25 International Financial Markets-II: Financial Derivatives

Vishal Kumar

 

1.  Learning Objective

 

After completing this module, you will be able to:

 

i.  Understand the meaning and concept of Financial Derivatives

ii. Understand various types of Financial Derivatives

iii. Know about the applications of derivative instruments, and

iv. Understand the economic functions of financial derivatives

 

 

2.  Introduction

 

Risk is a characteristic feature of all commodity and capital markets. Over time, variations in the prices of agricultural and non-agricultural commodities occur as a result of interaction of demand and supply forces. The last two decades have witnessed a many-fold increase in the volume of international trade and business due to the ever growing wave of globalization and liberalization sweeping across the world. As a result, financial markets have experienced rapid variations in interest and exchange rates, stock market prices thus exposing the corporate world to a state of growing financial risk. Increased financial risk causes losses to an otherwise profitable organisation. This underlines the importance of risk management to hedge against uncertainty. Derivatives provide an effective solution to the problem of risk caused by uncertainty and volatility in underlying asset. Derivatives are risk management tools that help an organisation to effectively transfer risk.

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Derivatives play a vital role in risk management of both financial and non-financial institutions. But, in the present world, it has become a rising concern that derivative market operations may destabilize the efficiency of financial markets. In today’s’ world the companies the financial and non-financial firms are using forward contracts, future contracts, options, swaps and other various combinations of derivatives to manage risk and to increase returns. It is true that growth of derivatives market reveals the increasing market demand for risk managing instruments in the economy. But, the major concern is that, the main components of Over the Counter (OTC) derivatives are interest rates and currency swaps. So, the economy will suffer surely if the derivative instruments are misused and if a major fault takes place in derivatives market.

 

3.  Meaning of Financial Derivatives 

 

The financial derivatives are financial instruments whose prices or values are derived from the prices of other underlying financial asset/instrument. The underlying asset or instrument may be equity shares, stock, bonds, debentures, foreign currency or even another derivative asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of  wheat which is the “underlying”.

 

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The basic purpose of these instruments is to provide commitments to prices for future dates for giving protection against adverse movements in future prices in order to reduce the extent of financial risk. The transactions in the derivative market are used to offset the risk of price changes in the underlying asset, because it is linked with the price of underlying asset that will automatically offset the price of financial asset. Thus, these instruments play a pivotal role in the capital market.

 

According to Securities Contracts (Regulation) Act, 1956 “Financial   derivatives   are   financial   products   which   are   derived   from   another   financial asset/instrument called the underlying. i.e. in case of Nifty futures, Nifty Index is the underlying”

 

SC(R)A defines “derivative” to include-

  1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.
  2. A contract which derives its value from the prices, or index of prices, of underlying securities.

 

Derivatives are securities under the SC(R) A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.

 

4.  Features of Financial Derivatives 

 

1.  It is a future contract between the two entities.

2. Derivative instruments derived from the underlying financial assets.

3.  The obligation of the parties is specified.

4.  Derivative instruments can be undertaken directly or through a particular stock exchange.

5.  Taking or making of delivery of underlying asset is not involved.

6.  The delivery/payment is deferred.

7.  Generally, derivative instruments are standardised but still OTC traded derivatives are in existence.

 

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5.  Factors Driving the Growth of Derivatives

 

Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are:

  1. Increased volatility in asset prices in financial markets,
  2. Increased integration of national financial markets with the international markets,
  3. Marked improvement in communication facilities and sharp decline in their costs,
  4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and
  5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets

 

6.  Types of Derivative Products 

Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used.

 

Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. It is a contractual agreement between the two parties i.e.  a buyer and a seller, to buy or sell a designated financial asset at a mutually agreed forward rate to be settled on a designated future date. It involves entering into a legally binding contract to exchange financial asset at a future date, with the exchange rate, agreed upon at the time when the contract is established.

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Futures: A future contract is an agreement to buy or sell a standard quantity of a specific financial asset on a future date at a specified price agreed upon between the parties through a transaction on the floor of organised future exchange. It 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 the sense that the former are standardized exchange-traded contracts.

 

Options: An Option is a contract for the future delivery of a specific financial asset in exchange for another, in which the Option holder has the right to buy/sell the financial at an agreed price, exercise price or strike price, but is not required to do so. The right to buy is a Call Option and right to sell is a Put Option. For such a right the Option buyer pays the amount to the Option seller, called as ‘Option Premium’. The Option seller receives the premium and is obliged to make (or take) the delivery at an agreed upon price, if the buyer exercise his Option.

 

Swaps: Financial Swaps are an asset liability management technique which permits the borrower to access one market and then exchange the liability with another type of liability. The investor can also exchange one type of asset for another with preferred income stream. Swaps are not funding instruments rather they are used as device to obtain the desired form of financing which is in accessible or too expensive. The two commonly used Swaps are:

  • Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
  • Currency Swaps: These 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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7.  Participants in Derivatives Market 

 

The following are the participants in derivatives market:

  1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of an asset. Majority of the participants in derivatives market belongs to this category.
  2. Speculators: They transact futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.
  3. Arbitrageurs: Their behaviour is guided by the desire to take advantage of a discrepancy between prices of more or less the same assets or competing assets in different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

 

8.  Applications of Financial Derivatives 

 

Some of the applications of financial derivatives can be enumerated as follows:

 

1. Management of risk: This is most important function of derivatives. Risk management is not about the elimination of risk rather it is about the management of risk. Financial derivatives provide a powerful tool for limiting risks that individuals and organizations face in the ordinary conduct of their businesses. It requires a thorough understanding of the basic principles that regulate the pricing of financial derivatives. Effective use of derivatives can save cost, and it can increase returns for the organisations.

 

2. Efficiency in trading: Financial derivatives allow for free trading of risk components and that leads to improving market efficiency. Traders can use a position in one or more financial derivatives as a substitute for a position in the underlying instruments. In many instances, traders find financial derivatives to be a more attractive instrument than the underlying security. This is mainly because of the greater amount of liquidity in the market offered by derivatives as well as the lower transaction costs associated with trading a financial derivative as compared to the costs of trading the underlying instrument in cash market.

3. Speculation: This is not the only use, and probably not the most important use, of financial derivatives. Financial derivatives are considered to be risky. If not used properly, these can leads to financial destruction in an organisation like what happened in Barings Plc. However, these instruments act as a powerful instrument for knowledgeable traders to expose themselves to calculated and well understood risks in search of a reward, that is, profit.

 

4. Price discovery: Another important application of derivatives is the price discovery which means revealing information about future cash market prices through the futures market. Derivatives markets provide a mechanism by which diverse and scattered opinions of future are collected into one readily discernible number which provides a consensus of knowledgeable thinking.

 

5. Price stabilization function: Derivative market helps to keep a stabilising influence on spot prices by reducing the short-term fluctuations. In other words, derivative reduces both peak and depths and leads to price stabilisation effect in the cash market for underlying asset.

 

9.  Economic Functions of the Derivative Market 

 

Inspite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions.

  1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.
  2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for risk.
  3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
  4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.
  5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well- educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.

 

In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

 

10.  Exchange Traded Vs OTC Derivatives Markets 

 

Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. As the word suggests, derivatives that trade on an exchange are called exchange traded derivatives, whereas privately negotiated derivative contracts are called OTC contracts.

The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets.

 

The OTC derivatives markets have the following features compared to exchange- traded derivatives:

  1. The management of counter-party risk is decentralized and located within individual institutions,
  2. There are no formal centralized limits on individual positions, leverage, or margining,
  3. There are no formal rules for risk and burden-sharing,
  4. There  are  no  formal  rules  or  mechanisms  for  ensuring  market  stability  and  integrity,  and  for safeguarding the collective interests of market participants, and
  5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self- regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

 

Some of the features of OTC derivatives markets embody risks to financial market stability. The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (i) the dynamic nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative activities on available aggregate credit; (iv) the high concentration of OTC derivative activities in major institutions; and (v) the central role of OTC derivatives markets in the global financial system.

 

HISTORY OF DERIVATIVES MARKETS IN INDIA 

  • Derivatives markets in India have been in existence in one form or the other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading way back in 1875.
  • In 1952, the Government of India banned cash settlement and options trading. Derivatives trading shifted to informal forwards markets. In recent years, government policy has shifted in favour of an increased role of market-based pricing and less suspicious derivatives trading.
  • The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of prohibition on options in securities.
  • The last decade, beginning the year 2000, saw lifting of ban on futures trading in many commodities. Around the same period, national electronic commodity exchanges were also set up. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. C. Gupta committee.
  • Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Initially, SEBI approved trading in index futures contracts based on various stock market indices such, S&P CNX, Nifty and Sensex.
  • Subsequently, index-based trading was permitted in options as well as individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001.

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  • The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001.
  • Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX. In June 2003, NSE introduced Interest Rate Futures which were subsequently banned due to pricing issue.

 

11.  Summary

 

The emergence and growth of market for derivative instruments can be traced back to the willingness of risk- averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. Derivatives are meant to facilitate hedging of price risk of inventory holding or a financial/commercial transaction over a certain period. They serve as instruments of risk management. By locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market liquidity and efficiency and are seen to be facilitating the flow of trade and finance.

 

Suggested Readings

  1. Gupta, S.L. Financial Derivatives. Prentice Hall of India Private Limited. New Delhi.
  2. Cherunilam Francis (2010). International Business. Prentice Hall of India Private Limited. New Delhi.
  3. Cherunilam Francis (2013). Global Economy and Business Environment. Himalaya Publishing House, New Delhi.
  4. Levi MauriceD. (2009). International Finance. Routledge.
  5. Conklin David w. (2011). The Global Environment of Business. Sage Publications.
  6. Mithani D M. (2009). Economics of Global Trade and Finance. Himalaya Publishing House New Delhi.
  7. Cherunilam Francis (2011). International Business Environment. Himalaya Publishing House, New Delhi.
  8. Saleem Shaikh (2010). Business Environment. Pearson Education, New DelhiSundharam K.P.M. and Datt Ruddar (2010). Indian Economy, S. Chand & Sons, New Delhi.
  9. Sharan Vyptakesh (2003). International Business: Concept, Environment and Strategy. Pearson Education, New Delhi
  10. Cullen. (2010). International Business. Routledge.
  11. Bennett Roger (2011). International Business. Pearson Education, New Delhi
  12. Paul Justin (2010). Business Environment-Text and Cases. Tata McGraw Hill, New Delhi.