is derivative market beneficial for all
TRANSCRIPT
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Is derivative market beneficial for
all? How it can be beneficial forimport - export trading?
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Contents
Introduction- What is derivatives?? Type of Derivatives
(i) forwards
(ii) futures
(iii) options
(iv) swaps
Purpose of derivative market
Benefits of Derivative markets
Derivatives markets in india
Criticism to Derivative market
Benefits to import-export trading
Conclusion
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Introduction
The liberalized policy being followed by the Government of Indiaand the gradual withdrawal of the procurement and distribution channel
necessitated setting in place a market mechanism to perform the
economic functions of price discovery and risk management.
To reduce this risk, the concept of derivatives comes into thepicture. Derivatives are products whose values are derived from one or
more basic variables called bases .
India is traditionally an agriculture country with strong
government intervention. Government arbitrates to maintain bufferstocks, fix prices, impose import-export restrictions, etc. This paper
focuses on the basic understanding about derivatives market and its
development in India.
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What is Derivatives ?
Derivatives are financial contracts whose values are derivedfrom the value of an underlying primary financial instrument, commodity
or index, such as: interest rates, exchange rates, commodities, and
equities.
Derivatives include a wide assortment of financial contracts,including forwards, futures, swaps, and options.
The International Monetary Fund defines Derivatives as
"financial instruments that are linked to a specific financial instrument
or indicator or commodity and through which specific financial risks canbe traded in financial markets in their own right. The value of financial
derivatives derives from the price of an underlying item, such as asset
or index. Unlike debt securities, no principal is advanced to be repaid
and no investment income accrues."
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Types of Derivatives(1)Forward Contracts: -
A forward contract is an agreement between two parties a buyer and aseller to purchase or sell something at a later date at a price agreed upon
today and without the right of cancellation
(2) Future Contracts: -
A futures contract is an agreement between two parties a buyer and a
seller to buy or sell something at a future date. The contact trades on a
futures exchange and is subject to a daily settlement procedure.
(3) Options Contracts: -
It is of two types: -
(i) Calls: -
. Calls give the buyer the right but not the obligation to buy a given
quantity of the underlying asset, at a given price on or before a given future
date.
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Types of Derivatives contd..
(ii) Puts give the buyer the right, but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a given date.
(4) Swaps: -
Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can beregarded as portfolios of forward contracts.
The two commonly used swaps are interest rate swaps and currency
swaps.
(i)Interest rate swaps involves swapping only the interest related cash
flows between the parties in the same currency.
(ii) Currency swaps entail swapping both principal and interest between
the parties, with the cash flows in one direction being in a different
currency than those in the opposite direction.
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The need for a derivatives market
Changes in interest rates and equity markets around the world
Currency exchange rate shifts
Changes in global supply and demand for commodities such as agricultural
products, precious and industrial metals, and energy products such as oil and
natural gas .
Help in transferring risks from risk adverse people to risk oriented people
Help in the discovery of future as well as current prices They increase the
volume traded in markets because of participation of risk adverse people in
greater numbers.
They increase savings and investment in the long run
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Benefits of Derivative market
The two most widely recognized benefits attributed to derivative
instruments are price discovery and risk management.
1. Price Discovery: -
Futures market prices depend on a continuous flow of
information from around the world and require a high degree oftransparency
A broad range of factors (climatic conditions, political
situations, debt default, refugee displacement, land reclamation and
environmental health, for example) impact supply and demand of assets(commodities in particular) and thus the current and future prices of
the underlying asset on which the derivative contract is based.
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1.Price Discovery
With some futures markets, the underlying assets can be
geographically dispersed, having many spot (or current) prices in
existence. The price of the contract with the shortest time to expiration
often serves as a proxy for the underlying asset.
Second, the price of all future contracts serve as prices that can beaccepted by those who trade the contracts in lieu of facing the risk of
uncertain future prices.
Options also aid in price discovery, not in absolute price terms, but in
the way the market participants view the volatility of the markets. This isbecause options are a different form of hedging in that they protect
investors against losses while allowing them to participate in the asset's
gains.
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2. Risk Management
Risk management is the process of identifying the desired level of risk,identifying the actual level of risk and altering the latter to equal the former.
This process can fall into the categories of hedging and speculation.
Hedging has traditionally been defined as a strategy for reducing the risk
in holding a market position
Speculation referred to taking a position in the way the markets will
move. Today, hedging and speculation strategies, along with derivatives, are
useful tools or techniques that enable companies to more effectively manage
risk.
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Other benefits
3. They Improve Market Efficiency for the Underlying Asset
If the cost of implementing these two strategies is the same, investors
will be neutral as to which they choose.
If there is a discrepancy between the prices, investors will sell the
richer asset and buy the cheaper one until prices reach equilibrium. In this
context, derivatives create market efficiency.
4. Derivatives Also Help Reduce Market Transaction Costs
Derivatives are a form of insurance or risk management, the cost oftrading in them has to be low or investors will not find it economically sound to
purchase such "insurance" for their positions
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Derivatives Market in India
Derivatives markets have had a slow start in India. The firststep towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendments) Ordinance, 1995,
which withdrew the prohibition on options in securities.
SEBI set up a 24-member committee under the Chairmanship ofDr. L.C. Gupta on 18th November 1996 to develop appropriate
regulatory framework for derivatives trading in India.
SEBI was given more powers and it starts regulating the stock
exchanges in a professional manner by gradually introducing reforms in
trading.
Derivatives trading commenced in India in June 2000 after
SEBI granted the final approval in May 2000.
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Derivatives Market in India
SEBI permitted the derivative segments of two stock exchanges, viz
NSE and BSE, and their clearing house/corporation to commence trading and
settlement in approved derivative contracts.
Index futures on CNX Nifty and BSE Sensex were introduced during
2000. The trading in index options commenced in June 2001 and trading in
options on individual securities commenced in July 2001.
Futures contracts on individual stock were launched in November 2001.
June 2003, SEBI/RBI approved the trading in interest rate derivatives
instruments and NSE introduced trading in futures contract on June 24, 2003on 91 day Notional T-bills.
. Derivatives contracts are traded and settled in accordance with the
rules, bylaws, and regulations of the respective exchanges and their clearing
house/corporation duly approved by SEBI and notified in the official gazette.
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Criticisms ofDerivatives
Options offer the potential for huge gains and huge losses. While
the potential for gain is alluring, their complexity makes them
appropriate for only sophisticated investors with a high tolerance for
risk.
(1) When a derivative fails to help investors achieve their objectives, the
derivative itself is blamed for the ensuing losses when, in fact, it's often
the investor who did not fully understand how it should be used, its
inherent risk, etc.
(2) Some view derivatives as a form of legalized gambling enabling users
to make bets on the market.
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Criticisms ofDerivatives
Lifespan - Derivatives are "time-wasting" assets. As each day passes
and the expiration date approaches, you lose more and more "time"
premium and the option's value decreases.
Direction and Market Timing - In order to make money with many
derivatives, investors must accurately predict the direction in which
the market or index will move (up or down) and the minimum magnitude
of the move during a set period of time. A mistake here almost
guarantees a substantial investment loss.
Costs - The bid/ask spreads of more common derivatives such as
options can be daunting. An option with a bid of 5.25 and an ask of
5.875 means an investor could buy a round lot (100 units) for Rs.
587.50 but could only sell them for Rs 525, resulting in an immediate
loss of Rs 61.50 before factoring in commissions.
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Interest Rate Exposure Interest Rate Derivatives instruments used to manage
interest rate risk
Interest Rate Swaps
Interest Rate Futures
Interest Rate Options
Interest Rate Cap - ensures a floating rate loan receives aceiling if interest rates rise
Interest Rate Floor - a hedge against rates dropping below a
certain level
Interest Rate Collar - combo of Cap and Floor that effectively
locks in a range for its borrowing costs Forward Rate Agreement (FRA)
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FX Rate Exposure
Types of FX Exposure Economic Exposure - long term effect of exchange
rate changes on present value of future cash flows
Transaction Exposure- balance sheet exposed to
foreign exchange rates
Translation Exposure - foreign subsidiaries or
operations exposed when converting currency to
parents home currency Currency derivatives used to manage FX rate
risk
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FX Rate Exposure FX Derivatives:
Currency or FX Forwards - commitment to buy foreign
currency at a future date.
Currency Futures - Similar to forwards but traded on
the exchange and standard contract. Currency Swaps - exchange of floating rate cash flow
in one currency for fixed in another currency.
Currency Options - right to buy or sell fixed amount of
foreign currency at a fixed exchange rate, on or beforespecified date.
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Commodity Price Exposure
Price Exposure- potential for changes in price
of commodity
Delivery Exposure- regular supply ofcommodity is crucial
Exposure hedged by forwards, futures, swaps
and options
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Derivative Instruments
Forwards Contracts between two parties that require specific
action at a later date at a price agreed upon today
Future Date = Maturity Date
Contract Price = Delivery price Not traded on an organized exchange
The buyer is in a long position, the seller is in a short
position
Long position gains value when the price rises andloses when the price falls
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Derivative Instruments Futures
Same as Forward, but traded on organized exchanges
Chicago Board of Trade (grains, metals, financials)
Chicago Mercantile Exchange (livestock, wood,
meat)
International Money Market (foreign currency
futures)
New York Mercantile Exchange (metals, petroleum,
fiber)
Requires a margin account
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Derivative Instruments
Swaps - Agreement to exchange a set of cash
flows at a future point in time
Interest rate swap most common type of swap.
One party swaps its floating interest rate for a fixedrate and vice versa
Allows Companies with weaker credit ratings to get
better rates
Other types include currency and commodity
swaps
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Derivative Instruments Options - Contract between two parties where the buyer has the rightto buy
or sell a fixed amount of underlying asset at a fixed price on or before aspecified date
Call Option: the contract allows the owner to buy the asset at a fixed price
Put Option: the owner has the right to sell the asset at a fixed price
Fixed price is the strike/exercise price of contract
Possible relationships between premium and strike price:
At-the-money asset price = strike price
Call Out-of-the-Money asset price less than strike price
Put Out-of the-Money asset price greater than strike price
Call In-the-Money asset price greater than strike price
Put In-the-Money asset price less than strike price