BoG’s forward FX sale to inspire the growth of derivative market

A derivative is rarely used in finance or transactions in Ghana. This is because the instrument is not fully appreciated in the financial markets of the country.

In addition, the market or platform for trading this instrument is virtually nonexistent. However, the forex forward transaction introduced by the Bank of Ghana could be what it takes to have a viable derivative market in Ghana.

A derivative is a financial contract that derives its value from an underlying asset and the buyer accepts to purchase the asset on a specific date at a specific price. The most used types of derivatives are forwards, futures, options and swaps.

Derivatives have a significant effect on modern finance and provide several benefits to financial markets. These include hedging of risk, price determination/discovery, and provides the opportunity to achieve an efficient market.

FX forward is a derivative contract between two parties. It is usually a contractual agreement between a customer and a Bank or a Non-Bank financial institution to exchange a pair of currencies at a specified exchange rate on a future date.

The purpose is to lock the exchange rate between two currencies thereby reducing the risk of price volatility. This is very important in determining forex prices via the interaction of variables such as interest rates, inflationary expectations, trade balances, and other macroeconomic factors.

The Bank of Ghana, in this case, is using forwards, funded forwards specifically where the buyer and the seller (Bank of Ghana and the customer through their bankers), conclude a sale and purchase agreement with full performance of the seller’s obligation on the spot.

However, the buyer promises an interest (a premium) on the performance of his or her obligation in the future. This is the seller’s reward for delivering his or her side of the deal on the spot rather than in the future.

In this case the premium of paying the cedi upfront by the customer is factored into the determination of the rate of exchange by the Bank of Ghana.

Businesses are exposed to several types of risks, including foreign exchange risks, credit risk, liquidity risks, interest rate risks and others.

It is therefore not surprising that the volume of derivative traded continues to increase to minimize these risks. In fact, US$25 billion derivatives were traded in 2017. In most cases, hedging of these risks is the main reason for investors or trading parties deciding to enter derivative contracts.

For instance, currencies fluctuate in many cases, therefore locking the rate now for a future transaction ensures less speculation and uncertainty. In addition, the uncertainty is weakened because the contract is binding. This means that the Bank of Ghana for example is obligated to provide the foreign currency to the other parties at the agreed rate and date.

The decision of the central bank to intervene in the forex market through funded forward contracts is laudable. It will help mop up excess liquidity, manage risk and expectations and aid price discovery on the forex market as envisaged by the Bank of Ghana.

Usually, in the first and fourth quarters of every year, the Ghana Cedi records a relatively higher depreciation rate against the major trading currencies, especially the US Dollar. In these cases, the central bank usually intervenes to increase the supply of foreign exchange to the market to ease the shortfall in supply of the US Dollar.

The approach intervening in the market this year is via fx funded forwards. So far, the exercise has helped to fairly manage expectations in the forex market by significantly reducing the average daily depreciation rate against the US Dollar.

The average daily depreciation rate of the Cedi has fallen from 0.4 percentage points in September 2019 to 0.3 percentage points in October 2019. This means that on average, the depreciation rate of the Cedi against the US Dollar has reduced partly due to the strategy adopted by the central bank.

As a result, the Cedi recorded a lower depreciation of 0.44% in October 2019 relative to 0.51% and 0.72% in August 2019 and September 2019 respectively against the US Dollar.

The seeming success so far of the program provides the perfect platform for traders and investors to turn to derivatives as the modern way of protection against risk in finance.

Since the regulator has taken the initiative, it is important for banks to also make conscious efforts to educate their customers about the importance of derivative contracts and why on the spot transactions are not always prudent.

Finally, the role of the derivative market cannot be underestimated. A well-developed derivative market directly plays a vital role in a financial system and greatly contributes to various aspects of an economy.

It offers an effective mechanism that facilitates the sharing of price risks and it is widely accepted as a means of risk reduction and redistribution, price discovery and a price stabilizer.

Serving as a key hedging and risk management tool, it enhances capital inflows into emerging and developing economies. Therefore, there should be no moving back. We can only look back for lessons from our forward market to ensure a competitive derivative market.