Derivatives in India

Why do we need derivatives??

We need derivatives because then we get the ability to price risk. We need derivative
markets, because then we get the ability to trade risk. And beause diferent people have
different risk preferences at different point in time, this becomes qa very crucial financial
need. Even though derivatives are a zero sum game. It works because it allows one to
explicity trade risk. Everything else remains same. People enater into a derivatives trade,
only if they are better off as a consequence of this reallocation of risk.
Users of Derivatives

Index funds:

Index funds being passively managed, constitute a challenge in tracking. When fund
managers face redemptions what they do is sell equity. For example suppose NSE-50 has
to redeem its index funds it will go to the market and sell equity shares meet the
redemption costs, the impact costs of such massive sale of equity shares is very high and
it leads to a large tracking error. In simpler words it depresses the market.

We can use derivatives to manages such impacts. What a fund manager will do is to
borrow money to service redemptions, mutual fund regulations in India permit managers
to do this. He will simultaneously go short on Index future. Later he will square his
position by gradually selling shares and buying back index futures. This trade is done
without urgency and there can be numerous small trades. Finally the borrowing can be
repaid. If the index futures are efficently priced, the tracking error will be low.

Conversely, when money comes into an open-ended index fund, the fund would have the
ohoice of buying futures immediately , and gradually unwinding the ftures position as
shares are acumulated at low impact cost. The fund manager of an index fund can thus
handle tracking more comfortably when the fund size is volatile, when he has access to
index futures.

What is happening in India???

2. Balance funds
Banlanced funds can also use . For example in 1995-96, US-64 underwent a large
redemption by its institutional invcestors. This is a very large fund, and when such a fund
experiences sizeable redemptions, life can be very uncomfortablle for fund managers. As
the year began, the NAV Of the aggregate fund was over Rs 25000 crore. As the year
ended, Rs. 4800 crore was lopped off the NAV.
About 30% of the fund was invested in debt, but the illiquidity of the secondary
debt market made sales of debt problematic. Funds redemptions had therefore to be met
through the sale of equities. This further depressed a falling market.

This episode serves as excellent motivation for index derivatives. Even though
US-64 is not an index fund, like all diversified equity portfolios it is highly correlated
with the index, so the “basis risk” which the equity component of US-64 faces against the
inde is quite small.
One alternative, which reacts to redemptions, is a lot like the index fund example” we
could meet redemptions by borowing, but simultaneously reduce our equity exposure by
selling index futures. Later, without the ambience of a distress sale, we would be able to
sell shares and buy back the futures.

An alternative strategy cope swith expected redemptions in the future by buying

put options on the index. This endows the fund manager with the option to sell the index
at a contracted strike price, though he has no obligation toy do so if the market price is
higher than the strike price when the options maturs. This prevents the value to the
ortfolio of the equity sale from falling below the strike price.

Asset reallocation in a balance fund

One of th emost important decisions made in a balanced fund is the choice of the extent
of debt and equity. More generally, we can think of many asset classes – government
securities and commmodities are tow other asset classes. One major question which the
fund manager has to grapple with is his wighting across various asset classes.

Without the derivatives markets, the ability of a fund manager to shift across asset classes
is limited by the transactions costs faced in makin such changes. Furthermore , fund
managers who foresee a need for asset reallocation in the future would tend to constrain
their portfolio formation to the most liquid assets.

Let us take an example from 1994 , the year when US-64 moved sharlply from
debt to equity. There was a time around 1992 and 1993 when just 30% of US-64 was
invested in equity, with the remainder in debt. By about late 1994 the proportion got
reversed, largely because the fund managers believed that there was an upside in the
equity market.

Purely with the benefit of hinsight k we know that the peak came in September
1994 and after that the equity market has droped. When these revised expectations set in ,
the fund manager would ideally like to have substituted back from equity to debt, but he
could not do so because the debt market was illiquid and because the transactions costs
faced in selling off equity were high.

Asset reallocation would be dramatically easier in a world where fund managers had
access to a rich variety of derivatives. Changes in asset exposure would be achieved by
trading in liquid futures. THE underlying assets could be traded slowly, while asset
allocation could be modified sharply based on forecasts of returns in asset classes. Thus,
if a fund manager wished to bias an existing portfolio away from equities and towards
bonds, he w2ould sell equity index futures and buy bond futures. He could subsequently
gradually sell equity , buy bonds and unwind all futures.

International diversification
The RBI has now permitted investments by mutual funds overseas. SEBI has set up a
group to formulate guidelines for this purpose, and it is expected that sometime in 1998,
UTI will be in a position to actually achieve international diversification.

International diversification gives an opportunity to reduce portfolio risk. Yet a problem

arises if overseas assets have lower expected returns. We know that with AAA fixed
income securities in India, expected returns are at present slightly over 12%. If we look at
really good quality debt overseas, we get substantially lower expected returns.
Therefore, investing in fixed income assets overseas is attractive since they are
uncorrelatd with our core portfolio, thereby providing a reduction in portfolio risk. Yet
the return on the overall portfolio falls since average returns overseas are well below
those seen in India.
Leveragingh provides a possible solution to this problem. First, the fund manager
chooses oerseas assets such that their returns are strongly uncorrelated with the returns on
domestic assets. Scond he would go long on these assets, by purchasing leveraged
intruments like index futures overseas, until reutrns aer comparable with domestic
returns. With diversification the aggregate portfolio risk could reduce, and by leveraging,
we would maintain the average return of the portfolio. By doing this we successfully be
able to harness the gains of international diversification without a lowering of expected
returns.

Banks
A Bank can use derivatives for the following 3 purposes.

1. Manage its Balance Sheet using Asset liability Management (ALM)

2. Trade derivative products for profits
3. Widen the portfolio of products that it offers to clients.

Asset Liability Management

There can be nothing more obvious than the need of a bandk to manage its own, often
complicated balance sheet. A corporate faces a lot of interst rate risk. Suppose if the
deposits are mainly short-term, but the loans are medium tere. The loans can not always
be re-evaluated, unlike the deposits (which get repriced art every rollover). Furthermore,
the borowings are mfanly on an overnight basis, but the investments are for long
maturities.

In each of these mismatches of duration, if interest rates riese, the bank will pay more for
its deposits and its overnight borrowings. However, interest rates on itsloan portfolio
remain the same and its investments portfolio will depreciate. All these will obviously
have a significant adverse impact on profitability. Interest rate risks can be hedged
through a varietuy of derivative products.

Widening the product base for clients

Customer flows are very important for the long term survival of a bank. Hence, it is very
important that new products get developed to satisfy changing customer needs. Todays
customers are very demanding, and most product development in derivatives has been
driven by demand from the corporate world.

 Interest rate options

 Dollar-rupee swaps

How would derivatives increase the liquidity of the underlying market?

For a country that first traded commodity and equity futures more than a century ago,
India has been slow to adopt many basic forms of derivative contract. That is because
the government frowns on speculation of any sort. In the 1960s, it even banned trading
in commodity and equity futures. Only in recent years has this ban been relaxed for
such commodities as pepper, edible oils and coffee. The government-owned banks
however, still refuse to lend to stockbrokers for fear that this might lure them into
speculative excesses. Yet Indian stockmarkets are among the world’s most speculative.
One factor about the Indian equity market deserves our attention is that the underlying
cash market with transactions to buy and sell stock, has got a delivery percentage of 10%.
This means that 90% of the transactions carried out in the market place are non delivery.
I.e. in 90% market transactions no shares actually change hands. Rather, a form of
speculation known as badla has thrived. This is a way of carrying trades forward
without settling them, and of borrowing shares or cash to take those positions
Badla-users have been required to post only very small margin deposits, making the
system highly dangerous. On one occasion a badla-induced default led to the closure
of the BSE for three days. In late 1993, a few defaults, in which badla was suspected
to have played a role, prompted the Securities Exchange Board of India ( SEBI ), the
regulator, to ban badla. But sustained lobbying by the BSE brought back a new, more
regulated version in 1996. Initially, the clubby, broker-controlled BSE opposed the
introduction of derivatives, partly because it seemed a threat to badla, or the old way of
doing things.

The consequence of the Badla system is that the spot and the forwards markets are mixed
up. These two markets are economically the same, with the derivatives markets trading
the spot mareket instruments at a date in the future. But the prices of the two are
economically different. When we have a situation where both the markets are constrained
to showing one common price for both the spot and the derivative, then the market sees
prices that are not the true price. One of the biggest reasons for seperating the spot and
the derivative market is to have the true price of the asset revealed.

In addition , since both the spot and the derivative are essentially the same good,
seplarated only by the dimension of time, the prices on one market have a disciplining
influence on the prices of the other market. Therefore the presence of derivative market
will improve the cash market prices directly or indirectly.
Derivatives would also increase the liquidity of the underlying stock market, till recently
anyone who wanted to speculate on the Indian economy used the stocks on the equity
market. This led to most of the volumes isolated in around five stocks, driven by
speculators and arbitrageurs. With the derivatives market , people will be able to
speculate on the economy using index futures and options. The Nifty index future will
increase liquidity of these fifty stocks, at least.

Speculative activity in the index means that speculation is on the behaviour of the fifty
stocks in the index, which in turn menas that there will be increased arbitrage
opportunities in these fifty stocks. Whenever the price of the index futures strays too far
away from the price of the index arbitrageurs will step in to go either short of long on the
index futures, and take the opposite position on the index itself. This means that arbitrage
will create a lot of activity on the underlying stocks in the index itself, whick will lead to
a broader base of liquidity in th eunderlying stock market that we have seen in india so
far.

Why an Index future to begin with??

 If the stock index futures are cash-settled, the supply of stock index is unlimited. In
case of an individual security, there is always the problem of a short-squeeze arising
from the limited supply of the security. This bodes well for high liquidity on the stock
index futures market since it allows large volumes.
 Portfolio hedging facilities through derivatives on individual stocks can be quiete
costly and time consuming, whereas a single instrument like an index proves to be
much more cost-effective.
 In India, a lack of a benchmark yield curve in the debt market is a deep and
fundamental problem that creates problems for using derivatives tohedge interest rate
risk. The liquidity of the Indian debt market is decidedly based towards the short
term. Without a good yield curve, there is no clear price for different instruments.
Without a price there is low trading and low liquidity. Without good liquidity, it is
difficult to get a price or a yield curve. In terms of the barriers to crating an interest-
rate futures market, product design is as yet a question mark. If we do not have
liquidity in the underlying physical settlement is a broblem. If we do n not have a
reference price for the securities to be delivered, then cash-settlement will prove to be
a problem.