A Study of How Derivative is Progressing in In

8/7/2019 A Study of How Derivative is Progressing in In

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INTRODUCTION TO DERIVATIVES

Derivatives are defined as financial instruments whose value derived from the prices of one or moreother assets such as equity securities, fixed-income securities, foreign currencies, or commodities.Derivatives are also a kind of contract between two counterparties to exchange payments linked to theprices of underlying assets.

Derivative can also be defined as a financial instrument that does not constitute ownership, but apromise to convey ownership.

Examples are options and futures. The simplest example is a call option on a stock. In the case of a calloption, the risk is that the person who writes the call (sells it and assumes the risk) may not be inbusiness to live up to their promise when the time comes. In standardized options sold through theOptions Clearing House, there are supposed to be sufficient safeguards for the small investor againstthis.

The most common types of derivatives that ordinary investors are likely to come across are futures,options, warrants and convertible bonds. Beyond this, the derivatives range is only limited by theimagination of investment banks. It is likely that any person who has funds invested an insurancepolicy or a pension fund that they are investing in, and exposed to, derivatives-wittingly or unwittingly.


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UNDERSTANDING DERIVATIVES

The primary objectives of any investor are to maximize returns and minimize risks. Derivatives arecontracts that originated from the need to minimize risk. The word 'derivative' originates frommathematics and refers to a variable, which has been derived from another variable. Derivatives areso called because they have no value of their own. They derive their value from the value of some

other asset, which is known as the underlying.

For example, a derivative of the shares of Infosys (underlying), will derive its value from the shareprice (value) of Infosys. Similarly, a derivative contract on soybean depends on the price of soybean.

Derivatives are specialized contracts which signify an agreement or an option to buy or sell theunderlying asset of the derivate up to a certain time in the future at a prearranged price, the exerciseprice.

The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date ofcommencement of the contract. The value of the contract depends on the expiry period and also on the

price of the underlying asset.

For example, a farmer fears that the price of soybean (underlying), when his crop is ready for deliverywill be lower than his cost of production.

Let's say the cost of production is Rs 8,000 per ton. In order to overcome this uncertainty in the sellingprice of his crop, he enters into a contract (derivative) with a merchant, who agrees to buy the crop at acertain price (exercise price), when the crop is ready in three months time (expiry period).

In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton. Now, the value of thisderivative contract will increase as the price of soybean decreases and vice-a-versa.

If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will be morevaluable for the farmer, and if the price of soybean goes down to Rs 6,000, the contract becomes evenmore valuable.

This is because the farmer can sell the soybean he has produced at Rs .9000 per tonne even though themarket price is much less. Thus, the value of the derivative is dependent on the value of the underlying.

If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold, silver, preciousstone or for that matter even weather, then the derivative is known as a commodity derivative.

If the underlying is a financial asset like debt instruments, currency, share price index, equity shares,etc, the derivative is known as a financial derivative.

Derivative contracts can be standardized and traded on the stock exchange. Such derivatives are calledexchange-traded derivatives. Or they can be customised as per the needs of the user by negotiating withthe other party involved.

Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the example of thefarmer above, if he thinks that the total production from his land will be around 150 quintals, he can


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either go to a food merchant and enter into a derivatives contract to sell 150 quintals of soybean inthree months time at Rs 9,000 per ton. Or the farmer can go to a commodities exchange, like theNational Commodity and Derivatives Exchange Limited, and buy a standard contract on soybean.

The standard contract on soybean has a size of 100 quintals. So the farmer will be left with 50 quintalsof soybean uncovered for price fluctuations. However, exchange traded derivatives have some

advantages like low transaction costs and no risk of default by the other party, which may exceed thecost associated with leaving a part of the production uncovered.

TYPES OF DERIVATIVES:

There are mainly four types of derivatives i.e. Forwards, Futures, Options and swaps.

Derivatives

Forwards Futures Options Swaps

The most commonly used derivatives contracts are Forward, Futures and Options. Here somederivatives contracts that have come to be used are covered.

FORWARD:-

A forward contract is a customized contract between two entities, where settlement takes place on aspecific date in the future at todays pre-agreed price.. Forwards are contracts customizable in terms ofcontract size, expiry date and price, as per the needs of the user.

FUTURES:-

As the name suggests, futures are derivative contracts that give the holder the opportunity to buy or sellthe underlying at a pre-specified price some time in the future.

They come in standardized form with fixed expiry time, contract size and price

A futures contact is an agreement between two parties to buy or sell an asset at a certain time in thefuture at a certain price. Futures contracts are special types of forward contracts in the sense that theformer are standardized exchange-traded contracts.


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For example:- A, on 1 Aug. agrees to sell 600 shares of Reliance Ind. Ltd. @ Rs. 450 to B on 1st sep.

A, on 1st Aug. agrees to buy 600 shares of Reliance Ind. Ltd. @ Rs. 450 to B on 1st sep.

FEATURE FORWARD CONTRACT FUTURE CONTRACT

OperationalMechanism

Traded directly between two parties (not traded on theexchanges).

Traded on the exchanges.

ContractSpecifications

Differ from trade to trade. Contracts are standardized contracts.

Counter-party risk Exists. Exists. However, assumed by theclearing corp., which becomes thecounter party to all the trades orunconditionally guarantees their

settlement.

LiquidationProfile

Low, as contracts are tailormade contracts catering tothe needs of the needs of theparties.

High, as contracts are standardizedexchange traded contracts.

Price discovery Not efficient, as markets arescattered.

Efficient, as markets are centralized andall buyers and sellers come to a commonplatform to discover the price.

Examples Currency market in India. Commodities, futures, Index Futures

and Individual stock Futures in India.

OPTIONS:-

Options are a right available to the buyer of the same, to purchase or sell an asset, without anyobligation. It means that the buyer of the option can exercise his option but is not bound to do so.

Options are of 2 types: calls and puts.

CALLS:-

Call gives the buyer the right, but not the obligation, to buy a given quantity of the underlying asset, ata given price, on or before a given future date.

example:- A, on 1st Aug. buys an option to buy 600 shares of Reliance Ind. Ltd. @ 450 Rs 450 on orbefore 1st Sep. In this case, A has the right to buy the shares on or before the specified date, but he isnot bound to buy the shares.

PUTS:-


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Put gives the buyer the right, but not the obligation, to sell a given quantity of the underlying asset, at agiven price, on or before a given date.

For example:- A, on 1st Aug. buys an option to sell 600 shares of Reliance Ind. Ltd. @ Rs 450 on orbefore 1st Sep. In this case, A has the right to sell the shares on or before the specified date, but he is notbound to sell the shares.

In both the types of the options, the seller of the option has an obligation but not a right to buy or sellan asset. His buying or selling of an asset depends upon the action of buyer of the option. His positionin both the type of option is exactly the reverse of that of a buyer.

Particulars Call Options Put Options

If you expect a fall in price(Bearish) Short Long

If you expect a rise in price(Bullish) Long Short

WARRANTS:-

Options generally have lives of up to one year, the majority of options exchanges having a maximummaturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

LEAPS:-

The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having amaturity of up to three years.

BASKET:-

Basket options are options on portfolios of underlying assets are usually a moving average of a basketof assets. Equity index options are a form of basket options.

SWAPS:-

Swaps are private agreement between two parties to exchange cash flows in the future according to apre arranged formula. They can be regarded as portfolios of forward contract. The two commonly usedswaps are

1. INTEREST RATE SWAPS:-

These entail swapping only the interest related cash flows between the parties in the same currency.

CURRENCY SWAPS:-

These entail swapping both principal and interest between the parties, with the cash flows in onedirection being in a different currency than those in the opposite direction.

SWAPTIONS:-


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Swaptions are options to buy or sell a swap that will become operative at the expiry of the options.Thus, a swaptions is an option on a forward swap. Rather than have calls and puts, the swaptionsmarket has receiver swaptions and payer swaptions. A receiver swaptions is an option to receive fixedand pay floating. A payer swaptions is an option to pay fixed and receive floating.

Out of the above mentioned types of derivatives forward, future and options are the most commonly

used.

DERIVATIVE MARKET

The Derivatives Market is meant as the market where exchange of derivatives takes place. Derivativesare one type of securities whose price is derived from the underlying assets. And value of thesederivatives is determined by the fluctuations in the underlying assets. These underlying assets are mostcommonly stocks, bonds, currencies, interest rates, commodities and market indices. As Derivatives aremerely contracts between two or more parties, anything like weather data or amount of rain can be usedas underlying assets. The Derivatives can be classified as Future Contracts, Forward Contracts,Options, Swaps and Credit Derivatives.

PARTICIPANTS OF THE DERIVATIVE MARKET

Market participants in the future and option markets are many and they perform multiple roles,depending upon their respective positions. A trader acts as a hedger when he transacts in the market forprice risk management. He is a speculator if he takes an open position in the price futures market or ifhe sells naked option contracts. He acts as an arbitrageur when he enters in to simultaneous purchaseand sale of a commodity, stock or other asset to take advantage of misruling. He earns risk less profit in

this activity. Such opportunities do not exist for long in an efficient market. Brokers provide services toothers, while market makers create liquidity in the market.

Hedgers

Hedgers are the traders who wish to eliminate the risk (of price change) to which they are alreadyexposed. They may take a long position on, or short sell, a commodity and would, therefore, stand tolose should the prices move in the adverse direction.

Speculators

If hedgers are the people who wish to avoid the price risk, speculators are those who are willing to takesuch risk. These people take position in the market and assume risk to profit from fluctuations in prices.In fact, speculators consume information, make forecasts about the prices and put their money in theseforecasts. In this process, they feed information into prices and thus contribute to market efficiency. Bytaking position, they are betting that a price would go up or they are betting that it would go down.

The speculators in the derivative markets may be either day trader or position traders. The day tradersspeculate on the price movements during one trading day, open and close position many times a dayand do not carry any position at the end of the day.


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They monitor the prices continuously and generally attempt to make profit from just a few ticks pertrade. On the other hand, the position traders also attempt to gain from price fluctuations but they keeptheir positions for longer durations may is for a few days, weeks or even months.

Arbitrageurs

Arbitrageurs thrive on market imperfections. An arbitrageur profits by trading a given commodity, orother item, that sells for different prices in different markets. The Institute of Chartered Accountant ofIndia, the word ARBITRAGE has been defines as follows:-

Simultaneous purchase of securities in one market where the price there of is low and sale thereof inanother market, where the price thereof is comparatively higher. These are done when the samesecurities are being quoted at different prices in the two markets, with a view to make profit and carriedon with conceived intention to derive advantage from difference in prices of securities prevailing in thetwo different markets

Thus, arbitrage involves making risk-less profits by simultaneously entering into transactions in two or

more markets.

HISTORY OF DERIVATIVES

The history of derivatives is surprisingly longer than what most people think. Some texts even findthe existence of the characteristics of derivative contracts in incidents of Mahabharata. Traces ofderivative contracts can even be found in incidents that date back to the ages before Jesus Christ.

However, the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, oroverproduction.

The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650.These were evidently standardised contracts, which made them much like today's futures.

The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was establishedin 1848 where forward contracts on various commodities were standardised around 1865. Fromthen on, futures contracts have remained more or less in the same form, as we know them today.

Derivatives have had a long presence in India. The commodity derivative market has beenfunctioning in India since the nineteenth century with organized trading in cotton through theestablishment of Cotton Trade Association in 1875. Since then contracts on various other

commodities have been introduced as well.

Exchange traded financial derivatives were introduced in India in June 2000 at the two major stockexchanges, NSE and BSE. There are various contracts currently traded on these exchanges.

The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with thelaunch of index futures on June 12, 2000. The futures contracts are based on the popular benchmarkS&P CNX Nifty Index.


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The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE alsobecame the first exchange to launch trading in options on individual securities from July 2, 2001.Futures on individual securities were introduced on November 9, 2001. Futures and Options onindividual securities are available on 227 securities stipulated by SEBI.

The Exchange provides trading in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTYJUNIOR, CNX 100 and NIFTY MIDCAP 50 indices. The Exchange is now introducing miniderivative (futures and options) contracts on S&P CNX Nifty index w.e.f. January 1,2008.

National Commodity & Derivatives Exchange Limited (NCDEX) started its operations inDecember 2003, to provide a platform for commodities trading.The derivatives market in India hasgrown exponentially, especially at NSE. Stock Futures are the most highly traded contracts.

The size of the derivatives market has become important in the last 15 years or so. In 2007 the total

world derivatives market expanded to $516 trillion.

With the opening of the economy to multinationals and the adoption of the liberalized economicpolicies, the economy is driven more towards the free market economy. The complex nature offinancial structuring itself involves the utilization of multi currency transactions. It exposes theclients, particularly corporate clients to various risks such as exchange rate risk, interest rate risk,economic risk and political risk.

With the integration of the financial markets and free mobility of capital, risks also multiplied. Forinstance, when countries adopt floating exchange rates, they have to face risks due to fluctuations inthe exchange rates. Deregulation of interest rate cause interest risks. Again, securitization hasbrought with it the risk of default or counter party risk. Apart from it, every assetwhethercommodity or metal or share or currencyis subject to depreciation in its value. It may be due tocertain inherent factors and external factors like the market condition, Governments policy,economic and political condition prevailing in the country and so on.

In the present state of the economy, there is an imperative need of the corporate clients to protectthere operating profits by shifting some of the uncontrollable financial risks to those who are able tobear and manage them. Thus, risk management becomes a must for survival since there is a highvolatility in the present financial markets

In this context, derivatives occupy an important place as risk reducing machinery. Derivatives areuseful to reduce many of the risks discussed above. In fact, the financial service companies can playa very dynamic role in dealing with such risks. They can ensure that the above risks are hedged byusing derivatives like forwards, future, options, swaps etc. Derivatives, thus, enable the clients totransfer their financial risks to he financial service companies. This really protects the clients fromunforeseen risks and helps them to get there due operating profits or to keep the project well withinthe budget costs. To hedge the various risks that one faces in the financial market today, derivativesare absolutely essential.


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SCOPE OF DERIVATIVES IN INDIA

In India, all attempts are being made to introduce derivative instruments in the capital market. TheNational Stock Exchange has been planning to introduce index-based futures. A stiff net worth criteriaof Rs.7 to 10 corers cover is proposed for members who wish to enroll for such trading. But, it has notyet received the necessary permission from the securities and Exchange Board of India.

In the forex market, there are brighter chances of introducing derivatives on a large scale. Infact, thenecessary groundwork for the introduction of derivatives in forex market was prepared by a high-levelexpert committee appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committees report wasalready submitted to the Government in 1995. As it is, a few derivative products such as interest rateswaps, coupon swaps, currency swaps and fixed rate agreements are available on a limited scale. It iseasier to introduce derivatives in forex market because most of these products are OTC products (Over-the-counter) and they are highly flexible. These are always between two parties and one among them isalways a financial intermediary.

However, there should be proper legislations for the effective implementation of derivative contracts.

The utility of derivatives through Hedging can be derived, only when, there is transparency with honestdealings. The players in the derivative market should have a sound financial base for dealing inderivative transactions. What is more important for the success of derivatives is the prescription of proper capital adequacy norms, training of financial intermediaries and the provision of well-established indices. Brokers must also be trained in the intricacies of the derivative-transactions.

Now, derivatives have been introduced in the Indian Market in the form of index options and indexfutures. Index options and index futures are basically derivate tools based on stock index. They are


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really the risk management tools. Since derivates are permitted legally, one can use them to insulate hisequity portfolio against the vagaries of the market.

Every investor in the financial area is affected by index fluctuations. Hence, risk management usingindex derivatives is of far more importance than risk management using individual security options.Moreover, Portfolio risk is dominated by the market risk, regardless of the composition of the portfolio.Hence, investors would be more interested in using index-based derivative products rather than security based derivative

There are no derivatives based on interest rates in India today. However, Indian users of hedgingservices are allowed to buy derivatives involving other currencies on foreign markets. India has astrong dollar- rupee forward market with contracts being traded for one to six month expiration. Dailytrading volume on this forward market is around $500 million a day. Hence, derivatives available inIndia in foreign exchange area are also highly beneficial to the users

RECENT DEVELOPMENTS

At present Derivative Trading has been permitted by the SEBI on derivative segment of the BSE andthe F&0 segment of the NSE. The natures of derivative contracts permitted are:

Index Futures contracts introduced in June, 2000, Index options introduced in June, 2001, and Stock options introduced in July 2001

The minimum contract size of a derivative contract is Rs.2 lakhs. Besides the minimum contractsize, there is a stipulation for the lot size of a derivative contract. The lot size refers to number ofunderlying securities in one contract. The lot size of the underlying individual security should be inmultiples of 100 and tractions, if any should be rounded of to next higher multiple of 100. Thisrequirement along with the requirement of minimum contract size from the basis for arriving at thelot size of contract.

Apart from the above, there are market wide limits also. The market wide limit for index productsin NIL. For stock specific products it is of open positions. But, for option and futures the followingwide limits have been fixed.

30 times the average number of shares traded daily, during the previous calendar month in thecash segment of the exchange.

Or 10% of the number of shares held by non-promoters, i.e., 10% of the free float in terms ofnumber of shares of a company.


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Scenario of Derivative Markets in India

The emergence of the market for derivatives products, most notable forwards, futures, options andswaps can be traced back to the willingness of risk-averse economic agents to guard themselves againstuncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets can

be subject to a very high degree of volatility. Through the use of derivative products, it is possible topartially or fully transfer price risks by locking-in asset prices. As instruments of risk management,derivatives products generally do not influence the fluctuations in the underlying asset prices.However, by locking-in asset prices, derivatives products minimize the impact of fluctuations in assetprices on the profitability and cash flow situation of risk-averse investors.

Starting from a controlled economy, India has moved towards a world where prices fluctuate everyday. The introduction of risk management instruments in India gained momentum in the last few yearsdue to liberalisation process and Reserve Bank of Indias (RBI) efforts in creating currency forwardmarket. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging themarket requirements initiated the process of setting up derivative markets in India. In July 1999,

derivatives trading commenced in India

Chronology of instruments

1991 Liberalisation process initiated

14 December 1995 NSE asked SEBI for permission to trade indexfutures.

18 November 1996 SEBI setup L.C.Gupta Committee to draft a policyframework for index futures.

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rateagreements (FRAs) and interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and optionson an Indian index.

25 May 2000 SEBI gave permission to NSE and BSE to do indexfutures trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.


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12 June 2000 Trading of Nifty futures commenced at NSE.

25,September 2000 Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives

Factors generally attributed as the major driving force behind growth offinancial derivatives are:

Increased Volatility in asset prices in financial markets,Increased integration of national financial markets with the international markets,Marked improvement in communication facilities and sharp decline in their costs,Development of more sophisticated risk management tools, providing economic agents a wider choiceof risk management strategies, andInnovations in the derivatives markets, which optimally combine the risks and returns over a largenumber of financial assets, leading to higher returns, reduced risk as well as transaction costs ascompared to individual financial assets.

The need for a derivatives market:

The derivatives market performs a number of economic functions:

1. they help in transferring risks from risk adverse people to risk oriented people2. They help in the discovery of future as well as current prices3. They catalyze entrepreneurial activity4. They increase the volume traded in markets because of participation of risk adverse people in greaternumbers

5. They increase savings and investment in the long run

The Types of Derivative Market

The Derivative Market can be classified as Exchange Traded Derivatives Market and Over the CounterDerivative Market.

Exchange Traded Derivatives are those derivatives which are traded through specialized derivativeexchanges whereas Over the Counter Derivatives are those which are privately traded between twoparties and involves no exchange or intermediary. Swaps, Options and Forward Contracts are traded inOver the Counter Derivatives Market or OTC market.

The main participants of OTC market are the Investment Banks, Commercial Banks, Govt. SponsoredEnterprises and Hedge Funds. The investment banks markets the derivatives through traders to theclients like hedge funds and the rest.

In the Exchange Traded Derivatives Market or Future Market, exchange acts as the main party and bytrading of derivatives actually risk is traded between two parties. One party who purchases futurecontract is said to go long and the person who sells the future contract is said to go short. Theholder of the long position owns the future contract and earns profit from it if the price of the


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underlying security goes up in the future. On the contrary, holder of the short position is in aprofitable position if the price of the underlying security goes down, as he has already sold the futurecontract. So, when a new future contract is introduced, the total position in the contract is zero as noone is holding that for short or long.

The trading of foreign exchange traded derivatives or the future contracts has emerged as very

important financial activity all over the world just like trading of equity-linked contracts or commoditycontracts. The derivatives whose underlying assets are credit, energy or metal, have shown a steadygrowth rate over the years around the world. Interest rate is the parameter which influences the globaltrading of derivatives, the most.

THE TREND OF DERIVATIVE MARKET IN INDIA

Derivative products made a debut in the Indian market during 1998 and overall progress of derivativesmarket in India has indeed been impressive.

The Indian equity derivatives market has registered an "explosive growth" and is expected to continue

its dream run in the years to come with the various pieces that are crucial for the market's growthslowly falling in place.

Over the counter derivatives market in Interest Rate and Foreign Exchange has also witnessedimpressive growth with RBI allowing the local banks to run books in Indian Rupee Interest Rate andFX derivatives. The complexity of market continues to increase as clients have become savvier,demanding more fine tuned solution to meet their risk management objectives, rather than using thevanilla products.

Besides Rupee derivatives offered by the local players, RBI has also allowed the client to use moreexotic products like barrier options. These products are offered by the local bank on back-to-back basis,

wherein they buy similar product from market maker from the offshore markets.

The complexity of derivatives market has increased, but the growth in deployment of risk managementsystems required to manage such complex business has not grown at the same pace.

The reason being, the very high cost of such system and absence of any local player who could offerthe solution, which could compete with product offered by the international vendors.

DERIVATIVE MARKET GROWTH

The Derivatives Market Growth was about 30% in the first half of 2007 when it reached a size of $US370 trillion. This growth was mainly due to the increase in the participation of the bankers, investorsand different companies. The derivative market instruments are used by them to hedge risks as well asto satisfy their speculative needs.


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The derivative market growth for different derivative market instruments may be discussed under thefollowing heads.

Derivative Market Growth for the Exchange-traded-Derivatives

The Derivative Market Growth for equity reached $114.1 trillion. The open interest in the futures and

options market grew by 38 % while the interest rate futures grew by 42%. Hence the derivative marketsize for the futures and the options market was $49 trillion.

Derivative Market Growth for the Global Over-the-Counter Derivatives

The contracts traded through Over-the-Counter market witnessed a 24 % increase in its face value andthe over-the -counter derivative market size reached $70,000 billion. This shows that the face value ofthe derivative contracts has multiplied 30 times the size of the US economy. Notable increases wererecorded for foreign exchange, interest rate, equity and commodity based derivative following anincrease in the size of the Over-the Counter derivative market.

The Derivative Market Growth does not necessitate an increase in the risk taken by the differentinvestors. Even then, the overshoot in the face value of the derivative contracts shows that thesederivative instruments played a pivotal role in the financial market of today.

Derivative Market Growth for the Credit Derivatives

The credit derivatives grew from $4.5 trillion to $0.7 trillion in 2001. This derivative market growth isattributed to the increase in the trading in the synthetic collateral Debt obligations and also to theelectronic trading systems that have come into existence.

The Bank of International Settlements measures the size and the growth of the derivative market.

According to BIS, the derivative market growth in the over the counter derivative market witnessed aslump in the second half of 2006. Although the credit derivative market grew at a rapid pace, suchgrowth was made offset by a slump somewhere else. The notional amount of the Credit Default Swapwitnessed a growth of 42%. Credit derivatives grew by 54%. The single name contracts grew by 36%.The interest derivatives grew by 11%. The OTC foreign exchange derivatives slowed by 5%, the OTCequity derivatives slowed by 10%. Commodity derivatives also experienced crawling growth pattern.

MYTHS AND REALITIES ABOUT DERIVATIVES

In less than three decades of their coming into vogue, derivatives markets have become the mostimportant markets in the world. Financial derivatives came into the spotlight along with the rise inuncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchangerates leading to introduction of currency derivatives followed by other innovations including stockindex futures. Today, derivatives have become part and parcel of the day-to-day life for ordinarypeople in major parts of the world. While this is true for many countries, there are still apprehensionsabout the introduction of derivatives. There are many myths about derivatives but the realities that aredifferent especially for Exchange traded derivatives, which are well regulated with all the safetymechanisms in place.

What are these myths behind derivatives?


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Derivatives increase speculation and do not serve any economic purposeIndian Market is not ready for derivative tradingDisasters prove that derivatives are very risky and highly leveraged instrumentsDerivatives are complex and exotic instruments that Indian investors will finddifficulty in understandingIs the existing capital market safer than Derivatives?

1. Derivatives increase speculation and do not serve any economic purpose

While the fact is...

Numerous studies of derivatives activity have led to a broad consensus, both in the private and publicsectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodityprices, or exchange rates.

The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futuresand options helped farmers and processors hedge against commodity price risk. After the fallout ofBretton wood agreement, the financial markets in the world started undergoing radical changes. Thisperiod is marked by remarkable innovations in the financial markets such as introduction of floatingrates for the currencies, increased trading in variety of derivatives instruments, on-line trading in thecapital markets, etc. As the complexity of instruments increased many folds, the accompanying riskfactors grew in gigantic proportions. This situation led to development derivatives as effective riskmanagement tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional investors to effectivelymanage their portfolios of assets and liabilities through instruments like stock index futures andoptions. An equity fund, for example, can reduce its exposure to the stock market quickly and at arelatively low cost without selling off part of its equity assets by using stock index futures or indexoptions.

By providing investors and issuers with a wider array of tools for managing risks and raising capital,derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering thecost of capital formation and stimulating economic growth.Now that world markets for trade and finance have become more integrated, derivatives havestrengthened these important linkages between global markets, increasing market liquidity andefficiency and facilitating the flow of trade and finance.

2. Indian Market is not ready for derivative trading


Often the argument put forth against derivatives trading is that the Indian capital market is not ready forderivatives trading. Here, we look into the pre-requisites, which are needed for the introduction ofderivatives and how Indian market fares:


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PRE-REQUISITES INDIAN SCENARIO

Large market Capitalisation India is one of the largest market-capitalised countries inAsia with a market capitalisation of more than Rs.765000crores.

High Liquidity in theunderlying

The daily average traded volume in Indian capital markettoday is around 7500 crores. Which means on an averageevery month 14% of the countrys Market capitalisation getstraded. These are clear indicators of high liquidity in theunderlying.

Trade guarantee The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form ofNational Securities Clearing Corporation (NSCCL). NSCCLis responsible for guaranteeing all open positions on the

National Stock Exchange (NSE) for which it does theclearing.

A Strong Depository National Securities Depositories Limited (NSDL) whichstarted functioning in the year 1997 has revolutionalised thesecurity settlement in our country.

A Good legal guardian In the Institution of SEBI (Securities and Exchange Board ofIndia) today the Indian capital market enjoys a strong,

independent, and innovative legal guardian who is helpingthe market to evolve to a healthier place for trade practices.

3. Disasters prove that derivatives are very risky and highly leveraged instruments


Disasters can take place in any system. The 1992 Security scam is a case in point. Disasters are notnecessarily due to dealing in derivatives, but derivatives make headlines... Here I have tried to explainsome of the important issues involved in disasters related to derivatives. Careful observation will tell us

that these disasters have occurred due to lack of internal controls and/or outright fraud either by theemployees or promoters.

Barings Collapse

233 year old British bank goes bankrupt on 26th February 1995Downfall attributed to a single trader, 28 year old Nicholas LeesonLoss arose due to large exposure to the Japanese futures market


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Leeson, chief trader for Barings futures in Singapore, takes huge position in index futures of Nikkei225Market falls by more than 15% in the first two months of 95 and Barings suffers huge lossesBank looses $1.3 billion from derivative tradingLoss wipes out the entire equity capital of Barings

The reasons for the collapse:

Leeson was supposed to be arbitraging between Osaka Securities Exchange and SIMEX -- a risk lessstrategy, while in truth it was an unhedged position.Leeson was heading both settlement and trading desk -- at most other banks the functions aresegregated, this helped Leeson to cover his losses -- Leeson was unsupervised.Lack of independent risk management unit, again a deviation from prudential norms.There were no proper internal control mechanisms leading to the discrepancies going unnoticed Internal audit report which warned of "excessive concentration of power in Leesons hands" wasignored by the top management.

The conclusion as summarised by Wall Street Journal article

" Bank of England officials said they did not regard the problem in this case as one peculiar toderivatives. In a case where a trader is taking unauthorised positions, they said, the real question is thestrength of an investment houses internal controls and the external monitoring done by Exchanges andRegulators. "

Metallgesellschaft

Metallgesellshaft (MG) -- a hedge that went bad to the tune of $1.3 billionGermanys 14th largest industrial group nearly goes bankrupt from losses suffered through itsAmerican subsidiary - MGRMMGRM offered long term contracts to supply 180 million barrels of oil products to its clients --commitments were quite large, equivalent to 85 days of Kuwaits oil outputMGRM created a hedge position for these long term contracts with short term futures market throughrolling hedge --, As there was no viable long term contracts availableCompany was exposed to basis risk -- risk of short term oil prices temporarily deviating from long termprices.In 1993, oil prices crashed, leading to billion dollars of margin call to be met in cash. The Companywas faced with temporary funds crunch.New management team decides to liquidate the remaining contracts, leading to a loss of 1.3 billion.Liquidation has been criticised, as the losses could have decreased over time.Auditors report claims that the losses were caused by the size of the trading exposure.

Reasons for the losses:

The transactions carried out by the company were mainly OTC in nature and hence lacked transparencyand risk management system employed by a derivative exchangeLarge exposureTemporary funds crunchLack of matching long-term contracts, which necessitated the company to use rolling short term hedge-- problem arising from the hedging strategy


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Basis risk leading to short term loss

Derivatives are complex and exotic instruments that Indian investors will have difficulty in

understanding


Trading in standard derivatives such as forwards, futures and options is already prevalent in India andhas a long history. Reserve Bank of India allows forward trading in Rupee-Dollar forward contracts,which has become a liquid market. Reserve Bank of India also allows Cross Currency options trading.

Forward Markets Commission has allowed trading in Commodity Forwards on CommoditiesExchanges, which are, called Futures in international markets. Commodities futures in India areavailable in turmeric, black pepper, coffee, Gur (jaggery), hessian, castor seed oil etc. There are plansto set up commodities futures exchanges in Soya bean oil as also in Cotton. International markets havealso been allowed (dollar denominated contracts) in certain commodities. Reserve Bank of India alsoallows, the users to hedge their portfolios through derivatives exchanges abroad. Detailed guidelines

have been prescribed by the RBI for the purpose of getting approvals to hedge the users exposure ininternational markets.

Derivatives in commodities markets have a long history. The first commodity futures exchange was setup in 1875 in Mumbai under the aegis of Bombay Cotton Traders Association (Dr.A.S.Naik, 1968,Chairman, Forwards Markets Commission, India, 1963-68). A clearinghouse for clearing andsettlement of these trades was set up in 1918. In oilseeds, a futures market was established in 1900.Wheat futures market began in Hapur in 1913. Futures market in raw jute was set up inCalcutta in 1912. Bullion futures market was set up in Mumbai in 1920.

History and existence of markets along with setting up of new markets prove that the concept of

derivatives is not alien to India. In commodity markets, there is no resistance from the users or marketparticipants to trade in commodity futures or foreign exchange markets. Government of India has alsobeen facilitating the setting up and operations of these markets in India by providing approvals anddefining appropriate regulatory frameworks for their operations.

Approval for new exchanges in last six months by the Government of India also indicates thatGovernment of India does not consider this type of trading to be harmful albeit within properregulatory framework.

This amply proves that the concept of options and futures has been well ingrained in the Indian equitiesmarket for a long time and is not alien as it is made out to be. Even today, complex strategies of optionsare being traded in many exchanges which are called teji-mandi, jota-phatak, bhav-bhav at different places in India (Vohra and Bagari,1998In that sense, the derivatives are not new to India and are also currently prevalent in various marketsincluding equities markets.

5. Is the existing capital market more safer than Derivatives?



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World over, the spot markets in equities are operated on a principle of rolling settlement. In this kind oftrading, if you trade on a particular day (T), you have to settle these trades on the third working dayfrom the date of trading (T+3).

Futures market allow you to trade for a period of say 1 month or 3 months and allow you to net thetransaction taken place during the period for the settlement at the end of the period. In India, most of

the stock exchanges allow the participants to trade during one-week period for settlement in thefollowing week. The trades are netted for the settlement for the entire one-week period. In that sense,the Indian markets are already operating the futures style settlement rather than cash markets prevalentinternationally.

In this system, additionally, many exchanges also allow the forward trading called badla in Gujaratiand Contango in English, which was prevalent in UK. This system is prevalent currently in France intheir monthly settlement markets. It allowed one to even further increase the time to settle for almost 3months under the earlier regulations. This way, a curious mix of futures style settlement with facility tocarry the settlement obligations forward creates discrepancies.

The more efficient way from the regulatory perspective will be to separate out the derivatives from thecash market i.e. introduce rolling settlement in all exchanges and at the same time allow futures andoptions to trade. This way, the regulators will also be able to regulate both the markets easily and it will provide more flexibility to the market participants.

In addition, the existing system although futures style, does not ask for any margins from the clients.Given the volatility of the equities market in India, this system has become quite prone to systemiccollapse. This was evident in the MS Shoes scandal. At the time of default taking place on the BSE, thedefaulting member of the BSE Mr.Zaveri had a position close to Rs.18 crores. However, due to thedefault, BSE had to stop trading for a period of three days. At the same time, the Barings Bank failedon Singapore Monetary Exchange (SIMEX) for the exposure of more than US $ 20 billion (more thanRs.84,000 crore) with a loss of approximately US $ 900 million ( around Rs.3,800 crore). Although, theexposure was so high and even the loss was also very big compared to the total exposure on MS Shoesfor BSE of Rs.18 crores, the SIMEX had taken so much margins that they did not stop trading for asingle minute.

Comparision of New System with Existing System

Many people and brokers in India think that the new system of Futures & Options and banning ofBadla is disadvantageous and introduced early, but I feel that this new system is very useful especiallyto retail investors. It increases the no of options investors for investment. In fact it should have beenintroduced much before and NSE had approved it but was not active because of politicization in SEBI

THE NEW ERA OF DERIVATIVES

Different types of derivatives available for use by these institutional investors in India: Equity, ForeignCurrency, and Commodity Derivatives. The intensity of derivatives usage by any institutional investoris a function of its ability and willingness to use derivatives for one or more of the following purposes:

1. Risk Containment: Using derivatives for hedging and risk containment purposes.


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2. Risk Trading/Market Making: Running derivatives trading book for profits and arbitrage.

The different institutional investors could be meaningfully classified into: Banks, All India FinancialInstitutions (FIs), Mutual Funds (MFs), Foreign Institutional Investors (FIIs) and Life and GeneralInsurers.

Banks

Based on the differences in governance structure, business practices and organizational ethos, it ismeaningful to classify the Indian banking sector into the following:

1. Public Sector Banks (PSBs);

2. Private Sector Banks (Old Generation);

3. Private Sector Banks (New Generation); and

4. Foreign Banks (with banking and authorized dealer license).

Foreign Currency Derivatives Of Banks

Banks that are Authorized Dealers (ADs) under the exchange control law are permitted by RBI toundertake the following foreign currency (FCY) derivative transactions:

For bank customers for hedging their FCY risks.

FCY: INR Forward Contracts, and Swaps

Cross-Currency Forward Contracts and Swaps.

Cross-Currency Options.

There is now an active Over-The-Counter (OTC) foreign currency derivatives market in India.However, the activity of most PSB majors in this market is limited to writing FCY derivatives contractswith their corporate customers on fully covered back-to-back basis. And, most PSBs do not run anactive foreign currency derivative trading book, on account of the impediments enumerated earlier thatneed to be overcome at their end.

All India financial institutions (FIs)

With the merger of ICICI into ICICI Bank, the universe of all-India FIs comprises IDBI, IFCI, IIBI,SIDBI, EXIM, NABARD and IDFC. In the context of use of financial derivatives, the universe of FIscould perhaps be extended to include a few other financially significant players such as HDFC andNHB.

Foreign Currency Derivatives Of FIs


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Most FIs with foreign currency borrowings have been users of FCY:INR swaps, cross currency swaps,CC-IRS, and FRAs for their liabilities management. With the prior approval of RBI, FIs can also offerforeign currency derivatives as a product to their corporate borrowers on a fully covered back-to-back basis. Yet, most FIs have not yet readied themselves to explore this business opportunity.

Mutual funds

Foreign currency derivatives

In September 1999, 9 Indian mutual funds were allowed to invest in ADRs/GDRs of Indian companiesin the overseas market within the overall limit of US$ 500 million with a sub-ceiling for individualmutual funds of 10 percent of net assets managed by them (at previous year-end), subject to maximumof US$ 50 million per mutual fund. Several mutual funds had obtained the requisite approvals fromSEBI and RBI for making such investments. However, given that most ADRs/GDRs of Indiancompanies traded in the overseas market at a premium to their prices on domestic equity markets, thisfacility has remained largely unutilized. Therefore, the question of using FCY: INR forward cover orswap did not much arise. However, recently, from 30 March 2002, 10 domestic mutual funds have been

permitted to invest in foreign sovereign and corporate debt securities (AAA rated by S&P or Moody orFitch IBCA) in countries with fully convertible currencies within the overall market limit of US$ 500million, with a sub-ceiling for individual mutual funds of four percent of net assets managed by them ason 28 February 2002, subject to a maximum of US$ 50 million per mutual fund.

Several mutual funds have now obtained the requisite SEBI and RBI approvals for making theseinvestments. Once investment in foreign debt securities pick-up, mutual funds ought to emerge asactive users of FCY: INR swaps to hedge the foreign currency risk in these investments.

Life and general insurance

Foreign currency derivatives

Given the long-term nature of life insurance contracts, insurance regulations in many parts of the worldapply currency-matching principle for assets and liabilities under life insurance contracts. Indianinsurance law too prohibits investment of funds from insurance business written in India, into overseasor foreign securities. Hence, Indian life and general insurers have no presence in the foreign currencyderivatives market in India

Documents

A Study of How Derivative is Progressing in In