Innovative Derivative Products

2009
FDRM
SUBMITTED TO:
Dr. Rekha
SUBMITTED BY-Group 7:
Amritha Pal (08PG080)
Anurag Agarwal (08PG155)
Dipti Jha (08PG225)
P.Varun Nair (08PG177)
Sanjeev Agarwal (08PG267)
V.Pushpa (08PG352)
[FDRM] December 7, 2009
1. Derivatives are still new in Indian markets, lots of efforts is required to be

made by all the policies concerned including regulatory authority. Comment on
the statement and bring out various implications connected with the statement.
The emergence of the market for derivative products such as futures and forwards can
be traced back to the willingness of risk-averse economic agents to guard themselves
against uncertainties arising out of price fluctuations in various asset classes. By their
very nature, the financial markets are marked by a very high degree of volatility.
Through the use of derivative products, it is possible to partially or fully transfer price
risks by locking in asset prices. However, by locking in asset prices, derivative products
minimize the impact of fluctuations in asset prices on the profitability and cash flow
situation of risk-averse investors. This instrument is used by all sections of businesses,
such as corporate, SMEs, banks, financial institutions, retail investors, etc.
According to the International Swaps and Derivatives Association, more than 90 percent
of the global 500 corporations use derivatives for hedging risks in interest rates, foreign
exchange, and equities. In the over-the-counter (OTC) markets, interest rates (78.5%),
foreign exchange (11.4%), and credit form the major derivatives, whereas in the
exchange-traded segment, interest rates, government debt, equity index, and stock
futures form the major chunk of the derivatives.
REGULATORY AUTHORITY
There are four main legislations governing the securities market:
a. The SEBI Act, 1992, which establishes SEBI to protect investors and develop and
regulate the securities market.
b. The Companies Act, 1956, which sets out the code of conduct for the corporate
sector in relation to issue, allotment, and transfer of securities, and disclosures to
be made in public issues.
c. The Securities Contracts (Regulation) Act, 1956, which provides for regulation of
transactions in securities through control over stock exchanges.
d. The Depositories Act, 1996, which provides for electronic maintenance and
transfer of ownership of demat securities.
In India, the responsibility of regulating the securities market is shared by DCA (the
Department of Company Affairs), DEA (the Department of Economic Affairs), RBI (the
Reserve bank of India), and SEBI (the Securities and Exchange Board of India).
The DCA is now called the ministry of company affairs, which is under the ministry of
finance. The ministry is primarily concerned with the administration of the Companies
Act, 1956, and other allied Acts and rules & regulations framed there-under mainly for
regulating the functioning of the corporate sector in accordance with the law.
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The ministry exercises supervision over the three professional bodies, namely Institute
of Chartered Accountants of India (ICAI), Institute of Company Secretaries of India
(ICSI), and the Institute of Cost and Works Accountants of India (ICWAI), which are
constituted under three separate Acts of Parliament for the proper and orderly growth
of professions of chartered accountants, company secretaries, and cost accountants in
the country.
SEBI
Protects the interests of investors in securities and promotes the development of the
securities market. The board helps in regulating the business of stock exchanges and
any other securities market. SEBI is also responsible for registering and regulating the
working of stock brokers, sub-brokers, share transfer agents, bankers to an issue,
trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio
managers, investment advisers, and such other intermediaries who may be associated
with securities markets in any manner.
The board registers the venture capitalists and collective investments like mutual funds.
SEBI helps in promoting and regulating self regulatory organizations.
Derivatives and New Products Departments (DNPD) - concerned with supervising

trading at derivatives segments of stock exchanges, introducing new products to be
traded and consequent policy changes.
Committee on regulation of derivatives trading
Derivative products are being intensively used in most of the major markets of the
world. These products have been used as tools for risk management and hedging by
investors. Derivatives, though are highly complex products, have found an increasing
international acceptability among the market intermediaries, corporate and retail
investors.
Presently, in India, a few derivative products in currency and commodity markets are
available. The SEBI felt the need to introduce derivative products in the Indian
securities market and accordingly appointed a Committee under the Chairmanship of
Dr. L. C. Gupta. The Committee submitted its report to SEBI on March 17, 1998. The
main recommendations of the Committee are given below:
Major Recommendations of L. C. Gupta Committee
 The Committee strongly favours the introduction of financial derivatives in order

to provide the facility for hedging in the most cost-efficient way against market
risk. This serves an important economic purpose. At the same time, it recognises
that in order to make hedging possible, the market should also have speculators
who are prepared to be counter-parties to hedgers. A derivatives market wholly
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or mostly consisting of speculators is unlikely to be a sound economic institution.

A soundly based derivatives market requires the presence of both hedgers and
speculators.
 The Committee is of the opinion that there is need for equity derivatives, interest
rate derivatives and currency derivatives. In the case of equity derivatives, while
the Committee believes that the type of derivatives contracts to be introduced
will be determined by market forces under the general oversight of the SEBI and
that both futures and options will be needed. The Committee suggests that a
beginning may be made with stock index futures.
 The Committee favours the introduction of equity derivatives in a phased

manner so that the complex types are introduced after the market participants
have acquired some degree of comfort and familiarity with the simpler types.
This would be desirable from the regulatory angle too.
 The Committee's recommendations on regulatory framework for derivatives

trading envisage two-level regulation, i.e. exchange-level and the SEBI-level. The
Committee’s main emphasis is on exchange-level regulation by ensuring that the
derivative exchanges operate as effective self-regulatory organisations under the
overall supervision of the SEBI.
 Since the Committee has placed considerable emphasis on the self-regulatory

competence of derivatives exchanges under the over-all supervision and
guidance of the SEBI, it is necessary that the SEBI should review the working of
the governance system of stock exchanges and strengthen it further. A much
stricter governance system is needed for the derivative exchanges in order to
ensure that a derivative exchange will be a totally disciplined market place.
 The Committee is of the opinion that the entry requirements for brokers/dealers
for derivatives market have to be more stringent than for the cash market. These
include not only capital adequacy requirements but also knowledge
requirements in the form of mandatory passing of a certification programme by
the brokers/dealers and the sales persons. An important regulatory aspect of
derivatives trading is the strict regulation of sales practices.
 Many of the SEBI's important regulations relating to exchanges, brokers-dealers,

prevention of fraud, investor protection, etc., are of general and over-riding
nature and hence, these should be reviewed in detail in order to be applicable to
derivatives exchanges and their members.
 The Committee has recommended that the regulatory prohibition on the use of
derivatives by mutual funds should go. At the same time, the Committee is of the
opinion that the use of derivatives by mutual funds should be only for hedging
and portfolio balancing and not for speculation. The responsibility for proper
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control in this regard should be cast on the trustees of mutual funds. The
Committee does not favour framing of detailed SEBI regulations for this purpose
in order to allow flexibility and development of ideas.
 The SEBI, as the overseeing authority, will have to ensure that the new futures
market operates fairly, efficiently and on sound principles. The operation of the
underlying cash markets, on which the derivatives market is based, needs
improvement in many respects. The equity derivatives market and the equity
cash market are part of the equity market mechanism as a whole.
 The SEBI should create a Derivatives Cell, a Derivatives Advisory Committee, and
Economic Research Wing. It would need to develop a competence among its
personnel in order to be able to guide this new development along sound lines.
Current Regulatory Framework
In the light of increasing use of structured products and to ensure that customers
understand the nature of the risk in these complex instruments, RBI after extensive
consultations with market participants issued comprehensive guidelines on derivatives
in April 2007, which cover the following aspects:
 Participants have been generically classified into two functional categories,

namely, market-makers and users, which would be specific to the position taken
by the participant in a transaction. This categorisation was felt important from
the perspective of ensuring Suitability & Appropriateness compliance by market
makers on users.
 The guidelines also define the purpose for undertaking derivative transactions
by various participants. While Market-makers can undertake derivative
transactions to act as counterparties in derivative transactions with users and
also amongst themselves, Users can undertake derivative transactions to hedge -
specifically reduce or extinguish an existing identified risk on an ongoing basis
during the life of the derivative transaction - or for transformation of risk
exposure, as specifically permitted by RBI.
 The guidelines clearly enunciate the broad principles for undertaking derivative
transactions :
 Any derivative structure is permitted as long as it is a combination of two or

more of the generic instruments permitted by RBI and
 Market-makers should be in a position to mark to market or demonstrate

valuation of these products based on observable market prices.
 Further, it is to be ensured that structured products do not contain derivative(s),

which is/ are not allowed on a standalone basis. This will also apply in case the
structure contains ‘cash’ instrument(s).
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 All permitted derivative transactions shall be contracted only at prevailing

market rates.
 The guidelines set out the basic principles of a prudent system to control the
risks in derivatives activities. It is required that all risks arising from derivatives
exposures should be analysed and documented and the management of
derivative activities should be integrated into the bank’s overall risk
management system using a conceptual framework common to the bank’s other
activities.
 The critical importance of ‘suitability’ and ‘appropriateness’ policies within

banks for derivative products being offered to customers (users) have been
underlined. It is imperative that market-makers offer derivative products in
general, and structured products, in particular only to those users who
understand the nature of the risks inherent in these transactions and further that
products being offered are consistent with users’ internal policies as well as risk
appetite.
Within the above broad framework, the specifics of the forex and interest rate
derivatives permitted are explained below:
I. Forex derivatives
Economic entities in India currently have a menu of OTC products, such as forwards,
swaps and options, for hedging their currency risk and the markets for the same are
fairly deep and liquid, as reflected in the volumes and bid-offer spreads. The origin of
the forex market development in India could be traced back to 1978 when banks were
permitted to undertake intra-day trades. However, the market witnessed major
activities only in the 1990’s with the floating of the currency in March 1993, following
the recommendations of the Report of the High Level Committee on Balance of
Payments (Chairman: Dr. C. Rangarajan).
In respect of forex derivatives involving rupee, residents have access to foreign

exchange forward contracts, foreign currency-rupee swap instruments and currency
options – both cross currency as well as foreign currency-rupee. In the case of
derivatives involving only foreign currency, a range of products such as IRS, FRAs,
option are allowed. While these products can be used for a variety of purposes, the
fundamental requirement is the existence of an underlying exposure to foreign
exchange risk whether on current or capital account. While initially the forward
contracts could not be rebooked once cancelled, greater flexibility has now been given
for booking cancellation and rebooking of forward contracts. In the case of exporters
and importers, they are also allowed to book forward contracts based on past
performance and the delivery condition has also been gradually liberalized.
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In order to simplify procedural requirements for Small and Medium Enterprises (SME)
sector, RBI has recently granted flexibility for hedging both underlying as well as
anticipated and economic exposures without going through the rigours of complex
documentation formalities. In order to ensure that SMEs understand the risks of these
products, only banks with whom they have credit relationship are allowed to offer such
facilities. These facilities should also have some relationship with the turnover of the
entity. Similarly, individuals have been permitted to hedge upto USD 100,000 on self
declaration basis.
AD banks may also enter into forward contracts with residents in respect of
transactions denominated in foreign currency but settled in Indian Rupees including
hedging the currency indexed exposure of importers in respect of customs duty payable
on imports. ADs have been delegated powers to allow residents engaged in import and
export trade to hedge the price risk on all commodities in international commodity
exchanges, with few exceptions like gold, silver, and petroleum. Domestic
producers/users are allowed to hedge their price risk on aluminum, copper, lead, nickel
and zinc as well as aviation turbine fuel in international commodity exchanges based on
their underlying economic exposures.
Facilities for Non-residents
Foreign Institutional Investors (FII), person’s resident outside India having Foreign
Direct Investment (FDI) in India and Non-resident Indians (NRI) are allowed access to
the forwards market to the extent of their exposure in the cash market. FIIs are
permitted to hedge currency risk on the market value of entire investment in equity
and/or debt in India as on a particular date using forwards. For FDI investors, forwards
are permitted to (i) hedge exchange rate risk on the market value of investments made
in India since January 1, 1993 (ii) hedge exchange rate risk on dividend receivable on
the investments in Indian companies and (iii) hedge exchange rate risk on proposed
investment in India. NRIs can hedge balances/amounts in NRE accounts using forwards
and FCNR (B) accounts using rupee forwards as well as cross currency forwards.
Currency Futures
In the context of growing integration of the Indian economy with the rest of the world,
as also the continued development of financial markets, there is a need to allow other
hedging instruments to manage exchange risk like currency futures. The Committee on
Fuller Capital Account Convertibility had recommended that currency futures may be
introduced subject to risks being contained through proper trading mechanism,
structure of contracts and regulatory environment. Accordingly, Reserve Bank of India
in the Annual Policy Statement for the Year 2007-08 proposed to set up a Working
Group on Currency Futures to study the international experience and suggest a suitable
framework to operationalise the proposal, in line with the current legal and regulatory
framework.
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The group has had extensive consultations with a cross section of market participants
including bankers associations, banks, brokers, exchanges, both Indian and
international, and is in the process of finalizing its report. Given that India is not yet
fully convertible on capital account, various options are available to deal with the issue
of reconciling the regulatory framework in the cash and OTC forward market with the
currency futures segment. The international experience in this regard is mostly from
OECD countries except for one single exception of South Africa which has very recently
introduced domestic currency futures. The draft report of the group will be placed in
public domain for wider dissemination and feedback.
Rupee Interest rate derivatives
Rupee derivatives in India were introduced in July 1999 when RBI permitted
banks/FIs/PDs to undertake Interest rate swaps and Forward rate agreements. These
institutions were allowed to offer these products to corporates for hedging interest rate
risk as well as deal in these instruments for their own balance sheet hedging and
trading purposes. Since then, many initiatives have been undertaken to deepen and
broaden the market.
The rupee interest rate derivatives presently permissible are Forward Rate Agreements
(FRA), Interest Rate Swaps (IRS) and Interest Rate Futures (IRF). The permitted
benchmarks for FRA/IRS are any domestic money or debt market rupee interest rate;
or, rupee interest rate implied in the forward foreign exchange rates, as permitted in
respect of MIFOR swaps. While both banks and PDs are allowed as market makers in the
swap market, all business entities (including banks and PDs) are permitted to hedge
their underlying exposures using these instruments. PDs have been also permitted to
hold trading position in IRF, subject to internal guidelines in this regard. The interest
rate swap market has grown rapidly with participation from banks and corporates. The
market is liquid and bid-offer spreads are narrow.
Transparency and reporting
In order to have a mechanism for transparent capture and dissemination of trade

information, the Clearing Corporation of India, at the instance of RBI, has recently
developed a reporting system for OTC interest rate swaps. The reported deals are
processed by CCIL which also offers certain post trade processing services like resetting
interest rates, providing settlement values etc. to the reporting members. Information in
regard to traded rates and volumes are made available through CCIL's website.
Once things stabilize, the next phase could be development of post-trade processing
infrastructure to address some of the attendant risks.
Interest rate futures
While FRA/IRS markets have shown phenomenal growth, the interest rate futures, first
introduced on NSE in 2003, have not picked up on account of certain structural factors.
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A sub-group of the RBI Technical Advisory Committee on Markets having

representatives from the industry and academia, has been constituted to examine the
issues, including the following:
(i) Review the experience with the Interest Rate Futures so far, with particular
reference to product design issues and make recommendations for activating the
Interest Rate Futures.
(ii) Examine whether regulatory guidelines for banks for Interest Rate Futures need to
be aligned with those for their participation in Interest Rate Swaps.
(iii) Examine the scope and extent of the participation of non-residents, including
Foreign Institutional Investors (FIIs), in Interest Rate Futures, consistent with the policy
applicable to the underlying cash bond market.
The draft report of the group would be placed in the public domain for comments.
Structured Credit and Credit derivatives
The structured credit market internationally has grown phenomenally into a distinct
asset class, encompassing a slew of complex products which have facilitated risk
transfer across multiple chains of investors, leveraging several times on the original
loan amount. The downside of this model has been eloquently demonstrated in the US
sub-prime related fallout globally, which I will discuss later. In India, the structured
credit market is still in its infancy, primarily constituting securitization products, and
the lessons of recent events can hold important lessons for the future development of
this market here.
Securitization in India has been in existence for over a decade confined mainly to a few
banks and non-banking finance companies. Both mortgage backed securities and asset-
backed securities are in vogue. The securitization market has matured over the last few
years and there is now an established investor community and regular issuers. As per
ICRA's estimates, the structured issuance volumes have grown from Rs. 77 billion in
2003 to Rs. 369 billion in 2006-07. The growth in 2006-07 has been primarily on
account of securitization of single corporate loans, which accounted for nearly a third of
the total volume. However, ABS is the largest product class at more than 60%, with
securitization of retail loans remaining popular. The growth of ABS market can be
attributed to a number of factors such as the growing retail loan portfolios held by
banks and other financial institutions, investors' familiarity with the underlying assets
class the relatively short tenor of such issues. Growth of the MBS market has been
slower despite the growth in the underlying housing finance market mainly due to the
relatively long tenor, lack of secondary market liquidity and the risk arising from
prepayment/repricing of the underlying loans.
In the light of the differing practices followed by banks in India and certain concerns on
accounting, valuation and capital treatment, the RBI issued formal guidelines in
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February 2006 after extensive consultation with market participants. The guidelines are
largely in line with those issued by other supervisors internationally and envisage the
following:
 Detailed set of guidelines to ensure 'arms' length relationship between the

originator and the SPV
 Credit enhancements provided by the originator for first as well as second losses
to be deducted from the capital. For the first loss facility, the deduction is capped
at the amount of capital that the bank would have been required to hold for the
full value of assets. Thus a disincentive is created for an originator trying to
provide second loss facility also. (However, the proposed Basel II guidelines
envisage risk weight for securitized exposures, depending upon rating, will range
from 20% to 400% or even deduction from capital)
 Any profit/premium arising on account of sale not allowed to be booked upfront

and is to be amortised over the life of the securities issued or to be issued by the
SPV.
 Provision of liquidity facility to be treated as an off- balance sheet item and

attract 100% credit conversion factor as well as 100 % risk weight.
 Disclosure by the originator, as notes to accounts, presenting a comparative

position for two years: total number and book value of loan assets securitised;
 Sale consideration received for the securitised assets and gain/loss on sale on
account of securitisation;
 Form and quantum (outstanding value) of services provided by way of credit

enhancement, liquidity support, post-securitisation asset servicing, etc.
In the context of recent global events, the above guidelines will go a long way in laying
the foundation of a healthy structured credit market.
In respect of distressed assets, the legal framework was provided by the Securitisation
and Reconstruction of Financial Assets and Enforcement of Security Interests Act,
2002", more commonly called SARFAESI Act. This led to the constitution of asset
reconstruction companies specializing in securitizing distressed assets purchased from
banks. The issuance of security receipts has since grown significantly, though the
secondary market activity has not been large enough. To encourage proper market
valuation, securitization companies have been advised to take into account rating of
instruments by SEBI registered rating agencies, based on 'recovery ratings’ for declaring
the NAV of the issued security receipts.
Recently, The Securities Contracts (Regulation) Amendment Act, 2007 has amended
Securities Contract (Regulation) Act to include "securitised instruments" in the
definition of "securities" as defined in Securities Contract (Regulation) Act. The
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amendment is made to allow listing of securitised debt on stock exchanges and

therefore, make the market more liquid.
Credit derivatives
The issue of allowing credit derivatives in India is under consideration for some time
now. The draft guidelines for introduction of credit default swaps were put in public
domain this year and feedback from various quarters has since been received. These
basically envisaged introductions of single entity CDS instruments, allowing protection
selling and buying to resident financial entities (banks, PDs and other entities as
permitted by respective regulators) under the overall ISDA framework. Special
Investment Vehicles (SIV) and conduits are not envisaged. Banks that are active in the
credit derivative market are required to have in place internal limits on the gross
amount of protection sold by them on a single entity as well as the aggregate of such
individual gross positions. These limits shall be set in relation to the bank’s capital
funds. Banks shall also periodically assess the likely stress that these gross positions of
protection sold, may pose on their liquidity position and their options / ability to raise
funds, at short notice. Banks have to determine an appropriate liquidity reserve to be
held against revaluation of these positions. This is important especially where the
reference asset is illiquid like a loan.
Learning from the global experience in this regard, it will be of utmost importance that
proper disclosure and reporting framework, accounting and valuation policies and
clearing & settlement system for these OTC transactions develops concomitantly with
the market. This would go a long way in addressing some of the associated concerns.
Concluding thoughts
The recent episode of financial turbulence has provoked debate about the
measurement, pricing and allocation of risk by way of derivatives, which can have
important lessons for India. I wish to conclude by flagging some of these issues:
(i) Credit risk transfer
Over the past decade or so, the business models of global banks have evolved from a
"buy-and-hold" to an "originate-to-distribute" model. Instruments to transfer risks from
the balance sheets of the originating institution have developed in size and in
complexity. Risks have been repackaged and spread throughout the economy. The
greater part of these risks is sold to other banks and to leveraged investors, very often
the originating bank itself funding the investors. Small and regional banks, in particular,
were significant buyers of subprime and other structured products. Insurance
companies are also increasingly using such instruments to securitise their liabilities.
This wider distribution of credit risks within the global financial system should in
principle limit risk concentrations and reduce the risk of a systemic shock.
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Recent events, however, suggest some reservations about this positive assessment. One
reservation is that banks have become increasingly able to sell quickly even the equity
tranches of their loan portfolios (retaining no exposures). This means they have fewer
incentives to effectively screen and monitor borrowers. A systematic deterioration in
lending and collateral standards would of course entail losses greater than historical
experience of default and loss-given-default rates would indicate, and it is not clear that
current risk management practices make enough allowance for this. Further the gap
between the original borrower and the ultimate investors widened with a number of
vehicles in between.
Secondly, events may force banks to re-assume risks they had assumed transferred to
other parties – either to preserve a bank’s reputation (eg related to investment funds
sponsored by a bank) or to honour contingency liquidity/credit lines. In a crisis, major
banks could therefore end up holding a larger share of exposures that they had planned
to securitise.
(ii) Ratings for structured products
Ratings on structured finance products provide investors with an independent

assessment of risks embedded in them. Given the complexity of such products, some
form of expert assessment is desirable. Nevertheless, some investors failed to
appreciate that ratings did not purport to cover market risk. And the use of ratings in
investment mandates may have tempted some fund managers to "reach for yield"
without altering their measured risk exposures. The investment grade status given to
tranches of highly leveraged structures (such as CPDOs) has also raised questions. Some
have argued that ratings should put more emphasis on the uncertainty associated with
the rating of a given structured product – especially those involving the leveraged
exposure to market and liquidity risk. Others argue that ratings should cover more than
just the dimension of the probability of default.
(iii) Valuation of financial assets
A growing share of the assets of financial firms has now to be measured at "fair-value".
This fosters more active risk management but also makes reported earnings and capital
more sensitive to the volatility of asset prices. In the absence of traded prices, fair-value
estimates are determined using a chosen pricing model. An intrinsic problem is that the
parameter values used in all such models (especially default correlations and recovery
rates) are inevitably matters of judgment given limited historical data. This can bias
conclusions as default correlations inevitably rise during periods of market stress, when
confidence in mark-to-model prices is undermined. As uncertainty about the true
market value of securities with model-driven prices rose, trading in these securities
almost ground to a halt.
A final aspect is that historical data available before recent events may not have been
representative of a full credit cycle. The recent experience may go some way to
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correcting this shortcoming, and make model-driven estimates more reliable in the
future. This could in turn induce a significant change in the behaviour of investors for
some time.
(iv) Value at Risk (VaR)
Most financial firms use VaR and stress tests to measure market risks and assign
position limits. Despite declining financial market volatility during recent years, most
large banks have nevertheless reported a trend rise in the aggregate VaR of their
trading book. This presumably implies that they have taken larger positions. This is not
necessarily a matter of concern because trading profits and capital increased broadly in
line with higher VaRs.
Yet the marked movement in the absolute VaRs of large firms over time does raise
questions. These changes could reflect: (a) underlying market volatility; (b) frequent
changes in the firm’s positioning; or (c) changes in various aspects of methodology. If
firms, conscious of methodological shortcomings, frequently modify how they compute
their VaRs, changes over time may not be a good guide to changes in underlying risk
exposures. This would also make it harder for counterparties to keep accurate track of
how underlying risks are evolving.
(v) Stress tests
Stress tests used by banks probably do not adequately reflect their substantial reliance
on liquid capital and money markets for managing, distributing and hedging risks. Some
of the problems (e.g., difficulties in the leveraged loan market, the valuation of complex
products) are not typically incorporated in stress tests. Stress tests at many banks also
may fail to adequately capture the potentially significant growth in balance sheet
exposures resulting from contingent credit and liquidity facilities to ABCP conduits.
Moreover, stress tests tend to focus on a few risks and thus often fail to capture the
potential interactions between many different risk factors. And in such stress tests,
banks frequently assume an ability to unwind positions across a wide range of asset
classes – including structured credit and other complex products – that may not be
feasible in stressed conditions. In addition, attempts to reduce risk exposures during a
credit event can further impair market liquidity.
This failure to take into consideration the likelihood that leveraged firms (during a
period of market stress) would attempt to reduce exposures in virtually identical ways
might explain why large financial shocks have been more frequent during the past 10
years than models predicted – even as underlying macroeconomic conditions have
become more stable.
It is thus clear that recent bouts of market uncertainty have been aggravated by the lack
of information about the distribution of risks in the global financial system and the risk
profiles of individual institutions. New, complex financial instruments have increased
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linkages across financial institutions and made the assessment of their exposures more
difficult. It has also become harder to update the valuation of collateral as market
developments have unfolded. Incomplete and differing disclosures also complicate
attempts to draw comparisons between them. This insufficient transparency at the firm
level probably undermined ex ante market discipline. These issues, which have been
well-known to the regulators and the industry for some years, become pressing mainly
in a crisis. Lending institutions find it difficult, if not impossible, to simultaneously
review in a thorough manner a large proportion of their exposures. How effectively ex
post market discipline is allowed to operate will have a significant impact on the future
conduct of financial firms.
To conclude, the derivatives market in India has been expanding rapidly and will
continue to grow. While much of the activity is concentrated in foreign and a few private
sector banks, increasingly public sector banks are also participating in this market as
market makers and not just users. Their participation is dependent on development of
skills, adapting technology and developing sound risk management practices.
Corporates are also active in these markets. While derivatives are very useful for
hedging and risk transfer, and hence improve market efficiency, it is necessary to keep
in view the risks of excessive leverage, lack of transparency particularly in complex
products, difficulties in valuation, tail risk exposures, counterparty exposure and hidden
systemic risk. Clearly there is need for greater transparency to capture the market,
credit as well as liquidity risks in off-balance sheet positions and providing capital
therefore. From the corporate point of view, understanding the product and inherent
risks over the life of the product is extremely important. Further development of the
market will also hinge on adoption of international accounting standards and disclosure
practices by all market participants, including corporate
Myths And Realities About Derivatives
In less than three decades of their coming into vogue, derivatives markets have become
the most important markets in the world. Financial derivatives came into the spotlight
along with the rise in uncertainty of post-1970, when US announced an end to the
Bretton Woods System of fixed exchange rates leading to introduction of currency
derivatives followed by other innovations including stock index futures.
Today, derivatives have become part and parcel of the day-to-day life for ordinary
people in major parts of the world. While this is true for many countries, there are still
apprehensions about the introduction of derivatives. There are many myths about
derivatives but the realities that are different especially for Exchange traded
derivatives, which are well regulated with all the safety mechanisms in place.
What are these myths behind derivatives? What is the underlying truth behind such
myths? The myths and the realities behind them are:
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1. Derivatives increase speculation and do not serve any economic purpose
Numerous studies of derivatives activity have led to a broad consensus, both in the
private and public sectors that derivatives provide numerous and substantial benefits to
the users. Derivatives are a low-cost, effective method for users to hedge and manage
their exposures to interest rates, commodity prices, or exchange rates.
The need for derivatives as hedging tool was felt first in the commodities market.
Agricultural futures and options helped farmers and processors hedge against
commodity price risk. After the fallout of Bretton wood agreement, the financial
markets in the world started undergoing radical changes. This period is marked by
remarkable innovations in the financial markets such as introduction of floating rates
for the currencies, increased trading in variety of derivatives instruments, on-line
trading in the capital markets, etc. As the complexity of instruments increased many
folds, the accompanying risk factors grew in gigantic proportions. This situation led to
development derivatives as effective risk management tools for the market
participants.
Looking at the equity market, derivatives allow corporations and institutional investors
to effectively manage their portfolios of assets and liabilities through instruments like
stock index futures and options. An equity fund, for example, can reduce its exposure to
the stock market quickly and at a relatively low cost without selling off part of its equity
assets by using stock index futures or index options.
By providing investors and issuers with a wider array of tools for managing risks and
raising capital, derivatives improve the allocation of credit and the sharing of risk in the
global economy, lowering the cost of capital formation and stimulating economic
growth. Now that world markets for trade and finance have become more integrated,
derivatives have strengthened these important linkages between global markets,
increasing market liquidity and efficiency and facilitating the flow of trade and finance.
2. Indian Market is not ready for derivative trading
Often the argument put forth against derivatives trading is that the Indian capital
market is not ready for derivatives trading. Here, we look into the pre-requisites, which
are needed for the introduction of derivatives and how Indian market fares:
Large market Capitalization - India is one of the largest market-capitalized countries in

Asia with a market capitalization of more than Rs.765000 crores.
High Liquidity in the underlying - The daily average traded volume in Indian capital
market today is around 7500 crores. Which means on an average every month 14% of
15
the country's Market capitalization gets traded. These are clear indicators of high
liquidity in the underlying.
Trade guarantee - The first clearing corporation guaranteeing trades has become fully
functional from July 1996 in the form of National Securities Clearing Corporation
(NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock
Exchange (NSE) for which it does the clearing.
A Strong Depository - National Securities Depositories Limited (NSDL) which started

functioning in the year 1997 has revolutionalised the security settlement in our
country.
A Good legal guardian - In the Institution of SEBI (Securities and Exchange Board of
India) today the Indian capital market enjoys a strong, independent, and innovative
legal guardian who is helping the market to evolve to a healthier place for trade
practices.
3. Disasters prove that derivatives are very risky and highly leveraged instruments
Disasters can take place in any system. The 1992 Security scam is a case in point.
Disasters are not necessarily due to dealing in derivatives, but derivatives make
headlines. Some of the reasons behind disasters related to derivatives are:
1. Lack of independent risk management
2. Improper internal control mechanisms
3. Problems in external monitoring done by Exchanges and Regulators
4. Trader taking unauthorized positions
5. Lack of transparency in the entire process
4. Derivatives are complex and exotic instruments that Indian investors will have
difficulty in understanding
Trading in standard derivatives such as forwards, futures and options is already

prevalent in India and has a long history. Reserve Bank of India allows forward trading
in Rupee-Dollar forward contracts, which has become a liquid market. Reserve Bank of
India also allows Cross Currency options trading.
Forward Markets Commission has allowed trading in Commodity Forwards on

Commodities Exchanges, which are, called Futures in international markets.
16
Commodities futures in India are available in turmeric, black pepper, coffee, Gur
(jaggery), hessian, castor seed oil etc. There are plans to set up commodities futures
exchanges in Soya bean oil as also in Cotton. International markets have also been
allowed (dollar denominated contracts) in certain commodities. Reserve Bank of India
also allows, the users to hedge their portfolios through derivatives exchanges abroad.
Detailed guidelines have been prescribed by the RBI for the purpose of getting
approvals to hedge the user's exposure in international markets.
Derivatives in commodities markets have a long history. The first commodity futures
exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton Traders
Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission, India, 1963-
68). A clearinghouse for clearing and settlement of these trades was set up in 1918. In
oilseeds, a futures market was established in 1900. Wheat futures market began in
Hapur in 1913. Futures market in raw jute was set up in Calcutta in 1912. Bullion
futures market was set up in Mumbai in 1920.
History and existence of markets along with setting up of new markets prove that the
concept of derivatives is not alien to India. In commodity markets, there is no resistance
from the users or market participants to trade in commodity futures or foreign
exchange markets. Government of India has also been facilitating the setting up and
operations of these markets in India by providing approvals and defining appropriate
regulatory frameworks for their operations.
Approval for new exchanges in last six months by the Government of India also
indicates that Government of India does not consider this type of trading to be harmful
albeit within proper regulatory framework.
This amply proves that the concept of options and futures has been well ingrained in the
Indian equities market for a long time and is not alien as it is made out to be. Even
today, complex strategies of options are being traded in many exchanges which are
called teji-mandi, jota-phatak, bhav-bhav at different places in India (Vohra and Bagari,
1998) In that sense, the derivatives are not new to India and are also currently
prevalent in various markets including equities markets.
5. The existing capital market is safer than Derivatives?
World over, the spot markets in equities are operated on a principle of rolling
settlement. In this kind of trading, if you trade on a particular day (T), you have to settle
these trades on the third working day from the date of trading (T+3).
Futures market allow you to trade for a period of say 1 month or 3 months and allow
you to net the transaction taken place during the period for the settlement at the end of
the period. In India, most of the stock exchanges allow the participants to trade during
one-week period for settlement in the following week. The trades are netted for the
17
settlement for the entire one-week period. In that sense, the Indian markets are already
operating the futures style settlement rather than cash markets prevalent
internationally.
In this system, additionally, many exchanges also allow the forward trading called badla
in Gujarati and Contango in English, which was prevalent in UK. This system is
prevalent currently in France in their monthly settlement markets. It allowed one to
even further increase the time to settle for almost 3 months under the earlier
regulations. This way, a curious mix of futures style settlement with facility to carry the
settlement obligations forward creates discrepancies.
The more efficient way from the regulatory perspective will be to separate out the
derivatives from the cash market i.e. introduce rolling settlement in all exchanges and at
the same time allow futures and options to trade. This way, the regulators will also be
able to regulate both the markets easily and it will provide more flexibility to the market
participants.
In addition, the existing system although futures style, does not ask for any margins
from the clients. Given the volatility of the equities market in India, this system has
become quite prone to systemic collapse. This was evident in the MS Shoes scandal. At
the time of default taking place on the BSE, the defaulting member of the BSE Mr.Zaveri
had a position close to Rs.18 crores. However, due to the default, BSE had to stop
trading for a period of three days. At the same time, the Barings Bank failed on
Singapore Monetary Exchange (SIMEX) for the exposure of more than US $ 20 billion
(more than Rs.84,000 crore) with a loss of approximately US $ 900 million ( around
Rs.3,800 crore). Although, the exposure was so high and even the loss was also very big
compared to the total exposure on MS Shoes for BSE of Rs.18 crores, the SIMEX had
taken so much margins that they did not stop trading for a single minute.
18
2. Discuss the scope of innovative financial products in the Indian derivative

markets.
INTRODUCTION
The last twenty five years have seen dramatic changes in the global financial
system and another wave of innovation in finance. The most dramatic developments
in the global financial system are the enormous growth in instruments for risk transfer
and risk management, the growing role played by no n-bank financial institutions in
capital markets around the world (especially the increased role of hedge funds in
bearing risk in derivatives markets and the financial systems generally), and the much
greater integration o f natio nal financial systems .These changes appear to have mad e
the financial system able to absorb more easily a broader set of shocks, but they have not
eliminated risk.
FINANCIAL INNOVATION
Financial innovation is defined as the introduction of a new instrument to a

market or the production of an existing one in a new manner. Financial innovations
appear because market participants are constantly searching for new modalities to make
greater profits. The process of "financial innovation" includes important changes in
financial instrument, institutions, practices and markets. Financial innovations include
new forms of derivatives (credit derivatives, weather derivatives) insurance contracts,
corporate securities, and pooled investment products; process innovations include
improvements on securities-distribution methods and pricing transactions.
The most important forces behind the growing wave o f financial innovations have been
the reduction in the cost of computer and communications technology and the many
advances in financial theory. Technological developments have radically modified the
potential for making financial transactions around the world and have enabled large
numbers of prices to be stored and extensive calculations can be made in various
risk models. Furthermore, the volatility of market prices and complex global
exposures increase the need for new risk management and hedging instruments.
Financial innovation often seeks to avoid unintended restrictive regulations and take
advantages of disparate accounting and tax rules. Most of the financial innovations took
place in derivatives markets. Derivatives are financial instruments whose promised
payoffs are derived from the values of something else, generally called the underlying.
The underlying asset can be: interest rates, foreign exchange rates, equities, other fixed-
income instruments, equity indices, or commodities. Derivatives are used for several
purposes, including the following:
- To protect against the market risk of financial losses on commercial transactions

and financial instruments (to hedge);
- To reflect a view on the future direction of the market (to speculate);
- To lock in an arbitrage profit;
- To change the nature of an asset or liability;
- To change the nature on an investment without incurring the costs of selling one
portfolio and buying another.
19
Examples of derivatives are futures, forwards, options and swaps. In the recent years
new products have been developed such as: credit derivatives, weather derivatives,
certificates, knockouts, warrants, etc
1) Credit derivatives
Credit derivatives are the fastest growing segment in the global derivatives race and in
2001 the total notional principal for outstanding credit derivatives contracts was
about $800 billion. By June 2006 this had grown to over $26 trillion, according to a
stud y conducted by the International Swaps and Derivatives Association (ISDA). The
British Bankers’ Association (BBA) estimated the credit derivatives market at $33 trillion
in 2008, which represents an increase of 65% compared to 2006. This growth has
been accompanied by significant product innovation, notably the development of
synthetic collateralized debt obligations (CDOs), which allow the credit risk of a
portfolio of underlying exposures to be divided into different segments, each with
different risk and return characteristics.
Credit derivatives are contracts where the payoff dep ends on the creditworthiness of an
agreed reference entity (a company or a country). Credit derivatives allow companies to
trade risks in much the same way as they trade market risks, to diversify credit risk s,
and to transfer credit risks to a third party . Most segments of the credit risk transfer
markets are global markets with the counterparties often domiciled in different
countries.
The simplest and most used type of credit derivative is the credit default swap (CDS).
Under a credit default swap , one party (the protection buyer ) agrees to pay an
amount (the fixed amount ), either initially or periodically, to the other party (the
protection seller). The protection seller agrees to pay an amount to, or buy a debt
obligation from the protection buyer on the occurrence of specified credit-related
contingencies (each a credit event ). The contract under CDS depends upon the default
event and the cash flow transaction is triggered only when the default occurs and not
otherwise. This not only helps market participants to seek protection, but also motivates
them to buy and sell positions for reasons of speculation and arbitrage, without having
the direct exposure to the underlying security.
Credit Default Swaps are widely believed to facilitate risk-sharing across financial
intermediaries and, hence, to have reduced the probability that difficulties at a single
intermediary could affect the entire financial system.
2) Weather Derivatives,
Recently, firms have used weather derivatives, relatively new type of derivatives that
allow them to purchase protection against unexpected weather conditions. More and
more companies’ revenues and earnings are adversely affected by the weather. The U.S.
Department of Energy has estimated that nearly 20% of the US economy is directly
affected by the weather, and that the profitability and revenues of almost every industry
depend to a great extent on the vagaries of the temperature4. Weather conditions
directly affect agricultural outputs, the demand for energy products, and indirectly
affect retail businesses, entertainment, construction, travel and others. For instance,
earnings of the power industry depend on the retail prices and the sales quantities of
20
electricity, which in turn are affected by weather conditions. An exceptionally warm

winter can leave utility and energy companies with excess supplies of oil or natural gas
(because people need less to heat their homes).
Until 1997, insurance has been the main tool used by the firms for protection against
unexpected weather conditions while volumetric risks were largely left uncovered. The
need to hedge the volumetric risk caused by unexpected weather conditions has created
a new class of derivatives, the weather derivatives. The first overthe- counter (OTC)
weather derivative trade took place in 1997 and the field of weather risk management
was born. In September 1999, the Chicago Mercantile Exchange introduced exchange-
traded weather futures and options on futures - the first products of their kind. CME
weather futures and options on futures are standardized contracts traded publicly on
the open market in an electronic auction, with continuous negotiation of prices and
complete price transparency. The contracts are on the cumulative HDD (Heating Degree
Days) and CDD (Cooling Degree Days) for a month observed at a weather station. These
derivatives are legally binding agreements made between two parties and settled in
cash.
Emergence of weather derivatives as an alternative risk hedging tool
A financial weather derivative contract may be termed as a weather contingent contract

whose payoff will be in an amount of cash determined by future weather events. The
settlement value of these weather events is determined from a weather index,
expressed as values of a weather variable measured at a stated location.
Weather derivatives are regarded a better, low-cost, sustainable alternative system of

agriculture risk management. These contracts can be designed with good deal of
flexibility to help farmers manage drought risk by making a payment when rainfall in a
given period goes below a certain pre-agreed level. Besides the developed countries,
these contracts are already in operation in some developing countries, too, for instance,
Morocco, Mexico, Ukraine, Mangolia and Romania due to their numerous advantages:
 Under these contracts the payout is not based on actual yield. Rather, it is linked
with a pre-defined specific weather parameter. This makes it impossible to
indulge in moral hazard practices. Also, the possibility of adverse selection is
minimized.
 These contracts involve low administrative costs as they do not require any
underwriting or inspection of farms.
 There also exists wide scope for reinsurance to neutralize the possible
widespread crop losses.
As regards the state of weather derivative contracts in India, initiatives are under-way
at various levels. National Commodities and Derivative Exchange (NCDEX) has finalized
plans to launch weather-index-based derivatives. These are waiting for the approval of
government. Certain amendments have to be made in the Securities Contract Regulation
Act and the Forward Contract Regulation Act, as current regulations do not permit
trading in instruments that cannot be delivered in physical form.
The weather-index based insurance product developed by ICICI Lombard and IFFCO –
TOKIO General Insurance CO. Ltd. (ITGI) – have been very recently launched and
21
intended to cover yield loss due to uncontrollable weather related risks. Since these
products are at initial stages of development and implementation, it would be
premature to comment on their effectiveness as a risk-hedging tool. Although there is
strong empirical evidence of successful use of weather derivatives in agriculture sector
across the world. We are presenting some of the important empirical studies here.
Weather derivative contract as protection against less than normal

rainfall
A rainfall-based weather derivative, floor or put options, may be used by the buyer of
the contract to hedge against the volume related risk in case of less than normal rainfall.
A floor contract provides protection to the buyer against the risk from low rainfall in the
form of specified payment per mm of rain and the loss of premium amount may be
recovered from increased profit due to more than normal rainfall.
Let us assume that 500 mm of average rainfall is necessary for a healthy productivity of
rice crop during the crop season. Suppose any rainfall deficiency below this level will
adversely affect the crop yield and result in an approximate loss of Rs. 5,000 per mm.
Based on this information, a weather derivative floor contract may be designed with the
following provision. The buyer of the contract pays a premium of Rs. 0.1 million which
may be termed as the maximum cost incurred by the buyer in case of high rainfall. If the
actual rainfall, during the contract period, is below the 500 mm level, the farmer will be
paid Rs. 5,000 per mm. The maximum payment will not exceed Rs. 1 million. As such,
the farmer holding this contract may be said to have secured himself against the risk of
low rainfall up to 200 mm below the strike. If rainfall stays above 500 mm, called
“strike” point, then no payment is made to the farmer.
Thus, we can understand how weather derivatives protect the farming community
against the risk of bad weather (low rainfall). We realize from the information given
above that the premium component in case of weather derivatives remains somewhat
on the higher side as compared to the insurance premium but this problem is likely to
be resolved when this instrument of risk hedging gains popularity and market for
weather derivatives expands. Weather derivatives are in use in many other sectors, as
well. These include sectors like power, hospitality and entertainment, transportation,
sports etc.
Power sector
As on December 31, 2005 the total installed power generation capacity of the country
stood at 0.123 million MW. More than 90 per cent of this power generation capacity is
government owned and only 10 percent under private sector. Nationwide, the shortfall
in energy supply is conservatively estimated at 8.8 and 12 percent during peak hours.
India's power sector is suffering from capacity shortages, frequent power failures, poor
reliability, and deteriorating physical and financial conditions. 70 percent power is
generated through thermal sources that heavily rely on fossil fuels and generate carbon
emission. As a public policy, the government is encouraging the hydro and wind energy
sources that are environment-friendly. India has an estimated unutilized hydro power
potential of more than 0.15 million MW. This indicates the growing importance of
22
weather dependent hydro and wind base power projects. Power generation through
these sources depends on critical weather factors like rainfall, snowfall and wind speed.
Weather derivative products based on these indices are already in use in many
countries. With the introduction of “availability based tariff” the spot market for
electricity trading has come up where electricity is bought and sold by market
participants like producers, consumers and intermediaries. These developments have
taken the market for electricity closer to other normal markets in the economy where
derivative trading has been successfully going on.
3) Electricity derivatives
Derivatives trading in almost all the major commodities are successfully going on in the
Indian commodities exchanges but derivatives trading in power (electricity) has not
commenced and weather derivatives are likely to be traded once the parliament
approves the amendment in Forward Contract (securities) Regulation Act. Electricity
derivative markets all over the world have not met with great success. The case of USA's
electricity derivative market is evidence to this fact. The market for electricity
derivatives started in 1996 with New York Mercantile Exchange (NYMEX) launching
electricity futures but by February 2002, NYMEX decided to delist all of its futures
contracts due to lack of trading. Similarly the Chicago Board of Trade (CBOT) and the
Minneapolis Grain Exchange (MGE) also suspended trading in electricity futures. Over
the counter (OTC) market for electricity derivatives also met with same fate with the
exit of Aquila and Dynegy. Enron Corporation's collapse, a major player and innovator
in power derivatives market, came as a fatal blow to already dying electricity derivative
market. Even one of the most mature and successful power exchange of the world “Nord
Pool” has witnessed a decline in the growth of electricity derivatives, forwards, options
and contacts for difference (CFDs) in terms of electricity volume at Nord Pool. Nord Pool
power exchange serves the electricity markets of Nordic countries comprising of
Norway, Finland, Denmark and Sweden.
These are requirements that should be fulfilled for developing a viable electricity
derivative market:
 A vibrant and competitive spot market for electricity trading with large number
of participants.
 Open access system for distribution and transmission of power.
 Presence of adequate number of power exchanges catering for the need of each
geographically segmented electricity market.
 Non-storability of electricity, and hence, lack of inventories makes electricity a
difficult commodity to trade on real time basis until and unless there is sufficient
surplus power generation capacity available and power may be transmitted to
This indicates that the electricity market in India is highly non-competitive.
Researchers have argued that in a non-competitive industry major demand for
power should be met by long-term power purchasing agreements and very small
part of electricity should be traded in the spot market because of price volatility).
This holds good about Indian power market where only a small fraction of power
is traded in spot market and most of the power produced is traded by means of
long-term power purchasing agreements signed by the central and state
government power utilities.
23
Regulatory Challenges Ahead for Electricity Derivatives
Financial Risk to Ratepayers
The financial risks resulting from the use of derivatives are illustrated by the
number of companies that have suffered significant losses in derivative markets.
Large losses can be the result of well-intentioned hedging activities or of wanton
speculation. In either case, regulators must be concerned with the impact that
such losses could have on ratepayers who, absent protections, might be placed at
financial risk for large losses
Market Power
The preceding paragraphs have illustrated the complexity and non-homogeneity

of the electricity markets. Amid this dynamic environment, opportunities abound
for market power and gaming strategies to develop.
Conservation and Demand
One of the key tools available to regulators for reducing the volatility of
electricity prices is demand-side management programs. Electricity prices are
likely to be most volatile during the on-peak hours of the day and substantially
more stable (and lower) during the off-peak periods.
This fact, coupled with the hockey stick shaped supply cost curve suggests that
substantial reductions in volatility could be achieved through the use of market
mechanisms and demand-side management programs to shift consumption to
off-peak hours. State and Federal authorities have been examining a variety of
possible methods for shifting consumer demand for electricity; however, one of
the most direct methods—real-time pricing for large electricity
consumers—remains largely untapped.
Ideal features of the contract
Baseload and Peakload contracts should be listed based on the power supply
calendar and settlement cycle favoured by the industry with 12 months, 6
quarters and 4 seasons; No requirement to be a power supplier party; Margin
offset between Electricity Futures and Natural Gas Futures/Coal Futures/Crude
Oil Futures; Each contract will be physically deliverable and will be cleared by
one central counterparty, Minimum trading size will be 10 lots; Months, Quarters
and Seasons will be listed in parallel -- no cascading; All positions will be held as
months for maximum flexibility for participants.
Quality Specification
Electric energy delivered under this contract shall be in the form of three phase
current alternating at a nominal frequency as prescribed by the Central
24
Electricity regulatory authority, and be in conformance with the specifications of

the CERC.
Transmission
Except as set forth in, seller shall be required to make all transmission
arrangements to deliver electric energy to central buyers, and buyer shall be
required to make all transmission arrangements to receive electric energy at
Central sellers
Conclusion
There is an urgent impending need for a market driven vibrant instrument for
electricity futures, which would attract huge market participation automatically.
The electricity futures/options markets may provide useful information about

forward prices. Futures prices represent the market participants' forecasts of
what future spot prices will be. An essential feature of electricity futures
contracts (for delivery at a specific location) is that as the delivery date of the
futures contract approaches, the futures contract price and the spot price will
converge. While the futures contract prices provide forecasts of forward spot
prices, there is no assurance that the forecast will be correct, although the
forecast error can be expected to diminish, the shorter the time remaining to
futures contract maturity.
Implementation issues
The effectiveness and success of weather derivatives would depend on its successful
implementation which, in turn depends on:
 institutional infrastructure;
 regulatory mechanism; and
 education and awareness among market participants
Institutional infrastructure
An institutional set-up comprising of derivative exchanges, brokers, consumer

associations and weather observatories, is one of the most essential prerequisite for
implementing trading in weather derivatives. Securities and commodities derivative
trading already exist in many Indian exchanges and the same exchanges may be used for
trading derivative contracts on underlying weather parameters. Small farmers and
power consumers can access the weather derivative market through the consumer
associations or cooperatives. Most of all, institutional arrangements must be made to
provide the timely, reliable data (on weather parameters, crop yields and power
production and consumption) to all concerned parties.
25
Regulatory mechanism
A strong regulatory mechanism must be in place before the introduction of weather

based derivative contracts. The Forward Contract (Regulation) Act, at present covers
forward trading (derivative) in “goods” only. Necessary amendments are required to
broad base the scope of the act so as to permit derivatives trading on underlying
“intangibles” like weather parameters, electricity, etc. The Forward Contract
(Regulation) Amendment Bill 2006 is pending with the parliament which aims to
introduce such amendments and further seeks to transform the role of the Forward
Markets Commission (FMC) from a government department to an independent
regulator like Securities and Exchange Board of India (SEBI).
Presently, SEBI regulates spot and derivative trading on exchanges of all securities (i.e.
stocks and bonds). Commodity forwards and futures are regulated by the Forward
Market Commission (FMC) which continues to be a subordinate office of the
government department and has no autonomy to garner resources. More over, Ministry
of Agriculture, Ministry of Company Affairs and the Reserve Bank of India also exercise
direct or indirect regulation over securities and commodity trading. This overlapping
regulatory jurisdiction and multiplicity of regulators may pose regulatory challenges.
Establishment of an independent regulator with adequate resources and empowerment
is essential for regulating the markets for weather derivative.
Education and awareness among market participants
Various market participants need to be educated and trained for understanding the
benefits and risks associated with weather derivatives. Farmers, consumers, financial
intermediaries, etc. can be benefited from weather derivatives only if they are well
educated about the various derivatives products and their effectiveness.
Other requirements like developing appropriate weather-based indices and designing

pricing mechanism for weather derivative contracts may be easily fulfilled once a strong
institutional and regulatory infrastructure is in place.
26

Innovative Derivative Products

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Amritha Pal (08PG080)

Anurag Agarwal (08PG155)

Dipti Jha (08PG225)

P.Varun Nair (08PG177)

Sanjeev Agarwal (08PG267)

1. Derivatives are still new in Indian markets, lots of efforts is required to be

There are four main legislations governing the securities market:

Derivatives and New Products Departments (DNPD) - concerned with supervising

Committee on regulation of derivatives trading

Major Recommendations of L. C. Gupta Committee

 The Committee strongly favours the introduction of financial derivatives in order

or mostly consisting of speculators is unlikely to be a sound economic institution.

 The Committee favours the introduction of equity derivatives in a phased

 The Committee's recommendations on regulatory framework for derivatives

 Since the Committee has placed considerable emphasis on the self-regulatory

 Many of the SEBI's important regulations relating to exchanges, brokers-dealers,

Current Regulatory Framework

 Participants have been generically classified into two functional categories,

 Any derivative structure is permitted as long as it is a combination of two or

 Market-makers should be in a position to mark to market or demonstrate

 Further, it is to be ensured that structured products do not contain derivative(s),

 All permitted derivative transactions shall be contracted only at prevailing

 The critical importance of ‘suitability’ and ‘appropriateness’ policies within

In respect of forex derivatives involving rupee, residents have access to foreign

Facilities for Non-residents

Rupee Interest rate derivatives

Transparency and reporting

In order to have a mechanism for transparent capture and dissemination of trade

Interest rate futures

A sub-group of the RBI Technical Advisory Committee on Markets having

Structured Credit and Credit derivatives

 Detailed set of guidelines to ensure 'arms' length relationship between the

 Any profit/premium arising on account of sale not allowed to be booked upfront

 Provision of liquidity facility to be treated as an off- balance sheet item and

 Disclosure by the originator, as notes to accounts, presenting a comparative

 Form and quantum (outstanding value) of services provided by way of credit

amendment is made to allow listing of securitised debt on stock exchanges and

(i) Credit risk transfer

(ii) Ratings for structured products

Ratings on structured finance products provide investors with an independent

(iii) Valuation of financial assets

(iv) Value at Risk (VaR)

(v) Stress tests

Myths And Realities About Derivatives

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

2. Indian Market is not ready for derivative trading

Large market Capitalization - India is one of the largest market-capitalized countries in

A Strong Depository - National Securities Depositories Limited (NSDL) which started

1. Lack of independent risk management

2. Improper internal control mechanisms

3. Problems in external monitoring done by Exchanges and Regulators

4. Trader taking unauthorized positions

5. Lack of transparency in the entire process

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

Forward Markets Commission has allowed trading in Commodity Forwards on

5. The existing capital market is safer than Derivatives?

2. Discuss the scope of innovative financial products in the Indian derivative

Financial innovation is defined as the introduction of a new instrument to a

- To protect against the market risk of financial losses on commercial transactions

electricity, which in turn are affected by weather conditions. An exceptionally warm

Emergence of weather derivatives as an alternative risk hedging tool