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Derivatives return to favour as the market's volatility increases

Friday 4th May 2001

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Futures and options trading volumes are rising, as futures and options make a comeback, writes PETER V O'BRIEN

The need to hedge currencies and commodity prices in a period of high volatility has resulted in a substantial rise of activity on the New Zealand Futures and Options Exchange (NZFOE) after two quiet years.

The increase was significantly higher than its parent, the Sydney Futures Exchange, of which it became a subsidiary in 1992.

General manager Greg Boland told NBR Personal Investor many people were trading on the exchange apart from professional managers hedging physical positions in bank bills, government stock and equities.

The volume of contracts was 308,216 in the three months ended March, compared with 882,798 for the whole of 2000. The latter figure was well down on the 1.35 million plus recorded in calendar 1998.

Mr Boland said 1999 and 2000 were difficult years. "The OCR (Reserve Bank official cash rate) came in and interest rate volatility was low. Volatility is now a lot higher than last year. Volumes were up 77% over the same period last year."

Bank bill futures remained the exchange's biggest market, accounting for 92% of all contracts in the March quarter, down from the 96% of the total 464,348 in the first half of calendar 1999. The percentage decline in bank bills between 1999 and now was a result of higher volumes in three- and 10-year government stock futures.

Mr Boland said the exchange had been working with domestic bond price "markers" to encourage liquidity in those contracts, which by definition would result in higher volume. The NZFOE does not deal in currency hedging, which includes options on currency, cross-currency swaps and other currency derivatives; those are the province of the banks and their clients.

Currency derivatives are a big local business and can sell substantially when overseas-based speculators decide to make plays on various currencies and their cross-rates against others, including the New Zealand dollar.

The exchange's contract offerings have changed in the past two years (see tables). A futures contract on the trade-weighted index has gone and the futures contract on New Zealand electricity, North Island could be ignored, Mr Boland said.

Among equity options contracts, Auckland International Airport, Sky TV and The Warehouse Group have replaced Brierley Investments, Nufarm (then Fernz), FCL Energy, FCL Paper and Goodman Fielder.

Most of the volume is in Telecom options. Mr Boland said the total volume in share options last year was higher than in the previous two to three years, with more private clients using them, in line with the sharemarket's 8% improvement from the beginning of the year.

The advantage of investment in derivatives was described in NBR Personal Investor in 1999 but it is worth repeating the basics:

"Derivative investment has the advantage of leverage - the ability to earn large percentage gains from the low outlay - but leverage works both ways and can throw up a large loss if markets move against the investor. At that point a futures contract holder could be called for additional margin and, if the downside existed when the contract expires or is closed, everything could be lost."

An institution or individual holding the underlying physical securities would not be cleaned out unless the value of the security fell to nothing, a situation which could occur if a company went into receivership or some other event happened to make the share worthless. Physical bank bills and government stock would not fall to a nil value, except in the event of a bank failing.

The government's securities rise and fall in value, depending on movements in interest rates, the currency and the inflation rate, the three usually being interrelated, but they have never gone to zero in this country, or found the government in default at maturity.

Financial damage can be incurred if speculators start taking ever-larger positions to cover increasing losses on earlier contracts. But these cases are rare and have involved fraud and/or a lack of control and internal audit procedures in financial institutions or the industrial corporations which require physical commodities in their businesses.

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