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Stability slows growth in options and futures

By Peter V O'Brien

Friday 21st February 2003

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Volume trading among members of the New Zealand Futures and Options Exchange (NZFOE), now a subsidiary of the Sydney Futures Exchange (SFE), fell in the past two years.

A survey of financial derivatives in The National Business Review (May 4, 2001) noted there were 882,798 futures and options contracts of all types done on the exchange in the year ended December, 2000, compared with 1.35 million in calendar 1998.

The exchange had 627,018 contracts in 2002.

A decline in interest-rate volatility was the main reason for the fall in volumes, because the 90-day bank bill contract accounts for most of the exchange's business.

Lower interest rates and a volume fall in that contract coincided with a rise in the bank bill deal size from $500,000 to $1 million, although the initial margin was unchanged, another concession to an interest rate decline and less volatility.

There were changes to the NZFOE's membership in the past two years, arising mainly from reorganisation of broking firms and other dealers.

Current members are in the table above, classified as public brokers, introducing brokers and principal traders.

A public broker can accept clients and act on their behalf.

It can take orders and hold client funds but must have a high net asset value.

Introducing brokers can deal only with client instructions.

Their orders have to be passed to public brokers for execution, although introducing brokers get commission from public brokers.

Principal traders is a self-explanatory term. Classifications changed after the NZFOE became a subsidiary of the SFE.

The title "trading permit holder" was dropped.

Current facilities on the NZFOE have another difference from the 2001 situation.

Share options were available in 10 companies then but the contracts were withdrawn while the exchange worked with various entities to explore development of the New Zealand equity derivatives' market.

That exercise could be related to the NZSE's decision to change the structure of its indices and institutions' habit of using indices as benchmarks to weight portfolio.

There seems little sense in offering options on equities, whose weightings could alter substantially under the new system, until the arrangements get a settled history.

The NZFEO's derivatives are only part of the facilities available to local investors.

They trade into the Australian Stock Exchange (ASX) 200 futures' contracts.

It is understood the contracts attract 6000-10,000 deals a day globally but there is no information about how many emanate from New Zealand.

Most of the market for New Zealand-based financial futures is 90-day bank bills and government stock, although OM Financials chief executive Colin Churchouse said the volume fall was related to reasonable stability in the Reserve Bank's official cash rate (OCR) and a general decline in interest rates.

OM is a result of a management buyout of Ord Minnett Jardine Fleming Futures after US-based J P Morgan acquired brokers Ord Minnett and its subsidiary operations, and disposed of retail brokerage activities, retail equities to MacQuarie Bank, the Leveraged Equities operation to Forsyth Barr and derivatives to Mr Churchouse and two others.

Derivative investment has the advantage of leverage ­ the ability to earn percentage gains from a low initial outlay ­ provided one invests into a rising market.

The margin amount is the base investment but margins can also work against the investor in a declining market, so there is a risk element in derivatives.

An investor can be called on for additional margin when the market falls.

Continuing declines could lead to a situation where everything was lost when the contract expired or was closed out.

The likelihood of that happening when the full price was paid for physical securities would be minimal unless, for example, a company went broke and its shares were consequently worthless.

The holder of physical stock has to put up the full amount at the time of purchase and therefore can lose more in dollar terms than the derivatives' player.

Most New Zealand institutions require their fund managers to observe strict guidelines when investing in derivatives, the main one being that they must be related to the physical securities for which there is investment authorisation.

No local fund manager would be given approval to invest in the weird derivatives traded in overseas fringe markets where there has been a thriving business among scam merchants who have created "products" from their unlimited imaginations.

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