Effects of commodity derivatives on the risk profile of African domestic sovereign debt investments

Abstract: To leverage Africa’s growth trajectory the continent’s large infrastructure deficit needs to be addressed, which is likely to be funded through raising debt. Sub-Saharan African sovereigns have often looked to international markets to raise debt which exposes them to exchange rate risk. This makes domestic bond issuances an increasingly more favourable debt instrument for sovereigns but a riskier asset class for investors. The intended implication of this study is to increase the liquidity and demand for local currency denominated African debt and reduce foreign debt issuances by sovereigns, impacting related economic policies of sovereigns and asset allocation by investors. The study aims to investigate the effect of commodity derivatives on the risk profile of African domestic sovereign debt investments. In so doing close the gap between African sovereigns looking to issue domestic bonds in international markets, and fixed income investors looking for alpha in emerging market investments. The study question is centred around drawing a conclusion on what the impact is on the risk profile of Ghanaian, Namibian, Nigerian and Zambian domestic bond portfolio’s when a commodity future is introduced. A quantitative research approach has been used in this study. The results of the study concluded that based on cointegration and Granger causality, there is a weak relationship between African domestic bonds and their main export commodity. However, overall a muted relationship does exist between the variables as the movement of bond prices lags relative to commodity price movements. The study also revealed that by introducing a commodity future to a domestic bond portfolio, the impact on the risk profile varies per country and that the derivative reduces the overall risk for only some relationships. Thus, investors can find benefit in using a commodity derivative to manage the risk profile of African domestic sovereign bond exposure depending on the country, and taking into account that the relationship needs to be continuously monitored for macroeconomic changes that alter the relationship.M.Com. (Investment Management