The Hindu Business Line : Financial derivatives: Not a mystery world, after all

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Financial derivatives: Not a mystery world, after all

T. B. Kapali

What the buyer or seller of a derivative is exposed to in an exchange-traded market is the movement of the underlying — the most critical variable. Pricing for standardised derivative products is, therefore, bound to be better in the exchange markets than in the OTC market.

The pricing of financial derivatives — particularly options — is one of the least understood aspects of the overall financial markets. Not for nothing has options pricing been perceived as close to a black art. The difficulties and differences in perceptions about value are not restricted only to market practitioners. The arcane features of options and the opacity built into the pricing of these instruments provide a good platform for raking in super profits — particularly when these instruments are used in the OTC market.

For example, corporate end-users of currency options and other derivatives, by and large, do not have a good idea of how these instruments are appropriate for their operations, how they are priced and valued on an on-going basis. A derivative structure purporting to hedge a company's operating exposures could well be exposing the earnings stream to several layers of speculative risk.

Misrepresentation and non-disclosure of facts to the actual end-user is a matter of serious concern in the OTC derivatives markets. These risks and concerns are greatly reduced when it comes to the exchange-traded markets since the standardisation brought in by the exchange and the high level of competition implicit in an open market/order-driven system remove the discretionary element from pricing almost completely.

What the buyer or seller of a derivative is ultimately exposed to in an exchange-traded market is only the movement of the underlying — which, of course, is the most critical variable.

Pricing for standardised derivative products is, therefore, bound to be better in the exchange markets than in the OTC market. But the OTC market completely scores over the exchange when it comes to user flexibility — in terms of amounts, maturities, type of product, and so on.

Market abuse

While exchange-driven markets greatly reduce the scope for pricing and product abuses, they have not really overcome such practices completely. The global futures market in commodities provides enough evidence of product abuse — for instance, an operator cornering a big share of a particular contract/market — despite the exchanges expanding, over time, their surveillance and oversight of market operations.

Joining that long list of product abuses are the fictitious trades noticed in the National Stock Exchange's F&O segment in the recent past. SEBI, after a review of these trades, cautioned a number of brokers/intermediaries to `cease and desist' from activity in the F&O segment of the exchange. What is striking about the NSE F&O developments is the blatant misalignment in the pricing of stock options (one of the trading irregularities noticed by SEBI) without any material time decay between the buy and sell legs.

Manipulation, abuse and misalignments have been part of overall market activity and have not undermined overall market development in terms of products and institutions. The recent developments at the NSE should also focus attention on how existing products and practices can be improved upon.

Single-stock futures

An analysis of derivatives activity at the NSE shows that trading in futures dominates. Futures accounted, on average, for close to 85 per cent of all activity in the F&O segment in the past year, building on a pattern noted in previous years.

Within futures, contracts on individual stocks cornered a high share of 65 per cent, and a 50-55 per cent share of the overall market. Options accounted for the remaining 15 per cent of market activity, with individual stock options forming a low 2-3 per cent of the overall market.

What is driving this predominant share of single-stock and index futures activity? Is it in any way linked to the difficulties — real and perceived — about options as a product class, their pricing and hedging?

Futures as a product class are apparently easier to price than options. As the forward price of an asset, the futures takes into account only the rate of interest relevant for the time period being considered and the asset's prevailing spot price. Apart from the above parameters, the price of an option is also a function of how variable the stock (or any other asset) price movements have been and the asset price that the buyer of an option wants to protect.

These two factors, particularly the measure of variability of the asset's price moves, introduce the complexity in options pricing. But it should be noted that the price variability of the underlying asset is a factor in the futures market too. This variability measure is the basis for the margins that have to be put up for trading futures.

Less flexible

As the exchange equivalent of a plain vanilla forward contract, the futures contract does provide good hedging solutions. But such solutions may not be optimal. Options have the inherent flexibility of enabling the hedger to benefit from favourable price movements in the underlying asset. On the contrary, for the hedger, the effect of a futures contract is to lock in a price.

Also, in comparison with options, futures could be less flexible and efficient as a speculative vehicle. The margining system and daily mark-to-market in futures, for instance, could have an impact on an operator's regular cash-flows when the market is going against his position. That is not the case if a speculative position is taken through the options market and the position has a negative mark-to-market value.

Overall, the prospects for all kinds of financial derivatives are quite good in the Indian market. A lot of effort has perhaps to go into investor (retail) education and creating awareness and appreciation about various products. The statistics relating to derivatives trading and recent developments at the NSE's F&O segment only reiterate this.

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