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Empirical results on the use of derivatives in South Africa

Derivative instruments were widely identified as the main culprits causing the market turmoil in 2007/8. These often complex financial securities certainly played a prominent role in the crisis, but they cannot be solely blamed.

Despite the fact that some derivative products are complex, derivatives in general are very useful financial instruments and are often misunderstood by investors and the broad public. In order to show where the dangers and benefits of derivative instruments are for investors and to provide an overview about the current state of the South African derivatives market, a MCom study was undertaken by Stefan Schwegler at the Nelson Mandela Metropolitan University. He conducted an in-depth literature review and interviewed twenty one experts at a number of local financial institutions. Respondents were asked to provide some insight on the use and popularity of derivatives in South Africa as well as their involvement in the global financial crisis.

Stefan’s research indicates that derivative instruments play a major role in today’s global financial environment. This is evident from the fact that 94 percent of the world’s largest companies use derivatives on a continuous basis to manage their risk. The significance of derivatives markets is also shown by the fact that the total global market value of derivatives markets is approximately $600 trillion and that derivatives grow at a rate of between 20 to 30 percent a year (FinFund 2010; Bank for international settlements 2010). Thus, the global derivatives market is ten times larger than the whole world’s economic output and is the largest financial market ahead of equities, bonds and money markets.

Although the South African derivatives market makes up only a small percentage of that, the local market posts some impressive figures. Standardised derivatives trading in South Africa only commenced in 1987 and the first derivatives exchange opened in 1990. Until 2001, several derivative instruments, such as Single Equity Options, Single Stock Futures and options on futures were introduced to attract more investors. The introduction of Single Stock Futures was a significant milestone and made South Africa one of the most popular trading places in the world. In 2008, the Johannesburg Stock Exchange was the worldwide leader in Single Stock Futures contracts traded.

This topped the significant rise of the local derivatives market. From 2001 until 2008, the South African derivatives market grew by more than 1 200 percent. A survey conducted by Bartram, Brown and Fehle (2003) also showed that derivatives are very popular amongst South African companies. According to the survey, 90 percent of South African companies and financial institutions made use of some form of derivative instruments. Most companies used derivatives to hedge currency and interest rate positions due to South Africa’s volatile exchange and interest rates. The local market’s growth came only to a halt due to the financial crisis. The number of volumes traded decreased significantly (67 percent) in 2009 compared to the previous year and fell further in 2010 compared to 2009 (-29 percent). At the moment the derivatives market is recovering, the number of contracts traded is increasing and investors are gaining confidence again.

Several financial experts, politicians, the media and the public were quick in blaming derivatives for the global financial crisis. This is unjustified, as derivatives were not the main or only reason for causing the crisis, but they triggered and accelerated it. Financial institutions, especially in North America and Europe, were and still are invested in derivative structures known as Asset-Backed-Securities, Credit Default Swaps and/or Collateralized Debt Obligations. These complex and risky investments were traded on unregulated over-the-counter markets and relied heavily on the health of the North American housing market and low interest rates. Once interest rates rose and housing prices started to plummet, financial institutions across the globe started to lose money – fast and large sums.

Even though South Africa suffered from the financial crisis as much as other countries, the local financial market and system were not hit as hard as overseas markets. One reason, amongst others, was that complex and risky derivatives, such as the one mentioned above were hardly traded and available in South Africa. The products offered on the South Africa Futures Exchange are less complex, standardised and monitored by a clearing house. Thus, the risk of default is limited. Stefan’s empirical findings reveal that the most popular derivative instruments in South Africa are Single Stock Futures, Single Stock Options and Index Futures. Other products offered are Can-Do Options and Futures, Variance Futures, Index Options and Dividend Futures. Investors who want to get exposure to international companies have the chance to invest in derivatives on selected international companies. Like Can-Do Options and Futures (in 2006), derivatives on international companies were only introduced recently by the Johannesburg Securities Exchange (in 2008).

Options and futures on various commodities, such as gold, platinum, white or yellow maize are also offered by the Johannesburg Securities Exchange, and were in high demand over the past years, but experienced the same problems like equity derivatives during the financial crisis. This is certainly one of the more popular markets at the moment due to the increasing commodity prices.

Derivatives are investments not everybody would consider in their portfolios due to the reputation they have and the lack of knowledge amongst investors about these financial securities. However, investors should pay more attention to them as they are very helpful for hedging purposes, thus protecting portfolios against systematic and unsystematic risks. The study revealed that there are several variables that influence investors in their decision whether or not to use derivatives in their portfolios. Table 1 gives an overview of the variables identified in the literature. These are ranked in order of importance according to the experts in South Africa.

Table 1: Variables influencing investors’ decisions to use of derivatives

Rank

Variable

1

The level of information available and the transparency of price determination

2

Investor’s knowledge of different derivative instruments

3

Investor’s level of risk tolerance

4

The level of liquidity in the market

5

Investor’s knowledge and familiarity with financial markets

6

The level of regulation

7

The level of standardisation of products

8

Investor’s needs, goals and return expectations

9

Transaction costs

10

Product availability

11

Investor’s knowledge of different asset classes

12

The level of volatility

13

Investor’s level of wealth

14

Taxes

As evident from Table 1, the variables considered as most important for investors are the level of information available and the transparency of price determination; investor’s knowledge of different derivative products; investor’s level of risk tolerance; the level of liquidity in the market and investor’s knowledge and familiarity with financial markets. Due to the leverage derivatives contain, it is vital for investors to have a lot of information available of the derivative product they want to invest in, the underlying the derivative is priced on and that investors know how the derivative is priced. Only then investors can make a sound investment decision and screen alternatives.

Investors also have to understand derivative products and the variables that influence their prices. A little price movement of the underlying can lead to major changes in the derivative’s price and investors’ portfolio structures. Futures and options are considered to be the basic derivatives, but they need to be understood first in order to apply them properly in a portfolio.

The leverage derivatives offer attracts many investors who want to make large profits with only a small investment. However, derivatives are not only suitable for risk-seeking investors. Owing to their features and the fact that they are available as calls and puts (either long or short), they allow risk-averse investors to limit their portfolio risks with hedging.

As with any other financial security, the liquidity offered by the market is essential in trading derivatives. Small price movements of the underlying can have major effects on the derivative product. In order to benefit from such price movements, investors need to be able to trade fast without major price drops. This is only ensured with enough liquidity.

The price of a derivative instrument depends on several variables and on the underlying. In that, it is important for investors to have a sound understanding of what will have an impact on the derivative and the underlying. Furthermore, investors should be familiar with financial markets and know what products are available, where and how they can be traded and how micro and macro economic policies affect the financial market.

As the nature of derivatives is complex and as there are so many different variables influencing them, it is essential that investors are educated about them properly. Having said that, it is necessary to explain to investors how derivatives work, what products are available, where differences between the several products available are, where they can be traded as well as what the dangers and benefits are of the different products and markets they can be traded in.

Once investors are educated about derivative instruments, they will also lose their often negative sentiment they currently have towards these securities. That does not mean they should forget about the risk involved in derivatives and suddenly become risk-seeking, but they will understand that derivatives are very useful in protecting portfolio returns. Derivatives are useful tools for diversification as they allow investors to enter markets, such as the commodity markets, that were previously very expensive for them to access.

In order to make derivative markets more attractive for investors, the regulator should consider increasing transparency, especially in over-the-counter markets, which still bear major risks for investors. Furthermore, besides introducing new products (Can-Do Options and Futures) and underlying assets (gold, platinum and crude oil), as the Johannesburg Securities Exchange did, it might also be beneficial for investors to reduce costs, such as taxes and transaction fees.

(Dr Suzette Viviers at the University of Stellenbosch was Mr Schwegler‘s supervisor.)

List of sources

Bank for International Settlements. 2010. Semiannual OTC derivatives statistics at end-December 2009. Bank for International Settlements. [Online]. Available: http://www.bis.org/statistics/derstats.htm [25 March 2010].

Bartram, S.M., Brown, G.W. & Fehle, F.R. 2003. International evidence on financial derivatives usage. Lancaster: Lancaster University.

FinFund. 2010. Faith in emerging markets. Finweek, 25/03/2010:13.







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