The thesis indicates the importance of derivatives in financial markets of emerging economies. It signifies the fact that to attract foreign investment and for ones economic conditions to prosper it is necessary to change with time, the secret of the recent boom in Indian economy is market liberalization and deregulation. The introduction of financial derivatives in Indian financial markets is a confidence booster for the investor and an opportunity for them to invest in a relatively less risky environment, the introduction has allowed greater investments which are a result of effective policy changing at the right time. Emerging markets such as the Indian market can and have taken advantage of the derivatives and still have great potential to do even better in future.
I would like to acknowledge the support of my instructor who has been a great support and rich source of knowledge for me, who has always encouraged and appreciated my efforts because of which I have been able to come up with the following report. I also acknowledge the knowledge, hard work and dedication of the authors of the books and other resources that were referred during the writing for the collection of facts.
The paper is a research based thesis, numerous articles and books were referred that explained about the role of financial derivatives in general, what is their significance, what role do they play in financial markets, what is their importance in emerging economies and how has the Indian economy benefited from it.
The economical status of the country is greatly reflected by the performance of its capital markets, over the past decades the witnessed emerging economies such as India, South Korea, and China etc. have shown great progress in financial markets. The significance of capital markets is determined by its effect on other institutions of the economy, a strong and sustainable market indicates a progressive and powerful financial system which plays an important in attracting investors from all over.
Liberalization of the economy, globalization and deregulation made by India in the past few years have proved to provide substantial benefits, foreign investment has poured in, the confidence of local investors has grown which is reflected by the increased size of the capital markets. An Indian market with largest number of listed companies in the world has made great progress in the past few years and still shows great potential to capitalize on.
Financial derivatives are instruments which value depends upon the value of underlying. The underlying may include commodities, equities, bonds, interest rates, exchange rates etc. (Nobreqa 2008)
Financial derivatives allow investors to diversify and redistribute the potential risk attached with the investment; it gives an opportunity to the emerging markets specially to grow and that too with rapid speed. The growth in economy is assisted subsequently by increased dependence of companies on capital markets for funding which makes the role of financial derivatives even more important, it changes the risk profile of a business allows the investor to avoid undesired risk thus improving the quality of earnings for him.
Financial derivatives have played a vital role in the development of the great markets that we see today, but derivatives with all their benefits have a significant amount of criticism attached to them as they may allow the participants to manipulate accounts and hide crucial information.
Derivatives market in India had been flourishing since the 19th century, the Bombay Cotton Trade Association started futures trading in 1875. After the ban in 1952 the derivatives trading had to happen through informal channels until the early 2000s when the government lifted the ban on future commodities trading with the establishment of national electronic commodities exchanges. (Alaxender 2002)
The purpose of this thesis is to highlight the importance of the role of derivatives in capital markets and emerging markets in particular. The Indian market being one of the most popular and fastest growing economies of the world will remain the center of focus. The report discusses the different types of derivatives involved in capital markets, their roles and their importance. The different types of derivatives being employed in the Indian economy and their benefits are also part of the discussion, Indian derivative markets are discussed in detail that is starting from their history, to where they have come today and what is yet to be achieved and also what can be done to further improve it.
4) Derivatives-the history
After the Second World War the world saw an economic turnover which was based on Bretton Woodss system, in this system prices were centrally administered and had a fixed exchange rate. But the entire scenario of global recession in the early 70s gave rise to high inflation rates and high rate of unemployment which was subsequently followed by volatile interest rates and the Bretton Woods system had to be dismantled. The underdeveloped countries such as India had to open up their economies and vary the prices according to the market conditions. The fluctuating markets make it difficult for economies to prosper and businesses face a hard time in estimating cost of their operations, financial derivatives offer leverage to the businesses and minimizes the attached risks.
5) Types of Derivatives
The derivatives market depends on three basic types
5.1) Currency derivatives
The currency derivatives are commonly used in international trade, it is preferred by traders specially who trade in countries that have vulnerable economies and their currency rates change quite frequently. In trade deals involving millions a slightest change in the currency rate can make a huge difference for the parties involved. Therefore traders all over prefer currency derivatives in such situations. The currency derivative is a contract between two parties that a payment to be made in foreign currency will be made at a certain date and at a certain rate of the particular currency, no matter what the currency rate is at the declared date the transaction will be carried at the rate which was specified in the contract.
Speculations play a major part in the currency derivatives, and parties usually enter such contracts based on the speculation of may price hike, but this is a two edged sword as well if the speculation goes wrong then the company may end up losing a great amount of assets and resources. The Indian economic liberalization and the end of Bretton Woods practices opened up the Indian currency to the foreign market and the rates were now to be decided on the simple international principles of demand and supply, this gave confidence to the international investors as it was easier to speculate the currency rates and foreign trade became easier and less regulated. This gave an opportunity to the investors and we saw the advent of the currency derivatives in India.
5.2) Commodity Derivatives
Like the currency derivatives the commodity derivatives are also a contract between parties that specifies a certain amount and type of commodity to be sold and bought at a specified price and on a particular date. This is beneficiary for both the seller who is in this a regular farmer and the buyer which in this case might be a retailer or whole seller, as this ensures the availability of the commodity to the buyer on the required date and it guarantees an obviously profitable price for the commodity to the seller.
Agriculture plays a major role in Indian economy; it contributes 22% to the total Indian GDP, employs 57% of the total labor force and has 163 million hectares of land dedicated to farming numerous products making it the one of the top five commodity producers in the world. All this reflects the fact that India can be a highlight in the global commodities derivatives. The commodities derivatives exchange started operating in 2002, since then the number of commodities allowed to be exchanged on derivatives had increased from 8 to 80 in 2006, and the value of commodity derivatives nearly crossed $1 trillion.
Top Ten Commodities (as per Sep 2005)
Commodity Turnover in $ Millions*
Guar seed 4,432.71
Crude oil 3,380.13
Chana (chick peas) 2,100.15
Urad (Black Legume) 624.71
Soy oil 478.28
Gur (Jaggery: cane sugar) 369.72
Guar Gum 345.08
Tur (Lentils) 329.35
The Indian government has taken timely and effective steps to facilitate the commodity derivatives market, apart from decreased regulations proper formalized and regulated exchanges were developed to overlook the entire transactions thus increasing the level of confidence and security among the investors.
¢ The Multi Commodity Exchange of India limited (MCX) is completely recognized institution by the Indian government which is full De-mutualized, inaugurated in 2003 it has grown to become a renowned and reliable institution for online trading, clearing and settling operations in the commodity futures market all over the country.
¢ National Commodity & Derivatives Exchange Limited (NCDEX) is an expertly handled online commodity exchange promoted by a number of local business giants, it a public listed company, this market shows great potential as well because the promoting companies not only bring with them years of experience, professionalism and of course capital but also a market reputation and a level of trust among the local and foreign investors.(Kanuk 2007)
5.3) Equity Derivatives
Like all other derivatives markets equity derivatives are also contracts that enables a seller to sell a certain number of shares, at a particular time for a specified amount to a buyer.
Equity derivatives basic use is hedging that is it reduces the number of risk a holder bares for keeping any shares, derivatives can be used to counter speculations sometimes to avoid collapses and sometimes to hop on to speculated opportunities.
Equity derivative markets play a major role in any boom of capital markets any where in the world, it offers huge profits for short term investments in a much less regulated environment, and this is a major attraction for investors everywhere (Collins & Fabozzi 1999). Equity derivatives have also played a huge role in the recent boom in the Indian capital markets and the increased sustainability, the Indian government with their policies was able to attract not only foreign but also local investors who had stayed away from market due to it vulnerability. The National Stock Exchange (NSE) was introduced and has grown to become the second largest exchange of the region, the introduction of the exchange came at the right time as the introduction of a formalized body showed the concern of the authorities and their interest in the development of market which encourages investors.
6) Derivatives contract types
6.1) Future Contracts
Future contract is a derivative which obligates a person to buy a certain underlying at a specified date and the other person I obligated to sell the specified underlying at that fixed price.
Future contract are a common practices in businesses involving foreign currencies (Murty 2005)
The option contract is divided into two main parts; taking common stocks as an example a Call option enables the participant to buy a specified number of shares at a specified time at a specified rate, while a Put option enables the participant to sell the shares at the specified terms. The basic difference between a future contract and an option is that an option doesnt obligate the holder to fulfill the deal that is to buy or sell an entity where as a future contract on the other hand makes it necessary for the parties for abide by the agreement. Stock options are commonly given by companies to their employees as a practice of profit sharing.
Swap is one kind of derivative which allows an individual to swap a certain cash flow for another one over a given period of time. A common example is when the companies take debts on fixed rates as fluctuating rates may harm their businesses, they usually swap the existing rate for a negotiated fixed rate to be paid on the loan.
7) Uses of Derivatives
Derivatives for the most part are used for hedging, that is it is used to transfer risk of a transaction by shifting oneself to the other side of the deal. For example a participant enters a futures contract for a certain amount of shares at an agreed rate, by doing so the seller transfers or rather minimizes risk of prices at the time when he wants to buy the shares, and the buyer transfers risk of not only price but also the availability of the desired shares on a particular date. (Chorafas 2008)
Hedging is a common practice in derivatives market, it at its core deals with risk minimization to attract investments which has played a vital role in the recent popularity of derivatives in financial markets, emerging economies promote derivatives and the risk free side of it to create stability in their markets and enable it to grow
Unlike hedging speculation is more of a gamble than hedging it involves greater amount of risk, it enables participants to bet on vulnerability of the market. Based on calculations the investors speculate a behavior of the market in future and place their investments accordingly, the volume and value of trade in speculation is greater than true hedging.
This incorporates enormous amount of risk in the emerging markets specially because in newer market the individual investors are inexperienced and basically go with the flow, speculations play a major role in shaping the direction of market movement the trend of investments, speculation or as they are called tip(s) in South Asian markets are depended upon by investors than research about facts and that is why these markets prove to be more volatile and uncertain than others (Cuthbertson 2001).
In India it is mostly claimed that most of the derivatives trade is for hedging purposes, but it is hard to differentiate that the reason of trade is either hedging the risk or speculate a speculate a behavior. (Chorafas 2008)
8) Types of Derivatives trading
8.1) Over the Counter (OTC)
These are the derivatives that are traded between two parties, without the involvement of any intermediary or third party, there are no regulations and one doesnt have to go through the exchange procedures. The risk factor is greater in the OTC contracts as the other party that may owe you money might default and is unable to pay, OTC also gives flexible terms as the terms and conditions can be decided between the parties and as there is no formal body involved in the procedure both may agree on terms that suits them best. Over the counter trading of derivatives is disallowed in India for most of the shares. (Kolb & Overdahi 2002)
8.2) Exchange Traded (ET)
The exchange traded derivatives are those that are bought through a proper exchange, it is relatively more regulated and a token amount is kept from both the parties which is a fraction of the transaction amount as a guarantee that the exchange gives to the participants, hence it involves a lower level of risk. (Kolb & Overdahi) The introduction of formalized bodies such as the NSE, NCDEX, MCX etc were a step in the exchange traded derivatives by the Indian government, the involvement of the authorities along with the major market players gave stability and sustainability to the market and increased the credibility of these exchanges which provided a formalized platform for the investors to conduct their operations.
9) The Importance
The basic factor that is imbedded in financial markets globally is the risk involved with a particular investment. What derivatives do is that they reduce this amount of risk, introducing derivatives into emerging markets has proved out to be a success; to attract investors one needs to make sure of two things greater profits and minimum risk, even greater profits does not promise you definite investment especially from foreign investors for them the introduction of derivatives to a level ensures security.
The introduction of derivatives almost is directly proportional to the market index, as for emerging markets in specific the market index rise with the derivatives volume because it ensures quicker profits at minimal risk, not only that future buying and selling of foreign currencies helps companies to set up and make greater profits. For example a company has to buy a plant worth 50million euros and the current rate of euro is 1.3dollars, if the company speculates that the price of euro will appreciate in future when the company has to make the payment it may enter a future contract and close the deal of 50million euros at the days rate and agrees to pay 50.5million as it is paying at the days rate. At the time of payment if the euro appreciated and came to 1.5dollars a euro, the company will end up paying only 65.5million dollars instead of 75million dollars it would have paid had it not agreed on the future contract. (Sawyers 2000 )
Corporations and other financial institutions benefit from derivatives due less cost of funding and more diverse sources to fund the activities, it brings down the level of uncertainty involved and allows corporations t engage in activities in which they otherwise may not be involved into such as a foreign company wanting to invest but hesitant to do so considering the volatile foreign exchange rates.
10) Derivatives in Indian Markets-the development
The economic liberalization of the nineties laid down the foundation for the growth of capital markets in India, the adoption of market determined rate in 1993 and the policy that allowed full conversion of rupee on current account in 1994 were among some of the major steps that led to this rapid growth. (Banerjee & Richter 2003)
(Sarkar, Asani 2006)
The introduction of the national electronics commodities exchange was the first major step taken by the authorities to promote derivative in the markets, a system of trading in equity markets called Badla had been existing in the financial markets that involved a few elements of future contracts, but it was banned for good in 2001 by the Securities and Exchange in 2001 due to mal practicing. (Dhankhar 2005) To clear the way for the equity derivatives the government created the NSE a fully organized body to be the guarantee exchange of the securities, this increased the transparency of the process and increased the credibility thus attracting the investors. In 1995 the government lifted the ban imposed and allowed the options trading. (Banerjee & Richter 2003)
11) Indian market derivatives
The NSE introduces index futures in 2000 and index options in 2001 while futures and options of individual stocks were introduced in 2001. The introduction of equity derivatives has proved out to be the greatest success of the Indian markets as it has attracted the greatest number of investments. Single stock futures remain to be the highlight of all and in October 2005 they accounted for almost half of NSEs total traded value. The interest rate derivatives have not been that popular in the Indian markets in comparison to the equity derivatives. Since the interest rates have not been that high over the years hence the corporations have swapped their fixed rate debts to floating rates in order to save on cost.
Foreign Exchange derivatives have witnessed even less volume than the interest rate derivatives despite the fact that it has been around for the longest time in comparison. The growth in commodities derivatives has been uneven, it only started in 2000 and the volume is very small almost half of what it is for the equity derivatives.
Although there are numerous advantages of derivatives but derivatives may just backfire as well, derivatives allow the holder to earn great sums of money with every little movement in the prices of the under lying but if these changes happen against the holder then he can end up losing large sums as well, therefore where derivatives reduce the amount of risk yet they still carry their own amount of risk along with them. Since derivatives offer large rewards it also attracts small or individual investors, this may include the inexperienced investors as well who may end up losing large sums of money and may not be in a position to sustain it financially.
Due to the high notional values of the underlying assets it may become such a huge loss that the holder may not be able to compensate for considering this even people like Warren Buffet refer derivatives as the Weapons of Mass Destruction. Increased use of derivatives also dents the economy because the base of derivatives is debt and weaker economies may not be able to sustain the pressure and might go into recession or face consequences such as high rates of inflation, unemployment etc.
The holder has to bare the credit risk i.e. the risk that if the counterparty fails to pay the dues in time, the loss that the holder bares on the contract is the price of involving a new counterparty in the contract. Derivatives may tempt the presenters to manipulate the information and not disclose necessary information or do any such malpractice which may harm
Financial derivatives financial markets, though the introduction of derivatives reduced the risk baring and increased the profit margins it also resulted in the increase of risk to capital ratio of some entities and encouraged them to manipulate key financial information and dodging regularities, in the end it created speculations of a crisis situation and when the crisis finally came it made it more difficult and prolonged. Financial derivatives amplify the vulnerability of capital markets, that is in any negative shock to a country with a rather underdeveloped economy will result in a sell off trend in the market which may further deepen the crisis and gives a rather severe blow to the already ailing economy, countries in this situation are stuck in a dilemma of economic recession and it effects.
13) The Derivative Users in India
The Indian financial system has different regulations for financial and non financial institutions regarding the use of derivatives. The financial institutions have not really shown promising potential in the derivatives market in 2005 the financial institutions were only accounted for 8% of the total trade at the NSE although the ratio has improved but still lacks the strength that is expected of it. Despite a weak show in the exchange trade (ET) markets banks and other financial institutions have been championing the OTC markets, dominating the currency forwards and interest rate swaps. Transactions between banks have been a highlight in the interest rate derivatives market. This decreased interest is because of decreased presence of banks in the equity market due to banking regulations, hence financial institutions only use derivatives to rebalance their existing portfolios. (Gopalsamy 2005)
The Foreign Institutional Investors (FII) have played a major role in the Indian derivatives market, foreign nationals need to get themselves registered as the FII in order to invest in the exchange traded contract and are also assigned a limit for trading else they can be registered as brokers as well. Foreign investors can also indirectly trade without registering; they can do so by trading through a locally registered broker. (Jalan 2004) Retail or individual investors are the most participative fraction, they almost constitute up to 60% of the equity derivative markets, and their increased interest could be because of their prior experience with the badla system that prevailed in the Indian markets before it was banned in 2001. Another reason of attraction for the individual investors could be the smaller size of future contract which in other countries is considerably larger. Retail investors besides equity also dominate the commodities future contracts. (Dhankhar 2005)
The impact of derivatives proved beneficial for the Indian economy the struggling economy not only survived the test of time but in fact prospered, the liberalization of economies where greatly affected many countries such as S.Korea, Brazil etc there it did effect India as well, deregulation not only attracted foreign investment but also the local investment it gave confidence to the investors and encouraged them. (Rathore 2003)
Since 2002 the commodity future market in India is in a great boom it nearly crossed $1 trillion in 2006, the country now has 3 electronic commodity exchanges and more than 21 regional exchanges, the NEC has extended its operations and has come in worlds top 20 biggest derivative exchanges
International Comparison end December, 2000. Particular USA UK Japan Germany Singapore Hong Kong China India
No.of listed company 7524 1904 2561 1022 418 779 1086 9922
Market Cap. ($bn) 15104 2577 3157 1270 153 623 581 166
Market Capitalization Ratio (%) 358.8 130.7 66.4 50.8 95.9 228.8 73.6 54.5
Turnover ($bn) 31862 1835 2694 1069 91 378 72.2 621
Turnover Ratio (%) 200.8 66.6 69.9 79.1 52.1 61.3 158.3 374.7
The market capitalization of the NSE in October 2007 computed to $1.46 trillion, it has become the second largest stock exchange in the Sub-Continent only second to the Indias own Bombay Stock Exchange (BSE), and it is the worlds third biggest stock exchange based on equity trading numbers.
The growth of the Indian capital market after the introduction of derivatives has proved to be phenomenal the figures have multiplied every year after the introduction this has resulted into not only a strong financial system but also and attractive economy to invest in. (Rathore)
India in the last five years has shown tremendous progress in and the Indian economys boom has been a result of numerous policy changes over the course of time. The Indian policies have been focused on attracting foreign investments and one of the major reason for this boom are the non resident Indians who have now come back and investing in their own country appreciating the changes. (Nobreqa) This has not only given sustainability to the economy but also has made it prosperous because of enormous amounts of foreign exchange coming back in to the country. Integrating the currency with the international market and letting the rate to be decided through demand and supply has made the trade among countries easier and the currency over the past few years has maintained the rate if not appreciated.
The introduction of derivatives proved to be a vital step, the country has progressed and still has great potential for future. Derivatives have given and opportunity for new investors to not only enter the market but also enable it to grow with them, bigger institutions such as major banks and mutual funds are yet to fully utilize the opportunity what they are using the derivatives at this moment are to balance out their portfolios hence the derivative market is playing part of a substitute for them to equity, but once they fully enter the field we will see more coming from the Indian markets in the years to come.
What needs to be done is that the system should be made more transparent to attract further foreign investments because South Asian countries are usually attributed with backdoor channels and corruption which also at the end of the day is a great resistance. The OTC contracts must also be appreciated, certain regulations can be added to make it formalized and more secure for the investor so that he is encouraged to invest if he is resistant in doing exchange trading ET. Laws should be made and implemented to regulate all sorts of transactions and to loop holes must be filled so that mal-practicing of authority can be prevented, clauses should be added and the types of information must be specified that needs to be disclosed hence leaving no way available for the reporters to get involved in such activities.
The investor needs to be educated so that he can understand the research and make his own decision rather than depending on speculation and cheap brokers to gamble around with his money. India and countries such as Pakistan have put investor education programs in place that are focused to in crease the investor understanding of the situation and to enable him to make a wise decision for his investment. Derivatives cannot be entirely dependent upon to revive or fill life in a countrys economy what is needed to be done is that proper integration of the entire economical system of the country capital markets being a major reflector needs to reflect a true picture of the economy, investors are to be attracted through any means including the derivative markets but at the same time policies should be made as such that these and more investors not just stick to this side of the market but also expand and explore other markets of the country.
The stable markets of the world have come to a saturation level and saturated markets do not offer higher returns, higher returns are only expected from markets that are growing. Emerging markets involve a greater amount of risk but in accordance with the basic formula of more risk equals more return they offer greater returns. With stable economies having saturated markets the emerging economies show great potential ad promise a better use of money for the investor but the only thing that lacks is the security of this investment countries such as South Korea, India, Mexico, Brazil etc have amended policies and brought drastic changes in their system to increase this amount of security required for such investments. The exchanges are needed to be more empowered and strong enough to guarantee the transactions that take place. (Ahuja 2006)
The foreign exchange derivatives can be a great resource for cross border trades at a time of vulnerable rates, this is where India really succeeded as they let their currency rate be dependent on the international markets demand and supply, this gives confidence to the traders against the rapidly changing exchange rates, the foreign currency derivatives enable the holder to counter any speculation going against him but at the same time it increases the risk that if that speculation turns out to be not true then the holder may end up losing large sums of money.
Besides financial policies the sociopolitical environment of the country also play a huge part in attracting investments, India has progressed greatly in this sector as well, the political situation of the country is quite stable for the past ten years in particular. The elections were held as per schedule since the last two times and the governments completed their tenure reflecting the stability and strength of the worlds biggest democracy. The law and order situation has been stable compared to the regional instability involving terrorist activities in the neighboring countries of Pakistan and Sri Lanka and political unrest in Nepal, India has shown great strength against any such activities and has made sure nip the problems in the bud.
The education rate again very high relative to the region and considering the size of the population it is a great sign, the middle class is growing and more people are working than ever before, the labor is cheap considering the higher standards of wages set by the western stable economies, hence by any means the country has great potential that is why it has kept on attracting investors from all over. The sociopolitical environment plays a major part in attracting not only short term investors but also long term investors who play a great role in the countrys economic progress, consistent and improving political and economical conditions ensures security and boosts the confidence of anyone investing as he can witness the progress being made and how much more can he earn off his share in the economy.
The significance of the political stability can be calculated by the fact that both the economies of India and of Pakistan were in a boom in the past few years but Pakistani politics being more vulnerable and terrorist activities prevail spoiling the peace of the country has brought the markets to level that the KSE 100 index of Pakistan lost almost four thousand points in the last few weeks while the Indian market although moving at a slower pace due to global recession has sustained the pressure globally and has maintained its level. (Nayyar 1996)
The potential of the Indian capital markets can be imagined by considering the fact that numerous global financial giants such as J.P. Morgan, HSBC Global Asset Management etc have entered the Indian markets, the presence of these companies indicate that these markets promise a lot. The Indian economy has passed the test of times and has sustained global crisis and is still growing it is a clear reflection of effective policy making and timely innovation to expand the pool of investments.
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