PROJECT ON DERIVATIVES

Derivatives are contracts which derive their values from the value of one or more of the underlying assets namely equities, foreign exchange, interest bearing securities and commodities. Some of the most commonly traded derivatives are futures, options, forwards and swaps.

A brief details of futures and options are given below:

FUTURES:

The futures market is a zero sum game. All future market participants taken together as a sample can neither make any loss nor make any gain. The process of operation of a futures contract is described below:

Futures are a contract to buy or sell an underlying instrument at a specified future date at the same price the original contract was entered into. The idea behind financial futures contract is to transfer the future changes in security prices from one party in the contract to the other party. It offers a means to manage the risk in participating financial market. Futures basically transfer value rather than create it. It reduces risk faced by one party while at the same time makes the other party assume risk in anticipation of profit. Every futures contract has a two way willing buyer and a willing seller. As a result if one party to the contract makes profit, the other party to the contract will definitely make a loss. That is why this futures market is called a zero sum game.
For successful futures two types of participants are necessary namely HEDGERS and SPECULATORS. Financial futures contracts may be of various types such as:

Ø Interest Rate futures
Ø Treasury Bill Futures
Ø Euro-Dollar Features
Ø Treasury Bond Futures
Ø Stock Index Futures
Ø Currency Futures

However future prices reflect demand and supply conditions in future markets. As is the case in other markets, an increase or decrease in supply lowers or increases the prices of instruments for future delivery.

OPTIONS:

An option contract conveys the right to buy or sell a specific security or commodity at a specified price within a specified period of time. The right to buy is called a call option whereas a right to sell is called a put option. An option contract will comprise the following:
q Type of the option
q Underlying security date
q Strike price at which option maybe exercised

Options are described basically with reference to the underlying commodity. An option on a common stock is called a stock option, an option on bonds are known as bond option, an option on foreign currency are known as currency options while options on future contracts are called future options. The specified price at which the underlying commodity may be bought or sold in case of call option or put option is called the strike price of the option.

The scheme of mechanism as to how the put and call options work is given below:
The basic purpose of exercising any option is to buy or sell the underlying commodity after entering into the option contract. The options are to be exercised before the expiration date. The buyer of an option pays the seller an amount of money called option premium. In return the buyer of the option receives the privilege or right but there is no obligation to buy (in case of call option) or sell ( in case of put option) the underlying commodity at the exercise price. In case of a call option if the price of the commodity exceeds the exercise price, it is advantageous for the buyer to exercise the call option, thereby earning the difference between the two prices, also known as intrinsic value. However contrary to the above if the exercise price exceeds the price of the underlying commodity, the call option is said to be out of money and intrinsic value will be zero and thereby the call option will not be exercised. But the above situation will be advantageous to the put option buyer. The latter can exercise the option to earn the difference between the exercise price and commodity price. From the above it can be seen that options provide investors an opportunity to hedge investments in share portfolios and underlying shares.

Futures and options allow investors to buy and sell forward or at a future date. However it is the upfront amount or the premium paid by them, which acts as a factor of interest rate depending on the volatility of particular scrip. An investor may not be willing to buy immediately due to uncertain market conditions, but he can always buy an option to pick up the shares at a future date. As for every buyer of shares there will be a corresponding seller thereby creating a liquid demand supply market for shares.

Financial derivatives are important tools that can help organizations to meet there specific risk-management objectives and it is important that the user understand the tools intended function and that the necessary safety precautions be taken before the tool is put to use. Financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage risks. Ultimately, financial
derivatives should be considered part of any firm's risk-management strategy to ensure that value-enhancing investment opportunities are pursued. The freedom to manage risk effectively must not be taken away.

The advantages of derivatives to the capital market as a whole are given below :

A tool for hedging: Derivatives provides an excellent mechanism to hedge the future price risk. Think of a farmer, who doesn’t know what price he is going to get for his crop at the time of harvest. He can sell his crop in the futures’ market & lock in the price. If the future spot price is more than the futures price, he can take the off setting position & can get out of the market (with a marginal loss). Otherwise he will get the locked in price.

Risk management: Derivatives provide an excellent mechanism to Portfolio Managers for managing the portfolio risk and to Treasury Managers for managing interest rate risk. The importance of index futures & Forward Rate Agreement (FRA) in this process can’t be overstated.

Better avenues for raising money: With the introduction of currency & interest rate swaps, Indian corporate will be able to raise finance from global markets at better terms.

Price discovery: These derivative instruments make the spot price discovery more reliable using different models like Normal Backwardation hypothesis. These instruments will cause any arbitrage opportunities to disappear & will lead to better price discovery.

Increasing the depth of financial markets: When a financial market gets such sort of risk-management tools, its depth increases since the Institutional Investors get better ways of hedging their risks against unfavorable market movements.

Derivatives market on Indian underlying elsewhere: These days, with the advent of technology, Indian prices are available globally on Reuters & Knightrider. Nothing prevents any foreign market from launching derivatives on these Indian underlying. This will put Indians in a disadvantageous position as they can’t take the advantages of derivatives of securities or commodities traded in India but someone lese can take. So we will have to move fast in this direction.

Empirical evidence: There is strong empirical evidence from other countries that after derivative markets have come about, the liquidity and market efficiency of the underlying market has improved.

A few disadvantages have also been outlined below :

Speculation: Many people fear that these instruments will unnecessarily increase the speculation in the financial markets, which can have far reaching consequences. The recent Barrings Bank incident is the classic case in point.

Market efficiency: Many people fear that the Indian markets are not mature & efficient enough to introduce these instruments. These instruments require a well functioning & mature spot market. Like recently The Economic Times reported the strong correlation of Indian equity markets to the NASDAQ. Such type of market imperfections makes the functioning of derivatives market all the more difficult.

Volatility: The increased speculation & inefficient market will make the spot market more volatile with the introduction of derivatives.

Counter party risk: Most of the derivative intruments are not exchange traded. So there is a counter party default risk in these intruments. Again the same Barrings case, Barrings declared itself bankrupt when it faced huge losses in these instruments.

Liquidity risk: Liquidity of a market means the ease with which one can enter or get out of the market. There is a continued debate about the Indian market’s capability to provide enough liquidity to derivative trader.

FOREIGN EXCHANGE DERIVATIVES:

The gradual liberalization of Indian economy has resulted in substantial inflow of foreign Capital into India. Simultaneously dismantling of trade barriers has also facilitated the Integration of domestic economy with world economy. With the globalization of trade and relatively free movement of financial assets, risk management through derivatives products has become a necessity in India also, like in other developed and developing countries. As Indian businesses become more global in their approach, evolution of a broad based, active and liquid forex derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures. The global market for derivatives has grown substantially in the recent past.

This tremendous growth in global derivative markets can be attributed to a number of factors. They reallocate risk among financial market participants, help to make financial markets more complete, and provide valuable information to investors about economic fundamentals. Derivatives also provide an important function of efficient price discovery and make unbundling of risk easier.

The forex derivative products that are available in Indian financial markets can be sectored into three broad segments viz. forwards, options, currency swaps.



Rupee Forwards

An important segment of the forex derivatives market in India is the Rupee forward contracts market. This has been growing rapidly with increasing participation from corporates, exporters, importers, banks and FIIs. Till February 1992, forward contracts were permitted only against trade related exposures and these contracts could not be cancelled except where the underlying transactions failed to materialize. In March 1992, in order to provide operational freedom to corporate entities, unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade related or not, were permitted.Although due to the Asian crisis, freedom to rebook cancelled contracts was suspended, which has been since relaxed for the exporters but the restriction still remains for the importers.

The exposures for which the rupee forward contracts are allowed under the existing RBI notification for various participants are as follows:

Residents:
§ Genuine underlying exposures out of trade/business
· Exposures due to foreign currency loans and bonds approved by RBI
· Receipts from GDR issued
· Balances in EEFC accounts

Foreign Institutional Investors:
· They should have exposures in India .
· Hedge value not to exceed 15% of equity as of 31 March 1999 plus increase in market value/ inflows

Non−resident Indians/ Overseas Corporates:
· Dividends from holdings in a Indian company
· Deposits in FCNR and NRE accounts
· Investments under portfolio scheme in accordance with FEMA






Cross Currency Forwards:

Cross currency forwards are also used to hedge the foreign currency exposures, especially by some of the big Indian corporates. The regulations for the cross currency forwards are quite similar to those of Rupee forwards, though with minor differences. For example, a corporate having underlying exposure in Yen, may book forward contract between Dollar and Sterling. Here even though its exposure is in Yen, it is also exposed to the movements in Dollar vis a vis other currencies.

Currency Futures

Indian forwards market is relatively illiquid as most of the contracts traded are for the month ends only. One of the reasons for the market makers’ reluctance to offer these contracts could be the absence of a well−developed term money market. It could be argued that given the future like nature of Indian forwards market, currency futures could be allowed.

Some of their advantages are :

Ø Their minimal margin requirements and the low transactions costs relative to over−the−counter markets due to existence of a clearinghouse, also strengthen the case of their introduction.
Ø Credit risks are further mitigated by daily marking to market of all futures positions with gains and losses paid by each participant to the clearinghouse by the end of trading session.
Ø Moreover, futures contracts are standardized utilizing the same delivery dates and the same nominal amount of currency units to be traded. Hence, traders need only establish the number of contracts and their price.
Ø Contract standardization and clearing house facilities mean that price discovery can proceed rapidly and transaction costs for participants are relatively low.







Cross currency options :

The Reserve Bank of India has permitted authorised dealers to offer cross currency options to the corporate clients and other interbank counter parties to hedge their foreign currency exposures. Before the introduction of these options the corporates were permitted to hedge their foreign currency exposures only through forwards and swaps route. Forwards and swaps do remove the uncertainty by hedging the exposure but they also result in the elimination of potential extraordinary gains from the currency position. Currency options provide a way of availing of the upside from any currency exposure while being protected from the downside for the payment of an upfront premium.

Rupee currency options :

Corporates in India can use instruments such as forwards, swaps and options for hedging cross−currency exposures. However, for hedging the USD−INR risk, corporates are restricted to the use of forwards and USD−INR swaps.
Introduction of USD−INR options would enable Indian forex market participants manage their exposures better by hedging the dollar−rupee risk.

Foreign currency − rupee swaps

Another spin−off of the liberalization and financial reform was the development of a fledgling market in FC− RE swaps. A fledgling market in FC− RE swaps started with foreign banks and some financial institutions offering these products to corporates. Initially the market was very small and two way quotes were quite wide, but the market started developing as more market players as well as business houses started understanding these products and using them to manage their exposures. Corporates started using FC−RE swaps mainly for the following purposes:

· Hedging their currency exposures (ECBs, forex trade, etc.)
· To reduce borrowing costs using the comparative advantage of borrowing in local markets (Alternative to ECBs − Borrow in INR and take the swap route to take exposure to the FC currency)




Conclusion:

The Indian forex derivatives market is still in a nascent stage of development but offers tremendous growth potential. The development of a vibrant forex derivatives market in India would critically depend on the growth in the underlying spot/forward markets, growth in the rupee derivative markets along with the evolution of a supporting regulatory structure. Factors such as market liquidity, investor behavior, regulatory structure and tax laws will have a heavy bearing on the behavior of market variables in this market.