A look behind the Kwacha Trading on the JSE

On October 3rd, 2014 the Kwacha, The Nigerian Naira, Kenyan Shilling and the Zambian Kwacha Friday made their début on the Johannesburg Stock Exchange (JSE), the largest and most liquid exchange in Africa. A move regarded as a Milestone by Government and the media alike. However, there seems to be a lot of confusion among Zambians about what this really means. So we answer some frequently asked questions behind this initiative and dispel some myths along the way.

The Zambian Kwacha started trading on the JSE on Friday

What is actually being traded?

The forex market on the JSE is not a currency bureau, where people can buy and sell the Kwacha. This is a futures market, where investors and businesses that import or export can buy Currency Options or Currency futures, which belong to the derivatives market.

  • A Currency Option (CO) is a contract that gives the investor, the right, but not the obligation, to buy or sell a currency on a future date at a fixed price. A variation of a currency option is called a Put Option, that gives the investor a right to sell a currency at a future date at a particular price.
  • A Currency Futures (CFs) Contract is an agreement that gives the investor the right to buy or sell an underlying currency at a fixed exchange rate at a specified date in the future.
    These instruments are primarily used as hedging mechanism to protect investors and businesses from the adverse effects of currency fluctuations. “The message is simply: hedge your foreign exchange risk on the JSE and go and do your business,” according to Andrew Gillespie, head of futures at Tradition Futures, which partnered with the JSE and Barclays bank to launch the platform.

Is the Zambian currency now being held as a reserve in South Africa?

The Zambian currency will not actually be held in South Africa or on the exchange. This is a derivative, which is a special type of contract that derives its value from the performance of an underlying entity. In this case that underlying entity is the future value of the kwacha that is being traded. Therefore all contracts are based off the value of the kwacha, but the kwacha is never actually held, so the kwacha will not all of a sudden appreciate because of a new demand for kwacha caused by the JSE. In fact the contracts are cash settled in Rands and no physical delivery of the foreign currency ever takes place. So if a Zambian importer buys a currency option on the JSE and the kwacha declines in value, making their imports more expensive, that importer will be compensated the difference in value in Rands.

Why Zambia, why Africa?

The parties behind this initiative include the JSE, Barclay’s Africa and Tradition Futures, A Swiss financial company that is one of the world’s largest interdealer brokerage firms (A company that facilitates transactions between financial institutions). Strategically, this is a pilot initiative, therefore three countries from each region (except North Africa) needed to be selected, Nigeria and Kenya are the economic powerhouses in their respective region, while Zambia has boasted stellar economic growth over the years and has become one of the leading destinations for South Africa’s exports, not to mention the number of South African retailers trading in kwacha, but need to repatriate their profits in Rands back to their home country. There are many pundits that feel, that Africa is the next big emerging market and this is a strategic step by two huge financial powerhouses in Barclays and Tradition Futures to further position themselves in the African financial market and a move by the JSE to increase its visibility to the international capital markets. Therefore if these initial 3 listings are considered a success, more African currencies will follow.

Who make Money on this initiative?

There are three parties involved in these types of transactions:

  1. The party buying the instrument- which are usually investors, which is a very broad definition, but the bulk will be financial institutions, and businesses (small and large) that import and export in Kwacha. Most large businesses have entire finance departments that work on currency hedging.
  2. The JSE, which earns fees from listing the currency
  3. The Counterparty, which again is the JSE (though it would be no surprise if there are other parties involved behind the scenes). The counterparty is the party offering the contract and receiving the fee from the party buying the instrument. Think of the counterparty as the Insurance Company, they take premiums and if need be they are the parties responsible for paying the loss should one occur.

How will this help the Zambian Economy?

Directly, this will not help the Zambian economy as this will be mainly utilized by businesses and investors for their hedging purposes.

Indirectly they may be some benefits to the Zambian economy; one such area, is it may help provide additional confidence to investors making investments into Zambian money markets. For example, there are many institutional investors that like the interest rates of Zambian treasury bills (north of 20% over the last few months), but will not make the investment because of the currency risk associated with the investment. That is why we have seen over the last few months, the Bank of Zambia Treasury auctions being heavily under-subscribed, but the Eurobonds in U.S dollar being oversubscribed. Now that the currency can be hedged, you may see these types of investors consider investing in Zambia.

However there are still some variables that will impact their investment decision like the price of the contract. Without getting into the complex details of how derivatives are priced, the simplest manner will be to think of the kwacha as one unit, the premium paid is then a percentage of that unit. If that percentage is 10%, then investing in the Zambian money market becomes less attractive because 10% of your 20% yield is going towards hedging the currency. As the volatility of the currency increases or decreases, the price is adjusted accordingly to ensure the counter party is making money.
The durations of the contracts are 3 months to 12 months, so this will have very little bearing on the decision to place Foreign Direct Investment into Zambia, where capital project into roads and manufacturing plants, for example, take years.

Will this lead to speculation that can hurt the Zambian Kwacha?

There are forex markets are all over the world and you always have speculators who use CFs to make a profit on short-term movements in currency prices and Arbitrageurs who use them to profit from the price differentials of similar products in different markets. So you will see speculations against the Zambian kwacha occurring and this type of market allows speculators to amplify their bets, as they can be done without actually needing to have the kwacha on hand (a term called leverage). While, intentional sabotage of the Zambian kwacha to make profits on the JSE is possible, it is highly unlikely especially over a long period of time, because of the number of complex mechanisms that would need to occur, not to mention, the more volatility in the kwacha, the higher the premiums will become or the counterparty will stop selling the kwacha contracts all together, because for every party that makes a profit, there is another party taking a loss. In an open market, products and prices always correct themselves to meet the appropriate levels of supply and demand.

By Mawano Kambeu

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