Indian Derivatives Markets1

7/31/2019 Indian Derivatives Markets1

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INDIAN DERIVATIVES MARKETS1

Asani Sarkar

Forthcoming in:The Oxford Companion to Economics in India, edited by Kaushik Basu, to be

published in 2006 by Oxford University Press, New Delhi

1

I gratefully acknowledge the assistance of Arkadev Chatterjea, Neel Krishnan, Golaka C.

Nath and V.Soundararajan in the preparation of this article. The views expressed in this article are

mine alone, and do

not necessarily reflect those of the Federal Reserve Bank of New York, or the Federal

Reserve System.Derivatives OUP 1

1. Rise of Derivatives

The global economic order that emerged after World War II was a system where manyless developed countries administered prices and centrally allocated resources. Even the

developed economies operated under the Bretton Woods system of fixed exchange rates.The system of fixed prices came under stress from the 1970s onwards. High inflation and

unemployment rates made interest rates more volatile. The Bretton Woods system was

dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries likeIndia began opening up their economies and allowing prices to vary with market

conditions.

Price fluctuations make it hard for businesses to estimate their future production costs

and revenues.2

Derivative securities provide them a valuable set of tools for managingthis risk. This article describes the evolution of Indian derivatives markets, the popularderivatives instruments, and the main users of derivatives in India. I conclude by

assessing the outlook for Indian derivatives markets in the near and medium term.

2. Definition and Uses of DerivativesA derivative security is a financial contract whose value is derived from the value of

something else, such as a stock price, a commodity price, an exchange rate, an interest

rate, or even an index of prices. In the Appendix, I describe some simple types of

derivatives: forwards, futures, options and swaps.Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge

some preexisting risk by taking positions in derivatives markets that offset potential

losses in the underlying or spot market. In India, most derivatives users describethemselves as hedgers (FitchRatings, 2004) and Indian laws generally require that

derivatives be used for hedging purposes only. Another motive for derivatives trading is

speculation (i.e. taking positions to profit from anticipated price movements). In practice,it may be difficult to distinguish whether a particular trade was for hedging or

speculation, and active markets require the participation of both hedgers and speculators.

3


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A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of

spot and derivatives prices, and thereby help to keep markets efficient. Jogani and

Fernandes (2003) describe Indias long history in arbitrage trading, with line operatorsand traders arbitraging prices between exchanges located in different cities, and between

two exchanges in the same city. Their study of Indian equity derivatives markets in 2002

indicates that markets were inefficient at that time. They argue that lack of knowledge,market frictions and regulatory impediments have led to low levels of capital employed

2

Price volatility may reflect changes in the underlying demand and supply conditions andthereby provide

useful information about the market. Thus, economists do not view volatility as necessarily

harmful.

3Speculators face the risk of losing money from their derivatives trades, as they do with

other securities.

There have been some well-publicized cases of large losses from derivatives trading. In

some instances,these losses stemmed from fraudulent behavior that went undetected partly because

companies did not haveadequate risk management systems in place. In other cases, users failed to understand why

and how they

were taking positions in the derivatives. Derivatives OUP 2

in arbitrage trading in India. However, more recent evidence suggests that the efficiency

of Indian equity derivatives markets may have improved (ISMR, 2004).

3. Exchange-Traded and Over-the-Counter Derivative InstrumentsOTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated

between two parties. The terms of an OTC contract are flexible, and are often customized

to fit the specific requirements of the user. OTC contracts have substantial credit risk,which is the risk that the counterparty that owes money defaults on the payment. In India,

OTC derivatives are generally prohibited with some exceptions: those that are

specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities(which are regulated by the Forward Markets Commission), those that trade informally in

havala or forwards markets.

An exchange-traded contract, such as a futures contract, has a standardized format that

specifies the underlying asset to be delivered, the size of the contract, and the logistics ofdelivery. They trade on organized exchanges with prices determined by the interaction of

many buyers and sellers. In India, two exchanges offer derivatives trading: the Bombay

Stock Exchange (BSE) and the National Stock Exchange (NSE). However, NSE nowaccounts for virtually all exchange-traded derivatives in India, accounting for more than

99% of volume in 2003-2004. Contract performance is guaranteed by a clearinghouse,

which is a wholly owned subsidiary of the NSE.4Margin requirements and daily

marking-to-market of futures positions substantially reduce the credit risk of

exchangetraded contracts, relative to OTC contracts.

5


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4. Development of Derivative Markets in India

Derivatives markets have been in existence in India in some form or other for a long

time. In the area of commodities, the Bombay Cotton Trade Association started futurestrading in 1875 and, by the early 1900s India had one of the worlds largest futures

industry. In 1952 the government banned cash settlement and options trading and

derivatives trading shifted to informal forwards markets. In recent years, governmentpolicy has changed, allowing for an increased role for market-based pricing and less

suspicion of derivatives trading. The ban on futures trading of many commodities was

lifted starting in the early 2000s, and national electronic commodity exchanges werecreated.

In the equity markets, a system of trading called badla involving some elements of

forwards trading had been in existence for decades.

6However, the system led to a

number of undesirable practices and it was prohibited off and on till the Securities and

4

A clearinghouse guarantees performance of a contract by becoming buyer to every sellerand seller to

every buyer.5

Customers post margin (security) deposits with brokers to ensure that they can cover a

specified loss onthe position. A futures position is marked-to-market by realizing any trading losses in cash

on the day they

occur.

6Badla allowed investors to trade single stocks on margin and to carry forward positions

to the next

settlement cycle. Earlier, it was possible to carry forward a position indefinitely but laterthe maximum

carry forward period was 90 days. Unlike a futures or options, however, in a badla trade

there is no fixedexpiration date, and contract terms and margin requirements are not standardized.

Derivatives OUP 3

Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the

stock market between 1993 and 1996 paved the way for the development ofexchangetraded equity derivatives markets in India. In 1993, the government created the

NSE in

collaboration with state-owned financial institutions. NSE improved the efficiency andtransparency of the stock markets by offering a fully automated screen-based trading

system and real-time price dissemination. In 1995, a prohibition on trading options was

lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives.The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased

introduction of derivative products, and bi-level regulation (i.e., self-regulation by

exchanges with SEBI providing a supervisory and advisory role). Another report, by the

J. R. Varma Committee in 1998, worked out various operational details such as the


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margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or

SC(R)A, was amended so that derivatives could be declared securities. This allowed

the regulatory framework for trading securities to be extended to derivatives. The Actconsiders derivatives to be legal and valid, but only if they are traded on exchanges.

Finally, a 30-year ban on forward trading was also lifted in 1999.

The economic liberalization of the early nineties facilitated the introduction of derivativesbased on interest rates and foreign exchange. A system of market-determined exchange

rates was adopted by India in March 1993. In August 1994, the rupee was made fully

convertible on current account. These reforms allowed increased integration betweendomestic and international markets, and created a need to manage currency risk. Figure 1

shows how the volatility of the exchange rate between the Indian Rupee and the U.S.

dollar has increased since 1991.7

The easing of various restrictions on the free movementof interest rates resulted in the need to manage interest rate risk.

Figure 1: Volatility of Exchange Rate Between

Indian Rupee and U.S. Dollar

00.5

11.5

2

2.53

3.5

1973

19751977

1979

19811983

1985

19871989

1991

1993

19951997

1999

20012003

2005

VolatilitySource: Authors calculations, based on daily exchange rate data.

5. Derivatives Instruments Traded in India

In the exchange-traded market, the biggest success story has been derivatives on equity

products. Index futures were introduced in June 2000, followed by index options in June


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2001, and options and futures on individual securities in July 2001 and November 2001,

respectively. As of 2005, the NSE trades futures and options on 118 individual stocks and

7

Volatility is measured as the yearly standard deviation of the daily exchange rate series.

Derivatives OUP 43 stock indices. All these derivative contracts are settled by cash payment and do not

involve physical delivery of the underlying product (which may be costly).

8Derivatives on stock indexes and individual stocks have grown rapidly since inception. In

particular, single stock futures have become hugely popular, accounting for about half of

NSEs traded value in October 2005. In fact, NSE has the highest volume (i.e. number of

contracts traded) in the single stock futures globally, enabling it to rank 16 among worldexchanges in the first half of 2005. Single stock options are less popular than futures.

Index futures are increasingly popular, and accounted for close to 40% of traded value in

October 2005. Figure 2 illustrates the growth in volume of futures and options on the

Nifty index, and shows that index futures have grown more strongly than index options.9

Figure 2: Volume of Futures and Options on NiftyIndex

0

20004000

6000

Number of contracts

6/01 12/01 6/02 12/02 6/03 12/03 6/04 12/04Futures volume (in units of 1 lakh contracts)

Options volume (in units of 10,000 contracts)

Source: Authors calculations, based on NSE data.NSE launched interest rate futures in June 2003 but, in contrast to equity derivatives,

there has been little trading in them. One problem with these instruments was faulty

contract specifications, resulting in the underlying interest rate deviating erratically fromthe reference rate used by market participants. Institutional investors have preferred to

trade in the OTC markets, where instruments such as interest rate swaps and forward rate

agreements are thriving. As interest rates in India have fallen, companies have swapped

their fixed rate borrowings into floating rates to reduce funding costs.10

Activity in OTC

markets dwarfs that of the entire exchange-traded markets, with daily value of tradingestimated to be Rs. 30 billion in 2004 (FitchRatings, 2004).

Foreign exchange derivatives are less active than interest rate derivatives in India, even

though they have been around for longer. OTC instruments in currency forwards andswaps are the most popular. Importers, exporters and banks use the rupee forward market

8

Settlement represents the exchange of a security and its payment.


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9

Nifty is an index of 50 stocks comprising 60% of NSEs total market capitalization as of

March 31 2005.10

In an interest rate swap, a company may receive a floating rate (linked to a benchmark

rate) and pay afixed rate. A forward rate agreement allows a company to lock in a particular interest rate.

Derivatives OUP 5

to hedge their foreign currency exposure. Turnover and liquidity in this market has been

increasing, although trading is mainly in shorter maturity contracts of one year or less

(Gambhir and Goel, 2003). In a currency swap, banks and corporations may swap its

rupee denominated debt into another currency (typically the US dollar or Japanese yen),or vice versa. Trading in OTC currency options is still muted. There are no exchangetraded

currency derivatives in India.

Exchange-traded commodity derivatives have been trading only since 2000, and the

growth in this market has been uneven. The number of commodities eligible for futurestrading has increased from 8 in 2000 to 80 in 2004, while the value of trading has

increased almost four times in the same period (Nair, 2004). However, many contractsbarely trade and, of those that are active, trading is fragmented over multiple market

venues, including central and regional exchanges, brokerages, and unregulated forwards

markets. Total volume of commodity derivatives is still small, less than half the size ofequity derivatives (Gorham et al, 2005).

6. Derivatives Users in India

The use of derivatives varies by type of institution. Financial institutions, such as banks,

have assets and liabilities of different maturities and in different currencies, and areexposed to different risks of default from their borrowers. Thus, they are likely to use

derivatives on interest rates and currencies, and derivatives to manage credit risk.

Nonfinancial institutions are regulated differently from financial institutions, and thisaffects

their incentives to use derivatives. Indian insurance regulators, for example, are yet to

issue guidelines relating to the use of derivatives by insurance companies.In India, financial institutions have not been heavy users of exchange-traded derivatives

so far, with their contribution to total value of NSE trades being less than 8% in October

2005. However, market insiders feel that this may be changing, as indicated by the

growing share of index derivatives (which are used more by institutions than by retailinvestors). In contrast to the exchange-traded markets, domestic financial institutions and

mutual funds have shown great interest in OTC fixed income instruments. Transactions

between banks dominate the market for interest rate derivatives, while state-owned banksremain a small presence (Chitale, 2003). Corporations are active in the currency forwards

and swaps markets, buying these instruments from banks.

Why do institutions not participate to a greater extent in derivatives markets? Someinstitutions such as banks and mutual funds are only allowed to use derivatives to hedge

their existing positions in the spot market, or to rebalance their existing portfolios. Since

banks have little exposure to equity markets due to banking regulations, they have little

incentive to trade equity derivatives.


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11

Foreign investors must register as foreign

institutional investors (FII) to trade exchange-traded derivatives, and be subject toposition limits as specified by SEBI. Alternatively, they can incorporate locally as a

11

Under RBI directive, banks direct or indirect (through mutual funds) exposure to capitalmarkets

instruments is limited to 5% of total outstanding advances as of the previous year-end.

Some banks mayhave further equity exposure on account of equities collaterals held against loans in default.

Derivatives OUP 6

broker-dealer.12

FIIs have a small but increasing presence in the equity derivatives

markets. They have no incentive to trade interest rate derivatives since they have little

investments in the domestic bond markets (Chitale, 2003). It is possible that unregisteredforeign investors and hedge funds trade indirectly, using a local proprietary trader as a

front (Lee, 2004).Retail investors (including small brokerages trading for themselves) are the major

participants in equity derivatives, accounting for about 60% of turnover in October 2005,

according to NSE. The success of single stock futures in India is unique, as thisinstrument has generally failed in most other countries. One reason for this success may

be retail investors prior familiarity with badla trades which shared some features of

derivatives trading. Another reason may be the small size of the futures contracts,

compared to similar contracts in other countries. Retail investors also dominate themarkets for commodity derivatives, due in part to their long-standing expertise in trading

in the havala or forwards markets.

7. Summary and ConclusionsIn terms of the growth of derivatives markets, and the variety of derivatives users, the

Indian market has equalled or exceeded many other regional markets.13

While the growthis being spearheaded mainly by retail investors, private sector institutions and large

corporations, smaller companies and state-owned institutions are gradually getting into

the act. Foreign brokers such as JP Morgan Chase are boosting their presence in India in

reaction to the growth in derivatives. The variety of derivatives instruments available fortrading is also expanding.

There remain major areas of concern for Indian derivatives users. Large gaps exist in the

range of derivatives products that are traded actively. In equity derivatives, NSE figuresshow that almost 90% of activity is due to stock futures or index futures, whereas trading

in options is limited to a few stocks, partly because they are settled in cash and not the

underlying stocks. Exchange-traded derivatives based on interest rates and currencies arevirtually absent.

Liquidity and transparency are important properties of any developed market. Liquid

markets require market makers who are willing to buy and sell, and be patient while

doing so. In India, market making is primarily the province of Indian private and foreign


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banks, with public sector banks lagging in this area (FitchRatings, 2004). A lack of

market liquidity may be responsible for inadequate trading in some markets.

Transparency is achieved partly through financial disclosure. Financial statements12

In practice, some foreign investors also invest in Indian markets by issuing Participatory

Notes to an offshore investor.13

Among exchange-traded derivative markets in Asia, India was ranked second behind S.

Korea for thefirst quarter of 2005. How about China, with who India is frequently compared in other

respects? China is

preparing to develop its derivatives markets rapidly. It has recently entered into joint

ventures with theleading U.S. futures exchanges. It has taken steps to loosen currency controls, and the

Central Bank has

allowed domestic and foreign banks to trade yuan forward and swaps contracts on behalf of

clients.However, unlike India, China has not fully implemented necessary reforms of its stock

markets, which islikely to hamper growth of its derivatives markets. Derivatives OUP 7

currently provide misleading information on institutions use of derivatives. Further,there is no consistent method of accounting for gains and losses from derivatives trading.

Thus, a proper framework to account for derivatives needs to be developed.

Further regulatory reform will help the markets grow faster. For example, Indian

commodity derivatives have great growth potential but government policies have resultedin the underlying spot/physical market being fragmented (e.g. due to lack of free

movement of commodities and differential taxation within India). Similarly, credit

derivatives, the fastest growing segment of the market globally, are absent in India andrequire regulatory action if they are to develop.

14

As Indian derivatives markets grow more sophisticated, greater investor awareness will

become essential. NSE has programmes to inform and educate brokers, dealers, traders,

and market personnel. In addition, institutions will need to devote more resources to

develop the business processes and technology necessary for derivatives trading.14

See Chitale (2002) for an assessment of reforms needed for the development of credit

derivatives. Derivatives OUP 8References

Chitale, Rajendra P., 2003, Use of Derivatives by Indias Institutional Investors: Issues

and Impediments, in Susan Thomas (ed.), Derivatives Markets in India, Tata McGrawHillPublishing Company Limited, New Delhi, India.

FitchRatings, 2004, Fixed Income Derivatives---A Survey of the Indian Market,

www.fitchratings.com

www.fitchratings.com


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Gambhir, Neeraj and Manoj Goel, 2003, Foreign Exchange Derivatives Market in India--

-Status and Prospects, Susan Thomas (ed.), Derivatives Markets in India, Tata McGrawHill

Publishing Company Limited, New Delhi, India.Gorham, Michael, Thomas, Susan and Ajay Shah, 2005, India: The Crouching Tiger,

Futures Industry.

Lee, Rupert, 2004, Seeing Double, FOW.ISMR, Indian Securities Market: A Review, 2004, National Stock Exchange of India

Limited, Mumbai, India.

Jogani, Ashok and Kshama Fernandes, 2003, Arbitrage in India: Past, Present and Future,in Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw-Hill Publishing

Company Limited, New Delhi, India.

Nair, C. G. K., 2004, Commodity Futures Markets in India: Ready for Take Off?

National Stock Exchange of India Limited, Mumbai, India. Derivatives OUP 9

APPENDIX: Forwards, Futures, Options, and Swaps

I begin with a description of the simplest types of derivatives: forwards, futures, options

and swaps. To illustrate a forward contract, consider the following example (unlessotherwise stated, all prices are in rupees per gram). Jewelry manufacturer Goldbuyer

agrees to buy gold at Rs. 600 (the forward or delivery price) three months from now(the delivery date) from gold mining concern Goldseller. This is an example of a

forward contract. No money changes hands between Goldbuyer and Goldseller at the

time the forward contract is created. Rather, Goldbuyers payoff depends on the spotprice at the time of delivery. Suppose that the spot price reaches Rs. 610 at the delivery

date. Then Goldbuyer gains Rs. 10 on his forward position (i.e. the difference between

the spot and forward prices) by taking delivery of the gold at Rs. 600.

A futures contract is similar to a forward contract, with some exceptions. Futurescontracts are traded on exchange markets, whereas forward contracts typically trade on

OTC (over-the-counter) markets. Also, futures contracts are settled daily (marked-

tomarket), whereas forwards are settled only at expiration.Returning to the example above, suppose that Goldbuyer believes that there is some

chance for the spot price to fall below Rs. 600, so that he loses on his forward position.

To limit his loss, Goldbuyer could purchase a call option for Rs. 5 (the option price orpremium) at a strike or exercise price of Rs. 600 with an expiration date three months

from now. The call option gives Goldbuyer the right (but not the obligation) to buy gold

at the strike price on the expiration date.

15Then, if the spot price indeed declines, he

could choose not to exercise the option, and his loss would be limited to the purchase

price of Rs. 5. Alternatively, Goldbuyer may anticipate that the spot gold price is verylikely to decline, and attempt to profit from such an eventuality by buying a put option,

giving him the right to sell gold at the strike price on the expiration date.

Swaps are derivatives involving exchange of cash flows over time, typically between twoparties. One party makes a payment to the other depending upon whether a price is above

or below a reference price specified in the swap contract.

15


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The example describes a European option. By contrast, an American option would have

allowed the

buyer to exercise the option on or before the exercise date.

Derivatives Market: Types of

DerivativesThursday, June 9, 2011, 16:51 [IST]

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Primarily, Derivatives Market has been divided in two parts:

Over-the-counter (OTC) Market and Exchange-traded Market

where derivatives like Forwards, Futures, Swaps and Options

are traded.

Normally, these derivatives are tool to manage risk attached to

asset, but one needs to have lot of expertise to use them in their

trading strategy due to their complexity. Below is the detailed

explanation of the various derivative contracts.

Forwards:A forward contract is the customized contract

between two parties, where settlement takes place on a specific

date in future at today's pre-agreed price. Forwards represent

the obligation to make a transaction at a set point in time in the

future. Once you enter into a forward-based contract, you are

obligated to make the transaction unless both parties agree to

cancel or otherwise modify the agreement.

Forward contracts trade over the counter (OTC), thus the terms

of the deal can be customized to fit the needs of both the buyer

and the seller. They are unique in terms of contract size, expiry

date, asset type and quality.

Forward contracts draw in counter-party risk i.e. the counter-

party defaults and is unable to pay the cash difference or deliver

the asset.

Futures: A futures contract is an agreement between two parties

to buy or sell an asset at a certain time in the future at a certain

price. Futures contracts are special types of forward contracts in


12/28

the sense that the former are standardized exchange-traded

contracts. When a forward contract is traded on a recognized

exchange, it is referred to as a futures contract". Examples of

futures include commodities, interest rates, currencies, and stock

market indices.

Futures can be used either to hedge or to speculate on the price

movement of the underlying asset. For example, an airline uses

crude oil futures for hedging purpose to lock in a certain price

and reduce risk. Similarly, anybody could speculate on the price

movement of crude oil by going long or short using futures.Some future contracts may call for physical delivery of the asset,

while others are settled in cash.

How Futures Contract work?

The futures market is a centralized market place for buyers and

sellers from around the world who meet and enter into futures

contracts. Pricing can be based on an open cry system, or bidsand offers can be matched electronically. The futures contract

will state the price that will be paid and the date of delivery, also

known as the expiry date.

Options: An option gives the contract holder the right to buy or

sell on a specified date in the future - but they are under no

obligation. Options are of two types - calls and puts. Calls give

the buyer the right but not the obligation to buy a given quantity

of the underlying asset, at a given price on or before a given

future date. Puts give the buyer the right, but not the obligation to


13/28

sell a given quantity of the underlying asset at a given price on or

before a given date.

Players in the Options Market:Developmental institutions, Mutual Funds, Financial Institutions,

FIIs, Brokers, Retail Participants are the likely players in the

Options Market.

Some of the examples of Options are Index Options, Options on

individual stocks, Bond options, Interest Rate Futures Options,

etc.

Swaps: Swaps are the types of Forward contracts and they

occupy an important role in International Finance. They are

private agreements between two parties to exchange cash flows

in the future according to a prearranged formula. They are

generally an agreement to exchange one stream of cashflows to

another.

Swaps have been categorised into four parts:

Interest rate swaps

Currency swaps

Commodity swaps

Equity swaps

OneIndia Money

Advantages and Disadvantages ofDerivatives


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ADVERTISEMENTS

Derivatives serve an important function in the market.They are a very good tool to hedge your risk. Rememberthat you may lose chance to make extra money if thingsturn out extremely well. This is important for you tounderstand because derivatives are tools for hedging. Ifyou are willing to take risk and speculate, you make bigmoney but there is equal chance of losing big money.

Secondly, derivatives help discover price of an asset. Howwill you decide what price to pay for a stock of a company?The price of a stock in Capital Market segment follows theprice of a derivative on the stock of the same company.However, sometimes vice-versa is also true.Thirdly, derivatives have become a very important tool intodays market where businesses, exchanges, banks, andfinancial centers are connected. The trade amongcountries has multiplied but that has also given rise to riskof currency, inflation, and interest rate. Derivatives can beused to hedge many of these risks.

Lastly (and there will be certainly more), derivatives arean innovative financial products. There is no risk, noscenarios, which derivatives cannot take care. The sheeropportunity for product innovation in the area ofderivatives has given it a formidable size in todaysmarket. As an estimate, in the peak time of 2008, therewere more than $60 trillion derivatives in the market. Thisis much more than the GDP of the world.

1. Introduction

Derivative securities generate profits that are functions of changes in the price ofunderlying assets. Why do investment managers use derivatives? Theoretical work has


15/28

advocated derivatives as a useful tool that allows investment managers to utilize

information better, manage risk, and reduce transaction costs [Scholes (1981) and Stoll

and Whaley (1985)]. In contrast, recent popular press commonly portrays derivatives asspeculative, high-risk investments [see, for example, McGough (1995a, 1995b)]. Public

concern has been strong enough to prompt the Securities and Exchange Commission to

reevaluate risk disclosure requirements for mutual funds [Taylor and Calian (1995)] andto provoke possible regulatory initiatives [Anderson (1994)].

Although derivative us e ha s gene r a t ed subs t ant i a l a t t ent ion f rom many

communities, no empirical evidence exists that documents how derivative securities areactually used by investment managers. This paper analyzes the use of derivatives by

equity mutual funds, by comparing the return characteristics of funds that use derivatives

to those that do not. We study portfolio returns, instead of individual trading in

derivatives, because the ability to trade derivatives is likely to affect managers decisionsto trade non-derivatives. Our focus is on three alternative ways derivatives may affect the

distribution of a mutual funds returns. First, funds that invest in derivatives may have

higher or lower risk than funds that do not invest in derivatives. Second, managers

investing in derivatives may improve net portfolio performance, either due to lowertransaction costs or because managers better utilize information.

1Finally, managers may

use derivatives to affect intertemporal changes in the funds risk exposure, for example, to

respond to cash flows from investor purchases and redemptions, or to allow fu

Financial

Institutions

CenterRisks in Derivatives Markets

by

Ludger HentschelClifford W. Smith, Jr.

96-24THE WHARTON FINANCIAL INSTITUTIONS CENTER

The Wharton Financial Institutions Center provides a multi-disciplinary research approachto

the problems and opportunities facing the financial services industry in its search for

competitive excellence. The Center's research focuses on the issues related to managing

riskat the firm level as well as ways to improve productivity and performance.

The Center fosters the development of a community of faculty, visiting scholars and Ph.D.

candidates whose research interests complement and support the mission of the Center.The

Center works closely with industry executives and practitioners to ensure that its research

isinformed by the operating realities and competitive demands facing industry participants as

they pursue competitive excellence.

Copies of the working papers summarized here are available from the Center. If you would

like to learn more about the Center or become a member of our research community, please


16/28

let us know of your interest.

Anthony M. Santomero

DirectorThe Working Paper Series is made possible by a generous

grant from the Alfred P. Sloan FoundationLudger Hentschel and Clifford W. Smith are at

the William E. Simon School of Business Administration, University1

of Rochester, Rochester, NY 14627.

The authors gratefully acknowledge financial support from the John M. Olin Foundationand the Bradley Policy Research

Center, as well as helpful conversations with D.H. Chew, S.P. Kothari, R.J. Mackay, and

C.W. Smithson. In addition, two

anonymous referees made many helpful suggestions. Parts of the analysis in this paperappeared in less technical form in

"Controlling Risks in Derivatives Markets," Journal of Financial Engineering, (Vol. 4, No.

2, pp. 101-125).

Risks in Derivatives Markets1

November 20, 1995Abstract : The debate over risks and regulation in derivatives markets has failed to provide

a clear analysis of what risks are and whether regulation is useful for their control. In this

paper we provide a parametric model to analyze default risk in derivative contracts. A firmis less likely to default on an obligation on derivatives than on its corporate bonds because

bonds are always a liability, while derivatives can be assets. Using default rates for

corporate bonds, we provide an upper bound for the default risk of derivativesone

substantially lower than the popular debate seems to imply. Systemic risk is theaggregation of default risks; since default risk has been exaggerated, so has systemic risk.

Finally, this debate seems to have ignored what we call "agency risk." Features of widely

used incentive contracts for derivatives traders can induce them to take very riskypositions, unless they are carefully monitored.

Keywords : Agency risk, default, derivatives, futures, forwards, hedging, options, risk

management, regulation, swaps.1. IntroductionThe continuing discussion of risks and regulation in derivative markets illustrates

that there is little agreement on what the risks are or whether regulation is a

useful tool for their control.

1One source of confusion is the sheer profusion of

names describing the risks arising from derivatives. Besides the price risk of

potential losses on derivatives from changes in interest rates, foreign exchangerates, or commodity prices, there is default risk (sometimes referred to as

counterparty risk ), liquidity (or funding) risk, legal risk, settlement risk

(or, a variation thereof, Herstatt risk), and operations risk. Last, but notleast, is systemic riskthe notion of problems throughout the financial system

that seems to be at the heart of many regulatory concerns.

In this paper, we analyze the risks associated with derivative transactions,


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and the impact of regulation in limiting these risks. We provide a simple, parametric

framework in which one can analyze price, default and systemic risk. In

section 2, we review price riskthat is, the potential for losses on derivativepositions stemming from changes in the prices of the underlying assets (for instance,

interest rates, exchange rates, and commodity prices). In section 3, we

examine default risk by either party to a derivatives contracta risk that webelieve has been largely misunderstood and exaggerated. The existence of price

risk has been documented by several large, highly publicized derivatives losses.

There are, however, hardly any examples of default in derivative markets. Weargue that this is a trend can be expected to continue.

In section 4, we argue that systemic risk is simply the aggregation of default

risks faced by individual firms in using derivatives. In brief, we argue that

the possibility of widespread default throughout the financial system caused byderivatives has been exaggerated, principally due to the failure to appreciate the

low default risk associated with individual derivative contracts. Partly for this

reason, current regulatory proposals should be viewed with some skepticism.

In particular, none of the proposals recognize the fundamental dependence ofdefault risk on how derivatives are used.

1We use the term derivative to refer to financial contracts that explicitly have the features

of options, futures, forwards, or swaps.2 Risks in Derivatives Markets

In section 5, we suggest that recent, highly publicized losses can be attributed largely toimproper compensation, control and supervision within firms.

We define derivative risks stemming from these sources as agency risks, a reference to

the principalagent conflicts from which they arise. For instance, we

believe that some standard evaluation and compensation systems can be illsuited foremployees granted decision rights over derivatives transactions. Firms

that pay large bonuses based on short-term performance can encourage excessive

risk-taking by employees. Despite limited public discussion, it appears that firmsare aware of these issues and are working to control the problems. In section 6,

we offer a few concluding remarks.

2. Price RiskThe modern analysis of financial derivatives is unified by the successful application of

absence of arbitrage pricing arguments. In their seminal work, Black and

Scholes (1973) and Merton (1973) first showed how to price optionsthe last

class of derivatives to elude this analysisvia absence of arbitrage.The ability to use arbitrage pricing in valuing derivatives has at least one

profound implication for the current public debate on derivatives. Redundant

securities logically cannot introduce any new, fundamentally different risks intothe financial system. To the extent that derivatives are redundant, they cannot

increase the aggregate level of risk in the economy. Derivatives can, however,

isolate and concentrate existing risks, thereby facilitating their efficient transfer.Indeed, it is precisely this ability to isolate quite specific risks at low transactions

costs that makes derivatives such useful risk-management tools.

For derivatives, the composition of the replicating portfolios can vary considerably over

time and maintaining these portfolios can involve extensive and


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costly trading.

2

Even if such trading costs introduce a degree of imprecision intoderivative pricing models, virtually all derivatives can be valued using arbitrage

models. (In fact, to the extent that transaction costs introduce a degree of im-

2Note that the trading required to replicate the payoffs depends critically on the other

outstanding positions managed by the firm. Required trading costs for a market maker with

anextensive derivatives position book are generally dramatically less than the sum of the

trades

to replicate the individual contracts.Sec. 2] Price Risk 3

precision into derivative pricing models, derivatives are likely to provide moreefficient hedges than synthetic derivatives used to hedge the same risks. )

The standard use of derivatives is in managing price risks through hedging. Firms with a

core business exposure to underlying factors such as commodity prices, exchange or

interest rates, can reduce their net exposures tothese factors by assuming offsetting exposures through derivatives. Rational,

value-maximizing motivations for such corporate hedging activities are providedby Mayers and Smith (1982, 1987); Stulz (1984); Smith and Stulz (1985); and

Froot, Scharfstein, and Stein (1993) among others.

Although risk aversion can provide powerful incentives to hedge for individuals, thisusually is not the motive for large public companies whose owners

can adjust their risk exposures by adjusting the composition of their portfolios.

Rather, current theory suggests that incentives to hedge stem from progressive

taxes, contracting costs, or underinvestment problems. All of these issues areinternal to the firm and cannot be solved by external investors.

2.1. Exposure

For simplicity, we assume that the value of the firm is inherently quadratic in aassume that the firm is operating with fixed production technology and scale

case, the firm has an incentive to reduce its exposure to the underlying factors

in order to reduce the quadratic cost term.This formulation can be interpreted as a local approximation to firm value

for any of the aforementioned hedging motives. For example, if taxes motivate

hedging, after-tax income is a concave function of income and the quadratic

specification can be viewed as an approximation to after-tax income. Similarly,3

While this gives rise to negative firm values, adding back a constant mean does not

produce additional insights.4 Risks in Derivatives Marketsif bankruptcy or underinvestment costs rise as firm value falls, then the above

formulation can approximate this behavior.

42.2. Hedging

Next, assume that there is a set of financial instruments with mean zero (net)

be applied to any financial contract in efficient markets. For derivative contracts

such as forwards, futures, or swaps, whose payoffs are linear in the underlying


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For derivatives like forwards and options, the single payment date is an

accurate representation of the actual contract. For derivatives like futures and

swaps with multiple payment dates, this characterization ignores the sequentialnature of payments. For these contracts, the single payment date can be interpreted as the

maturity date of the contract, with all payments cumulated to

maturity.If the firm can transact in this financial market without costs, then firm

value is given by

(2)The characterization of the firm and its derivatives positions in eq. (2) abstracts from most

dynamic intertemporal features. The single-period framework,

however, permits us to better focus on the relation between derivatives positions

and default than alternative dynamic approaches. Johnson and Stulz (1987),for example, assume that the net worth of an option writer and the underlying

price have a constant correlation that is exogenous to their model. Conditional

on this assumption, they can exactly price options with default risk. Cooper

and Mello (1991), Sorensen and Bollier (1994), Jarrow and Turnbull (1995), and4

Although we dont view this as the typical hedging motivation, our parameterization offirm value also can be interpreted as a quadratic approximation to the concave utility

function

of a risk averse owner.5

Referring to these cases, we will not always make a careful distinction between underlying

prices and payoffs. For contracts such as options, whose payoffs are nonlinear in the

underlyingprice, this distinction is important, however.Sec. 2] Price Risk 5

Longstaff and Schwartz (1995) also provide pricing models for financial contracts

in the presence of default risk. They make the same tradeoff as Johnson andStulz (1987) and take the source of the default risk as exogenous to their model.

In contrast, we structure our model specifically to illustrate that the correlation

between firm value and derivative obligations is a crucial ingredient in defaultrisk, and furthermore that this correlation depends on the firms derivatives position.

2.3. Impact of Hedging

The optimal position in the financial contracts is found by optimizing the value

(3)(4)

is the matrix of

(5)To be an effective hedge, the financial contract must be highly correlated

is small in order to limit the introduction of additional uncertainty through

of derivatives is that they individually target the potentially large sources ofvariation, such as interest rates, exchange rates, or commodity prices, without

introducing additional sources of variation.6 Risks in Derivatives Markets

FIGURE 1: Firm value, exposures, and hedging.

that the firms exposure to x is negative.


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6

To display the payoff from the finanby the dashed line. Finally, the dashed and dotted

curve labeled VH shows thenet exposure of firm value including the derivatives contracts.

The figure shows that hedging operates through two channels. First, the

hedge reduces the net exposure to the underlying risk factor, which reducesvariation in firm value. This is evident from the reduced slope of VH compared

The exposure shown in figure 1 might be appropriate for a chemical proan oil producer is

likely to have a positive exposure to the price of crude oil. Inour framework, the oil producers firm value would be that of the oil consumer

producer, but it would be upward sloping. In this case, hedging would again

reduce both the slope and the concavity of this value function.

as exposure in the context of exchange and interest rates, respectively.Sec. 3] Default risk 73. Default risk

Default risk is the risk that losses will be incurred due to default by the counterparty. As

noted above, part of the confusion in the current debate about derivatives stems from the

profusion of names associated with default risk. Terms suchas credit risk and counterparty risk are essentially synonyms for default risk.

Legal risk refers to the enforceability of the contract. Terms such as settlement risk andHerstatt risk refer to defaults that occur at a specific point in

the life of the contract: the date of settlement. These terms do not represent

independent risks; they just describe different occasions or causes of default.In most derivatives contracts, either party may default during the life of

the contract.

7

In a swap, for example, either side could default on any of thesettlement dates during the life of the swap. In practice, a firm may be able to

accelerate default. For example, once it becomes clear that a firm will ultimately

be unable to meet all of its obligations, the firm may elect to enter bankruptcyproceedings now, even though current obligations do not force this step. The

firm would only chose this path if it is in the firms best interest, and hence there

may be an optimal default policy. While such timing issues may be important,especially for firms near bankruptcy, we abstract from these complications and

continue to focus on the default risk posed by one side of the contract at a single

payment dates.

8Default risk has two components: the expected exposure, (the expected

replacement cost of the contract minus the expected recovery from the counterparty) and

the probability that default will occur.3.1. Expected exposure

The expected exposure measures how much capital is likely to be at risk should

7Options form the notable exception to this rule. An option buyer cannot default after

the purchase of the option since he does not have any further obligations to pay under the

option contract. Hence, in option markets only the option writer poses default risk.

8


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One reason we believe that this is a reasonable tradeoff is that it is unlikely that payments

obligated under derivatives trigger default. The more likely it is that default is triggered by

obligated payments to other claim holders, the less important it is to focus on theintertemporal

details of the cashflows under derivatives contracts without modeling these details of bond,

employee, and lease contracts.8 Risks in Derivatives Marketsthe counterparty default. The notional principal amounts of derivatives like

forwards and swaps grossly overstate actual default exposure. For example, in

interest rate swaps only net interest payments are exchanged. These paymentsare a small fraction of the notional principal of the swap. In fact, the US General

Accounting Office (GAO) estimates that the net credit exposure on swaps is

approximately l% of notional principal.

In addition to the expected value of the derivative at the time of default, expected exposurealso depends on expected recovery rates after default. (Current

capital standards implicitly assume that the recovery rate is zero, which leads

to a material overstatement of the expected loss.) Most swaps are unsecured

claims in bankruptcy proceedings. For unsecured (senior) claims, recovery ratesaverage about 50% (Franks and Torous, 1994for collateralized claims recovery

rates are closer to 80%. )Finally, the expected exposure depends on whether the contract includes

imbedded options. Specifically, if the swap stipulates a floor rate, the buyers

obligations and the magnitude of the losses it could cause in a default are contractuallylimited.

3.2. Probability of default

Default on any financial contract, including derivatives, occurs when two conditions are

met simultaneously: a party to the contract owes a payment under thecontract, and the counterparty cannot obtain timely payment.

9

Under U.S. law,this means that the defaulting party either has insufficient assets to cover the

required payments, or has successfully filed for protection under the bankruptcy

code.The fact that default only occurs when two conditions hold simultaneously

implies that it is a bivariate phenomenon. To capture the nature of default risk,

we therefore have to consider the bivariate distribution of the counterpartys

obligation under the derivative contract as well as its ability to pay. For simplic-9

In our discussion of default, we generally ignore technical default since it has no direct

cash flow consequences. However, many derivative contracts have cross-default clauseswhich

can place a party into technical default. Should the counterparty try to unwind the contract

under the default terms but fail, then default occurs. On the other hand, if the contract canbe unwound at market value, then technical default has no valuation consequences.Sec. 3]

Default risk 9

FIGURE 2: Insolvency and default on derivatives.

Conversely, we assume that the firms obligation under the derivative contract


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is illustrated in figure 2. Although the firm is insolvent in the shaded areas

of quadrants II and III, it only owes payments on the derivative in the shaded

areas of quadrants III and IV. Hence, default on the derivative is confined to thecross-hatched area in quadrant III.

The probability of default is given by the joint probability that the firm

which is given by the cumulative density function(6)10 Risks in Derivatives Markets

FIGURE 3: Firm value and asset prices. The case of zero correlation.

Moreover, if we are willing to make specific distributional assumptionsand Wishart densities.) In principle, one could also directly estimate the joint

As we will argue later, however, default is a relatively rare phenomenon, which

implies that the default probability depends strongly on the tail behavior of the

density. This makes precise empirical estimates difficult.3.2.1 Complete hedging

in default, respectively. In figure 3, the inside contour contains the combinationsSec. 3]

Default risk 11

FIGURE 4: Default and the correlation between firm and derivative value.will be outside the next largest contour drops to 1%; and the probability that

the joint density in figure 3, the likelihood of default in eq. (8) is less than %,the volume above the shaded default area in quadrant III and underneath the

probability density function.

lated. While this may be the case, generally the two could have either positiveor negative correlation. Figure 4 illustrates how the correlation affects the likelihood of

default. In both panels of figure 4, the distribution shows a strong

correlation between the value of the firm and the payoff from the derivative.

(9)12 Risks in Derivatives Markets3.2.2 Partial hedging

Panel A of figure 4 illustrates the negative correlation between firm value and

arise when the firm in figure 1 is holding fewer than the variance-minimizingthe contract is lower than if firm and derivative value are uncorrelated.

10

Thel% confidence region barely touches the shaded area of quadrant III. Compared

to figure 3, a considerable amount of the probability mass has been shifted from

quadrant III to quadrant IIaway from the default area.

113.2.3 Overhedging

the firms assets. This situation can arise if a firm with negative core exposures

firm, the likelihood of distress-induced default on the derivatives is higher. Nowthe l% confidence region reaches well into the shaded area of quadrant III and

probability mass has been shifted to the default area. Alternatively, the positive

long position in the derivative.Figure 4 shows that the likelihood of distress-induced default on derivatives

increases with the correlation between the value of the firm and the value of the

derivative.

10


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This is true in the typical case when there is considerable residual variation. If a perfect

insolvent or default.

11The panel assumes that the negative net exposure does not stem from a large short

default area would be the area of insolvency in quadrant II.Sec. 3] Default risk 13

FIGURE 5: Derivatives positions and the probability of default3.3. Decomposing the probability of default

One can decompose the probability of default, P(D), into the probability of inFigure 5

presents this decomposition graphically for a range of hedge ratios,The probability of insolvency and the probability of default conditional on

insolvency both depend on the correlation between the value of the firm and

the value of the derivative. This correlation changes as the firm varies its hedge

ratio. With incomplete hedging, as the firm increases the size of its hedgingposition minimizes variations in firm value and the risk of insolvency. As the

firm increases its hedge ratio beyond this point, the firm overhedges and reverses

its net exposure. Eventually, firm volatility is dominated by the variations in

the derivatives position.14 Risks in Derivatives MarketsWhen the hedge ratio is below zero, the firm is using derivatives to increase

its exposures rather than to reduce them. Nonetheless, as long as firm value hasto fall below its expectation to induce insolvency, the probability of insolvency

is less than . This is indicated by the fact that, regardless of correlation, only

half of the probability mass is below the horizontal axis in figure 4.The middle panel of figure 5 shows how the probability of default conditional on

insolvency depends on the hedge ratio. As the firm increases its hedge

ratio above zero, it also increases the correlation between the value of the firm

and the value of the derivatives. This consequently increases the probability ofdefault conditional on insolvency since more of the probability mass is shifted

into the default region. At a hedge ratio of 1, firm and derivative value are uncorrelated (as

in figure 3) and the probability of default given insolvency is forsymmetric unexpected changes. But, if the hedge ratio is negative, default risk

jumps immediately. In panel A of figure 4, this would have the effect of switching the

default area into quadrant II; hence the discontinuous increase in thedefault probability.

12

In the extremes, if the firm acquires very large derivatives

positions, the firm is sure to default on these positions in the event of insolvency.Alternatively, the probability of default conditional on insolvency can be

interpreted as the probability of default on derivatives relative to the probability

clearly that the probability of default on derivatives is always less than theprobability of default on debt. Furthermore, for derivatives used to hedge (0

on debt. Not only is the default risk of derivatives significantly lower than that of

the firms debt, but hedging with derivatives helps reduce the default risk of debtby offsetting the firms core business exposures. Without doubt, the probability

of default on derivatives that are used to hedge is low by the standards of default

on corporate debt.


24/28


25/28

Options Contract is a type of Derivatives Contract which gives the

buyer/holder of the contract the right (but not the obligation) to buy/sell the

underlying asset at a predetermined price within or at end of a specified

period. The buyer / holder of the option purchases the right from the

seller/writer for a consideration which is called the premium. The seller/writer

of an option is obligated to settle the option as per the terms of the contract

when the buyer/holder exercises his right. The underlying asset could

include securities, an index of prices of securities etc.

Under Securities Contracts (Regulations) Act,1956 ,options on securities

has been defined as "option in securities" meaning a contract for the

purchase or sale of a right to buy or sell, or a right to buy and sell, securities

in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a

put and call in securities.

An Option to buy is called Call option and option to sell is called Put option.

Further, if an option that is exercisable on or before the expiry date is called

American option and one that is exercisable only on expiry date, is called

European option. The price at which the option is to be exercised is called

Strike price or Exercise price.

Therefore, in the case of American options the buyer has the right to

exercise the option at anytime on or before the expiry date. This request forexercise is submitted to the Exchange, which randomly assigns the exercise

request to the sellers of the options, who are obligated to settle the terms of

the contract within a specified time frame.

As in the case of futures contracts, option contracts can be also be settled

by delivery of the underlying asset or cash. However, unlike futures cash

settlement in option contract entails paying/receiving the difference between

the strike price/exercise price and the price of the underlying asset either at

the time of expiry of the contract or at the time of exercise / assignment ofthe option contract.

What are Index Futures and Index Option Contracts?A.


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Futures contract based on an index i.e. the underlying asset is the index, are

known as Index Futures Contracts. For example, futures contract on NIFTY

Index and BSE-30 Index. These contracts derive their value from the value

of the underlying index.

Similarly, the options contracts, which are based on some index, are known

as Index options contract. However, unlike Index Futures, the buyer of Index

Option Contracts has only the right but not the obligation to buy / sell the

underlying index on expiry. Index Option Contracts are generally European

Style options i.e. they can be exercised / assigned only on the expiry date.

An index, in turn derives its value from the prices of securities that constitute

the index and is created to represent the sentiments of the market as a

whole or of a particular sector of the economy. Indices that represent the

whole market are broad based indices and those that represent a particular

sector are sectoral indices.

In the beginning futures and options were permitted only on S&P Nifty and

BSE Sensex. Subsequently, sectoral indices were also permitted for

derivatives trading subject to fulfilling the eligibility criteria. Derivative

contracts may be permitted on an index if 80% of the index constituents are

individually eligible for derivatives trading. However, no single ineligible

stock in the index shall have a weightage of more than 5% in the index. Theindex is required to fulfill the eligibility criteria even after derivatives trading

on the index has begun. If the index does not fulfill the criteria for 3

consecutive months, then derivative contracts on such index would be

discontinued.

By its very nature, index cannot be delivered on maturity of the Index futures

or Index option contracts therefore, these contracts are essentially cash

settled on Expiry.

Why longer dated index options?

A.

Longer dated derivatives products are useful for those investors who want to

have a long term hedge or long term exposure in derivative market. The

premiums for longer term derivatives products are higher than for standard


27/28

options in the same stock because the increased expiration date gives the

underlying asset more time to make a substantial move and for the investor

to make a healthy profit.

What is Volatility Index?A.Volatility Index is a measure of expected stock market volatility, over aspecified time period, conveyed by the prices of stock / index options. Itdepicts the collective sentiment of the market on the implied future volatility.

What are the derivative contracts permitted by SEBI ?

A.

Derivative products have been introduced in a phased manner starting with

Index Futures Contracts in June 2000. Index Options and Stock Options

were introduced in June 2001 and July 2001 followed by Stock Futures in

November 2001. Sectoral indices were permitted for derivatives trading in

December 2002. During December 2007 SEBI permitted mini derivative

(F&O) contract on Index (Sensex and Nifty). Further, in January 2008,

longer tenure Index options contracts and Volatility Index and in April 2008,

Bond Index was introduced. In addition to the above, during August 2008,

SEBI permitted Exchange traded Currency Derivatives.

What do you mean by Initial Margin and Mark To Market in derivatives

market?

A.

Two type of margins have been specified -

Initial Margin - Based on 99% VaR and worst case loss over a

specified horizon, which depends on the time in which Mark to Marketmargin is collected.

Mark to Market Margin (MTM) - collected in cash for all Futures

contracts and adjusted against the available Liquid Networth for option

positions. In the case of Futures Contracts MTM may be considered as

Mark to Market Settlement.


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