25-08-2017, 09:32 PM
INDIAN DERIVATIVES MARKETS 1
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Rise of Derivatives
The global economic order that emerged after World War II was a system where many
less developed countries administered prices and centrally allocated resources. Even the
developed economies operated under the Bretton Woods system of fixed exchange rates.
The system of fixed prices came under stress from the 1970s onwards. High inflation and
unemployment rates made interest rates more volatile. The Bretton Woods system was
dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like
India began opening up their economies and allowing prices to vary with market
conditions.
Price fluctuations make it hard for businesses to estimate their future production costs
and revenues. 2 Derivative securities provide them a valuable set of tools for managing
this risk. This article describes the evolution of Indian derivatives markets, the popular
derivatives instruments, and the main users of derivatives in India. I conclude by
assessing the outlook for Indian derivatives markets in the near and medium term.
Definition and Uses of Derivatives
A derivative security is a financial contract whose value is derived from the value of
something else, such as a stock price, a commodity price, an exchange rate, an interest
rate, or even an index of prices. In the Appendix, I describe some simple types of
derivatives: forwards, futures, options and swaps.
Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge
some preexisting risk by taking positions in derivatives markets that offset potential
losses in the underlying or spot market. In India, most derivatives users describe
themselves as hedgers (FitchRatings, 2004) and Indian laws generally require that
derivatives be used for hedging purposes only. Another motive for derivatives trading is
speculation (i.e. taking positions to profit from anticipated price movements). In practice,
it may be difficult to distinguish whether a particular trade was for hedging or
speculation, and active markets require the participation of both hedgers and speculators. 3
Development of Derivative Markets in India
Derivatives markets have been in existence in India in some form or other for a long
time. In the area of commodities, the Bombay Cotton Trade Association started futures
trading in 1875 and, by the early 1900s India had one of the world’s largest futures
industry. In 1952 the government banned cash settlement and options trading and
derivatives trading shifted to informal forwards markets. In recent years, government
policy has changed, allowing for an increased role for market-based pricing and less
suspicion of derivatives trading. The ban on futures trading of many commodities was
lifted starting in the early 2000s, and national electronic commodity exchanges were
created.
Derivatives Users in India
The use of derivatives varies by type of institution. Financial institutions, such as banks,
have assets and liabilities of different maturities and in different currencies, and are
exposed to different risks of default from their borrowers. Thus, they are likely to use
derivatives on interest rates and currencies, and derivatives to manage credit risk. Non-
financial institutions are regulated differently from financial institutions, and this affects
their incentives to use derivatives. Indian insurance regulators, for example, are yet to
issue guidelines relating to the use of derivatives by insurance companies.
In India, financial institutions have not been heavy users of exchange-traded derivatives
so far, with their contribution to total value of NSE trades being less than 8% in October
2005. However, market insiders feel that this may be changing, as indicated by the
growing share of index derivatives (which are used more by institutions than by retail
investors). In contrast to the exchange-traded markets, domestic financial institutions and
mutual funds have shown great interest in OTC fixed income instruments. Transactions
between banks dominate the market for interest rate derivatives, while state-owned banks
remain a small presence (Chitale, 2003). Corporations are active in the currency forwards
and swaps markets, buying these instruments from banks.
Summary and Conclusions
In terms of the growth of derivatives markets, and the variety of derivatives users, the
Indian market has equalled or exceeded many other regional markets. 13 While the growth
is being spearheaded mainly by retail investors, private sector institutions and large
corporations, smaller companies and state-owned institutions are gradually getting into
the act. Foreign brokers such as JP Morgan Chase are boosting their presence in India in
reaction to the growth in derivatives. The variety of derivatives instruments available for
trading is also expanding.