During a brief interaction with Sundaram Janakiramanan (Jana) – the head of the Finance programme in the School of Business, SIM University, Singapore ( >http://bit.ly/F4TSundaram ) – one of the questions that came up was on the relevance of derivatives to the economy, considering the negative publicity these attracted during the recent economic crisis.

“Derivatives serve two purposes. First, they can be used to hedge the risk of changing prices of commodities, interest rates, exchange rates, credit rating, or equity and bond securities. The second, and the more important, purpose of derivatives is that they aid in price discovery in the underlying asset's spot market,” begins Jana. Our conversation continues over the e-mail. Excerpts from the interview:

Can you give an example to explain the relevance of derivatives?

Let us consider the commodity market and take the example of chana dal (Bengal gram). Even though economic theory suggests that the price of chana dal is determined based on the interaction of demand and supply, in practice, it is determined more by the suppliers based on their cost of production and storage. This can lead to price manipulation by the suppliers as they can decide to hoard the supply and release only a small portion to the market causing the price to increase. It is very difficult to regulate this type of behaviour.

Let us assume that futures are introduced on chana dal. The futures market determines the price at which chana dal is likely to sell at a known future time called the futures price. Since one can buy chana dal today and hold the same in stock until the specified future date, the futures price will be equal to the current spot price plus the cost of storing until the future date.

Thus, futures price is related to the current spot price. This relationship between futures price and the spot price puts a dampening effect on the ability to manipulate the spot market price because one needs to trade in both the spot market and the futures market at the same time which will be very difficult.

In addition, futures markets are regulated by the Forward Markets Commission (www.fmc.gov.in) which reduces the ability of traders to manipulate the futures price. Thus, the existence of futures market actually increases the efficiency of price discovery in the spot market. If options are also introduced, this will provide another market where prices are related to spot prices and futures prices and hence manipulation becomes even more difficult. This is the most important contribution of derivatives market to the economy.

The bad publicity that derivatives received was not due to the nature of derivatives but a lack of understanding about the risks involved in using these derivatives.

In what ways can students/teachers integrate practical realities to classroom discussions?

In teaching derivatives, the emphasis is placed on the following: The nature of the instrument, trading procedure, pricing methods and models, and uses of the instrument are explained by the teacher. Each instrument, namely, forward contract, futures contract, options contract, and swap contract are dealt with separately. Textbooks also provide the same treatment.

In real-life situation, it is not sufficient to know about each of the instruments separately. For example, currency risk can be managed by currency forwards, currency futures, currency options or currency swaps.

The students should be able to decide which of these instruments are more suitable for managing the currency risk at a given situation. This is not taught in classrooms. There are quite a few reasons for this. First, textbooks generally do not take this approach. They concentrate on treating each instrument separately. The academics who teach these courses just follow the textbook without putting effort to integrate all the instruments for any given situation.

Furthermore, the expected overall understanding of this subject matter on the part of the academics is not up-to-date. For graduating seniors who may be involved in risk management function, practical knowledge is important as they need to understand the risk involved in using the derivatives contracts. Any misunderstanding of the risk can lead to huge losses for the companies. This aspect needs to be taught in the classroom.

This can be accomplished by using case method of teaching. The cases need not have to be from real companies and the teachers can write their own cases based on the real-time data available.

The cases should provide situations where a company needs to manage a particular risk as well as details of all available derivative instruments and the students should be asked to analyse the situation and suggest appropriate instrument that can be sued to manage the risks as well as the risks that are involved in using the instrument.

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