DERIVATIVE trading, financial engineering, and algorithmic trading are among exotic trading strategies that are already commonplace in developed markets such as the US, Europe, and Japan, but not yet so in Jamaica. With major upcoming developments, the Jamaica Stock Exchange (JSE) is on the cusp of offering new products and trading strategies, including digital asset trading and short selling. We can therefore expect an influx of more investor sophistication, higher liquidity, and a more dynamic market.

As investors we need to be prepared to capitalise on these developments and understand the roles derivative trading and financial engineering may play in expanding the securities industry.

How Derivatives Have Changed the Investment Game

Derivatives are used to reduce unwanted risks, while giving exposure to securities, without directly purchasing them. They usually require a smaller investment than would be called for by actually purchasing the stock, bond or commodity. The most well known derivatives are forwards, futures, and options, which are used in hedging strategies or to speculate.

A forward contract is a non-standardised agreement to purchase or sell an asset at a future time, whilst futures are standardised forward contracts that are traded on an exchange. Both mechanisms work well to mitigate, for instance, the risk of adverse movements in the exchange rate or the risk of default by issuers of debt — two risks that pose everyday challenges to companies and individual investors alike.

An option is a contract that gives the purchaser a choice to buy or sell a specified asset at an agreed price at a future date. Options are mainly used by speculators with a high-risk tolerance and sufficient market knowledge to make forecasts on price movements.

Derivative trading is not new to the financial world, with its origins going as far back as ancient civilisations. In the 19th century a developed form of derivative trading became popular in the US with the Chicago Board of Trade (CBOT). The gross market value of outstanding over the counter (OTC) derivatives has grown by 47 per cent over six months to US$18.3 trillion as at June 2022, from US$12.4 trillion at the end of 2021, with the largest derivative exchanges being the National Stock Exchange of India (NSE), Chicago Mercantile Exchange (CME), and Eurex.

Financial Engineering Has Emerged to Solve Complex Financial Problems

Financial engineering emerged in the 1990s and applies mathematics, computer science, statistics, and economics to solve the complex financial problems of finding insights from trading patterns and developing new methods of evaluating and managing risks of different asset classes or financial products. It has become popular as more firms have started to utilise quantitative analysis to develop and improve financial models, products and investment strategies. Continuous financial innovation has resulted in increased demand for financial engineers or “quants”, especially with the deepening of the derivative market, digital asset trading, and high-frequency trading (HFT) strategies such as algorithmic trading. These last two are topics for another time.

Where does Jamaica stand with the Derivative Market and Financial Engineering?

The derivative market in Jamaica is relatively new and underdeveloped compared to more established markets such as the US or Europe. The JSE has, for many years, sought to sensitise the public on derivatives, starting with a futures and options workshop in 2011. Still, more than a decade later, there are limited options available for local investors seeking to trade derivatives locally as the Jamaican market remains in the nascent stages.

Corporate investors, having greater resources at their disposal, have increased their usage of derivatives, more so than individual retail investors. Call options and forward contracts have been used by local securities companies, and some local banks now offer foreign exchange forward contracts which can help their large clients hedge against exchange rate volatility.

Currently some major financial institutions in Jamaica, including commercial banks and insurance companies, use financial engineering techniques to manage risks and optimise their investment portfolios. This is evident from the use of securitisation techniques when structuring products, quantitative risk management, as well as modelling used in portfolio and asset management. However, the use of financial engineering in Jamaica is limited, considering its possibilities.

Regulation is currently a big deterrent for the advancement of derivative trading, especially because there is no established exchange for the trading of derivatives in the Caribbean. The development of an exchange would allow for a regional framework for the derivatives market and encourage individual country exchanges to facilitate trading in these instruments. Moreover, regulation is needed as this ensures an assessment of the integrity of the market and protects market participants.

As Jamaica positions itself to become the financial hub of the Caribbean through increased technological advancement and innovation in the financial sector, the expansion of derivatives trading is expected to accompany these developments and thus create new opportunities for financial engineering to be applied. Thus, the hope is that as the financial sector and market evolve and the nationwide STEM-related skill sets increase, the use of financial engineering will grow.

Tyra Cameron is a research analyst at VM Wealth Management with experience in economic and equity analysis.

Sources: Corporate Finance Institute, Bank for International Settlements, Indian Times, Management Study Guide, International Association for Quantitative Finance, Certificate in Quantitative Finance, Jamaica Observer, Gleaner, Financial Services Commission (FSC)