Enlighten Kenyans on benefits of futures trading

The introduction of commodity derivatives into the Kenya market will increase information flows in that market. FILE PHOTO | NMG 

By NDIRANGU NGUNJIRI

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Summary

• Commodity futures are derivative contracts that enable the purchaser, usually farmers, to fix the price that they will receive at a given future date for a given quantity of their produce.
• This helps reduce price uncertainty and revenue volatility, which eventually lead to more productive farming.
• Commodity derivative exchanges are platforms where commodity futures contracts trade.

The Capital Markets Authority (CMA) and the Nairobi Securities Exchange (NSE) have been planning how to launch a commodity futures market trading in Kenya.

More than 80 per cent of Kenyans are farmers and a key concern for this population is the price volatility associated with the commodities.

When they trade in the commodity market they will get opportunity for new ways to manage risk effectively. Unfortunately, they do not fully understand these complex instruments, their use and possible ramifications.

Derivative instruments came into existence in the early 17th century with commodity derivatives being the very first type. Simple commodity futures (rice futures) were the first ever such derivative contracts traded on the Dojima Rice Exchange.

The first modern organised derivative exchange to be established was the Chicago Board of Trade (CBOT) in 1848 where commodity futures were traded. In 1918, the first rival futures exchange, Chicago Mercantile Exchange (CME) was established and also dealt with futures on commodities.

The first option exchange (Chicago Boards Option Exchange – CBOE) was established in 1973 after Black & Scholes successfully developed the option pricing formula. A few years later, commodity swaps were introduced into the market as innovations in derivative research occurred.

Today, there are numerous commodity exchanges all over the world trading in all types of commodity derivative instruments.

With this development Kenya should establish its own commodity market. A commodity is a good produced to fulfill wants or needs, my aging grandmother will be able to fix prices of her produce and get a broad market.

Currently, she sell her produce at local spot marketswhere the contracts are immediately settled, with money and the commodity changing hands.

The same commodities are traded on the international markets and have fungibility,which means that the international market treats the commodities as equivalent no matter who produces them.

For example, a kilogramme of grade 1 coffee I produce in Muruguru farm is equivalent to a kilogramme of grade 1 coffee produced in Brazil.

Commodity futures are derivative contracts that enable the purchaser, usually farmers, to fix the price that they will receive at a given future date for a given quantity of their produce.

This helps reduce price uncertainty and revenue volatility, which eventually lead to more productive farming.

Commodity derivative exchanges are platforms where commodity futures contracts trade.

Liberalisation of agricultural products has largely increased since the 1994 Marrakech Agreement, which established import quotas and export subsidies, making many agricultural commodities more inelastic suggesting larger price swings from a given supply shock.

These features of commodity futures markets make them very beneficial for the Kenyan producers and exporters.

READ: What you must know when investing in derivatives market

A commodity futures market enables risk transfer amongst farmers and other market participants. By entering into futures contracts, my grandmother can effectively set the price that she will receive for her produce at a future date.

This enables her make prudent decisions on the whole production process ranging from the cost of production to the final quantity produced. This should ultimately lead to less dissatisfaction and increased agricultural productivity.

Derivative trading doesn’t affect the fundamentals of supply and demand and is a zero-sum game, where for every winner, there is a loser and vice versa.

CMA should develop derivative regulation to restrict and monitor large institutional investors from entering into large numbers of speculative trades.

Commodities derivative trading involves commodity exchanges where futures, options and swap contracts on underlying commodities are traded.

The traders involved in this market differ from the traditional spot markets where producers, middlemen and consumers trade.

The introduction of commodity derivatives into the Kenya market will increase information flows in that market, leading to a price-discovery function.