1.

INTRODUCTION OF DERIVATIVE MARKET

a.what is derivative market

The term `Derivative' indicates that it has no independent value, i.e. its value is
entirely `derived' from the value of the underlying asset. The underlying asset can be
securities, commodities, bullion, currency, livestock or anything else. In other words,
derivative means a forward, future, option or any other hybrid contract of pre-
determined fixed duration, linked for the purpose of contract fulfillment to the value
of a specified real or financial asset or to an index of securities.

B. Who are the operators in the derivatives market?

• Hedgers - Operators, who want to transfer a risk component of their portfolio.

• Speculators - Operators, who intentionally take the risk from hedgers in
pursuit of profit.
• Arbitrageurs - Operators who operate in the different markets simultaneously,
in pursuit of profit and eliminate mis-pricing.

C. What is the importance of derivatives?

There are several risks inherent in financial transactions. Derivatives are used to
separate risks from traditional instruments and transfer these risks to parties willing to
bear these risks.

1. The first is to eliminate uncertainty by exchanging market risks, commonly known

as hedging. Corporates and financial institutions, for example, use derivatives to
protect themselves against changes in raw material prices, exchange rates, interest
rates etc., as shown in the box below. They serve as insurance against unwanted price
movements and reduce the volatility of companies’ cash flows, which in turn results
in more reliable forecasting, lower capital requirements, and higher capital
productivity. These benefits have led to the widespread use of derivatives: 92 percent
of the world’s 500 largest companies manage their price risks using derivatives.

2. The second use of derivatives is as an investment. Derivatives are an alternative to

investing directly in assets without buying and holding the asset itself. They also

1
allow investments into underlying and risks that cannot be purchased directly.
Examples include credit derivatives that provide compensation payments if a creditor
defaults on its bonds, or weather derivatives offering compensation if temperatures at
a specified location exceed or fall below a predefined reference temperature.

3. Derivatives also allow investors to take positions against the market if they expect
the underlying asset to fall in value. Typically, investors would enter into a derivatives
contract to sell an asset (such as a single stock) that they believe is overvalued, at a
specified future point in time. This investment is successful provided the asset falls in
value. Such strategies are extremely important for an efficiently functioning price
discovery in financial markets as they reduce the risk of assets becoming excessively
under- or overvalued.7)

D.Cash flow

The payments between the parties may be determined by:

• the price of some other, independently traded asset in the future (e.g., a
common stock);
• the level of an independently determined index (e.g., a stock market index or
heating-degree-days);
• the occurrence of some well-specified event (e.g., a company defaulting);
• an interest rate;
• an exchange rate;
• or some other factor.

Some derivatives are the right to buy or sell the underlying security or commodity at
some point in the future for a predetermined price. If the price of the underlying
security or commodity moves into the right direction, the owner of the derivative
makes money; otherwise, they lose money or the derivative becomes worthless.
Depending on the terms of the contract, the potential gain or loss on a derivative can
be much higher than if they had traded the underlying security or commodity directly.

2
E. Portfolio

Derivatives such as futures, forwards and options can be valuable tools within any
portfolio. They can be used to reduce portfolio risk, to artificially diversify portfolio
holdings, to hedge against various types of risks and to improve revenue within a
portfolio. Derivatives are very flexible instruments that provide investors with the
ability to be more creative in their derivative investment choices.

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2. HISTORY OF DERIVATIVE MARKET

The first exchange for trading derivatives appeared to be the Royal Exchange in
London, which permitted forward contracting, it was characterized by forward
contracting on tulip bulbs around 1637. The first "futures" contracts are generally
traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently
standardized contracts, which made them much like today's futures.

In 1972 the Chicago Mercantile Exchange, responding to the now-freely floating

international currencies, created the International Monetary Market, which allowed
trading in currency futures. These were the first futures contracts that were not on
physical commodities. In 1975 the Chicago Board of Trade created the first interest
rate futures contract, one based on Ginnie Mae (GNMA) mortgages.

In the area of commodities, the Bombay Cotton Trade Association started futures
trading in 1875 and, by the early 1900s India had one of the world’s largest futures
industry. In 1952 the government banned cash settlement and options trading and
derivatives trading shifted to informal forwards markets.

Exchange-traded commodity derivatives have been trading only since 2000, and the
growth in this market has been uneven. The number of commodities eligible for
futures trading has increased from 8 in 2000 to 80 in 2004.?

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3. GLOBAL DERIVATIVE MARKET

A. FUNDAMENTAL AND MARKET CHARECTERISTICS

Derivatives are totally different from securities. They are financial instruments that
are mainly used to protect against and manage risks, and very often also serve
arbitrage or investment purposes, providing various advantages compared to
securities. Derivatives come in many varieties and can be differentiated by how they
are traded, the underlying they refer to, and the product type.

Derivatives must be distinguished from securities, where transactions are fulfilled

within a few days. Some securities have derivative-like characteristics – such as
certificates, warrants, or structured credit-linked securities – but they are not
derivatives

Derivatives contracts can be traded on derivatives exchanges but also bilaterally

between market participants. The latter segment – i.e. the OTC segment – currently
accounts for around 84 percent of the derivatives market

Breakdown of the global derivatives market – OTC versus on-exchange and by

underlying asset class

5
The derivatives market has grown rapidly in recent years as the benefits of using
derivatives, such as effective risk mitigation and risk transfer, have become
increasingly important. Europe is by far the most important region for derivatives that
have become a major part of the European financial services sector and a major direct
and indirect contributor to economic growth.

B. SIZE AND GROWTH OF THE MARKET

The Bank for International Settlements (BIS) in Basel Switzerland recently released
two reports that contained important new data on derivatives markets. One is the
semi-annual “Regular OTC Derivatives Market Statistics” and the other is the
triennial “Central Bank Survey of Foreign Exchange and Derivatives Market
Activity.”

GROWTH IN MARKET SIZE

The amount of outstanding derivatives in global over-the-counter (OTC)
markets grew at a 30% rate for the year ending June 30, 2004. The growth
rate has average 28% since 1990. That brought the global amount outstanding
OTC derivatives to $220.1 trillion dollars.

The growth in OTC derivatives was across the board; strong increases were
reported in foreign exchange, interest rate, equity and commodity based
derivatives.

The gross market value of these OTC derivatives, which measures the present
value of these outstanding contracts, was reduced over the year from $7.90
trillion to $6.40 trillion. After netting the gross market value between
counterparties, the gross credit exposure in the OTC market fell from $1.75
trillion to $1.48 trillion.

Meanwhile, outstanding amounts or ‘open interest’ in exchange traded futures

and options grew by 38% over the same period, with interest rate futures in
particular growing by 42%. That brought the global amount of outstanding
exchange traded futures and options to $49 trillion.
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Taken together, the outstanding amount of OTC and exchange traded
derivatives rose by mid-year 2004 to $269 trillion (that is,
$269,050,100,000,000).

CREDIT DERIVATIVES
The BIS also reported that the notional amount of outstanding credit
derivatives rose to $4.5 trillion – up from just $0.7 trillion in their last survey.
The increase was weighted heavily in credit default swaps where contract
terms have become standardized. Additional growth has come through the
trading in credit derivative indices, synthetic collateral debt obligations
(CDOs), and even the establishment of electronic trading platforms for credit
derivatives.

Europe’s leading role within the derivatives market

The derivatives market is the largest single segment of the financial market. As of
June 2007, the global derivatives market amounted to €457 trillion in terms of
notional amount outstanding. By this measure, the derivatives market is more than
four times larger than the combined global equity and bond markets measured by
market capitalization. However, the estimated gross market values of all derivatives
outstanding total only €10 trillion, which is markedly lower than the equity and bond
markets with a market capitalization of €43 trillion and €55 trillion, respectively. The
derivatives market is the fastest growing segment of the financial sector: since 1995,
its size has increased by around 24 percent per year in terms of notional amount
outstanding, far outpacing other financial instruments such as equities (11 percent)
and bonds (9 percent).

As described, the OTC segment accounts for almost 84 percent of the market with
around €383 trillion of notional amount outstanding. Recently, however, the exchange
segment has grown faster than the OTC segment. This is widely perceived to be a
result of the increasing standardization of derivatives contracts which facilitates
exchange trading. Other contributing factors are a number of advantages of on-
exchange trading: price transparency, risk mitigation and transaction costs are among
the most important.
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Size and growth of the global derivatives,equity and bond markets June 2007

The market for derivatives grew at the fastest pace in at least nine years to $516
trillion in the first half of 2007, the Bank for International Settlements said. Credit-
default swaps, contracts designed to protect investors against default and used to
speculate on credit quality, led the increase, expanding 49 percent to cover a notional
$43 trillion of debt in the six months ended June 30.
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 C. Global nature of the market

The OTC segment operates with almost complete disregard of national borders.
Derivatives exchanges themselves provide equal access to customers worldwide.
As long as local market regulation does not impose access barriers, participants can
connect and trade remotely and seamlessly from around the world (e.g. from their
London trading desk to the Eurex exchange in Frankfurt). The fully integrated, single
derivatives market is clearly a reality within the European Union. Taken as a whole,
the derivatives market is truly global. For example, today almost 80 percent of the
turnover at Eurex, one of Europe’s major derivatives exchanges, is generated outside
its home markets of Germany and Switzerland, up from only 18 percent ten years ago.

The exchange segment makes an especially strong contribution to operational and

price efficiency through its multilateral market organization, equal access and public
disclosure of prices supported by appropriate regulation. Efficient financial markets
lower the cost of capital, enable firms to invest, and channel resources to their most
valuable uses. Studies show that efficiently functioning financial markets can increase
real GDP growth considerably.

Europe’s leading role within the derivatives market

Today, Europe is the most important region in the global derivatives market, with 44
percent of the global outstanding volume – significantly higher than its share in
equities and bonds. The global OTC derivatives segment is mainly based in London.
Primarily due to principle-based regulation, which provides legal certainty as well as
flexibility, the OTC segment has developed especially favourably in the UK’s capital.
D. GLOBAL DERIVATIVE EXCHANGES

The derivatives market can be characterized as highly dynamic with plenty of market
entries. There are no legal, regulatory or structural barriers to entering the derivatives
market. Almost all derivatives exchanges across the world have been created during
the last three decades only.

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The United States was home to the first wave of equity options exchange foundations
in the 1970s in the wake of academic breakthroughs in options valuation and the
introduction of computer systems. The CBOE was founded in 1973, the American
Stock Exchange, Montreal Exchange and Philadelphia Stock Exchange started options
trading in 1975 while the Pacific Exchange commenced options trading in 1976. A
second wave of new derivatives exchanges occurred in the 1980s and early 1990s in
Europe.

During that time a financial derivatives exchange was established in almost every
major Western European financial market – the most important ones being London
with Liffe in 1982, Paris with Matif in 1986, and Frankfurt with DTB in 1990. Most
of these organizations formed their own clearing houses. In recent years, new
derivatives exchanges have started to compete with existing derivatives marketplaces.
For instance, ISE commenced trading in 2000 and became the market leader in US
equity options trading together with CBOE in 2003. In 2004, BOX successfully
entered US equity options trading.

ICE, founded in 2000, is an example of successful market entry into the commodity
derivatives market. Recently, two plans have been announced to establish further
derivatives trading platforms in the United States and Europe with the ELX and
project “Rainbow”, which aim to compete with established market places. In such a
dynamic market, the already large number of derivatives exchanges is likely to
continue growing.

Away from the developed markets, related activities in emerging markets are also
intensive. Three derivatives operations have commenced trading in the Middle East
since 2005: Dubai Gold and Commodities Exchange, Kuwait Stock Exchange, and
IMEX Qatar. India saw four new derivatives exchanges set up between 2000 and
2003: National Stock Exchange of India, Bombay Stock Exchange, MCX India, and
NCDEX India. China has seen the establishment of two derivatives exchanges since
2005: Shanghai Futures Exchange and China Financial Futures Exchange.

Banks are also constantly entering new product segments:

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Goldman Sachs, for example, has invested heavily into the commodity derivatives
segment in recent years. BNP Paribas has successfully developed the OTC equity
derivatives segment. There are numerous successful market entries into the OTC
segment such as ICAP or GFI, which provide trading services via electronic
platforms, or of clearing service providers such as Liffe’s Bclear, LCH.Clearnet’s
SwapClear or Intercontinental Exchange’s OTC clearing services.

Newly established derivatives exchanges are competing for energy and emission
rights trading. Three major exchanges are providing electricity derivatives trading and
clearing in Europe Nord Pool, Powernext, and EEX. Competitive trading and clearing
of European carbon emission allowances (EU allowances or EUAs) started on EEX
and ICE in January 2005 when the European Union Gas Emission Trading
Scheme (EU ETS) was launched. Bluenext, a joint venture of NYSE Euronext and
Caisse des Dépôts, has been offering comparable EUA derivatives since April 2008,
directly competing with established EUA marketplaces.

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In terms of size, today the U.S. accounts for almost 35% of futures and options
trading worldwide. However, the Korea Stock Exchange is the largest derivative
exchange in the world. The second largest by volume is the Eurex (German-Swiss),
followed by the Chicago Board of Trade, the London International Financial Futures
and Options Exchange, the Paris bourse, the New York Mercantile Exchange, the
Bolsa de Mercadorias & Futuros of Brazil, and the Chicago Board Options Exchange.
Note that in 2001, these exchanges traded in aggregate 70 million derivative contracts.

E. GROWTH OF GLOBAL OTC MARKET

The OTC derivatives market showed relatively steady growth in the second half of
2007, amid the turmoil in global financial markets, according to The Bank for
International Settlements (BIS) semiannual statistics.

Notional amounts of all categories of OTC contracts rose by 15% to $596 trillion at
the end of December. Growth remained particularly strong in the credit segment,
where the notional amounts of outstanding credit default swaps (CDSs) increased by
36% to $58 trillion. Expansion in the foreign exchange, interest rate and commodities
segments was also relatively robust, recording double digit growth rates, while the
equity segments showed a negative growth rate.

Gross market values, which measure the cost of replacing all existing contracts,
increased by 30% and reached $15 trillion in total at the end of December 2007. Gross
credit exposures, after netting agreements, also rose by 22% to $3.3 trillion.

The following trends are noted in the BIS statistical release:

 Strong growth in credit default swaps

 Solid growth in FX derivatives
 Moderate growth in interest rate derivatives
 Subdued activity in equity derivatives
 Robust growth in commodity derivatives

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  Market concentration stable and low, particularly for FX derivatives
4. CURRENT SCENARIO OF TYPES OF DERIVATIVES
TRADED GLOBALLY

What is a futures contract?

Futures contract means a legally binding agreement to buy or sell the underlying
security on a future date.

Future contracts are the organized/standardized contracts in terms of quantity, quality

(in case of commodities), delivery time and place for settlement on any date in future.

The contract expires on a pre-specified date which is called the expiry date of the
contract. On expiry, futures can be settled by delivery of the underlying asset or cash.

Cash settlement entails paying/receiving the difference between the price at which the
contract was entered and the price of the underlying asset at the time of expiry of the
contract.

What is a Forward contract?

A forward contract is basically a contract where the maturity and amount are flexible,
which can be traded over the counter, or by telephone, fax, etc. and honouring of the
contract is made generally by taking and giving delivery and counterparty risk
depends on the counterparty only.

In a forward contract, two parties agree to do a trade at some future date, at a price
and quantity agreed today. No money changes hands at the time the deal is signed

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Features of Forward contract

The main features of forward contracts are

• They are bilateral contracts and hence exposed to counter-party risk.

• Each contract is custom designed, and hence is unique in terms of contract

size, expiration date and the asset type and quality.

• The contract price is generally not available in public domain.

• The contract has to be settled by delivery of the asset on expiration date.

In case, the party wishes to reverse the contract, it has to compulsorily go to the same
counter party, which being in a monopoly situation can command the price it wants.

Options

Options are contracts that confer on the buyer of the contract certain rights (rights to
buy or sell an asset) for a predetermined price on or before a pre-specified date. The
buyer of the option has the right but not the obligation to exercise the option.

Options come in a variety of forms. Some Option contracts, which have been
standardized, are traded on recognized exchanges. Other Option contracts exist that
are traded "over-the-counter", i.e., a market where financial institutions and
corporates trade directly with each other over the phone. Besides these, options also
exist in an embedded form in several instruments.

Call Options

A call option gives the holder (buyer/ one who is long call), the right to buy specified
quantity of the underlying asset at the strike price on or before expiration date.

The seller (one who is short call) however, has the obligation to sell the underlying
asset if the buyer of the call option decides to exercise his option to buy.

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Put Options

A Put option gives the holder (buyer/ one who is long Put), the right to sell specified
quantity of the underlying asset at the strike price on or before a expiry date.
The seller of the put option (one who is short Put) however, has the obligation to buy
the underlying asset at the strike price if the buyer decides to exercise his option to
sell.

Swap
A swap is nothing but a barter or exchange but it plays a very important role in
international finance. A swap is the exchange of one set of cash flows for another. A
swap is a contract between two parties in which the first party promises to make a
payment to the second and the second party promises to make a payment to the first.
Both payments take place on specified dates. Different formulas are used to determine
what the two sets of payments will be.

Classification of swaps is done on the basis of what the payments are based on. The
different types of swaps are as follows.

• Interest rate swaps

• Currency Swaps
• Commodity swaps
• Equity swaps

Interest rate swaps

The interest rate swap is the most frequently used swap. An interest rate swap
generally involves one set of payments determined by the Eurodollar (LIBOR) rate.
Although, it can be pegged to other rates. The other set is fixed at an agreed-upon rate.
This other agreed upon rate usually corresponds to the yield on a Treasury Note with a
comparable maturity. Although, this can also be variable.

15
Additionally, there will be a spread of a pre-determined amount of basis points. This
is just one type of interest rate swap. Sometimes payments tied to floating rates are
used for interest rate swaps. The notional principal is the exchange of interest
payments based on face value. The notional principal itself is not exchanged. On the
day of each payment, the party who owes more to the other makes a net payment.
Only one party makes a payment.

Currency swaps

A currency swap is an agreement between two parties in which one party promises to
make payments in one currency and the other promises to make payments in another
currency. Currency swaps are similar yet notably different from interest rate swaps
and are often combined with interest rate swaps.

Currency swaps help eliminate the differences between international capital markets.
Interest rates swaps help eliminate barriers caused by regulatory structures. While
currency swaps result in exchange of one currency with another, interest rate swaps
help exchange a fixed rate of interest with a variable rate. The needs of the parties in a
swap transaction are diametrically different. Swaps are not traded or listed on
exchange but they do have an informal market and are traded among dealers.

A swap is a contract, which can be effectively combined with other type of derivative
instruments. An option on a swap gives the party the right, but not the obligation to
enter into a swap at a later date.

Commodity swaps

In commodity swaps, the cash flows to be exchanged are linked to commodity prices.
Commodities are physical assets such as metals, energy stores and food including
cattle. E.g. in a commodity swap, a party may agree to exchange cash flows linked to
prices of oil for a fixed cash flow.

Commodity swaps are used for hedging against

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 • Fluctuations in commodity prices or
• Fluctuations in spreads between final product and raw material prices (E.g.
Cracking spread which indicates the spread between crude prices and refined
product prices significantly affect the margins of oil refineries)

A Company that uses commodities as input may find its profits becoming very
volatile if the commodity prices become volatile. This is particularly so when the
output prices may not change as frequently as the commodity prices change. In such
cases, the company would enter into a swap whereby it receives payment linked to
commodity prices and pays a fixed rate in exchange. A producer of a commodity may
want to reduce the variability of his revenues by being a receiver of a fixed rate in
exchange for a rate linked to the commodity prices.

Equity swaps

Under an equity swap, the shareholder effectively sells his holdings to a bank,
promising to buy it back at market price at a future date. However, he retains a voting
right on the shares.

Warrants: Options generally have lives of upto one year, the majority of options
traded on 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 upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The

underlying asset is usually a moving average or a basket of assets. Equity index
options are a form of basket options.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at
the expiry of the options. Thus a swaption is an option on a forward swap. Rather than
have calls and puts, the swaptions market has receiver swaptions and payer swaptions.

17
A receiver swaption is an option to receive fixed and pay floating. A payer swaption
is an option to pay fixed and receive floating.

Global Exchange Derivatives Volumes --Statistical Overview

Financial derivatives are much more popular than non-financial derivatives, both in
volume terms and in number of exchanges offering them. Contract volume is the
preferred, although imperfect, measure for comparing exchange activity. Notional
value, which may be a better measure in economic terms, is usually not readily
available Global trading of exchange-traded futures and options is growing fast.
According to data provided by the US-based Futures Industry Association (FIA),
global exchange derivatives volume rose from 2.4 billion contracts in 1999 to 9.9
billion contracts in 2005, representing an annual growth rate of 27 per cent. The
growth rate is much higher than the 8 per cent in the global equity market over the
same period according to the statistics of the World Federation of Exchanges (WFE).
Nonetheless, equity market volumes are more volatile in the first half of 2006 a total
of 5.9 billion derivative contracts were traded, representing a pro-rata growth rate of
19 per cent over 2005, compared to a remarkable 42 per cent growth in global equity
trading. Equity and derivatives market growth on statistics during the years was due
partly to the increase in the number of exchanges reporting the statistics to the FIA or
WFE but mostly to growth in trading activity.

Global Volume by Product Type

Over 90 per cent of global derivatives trading is in financial derivatives. Among
financial derivatives, equity-related derivatives (on equity indices and individual
equities) were the most actively traded product type in 2005 and remained so in the
first half of 2006 (65 per cent and 62 per cent of global volume in the respective
periods).
Next came interest rate products (26 per cent and 28 per cent in the respective
periods) and finally currency products (2 per cent in both periods). Trading of non-
financial derivatives (the underlying assets of which include agricultural products,
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energy, precious metals and non-precious metals) contributed only 8 per cent of
global volume in both 2005 and the first half of 2006.

Among the 59 exchanges which report statistics to the FIA, 16 offer non-financial
(mainly commodity) derivatives only, 13 offer both financial and non-financial
derivatives and 30 offer financial derivatives only. The majority of exchanges offer
equity index futures (33 exchanges) and equity index options

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Ranking of Exchanges by Financial Derivatives Contract Volume
HKEx currently offers only financial derivatives. They are products on individual
equities (stock futures and stock options), equity indices (Hang Seng Index (HSI)
Futures and Options, H-shares Index Futures and Options, FTSE/ Xinhua China 25
Index Futures and Options, and Mini-HSI Futures and Options) and interest rate and
fixed income products (One-month and Three-month HIBOR Futures and Three-year
Exchange Fund Note Futures). In terms of contract volume of financial derivatives,
HKEx ranked 24th among a total of 43 reporting exchanges offering such products

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during the first half of 2006. Again, KRX, Eurex and CME were the top three
exchanges, contributing 51 per cent of global volume of financial derivatives in the
period

Proposal for improving derivative market statistics and global scenario

In the past two years, there has been more change in the derivatives industry than in
the last decade. Some have called these changes a "capital markets revolution."
Electronic trading, for example, is rapidly transforming the industry by giving end-
users unprecedented access to markets around the world. Just last month, in fact, the
CFTC permitted US customers electronic access, through authorized futures brokers
in the US, to derivatives markets in the UK, Germany, Australia, and France. US
exchanges currently have terminals for trading US products in each of these locations,
as well as in Japan, Singapore and Hong Kong--over 100 terminals in all. More such
arrangements are anticipated.

In addition to providing greater access to global markets, electronic technology also is

spurring the creation of new types of markets and new opportunities for retail and

21
institutional market participants. The Internet, for example, brings to the average
customer the power to evaluate financial instruments and products in every corner of
the globe. The CFTC is currently examining a proposal for the first US Internet-based
futures exchange. The proposed trading system, known as FutureCom, would offer
cash-settled live cattle futures over the Internet.

Similarly, the Internet also is prompting brokers to change. Some are developing their
own private networks to serve their customers. Others are refocusing their efforts on
providing credit as opposed to execution services.

In addition, over-the-counter trading continues to expand. Data from the Bank for
International Settlements suggests that OTC markets are playing an ever larger role
relative to organized exchanges in financial derivatives. The BIS's most recent
estimate puts the notional amount of outstanding global OTC derivatives at $80
trillion as of December 1998. The explosive growth in OTC markets has challenged
organized exchanges to develop equally competitive products.

Like many of the regulators represented here today, the CFTC has struggled to strike
the proper balance between market innovation and the regulator's mission to ensure
fair and efficient markets. In the coming months, however, the CFTC will be
especially immersed in these issues as a part of its periodic, statutory reauthorization
process. Through this process, the US Congress evaluates the work of the
Commission and examines the Commodity Exchange Act with an eye towards
modernizing it, where necessary.

Certainly, the question will be asked whether is the innovations enough. Even more
fundamentally, the Congressional oversight committees intend to examine whether
the Commission should operate as a "front-line" regulator or become more of an
"oversight" agency. Interestingly, this idea seems to run contrary to the trends we
have seen in other jurisdictions where regulators have had to consider the implications
of exchanges converting to for-profit entities and potentially weakening their self-
regulatory incentives.

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By moving to harmonize international regulatory requirements and by cooperating
with one another across markets and borders, regulators can more efficiently and
effectively deal with expanding global markets and advances in technology. This
requires that everybody understands the other's regulatory systems and assumes a
degree of trust by everybody in the other's ability to implement them. Such
understanding and trust is built on case-by-case experience in information-sharing and
by managing cross-border market events.

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5. HEDGING WITH FINANCIAL DERIVATIVES

Hedging is basically a protection against risk. Hedging differs from speculation in

terms of the participants’ risk position prior to executing a trade and overall trade
objectives. Speculators take a position that increases their risk profile. Hedgers focus
on avoiding or reducing risk. They enter futures transactions because their normal
business operations involve certain risks that they are trying to reduce. This
preexisting risk can be at least partially offset because futures prices tend to move
directly with cash prices, so futures rates closely track cash interest rates. Hedgers
take the opposite position in a futures contract relative to their cash market risk so that
losses in one market are reduced by gains in the other market.

Steps in Hedging.
In general, there are seven basic steps in implementing futures hedges for financial
institutions
1. Identify the cash market risk exposure that management wants to reduce.
2. Based on the cash market risk, determine whether a long or short futures
position is appropriate to reduce risk.
3. Select the best futures contract.
4. Determine the appropriate number of futures contracts to trade.
5. Implement the hedge by buying or selling futures contracts.
6. Determine when to get out of the hedge position, either by reversing the trades
in Step 5, letting contracts expire, or making or taking delivery.
7. Verify that futures trading meets regulatory requirements and conforms to the
bank’s internal risk management policies.

A long hedge
A long hedge is applicable for a participant who wants to reduce cash market risk
associated with a decline in interest rates. The applicable strategy is to buy futures
contracts on securities similar to those evidencing the cash market risk. If cash rates
decline, futures rates will typically also decline so that the value of the futures
position will likely increase. Any loss in the cash market is at least partially offset by
a gain in futures.

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Of course, if cash market rates increase, futures rates will also increase and the futures
position will show a loss. Using futures essentially fixes a rate or price. This latter
instance reveals an important aspect of hedging. If cash rates rise, the investor will
profit more from not hedging because cash rates move favorably. A hedger thus
forgoes gains associated with favorable cash market price moves. The hedge
objective, however, is assumed to be risk reduction. With hedging, risk is lower
because the volatility of returns is lower.

A short hedge
A short hedge applies to any participant who wants to reduce the risk of an increase in
cash market interest rates (or reduction in cash market prices). The applicable strategy
is to sell futures contracts on securities similar to those evidencing the cash market
risk. If cash rates increase, futures rates will generally increase so the loss in the cash
position will be at least partially offset by a gain in value of futures. Again, if cash
rates actually decrease, the gain in the cash market will be offset by a loss from
futures and a hedger gives up potential gains from an unhedged position. A hedger
essentially fixes the rate to be realized.

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6. NEW ENVIRONMENT IN INDIAN STOCK MARKET
REGARDING DERIVATIVES
Commodity futures trading has been in existence since 1953 and certain OTC
derivatives such as Forward Rate Agreements (FRAs) and Interest Rate Swaps (IRSs)
were allowed by RBI through its guidelines in 1999.

Trading in standard derivative such as forwards, future and options is already

prevalent in India and has a long history. Reserve Bank of India allowed forward
trading in Rupee Dollar forward contracts, which has become a liquid market and also
allowed Cross Currency options trading. 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. The spot markets / cash market in equities world over is operated on a
principle of rolling settlement. 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.

The more efficient way will be speeding up dematerialization of securities as non

dematerialized securities involve settlement delays and 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 initially for the broad market and then stock specific.
In less than three years, Indian equity markets have successfully transited from the
earlier paper based settlement to demat settlement. Today more than 99.5 percent of
the settlement in both NSE and BSE is in demat form. There is a substantial demat
coverage of equity markets.

In the Indian context, Bombay Stock Exchange popularly known as BSE introduced
equity derivative instruments, the Sensex Futures on June 9, 2000 and Options on
BSE Sensex, from June 1, 2001. Though a beginning was made with the introduction
of rolling settlement on a selected few stocks, effective from July 2, 2001, rolling

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settlement was introduced on a large number of stock i.e., on highly liquid stocks or
"A" Group shares. The SEBI the regulatory authority, propose to bring in the scripts
of the companies, which are presently not under compulsory rolling settlement w.e.f.
January 2,2002. Besides, from July 2, 2001 there is an index based market wide
circuit brakers system at three stages of movement either way at 10 percent, 15
percent and 20 percent. These circuit brakers will bring about a coordinated trading
halt and equity derivative markets nationwide. Movement of either BSE Sensex or
NSE S & P CNX, which ever is breached earlier, would trigger the market wide
circuit brakers. As futures and options were already in vogue both on BSE and NSE,
the option contracts on Individual securities was commenced from July 2, 2001 on
NSE and from July 9, 2001 in BSE on 31 securities approved by SEBI. The futures on
individual stocks however is not available at present. The underlying security (futures
and options) for broad market was S & P CNX NIFTY 50 and BSE 30 SENSEX. The
31 individual stocks as approved by SEBI for options in securities are common for
both the exchanges i.e., BSE and NSE. S&P CNX NIFTY 50 is well diversified 50
stock index accounting for 25 sectors of the economy. As on July 31, 2001 the total
market capitalization of 50 stocks was Rs. 2,82,608 crore representing about 45
percent of total market capitalization. Sectorwise, diversified accounted for 20.3
percent, followed by Petrochemicals 12.29 percent, Computers Software 11.16
percent, Refineries 8.88 percent, Pharma 7.15 percent, Cigarettes 6.88 percent and the
other sector accounting for less than 5 percent respectively.

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7.SAFETY AND EFFECTIVE RISK MITIGATION

There are wanted and unwanted risks in the derivatives market. Both the OTC and
exchange segments have arrangements in place to mitigate unwanted risks, although
these are inherently more effective in the exchange segment. The main reason for
using derivatives is to gain exposure to a “wanted” risk. This usually is a market risk
that either could compensate for an opposite risk (hedging) or that an investor wants
to benefit from for investment purposes – via the positive evolution of market prices.
However, as with other financial instruments, there are also “unwanted” risks
associated with derivatives trading that investors seek to avoid. These unwanted risks
are counterparty, operational, legal and liquidity risks. The different risks that market
participants face can ultimately lead to systemic risk, that is, the failure of one
counterparty having adverse effects on other market participants, potentially
destabilizing the entire financial market. A primary concern of all stakeholders,
including regulators, is to limit systemic risk to the greatest extent possible

Risk mitigation in the derivatives market

To fulfill its role of protecting against risks and providing the means for investing, the
derivatives market itself must be safe and mitigate unwanted risks effectively. The
derivatives market has arrangements in place to mitigate unwanted risks that arise
from conducting derivatives transactions. From a practical point of view these
arrangements have proven successful – the unwanted risks in the derivatives market
have been reduced to a tolerable level. Even when failures of market participants have
occurred, they have not seriously affected other market participants. The OTC and
exchange segments have taken different approaches to mitigate unwanted risks.

Counterparty risk
The scale of aggregated credit risks varies significantly between the OTC and
exchange segments. If no counterparty risk mitigation mechanisms were in place in
both segments, the required regulatory capital for counterparty risk would be around
€400 billion in the OTC segment and €90 billion in the exchange segment. This is not
surprising given the large differences between the two markets in the notional amount
outstanding. The most common means of mitigating counterparty risk are netting and
collateralization of counterparty risk exposures. In the OTC segment, these lead to the
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theoretic regulatory capital required being reduced by around 70 percent to
approximately €120 billion. For example, 76 percent of the counterparty risk exposure
arising from OTC transactions is subject to bilateral netting agreements and the total
amount of collateral posted in relation to OTC derivatives transactions is around
€1,200 billion. Central counterparties provide multilateral netting across all trading
parties and are well protected against default as they use several lines of defense
against their counterparty risk exposure.55) As a consequence, the use of CCPs
reduces the trading parties’ regulatory capital for credit risk from derivatives
transactions to zero irrespective of whether the transaction is OTC or on exchange.

Taking into account all lines of defense, CCP clearing is safer than bilateral clearing
in terms of counterparty risk. No major clearing house has ever come close to being in
financial difficulty, while there have been cases of individual derivatives dealers that
defaulted.

Operational risk
The key to minimizing operational risk is to minimize manual handling and
interference in derivatives trading and clearing processes, and to design reliable
electronic processes. Both the OTC and exchange segments use automated
processing. The exchange segment is fully automated across trading and clearing.
Derivatives exchanges and clearing houses usually have fully automated interfaces
resulting in seamlessly integrated processes. The OTC segment uses automated
processing solutions primarily for standard products. Newly introduced, exotic, less
liquid or complex OTC derivatives are usually handled manually, with resulting
delays and risks of errors. By December 2007, only 20 percent of OTC equity
derivatives were processed electronically compared to about 44 percent of OTC
interest rate derivatives and 91 percent of credit derivatives. Operational risk events
do occur more often in the OTC segment but they have not resulted in the complete
failure of players with the exception of outright fraud.

Legal risk
Legal risk is principally addressed by using standardized derivatives contracts and
agreements. It is particularly important that netting agreements work in case of
default, that is, that they are not impaired by insolvency procedures and other
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creditors’ claims. The OTC segment achieves this through the use of standard “master
agreements”, which are developed under the leadership of its industry associations,
such as the ISDA. The master agreements are supported by legal opinions from
leading law firms in all relevant jurisdictions. This “self-regulatory” solution provides
sufficient legal certainty to a large part of the OTC derivatives segment. As a result,
legal disputes concerning derivatives contracts arise in the OTC segment only
occasionally.

Derivatives exchanges offer almost only standardized derivatives contracts. They

alone in close coordination with the clearing houses that serve as CCPs for the
exchange design these contracts assisted by respective legal support. All contracts are
subject to one chosen and known jurisdiction. Together with legally binding rules for
participating in the trading and clearing of derivatives, this ensures that legal
uncertainty for on-exchange derivatives is negligible.

Liquidity risk
Most exchange-traded derivatives and standard OTC derivatives, such as foreign
exchange forwards and interest rate swaps, are very liquid. Market participants can
expect to find a party to trade with at a fair price. Liquidity risk is higher in smaller or
exotic OTC derivatives sub-segments or new, not yet established exchange-traded
derivatives segments. Illiquidity is almost not a problem in the exchange segment and
rarely a problem in the OTC segment. However, in situations where the entire
financial market is under stress, such as since the start of the financial crisis in 2007,
bilateral trading in the OTC segment can be difficult as there are fewer potential
trading parties available for transactions. This can be aggravated by the lack of
credible price information, as details of OTC transactions are not disclosed to other
trading parties and the public. Finally, trading parties might be dependent on a
particular OTC derivatives dealer to unwind positions if necessary. As a consequence,
illiquidity tends to be a bigger problem in the OTC than the on-exchange segment,
which has proven highly liquid even throughout the recent financial crisis.

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Implications for systemic risk
Despite the failures of individual market participants, the stability of the derivatives
market as a whole has never been threatened so far. In particular the exchange
segment with the mandatory use of CCPs contributes to this. If one market participant
fails, CCPs shield all other market participants from any adverse effects. A domino
effect, whereby other market participants fail and the crisis becomes systemic is
extremely unlikely if the CCPs are set up in a way that makes their failure close to
impossible. On the other hand, if a CCP failed, all market participants using that CCP
would be adversely affected and might fail themselves, increasing the chances of a
systemic crisis. CCPs must therefore be made as immune to failure as possible, and
certainly so far, they have proven resilient. By contrast, the largely bilateral nature of
the OTC segment means that the failure of a major derivatives dealer would affect
multiple other market participants. This might well result in a systemic crisis.
CCP clearing offers two further advantages:
(1) The CCP has a consolidated risk perspective on each trading party and across all
trading parties as a whole. This makes it easier to identify (early warning) and address
excessive risk taking by individual market participants as well as overall market
imbalances and allows early intervention.
(2) On-exchange derivatives trading produces publicly available price and transaction
data, which makes risks and market trends transparent to all market participants and
regulators.

Assessment
The unwanted risks in the derivatives market are well controlled and reduced as far as
possible, especially by using CCP clearing services. There are, nevertheless, some
ways in which the effectiveness of risk mitigation in derivatives markets could be
further improved. As the BIS report on OTC clearing concludes, CCPs are central to
an improved risk mitigation in the OTC segment: Legal certainty for derivatives
contracts could be improved by establishing a common international regulatory and
legal framework for OTC contracts and harmonizing insolvency rules.

In the derivatives market, transparency on market and counterparty risks and price
discovery, as well as safety could be improved by offering incentives such as capital
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reliefs to players in the OTC segment for disclosing prices and using CCPs. Agreeing
and adhering to common CCP standards internationally would make the safety and
reliability of CCPs more comparable and understandable, and ensure that risk
standards do not become a parameter of competition between CCPs, which might
erode the level of security they offer. The economic benefits of further eliminating
unwanted risks, however, could be offset by significantly higher costs for eliminating
these risks and should hence be analyzed in detail.

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Conclusion
The derivatives market is very dynamic and has quickly developed into the most
important segment of the financial market. Competing for business, both derivatives
exchanges and OTC providers, which by far account for the largest part of the market,
have fuelled growth by constant product and technology innovation. The competitive
landscape has been especially dynamic in Europe, which has seen numerous market
entries in the last decades. In the process, strong European players have emerged that
today account for around 44 percent of the global market in terms of notional amount
outstanding. The derivatives market functions very well and is constantly improving.
It effectively fulfills its economic functions of price efficiency and risk allocation. The
imperatives for a well-functioning market are clearly fulfilled: The exchange segment,
in particular, has put in place very effective risk mitigation mechanisms mostly
through the use of automation and CCPs. For its users, the derivatives market is
highly efficient. Transaction costs for exchange-traded derivatives are particularly
low. Innovation has been the market’s strongest growth driver and has been supported
by a beneficial regulatory framework especially in Europe. Overall, it is clearly
desirable to preserve the environment that has contributed to the impressive
development of the derivatives market and the success of European players in it.
There is thus no need for any structural changes in the framework under which OTC
players and exchanges operate today. However, some aspects of the OTC segment in
particular can still be improved further. Safety and transparency, and operational
efficiency could be enhanced along proven and successful models helping the global
derivatives market to become even safer and more efficient.

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