The Hindu Business Line : Derivatives: Not the rotten apple after all!

Most of the empirical evidence suggests that derivative markets do not increase volatility in cash markets (where contracts are settled immediately), but do tend to make them more liquid, and more information efficient.

Robin Roy
Chiragra Chakrabarty
Ankan Mondal

March 1996. Barings goes bottoms up due to “rogue trading”. 2001: Leading bank in Australia declares large trading losses. Megellashaft, Orange County and LTCM are not the names of some exotic holiday resorts but entities that have come to woes on use of derivatives. 2008: major European bank acknowledges huge losses from complex trading instruments. A leading commercial bank in India had to declare additional provisioning on credit derivatives. One of India’s largest engineering companies faces large notional losses due to trading on the London Metal Exchange. So what are “derivatives”?

For centuries, people have taken bets on uncertainties or possible happenings. A ship loaded with goodies from the Far East; would it return safely across the 7 seas? How does one cover the uncertainty here? Here was born the rudiments of insurance (marine insurance). Such instances of commercial activities multiplied over the years and human ingenuity started to discover uncertainties or elements of risk in “mundane” events like rainfall, prices of commodities, foreign exchange and other tradable goods and services.

The risks could technically be transferred or shifted to someone or some other asset. More importantly, apart from Credit Risk (risk of default of payment), Market Risk (reflecting uncertainties in the market due to a host of factors) became a key risk indicator and risk mitigating instruments were demanded to address market risks. Thus, risk products like options, swaps, swaptions etc were developed based on a certain asset class or set of cash flows.

Market types

Any activity related to the market should bring in efficiency and productivity. The Arrow-Debreu theorem has some basic lessons on markets: There are 3 discernible types of markets (Derivative Markets in India..Tata McGraw Hill series): Normal markets – for goods and services; Market for time – Credit (loan) markets and debt markets; and Market for risk products – derivatives etc.

The Arrow-Debreu theorem assumes that: Markets must exist. There must be a mechanism for trading goods and services for a price and these apply to markets for credit and risk also.

Markets must be competitive for the price to reflect the true value of the goods.

In sum, “under certain conditions of competition and existence of markets, you will get an efficient system and an efficient economy…”

The popular assertion that derivatives on equities, fixed income, currency and commodities tend to destabilise the underlying assets markets has persisted for decades. This has often been reinforced by large corporates and banks losing huge sums of money on “wrong bets”.

Derivatives can be classified, based on different types of assets (notional amount) such as commodities, equities (stocks), bonds, interest rates, exchange rates, indices (such as a stock market index, consumer price index or even an index of weather conditions, or other derivatives) and credit. The performance of the underlying asset determines both the amount and the timing of the payoffs (loss of profit).

Classification

The alternate school of thought classifies derivatives based on which market it is being traded. Broadly speaking, they can be categorised as Over the Counter (OTC) or Exchange Traded Derivatives (ETD). In the OTC market, orders are privately negotiated between the potential buyers and sellers without the intercession of an intermediary. Plain vanilla Swaps, Interest Rate Swaps (IRS), Forward Rate Agreements (FRA), Exotic Options, Range Accruals and structured products (financial derivatives) are traded on OTC markets. According to statistics published by the Bank for International Settlement statistics, the total outstanding notional amount stands at a whopping $516 trillion.

ETDs: The risk of credit default is virtually eliminated when derivatives are traded through an exchange. The exchange provides the platform for buyers and sellers to meet anonymously and trade, ensuring greater transparency and emancipation of prices of the underlying asset.

Like other derivatives (OTC), these publicly traded derivatives provide investors access to risk / reward and volatility (price/value fluctuations) characteristics that, while related to an underlying asset, nonetheless are distinctive.

Tracing its history

The advent of modern day derivatives contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, or overproduction. The first ‘futures’ contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. These were incidentally standardised contracts, which made them much like today’s futures. The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848, where forward contracts on various commodities were standardised around 1865. From then on, futures contracts have remained more or less in the same form, as we know them today.

Derivatives have had a long presence in India. The commodity derivatives market has been functioning in India since the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Since then, contracts on various other commodities have been introduced as well.

In India, exchange traded financial derivatives (where the underlying asset could be the stock price or stock market index) were introduced in the new millennium at the two major stock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges. Subsequently, three national level exchanges were introduced in 2003, to provide platforms for commodities derivatives trading. The derivatives market in India has grown exponentially, especially at NSE.

It should be understood that derivatives themselves are not to be considered investments since they are not considered as an asset class. They simply derive their values from assets such as fixed income securities, equities, currencies, commodities etc. and are used to either hedge those assets or improve the returns on those assets.

Since derivative markets allow producers to hedge price risk, the existence of futures may affect a producer’s decision of what to produce, how much to produce, and what production techniques to use. In addition, the futures price may contain information about anticipated demand that can feed a production decision.

(The authors are employed with PricewaterhouseCoopers.)

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