Expect to see tougher regulations on derivatives

D. Murali | Updated on March 09, 2011

Sundaram Janakiramanan, Author and Academician

Jana, the author of the recently-released book titled ‘Derivatives and Risk Management' (Pearson) is not happy with the level of general awareness and understanding about the subject and its relevance to investment planning. Investment can be offered as a course in schools starting at grade 6 so that the habit of savings and investment can be nurtured from an early age, suggests Sundaram Janakiramanan (Jana) who heads the Finance programme in the School of Business of Singapore-based SIM University ( > “For managers and business, periodic workshops can be conducted where the importance of risk management and use of derivatives can be explained,” he adds, during an interaction with Business Line. We continue our conversation over the -mail.Excerpts from the interview.

Looking forward, what is your take on the shape of derivatives to come?

Derivatives were first introduced to manage the basic risks such as commodity price risk, exchange rate risk, interest rate risk, and portfolio risk. In the 1990s, derivatives were introduced to manage credit risk. In the past decade, a number of derivatives such as weather derivatives, inflation derivatives, carbon credit derivatives and other exotic derivatives have been introduced in other countries and it is likely that some variations of these derivatives are likely to be introduced in India also.

The field of financial engineering has become very popular in the past few years. The researchers in financial engineering are developing more and more advanced mathematical models to come up with derivative securities that have different payoffs under different conditions. The number of derivatives that will be available is likely to increase in the next few years.

At the same time, it is likely that regulators will be watching the development in derivatives very carefully as the users of these exotic derivatives are usually hedge funds and investment banks which are highly unregulated. We can expect to see tougher regulations on the use of derivatives.

What should be the top concerns of audit committees with respect to derivatives?

Until recently, many of the exposures of companies to derivative contracts were not recorded in financial statements and investors were unaware of such exposures. However, accounting rules have been changed to indicate the value at risk of exposure to derivative contracts as well as to indicate gains and losses due to derivative trading.

In my opinion, value at risk does not really measure the exposure to losses and there should be a better model to calculate the possible losses. Companies should be asked to provide complete details of all derivative transactions used in a particular period and those contracts that are still outstanding so that the auditors can estimate the possible losses from these derivatives based on the underlying price movements.

Further, companies should be asked to provide the rationale for using the derivatives as well as the details of the risk of using these derivatives. These will form the basis of risk management strategies and the audit committee should look carefully at the risk management strategies and procedures.

Do you feel that derivatives are leveraged enough by corporations?

In my opinion, corporations are not using the available derivative securities efficiently. There are a number of reasons for this.

First, many companies do not have experienced personnel who are able to understand and use the derivative securities efficiently. The academic institutions do not produce graduates who understand the practical aspects of using the derivatives and hence the knowledge of using derivatives among practitioners needs to be improved.

Second, many companies still use some thumb rules for hedging risks instead of finding out whether hedging is necessary at all.

Third, for effective use of derivatives, companies should first start a risk management division which consists of analysts who can provide inputs on how the prices are likely to move so that appropriate hedging activity can be undertaken.

The benefits and costs of hedging are not understood by many companies and hence more often hedging is considered as an ad hoc activity rather than a planned activity.

To what extent can regulators ensure that toxic products do not spread in the financial system?

Regulators have a difficult role in controlling what products can be introduced in the market. While the Securities and Exchange Board of India, the Reserve Bank of India, and the Forward Markets Commission can pass regulations on products that are traded in exchanges, it is almost impossible for regulators to control those products which are transacted as private deals between two parties in the over-the-counter market.

The financial system is affected when those parties who can influence the trading in stock market or exchange rate market are involved in toxic derivative products. These parties tend to be investment banks and hedge funds that do not come under strict regulations.

It may be necessary to introduce some regulations on investment banks which would make them think long and hard before they enter into derivative transactions which are highly risky. If investment banking is part of the commercial banking group, capital adequacy regulations can be imposed on the investment banking part also.

It is difficult to regulate hedge funds as to what type of products they can use. In my opinion, regulators can try to pass regulations trying to curb the use of toxic products, but it will be impossible to stop them altogether. As long as perquisites and compensation of executives is tied to performance, many funds are likely to enter into transactions which promise high returns even though these involve high risk. Thus, regulation should concentrate of compensation package rather than on products themselves.

In this regard, one of the regulations being considered by the Monetary Authority of Singapore is worth mentioning. It classifies investors as vulnerable and non-vulnerable, based on their educational background. All those who have educational background in accounting, economics or finance are considered non-vulnerable as they are likely to understand the nature of the instruments they are offered. All the others are considered vulnerable investors and no instrument can be offered to them without clearly explaining the nature of the instrument and the risks involved in using the instruments.

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Published on March 09, 2011
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