The Importance of Derivatives Markets for Risk Management and Economic Growth

The Importance of Derivatives Markets for Risk Management and Economic Growth

Extreme currency fluctuations have highlighted the need for expanded derivative offerings in financial markets. The volatility of international capital flows, coupled with ongoing budget deficits, high indebtedness, and diminished competitiveness, underscores the importance of local derivatives markets as an alternative risk management strategy.

South Africa's well-established derivatives market serves as an illustrative example. It has not only enabled self-insurance against capital flow volatility and risk management related to asset price fluctuations but has also fostered efficient risk pricing, unbundling, and transfer among market participants.

Businesses worldwide are increasingly utilizing derivatives to hedge risks and mitigate uncertainty. Data from the World Federation of Exchanges reveals significant growth in currency derivatives, commodity derivatives, equity derivatives, and interest rate derivatives. This surge demonstrates the value of derivatives in risk management processes.

Asset managers, insurance companies, pension plans, and alternative/hedge fund managers rely on derivatives as risk management tools. The inclusion of derivatives in their portfolios underscores their importance in capital preservation and growth.

Moreover, derivatives markets can provide an alternative funding source to bank credit, creating a more stable local currency funding environment. This can cushion against the impact of capital flow reversals and sudden stops in funding.

To foster a robust local derivatives market, hedging instruments such as currency derivatives, interest rate derivatives, and commodity derivatives must be readily available. The urgency for these measures is evident given Kenya's agricultural economy, exposure to capital flight, and active regional bond market. However, any market expansion should be accompanied by robust regulation and supervision.