DERIVATIVE MARKET IN DERIVATIVE MARKET IN INDIAINDIA

RISK IS THE BASIS OF RISK IS THE BASIS OF BANKING…BANKING…

No No Risk !!!!Risk !!!!

NO NO GAIN!!GAIN!!

TO WIN WITHOUT RISK IS TO TRIUMPH WITHOUT GLORY………

INTRODUCTION- RISK INTRODUCTION- RISK MANAGMENTMANAGMENT

Risk management is a discipline that helps bringing risks Risk management is a discipline that helps bringing risks to manageable extent . to manageable extent .

One risk does not get transformed into undesirable risk.One risk does not get transformed into undesirable risk. PLAYERS:PLAYERS:

Hedgers, Speculators and Arbitrageurs - Market RoleHedgers, Speculators and Arbitrageurs - Market Role Hedgers and investors provide the economic substance to Hedgers and investors provide the economic substance to

any financial market. Without them the markets would any financial market. Without them the markets would lose their purpose and become mere tools of gambling. lose their purpose and become mere tools of gambling.

(E.g. Banks)(E.g. Banks) Speculators provide liquidity and depth to the market.Speculators provide liquidity and depth to the market. ArbitrageursArbitrageurs

VARIOUS TYPES OF RISKS IN VARIOUS TYPES OF RISKS IN BANKSBANKS

Solvency Risks-Solvency Risks- Risk of total financial failure of a Risk of total financial failure of a bank.bank.

Liquidity Risk-Liquidity Risk- Inability to meet the repayment Inability to meet the repayment requirementsrequirements

Credit Risk-Credit Risk- Loss of Bank as a result of default Loss of Bank as a result of default Interest Rate Risk-Interest Rate Risk- Changes in Interest rate. Changes in Interest rate. Price Risks-Price Risks- Risk of loss/gain in value of assets & Risk of loss/gain in value of assets &

liabilities due to volatility in exchange rates.liabilities due to volatility in exchange rates. Operating Risks-Operating Risks- Risks arising from out of failures in Risks arising from out of failures in

operations, supporting system, sabotage, fraud etc.operations, supporting system, sabotage, fraud etc. Market & Foreign exchange Risk.Market & Foreign exchange Risk.

Process of Risk Management Process of Risk Management in Banksin Banks

Identification of risksIdentification of risks Quantification of risksQuantification of risks Policy FormulationPolicy Formulation Strategy Formulation Strategy Formulation

Derivatives come in Derivatives come in playplay

Monitoring RisksMonitoring Risks

HISTORY OF DERIVATIVES HISTORY OF DERIVATIVES AND THE MARKET IN INDIA AND THE MARKET IN INDIA

According to Mr. Asani Sarkar’s research work, Derivatives market has been in existence in India since 1875

He also mentions that in early 1900s India had the largest Futures Industry

In 1952, Indian Government banned the options and futures trading

But, by 2000 various reforms assisted in lifting all such bans and the derivatives market is booming since then

Contd..Contd..

The exchange traded derivative market is The exchange traded derivative market is the largest in terms of number of contracts the largest in terms of number of contracts mademade

In 2004, the daily trading value was 30 In 2004, the daily trading value was 30 billion USDbillion USD

The commodities eligible for futures trading The commodities eligible for futures trading was 8 and in 2004 it was increased to 80was 8 and in 2004 it was increased to 80

DERIVATIVESDERIVATIVES

Derivatives are financial contracts whose value/price is dependent Derivatives are financial contracts whose value/price is dependent

on the behavior of the price of one or more basic underlying assets on the behavior of the price of one or more basic underlying assets

(often simply known as the underlying). These contracts are (often simply known as the underlying). These contracts are

legally binding agreements, made on the trading screen of stock legally binding agreements, made on the trading screen of stock

exchanges, to buy or sell an asset in future. The asset can be a exchanges, to buy or sell an asset in future. The asset can be a

share, index, interest rate, bond, rupee dollar exchange rate, share, index, interest rate, bond, rupee dollar exchange rate,

sugar, crude oil, soybean, cotton, coffee and what have you.sugar, crude oil, soybean, cotton, coffee and what have you.

EX: derivatives is curd, which is derivative of milk. The price of EX: derivatives is curd, which is derivative of milk. The price of

curd depends upon the price of milk which in turn depends upon curd depends upon the price of milk which in turn depends upon

the demand and supply of milk.the demand and supply of milk.

Financial derivatives are financial instruments whose Financial derivatives are financial instruments whose prices are derived from the prices of other financial prices are derived from the prices of other financial instruments which are also know as underlying. It instruments which are also know as underlying. It relates to equities, loans, bonds, interest rates and relates to equities, loans, bonds, interest rates and currencies. currencies.

Section 2(ac) of Securities Contract Regulation Act Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative as:(SCRA) 1956 defines Derivative as:

a) “a security derived from a debt instrument, share, loan a) “a security derived from a debt instrument, share, loan whether secured or unsecured, riskwhether secured or unsecured, risk

instrument or contract for differences or any other form of instrument or contract for differences or any other form of security;security;

b) “a contract which derives its value from the prices, or b) “a contract which derives its value from the prices, or index of prices, of underlying securities”.index of prices, of underlying securities”.

MOTIVES OF USING MOTIVES OF USING DERIVATIVESDERIVATIVES

Spreads tradeSpreads trade Currency risk management.Currency risk management. Interest risk Real time trading in the market Interest risk Real time trading in the market

( Treasury Activities)( Treasury Activities)

ApplicationsApplications of Financial of Financial DerivativesDerivatives

1. 1. Management of risk:Management of risk:

2. 2. Efficiency in trading: Efficiency in trading:

3. 3. Speculation:Speculation:

4. 4. Price discover: Price discover:

5. 5. Price stabilization function:Price stabilization function:

Derivatives

Derivatives

Exotic, Swaptions and LEAPS etc.

Exotic, Swaptions and LEAPS etc.

FinancialFinancialCommodity

Commodity

ForwardForward

Basic InstrumentBasic Instrument

ComplexInstrumentsComplexInstruments

FuturesFutures OptionsOptions SwapsSwaps

STRATEGIES OF RISK STRATEGIES OF RISK MANAGEMENT IN BANKS.MANAGEMENT IN BANKS.

Hedging the Risk . – Hedging the Risk . – DerivativesDerivatives

ForwardsForwardsFuturesFuturesOptionsOptionsSwapsSwapsCredit Derivatives (Not available in Credit Derivatives (Not available in

India)India)

EXAMPLE EXAMPLE

Jewelry manufacturer Gold buyer agrees to buy gold at Rs. Jewelry manufacturer Gold buyer agrees to buy gold at Rs. 600 (the forward or delivery price) three months from now 600 (the forward or delivery price) three months from now (the delivery date) from gold mining concern Gold seller. (the delivery date) from gold mining concern Gold seller. This is an example of a forward contract. No money changes This is an example of a forward contract. No money changes hands between Gold buyer and Gold seller at the time the hands between Gold buyer and Gold seller at the time the forward contract is created. Rather, Gold buyer’s payoff forward contract is created. Rather, Gold buyer’s payoff depends on the spot price at the time of delivery. Suppose depends on the spot price at the time of delivery. Suppose that the spot price reaches Rs. 610 at the delivery date. Then that the spot price reaches Rs. 610 at the delivery date. Then Gold buyer gains Rs. 10 on his forward position (i.e. the Gold buyer gains Rs. 10 on his forward position (i.e. the difference between the spot and forward prices) by taking difference between the spot and forward prices) by taking delivery of the gold at Rs. 600. delivery of the gold at Rs. 600.

.

Features of forward contract…

It is a negotiated contract between two parties and hence exposed to counter party risk.

Each contract is custom designed and hence unique in terms of contract size, expiration date, asset type, asset quality etc.

A contract has to be settled in delivery or cash on expiration date.

In case one of the two parties wishes to reverse a contract, he has to compulsorily go to the other party. The counter party being in a monopoly situation can command the price he wants.

The standard Feature in any futures contract

Obligation to buy or sell Stated quantity At a specific price Stated date (Expiration Date) Marked to Market on a daily basis

EX: when you are dealing in March 2002 Satyam futures contract, you know that the market lot, ie the minimum quantity you can buy or sell, is 1,200 shares of Satyam, the contract would expiry on March 28, 2002, the price is quoted per share, the tick size is 5 paise per share or (1200*0.05) = Rs60 per contract/ market lot, the contract would be settled in cash and the closing price in the cash market on expiry day would be the settlement price.

Motives behind using Futures

Hedging: It provides an insurance against an increase in the price.

The futures market has two main types of foreseeable risk:

- price risk

- quantity risk

Interest Rate Futures

An interest rate futures contract is an agreement to buy or sell a standard quantity of specific interest bearing instruments, at a predetermined future date and a price agreed upon between parties

OPTIONS

Options contracts grant their purchasers the right but not the obligation to buy or sell a specific amount of the underlying at a particular price within a specified period.

OPTIONS Terminology …

Commodity options Stock Options Buyer of an option Writer of an option Call option Put option Option price

Buyer of call options : long call

Writer of call options : short call

Buyer of put options : long put

Writer of call options : short put

Distinguishing Options & Futures

SWAPSSWAPS

Swaps are derivatives involving exchange Swaps are derivatives involving exchange of cash flows over time, typically between of cash flows over time, typically between two parties. One party makes a payment two parties. One party makes a payment to the other depending upon whether a to the other depending upon whether a price is above or below a reference price price is above or below a reference price specified in the swap contract. specified in the swap contract.

Characteristics of SWAPSCharacteristics of SWAPS

1. Basically a forward1. Basically a forward

It is combination of Forwards. It has all the It is combination of Forwards. It has all the properties of Forward contract.properties of Forward contract.

2. Double coincidence of wants2. Double coincidence of wants

It requires that two parties with equal and opposite It requires that two parties with equal and opposite needs must come into contact with each other.needs must come into contact with each other.

3. Comparative credit advantage3. Comparative credit advantage

Borrowers enjoying comparative credit advantage in Borrowers enjoying comparative credit advantage in floating rate debts will enter into swap agreement.floating rate debts will enter into swap agreement.

Contd..Contd..

4. Flexibility4. Flexibility

Lenders have the flexibility to exchange Lenders have the flexibility to exchange floating rates according to the conditions floating rates according to the conditions prevailing in the market.prevailing in the market.

5. Necessity of an intermediary5. Necessity of an intermediary

It requires two counter parties with It requires two counter parties with opposite and matching needs. Thus it has opposite and matching needs. Thus it has created the necessity of an intermediary.created the necessity of an intermediary.

Contd..Contd..

6. Settlements6. Settlements

Even though the principal amount is Even though the principal amount is mentioned it is not exchanged. Here stream of mentioned it is not exchanged. Here stream of fixed rate is exchanged for floating rate interest.fixed rate is exchanged for floating rate interest.

7. Long term agreement7. Long term agreement

Forwards are for short term. Long dated Forwards are for short term. Long dated forward contracts are not preferred because forward contracts are not preferred because they involve more risk.they involve more risk.

Business Growth of Derivatives at Business Growth of Derivatives at NSE from 2000-2009NSE from 2000-2009

IMPORTANCEIMPORTANCE

To minimize risk.To minimize risk. To protect the interest of individual and institutional To protect the interest of individual and institutional

investors.investors. Offers high liquidity and flexibility.Offers high liquidity and flexibility. Does not create new risk and minimizes existing Does not create new risk and minimizes existing

ones.ones. Lowers transaction cost.Lowers transaction cost. Provides information on market movement.Provides information on market movement. Provides wide choice of hedging.Provides wide choice of hedging. Convenient, low cost and simple to operate.Convenient, low cost and simple to operate.