Michael R Nhete IN August 2021, Finance and Economic Development minister Mthuli Ncube launched the Zimbabwe Mercantile Exchange (ZMX), the first such commodities exchange since the closure of the commodity exchange known as Zimbabwe Agriculture Commodity Exchange 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, will start trading in March 2022. It was announced by Ncube that ZMX would provide commodities derivatives trades such as options, futures and swaps in addition to the normal buying and selling of commodities.
The introduction of ZMX provides the much-needed price discovery and transparency in commodity pricing.
Proper commodity pricing and trade in 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 cashflows, returns and risk appetite of both local and international investors, traders, arbitragers and speculators.
The engineering and synthesis of financial products play a comprehensive role in product diversification, liquidity creation, risk management as well as asset 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.
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Income is received from CDS premiums replicates interest income on lending. The advantage of the synthetic agro-lending through CDS is that income is earned without committing capital plus it requires less credit monitoring and less due diligence.
The ZMX provides a platform for price discovery and traceable commodity prices, which makes it an ideal platform for exchange traded agro-bonds.
The 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 on 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.
The cash inflows on maturity on the long position agro-bond replicates the cash received on the desired start date of the forward loan.
The cash outflow on maturity of the short position on the agro-loan replicates the forward loan repayment on the maturity date.
The 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 commodity-backed loans can be converted into tradable 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 commodity-backed loans from acquiring the true market value from the ZMX.
The cash received on the new securitisation products can be used to invest in riskless assets such as government Treasury Bills.
The banks will basically be manipulating the inverse relationship between capitalisation and RWA and taking advantage of the presence of transparent commodity 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.
This 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. The 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.
The opposite can be done for a bearish investor who is expecting the prices for a ZMX commodity to fall.
The 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 a constant rise in inflation.
The 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.
- Michael R Nhete is a member of the South Africa Institute of Financial Markets and holds a Master of Science degree in Finance and Investments