat sent the dollar jumping 100 percent in value overnight. With all its sales in the local currency, such an airline faces very bleak prospects, serious loan defaults, and possible bankruptcy, if no risk management instrument was put in place. "Financial risk may even occur when no foreign currency or international transaction was involved," says Ike Uchendu, a Chicago-based corporate attorney. What Uchendu is referring to here is the risk that comes with the movement of interest rate. A Nigerian pharmaceutical manufacturer that took out a huge loan from a local bank in the 1980's at an interest rate less than 10 percent, found continued servicing of the loan impossible when interest rates rose above 25 percent. The loan had not been protected against interest rate shifts. Commodity price movements have been ruinous to many, both on the production and the consumption sides. The World Bank's Development Brief Number 30 reports what befell a cotton project in the Caribbean. At the time it was proposed, international market prices for cotton were at a peak. The financial plans discounted this by 10 percent. The plans also took into account the very good soil, the availability of skilled management, and the possibilities of two crops a year. On paper the prospects for this project looked very good. However, by the time the project took off three years later, the tables had turned. Global cotton production had soared, sending prices tumbling a full 40 percent. This was a development that made nonsense of all the prudence that had gone into the planning. The company went bankrupt. Derivatives could have prevented this. Cross currency transactions especially call for the deployment of derivatives. This allows for risk to be shifted from one currency to another as the financial and exchange rate atmosphere alters. Take a Tunisian entrepreneur who is into ceramics manufacturing. His market is mostly in Europe. Locally, he cannot lay his hands on any medium-term financing. So he must shop for this abroad. Dollars are available for him to borrow. So are deutshe marks, but at a higher interest rate. Since his market is partly in Europe, the revenues from his export will come in in currencies that are close to the mark. His business faces decision problems because apart from the fact that he faces transaction costs in moving back and forth from American to European currencies, the interest rate on the dollar might as well go up, canceling out whatever advantages he might have thought he initially had. Derivatives, in the hands of skilled risk managers, would have enabled him restructure these risks in a highly quantitative fashion, such that will shield his business from disasters. Derivatives are incredibly flexible financial instruments. They come in useful at very many different levels. Far more vital and strategic are the uses to which African governments can put these astounding instruments. Take Nigeria for example. That country's oil accounts for more than 90 percent of its exports, 80 percent of public revenue and 25 percent of Gross Domestic Product (GDP). The implication of this is that a small increase or decrease in the price of oil usually results in a disproportionate alteration in the country's foreign exchange earnings. A one dollar increase in the price of oil increases Nigeria's foreign exchange earnings by as much as $650 million, and its public revenues by $320 million a year. Last year's income from oil has been put at about $12.5 billion. A two-dollar drop in oil price this year, due to a factor such as Iraq's re-entry into the world's oil market can have a serious effect on the economy of that country. Derivatives might come in very useful for a Nigerian government that anticipates such a drop, or that just wishes to be on firm grounds as it makes plans for the financing of its policies and projects. The Nigerian government can then pre-sell its oil at a determined price, using futures contracts. That locks in the price at which Nigeria would sell its oil for the marked period, no matter what happens in the world's oil market. The problem here, of course, is if instead of turning down, oil prices begin to ride upwards. Having pre-sold its oil, the country stands to lose out on any such price rally that occurs. This will not be a loss as such; but only an inability to participate in the further income arising from a price increase. A different and more complex configuration, using the derivatives known as options, can guarantee that the country makes more income if the rally in oil prices sends prices up, and does not lose what it would already have made if prices decline. More skilled financial engineering can successfully fashion interesting combinations of different types of derivatives. For example, options on futures contracts can be constructed. And then this combination, configured in such a way as to result in a particular product called a collar, can be used to effectively force the earnings from Nigeria's oil to remain within a predetermined bracket, no matter what happens. The prices within this bracket might even turn out to be higher than average market prices during this period. The principle underlying the use of derivatives as risk-management tools is that the risk is transferred from one person to another who is ready to assume the risk, in the hopes that he might realize some good revenue doing so. The spectacular reputation that derivatives have acquired in the media comes mainly from their use for financial speculation. Speculators are usually such people as assume the risks of others. There is a lot of that going on daily in the world's financial markets, and the results are mind-boggling. In January 1995, a 21-year-old student of the University of Pennsylvania charged $2,400 on his credit card, and invested in derivatives. Seven months later, the young man was worth $240,000. All he'd had to do was to assume some risk away from those who felt that the stock market was going to decline. He was right; the market did not decline, so he made a fortune. According to Judith Helen Rawnsley, in her book "Total Risk," before he got reckless and crashed his bank, Nick Leeson, the British youth who was trading futures amongst other securities in Singapore for Barings Bank, was making as much as $10 million a week for his employers! The results of good derivatives trading are usually so staggering that no one ever talks about them. They are almost always shrouded in the strictest confidentiality. Only when things go wrong does the whole story come tumbling out. As exactly happened when Leeson, due to very lax supervision, amongst other malpractices, overreached his limits and ran up losses of almost a billion dollars. The bank crashed, and the whole story came out. Which at least served an important purpose. It underlined, more forcefully than anything else before, that dealing with derivatives on the speculation side is a very dangerous game. Profits can be breathtaking. Last December for example, there was a derivative security that appreciated all of 35,000 percent in a single day! But equally murderous can the losses be. Two days later, a very similar derivative security to the one mentioned in the last paragraph suffered a punishing loss of 98.5 percent in another single day! A loss of this magnitude wipes out a portfolio practically totally in the course of a single day. And when this happens, as it very often does, the media get to hear of it, and run with the story. The most substantial problem with introducing derivatives to the African financial market would be finding professionals who really understand the complexities. Even in the United States, most brokerage houses find it tough to recruit staff that have expertise in the management of derivatives. The most prominent reason identified as the cause of the Barings debacle was the inability of senior executives to understand what their subordinate Nick Leeson was up to. It was totally impossible for the management to set up such compliance machinery as would have detected the growing dangers before catastrophe happened. "African financial institutions and banks that intend to get involved in derivatives had better start early to get their people some very good training," says Kate Kenasi, a Houston-based financial consultant. "A good move might be to send some of their brightest to Asia, especially Singapore. That is a Third World country whose learning curve in derivatives has risen very steeply and very fast. And there is no putting it off. Derivatives are here to stay. It would be a foolish thing to ignore it." As a matter of fact, it has been a foolish thing to ignore it in the past. Especially in the management of Nigeria's debt problem. As well as those of many other African countries. "Loans to Nigeria were made on conditions that would turn out unfavorable in the future," says Phil Clark, "conditions like adjustable interest rates. Those moving interest rates have greatly compounded the debt burden, and increased the amount of funds required to service these loans. This unnecessary burden could have been avoided by using derivative instruments to hedge the interest rate exposures. Had this been done, the debt burden picture would be looking very different today." The origin of derivatives is a thing of great debate. There is a school of thought that believes that back in Biblical times, the seven-year labors of Jacob for the right to marry Laban's daughter Rachel in Genesis Chapter 29, constituted a very early form of derivative instrument. However, what is not so debated is that the first exchange for trading derivatives appears to be the Royal Exchange in London, which allowed the trading of forwards. The first futures contracts have been traced to the Yodoya rice market in Osaka, Japan, around 1650. In 1848, a commodity futures market developed in Chicago, USA, to help farmers and merchants reduce the impact that price fluctuations had on the profitability of their businesses. The real explosion of derivatives started in the early 1970s, after the commencement of the trading of financial futures contracts based on financial instruments instead of commodities, with the introduction of the foreign currency futures. In 1975, that was followed by what would be the most successful contracts in history: interest rate futures. The main allure of derivative instruments is the leverage they provide. A speculator may control assets worth hundreds of thousands of dollars with just one thousand dollars of investment. Any appreciation in the value of those assets, usually a great multiple of the sum invested, would be for the investor to keep. "With the inauguration of the Nigeria International Debt Fund, that African country has dipped its first toe into the river of derivatives," says Uchendu. "Whether it would be able to enjoy the enhancement of further dipping in, or whether it will get swept off by the fierce and turbulent rush of the river depends on the amount of preparedness that country's professionals bring to the table. Same for Nigeria; same for the rest of Africa." Perhaps in the near future, Ken Mosheshe would be able to satisfy every wish of his ancestors without calling on packets of Maalox to hedge his anxieties.
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