Derivatives market in the emerging capital markets 2 INTRODUCTION The economic performance of any country is partly based on the

strength and success of the financial or capital market functioning in that country. All the countries have always strived for and are still striving today for establishing a powerful financial market which is able to attract investors from all over the world to boost the economy of that country. Capital markets are important to raise long-term funds by issuing securities in order to finance major capital intensive projects. The world has witnessed considerable amount of progress in the emerging economies of the world like China, India, Brazil, Russia etc. The important financial markets which are responsible for the development of a countrys economy include capital markets consisting of stock market and bond market, commodity market, money market, derivatives market, insurance market and foreign exchange market. The focus of this dissertation paper is also on one such financial market whose significance has gradually increased over the years and is having a positive impact on the emerging economies of the world (Chance and Brooks, 2006). The paper will start by first explaining the essence of derivatives market and how do they function in an economy between all other financial and capital markets. Next, the paper will provide details on different types of derivatives functioning in the economy and their role will be evaluated. Also the importance of each derivative type will be discussed in order to better understand the role of derivatives in the progress of an economy. This entire thesis will lead the discussion on the impact the derivatives market have on the emerging economies of the world and few such economies will be discussed to explain the importance of derivates in these economies. The purpose of discussing the impact of derivatives market on emerging economies is to highlight their uses and benefits along with their role in serving these emerging economies in order to make them economically and financially stronger.

Derivatives market in the emerging capital markets 3 What are Derivates? The dictionary states that Derivates is like any other financial instrument whose value is based on the market value of underlying asset such as stocks, bonds or commodities etc. This means that derivative is a security whose value is viewed by viewing the value of the underlying security (Whaley, 2006). It is often referred to as a contract rather than an asset where the person promises in the contract that the value of the underlying asset will increase/decrease over a fixed period of time. The reason the security is named as derivative because the contracts value is being derived from the value of the underlying stocks, bonds, commodity or money etc. An example can be used to explain the derivatives concept. A derivative contract on the stock market promises the owner to buy a stock of share at fixed price for a fixed period of time. The value of the contract is directly related to the market value of the underlying asset which is the stock of shares in this case. If the share price increases then the contract will become more valuable since the owner can buy the shares at a fixed price though they actually cost more thus, offering more value to him. On the other hand, if the share price decreases then the value for the owner reduces since the market value of the underlying stock decreases. This way the derivative contracts value is being derived from the market value of the underlying asset or security (Hull, 2006). When we talk about the derivatives market, it refers to the financial market for derivatives. These are the markets where derivatives contracts are made and funds are raised for the financing of the capital intensive projects. The purpose of the derivatives was to minimize risk by making an agreement in order to ensure that the underlying asset mentioned in the contract can be bought or sold at a fixed price up to a certain date. Therefore, derivatives are also known as powerful risk management tools. Development of derivatives has become an important

Derivatives market in the emerging capital markets 4 event in the history since they are able to differentiate risk and divert it to those who have the potential to deal with it.

How Derivatives evolved? Traces of derivatives market can be found in the ancient times but the practice had been done through different ways. The rise of derivatives market was initiated by the need of farmers who wanted to secure the prices of their crops in advance from fear of any delay due to monsoon or excess production. This was done so that any fall in prices of the crops could not have an effect on the income of the farmers. The practice is old enough to belong to the 1650s where it was being practiced in the Yodoya rice market of Osaka, Japan. These contracts resembled the futures contracts of today which will be discussed later in the types of derivatives market. In 1948, a formal derivatives exchange was established called Chicago Board of Trade (CBOT) which is still the largest derivative exchange of the world. Standardized contracts were made through the exchange and these contracts are still prevalent today. Since then the derivatives market continued to develop and modernize itself with different types of derivatives market being seen all over the world (Johnson, 2008).

Importance of Derivatives Investors all over the world are interested in mainly one important thing that is maximizing their returns and minimizing their risks associated with the investment. The importance of derivatives can be judged from the fact that they are having a powerful impact on the emerging economies in mitigating risk and attracting investors towards these potential economies. Derivatives result in greater opportunities of trading, investments, risk and asset management in

Derivatives market in the emerging capital markets 5 the economy. Derivatives are needed by investors and market participants in order to hold the assets at minimum possible risk associated to them (Sanford, 2007). Derivatives market make possible that the risks are transferred and mitigated when and as desired so that the investors can easily adjust and liquidate their positions. These financial instruments ensure profits to be made with minimum risk within minimum time. The reasons which account for the use of derivatives make it important and significant for the investors who want to manage and mitigate risks. One reasons for using derivatives is that conditions of market volatility have existed since the mid 70s and these conditions have persisted on high and variable levels in the economy of different countries. In this volatile environment, policy makers and investors are not able to effectively manage risk and reduce its exposure due to their limited abilities which makes the use of derivatives obvious. For these reasons, derivatives evolved and flourished over time and now they comprise an important part of the financial securities market. It has been emphasized that derivatives make risk transferrable to those parties who are willing to bear risk from those who are not willing to bear it (Marthinsen, 2008). It is important to know what the risks are which some parties are not willing to bear while others are willing to bear. The fundamental risks involved in the financial instruments business include:

Credit Risk Credit risk is basically the risk of default of the party to pay off his debt obligations. This risk of failure to pay ones obligations is important because investors are unwilling to invest due to this risk of default.

Derivatives market in the emerging capital markets 6 Market Risk This risk is associated with changes and movements in the market prices and value of the underlying instrument which can result in a financial loss. Investors are always mindful of this risk and therefore, issue derivatives for investing in any underlying instrument.

Liquidity Risk Liquidity risk results when a firm becomes unable to arrange the funds for carrying out a transaction at the market price. Liquidity risk may be due to the underlying products or the funding activities of the company.

Legal Risk Some deals also involve legal aspects therefore; these contracts involve risk from judicial boundaries. Investors hold derivatives for minimizing and shifting their legal risks.

Types of Derivatives: By Contracts Derivatives are classified into four types based on the different types of contracts being made. A wide range of derivatives contract is possible due to different types of underlying assets and payment alternatives available. Despite the different contracts, all types have one common goal which is to minimize the risk for one party. The four main derivatives classified according to their contract types are as follows:

1. Futures: This type of contract is a standardized agreement between two parties where both promise to buy or sell the underlying asset at a certain price up to a fixed period of time.

Derivatives market in the emerging capital markets 7 They are special standardized contracts because they are traded on a futures exchange which means they are exchange traded contracts. The price which is set in the contract is called futures price and the fixed future date is called delivery date or final settlement date. The price on the delivery date is called settlement price. The point to remember about futures contract is that it gives the holder the obligation to buy or sell which means that on the settlement date, both the parties are obligated to fulfill the contract in any case(Chance and Brooks, 2006). The underlying asset is delivered by the seller to the buyer who pays the contracted price to the former thus, acquiring the asset. Futures trading is mostly done by hedgers and speculators which will be discussed in the later sections of this paper. In the case if the holder of the derivatives contract wants to exit the contract before the settlement date or in other words, wants to offset his position then he may have to buy a short position or sell off a long position. Position in derivatives terminology means the status or commitment of a contract holder to buy or sell the underlying asset under specified conditions. The holder by selling off the contract which he owns closes his long position or by buying back the contract which he has sold closes his short position. This is done so that the holder is free of all the contract obligations and the futures position is closed (Chance and Brooks, 2006).

2. Forwards: This contract is also similar to futures with the difference being that the agreement is made at todays pre-agreed price. The agreement is made between two entities to buy or sell the underlying asset at the fixed time but the price is paid for the underlying instrument before the control of instrument changes. The securities may be exchanged at a later date but the trade is done and the price is set before. This is why the term forward is used to denote these type of derivative contracts. The pre-agreed price is compared with the

Derivatives market in the emerging capital markets 8 price on the date of exchange which is called spot-price and any difference between the two either becomes the profit or loss for the purchasing party. Forward contracts are very useful since they allow the holder of the contract to hedge risk or to take advantage from the underlying instrument whose price is sensitive to time changes. Such instruments price changes with the passing time so investors make the deal at a pre-agreed price in order to avoid any risk of paying higher prices. The whole process can be explained with the help of an example. For example, A wants to buy a house in an years time and at the same time B wants to sell his house for $100, 000 in an years time too. Both A and B can enter into a contract called a forward contract to exchange the house at $104,000. This is done because in a years time the value of the house will increase lets say to $110,000. In such a case the buyer will gain the advantage of acquiring the house at a lesser price and the seller will lose the opportunity to gain more profit from the sale of his house. Forward contracts play an important role in the world of uncertainty where the market value of every asset and security continues to increase with time due to excessive inflation in the world. This way one party takes advantage from buying or selling the underlying asset at a pre-agreed price while the other party loses due to the pre-agreed price which might be greater than the spot price at the settlement date (Hull, 2006).

3. Options: Options are different from futures and forwards in that they do not give the holder the obligation or right to buy or sell an underlying asset. On the other hand, the options contract conveys the right to the holder of engaging in a future transaction on some underlying security. To explain it simply, the writer of the contract grants the option to the buyer to buy or sell the underlying asset at a certain price up to a fixed date. The right is

Derivatives market in the emerging capital markets 9 granted by the writer to the buyer in exchange of option price and the price at which the underlying asset may be bought or sold is called exercise price or strike price. Two types of options can be made- call option and put option. When the buyer is granted the right to purchase the underlying asset from the writer then it is called Call Option and when the buyer is granted the right to sell the underlying asset to the writer then it is called Put Option. The holder of the contract pays an option price when he is granted the right to buy or sell by the writer. If the holder decides not to buy or sell then the only amount he loses is the option price which becomes the profit for the writer. Option contracts might be traded over the exchanges which are called exchange traded options, or they might be traded between two private parties called Over-the-counter options, or they might be also issued by a company to its employees as compensation which are called Employee stock options (Johnson, 2008).

4. Swaps: The fourth and the final class of derivatives are Swaps which might appear to be a difficult concept to understand. These agreements are made between two private parties to exchange cash flows in the future according to a prearranged formula. Here rather than exchanging underlying asset for money, the streams of cash flows are exchanged which are called legs of the swaps. Swaps have a typical resemblance to the forwards therefore; portfolios of forward contracts are referred to as swaps. The cash flows can be due to interest rate or foreign exchange rate which is the variable factor. The most commonly used types of swaps are interest-rate swaps and currency swaps. In interest-rate swapping, cash flows related to the varying interest-rates are only swapped. It involves the swapping or exchange of a fixed-rate loan to a floating rate loan. This swapping is important to companies because some companies benefit from a fixed rate market while others benefit from a floating rate

Derivatives market in the emerging capital markets 10 market. Currency swap as the name indicates involves swapping the currency involved in the cash flows. The principal amount of the loan plus the fixed interest payments in one currency are swapped into a loan of equal principal amount and fixed interest payment in another currency. The purpose is to enable the companies to take advantage of paying off the loan and interest in currency which benefits them the most (Johnson, 2008).

Types of Derivatives: By Markets Derivatives can also be distinguished by the way they are traded on the market. This puts the derivatives into two important groups. These are:

1. Over-the-counter derivatives: In this kind of derivates market, the contracts and agreements are made between private parties without being traded on any exchange. It is a huge derivatives market and is common throughout the world. Swaps, forwards and options are mostly traded this way between two different parties (McDonald, 2005).

2. Exchange-traded derivatives: The trading of derivatives contracts that is done over the standardized exchanges is called exchange-traded derivatives. The exchange acts as an intermediary or third party whose role is to guarantee the exchange (McDonald, 2005).

The important differences between the two groups are further clarified in the following table:

Derivatives market in the emerging capital markets 11

Source: Strategies & Tactics, (2006). Risk Management Programs & The Use of Derivatives. Retrieved August 27, 2008, Web site: http://www.strategies-tactics.com/derivatives.htm

Uses of Derivatives

Derivatives started gaining momentum since the nineteenth century due to its rising importance attributed to its significant uses. These uses can also be referred to as the strategic applications of derivatives.

Risk Management One of the most important uses of derivatives is that they can be used as a tool for reducing the risk associated with an underlying asset. This is known as risk management. The contracts allows the holder to transfer risk when and as desired. This behavior of reducing or

Derivatives market in the emerging capital markets 12 transferring risk is known as Hedging. Hedging is mostly used by farmers and millers in order to avoid any risk associated with the price and availability of the crop. For example, a farmer enters into a futures contract with the miller to supply the crop at a specified price at a fixed date. This way the farmer reduces his risk associated with the uncertainty of price which might fall at a future date and similarly the miller reduces the risk by ensuring a constant availability of the crop (Marthinsen, 2008).

Speculation Another use to which derivatives are put is speculation which is often viewed negatively. Speculation refers to betting done on the movement of market value of the underlying asset or stock. The betting is done on the volatility of the underlying security and the people involved are called speculators. Investors can gain a lot of money through speculation but at the same time they can also lose a lot of money through this game. Options are the derivates used widely for speculation purposes. For example, speculators dont buy bonds whose value is expected to rise instead; they buy the option to purchase the bond at the option price which is much less than the actual price of the bond. This way through speculation, the speculators reduce their risk of loss which is only the option price while their profit opportunity still remains the same (Hull, 2006).

Reduced transaction costs Another use of derivatives is that it results in lower transaction costs during trading or exchange. This characteristic becomes especially useful in the case of exchange between the stocks and bonds. For example, if a person wants to change his stocks for bonds then he will

Derivatives market in the emerging capital markets 13 have to pay the required charges of doing so. But for trading derivatives no charges need to be paid and the same economic effect of exchanging stock for bonds can be achieved. This shows that the transaction costs were higher if stock is traded in exchange for bonds but with the use of derivatives, the cost reduces (Marthinsen, 2008).

Arbitrage This means that through the use of derivatives, the holder is able to circumvent certain regulatory restrictions, taxes and accounting rules. This is possible because by trading derivatives, the holder is able to sale the stock while at the same possessing it physically. This way the owner is able to defer taxes on the sale of the stock without even holding the stock (Whaley, 2006).

There are also other reasons for using derivatives. Besides managing risk, derivatives can be used to lower interest costs. This is possible because of the swap contracts in which the company can get a loan in foreign currency and do the payment in dollars by which it can reduce interest costs. Secondly, the use of derivatives gives the firm flexibility in their operations. This is because firms can achieve the sale of their assets while at the same time physically possessing it (McDonald, 2008). These uses are the common reasons because of which people use derivatives. People use

derivatives mainly as an alternative to simple sale or purchase in order to avoid risk of loss or unavailability of the underlying asset.

Derivatives market in the emerging capital markets 14 Derivatives Market in Emerging Economies of the World The trading of derivatives products has increased manifold in the emerging capital markets of the world since the beginning of 1990s. Though these markets are unregulated, illiquid, unstable and lack legal infrastructure but they are known to have a lot of potential for derivatives trading. They offer great advantages to the market participants and foreign investors. The trading is limited due to a number of obstacles in the spread of successful derivative products but once these obstacles are removed and misconceptions removed from the minds of the participants and investors, the emerging economies will become developed economies of the world in no time. These people must learn the key principles behind effective risk management for the development of sound derivatives products in the emerging markets of countries like India, China, Russia and Brazil etc. Each of these emerging derivatives market will be examined individually and analysis will be provided on the development of derivatives market in these emerging capital markets (Fernandez, 2006).

Derivatives market of India As far as the Indian financial markets are concerned, the history of derivatives can be traced way back from 1875. This concept was brought to Indian markets just after almost ten years when the concept was first experimented and introduced in the US markets in Chicago. However after the independence in 1952, the use of derivatives was banned in India because it was thought that derivatives and futures brought in high level of speculation in the market that would disrupt the healthy trading in the financial markets. Moreover, to support the decision m\of banning the concept of futures and derivatives, India faced droughts in many of its

Derivatives market in the emerging capital markets 15 provinces which led to farmers going default due to future trading. This also led to many unfortunate events including suicides (Harish, 2001). After a long ban of around 50 years, the new Indian government in 2002 again allowed the use of derivatives in Indian financial markets and the market rapidly showed its effects. The volume that was traded on the new systematic markets shot up manifolds and booms that made new records almost every passing day. In just 4 years, Indian financial markets were forecasted to break the record mark of a 1 trillion dollar worth value of future stocks. In this part of the paper we will se how the use of derivatives have had an impact over the Indian financial and stock markets and what is expected in the future regarding the use of derivatives in trading (Ahuja, 2006). Here is a brief general reason for why the use of derivatives was so beneficial for the Indian markets. India was among the top 5 producers of commodity items along with itself being a sound customer and consumer off commodity and energy goods as well. Being agriculture based economy, the contribution in the GDP of India is around 22% and the agriculture sector employs almost 57% of the total labor force employed in India. Also, agriculture sector of India has shown a remarkable growth trend of around 8- 10 % which shows that if applied effectively, India can prove to be the centre for trading using the commodity derivatives. The following table shows the Commodity futures trading at national Multi-Commodity Exchanges of India. It includes comparative data for three periods in USD millions (Kaur, 2000).

Derivatives market in the emerging capital markets 16

Source: Ahuja, N.L (2006).Commodity Derivatives Market in India: Development, Regulation and Future Prospects. International Research Journal of Finance and Econmics. 2, 154161. In the start of year 2000, there were only 8 companies listed for the future derivative trading, however when the new government realized the potential of future trading in 2002, there were as many as 80 commodities listed for future trading in just 2 years time. The most evident impact of the future trading derivative on the Indian financial market was the rise of value of trading from INR 350 billion to INR 1 trillion. To sum up, the rise in the value can alone give an idea to an observer about how big the impact of derivatives was on the Indian financial markets (Ahuja, 2006). Moreover domestic financial institutions mutual funds have also taken keen interest in OTC fixed income derivative instruments where transactions between banks play a great role in interest rate derivatives despite the presence of the state owned banks and financial regulatory authorities. Moreover financial institutions are actively contributing in currency markets, swap markets and buying other instrument fro banks and financial institutions.

Derivatives market in the emerging capital markets 17 Further more, when we talk about equity derivatives in the Indian financial markets, we see that small brokers and other retail investors are the major investors in this regard. Their contribution in value of such derivative techniques adds up to more then 60% of the total turnover because the success of stocks traded in future markets on single basis has a unique success story as compared to other countries and financial markets where the future derivative instrument has almost proved to be failure. There are many reasons for the exponential success of such future trading in Indian stock and equity markets and some general widely accepted reasons state that the popular concept of badla trading that drives the Indian market shares same characteristics as these future derivatives. Moreover the size of the future contracts in Indian markets is also quite small as compared to markets in other countries. In addition, the real investors in Indian financial markets are those who prefer commodity markets and their derivatives due to the fact that India is one of the biggest customers and consumers of retail commodities itself (Thakur, Karkun and Karla, 2000). With prevailing standard derivatives such as forwards, futures and options the reserve bank of India also allowed the forwarding trading in forward contracts including rupee and dollar making the exchange market a liquid market which also opened new opportunities regarding cross company option trading. International markets were also allowed to trade in derivatives relating to commodity markets of India. The following graph shows the volume of futures and options traded on Indias Stock Exchange over the years 2001- 04 on bimonthly basis (Sarkar, 2006).

Derivatives market in the emerging capital markets 18

Source: Sarkar, A (2006).INDIAN DERIVATIVES MARKETS. The Oxford Companion to Economics in India.

Financial derivatives have provided effective and low cost method for hedge users to manage their exposure to interest rates, exchange rates and price of commodities. Banks and financial institutions are now better able to re-price mismatches regarding long term funding in assets by the use of interest rate futures swaps. Majority of banks in India rely on Swaps in the sense that fixed or floating rates provided by these swaps are one of the most popular swaps in the financial markets of India after the introduction of derivatives. Under this system, parties are now able to pay fixed interest payments by at the same time receiving floating interest payments from another party (Mazin, 2006). Uncertainties have been reduced to a great extent by the introduction of derivatives in India enabling the corporations and organizations to initiate more productive activities. Foreign investors are now able to use financial derivatives in order to hedge against risk in foreign exchange that may cause problems otherwise while managing cash needed for the project due to free floating and volatile interest rates. Individual firms based in India are also using financial

Derivatives market in the emerging capital markets 19 derivatives to hedge against uncertainties in order to manage their cash as efficiently as never before. Derivatives and its instruments have enabled financial instructions, governments and corporations to identify more diversified funding resources by lowering the funding cost. a new trend is also seen in the currency and foreign exchange market where borrowers can borrow from cheapest capital markets regardless of the currency in which the debt interest is payable or in which the debt is denominated. Fixed or floating interest rates are also being used to finance foreign borrowing into a synthetic domestic currency (Kaur, 2000). Many corporations and institutions are maintaining and managing their portfolios of assets and liabilities effectively with the use of financial derivatives in the sense that equity funds are now able to reduce their exposure in the financial markets quickly and at comparatively lower costs without selling its equity assets or even a part of it. This is done by using stock index options and futures. It is believed by many financial analyst and literature reviews volatility of the market is reduced by incorporating the option derivative and trading concept. Over all it is believed that the volatility in the market either remains unchanged or reduces with the volatility in underlying stocks. Even if the change is positive after the use of such derivatives, the change is experienced for a very short span of time hut like the short time contract time in future trading., The FIIs are also relaxed and positive after the termination of the badla concept and the Introduction of derivatives in the markets. Those scripts in the markets that were previously enjoying the edge over other scrips in terms of high liquidity have come to an end by the introduction and incorporation of rolling settlements that restricts the top scripts from changing exchanges and markets. These scripts cannot switch exchanges and markets frequently because of the reduction

Derivatives market in the emerging capital markets 20 in settlement cycles in different markets and financial institutions. This has also helped to elevate the status of those stocks that were neglected due to the fact that they belonged to the B category (Ahuja, 2006). Pricing through options is one of the other impacts that have been seen in the financial markets of India. By taking the options approach pricing can be done by either of the two techniques, Black Sholes Model, or Binomial Model in order to cater both European and American style respectively. This has helped investment analysts and investment managers to save time without going into complex mathematical calculations; rather they can now use relationships and impact of different factors that might fluctuate price (Kaur, 2000). One of the major impacts of derivatives on financial markets is the amount of speculation that is involved in the market. This speculation does not allows a market to remain stagnant at one level and keeps it going by absorbing every bit of news and information from with in the country and from the international arena. Most of the investors have rough ideas about the economic political and social conditions of the country three months down the line which is more or less the same on the part of every individual due to the involvement of media in the game, thus the speculation about the market is pretty much fair from the investors side and depicts fairly true picture on the stock market index about the future. moreover surveys and researches have proven the fact that stock index future index have been the most popular equity derivatives followed by the stock index options with options on individual stocks being the third on the most popular derivatives list in Indian Financial Markets (Harish, 2001). Furthermore derivatives have helped mutual funds and other financial institutions in India in designing and structuring their investment strategy by enabling them to control risk and restructure portfolios easily. For example, previously, when a mutual fund decided to reduce its

Derivatives market in the emerging capital markets 21 equity exposure it could only be achieved by actually selling of equity holdings and thus the selling trend actually decreases the price of the equity which then affects the over all market. Moreover, selling of equity does wastes time because the broker may take time to find buyers for the equity and thus will charge extra cost. Therefore, if the index is sold in future by the means of derivatives, the sale of equity can be done with intervals depending on the best possible price that could be realized by the sale of the equity. Moreover in a derivative market an investor has a plenty of options available in order to opt for call or put options with more information available as compared to before when derivatives were not actually in the scene (Mazin, 2006). It is important to see that the economic benefits of different derivatives are not associated with the size of the company or the stock in trade. However, there are a lot of things that need to be taken care of while selecting a derivative. These things include, how they will perform under volatile economic pressures, the unique and price characteristics of these derivatives and how these derivatives are structured. It is to be noted that in the absence of a well planned strategy, use of derivatives can also prove to be dangerous for investors because it requires investors to have sound information about the current and future markets.

Need of Derivatives Market in China The impact of derivatives market on the emerging capital market can be looked at by studying and researching on necessity of the establishment of financial derivative market in China. It is crucial for the development of Chinas market economy to strengthen the financial derivative market which adds to its economic strength and development. This is important because the derivatives market will improve the capital structure of the country and the profitmaking ability of the commercial banks will increase. This will further strengthen the monetary

Derivatives market in the emerging capital markets 22 policy of the country and attract foreign capital investment which will lead China on paths of future growth. Derivatives offer unique advantages due to their risk-shifting characteristic and these instruments have had a successful experience in the advanced and developed countries of the world. Through their experience, the developing and emerging economies of the world have also realized the importance of establishing derivatives market in their country including China with the intention of accelerating economic growth. China has already achieved great success through its economy reforms and intends to grow continuously in the future. In order to sustain the continuous economic growth, the country feels that they need an important element of derivative market in their economy. The development of derivatives market in China seems to be extremely important from the point of view of attaining a deepening development in financial market (Tian, 2005). The financial functions in Chinas financial market are not efficient enough and also lack a scientific pricing mechanism. These functions include gathering function, adjusting function, distributing function and reflecting function. Establishment of derivatives market provides a solution to all these problems and restores the market efficiency in Chinas financial market. When participants will be involved in the repeated trade of derivatives instruments then they will form positive expectations about the derivatives market with the help of market information available to them. The utility of the information will increase and they will able to involve in repeated trades of derivatives. Moreover, the adjustment of prices during the trade will provide a basis of scientific pricing mechanism. All this will increase the amount of information available which will lead to more prudent way of investment and thus, will increase the market efficiency. In addition to this, the risk-shifting characteristic of the derivatives makes the distributing

Derivatives market in the emerging capital markets 23 function of the Chinas financial market more effective thus, adding to the importance of derivatives market in the emerging capital market of China (Anonymous, 2006). Today, all investors are guided by the motive of making maximum profits and fear the loss due to risk factor associated with the investment. This means that all investors and traders in any financial market are interested in hedging and speculation which are the principal uses of derivatives instruments. Hedging is done in order to transfer the risk of one party to another and speculation helps the market by taking the risk to make profit. This means that both hedging and speculation are important concepts to be developed for the sound development of a successful financial market economy. China lacks this mechanism of risk elusion and venture and therefore, the local as well as foreign investors do not show an interest in Chinas financial market due to the fear of risk and loss. This makes establishment of derivative market for China extremely important all the derivative contracts such as futures, forwards, options and swaps have risk elusive characteristics and will help in strengthening the financial derivative market of China (Tian, 2005). These days traders and investors are showing interest in new and innovative financial instruments due to increased financial liberalization. Demand for new instruments is increasing since traditional instruments have no room for expansion and yield only limited amount of profit. The introduction of derivatives will attract the attention of the investors since the derivatives market is a quite profitable and developed market in many advanced countries of the world. Though the Chinese financial market is not a very developed one and is at its primary stage but there is a demand for innovative products and instruments coming from the international market

Derivatives market in the emerging capital markets 24 which will lead to the effective establishment of the derivative market in the country. Therefore, derivative market is considered very important for the Chinese financial market development. As stated earlier, development of derivatives market in China will result in strengthening the capital structure and improving the profit making ability of the commercial banks. One of the problems in Chinas commercial banks is that there is irrational capital structure and they have bad capital liquidity. But the establishment of derivatives market will lead to the optimization of capital structure in the commercial banks since derivatives result in regular trade patterns and offer means for securitization. This point of view has been supported by many economists that for the efficient functioning of the commercial banks, China should promote the development of derivatives market to that its financial markets gains some strength in the international arena. In addition to this, commercial banks will be able to make more profit by issuing derivates and doing trade in them with little venture. Chinas commercial banks are rated as not competitive since they are not able to generate enough profit as compared to other foreign banks but the developed of derivates market will enable the commercial banks to become profitable and competitive in the international financial world (Tian, 2005). There is no doubt to the fact that Chinas economy had made considerable progress during the 1980s and it continues to do so but the troublesome fact is that there have been inflations and deflations in the economy over the recent years. This all makes one thing clear: the inefficiency of Chinas monetary policy. The monetary policy effect has not been strong enough to keep the inflation from persisting in the economy. With the establishment of derivatives market, there will be a pricing mechanism due to which considerable amount of information will be available to the economists about market expectations and operation instruments. Moreover

Derivatives market in the emerging capital markets 25 derivatives come with a lot of variety which adds to the effectiveness of the monetary policy since more the variety of financial instruments are available, the more effective monetary policy becomes. Due to the issues of capital liquidity and irrational capital structure, most foreign investors do not think it safe and wise enough to invest in Chinas financial market. They have failed to absorb a huge amount of international capital where as other developing and emerging economies have succeeded in this respect due to the development of derivatives market. The derivative market can offer means of trade and provide a guarantee to the investors that they will earn a good amount on their investment. This happens because since the derivatives have a riskshifting characteristic, the investors risk will decrease by investing in derivatives and they will show greater willingness to invest in Chinas financial market. Moreover, since derivative instruments come with a lot of varieties so they offer more options to the foreign investors who can invest according to their needs and interests. This all will lead to the promotion of financial globalization and economy development in China with the help of international capital (Anonymous, 2006). Finally, the establishment and development of derivatives market in China will also promote and develop international trade of which China is already a chief member. It is no doubt that China is counted amongst the top importers and exporters of the world but still it is faced with exchange rate risks. Fluctuation in exchange rates creates much problem for the Chinas economy but with the development of derivates, fixed exchange rates can be swapped with floating exchange rates to take the advantage of the opportunity at any point in time. Fluctuations

Derivatives market in the emerging capital markets 26 can block the economic growth but the derivatives market reliefs the economy from this problem and ensures a steady economic growth (Tian, 2005). The above research on the economic and financial market of China makes one thing clear that China should immediately focus on the development of its emerging capital market and make it a success in the eyes of the world. This is important not only from the international perspective but also from the economic development perspective. Derivative market will play an important role in accelerating the economy towards future growth. It is time that the economists should realize the importance of financial derivatives market and work on its development before other emerging economies and capital markets of the world succeed in this global race. Derivatives Market of Russia

Another emerging economy in which derivatives market plays an influential role is that of Russian capital market. Russia has gradually evolved as an important global equity market with a market capitalization of over USD one trillion. This has enabled the Russian capital market to attract a lot of foreign investors due to the growing success of this financial market. When it comes to the derivatives market of Russia, it is not yet developed due to limited awareness or knowledge of the people. Moreover, Russian assets are considered to be undervalued because of which investors do not take the risk of investing in the underlying assets of derivatives. Investors usually show interest in investing in Russian stock through which they can make high profits without much risk thus; they do not feel the need of issuing derivatives for this purpose. But in the recent years especially after 2006, the Russian market has seen great demand for derivates due to rise in equity indexes and investors base (Dobeck, 2007).

Derivatives market in the emerging capital markets 27 The trading in derivatives market of Russia began in 1992 but did not see much development due to the dominance of speculative trading, underdeveloped legal and regulatory infrastructure, defective governance and instability(Rotfub, 2007). This all led to a financial crisis in the Russian financial market in 1998 and eventually all trading business nearly came to a halt. There was a two-year pause after this financial crisis but the Russian derivatives market once again surged in 2000 and the year saw the opening of Russian exchanges for derivatives trading. There were regenerative developments in other financial markets of Russia as well and many new exchanges opened along with the old ones. The development was very slow and gradual because the investors considered derivatives risky instruments since they were linked to the financial crisis so the investors doubted their credibility. Because of this, participants had a lack of confidence in the governance and stability of derivatives trading due to which there limited trading was done on these markets. The market took a sharp turn with the opening of Saint Petersburg Currency Exchange (SPCEX) which started trading in currency and equity based derivatives securities. Also in the year 2000, the Moscow Interbank Currency Exchange (MICEX) re-opened its operations on the trading floor which started trading in futures on USD. The following year two other exchanges were also launched namely Russian trading system stock exchange (RTS) together with Stock Exchange Saint Petersburg (SPBEX). These exchanges began trading in equity based instruments and established a joint market for futures and options. The underlying equity was the ordinary shares of major Russian companies like Gazprom, Unified Energy Systems etc (Rotfub, 2007). As discussed previously, derivatives trading can be done on two major markets: over the counter and trade exchanges. Similarly, the Russian derivatives market was also organized on over-the-counter (OTC) market and four exchanges of the country. These four exchanges which

Derivatives market in the emerging capital markets 28 accounted for the major portion of the trading were SPCEX, MICEX, RTS and SPBEX. Of these four, the largest trading share was contributed by RTS and MICEX accounting for almost 90% of total exchange traded derivatives turnover followed by SPBEX and SPCEX. MICEX specializes in currency based derivatives whereas RTS is responsible for equity based derivatives. However, limited data is available on the over-the-counter markets but ample data is available for the trading done through exchanges. Bank of International Settlements is responsible for conducting the survey of Foreign Exchange and Derivatives Market Activity by making it mandatory for the central banks of each country to collect all the data and information of their respective foreign exchange and derivatives market. The data survey reveals that an average annual growth rate of exchange-traded derivative through 2000 to 2006 was 168% which is dramatic enough. By the end of 2006, the total turnover of exchange traded derivatives amounted to EUR 102bn (Ehinger, 2007). The following table presents important data regarding exchange traded derivatives in Russia.

Annual Turnover of Exchange-traded derivatives in Russia (in EUR million)

Derivatives market in the emerging capital markets 29

Source: Rotfub, W (2007).Options, Futures and other Derivatives in Russia: An Overview. Discussion Paper No. 07-059.

At the other end, the turnover on OTC derivatives market has grown at a monthly rate of 47% from April 2004 to April 2007. The Aug 2007 figures of the OTC market show a total turnover amount of EUR 781bn. The following table provides details on tradable derivatives instruments in both the Russian exchanges as well as the OTC market.

Derivatives market in the emerging capital markets 30

Source: Rotfub, W (2007).Options, Futures and other Derivatives in Russia: An Overview. Discussion Paper No. 07-059.

The table tells us the type of derivatives contracts traded like futures, options etc and on what currency like EUR, USD or RUR. The data analysis also reveals that 90% of total exchange

Derivatives market in the emerging capital markets 31 traded derivatives instruments are futures and that futures trading began much earlier than the options trading. The underlying instruments used in the trading are mostly currency and equity based while interest rate and commodity based instruments remain marginal. Swaps contracts in the OTC market mostly involve swapping from RUR against USD and USD against EUR in the tradable markets (Rotfub, 2007). The evaluation of Russian derivatives market makes this clear that this market is not developed enough as compared to other financial and capital markets of the country. Derivative markets have generally lagged whereas the spot markets have shown a positive growth trend over the years. This lagging is mainly attributed to the lack of confidence in market participants and regulators plus the foreign investors who are refrained by the risk of financial crisis. Russia needs a proper legal and regulatory environment along with reliable legal infrastructure which are deficient today and the main reasons for investors lack of confidence. With the installation of these systems, market participation will increase due to increased protection for investors and enhanced transparency (Dobeck, 2007).

Derivatives market of Brazil When it comes to Brazil, the derivative trading initiated in the country long back from 1917 done on mostly agricultural products of the country, Cotton and Coffee. The derivative trading was done on the Bolsa de Mercadoria de Sao Paulo (BMSP). By the beginning of 1970s and up to 1980s, the Brazil derivatives market showed immense growth and innovation as more and more variety of derivatives contracts became common in the market offering a greater variety of financial futures for agricultural purposes. Slowly and gradually, new derivatives exchanges were introduced in the country due to which the use of futures and options on

Derivatives market in the emerging capital markets 32 financial instruments increased considerably. The two stock exchanges of Brazil- BOVESPA and BVRJ also started trading futures and option with the underlying instruments being the individual stocks. By 1980, BMSP started trading futures based on gold which further strengthened the derivatives market thereby increasing the profits of the investors. In the year 1983, another exchange was created called Brazilian Futures Exchange which did the similar of trading futures and options based on stock and stock indexes. After few years in 1986, the most important exchange was created Bolsa de Mercadorias e de Futuros more popularly known as BM&F which was responsible for trading both forwards and futures on gold and futures on stock indexes. This shows that all three derivative exchanges in Brazil were trading similar products which led to a fierce competition between all three exchanges. For economic stability and development of the derivatives market, the three exchanges merged together by 1997 since all three performed similar task so they could function more productively if they merged together their operations. The merged exchange is known today as Brazilian Mercantile and Futures Exchange with the same initials of BM&F (Dodd and Griffith-Jones, 2007). This merger also inspired the two stock exchanges of the country to merge together and form a single stock exchange which also involved in some sort of derivatives trading. The final two exchanges are known and counted amongst the largest derivatives exchanges of the world. This shows that Brazilian derivatives market is already accelerating towards growth since it possesses the largest derivatives exchanges of the world. The survey by US Futures Industry Association reveals that BOVESPA ranks as the 8 th th and BM&F ranks as the 10 largest derivatives exchanges of the

world based on the number of derivatives contracts traded. The average yearly growth in the turnover of BM&F traded derivatives has been nearly 150%. The following chart shows the tradable commodities on the BM&F exchange which is famous worldwide.

Derivatives market in the emerging capital markets 33

Source: Dodd, R, & Griffith-Jones, S (2007). Report on derivatives market: stabilizing or speculative impact on Chile and a comparison with Brazil.Santiago: United Nations Publication.

BM&F does not only performs its role as a derivatives exchange but also functions as a clearing house for stocks, bonds, commodities, currency and various other assets. The variety of derivatives contracts traded on this exchange include forwards, futures, options, flex options and swaps(Fernandez, 2006). An innovative feature of this exchange is that it also makes derivative trading for small investors possible through minis. Minis are small sized contracts offered to small market participants who need a trading platform to invest their resources. The majority of

Derivatives market in the emerging capital markets 34 derivatives contracts are based on interest rate products whereas the exchange rate products are marginal. Apart from this there was an economic stabilization plan introduced in the July of 1994 which gave a strong boost to derivatives market in Brazil. The plan created a regulated environment which solved one of the major obstacles to the development of the derivative market (Dodd and Griffith-Jones, 2007). The derivatives contracts are not only traded on the exchange market but the Brazilian derivative market has also established an extensive over-the-counter (OTC) market for the trading of derivatives between private firms and institutions. Here also, the Bank of Settlements is responsible for collecting the data on exchange traded markets and OTC markets. The data analysis from the banks reports reveals that daily turnover of exchange traded derivatives amount up to $1bn per day. These derivatives are mostly based on foreign exchange products. In the case of OTC market, the figures were the same that is $1 billion daily trading volume per day on the OTC market. The trading derivatives were mostly based on single currency interest rate products. In addition to all this, the BM&F has a clearing house which increases the importance of the Brazilian derivatives exchange as this also performs the function of registering OTC derivatives. This strengthens the legal infrastructure of the derivatives market and also enhances transparency. All this analysis of Brazils derivative market reveals that the obstacles which are not letting the proper development of derivative market in other emerging economies of the world are not a problem here. The derivatives market of Brazil is quite old enough with its traces being found in 1917 which shows that market participants and investors have a lot of awareness and knowledge about this market. Moreover, the Brazil comprises of two largest exchanges of the world which further strengthens its derivatives market. Thus, we can say that the

Derivatives market in the emerging capital markets 35 establishment and development of derivatives market in Brazil has contributed significantly to its economic stability and prosperity accelerating future growth (Fernandez, 2006). Concluding Remarks This dissertation paper was based on the study and evaluation of different derivative markets in the emerging capital markets of the world with special attention paid to the economies of India, China, Russia and Brazil. The basic concepts of derivatives and its types were explained in detail in the beginning of the paper so as to move on to more difficult concepts of derivatives market developed in the next sections of the paper. The paper thus, concludes that emerging market countries can benefit from the derivative products. Investors and market participants in these economies are always wary of market changes and price fluctuations due to which they refrain from investing because of the risk factor. But with the establishment of derivatives market, protection is provided to such investors by preventing the market fluctuations in prices of the commodities as well as the monetary policy so that they do not result in shocks for these unconfident investors. Moreover, due to the risk-shifting characteristic of the derivatives, the investors are also able to lower transaction costs. The investment opportunities increase for them and they can invest rapidly in derivatives market which promise maximum returns with minimum risk. Derivatives are being used as an effective means to restore the supply demand imbalance in the economy and make the economy of any country stable, liquid along with a strong legal infrastructure and proper regulatory environment.

Derivatives market in the emerging capital markets 36

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