Derivative Trading In India

What is a derivative instrument ?

It is a contract whose value depends on or derives from the value of an underlying asset [say a share, forex, commodity or an index]. In its broadest sense a derivative attempts to hedge against the variability of any economic variable. Thus exposures or perceived risks to a firm arising from the variation
in interest rates, exchange rates, commodity prices and equity prices can be hedged through an appropriate derivative structure. Such a derivative structure covers a wide variety of financial contracts viz. Futures, Forwards, Options, Swaps and different variations thereof. These contracts can be traded on the various Exchanges in a standardized manner or by custom designed for individual requirements.

The history of derivatives can be traced to the middle ages when farmers and traders in grains and other agricultural products used certain specific types of futures and forwards to hedge, their risks. Essentially the farmer wants to ensure that he receives a reasonable price for the grain that he would harvest [say] three to four months later. An oversupply will hurt him badly. For the grain merchant, the opposite is true. A fall in the agricultural production will push up the prices. It made sense therefore for both of them to fix a price for the future. This was how the Futures market first developed in agricultural commodities such as cotton, coffee, petroleum, soya bean, sugar and then to financial products such at interest rates, foreign exchange and shares. In 1995 the Chicago Board of Trade commenced trading in Derivatives.

For the derivatives market to develop three kinds of participants are necessary. They are the hedgers, the speculators and the arbitrageurs. All three must co-exist. A hedger is risk averse. Typically in India he may be a Treasurer in a public sector company who wants to know with certainty his interest costs for the year 2002. Therefore based on current information he would enter into a futures contract and lock up his interest rate four years hence. But in doing so he consciously ignores what is called the upside potential - here the possibility that the interest rate may be lower in the year 2002 than what he had contracted four years earlier. A Hedger therefore plays it safe. For a hedging transaction to be completed there must be another person willing to take advantage of the price movements. That is the Speculator.

Contrary to the Hedger who avoids uncertainties the Speculator thrives on them. The speculator may lose plenty of money if his forecast goes wrong but stands to gain enormously if he is proved correct. The risk taking associated with speculation is an integral part of a Derivative market. The third category of participant is the Arbitrageur, who looks at riskless profit by simultaneously buying and selling the same or similar financial products in different markets. Markets are seldom perfect and there is a possibility to take advantage of time or space differentials that exist. Arbitrage evens out the price variations.

With the Government of India permitting futures trading in several commodities and with futures trading have arrived in the stock markets, index based derivative trading has finally arrived in India. For smooth functioning of derivative trading the Government of India has commenced the process of demeterialization of shares, short sale facility, electronic fund transfer facility and rolling settlements in stock markets. This will hopefully bring transparency in the process of price discovery of the derivative and also attract a broad spectrum of hedgers and speculators from out of professionally managed corporates that not only must have a good balance sheet but also significant trading and risk management skills. The Stock Holding Corporation of India has commenced discussions with the premier stock exchanges of India about setting up a clearing house for derivatives transactions.

Credit Derivatives

In July, 1999 the International Swaps and Derivative Association [ISDA] issued a new "master agreement" intended to standardize contracts for credit derivatives. But, there are legal conundrums here. Credit derivatives may be simple enough in theory, but they can be full of problems in practice. To make a finer point, let us look at the most common credit derivative product - `the default swap´. The buyer of a `default swap´ pays the seller a fee so that if a borrower defaults, the seller takes over the debt at face value. For starters the legal issue of what constitutes a `default´ [the credit risk that is sought to be covered] has to be defined properly in the contract and in the context to enable the buyer to declare that there is a "credit event" giving rise to a legal cause of action to make the swap-seller pay up the debt. A protective legal document must also take care of potential market manipulators. Most default swaps are settled physically: the buyer delivers securities or loans if a borrower defaults. The biggest legal problem would be that whatever risk coverage was perceived in the contract did not actually fall on all fours with the risk that actually occurred. Therefore, the contract must clearly spell out the type of security that is to be delivered by the protection-buyer and also the various kinds of risks that can be perceived and covered due to the default.

A typical agreement based on credit derivatives should offer three choices:

 (a)  What constitutes a credit event ?
 (b)  What classes of debts it would apply ?
 (c)  What types of debt can be delivered to the seller of the default swap ?

Further the agreement should clearly define out a reasonable time factor available to a borrower before the default mechanism is triggered off. The credit worthiness of the counter party is also an important decision that has to be considered and adequately reflected in the agreement. The contingencies of bankruptcy of the counter party has also to be gone into at the agreement stage through Counter Guarantee mechanisms and Escrow coverage.

Interest Rate Derivatives

A appropriate derivative structure to cover floating rates of interest immunizes a buyer against the risk of short term interest rates by swapping the periodic floating rate payments for a fixed rate payment. Like wise fluctuating short term yields on financial assets can be appropriately immunized from falling rate risks by locking it in fixed receipts for floating obligations. For example a floating short-term borrowing index like the LIBOR or perhaps the price of crude oil or natural gas from OPEC can be fixed for long periods by swapping the floating rates for a fixed rate. Hedges can be created through option structures too. Thus a firm can fix [called `cap´] a contract on LIBOR by conceding a ceiling on  the interest rate [called `strike rate´] to immunize itself against rising interests for a long period by paying a premium up front. Likewise the same firm can opt to set [called a `floor´] a minimum strike rate to immunize itself against falling short term interest rates.

In conclusion, it is pointed out that introducing derivatives in India is not going to be a smooth affair. A Committee, in India, under the chairmanship of Dr. L.C. Gupta, an economist and expert on the stock markets took almost sixteen months to finalize a report on the introduction of financial derivatives as also the need to have a proper legal framework for its implementation in India. For all the benefits they may promise, derivatives have proved to be a veritable mine field even in advanced countries like U.S. For every hedger, there has to be a speculator prepared to receive the risk. The level of preparedness amongst the market elements in India is very low at present. There is going to be confusion in contracts and lack of `consensus ad idem´ resulting in frustration of contracts due to impossibility of performance of the contract. All this will invalidate a contract and make it unenforceable in law. Indian credit and money markets has to offer a variety and depth of financial instruments that are available in contemporary markets elsewhere in the world to make Derivative Trading click in India. Deregulation and competition has undoubtedly made the Indian capital and financial markets more efficient, resulting in improved cost of funds for firms and the ultimate consumer.