Derivatives in Bangladesh

Derivatives -- a well-known term used in the parlance of the stock market -- are instruments derived from the securities or physical markets. They include futures, options, warrants and convertible bonds. Financial derivatives and hedge funds have played an increasingly important and often inter-related role in the context of the stock market. In the financial markets, derivatives are used as an instrument by the investors to make profit. Even a small value-change in the underlying worth of the asset can cause a large fluctuation in the derivative of the asset. By the way, if the prices are exactly going the way the investor expected, one may expect a profit. The purpose of a financial derivative is to give a stock owner or purchaser some kind of leverage, implying control of a large stock by using minimal investment. There have been numerous disasters in the cases of a number of financial institutions because of the use of financial derivatives. For example, in England, the Barings Bank failed miserably as a result of the risk that the bank incurred after making a financial derivative. One of the company's representatives made trades that did not come into force in the future. That was in 1995. This caused substantial losses to the bank and it went bankrupt at the end. There are, however, both sides of the coin -- the benefits and risks of financial derivatives. Futures and options are also forms of financial derivatives. Risk managers can use them to hedge financial risk. Two major roles of a financial derivative are about speculation and hedging. In case of risk management, derivatives facilitate production and investment activities by allowing companies and investors to reduce and manage risk exposure. A derivative trading also benefits the economy by revealing information about the value of underlying assets of contracts relating to derivatives. This can facilitate the market participants to make more informed decisions. Hedge funds are active traders of derivatives. Hedge funds compensate the management in part with annual performance fees and are typically engaged in active trading of the financial instruments. By law, they may accept capital, only from wealthy individuals and institutions. If financial derivatives can be strongly developed in our stock market - Dhaka Stock Exchange (DSE) and Chittagong Stock Exchange (CSE), the crash that has recently been recently witnessed there, could have, perhaps, been avoided. The chief of the Securities and Exchange Commission (SEC) has already talked about derivatives -- a kind of financial product of the stock market. The introduction of such products might be of help to prepare the local market operators well for getting themselves accustomed to such products that are already in use in the developed markets since long. Financial derivatives can play a significant role in the capital market. For such derivatives, one does not need to worry much about changes in the prices of current stocks. Invested wisely, the derivatives are bound to make profit. If the underlying asset changes in any specific direction, or stays around the same value, one can speculate and make some profit, if the worth of the asset moves exactly the way one wants. Holding of a financial derivative involves the transfer of risk from one party to some other party. Both the parties involved do normally have a reduced risk to handle. Derivatives can also be used to control large blocks of stocks for a much smaller sum than it would be required by outright purchase or sale. Due to their great flexibility, derivatives allow the investors the full range of investment strategy: speculation, hedging and arbitrage. Derivatives also offer the opportunity for sophisticated management of risk. In our neighbouring India, the derivative system has already become operational. The operators have

also got significant benefits out of it. Fluctuations in the stock market or in the dollar-rupee exchange rate do otherwise expose the Indian citizens to-day to greater price risks. That is one of the reason why derivatives are becoming a central part of the reforms process there. By giving investors the power to make choices about what risks - and to what extent -- they are comfortable to bear with and what risks - and to what extent - such risks can best be hedged away, derivatives do seek to make the investors there more tolerant of price risks. From a purely Bangladesh stock market perspective, derivatives are important as they are part and parcel of market development. A derivative-trading can help improve market liquidity, raise skills and deepen knowledge among the market participants. This should, therefore, be considered as a vital ingredient of future market reforms such as the transition to rolling settlement.