Derivatives

Introduction-

In recent decades, financial markets have been marked by excessive volatility. As foreign
exchange rates, interest rates and commodity prices continue to experience sharp and unexpected
movements, it has become increasingly important that corporations exposed to these risks be
equipped to manage them effectively. Price fluctuations make it hard for businesses to estimate
their future production costs and revenues. Derivative securities provide them a valuable set of
tools for managing this risk. Risk management, the managerial process that is used to control
such price volatility, has consequently risen to the top of financial agendas. It is here that
derivative instruments are of utmost utility. As instruments of risk management; these generally
do not influence the fluctuations in the underlying 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.

The most popularly used derivatives contracts are Forwards, Futures, Options and Swaps, which
we shall discuss in detail later. Here we take a brief look at various derivatives contracts that
have come to be used.

1.Forwards: A forward contract is a customized contract between two entities, where settlement
takes place on a specific date in the future at today's pre-agreed price. The rupee-dollar exchange
rates is a big forward contract market in India with banks, financial institutions, corporate and
exporters being the market participants.

2. Futures: A futures contract is an agreement between two parties to buy or sell an asset ata
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts. Unlike forward
contracts, the counterparty to a futures contract is the clearing corporation on the appropriate
exchange. Futures often are settled in cash or cash equivalents, rather than requiring physical
delivery of the underlying asset. Parties to a Futures contract may buy or write options on
futures.

3. Options: An option represents the right (but not the obligation) to buy or sell a security or
other asset during a given time for a specified price (the "strike price"). Options are of two types
- calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of
the underlying asset, at a given price on or before a given future date. Puts give the buyer the
right, but not the obligation to sell a given quantity of the underlying asset at a given price on or
before a given date.

4. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward, contracts.
Swaps generally are traded OTC through swap dealers, which generally consist of large financial
institution, or other large brokerage houses. There is a recent trend for swap dealers to mark to
market the swap to reduce the risk of counterparty default.

Hedging Currency Risk

Currency risk is the financial risk that arises from potential changes in the exchange rate of one
currency in relation to another. And it's not just those trading in the foreign exchange markets
that are affected. Adverse currency movements can often crush the returns of a portfolio with
heavy international exposure, or diminish the returns of an otherwise prosperous international
business venture. Companies that conduct business across borders are exposed to currency risk
when income earned abroad is converted into the money of the domestic country, and when
payables are converted from the domestic currency to the foreign currency.

The currency swap market is one way to hedge that risk. Currency swaps not only hedge against
risk exposure associated with exchange rate fluctuations, but they also ensure receipt of foreign
monies and achieve better lending rates.

Working Mechanism

 If a company does business around the world, it may experience currency risk - that the
exchange rate will change when converting foreign money back into domestic currency.
 Currency swaps are a way to help hedge against that type of currency risk by swapping
cash flows in the foreign currency with domestic at a pre-determined rate.
 Considered to be a foreign exchange transaction, currency swaps are not required by law
to be shown on a company's balance sheet the same way a forward or options contract
would.
 Many currency-hedged ETFs and mutual funds now exist to give investors access to
foreign investments without worrying about currency risk.

Forward Contract

A forward contract is an agreement between two parties to buy or sell underlying assets at a
predetermined future date at a price agreed when the contract is entered into. Forward contracts
are not standardized products. They are over-the-counter (not traded in recognized stock
exchanges) derivatives that are tailored to meet specific user needs. The underlying assets of this
contract include:

1.Traditional agricultural or physical commodities

2.Currencies (foreign exchange forwards)

3.Interest rates (forward rate agreements or FRAs)

Example: Suppose you decide to subscribe to cable TV. As the buyer, you enter into an
agreement with the cable company to receive a specific number of cable channels at a certain
price every month for the next year. This contract made with the cable company is similar to a
futures contract, in that you have agreed to receive a product at a future date, with the price and
terms for delivery already set. You have secured your price for now and the next year-even if the

The parties involved are usually businesses with international operations and banks. Forwards
allow businesses to close deals and budget future transactions at current exchange rates.

For your American company, this means you can know in advance how much U.S. dollars you
will receive for future payments in foreign currency. For example, you could sign a forward
contract with a local bank for a payment in Japanese yen that you'll receive in six months. You
agree on an exchange rate of 115 yen per dollar, so either if the exchange rate goes up to 125 or
down to 105, you will receive the same amount of dollars at 115 yen per dollar.

Forward contracts eliminate the uncertainty about future changes in the exchange rate.
Companies can plan ahead knowing that, regardless of market changes, they will be able to
exchange currencies at a fixed rate.

Exporters can know the exact value of future payments, and importers can anticipate the exact
costs of products. Therefore, forwards hedge the risk of exchange rate fluctuations.

Forwards effectively eliminate the risk of potential losses from adverse market movements.
However, they also eliminate the possibility of additional profits in the event of favorable
movements. If the foreign currency you'll be exchanging depreciates, the contract ensures that
you will still receive the same amount of local currency, so there is no risk of losses. However, if
the foreign currency appreciates, there will be no additional earnings because you will still
receive the same amount.

Working Mechanism

There are two kinds of forward-contract participants: hedgers and speculators.

Hedgers do not usually seek a profit but rather seek to stabilize the revenues or costs of their
business operations. Their gains or losses are usually offset to some degree by a corresponding
loss or gain in the market for the underlying asset.

Speculators are usually not interested in taking possession of the underlying assets. They
essentially place bets on which way prices will go. Forward contracts tend to attract more
hedgers than speculators.
Example

If you plan to grow 500 bags of wheat next year, you could sell your wheat for whatever the
price is when you harvest it, or you could lock in a price now by selling a forward contract that
obligates you to sell 500 bags of wheat to, say, Kellogg after the harvest for a fixed price. By
locking in the price now, you eliminate the risk of falling wheat prices. On the other hand, if
prices rise later, you will get only what your contract entitles you to.

If you are Kellogg, you might want to purchase a forward contract to lock in prices and control
your costs. However, you might end up overpaying or (hopefully) underpaying for the wheat
depending on the market price when you take delivery of the wheat.

Indian Derivative Market

The origin of derivatives can be traced back to the need of farmers to protect themselves against
fluctuations in the price of their crop. From the time it was sown to the time it was ready for
harvest, farmers would face price uncertainty. Through the use of simple derivative products, it
was possible for the farmer to partially or fully transfer price risks by locking-in asset prices.
These were simple contracts developed to meet the needs of farmers and were basically a means
of reducing risk. Derivative markets in India have been in existence in one form or the other for a
long time. In the area of commodities, the Bombay Cotton Trade Association started future
trading way back in 1875. This was the first organized futures market. Then Bombay Cotton
Exchange Ltd. in 1893, Gujarat Vyapari Mandall in 1900, Calcutta Hesstan Exchange Ltd. in
1919 had started future market. After the country attained independence, derivative market came
through a full circle from prohibition of all sorts of derivative trades to their recent
reintroduction. In 1952, the government of India banned cash settlement and options trading,
derivatives trading shifted to informal forwards markets. In recent years government policy has
shifted in favour of an increased role at market based pricing and less suspicious derivatives
trading. The first step towards introduction of financial derivatives trading in India was the
promulgation at the securities laws (Amendment) ordinance 1995. It provided for withdrawal at
prohibition on options in securities. The last decade, beginning the year 2000, saw lifting of ban
of futures trading in many commodities. Around the same period, national electronic commodity
exchanges were also set up. The more detail about evolution of derivatives are shown in table
No.1 with the help of the chronology of the events.

REGULATION OF DERIVATIVES TRADING IN INDIA-

The regulatory frame work in India is based on L.C. Gupta Committee report and J.R. Varma
Committee report. It is mostly consistent with the international organization of securities
commission (IUSCO). The L.C. Gupta Committee report provides a perspective on division of
regulatory responsibility between the exchange and SEBI. It recommends that SEBI‟s role
should be restricted to approving rules, bye laws and regulations of a derivatives exchange as
also to approving the proposed derivatives contracts before commencement of their trading. It
emphasizes the supervisory and advisory role of SEBI. It also suggests establishment of a
separate clearing corporation. DERIVATIVES MARKET IN INDIA. In India, there are two
major markets namely National Stock Exchange (NSE) and Bombay Stock Exchange (BSE)
along with other Exchanges of India are the market for derivatives. Here we may discuss the
performance of derivatives products in Indian market.

GROWTH OF INDIAN DERIVATIVES MARKET-

The NSE and BSE are two major Indian markets have shown a remarkable growth both in
terms of volumes and numbers of traded contracts. Introduction of derivatives trading in
2000, in Indian markets was the starting of equity derivative market which has registered on
explosive growth and is expected to continue the same in the years to come. NSE alone
accounts 99% of the derivatives trading in Indian markets. Introduction of derivatives has
been well received by stock market players. Derivatives trading gained popularity after its
introduction in very short time.

In terms of the growth of derivatives markets, and the variety of derivatives users, the
Indian market has equalled or exceeded many other regional markets. While the growth is being
spearheaded mainly by retail investors, private sector institutions and large corporations, smaller
companies and state-owned institutions are gradually getting into the act. Foreign brokers such as
JP Morgan Chase are boosting their presence in India in reaction to the growth in derivatives.
The variety of derivatives instruments available for trading is also expanding.

 There remain major areas of concern for Indian derivatives users. Large gaps exist in the
range of derivatives products that are traded actively. In equity derivatives, NSE figures show
that almost 90% of activity is due to stock futures or index futures, whereas trading in options is
limited to a few stocks, partly because they are settled in cash and not the underlying stocks.
Exchange-traded derivatives based on interest rates and currencies are virtually absent.

 Liquidity and transparency are important properties of any developed market. Liquid
markets require market makers who are willing to buy and sell, and be patient while doing so. In
India, market making is primarily the province of Indian private and foreign banks, with public
sector banks lagging in this area (FitchRatings, 2004). A lack of market liquidity may be
responsible for inadequate trading in some markets. Transparency is achieved partly through
financial disclosure. Financial statements currently provide misleading information on
institutions’ use of derivatives. Further, there is no consistent method of accounting for gains and
losses from derivatives trading. Thus, a proper framework to account for derivatives needs to be
developed.

 Further regulatory reform will help the markets grow faster. For example, Indian
commodity derivatives have great growth potential but government policies have resulted in the
underlying spot/physical market being fragmented (e.g. due to lack of free movement of
commodities and differential taxation within India). Similarly, credit derivatives, the fastest
growing segment of the market globally, are absent in India and require regulatory action if they
are to develop. As Indian derivatives markets grow more sophisticated, greater investor
awareness will become essential. NSE has programmes to inform and educate brokers, dealers,
traders, and market personnel. In addition, institutions will need to devote more resources to
develop the business processes and technology necessary for derivatives trading.