The Hindu Business Line : Derivatives controversy

Too much is being made of the derivatives controversy, in which some mid-cap entities of India Inc. have dragged a few aggressive banks, mostly in the private sector, to the courts. The shocking part is that those companies are putting up a naive defence, pleading that the transactions are void as they are not permitted by the RBI.

Surely, for most of the litigant corporates, the deals that turned sour may not have been the only ones they entered into.

It is most likely they would have made a killing in several similar deals in the past, when the markets were favourable or the bets were right. It may be worth the while to do a research on the extent of exotic derivative deals concluded in the last few years and see the net impact on the companies.

A derivative, in its simplistic definition, is an independent financial process or transaction or a series of transactions, ‘derived’ from a financial product (called underlying), primarily to protect the erosion in the value of the underlying due to market risks. The RBI defines derivative in the following manner:

“Derivative” means an instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called ‘underlying’), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the bank from time to time.

The derivative product and the underlying are two distinctly different independent transactions entered into in two or more different markets, which work in such a fashion that the loss in the value of underlying, if any, would more or less compensate by a gain in the other.

For instance, an investor buys some shares of L&T at a price in the stock market (cash stock market) with a view that the share price will appreciate, but not being quite certain, also sells NIFTY Futures (futures market) for a similar amount. If the market turns bearish and the investor loses the value of shares bought, he/she is most likely to gain in the NIFTY Futures shorted (sold). It is also possible to hedge the underlying of one market in totally unconnected market, like commodities or bullion and so on.

This is possible because investors globally move from one market to another and cause some markets to rise and few others to fall. Using basic market knowledge one can play around (within permissible space) with financial products in different markets, whether for hedging or making some additional profits.

One fundamental factor that one should keep in mind is, anything that has a price tagged to it will have its upward or downward movements, derivatives included. It is a question of making a reasonable guess on the future movements and taking a calculated position, which may or may not turn out the way one anticipated. Even the best among the financial wizards have lost large sums of money because their logical expectations have gone wrong for reasons beyond their anticipation. That is the how the markets function.

There cannot be a win-win situation in a zero-sum game. Someone somewhere will lose (actual or opportunistic) in the chain, if some others are gaining. Therefore, one has to take the pluses and minuses both in their stride. At the same time, ignorance cannot be an excuse to wriggle out of a contract, which has been duly executed by an employee on behalf of the company and any such act is binding on the employer.

Having said that, it becomes equally incumbent on the banks offering the financial products to spell out the downside risks in clear terms ab initio. At times, under intense pressure to perform and achieve lofty targets that would fetch handsome bonuses, this aspect is ignored by the knowledgeable but enthusiastic sales personnel. Indian firms are generally reluctant to pay upfront charges or premium, which is an ingredient of options.

This forces the market-makers to devise exotic products which may be a combination of two or more basic derivative products and pack them as a single product with zero cost and make the product look cosmetic and acceptable, which may sometimes disguise option writing by the customer, though not explicit in the product.

The RBI has in the past consulted the banks and Fixed Income Money Market and Derivatives Association (FIMMDA) and studied different kinds of derivative products that are offered in the market and has laid down clear guidelines to the banks offering such products.

S. Ravindranath Mumbai

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