INTRODUCTION TO DERIVATIVES

Derivatives are defined as financial instruments whose value derived from the prices of
one or more other 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 the prices of underlying assets.

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

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

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 the imagination of investment banks. It is likely that any person who has
funds invested an insurance policy or a pension fund that they are investing in, and
exposed to, derivatives-wittingly or unwittingly.
 Contracts agreement

Cash Derivatives

Forward Others like Swaps,

FRAs etc

Futures
Merchandisin Options
(Standardized
g, customized
)

NTSD TSD

UNDERSTANDING DERIVATIVES

The primary objectives of any investor are to maximize returns and minimize risks.
Derivatives are contracts that originated from the need to minimize risk. The word
'derivative' originates from mathematics and refers to a variable, which has been
derived from another variable. Derivatives are so 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 share price (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 the underlying asset of the derivate up to a certain time in the future at a prearranged
price, the exercise price.

The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the
date of commencement 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 delivery will 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 selling price of his crop, he enters into a contract (derivative) with a merchant, who
agrees to buy the crop at a certain 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 this derivative 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 more valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the
contract becomes even more valuable.

This is because the farmer can sell the soybean he has produced at Rs .9000 per tonne
even though the market 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, precious stone 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 called exchange-traded derivatives. Or they can be customised as per the
needs of the user by negotiating with the other party involved.

Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the
example of the farmer above, if he thinks that the total production from his land will be
around 150 quintals, he can either go to a food merchant and enter into a derivatives
contract to sell 150 quintals of soybean in three months time at Rs 9,000 per ton. Or the
farmer can go to a commodities exchange, like the National 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 quintals of 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 the cost 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
some derivatives 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 a specific date in the future at today’s pre-agreed price. . Forwards are contracts
customizable in terms of contract 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 sell the 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 the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts.

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 1 st sep.

FEATURE FORWARD CONTRACT FUTURE CONTRACT

Operational Traded directly between two Traded on the exchanges.
Mechanism parties (not traded on the
exchanges).
Contract Differ from trade to trade. Contracts are standardized contracts.
Specifications
Counter-party Exists. Exists. However, assumed by the
risk clearing corp., which becomes the
counter party to all the trades or
unconditionally guarantees their
settlement.
Liquidation Low, as contracts are tailor High, as contracts are standardized
Profile made contracts catering to exchange traded contracts.
the needs of the needs of the
parties.
Price discovery Not efficient, as markets are Efficient, as markets are centralized and
scattered. all buyers and sellers come to a
common platform 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 any obligation. 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.

1. CALLS:-
Call gives the buyer the right, but not the obligation, to buy a given quantity of the
underlying asset, at a 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 or before 1 st Sep. In this case, A has the right to buy the shares on or
before the specified date, but he is not bound to buy the shares.

2. PUTS:-

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

For example:- A, on 1 st Aug. buys an option to sell 600 shares of Reliance Ind. Ltd. @
Rs 450 on or before 1 st Sep. In this case, A has the right to sell the shares on or before
the specified date, but he is not bound 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 sell an asset. His buying or selling of an asset depends upon the action of
buyer of the option. His position in 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 maximum maturity 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 a maturity of up to three years.

 BASKET:-

Basket options are options on portfolios of underlying assets are usually a moving
average of a basket of 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 a pre arranged formula. They can be regarded as portfolios of forward
contract. The two commonly used swaps are

1. INTEREST RATE SWAPS:-

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

3. CURRENCY SWAPS:-

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

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 swaptions market has receiver swaptions and payer swaptions. A receiver
swaptions is an option to receive fixed and 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. Derivatives are one type of securities whose price is derived from the
underlying assets. And value of these derivatives is determined by the fluctuations in the
underlying assets. These underlying assets are most commonly stocks, bonds, currencies,
interest rates, commodities and market indices. As Derivatives are merely contracts
between two or more parties, anything like weather data or amount of rain can be used as
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 for price risk management. He is a speculator if he takes an
open position in the price futures market or if he sells naked option contracts. He acts as
an arbitrageur when he enters in to simultaneous purchase and 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 to others, 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 already exposed. They may take a long position on, or short sell, a commodity
and would, therefore, stand to lose 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 take such 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 these forecasts. In this process, they
feed information into prices and thus contribute to market efficiency. By taking 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 traders speculate on the price movements during one trading day, open
and close position many times a day and do not carry any position at the end of the day.

They monitor the prices continuously and generally attempt to make profit from
just a few ticks per trade. On the other hand, the position traders also attempt to gain
from price fluctuations but they keep their 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, or other item, that sells for different prices in different markets. The
Institute of Chartered Accountant of India, 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 in another market, where the price thereof is comparatively higher. These
are done when the same securities are being quoted at different prices in the two
markets, with a view to make profit and carried on with conceived intention to derive
advantage from difference in prices of securities prevailing in the two 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 find the existence of the characteristics of derivative contracts in
incidents of Mahabharata. Traces of derivative 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, or overproduction.

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 established in 1848 where forward contracts on various commodities were
standardised around 1865. From then 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
been functioning in India since the nineteenth century with organized trading in
cotton through the establishment 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 stock exchanges, 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 the launch of index futures on June 12, 2000. The futures contracts
are based on the popular benchmark S&P CNX Nifty Index.

The Exchange introduced trading in Index Options (also based on Nifty) on June 4,
2001. NSE also became 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 on individual securities are available on 227
securities stipulated by SEBI.

The Exchange provides trading in other indices i.e. CNX-IT, BANK NIFTY, CNX
NIFTY JUNIOR, CNX 100 and NIFTY MIDCAP 50 indices. The Exchange is now
introducing mini derivative (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 in December 2003, to provide a platform for commodities trading.The
derivatives market in India has grown 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
economic policies, the economy is driven more towards the free market economy.
The complex nature of financial structuring itself involves the utilization of multi
currency transactions. It exposes the clients, 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. For instance, when countries adopt floating exchange rates, they have to
face risks due to fluctuations in the exchange rates. Deregulation of interest rate cause
interest risks. Again, securitization has brought with it the risk of default or counter
party risk. Apart from it, every asset—whether commodity or metal or share or
currency—is subject to depreciation in its value. It may be due to certain inherent
factors and external factors like the market condition, Government’s 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 protect there operating profits by shifting some of the uncontrollable
financial risks to those who are able to bear and manage them. Thus, risk
management becomes a must for survival since there is a high volatility in the present
financial markets

In this context, derivatives occupy an important place as risk reducing machinery.

Derivatives are useful to reduce many of the risks discussed above. In fact, the
financial service companies can play a very dynamic role in dealing with such risks.
They can ensure that the above risks are hedged by using derivatives like forwards,
future, options, swaps etc. Derivatives, thus, enable the clients to transfer their
financial risks to he financial service companies. This really protects the clients from
unforeseen risks and helps them to get there due operating profits or to keep the
project well within the budget costs. To hedge the various risks that one faces in the
financial market today, derivatives are absolutely essential.

SCOPE OF DERIVATIVES IN INDIA

In India, all attempts are being made to introduce derivative instruments in the capital
market. The National Stock Exchange has been planning to introduce index-based
futures. A stiff net worth criteria of Rs.7 to 10 corers cover is proposed for members who
wish to enroll for such trading. But, it has not yet 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, the necessary groundwork for the introduction of derivatives in forex market was
prepared by a high-level expert committee appointed by the RBI. It was headed by Mr.
O.P. Sodhani. Committee’s report was already submitted to the Government in 1995. As
it is, a few derivative products such as interest rate swaps, coupon swaps, currency swaps
and fixed rate agreements are available on a limited scale. It is easier 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 is always 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 honest dealings. The players in the derivative market
should have a sound financial base for dealing in derivative 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 index futures. Index options and index futures are basically derivate tools based on
stock index. They are really the risk management tools. Since derivates are permitted
legally, one can use them to insulate his equity portfolio against the vagaries of the
market.
Every investor in the financial area is affected by index fluctuations. Hence, risk
management using index 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
products.

There are no derivatives based on interest rates in India today. However, Indian users of
hedging services are allowed to buy derivatives involving other currencies on foreign
markets. India has a strong dollar- rupee forward market with contracts being traded for
one to six month expiration. Daily trading volume on this forward market is around $500
million a day. Hence, derivatives available in India 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 and the F&0 segment of the NSE. The natures of derivative contracts permitted
are:

Ø Index Futures contracts introduced in June, 2000,

Ø Index options introduced in June, 2001, and
Ø Stock options introduced in July 2001

The minimum contract size of a derivative contract is Rs.2 lakhs. Besides the
minimum contract size, there is a stipulation for the lot size of a derivative contract.
The lot size refers to number of underlying securities in one contract. The lot size of
the underlying individual security should be in multiples of 100 and tractions, if any
should be rounded of to next higher multiple of 100. This requirement along with the
requirement of minimum contract size from the basis for arriving at the lot size of
contract.
 Apart from the above, there are market wide limits also. The market wide limit for
index products in NIL. For stock specific products it is of open positions. But, for
option and futures the following wide limits have been fixed.

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

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

Scenario of Derivative Markets in India

The emergence of the market for derivatives products, most notable forwards, futures,
options and swaps can be traced back to the willingness of risk-averse economic agents to
guard themselves against uncertainties 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 to partially 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 asset
prices 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 every day. The introduction of risk management instruments in India gained
momentum in the last few years due to liberalisation process and Reserve Bank of India’s
(RBI) efforts in creating currency forward market. Derivatives are an integral part of
liberalisation process to manage risk. NSE gauging the market 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 index
futures.
18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy
framework for index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate
agreements (FRAs) and interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and options
on an Indian index.
25 May 2000 SEBI gave permission to NSE and BSE to do index
futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at
BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25,September Nifty futures trading commenced at SGX.
2000
2 June 2001 Individual Stock Options & Derivatives
Factors generally attributed as the major driving force behind
growth of financial derivatives are:

(a) Increased Volatility in asset prices in financial markets,

(b) Increased integration of national financial markets with the international markets,
(c) Marked improvement in communication facilities and sharp decline in their costs,
(d) Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
(e) Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets, leading to higher returns, reduced
risk as well as transaction costs as compared to individual financial assets.

The need for a derivatives market:

(f) The derivatives market performs a number of economic functions:

1. they help in transferring risks from risk adverse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk
adverse people in greater numbers
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 Counter Derivative Market.
Exchange Traded Derivatives are those derivatives which are traded through specialized
derivative exchanges whereas Over the Counter Derivatives are those which are privately
traded between two parties and involves no exchange or intermediary. Swaps, Options
and Forward Contracts are traded in Over the Counter Derivatives Market or OTC
market.

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

In the Exchange Traded Derivatives Market or Future Market, exchange acts as the main
party and by trading of derivatives actually risk is traded between two parties. One party
who purchases future contract is said to go “long” and the person who sells the future
contract is said to go “short”. The holder of the “long” position owns the future contract
and earns profit from it if the price of the underlying security goes up in the future. On
the contrary, holder of the “short” position is in a profitable position if the price of the
underlying security goes down, as he has already sold the future contract. So, when a new
future contract is introduced, the total position in the contract is zero as no one 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 commodity contracts. The derivatives whose underlying assets are credit,
energy or metal, have shown a steady growth rate over the years around the world.
Interest rate is the parameter which influences the global trading 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 derivatives market 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 growth slowly falling in place.

Over the counter derivatives market in Interest Rate and Foreign Exchange has
also witnessed impressive growth with RBI allowing the local banks to run books in
Indian Rupee Interest Rate and FX 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 the vanilla products.

Besides Rupee derivatives offered by the local players, RBI has also allowed the
client to use more exotic 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
management systems 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 offer the 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 $US 370 trillion. This growth was mainly due to the increase in the participation
of the bankers, investors and different companies. The derivative market instruments are
used by them to hedge risks as well as to satisfy their speculative needs.

The derivative market growth for different derivative market instruments may be
discussed under the following 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 market size 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 and the over-the -counter derivative market size reached $70,000 billion. This
shows that the face value of the derivative contracts has multiplied 30 times the size of
the US economy. Notable increases were recorded for foreign exchange, interest rate,
equity and commodity based derivative following an increase 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
different investors. Even then, the overshoot in the face value of the derivative contracts
shows that these derivative 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 is attributed to the increase in the trading in the synthetic collateral Debt
obligations and also to the electronic 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 a slump in the second half of 2006. Although the credit derivative
market grew at a rapid pace, such growth was made offset by a slump somewhere else.
The notional amount of the Credit Default Swap witnessed 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 OTC
equity 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 most important markets in the world. Financial derivatives came into the spotlight
along with the rise in uncertainty of post-1970, when US announced an end to the Bretton
Woods System of fixed exchange rates leading to introduction of currency derivatives
followed by other innovations including stock index futures. Today, derivatives have
become part and parcel of the day-to-day life for ordinary people in major parts of the
world. While this is true for many countries, there are still apprehensions about the
introduction of derivatives. There are many myths about derivatives but the realities that
are different especially for Exchange traded derivatives, which are well regulated with all
the safety mechanisms in place.

What are these myths behind derivatives?

• Derivatives increase speculation and do not serve any economic purpose

• Indian Market is not ready for derivative trading
• Disasters prove that derivatives are very risky and highly leveraged
instruments
• Derivatives are complex and exotic instruments that Indian investors will find
difficulty in understanding
• Is 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 public sectors 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, commodity prices, or exchange rates.

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

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

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 the cost of capital formation and stimulating economic growth.

Now that world markets for trade and finance have become more integrated, derivatives
have strengthened these important linkages between global markets, increasing market
liquidity and efficiency and facilitating the flow of trade and finance.

2. Indian Market is not ready for derivative trading

While the fact is...

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

PRE-REQUISITES INDIAN SCENARIO

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

High Liquidity in the The daily average traded volume in Indian capital market
underlying today is around 7500 crores. Which means on an average
every month 14% of the country’s Market capitalisation
gets traded. These are clear indicators of high liquidity in
the underlying.

Trade guarantee The first clearing corporation guaranteeing trades has

become fully functional from July 1996 in the form of
National Securities Clearing Corporation (NSCCL).
NSCCL is responsible for guaranteeing all open positions
on the National Stock Exchange (NSE) for which it does
the clearing.

A Strong Depository National Securities Depositories Limited (NSDL) which

started functioning in the year 1997 has revolutionalised
the security settlement in our country.

A Good legal guardian In the Institution of SEBI (Securities and Exchange Board
of India) today the Indian capital market enjoys a strong,
independent, and innovative legal guardian who is helping
the market to evolve to a healthier place for trade practices.

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

While the fact is...

Disasters can take place in any system. The 1992 Security scam is a case in point.
Disasters are not necessarily due to dealing in derivatives, but derivatives make
headlines... Here I have tried to explain some 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 the employees or
promoters.
Barings Collapse

1. 233 year old British bank goes bankrupt on 26th February 1995
2. Downfall attributed to a single trader, 28 year old Nicholas Leeson
3. Loss arose due to large exposure to the Japanese futures market
4. Leeson, chief trader for Barings futures in Singapore, takes huge position in index
futures of Nikkei 225
5. Market falls by more than 15% in the first two months of ’95 and Barings suffers
huge losses
6. Bank looses $1.3 billion from derivative trading
7. Loss 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 less strategy, while in truth it was an unhedged position.
• Leeson was heading both settlement and trading desk -- at most other banks the
functions are segregated, 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 Leeson’s hands" was ignored 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 to derivatives. In a case where a trader is taking unauthorised positions, they
said, the real question is the strength of an investment houses’ internal controls and the
external monitoring done by Exchanges and Regulators. "
Metallgesellschaft
 1. Metallgesellshaft (MG) -- a hedge that went bad to the tune of $1.3 billion
Germany’s 14th largest industrial group nearly goes bankrupt from losses suffered
through its American subsidiary - MGRM
2. MGRM offered long term contracts to supply 180 million barrels of oil products
to its clients -- commitments were quite large, equivalent to 85 days of Kuwait’s
oil output
3. MGRM created a hedge position for these long term contracts with short term
futures market through rolling hedge --, As there was no viable long term
contracts available
4. Company was exposed to basis risk -- risk of short term oil prices temporarily
deviating from long term prices.
5. In 1993, oil prices crashed, leading to billion dollars of margin call to be met in
cash. The Company was faced with temporary funds crunch.
6. New management team decides to liquidate the remaining contracts, leading to a
loss of 1.3 billion.
7. 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 transparency and risk management system employed by a derivative exchange
• Large exposure
• Temporary funds crunch
• Lack of matching long-term contracts, which necessitated the company to use rolling
short term hedge -- problem arising from the hedging strategy
• Basis risk leading to short term loss

4. Derivatives are complex and exotic instruments that Indian investors will have
difficulty in understanding
While the fact is...

Trading in standard derivatives such as forwards, futures and options is already prevalent
in India and has 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

Commodities Exchanges, which are, called Futures in international markets.
Commodities futures in India are available in turmeric, black pepper, coffee, Gur
(jaggery), hessian, castor seed oil etc. There are plans to set up commodities futures
exchanges in Soya bean oil as also in Cotton. International markets have also been
allowed (dollar denominated contracts) in certain commodities. Reserve Bank of India
also allows, 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 user’s exposure in international markets.

Derivatives in commodities markets have a long history. The first commodity futures
exchange was set up 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 and settlement 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 in Calcutta 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 market participants to trade in commodity futures or foreign exchange
markets. Government of India has also been facilitating the setting up and operations of
these markets in India by providing approvals and defining appropriate regulatory
frameworks for their operations.
Approval for new exchanges in last six months by the Government of India also indicates
that Government of India does not consider this type of trading to be harmful albeit
within proper regulatory framework.

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

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

While the fact is...

World over, the spot markets in equities are operated on a principle of rolling settlement.
In this kind of trading, if you trade on a particular day (T), you have to settle these trades
on the third working day from 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 the transaction 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 the following 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 prevalent internationally.

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

The more efficient way from the regulatory perspective will be to separate out the
derivatives from the cash market i.e. introduce rolling settlement in all exchanges and at
the same time allow futures and options 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 systemic collapse. This was evident in the MS Shoes scandal. At the time
of default taking place on the BSE, the defaulting member of the BSE Mr.Zaveri had a
position close to Rs.18 crores. However, due to the default, BSE had to stop trading for a
period of three days. At the same time, the Barings Bank failed on Singapore Monetary
Exchange (SIMEX) for the exposure of more than US $ 20 billion (more than Rs.84,000
crore) with a loss of approximately US $ 900 million ( around Rs.3,800 crore). Although,
the exposure was so high and even the loss was also very big compared to the total
exposure on MS Shoes for BSE of Rs.18 crores, the SIMEX had taken so much margins
that they did not stop trading for a single minute.

5. Comparision of New System with Existing System

Many people and brokers in India think that the new system of Futures & Options and
banning of Badla is disadvantageous and introduced early, but I feel that this new system
is very useful especially to retail investors. It increases the no of options investors for
investment. In fact it should have been introduced 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, Foreign Currency, and Commodity Derivatives. The intensity of derivatives
usage by any institutional investor is 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.
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 Financial Institutions (FIs), Mutual Funds (MFs), Foreign Institutional Investors
(FIIs) and Life and General Insurers.

1. Banks
Based on the differences in governance structure, business practices and organizational
ethos, it is meaningful 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 to undertake 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 contracts with their corporate customers on fully covered back-to-back basis.
And, most PSBs do not run an active foreign currency derivative trading book, on
account of the impediments enumerated earlier that need to be overcome at their end.
2. 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 FIs could perhaps be extended to include a few other
financially significant players such as HDFC and NHB.

• Foreign Currency Derivatives Of FIs

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 offer foreign 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.

3. Mutual funds

• Foreign currency derivatives

In September 1999, 9 Indian mutual funds were allowed to invest in ADRs/GDRs
of Indian companies in the overseas market within the overall limit of US$ 500 million
with a sub-ceiling for individual mutual funds of 10 percent of net assets managed by
them (at previous year-end), subject to maximum of US$ 50 million per mutual fund.
Several mutual funds had obtained the requisite approvals from SEBI and RBI for
making such investments. However, given that most ADRs/GDRs of Indian companies
traded in the overseas market at a premium to their prices on domestic equity markets,
this facility has remained largely unutilized. Therefore, the question of using FCY: INR
forward cover or swap 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 or Fitch IBCA) in countries with fully
convertible currencies within the overall market limit of US$ 500 million, with a sub-
ceiling for individual mutual funds of four percent of net assets managed by them as on
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 these investments. Once investment in foreign debt securities pick-up, mutual
funds ought to emerge as active users of FCY: INR swaps to hedge the foreign currency
risk in these investments.

4. Life and general insurance

• Foreign currency derivatives

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