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A PROJECT REPORT

ON
DERIVATIVES

SUBMITTED BY:
SHWETA .C. SAWANT
ROLL NO. : 48

MASTER OF COMMERCE
BANKING & FINANCE
PART I (2013 2014)

MODEL COLLEGE
DOMBIVLI

INDEX
SR NO

TOPIC

SUMMARY

INTRODUCTION TO DERIVATIVES

ORIGIN OF DERIVATIVES

HISTORY OF DERIVATIVES

DEFINITION OF DERIVATIVES

FACTORS CONTRIBUTING TO THE GROWTH OF

DERIVATIVES
INDIAN DERIVATIVES MARKET

NEED FOR DERIVATIVES IN INDIA

TYPES OF DERIVATIVES

10

CONTRACT TYPES OF DERIVATIVES

11

ECONOMIC FUNCTION OF DERIVATIVES

12

USUAGE OF DERIVATIVES

13

BENEFITS OF DERIVATIVES

14
16

NATIONAL COMMODITY AND DERIVATIVE EXCHANGE


DERIVATIVES- CAUTIOUS APPROACH TO INNOVATION

17

BANK AND DERIVATIVES

21

DERIVATIVES RISK IN COMMERCIAL BANKING

30

CONCLUSION

31

RECOMMENDATIONS AND SUGGESTIONS

32

BIBLIOGRAPHY

SUMMARY

Derivatives trading in the stock market have been a subject of enthusiasm of research in
the field of finance the most desired instruments that allow the market participants to
manage risk in the modern securities trading are known as derivatives. The derivatives
are defined as the future contracts whose value depends upon the underlying assets. If
derivatives are introduced in the stock market, the underlying asset may be anything as
component of stock market like, stock prices or market indices, interest rates, etc. The
main logic behind derivative trading is that to reduce the risk by providing an additional
channel to invest with lower trading cost and it facilitates the investors to extend their
settlement through the future contracts.
Derivatives are assets, which derive their values from an underlying asset. The
underlying assets of derivatives are of various categories like

Commodities including grains, coffee beans, etc.


Precious metals like gold and silver.
Foreign exchange rates.
Equity and bonds including medium to long term negotiable debt.
Short term debt securities such as T-bills.
Over-the -counter (OTC) money market product such as loans and deposits.

There are various derivatives products traded. They are:


1.
2.
3.
4.

Forwards.
Futures.
Options.
Swaps.

A Forward contract is a transaction in which the buyer and the seller agree upon a
delivery of a specific quality and quantity of asset usually a commodity at a specified
future date. The price may be agreed on in advance or in future.
A Future contract is a firm contractual agreement between a buyer and a seller for a
specified as on a fixed date in future. The contract price will vary according to the market
place but it is fixed when the trade is made. The contract also has a standard specification
so both parties know exactly what is being done.
An Options contract confers the right but not the obligation to buy or sell a specified
underlying instrument or asset at a specified price- the strike or exercised price up until or
an specified future date- the expiry date. The Price is called premium and is paid by buyer
of the option to the seller or writer of the option.
Swaps are transactions which obligates the two parties to the contract to exchange a
series of cash flows at specified intervals known as payment or settlement dates.

INTRODUCTION

A derivative instrument is a contract between two parties that specifies conditions


(especially the dates, resulting values of the underlying variables, and notional amounts)
under which payments are to be made between the parties.
Under US law and the laws of most other developed countries, derivatives have special
legal exemptions that make them a particularly attractive legal form to extend credit.
However, the strong creditor protections afforded to derivatives counterparties, in
combination with their complexity and lack of transparency, can cause capital markets to
under price credit risk. This can contribute to credit booms, and increase systemic risks.
Indeed, the use of derivatives to mask credit risk from third parties while protecting
derivative counterparties contributed to the financial crisis of 2008 in the United States.
Derivatives can be used for speculation ("bets") or to hedge ("insurance"). For example, a
speculator may sell deep in-the-money naked calls on a stock, expecting the stock price
to plummet, but exposing himself to potentially unlimited losses. Very commonly,
companies buy currency forwards in order to limit losses due to fluctuations in the
exchange rate of two currencies.

ORIGIN OF DERIVATIVES

Derivatives have their roots in the agriculture-complex. From an historical context, it was
agricultural commodities futures (mainly grain) that first gained traction as viable
financial instruments. The genesis of these products dates back to the founding of the
Chicago Board of Trade (CBT) in the mid-eighteen hundreds.
Back in the eighteen hundreds large scale farming enterprises were difficult (risky) to
bank. The risk was embodied by the known costs associated with planting seed,
fertilizing and subsequent growth and harvest versus the often volatile, unpredictable
final selling price of a perishable commodity. Futures removedthis unknown from
the banking/farming relationship and transferred it to speculators for a nominal fee or
cost.
From 1850 59, American agricultural exports were $189 million/year (81% of total
exports). With agriculture occupying such a huge percentage of exports and GDP it was
only natural that business of this scale (potential fees and profits) would and did attract
the attention of the money changers. The advent of futures and forward contracts in the
agri-complex was productive: giving a higher degree of predictability to farm income
making the business of farming more bankable.

HISTORY

The history of derivatives is surprisingly longer than what most people think. Some texts
even find the existence of the characteristics of derivative contracts in incidents of
Mahabharata. Traces of derivative contracts can even be found in incidents that date back
to the ages before Jesus Christ .However, the advent of modern day derivative contracts
is attributed to the need for farmers to protect themselves from any decline in the price of
their crops due to delayed monsoon, or overproduction.
The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan
around 1650. These were evidently standardized contracts, which made them much like
today's futures.
The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was
established in 1848 where forward contracts on various commodities were standardized
around 1865. From then on, futures contracts have remained more or less in the same
form, as we know them today.
Derivatives have had a long presence in India. The commodity derivative market has
been functioning in India since the nineteenth century with organized trading in cotton
through the establishment of Cotton Trade Association in 1875. Since then contracts on
various other commodities have been introduced as well.
Exchange traded financial derivatives were introduced in India in June 2000 at the two
major stock exchanges, NSE and BSE. There are various contracts currently traded on
these exchanges.
National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in
December 2003, to provide a platform for commodities trading.
The derivatives market in India has grown exponentially, especially at NSE. Stock
Futures are the most highly traded contracts on NSE accounting for around 55% of the
total turnover of derivatives at NSE, as on April 13, 2005.

DEFINITION
7

A derivative is security whose price is dependent upon or derived from one or more
underlying assets. The derivative itself is merely a contract between two or more parties.
Its value is determined by fluctuations in the underlying asset. The most common
underlying assets include stocks, bonds, commodities, currencies, interest rates and
market indexes. Most derivatives are characterized by high leverage.
With Securities Laws (Second Amendment) Act 1999, Derivatives has been
included in the definition of Securities. The term Derivative has been defined in
Securities Contracts (Regulations) Act, as:A Derivative includes: 1. a security derived from a debt instrument, share, loan, whether secured or
unsecured, risk instrument or contract for differences or any other form of
security;
2. a contract which derives its value from the prices, or index of prices, of
underlying securities.

FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES


8

Factors contributing to the explosive growth of derivatives are price volatility,


globalization of the markets, technological developments and advances in the financial
theories.

1. Price Volatility
A price is what one pays to acquire or use something of value. The objects having value
may be commodities, local currency or foreign currencies. The concept of price is clear to
almost everybody when we discuss commodities. There is a price to be paid for the
purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of
another persons money is called interest rate. And the price one pays in ones own
currency for a unit of another currency is called as an exchange rate.
Prices are generally determined by market forces. In a market, consumers have demand
and producers or suppliers have supply, and the collective interaction of demand and
supply in the market determines the price. These factors are constantly interacting in the
market causing changes in the price over a short period of time. Such changes in the price
are known as price volatility. This has three factors: the speed of price changes, the
frequency of price changes and the magnitude of price changes.
The changes in demand and supply influencing factors culminate in market adjustments
through price changes. These price changes expose individuals, producing firms and
governments to significant risks. The breakdown of the BRETTON WOODS agreement
brought and end to the stabilizing role of fixed exchange rates and the gold convertibility
of the dollars. The globalization of the markets and rapid industrialization of many
underdeveloped countries brought a new scale and dimension to the markets. Nations that
were poor suddenly became a major source of supply of goods.
The Mexican crisis in the south east-Asian currency crisis of 1990s has also brought the
price volatility factor on the surface. The advent of telecommunication and data
processing bought information very quickly to the markets. Information which would
have taken months to impact the market earlier can now be obtained in matter of

moments. Even equity holders are exposed to price risk of corporate share fluctuates
rapidly.
This price volatility risk pushed the use of derivatives like futures and options
increasingly as these instruments can be used as hedge to protect against adverse price
changes in commodity, foreign exchange, equity shares and bonds. The original intended
use of derivatives was to manage risk (hedge); however, now they are often traded as
investments whether hedged, un-hedged or as component of a spread trading strategy.
The diverse range of potential underlying assets and pay-off alternatives leads to a wide
range of derivatives contracts available to be traded in the market.

2) Globalization of the Markets


Earlier, managers had to deal with domestic economic concerns; what happened in other
part of the world was mostly irrelevant. Now globalization has increased the size of
markets and as greatly enhanced competition .it has benefited consumers who cannot
obtain better quality goods at a lower cost. It has also exposed the modern business to
significant risks and, in many cases, led to cut profit margins
In Indian context, south East Asian currencies crisis of 1997 had affected the
competitiveness of our products vis--vis depreciated currencies. Export of certain goods
from India declined because of this crisis. Steel industry in 1998 suffered its worst set
back due to cheap import of steel from south East Asian countries. Suddenly blue chip
companies had turned in to red. The fear of china devaluing its currency created
instability in Indian exports. Thus, it is evident that globalization of industrial and
financial activities necessitates use of derivatives to guard against future losses. This
factor alone has contributed to the growth of derivatives to a significant extent.

3) Technological Advances
A significant growth of derivative instruments has been driven by technological break
through. Advances in this area include the development of high speed processors,
network systems and enhanced method of data entry. Closely related to advances in
10

computer

technology

are

advances

in

telecommunications.

Improvement

in

communications allow for instantaneous world wide conferencing, Data transmission by


satellite.
At the same time there were significant advances in software programmed without which
computer and telecommunication advances would be meaningless. These facilitated the
more rapid movement of information and consequently its instantaneous impact on
market price.
Although price sensitivity to market forces is beneficial to the economy as a whole
resources are rapidly relocated to more productive use and better rationed overtime the
greater price volatility exposes producers and consumers to greater price risk. The effect
of this risk can easily destroy a business which is otherwise well managed. Derivatives
can help a firm manage the price risk inherent in a market economy. To the extent the
technological developments increase volatility, derivatives and risk management products
become that much more important.

4) Advances in Financial Theories


Advances in financial theories gave birth to derivatives. Initially forward contracts in its
traditional form, was the only hedging tool available. Option pricing models developed
by Black and Scholes in 1973 were used to determine prices of call and put options. In
late 1970s, work of Lewis Edeington extended the early work of Johnson and started the
hedging of financial price risks with financial futures. The work of economic theorists
gave rise to new products for risk management which led to the growth of derivatives in
financial markets.

INDIAN DERIVATIVES MARKET

11

Starting from a controlled economy, India has moved towards a world instruments in
India gained momentum in the last few years due to liberalization process and Reserve
Bank of Indias (RBI) efforts in creating currency forward market. Derivatives are an
integral part of liberalization process to manage risk. NSE gauging the market
requirements initiated the process of setting up derivative markets in India. In July 1999,
derivatives trading commenced in India.
Derivatives typically have a large notional value. As such, there is the danger that their
use could result in losses for which the investor would be unable to compensate. The
possibility that this could lead to a chain reaction ensuing in an economic crisis was
pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual
report. Buffett called them 'financial weapons of mass destruction.' The problem with
derivatives is that they control an increasingly larger notional amount of assets and this
may lead to distortions in the real capital and equities markets. Investors begin to look at
the derivatives markets to make a decision to buy or sell securities and so what was
originally meant to be a market to transfer risk now becomes a leading indicator.
Derivatives massively leverage the debt in an economy, making it ever more difficult for
the underlying real economy to service its debt obligations, thereby curtailing real
economic activity, which can cause a recession or even depression.

Chronology of development of Financial Derivatives markets in India.


1991

Liberalization process initiated.


12

14 December 1995

NSE asked SEBI for permission to trade index futures.

18 November 1996

SEBI setup L.C.Gupta committee to draft a policy


framework for index futures.

11May 1998

L.C. Gupta committee submitted report.

7 July 1999

RBI gave permission for OTC forward rate


agreements (FRAs) and interest rate swaps.

24 May 2000

SIMEX choose Nifty for trading futures and options


on an Indian index.

25 May 2000

SEBI gave permission to NSE and BSE to do index


futures trading.

9 June 2000

Trading of BSE Sensex futures commenced at BSE.

12 June 2000

Trading of nifty futures commenced at NSE.

25 September 2000

Nifty futures trading commenced at SGX.

2 June 2001

Individual stock options and derivatives.

NEED FOR DERIVATIVES IN INDIA TODAY


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In less than three decades of their coming into vogue, derivatives markets have become
the most important markets in the world. Today, derivatives have become part and parcel
of the day to day life for ordinary people in major part of the world.
Until the advent of NSE, the Indian capital market had no access to the latest trading
methods and was using traditional out- dated methods of trading. There was a huge gap
between the investors aspirations of the markets and the available means of the trading.
The opening of Indian economy has precipitated the process of integration of Indias
financial markets with the international financial markets. Introduction of risk
management instruments in India has gained momentum in the last few years thanks to
Reserve Bank of Indias efforts in allowing forward contracts, cross currency options etc.
which have developed into a very large market.
Derivatives increase speculation and do not serve any economic purpose. Derivatives are
a low- cost, effective method for users to hedge and manage their exposures to interest
rates, commodity prices or exchange rates. As the complexity of instruments increased
many folds, accompanying risk factors grew in gigantic proportions. This situation led to
development derivatives as effective risk management tools for the market participants.

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TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives

over the Counter

Derivatives

National Stock Exchange

Index future

Bombay Stock Exchange

Index option

stock option

15

Derivative

stock future

Exchange-traded derivative

Are those derivatives instruments that are traded via specialized derivatives exchanges or
other exchanges. A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange. A derivatives exchange
acts as an intermediary to all related transactions, and takes initial margin from both sides
of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of
transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), and
CME group (made up of the 2007 merger of the Chicago Mercantile Exchange and the
Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange).
According to BIS, the combined turnover in the world's derivatives exchanges totaled
USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade
on traditional exchanges. For instance, hybrid instruments such as convertible bonds
and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or
"rights") may be listed on equity exchanges. Performance Rights, Cash and various other
instruments that essentially consist of a complex set of options bundled into a simple
package are routinely listed on equity exchanges. Like other derivatives, these publicly
traded derivatives provide investors access to risk/reward and volatility characteristics
that, while related to an underlying commodity, nonetheless are distinctive.

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Over The Counter Derivatives

Are contracts that are traded (and privately negotiated) directly between two parties
without going through an exchange or other intermediary. Products such as swaps,
forward rate agreements, exotic options - and other exotic derivatives - are almost always
traded in this way. The OTC derivative market is the largest market for derivatives, and is
largely unregulated with respect to disclosure of information between the parties, since
the OTC market is made up of banks and other highly sophisticated parties, such as hedge
funds. Reporting of OTC amounts are difficult because trades can occur in private,
without activity being visible on any exchange. According to the Bank for International
Settlements, the total outstanding notional amount is US$708 trillion (as of June 2011).Of
this total notional amount, 67% are interest rate contracts, 8% are credit default swaps
(CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity
contracts, and 12% are other. Because OTC derivatives are not traded on an exchange,
there is no central counter-party. Therefore, they are subject to counter-party risk, like an
ordinary contract, since each Counter- Party relies on the other to perform. The problem
is more acute as heavy reliance on OTC derivatives creates the possibility of systematic
financial events, which fall outside the more formal clearing house structures.

CONTRACT TYPES OF DERIVATIVES


17

Some of the common variants of derivative contracts are as follows:


1. Forwards: A tailored contract between two parties, where payment takes place at a
specific time in the future at today's pre-determined price.

2. Futures: Are contracts to buy or sell an asset on or before a future date at a price
specified today. A futures contract differs from a forward contract in that the futures
contract is a standardized contract written by a clearing house that operates an
exchange where the contract can be bought and sold; the forward contract is a nonstandardized contract written by the parties themselves.

3. Options: Are contracts that give the owner the right, but not the obligation, to buy (in
the case of a call option) or sell (in the case of a put option) an asset. The price at
which the sale takes place is known as the strike price, and is specified at the time the
parties enter into the option. The option contract also specifies a maturity date. In the
case of a European option, the owner has the right to require the sale to take place on
(but not before) the maturity date; in the case of an American option, the owner can
require the sale to take place at any time up to the maturity date. If the owner of the
contract exercises this right, the counter-party has the obligation to carry out the
transaction. Options are of two types: call option and put option.

4. Binary options: Are contracts that provide the owner with an all-or-nothing profit
profile.
5. Warrants: Apart from the commonly used short-dated options which have a maximum
maturity period of 1 year, there exists certain long-dated options as well, known as
Warrant (finance). These are generally traded over-the-counter

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6. Swaps : Are contracts to exchange cash (flows) on or before a specified future date
based on the underlying value of currencies exchange rates, bonds/interest rates,
commodities exchange, stocks or other assets. Another term which is commonly
associated to Swap is Swaption which is basically an option on the forward Swap.
Similar to a Call and Put option, a Swaption is of two kinds: a receiver Swaption and
a payer Swaption. While on one hand, in case of a receiver Swaption there is an
option wherein you can receive fixed and pay floating, a payer swaption on the other
hand is an option to pay fixed and receive floating.

7. The buyer of a Call option has a right to buy a certain quantity of the underlying
asset, at a specified price on or before a given date in the future, he however has no
obligation whatsoever to carry out this right. Similarly, the buyer of a Put option has
the right to sell a certain quantity of an underlying asset, at a specified price on or
before a given date in the future, he however has no obligation whatsoever to carry
out this right.

Economic function of the derivative market


Some of the salient economic functions of the derivative market include:
1. Prices in a structured derivative market not only replicate the discernment of the
market participants about the future but also lead the prices of underlying to the
19

professed future level. The derivatives market relocates risk from the people who
prefer risk aversion to the people who have an appetite for risk.

2. The intrinsic nature of derivatives market associates them to the underlying Spot
market. Due to derivatives there is a considerable increase in trade volumes of the
underlying Spot market. The dominant factor behind such an escalation is
increased participation by additional players who would not have otherwise
participated due to absence of any procedure to transfer risk.

3. As supervision, reconnaissance of the activities of various participants becomes


tremendously difficult in assorted markets; the establishment of an organized
form of market becomes all the more imperative. Therefore, in the presence of an
organized derivatives market, speculation can be controlled, resulting in a more
meticulous environment.

4. A significant accompanying benefit which is a consequence of derivatives trading


is that it acts as a facilitator for new Entrepreneurs.

Usage of derivative
Derivatives are used by investors for the following:

20

To provide leverage (or gearing), such that a small movement in the underlying
value can cause a large difference in the value of the derivative.

To speculate and make a profit if the value of the underlying asset moves the way
they expect (e.g., moves in a given direction, stays in or out of a specified range,
reaches a certain level).

To hedge or mitigate risk in the underlying, by entering into a derivative contract


whose value moves in the opposite direction to their underlying position and
cancels part or all of it out.

To obtain exposure to the underlying where it is not possible to trade in the


underlying (e.g., weather derivatives)

To create option ability where the value of the derivative is linked to a specific
condition or event (e.g. the underlying reaching a specific price level).

BENEFITS OF DERIVATIVES

21

Derivative markets help investors in many different ways:

1) RISK MANAGEMENT- Futures and options contract can be used for altering the
risk of investing in spot market. For instance, consider an investor who owns an
asset. He will always be worried that the price may fall before he can sell the
asset. He can protect himself by selling a futures contract, or by buying a put
option. If the spot price falls, the short hedgers will gain in the futures market.
This will help offset their losses in the spot market. Similarly, if the spot price
falls below the exercise price, the put option can always be exercised.
2) PRICE DISCOVERY- Price discovery refers to the market ability to determine
true

equilibrium prices. Futures prices are believed to contain information

about future spot prices and help in disseminating such information. As we have
seen, futures markets provide a low cost trading mechanism. Thus information
pertaining to supply and demand easily percolates into such markets. Accurate
prices are essential for ensuring the correct allocation of resources in a free
market economy.
3) OPERATIONAL ADVANTAGES- As opposed to spot markets, derivatives
markets involve lower transactions costs. Secondly, they offer greater liquidity.
Large spot transactions can often lead to significant price changes. However,
futures markets tend to be more liquid than spot markets, because here in you can
take large positions by depositing relatively small margins.

Consequently, a large position in derivatives markets is relatively easier to take


and has less of a price impact as opposed to a transaction of the same magnitude
in the spot market. Finally, it is easier to take a short position in derivatives
markets than it is to sell short in spot markets.
22

4)

MARKET EFFICIENCY- The availability of derivatives makes markets more


efficient spot, futures and options markets are inextricably linked. Since it is
easier and cheaper to trade in derivatives, it is possible to exploit arbitrage
opportunities quickly and to keep prices in alignment. Hence these markets help
to ensure that prices reflect true values.

5) EASE OF SPECULATION- Derivative markets provide speculators with a


cheaper alternative to engaging in spot transactions. Also, the amount of capital
required to take a comparable position is less in this cased. This is important
because facilitation of speculation is critical for ensuring free and fair markets.
Speculators always take calculated risks. A speculator will accept a level of risk
only if he is convinced that the associated expected return is commensurate with
the risk that he is taking. Speculative trading in derivatives gained a great deal of
notoriety in 1995 when Nick Lesson, a trader at Barings Bank, made poor and
unauthorized investments in futures contracts. Through a combination of poor
judgment, lack of oversight by the bank's management and regulators, and
unfortunate events like the Kobe earthquake, Lesson incurred a US$1.3 billion
loss that bankrupted the centuries-old institution.

National Commodity and Derivatives Exchange

National Commodity & Derivatives Exchange Limited (NCDEX) is an online multi


commodity exchange based in India. It was incorporated as a private limited company
incorporated on 23 April 2003 under the Companies Act, 1956. It obtained its Certificate
23

for Commencement of Business on 9 May 2003. It has commenced its operations on 15


December 2003. NCDEX is a closely held private company which is promoted by
national level institutions and has an independent Board of Directors and professionals
not having vested interest in commodity markets.
NCDEX is a public limited company incorporated on 23 April 2003 under the Companies
Act, 1956. NCDEX is regulated by Forward Market Commission (FMC) in respect of
futures trading in commodities. Besides, NCDEX is subjected to various laws of the land
like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation)
Act and various other legislations, which impinge on its working. On 3 February 2006,
the FMC found NCDEX guilty of violating settlement price norms and ordered the
exchange to fire one of their executive. NCDEX is located in Mumbai and offers facilities
in more than 550 centers in India. NCDEX also offers as an information product, an
agricultural commodity index. This is a value weighted index, called DHAANYA and is
computed in real time using the prices of the 10 most liquid commodity futures traded on
the NCDEX platform.

Derivatives | Cautious approach to innovation

One of the key reasons why the Indian financial system was not affected by the 2008
global meltdown was the banking regulators conservatism. The central bank ring-fenced
24

the Indian banking system by imposing stringent criteria on various


instruments, including trades in permitted derivative products, and
deferring the introduction of others, one of which was blamed for
sinking large global financial institutions.
The Reserve Bank of India (RBI) had proposed the introduction of
credit default swaps (CDS) a number of times since 2003, but drew
up final guidelines for them only this year.
Developments in the currency and interest rate derivatives markets
show RBI has only recently opened up the space. In 2010, it
introduced currency options though currency futures were launched
just before the credit crisis in 2008. Both have garnered reasonable
volume, but are nowhere close to their volumes overseas.
Derivatives allow companies to hedge their currency risks and play a
key role in asset-liability management. It is a must-have for firms
with most of their inflows in dollars and costs in rupees.

We live in a world where there is mismatch and we need certainty that the mismatch can
be bridged. Thats why we need various kinds of derivatives, said Ruston Ravanan, chi
the buyer of a Call option has a right to buy a certain quantity of the underlying asset, at a
specified price on or before a given date in the future, he however has no obligation
whatsoever to carry out this right. Similarly, the buyer of a Put option has the right to sell
25

a certain quantity of an underlying asset, at a specified price on or before a given date in


the future, he however has no obligation whatsoever to carry out this right.
ef financial officer of software firm Mind Tree Ltd. Availability and access to a robust
derivatives market is what brings stability in the operation of a corporate.
As Indian firms get connected to the world for their operations, the need for derivatives is
on the rise, say bankers. Derivatives are here to stay, said Ananth Narayan G., head of
fixed income, currencies and commodities at Standard Chartered Bank. Risk remains
extremely high to stay un-hedged. Clients risk-management needs will always be there,
so will derivatives.
One critical derivative product introduced after the downturn is the cross-currency option,
launched on the exchanges in October 2010. RBI allowed options on four currency pairs:
rupee-dollar, rupee-yen, rupee-pound sterling and rupee-euro. Volume in this segment has
crossed $500 million on the National Stock Exchange, but is far below volumes in the
currency forwards market.
Volume in futures and options combined crossed Rs1 trillion in July, in a sign the
currency derivatives market is picking up pace. Average volume in exchange-traded
currency derivatives is Rs60000-80,000crore. Banks and retail investors dabble in the
segment as speculators. Small and medium enterprises enter the market for their simple
needs, but big firms largely stay away as their needs are complex and they need custom
contracts that exchanges cannot provide.

RBI governor D. Subbarao has indicated he believes in the dictum Festina lente -make
haste slowlywhen it comes to reforms. This, say bond market dealers, indicates RBI
will be cautious and ensure regulations are well entrenched before introducing more
derivative products.
26

The central bank has been cautious regarding the introduction of new products. It issued
four draft discussion papers and guidelines before coming up with final guidelines on
CDS in India.
There are two kinds of derivativestraded bilaterally over the counter (OTC) and
exchange-traded. Untila few years ago, most of the derivatives in India were of the
OTC kind. Even now, the size of the OTC currency market is larger than that of its
exchange-traded counterpart.
The currency derivatives segment includes foreign currency forwards, currency swaps
and currency options. The interest rate derivatives segment includes interest rate swaps,
forward-rate agreements and interest rate futures (IRF). Then, there are products linked to
the overnight money markets, such as collateralized borrowing, lending obligations and
overnight index swaps.
Overnight money market-linked products are overwhelmingly successful, but products
that involve a loan. In most developed nations, fixed-income markets compete with
equity markets to attract investors. In contrast, in India, the daily equity market volume is
at least double that of the debt market, including government and corporate bonds.
A few large investors, mostly banks, control the bond market. Other investors include
insurance companies, a few mutual funds, and pension and provident funds. They are also
the medium through which RBI intervenes in the bond and currency markets.

Several committees have been formed to deliberate on measures to deepen the bond
market and introduce new products. The most influential was headed by R.H. Patil,
chairman of National Securities Depository Ltd and Clearing Corp. of India Ltd. The key
recommendations of the committee, submitted in 2005, are yet to be implemented despite
the finance ministrys acceptance of them.

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The cautious attitude of the regulatorthat derivatives are used for hedging and not
speculationis helping to safeguard the financial system, but may be impeding the
markets growth. As the derivatives market will be dominated by hedging needs rather
than speculation purposes, currency derivatives will continue to outshine interest rate
derivatives, say experts.
Many banks have significantly downsized or completely wound down their derivatives
teams, especially after RBI clamped down on exotic deals.
In a way, this indicates that the future of derivatives may be constrained by RBI if it
continues with its tough supervisory stance. There will not be many entities to make twoway quotes available or extend liquidity in the market.

In

global markets, interest rate derivatives are the most popular


products, followed by currency derivatives. The volume in
equity derivatives is small in comparison. But in India,
equity derivatives have notched up large volumes compared
with currency and interest rate derivatives. In fact, currency
derivatives are picking up well, but interest rate derivatives,
particularly interest rate futures, have not been accepted.
Experts say India has all the derivatives products that make a
market vibrant. New products, they say, may not be needed

to

all.

BANKS AND DERIVATIVES


In the last ten to fifteen years financial derivative securities have become an important,
and controversial, product.1These securities are powerful instruments for transferring and
hedging risk. However, they also allow agents to quickly and cheaply take speculative

28

risk. Determining whether agents are hedging or speculating is not a simple matter
because it is
Difficult to value portfolios of derivatives. The relationship between risk and derivatives
is especially important in banking, since banks dominate most derivatives markets and,
within banking, derivative holdings are concentrated at a few large banks. If large banks
are using derivatives to increase risk, then recent losses on derivatives, such as those of
Procter and Gamble and of Orange County, may seem small in comparison with the
losses by banks. If, in addition, the major banks are all taking similar gambles, then the
banking system is vulnerable.
This is to estimate the market-value and interest-rate sensitivity of bank derivative
positions. We focus on a single important derivative security, interest-rate swaps, and find
evidence that the banks, as a whole, take the same side in interest-rate swaps. The
banking system's net position is somewhat interest-rate sensitive. Relatively small
increases in interest rates can cause fairly large decline in the value of swaps held by
banks.

A large number of reports by government and trade organizations have been devoted to
Studying derivatives. Such as:
Bank for International Settlements (1992),
Bank of England (1987, 1993),
29

Basle Committee on Banking Supervision (1993a, b, c, d),


Board of Governors of the Federal Reserve System et al. (1993),
Commodity Futures Trading Commission (1993),
Group of Thirty (1993a, b, 1994),
House Banking Committee Minority Staff (1993),
House Committee on Banking, Finance, and Urban Affairs (1993),
U.S. Comptroller of the Currency (1993A, B),
U.S. Government Accounting Office (1994).
Derivative securities are contracts that derive their value from the level of an underlying
interest rate, foreign exchange rate, or price. Derivatives include swaps, options,
forwards, and futures. At the end of 1992 the notional amount of outstanding interest-rate
swaps was $6.0 trillion, and the outstanding notional amount of currency swaps was $1.1
trillion (Swaps Monitor (1993)). U.S. commercial banks alone held $2.1 trillion of
interest rate swaps and $279 billion of foreign-exchange swaps (Call Reports of Income
and Condition). Moreover, derivatives are concentrated in a relatively small number of
financial intermediaries. For example, almost two-thirds of swaps are held by only 20
financial intermediaries. Of the amount held by U.S. commercial banks, seven large
dealer banks account for over 75%.

An interest-rate swap is a contract under which two parties exchange the net interest
payments on an amount known as the "notional principal." In the simplest interest-rate
swap, at a series of six-month intervals, one party pays the current interest rate (such as
the six-month LIBOR) on the notional principal while its counterparty pays a preset, or
30

fixed, interest rate on the same principal. The notional principal is never exchanged. By
convention, interest rates in a swap are set so that the swap has a zero market value at
initiation. If there are unanticipated changes in interest rates, the market value of a swap
will change, becoming an asset for one party and a liability for the counterparty
The key factor in determining the risk of a swap portfolio is the interest-rate sensitivity of
the portfolio. Swap value can be very volatile. If interest rates change slightly, the value
of a swap can change dramatically. Thus, monitoring the risks from swaps is difficult.
Partially in response to this, proposals for reforming swap reporting require institutions to
reveal the interest-rate sensitivity of their swap positions (as well as sensitivities to other
factors such as foreign exchange rates). Until institutions are required to report the
interest-rate sensitivity of their swap portfolios, swaps are an easy way to quickly and
inexpensively alter the risk of a portfolio.
Starting in 1994, banks are required to report for interest rate, foreign exchange, equity,
and commodity derivatives the value of contracts that are liabilities as well as the value
of contracts that are assets.

AN INTEREST-RATE SWAP
An interest-rate swap is a contract under which two parties agree to pay each other's
interest obligations. The cash flows in a swap are based on a "notional" principal which is
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used to calculate the cash flow (but is not exchanged). The two parties are known as
"counterparties." Usually, one of the counterparties is a financial intermediary. At a series
of stipulated dates, one party (the fixed-rate payer) owes a "coupon" payment determined
by the fixed interest rate set at contract origination, in return, is owed a "coupon"
payment based on the relevant floating rate. For most swap contracts, LIBOR is used as
the floating rate while the fixed rate is set to make the swap have an initial value of zero.
The fixed rate can be thought of as a spread over the appropriate-maturity Treasury bond,
where the spread can reflect credit risk.
A swap is a zero-sum transaction. While the initial value of a swap is zero, over the life of
the swap interest rates may change, causing the swap to become an asset to one party (the
fixed-rate payer if rates rise) or a liability (for the fixed-rate payer if rates fall); clearly,
one party's gain is the other's loss. For example, if the floating rate rises from rate to rate,
then the difference check received by the fixed-rate payer rises from (rt - rN)L to (r; rN)L.

Figure 2- SWAP EXAMPLES


Bank in Long Position: Pays Fixed and Receives Floating

32

6- MONTH
LIBOR

7.15%

Figure 3
Bank in Short Position: Pays Floating and Receives Fixed

6- MONTH
LOBOR
COUNTER
PARTY

BANK
7.25%

Figure 4
Bank in Hedged Position
6-MON
LIBOR

6MON
33

COUNTER
PARTY X

BANK

7.15
%

COUNTER
PARTY
7.25
%

Figure 1 provides examples of a swap. We define a swap participant as "long" if the


participant pays a fixed rate and receives a floating rate. The top panel shows a bank with
a long position. The bank pays 7.15% to its counterparty and receives the six-month
LIBOR rate. So, if the notional principal is $1 million and payments are made every six
months, then when LIBOR is 6.5%, the bank pays a net of $3250 to its counterparty [$1
million x (7.15% - 6.5%)/2]. When LIBOR is 7.5%, on the other hand, the bank receives
$1750. Thus, the bank gains when interest rates rise.
The middle panel shows the bank in a short position. Notice that we have implicitly
assumed that the bank is a dealer, since the fixed rate it pays is 10 basis points less than
the fixed rate it receives. This difference is the dealer fee. When a bank has a short
position, it loses if interest rates rise.
The last panel of Figure 1 shows the bank making both "legs" of a swap. The bank's
position is hedged, since no matter how interest rates

RISKS IN SWAPS

34

The major risks from swaps include those that are common to all fixed income securities.
Interest-rate risk exists because changes in interest rates affect the value of a swap. Also,
credit risk exists because a counter party may default. If a swap is a liability, then default
by a counter party is not costly. Also, notional principal is not exchanged in a swap, so
the magnitude of credit risk is reduced.
If the swap is an asset, however, then default means that the counterparty should be
making payments, but does not. The loss to the holder is equivalent to the value of the
swap at that point. The replacement cost of a swap is the loss that would be incurred if the
counterparty defaulted. Note that replacement cost is always nonnegative, since default
by an asset holder implies a zero loss to its counterparty.

DERIVATIVES RISK IN COMMERCIAL BANKING

35

Derivatives activity at commercial banks, as measured by total notional values of over $56 trillion
as of December 31, 2002, continues to grow dramatically. Derivatives serve an essential role in
the U.S. and world economies but also present certain risks to the deposit insurance funds.

Derivatives: What They Are and the Role That They Have in the Economy
Derivatives are financial instruments or contracts with values that are linked to, or
derived from, the performance of underlying financial instruments, interest rates,
currency exchange rates, or indexes. In a simplified sense, a derivative links its holder to
the risks and rewards of owning an underlying financial instrument without actually
owning the financial instrument.
Derivatives are important to the financial markets and the world economy because they
provide a means for companies to separate and trade various kinds of risks. The ability of
participants in the financial markets to adjust specific risk exposures enhances the
efficiency of capital flows by allowing companies to conduct business activities without
amassing certain risks that would otherwise attend that business. For instance, mortgage
lenders that are comfortable with the credit risk of mortgage lending may be less
comfortable with the amount of exposure to interest rate movements that accompany a
large mortgage portfolio. A mortgage company can use derivatives to lessen their
exposure to the effect that interest rate movements might have on the value of their
business and continue to make mortgage loans.

CONCLUSION

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Derivative is growing very fast in the Indian economy. The turnover of derivative market
is increasing year by year in the Indias largest stock exchange. In the case of index future
there is a phenomenal increase in the number of the contracts. But whereas the turnover is
declined considerably. In the case of stock future there was a slow increase observed in
the number of contracts whereas a decline was also observed in its turnover. In the case
of index option there was a huge increase observed both in the number of contracts and
turnover.
Most significant derivatives losses to date have occurred because of rogue traders or
because investment policies were either ignored or not appropriate for the institution
involved. Credit exposure from derivatives amounts to a concentration for several dealer
banks; but concern is mitigated by the credit quality of the counterparties and the nature
of the transactions. Significant differences in the positive and negative values of
derivatives at a few major dealers suggest that these banks are managing market risk
using risk management techniques other than matched trading. Extensive use of other
techniques requires a high degree of confidence in the reliability of the banks' models,
and these techniques should be approached particularly cautiously in thinly-traded
markets.
Derivative contract types that are well-understood by risk managers do not pose
significant risk unless circumstances dictate that a dealer's positions in these contracts
change more quickly than market liquidity can bear. An erosion of confidence in any one
of the major dealers could result in a rapid change in its risk profile and cause market
disruptions because of the influence that any major dealer has in the derivatives market.
Troubles at one major dealer also may transmit to other dealers because of the volume of
inter-dealer transactions.
A dislocated market may make hedging more expensive and less effective for a number
of institutions at least temporarily. Extensive dealing in less well-understood derivatives
should be pursued only when the bank's risk managers develop the ability to reliably
quantify the associated risks, even if this requires sacrificing higher potential margins in
the interim.
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Derivatives have sound economic and commercial benefits, and have been and remain
necessary to the development of trade and commerce, but the manner in which they are
used can pose a risk to the system.

Derivatives have an important economic function, namely redistribution of risk, but some
forms of derivatives can be used as tools for speculation by participants in the financial
market who have ownership of the underlying asset. Coupled with a lack of transparency
in the market, where build-ups in risk cannot be detected by actors or supervisors,
derivatives could help destabilize the financial system, particularly if there is a significant
shift in the value of underlying assets.

Derivatives have proven to be the most efficient vehicle for these exposures to be handled
with optimum risk management techniques. It has also been shown that the City of
London, through Euro next. Life plays a central role in facilitating an efficient platform
for the all important OTC segment of the derivatives

RECOMMENDATIONS AND SUGGESTIONS

38

1) First, institutions should provide financial statement users with a clear picture of their
trading and derivatives activities. They should disclose meaningful summary information,
both qualitative and quantitative, on the scope and nature of their trading and derivatives
activities and illustrate how these activities contribute to their earnings profile. They
should also disclose information on the major risks associated with their trading and
derivatives activities and their performance in managing these risks.
2) Second, institutions should disclose information produced by their internal risk
measurement and management systems on their risk exposures and their actual
performance in managing these exposures. Linking public disclosure to internal risk
management processes helps ensure that disclosure keeps pace with innovations in risk
measurement and management techniques.
3) RBI Should plays a greater role in supporting derivatives.
4) Derivatives market should be developed in order to keep it as per with other derivative
markets in the world.
5) Speculation should be discouraged.
6) There must be more derivative instrument aimed at individual investors.
7) SEBI should conduct seminars regarding the use of derivatives to educate individual
investors.

BIBLIOGRAPHY
Books referred:

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Options, futures, and other derivatives by John c Hull.


Derivatives in banking by S.P. DAS.
Financial markets and services by P.K.BANDGAR.
Innovations in banking by ROMEO.S.MASCARENHAS

Websites visited:

WWW.nse-india.com
WWW.bseindia.com
WWW.sebi.gov.in
WWW.ncdex.com
WWW.google.com
WWW.derivativesindia.com
WWW.yahoo.com

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