The Derivatives Market: In Retrospect and Prospect

 Nidhi Sethi, IMT Ghaziabad

Introduction:  Evolution in India

A derivative is a financial contract whose value depends on a risk factor (s) of a single or a combination of assets, such as Price of a bond, commodity, currency, share, a yield or interest rate etc. and allows organization to break financial risk into smaller components to best meet specific risk objectives.

The global economy, in particular the financial markets across the globe showed signs of complexity and volatility. The emerging inclination towards risk management in financial markets paved the way for introduction of derivatives. In India, Derivates first emerged as hedging devices to hedge market and operations risks. Traded over the counter, these instruments were mainly used by Hedgers to reduce or eliminate the risk associated with

Price of an asset or commodity like cotton, along with Speculators to get extra leverage in betting on future movements in the price of an asset and Arbitrageurs who take advantage of a discrepancy between prices in two different markets.

Thereafter, The gradual liberalization of Indian economy in the 1990’s, substantial inflow of foreign capital, dismantling of trade barriers, and integration of domestic economy with world economy led to the need for re-introduction of derivatives in the Indian market. The Securities Laws (Amendment) Ordinance promulgated on January 25, 1995 withdrew the prohibitions by repealing section 20 of the SCRA.

In Nov 1996, government led L. C. Gupta Committee helped develop regulatory framework for derivatives trading in India by recommending derivatives to be declared as ‘securities’. This helped catalyze entrepreneurial activity and transfer risks from risk adverse people to risk oriented people. Again the J.R.Verma committee recommendations to develop settlement and risk management systems for derivatives including upfront margins, daily settlement, online surveillance and position monitoring and risk management marked a new development. These structural changes in the equity derivative market made it organized and transparent. The beginning of index futures trading on June 9, 2000 was perhaps the defining moment for the BSE in the context of equity derivatives The NSE began trading futures with the S&P CNX Nifty as the underlying, three days after the launch of Sensex futures. June 12, 2000. Initially, the creation of derivative market as standardized key to unbundling and managing risk in banking, investment, capital and insurance markets was opposed on various grounds by BSE broker-dealers who dominated the markets as principals for their own benefit (opaque badla) , rather than acting as mere intermediaries between issuers of securities and ultimate investors. Subsequesntly, With  participation from risk averse people in greater numbers, the trading volumes upsurged. Tata Mutual Fund became country's first fund for investments in the equity derivatives market to have a proper hedging mechanism. Lower risk, lower investments and higher returns made this segment popular with investors. The turnover in the derivatives market spurted by over 5 times during 2002. The derivatives market turnover touched a record high of nearly Rs. 40bn, which was almost 75% of the cash market. This market the beginning of a new era.

Years after their introduction, derivatives markets in India have shown considerable growth in contracted volumes. Since pricing of derivatives is majorly done by arbitrage, the relationship between the spot price and future prices has helped improve the underlying equity market. Derivatives, as a part of a diversified investor portfolio, offer Liquidity and market efficiency. It helps increase savings and investment in the long run.

The NSE today accounts for more than 97 per cent of India's equity derivative market. In addition to the activity associated with expiration of contracts, derivatives' participants have indicated that retail participation has increased in the wake of buoyancy in equities. The leverage that derivatives offer (for instance, a contract value of a couple of lakh rupees require an initial payment of a few thousand rupees) is the key to attracting retail interest said brokers. THE aggregate turnover in the derivatives segment on the National Stock Exchange (NSE) was at an all-time high of Rs 6,073.66 crore on Wednesday.

Problems: Though showing volumes, But equity derivative market is not growing as fast as it should in terms of price discovery, the temporal spread of contracts and the range and diversity of contracts and instruments. The problems relating to the market are manifold.

• The India’s financial system between market operators and regulators is too prone to political pressure and regulatory capture. this has sub stained the market from opening further.

• Low average per capita income, inadequate physical and institutional infrastructure, primitive public services and dysfunctional political and legal systems have made India lag behind many developed financial markets across the globe.

• Uncertainty in Indian tax laws and rules whereby derivative transactions are treated as ‘speculative’ discourages active investor participation in the market.

• Another problems which the investors face is the lack of proper training to deal in this market, where, unlike the cash market, certification is required

• The J.R.Verma committee felt that there was a need to protect particularly the small investors who may be lured by the sheer speculative gains in this market where threshold limit of the transactions has been pegged not below Rs. 2 lakhs. This has compelled the retail investors to approach the markets through the indirect routes like mutual funds etc.

• Chauhan & Thomas clearly point out that intermediaries operating in Indian capital markets still lack (a) a single interface for dealing in both spot and derivatives markets thus compounding inefficiency in executing simultaneous trading strategies (b) essential analytical tools and adequate systems to support trading and risk management; (e) proper back office control and containment systems which ultimately hinder the growth in the market.RBI stipulations restricting entry of players into some part of derivative market and other stringent regulations restrict Free trade in the derivative markets

• Price recovery and narrow risk-bearing capacity on the part of option-writers is yet another concern as it makes risk hedging for more than one calendar quarter very difficult for investors.

Prospects:–.

             The derivatives market in India, which hangs between nascence and maturity stage, holds high prospects.

•  Introduction of three new products- options on index, options on individuals and covered warrants, Enabling FIIs, foreign insurance companies and mutual funds to participate more fully in derivatives markets, along with the availability of a wider range of derivatives, would enhance the use and quality of equity derivatives as considerably ‘more perfect’ rather than still ‘highly imperfect’ risk-management instruments. The recent ICICI bond issue bundles a twelve- year expiration BSE Sensex warrants with the bond. If this warrant is detached and traded, it would be an exchange-traded index derivatives

• The established mind-sets of regulatory and tax authorities on ‘speculation’ is limiting the propensity of option writers to be bolder in market-making for derivatives contracts .Jogani & Fernandes, in their paper make the case that arbitrage is not opportunistic or counterproductive speculation but an essential form of financial intermediation that makes markets more efficient by smoothing out price distortions. Thus, Policies should now shift to ensure the soundness of information and transparency such that wider investor participation can be attained.

• Introduction of index derivatives which are less volatile and difficult to manipulate as compared to individual stock prices have large prospects for small retail investors.

• since index future do not represent physically deliverable asset ,they are cash settled all over the world on the premise that index value is derived from the cash market, hence these require less margin capital which induces more players to join the market. 

• the unusual arbitrage opportunities due to the large pricing anomalies persisting between BSE/NSE prices for the same underlying shares again makes the market really attractive.

• Expansion in the derivative market would also increase the flow of FII and FDI investment. The currency risk and country risks of these investors can easily be mitigated by diversifying the derivatives market by introducing dollar- rupee futures and options for the first one; and index futures and options for the second one.

• While India lacks index derivatives as of today, there is a direct opportunity to make progress on these issues via the dollar-rupee forward market. The constraints that are placed in the way of FII's on using the dollar-rupee forward market are counterproductive. If the FII is allowed to obtain insurance using this market, they will bring more money to India.

Thus India needs to overcome its recent sluggish pace toward derivatives trading and pave the way for a open and developed financial market which have great prospects.

Commodity Derivatives:

Existing in India from the nineteenth century, through the establishment of Cotton Trade Association, trading in commodity futures was banned in 1960s due to excessive speculation. To tap the spur growth in commodities, worldwide, Future commodity trading was re-opened in 54 commodities in Feb., 2003. Three national electronic exchanges NCDEX, MCX and NMCE, along with 20 other regional offline commodity exchanges like The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee Owners Futures Exchange of India (COFEI), were authorized to re-introduce commodity derivatives in India.

The daily global volume in Commodity Trading touches 3 times of equity derivative market. With just a few months in action, ICICI bank promoted NCDEX alone registers about 85000 to 100000 trades per day. The reestablishment of commodity derivatives was welcomed by arbitragers and hedgers. Even retail investors showed interest, as unlike equity futures, he could start with as low as Rs.5000 and because of flexibility in contract sizes for different commodities, the ability to leverage was also much higher. MCX allows Indian shipping industry to hedge their freight rate risks. Daily volume of commodity trading of Rs.2500 crores has surpassed 2000 crores turnover at the BSE.commodity futures involve a large number of small participants from jan to may 2004 there were 237579 trades of value Rs.3175 crore, giving an average transaction of Rs.133640.

The But The problem is that this market lacks global standards and good supervision (regulated by FMC which is under control of Ministry of Food and Agriculture) Graphs

There exists a huge prospect in the commodity derivative market. It is now being extended to edible oils, oilseeds, oil cakes and sugar industry. Indian derivative market can capitalize on this opportunity by emphasizing upon an open and well distributed market with adequate spot price recovery and effective risk settlement to improve the Smaller and retail level participation. With gold prices at an 8 year hike, crude oil at its hike since the Iraq war, wheat, copper, silver, oilseeds markets at growth, many equity investors are keen on shifting to commodity derivatives. This is possible only when separate regulatory framework is established for the same which will benefit both the hedgers by lowering the transaction costs and the arbitragers with efficient price recovery. Impersonal online system, Exorbitant admission and membership fees and subscription, heavy security deposits, high variety and special margins, daily clearing, narrow price fluctuations with circuit breakers, limits on open positions and trading have adversely affected investor interest in commodity derivatives, ultimately affecting liquidity in the market. Elimination of the underground and illegal commodity derivative market can further accelerate the growth.

A soft interest rate and a weak dollar have increased the demand for commodities around the world. Increasing demand from china for commodities and global economic recovery can help grow it further. Commercial banks are chasing this opportunity with attractive lending rates between 8%-8.5percent as against normal rates of 11%-14%.  SEBI is also considering altering Regulation 43 thereby allowing mutual funds to float commodity focused funds, which invest in commodity derivatives which will further encourage smooth markets, help better price recovery and translate into more efficient distribution of commodities. With extended interest from FIIs, banks and mutual funds, the commodity derivative market is heading towards north.

Forex derivatives:

The economic liberalization in the early nineties provided the economic rationale for the introduction of FX derivatives. Foreign markets were approached for capital and direct investment opportunities. Increase convertibility on the capital account and the current account aided the process of integration of the Indian financial markets with international markets. With limited convertibility on the trade account being introduced in 1993, the environment became even more conducive for the introduction of these hedge products. forex derivatives provide better opportunities for the Corporates to Hedge their currency exposures (ECBs, forex trade, etc.), reduce borrowing costs using the comparative advantage of borrowing in local markets .

After scraping the prohibition on options in SCRA in 1995 RBI permitted foreign currency options in currency pairs other than Rupee , interest rate swaps, currency swaps and other risk reductions OTC derivative products to be traded in the market.  It also helped to become forex trading more efficient and time frame for transactions has also improved.Currency futures, when they are finally allowed, will have to address a number of limits on hedging, but they will have clear advantages over forwards: no default risk, more liquidity in times of uncertainty or crisis, and price transparency, since margin is not calculated based on spot values.

Average daily global turnover in traditional foreign exchange markets rose to $1.9 trillion in April 2004, up by 57% at current exchange rates and by 36% at constant exchange rates as compared to April 2001. Corresponding average daily global turnover in the OTC is $1.2 trillion, 112% and 77% respectively.

Rupee forward contracts market has been growing rapidly with increasing participation from corporate, exporters, importers, banks and FIIs. Operational freedom to corporate entities through rebooking cancelled contracts helped sustain growth. Due to tenuous links with the interest rate differential and low bid offer spread, the liquidity in the Indian forwards market is mainly for the end maturity contracts. Recently mutual funds have been allowed to invest in rated securities of countries with convertible currencies within existing limits.

The RBI has permitted authorized dealers to offer cross currency options to the corporate clients and other inter bank counter parties to hedge their foreign currency exposures clearing the way for potential extraordinary gains from the currency position. Another spin-off of the liberalization and financial reform was the development of a fledgling market in FC− RE swaps

The Indian forex derivatives market is still in a nascent stage of development but offers

Tremendous growth potential. Growth in the underlying spot/forward markets, growth in the rupee derivative markets, increasing convertibility on the capital account, supporting regulatory structure and favorable tax laws can further develop this market. Further, as suggested by the Tarapore committee report Introduction of foreign currency-rupee options, rupee and cross currency swaptions, exotic options would further enable Indian forex market participants manage their exposures better and offer liquidity in the market. Although global trade in currency derivatives has been substantial, forex derivatives in India are still dominated by INR/USD forward contracts with RBI stipulations governing entry of players has left problems of term, tenor, depth and liquidity unattended.

Credit derivatives: An Emerging prospect :

Credit derivatives are contracts seeking to transfer an asset’s risk and returns from one counter party to another without transferring the ownership. Credit derivatives trades today are more trading tools (as a proxy tool to allow trading in the general credit of a reference entity, and thereby replicating a cash bond) than hedging tools (to protect against credit risks, default risks inherent in exposures held by banks) these derivatives are traded over-the-counter (OTC) in developed markets. 

Credit derivatives like Total Return Swaps, Credit Default Swaps, Credit Spread Options and Credit Linked Notes help Reduce a particular risk concentration in the portfolio, Control credit risks of any debt instrument,  and gain exposure to another bank's loan portfolio.The recent bankruptcies in US, for e.g. Enron, WorldCom and Swissair etc. could have completely devastated even the giant economy of US, if the risk was not mitigated and the losses effectively spread from such defaults, with short term leverage to insurance firms, and others, by using CDS .

Though these tools currently have a limited presence in India, their market could see an explosive growth given the needs for the product and thrust from key areas. Most Indian nationalized banks, saddled with NPAs to the tune of 5-6% of their total asset base, creates an obvious need for credit protection . However, in the Indian context, the sell side market is absent. For the segment to develop, the sellers of credit protection need to be able to hedge their risks, enabling them to quote a price for the protection they are selling. The scenarios and factors such as opening up of the insurance sector, relief to investors, tax benefits to corporate would provide the necessary impetus to the credit derivatives market to develop in India, boosting yields and lowering risk for both the corporate as well as the banking sector.

Energy derivatives:

India is the sixth largest producer and consumer of energy in the world. According to global estimates, total energy trading in the world is around $8 trillion, and growing at a phenomenal rate of 30 percent per annum. Deregulation has changed the dynamics of energy markets from a supply market at a pre-determined price to a price-sensitive market where energy is traded on exchanges. Energy commodities are fast moving, non-storage products with volatile prices.  recent casualties of major electricity generators in California has explained that companies owing physical assets or retail obligations like electric generators, power and gas distributors, and oil refiners have large physical ,spot price-risk exposure that can be effectively managed and optimized using sophisticated risk management strategies.

In India, where the energy markets are plagued by losses in extraction, conversion and transmission, resulting into losses for producers, marketers and consumers, effective risk management through the use of energy derivatives has become crucial.

participation from multiple players in the areas of production, trading and marketing of energy products will further brighten the prospects. One of the Delhi based IT majors Vedaris provides energy trading and derivative risk management software the ‘Contango’ designed as an integrated solution for multi-commodity and multi-currency trading, within the energy derivatives market. The market for this product is principally gas and electricity, but also includes oil, coal, weather, bandwidth and emissions trading.

Indian Oil Minister Mani Shankar Aiyar told a regional energy conference that India, which has a vital interest in stable oil markets as it sources 70 percent of its crude oil needs abroad, should allow for derivatives trading keeping a check on oil price fluctuations and hedge risk.

Weather Derivative: Prospects

The emergence of the wholesale power market in response to the deregulation of the Power Industry and changed role of utility has helped weather derivative market to develop and stabilise volatility in revenue and expenses, caused by unpredictability of weather conditions. Unofficially the OTC weather derivative market began in 1996 when Entergy-Koch and Enron completed a HDD swap for the winter of 1997 in Milwaukee, WI.  According to a Price Waterhouse Survey, this is estimated at $12 billion by the end of this year.

In an agrarian economy like India, where Fifty per cent of irrigation is rain-fed and monsoons determine rural demand patterns, fertilizer off take, agricultural commodity prices, water utilities, energy consumption and construction costs, Weather derivatives can aptly be positioned as hedging instruments for farmers. These prospects in Weather risk management will also benefit the Utility and energy companies to protect their volume-related revenues against unnatural weather, Distributors of crude oil to make up for reduced business in the winter, Agricultural companies to minimise the uncertainty in revenue due to flood, freeze or drought and also Insurance companies to reduce their own exposure to weather-related claims.

In India, RaboBank and ABN Amro have been the first off the block to introduce weather derivatives help manage weather risk, which has now expanded to include end user industries such as beverage sales, agriculture, power generation, oil exploration, tourism, insurance , cold drink breweries, wind farms and sugar industries.

As a start (Jan 11, 2005), With all the necessary infrastructure to offer deliveries  through dematerialised warehouse receipts by linking up with panchayats and anticipating a strong demand , NCDEX is in favour of launching this product. More demand can be generated by an amendment of the existing Securities Contract (Regulation) Act, where derivative trading is allowed in a commodity, which can be physically delivered.

The phase I, whereby NCDEX will offer trading in futures of bullion and seven agri-products — soybean, soyoil, mustard seed and its oil; crude palm oil, RBD palmolein and cotton, is expected to attract many counterparts who would be more than willing to absorb the risk

• The institutional segment of the capital market has not yet begun to use derivatives for risk hedging or for position taking in the way that such investors should. First, the development of derivatives has so far been excessively skewed toward derivatives used in the equity rather than debtor forex markets. Second, One the one side India have foreign and privately owned (new generation) domestic banks who run a (interest rate) derivative trading book but do not have the ability to set significant counter party credit limits on a large segment of corporate customers of PSBs. On the other side, are PSBs who have the ability to set significant counter party  credit limits, but are unable or unwilling to write IRS’ or FRAs with them.

• Regulatory conservatism and failure are inhibiting the emergence of more types of derivatives – e.g. currency, interest-rate and credit derivatives as well as long-term tailored as well as traded swaps and swaptions.

Without speculative counter-parties, financial markets would be illiquid, inefficient and ineffective in fulfilling their main purpose as resource mobilising and allocating mechanisms. In financial markets it is speculators (or, in more neutral parlance, insurers, market-makers and options-writers) who enable efficient price-discovery in real-time and allow for efficient, continuous two-way, ‘bid-ask’ market-making.

Nidhi Sethi  

PGDBM 2006, IMT Ghaziabad,  

sethi.nidhi@gmail.com