is derivative market beneficial for all

8/8/2019 Is Derivative Market Beneficial for All

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Is derivative market beneficial for

all? How it can be beneficial forimport - export trading?


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Contents

Introduction- What is derivatives?? Type of Derivatives

(i) forwards

(ii) futures

(iii) options

(iv) swaps

Purpose of derivative market

Benefits of Derivative markets

Derivatives markets in india

Criticism to Derivative market

Benefits to import-export trading

Conclusion


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Introduction

The liberalized policy being followed by the Government of Indiaand the gradual withdrawal of the procurement and distribution channel

necessitated setting in place a market mechanism to perform the

economic functions of price discovery and risk management.

To reduce this risk, the concept of derivatives comes into thepicture. Derivatives are products whose values are derived from one or

more basic variables called bases .

India is traditionally an agriculture country with strong

government intervention. Government arbitrates to maintain bufferstocks, fix prices, impose import-export restrictions, etc. This paper

focuses on the basic understanding about derivatives market and its

development in India.


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What is Derivatives ?

Derivatives are financial contracts whose values are derivedfrom the value of an underlying primary financial instrument, commodity

or index, such as: interest rates, exchange rates, commodities, and

equities.

Derivatives include a wide assortment of financial contracts,including forwards, futures, swaps, and options.

The International Monetary Fund defines Derivatives as

"financial instruments that are linked to a specific financial instrument

or indicator or commodity and through which specific financial risks canbe traded in financial markets in their own right. The value of financial

derivatives derives from the price of an underlying item, such as asset

or index. Unlike debt securities, no principal is advanced to be repaid

and no investment income accrues."


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Types of Derivatives(1)Forward Contracts: -

A forward contract is an agreement between two parties a buyer and aseller to purchase or sell something at a later date at a price agreed upon

today and without the right of cancellation

(2) Future Contracts: -

A futures contract is an agreement between two parties a buyer and a

seller to buy or sell something at a future date. The contact trades on a

futures exchange and is subject to a daily settlement procedure.

(3) Options Contracts: -

It is of two types: -

(i) Calls: -

. 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.


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Types of Derivatives contd..

(ii) Puts give the buyer the right, but not the obligation to sell a given

quantity of the underlying asset at a given price on or before a given date.

(4) Swaps: -

Swaps are private agreements between two parties to exchange cash

flows in the future according to a prearranged formula. They can beregarded as portfolios of forward contracts.

The two commonly used swaps are interest rate swaps and currency

swaps.

(i)Interest rate swaps involves swapping only the interest related cash

flows between the parties in the same currency.

(ii) Currency swaps entail swapping both principal and interest between

the parties, with the cash flows in one direction being in a different

currency than those in the opposite direction.


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The need for a derivatives market

Changes in interest rates and equity markets around the world

Currency exchange rate shifts

Changes in global supply and demand for commodities such as agricultural

products, precious and industrial metals, and energy products such as oil and

natural gas .

Help in transferring risks from risk adverse people to risk oriented people

Help in the discovery of future as well as current prices They increase the

volume traded in markets because of participation of risk adverse people in

greater numbers.

They increase savings and investment in the long run


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Benefits of Derivative market

The two most widely recognized benefits attributed to derivative

instruments are price discovery and risk management.

1. Price Discovery: -

Futures market prices depend on a continuous flow of

information from around the world and require a high degree oftransparency

A broad range of factors (climatic conditions, political

situations, debt default, refugee displacement, land reclamation and

environmental health, for example) impact supply and demand of assets(commodities in particular) and thus the current and future prices of

the underlying asset on which the derivative contract is based.


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1.Price Discovery

With some futures markets, the underlying assets can be

geographically dispersed, having many spot (or current) prices in

existence. The price of the contract with the shortest time to expiration

often serves as a proxy for the underlying asset.

Second, the price of all future contracts serve as prices that can beaccepted by those who trade the contracts in lieu of facing the risk of

uncertain future prices.

Options also aid in price discovery, not in absolute price terms, but in

the way the market participants view the volatility of the markets. This isbecause options are a different form of hedging in that they protect

investors against losses while allowing them to participate in the asset's

gains.


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2. Risk Management

Risk management is the process of identifying the desired level of risk,identifying the actual level of risk and altering the latter to equal the former.

This process can fall into the categories of hedging and speculation.

Hedging has traditionally been defined as a strategy for reducing the risk

in holding a market position

Speculation referred to taking a position in the way the markets will

move. Today, hedging and speculation strategies, along with derivatives, are

useful tools or techniques that enable companies to more effectively manage

risk.


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Other benefits

3. They Improve Market Efficiency for the Underlying Asset

If the cost of implementing these two strategies is the same, investors

will be neutral as to which they choose.

If there is a discrepancy between the prices, investors will sell the

richer asset and buy the cheaper one until prices reach equilibrium. In this

context, derivatives create market efficiency.

4. Derivatives Also Help Reduce Market Transaction Costs

Derivatives are a form of insurance or risk management, the cost oftrading in them has to be low or investors will not find it economically sound to

purchase such "insurance" for their positions


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Derivatives Market in India

Derivatives markets have had a slow start in India. The firststep towards introduction of derivatives trading in India was the

promulgation of the Securities Laws (Amendments) Ordinance, 1995,

which withdrew the prohibition on options in securities.

SEBI set up a 24-member committee under the Chairmanship ofDr. L.C. Gupta on 18th November 1996 to develop appropriate

regulatory framework for derivatives trading in India.

SEBI was given more powers and it starts regulating the stock

exchanges in a professional manner by gradually introducing reforms in

trading.

Derivatives trading commenced in India in June 2000 after

SEBI granted the final approval in May 2000.


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Derivatives Market in India

SEBI permitted the derivative segments of two stock exchanges, viz

NSE and BSE, and their clearing house/corporation to commence trading and

settlement in approved derivative contracts.

Index futures on CNX Nifty and BSE Sensex were introduced during

2000. The trading in index options commenced in June 2001 and trading in

options on individual securities commenced in July 2001.

Futures contracts on individual stock were launched in November 2001.

June 2003, SEBI/RBI approved the trading in interest rate derivatives

instruments and NSE introduced trading in futures contract on June 24, 2003on 91 day Notional T-bills.

. Derivatives contracts are traded and settled in accordance with the

rules, bylaws, and regulations of the respective exchanges and their clearing

house/corporation duly approved by SEBI and notified in the official gazette.


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Criticisms ofDerivatives

Options offer the potential for huge gains and huge losses. While

the potential for gain is alluring, their complexity makes them

appropriate for only sophisticated investors with a high tolerance for

risk.

(1) When a derivative fails to help investors achieve their objectives, the

derivative itself is blamed for the ensuing losses when, in fact, it's often

the investor who did not fully understand how it should be used, its

inherent risk, etc.

(2) Some view derivatives as a form of legalized gambling enabling users

to make bets on the market.


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Criticisms ofDerivatives

Lifespan - Derivatives are "time-wasting" assets. As each day passes

and the expiration date approaches, you lose more and more "time"

premium and the option's value decreases.

Direction and Market Timing - In order to make money with many

derivatives, investors must accurately predict the direction in which

the market or index will move (up or down) and the minimum magnitude

of the move during a set period of time. A mistake here almost

guarantees a substantial investment loss.

Costs - The bid/ask spreads of more common derivatives such as

options can be daunting. An option with a bid of 5.25 and an ask of

5.875 means an investor could buy a round lot (100 units) for Rs.

587.50 but could only sell them for Rs 525, resulting in an immediate

loss of Rs 61.50 before factoring in commissions.


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Interest Rate Exposure Interest Rate Derivatives instruments used to manage

interest rate risk

Interest Rate Swaps

Interest Rate Futures

Interest Rate Options

Interest Rate Cap - ensures a floating rate loan receives aceiling if interest rates rise

Interest Rate Floor - a hedge against rates dropping below a

certain level

Interest Rate Collar - combo of Cap and Floor that effectively

locks in a range for its borrowing costs Forward Rate Agreement (FRA)


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FX Rate Exposure

Types of FX Exposure Economic Exposure - long term effect of exchange

rate changes on present value of future cash flows

Transaction Exposure- balance sheet exposed to

foreign exchange rates

Translation Exposure - foreign subsidiaries or

operations exposed when converting currency to

parents home currency Currency derivatives used to manage FX rate

risk


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FX Rate Exposure FX Derivatives:

Currency or FX Forwards - commitment to buy foreign

currency at a future date.

Currency Futures - Similar to forwards but traded on

the exchange and standard contract. Currency Swaps - exchange of floating rate cash flow

in one currency for fixed in another currency.

Currency Options - right to buy or sell fixed amount of

foreign currency at a fixed exchange rate, on or beforespecified date.


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Commodity Price Exposure

Price Exposure- potential for changes in price

of commodity

Delivery Exposure- regular supply ofcommodity is crucial

Exposure hedged by forwards, futures, swaps

and options


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Derivative Instruments

Forwards Contracts between two parties that require specific

action at a later date at a price agreed upon today

Future Date = Maturity Date

Contract Price = Delivery price Not traded on an organized exchange

The buyer is in a long position, the seller is in a short

position

Long position gains value when the price rises andloses when the price falls


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Derivative Instruments Futures

Same as Forward, but traded on organized exchanges

Chicago Board of Trade (grains, metals, financials)

Chicago Mercantile Exchange (livestock, wood,

meat)

International Money Market (foreign currency

futures)

New York Mercantile Exchange (metals, petroleum,

fiber)

Requires a margin account


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Derivative Instruments

Swaps - Agreement to exchange a set of cash

flows at a future point in time

Interest rate swap most common type of swap.

One party swaps its floating interest rate for a fixedrate and vice versa

Allows Companies with weaker credit ratings to get

better rates

Other types include currency and commodity

swaps


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Derivative Instruments Options - Contract between two parties where the buyer has the rightto buy

or sell a fixed amount of underlying asset at a fixed price on or before aspecified date

Call Option: the contract allows the owner to buy the asset at a fixed price

Put Option: the owner has the right to sell the asset at a fixed price

Fixed price is the strike/exercise price of contract

Possible relationships between premium and strike price:

At-the-money asset price = strike price

Call Out-of-the-Money asset price less than strike price

Put Out-of the-Money asset price greater than strike price

Call In-the-Money asset price greater than strike price

Put In-the-Money asset price less than strike price

is derivative market beneficial for all

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