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Synopsis of Derivatives

Category : NCFM-Equity Derivatives

31st Jan. 2012, Gaurav Pal – Intelivisto

Definition

A derivative instrument 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.

Rise of Derivatives

The global economic order that emerged after World War II was a system where many under developed countries administered and controlled prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates for currencies/foreign exchange.

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 as per demand and supply. Under developed countries like India began opening up their economies and allowing prices to vary with market conditions in early 90’s with start of economic liberalisation process and RBI started playing little role in controlling the foreign exchange prices.

Price fluctuations make it hard for businesses to estimate their future production costs and revenues. Derivative securities provided them a valuable set of tools for managing this risk.

Uses of Derivatives

Derivatives may be traded for a variety of reasons. A derivatives contract enables a trader to hedge some market risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market.

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.

A third type of trader, called arbitrageurs, profit from discrepancies or mispricing in the relationship of spot and derivatives prices, and thereby help to keep markets efficient.

Exchange-Traded and Over-the-Counter Derivative Instruments

India is one of the most successful developing countries in terms of a vibrant market for exchange-traded derivatives. This reiterates the strengths of the modern development of India’s securities markets, which are based on nationwide market access, anonymous electronic trading, a predominantly retail market and an active regulatory framework. There is an increasing sense that the equity derivatives market is playing a major role in shaping price discovery.

OTC (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 “hawala” 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 of delivery. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the exchanges trading derivatives as per present market structure in India. Margin requirements and daily marking-to-market of futures positions substantially mitigate the credit risk of exchange-traded contracts, relative to OTC contracts.

 

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 are exposed 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. Non-financial institutions are regulated differently from financial institutions, and this affects their incentives to use derivatives.

In India, financial institutions have not been heavy users of exchange-traded derivatives so far. 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 retail investors). Transactions between banks dominate the market for interest rate derivatives, while state-owned banks remain a small presence. 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? Some institutions 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.

Foreign investors must register as foreign institutional investors (FII) to trade exchange-traded derivatives, and be subject to position limits as specified by SEBI. In practice, some foreign investors also invest in Indian markets by issuing Participatory Notes to an off-shore investor. FIIs have a significant and 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.

Retail investors (including small brokerages trading for themselves) are the major participants in equity derivatives. The success of single stock futures in India is unique, as this instrument 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 the markets for commodity derivatives, due in part to their long-standing expertise in trading in the “hawala” or forwards markets.

Summary and Conclusions

In terms of the growth of derivatives markets, and the variety of derivatives users, the Indian market has equalled or exceeded many other regional markets. While the growth is being spearheaded by retail investors, private sector institutions and large corporations, smaller companies and state-owned institutions are gradually getting into the act. Foreign brokers are boosting their presence in India in reaction to the growth in derivatives. The variety of derivatives instruments available for trading is also expanding.

In the past, there were 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 figures showed that almost 90% of activity was due to index options, index futures & stock futures, whereas trading in options is limited to a few stocks, partly because stock options were of American style & they are settled in cash and not the underlying stocks. But with the start of 2011 all stock options available for trading were changed to European style. This change has led to the liquidity in stock options not only close to ATM strikes but also across multiple strikes just as in case of index options. This change has encouraged the options writers to go ahead eliminating the assignment risk prior to expiry which will eventually benefit them.

Considering these changes derivatives market in India is poised to grow and mature further to accommodate larger participation across varied asset classes by wide range of participants.

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