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Decision support system in Indian Derivatives Markets

Dr. Teena Shivnani


Faculty Center for Enterpreurship and Small Business Management Maharshi Dayanand Saraswati University , Ajmer. (Raj.) Phone No. 09828487687 E-mail:- teenashivnani13@gmail.com &

Ms. Vrinda Goel


Research Scholar , Department of Management Studies, Maharshi Dayanand Saraswati University, Ajmer. (Raj.) Phone No. 09783968032 E-mail:- vrinda.fms@gmail.com

Paper to be presented at the UGC National Seminar on

Decision Accounting & Management Control System


Organised by Jai Narain Vyas University Jodhpur.

March 6 7, 2010
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Decision support system in Indian Derivatives Markets


Dr. Teena Shivnani * Ms. Vrinda Goel ** ABSTRCT

The innovation and growth of derivative instruments was the result of satisfaction of demand of market players for a means to hedge price risk of holding an inventory of commodities. While they first emerged as hedging devices against fluctuations in commodity prices and commodity linked derivatives and were the sole forms of such products for a long time, they were replicated for financial instruments as well in the post-1970 period due to growing instability in the financial markets. This, more than anywhere else, holds true for the financial markets, which are known to innovate to keep pace with the growing needs and changing risk appetite of market participants. History of financial markets is replete with examples of growth of markets giving rise to demands for new, different instruments to enable investors to manage risks and markets innovating to satisfy these demands. In the recent years, the market for financial derivatives has grown both in terms of variety of instruments available, their complexity and turnover. The factors that have been driving the growth of financial derivatives worldwide are technological developments leading to development of more sophisticated risk management tools; increased volatility in asset prices in financial markets; increased integration of national financial markets with international markets and the inherent characteristic of the derivatives markets to be able to optimally combine the risks and returns over a large number of financial assets. These financial instruments are becoming an increasingly important vehicle for unbundling risks as they enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it. However, on their journey of innovation, derivatives have not been free from controversies. They have often been held to be too complex to comprehend. The leverage that these products provide to investors raises concern. Policy markers around the world are now having a re look as the problems being posed by derivatives viz. lack of homogeneous rules and accounting standards; the excessive freedom allowed to market players to innovate and the lack of complete statistics for exchange-traded and OTC transactions. Government needs more transparency and accountability in the functioning of derivative markets. The aim of this paper is to present the historical perspective in which derivatives have developed in India and present certain issues which have been widely debated in the context of these markets in India. This paper will shed light on some policy issues which effects the Indian derivatives markets decisions system .

Introduction
On their journey of innovation, derivatives have not been free from controversies. They have often been held to be too complex to comprehend. The leverage that these products provide to investors raises concern. Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset. 2

Development of exchange-traded derivatives Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. The derivatives market performs a number of economic functions: They help in transferring risks from risk averse people to risk oriented people They help in the discovery of future as well as current prices They catalyze entrepreneurial activity They increase the volume traded in markets because of participation of risk averse People in greater numbers They increase savings and investment in the long run Types of Derivatives Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts Options: Options are of two types - calls and puts. 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. 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. Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. Leaps: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are : Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These 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.

Progress of Derivatives in India The regulatory framework for Indian derivative markets has evolved overtime starting with promulgation of the Securities Laws (Amendment) Ordinance, 1995 which withdrew the prohibition on options in securities by repealing section 20 of the Securities Contracts (Regulation) at, 1956 [SC(R)A]. There after, the Securities and Exchange Board of India (SEBI) appointed committee under the chairmanship of Dr. L. C. Gupta in November 1996, which recommended an appropriate regulatory framework for derivatives trading in India. In March 1998, the L. C. Gupta Committee (LCGC) submitted its report recommending the introduction of derivatives markets in a phased manner beginning with the introduction of index futures. The Committee noted that: "The evolution of markets in commodities and financial assets may be viewed as a worldwide long-term historical process. In this process, the emergence of futures has been recognized in economic literature as a financial development of considerable significance." It further opined that: "financial futures have quickly spread to an increasing number of developed and developing countries. They are recognized as the best and most cost-efficient way of meeting the felt need for risk-hedging in certain types of commercial and financial operations. Countries not providing such globally accepted risk-hedging facilities are disadvantaged in today's rapidly integrating global economy." Thus, the decision to commence with derivatives trading was taken and another committee appointed by SEBI in June 1998, under Prof. J.R. Varma, to recommend measures for risk containment for these markets. Derivatives trading commenced in June 2000, after necessary legislative amendments12 and SEBI approval, on the NSE and BSE. Trading first commenced in Index futures contracts in June 2000, followed by index options in June 2001, options in individual stocks in July 2001 and futures in single stock derivatives in November 2001. The LCGC was cautious in its approach towards launching of equity derivatives in India. It favored: " the introduction of equity derivatives in a phased manner so that the complex types are introduced after the market participants have acquired some degree of comfort and familiarity with the simpler types. This would be desirable from the regulatory angle too." India's experience with derivative products has been very encouraging and we quickly emerged as one of the most successful developing countries in terms of a vibrant market for exchangetraded derivatives. The turnover in the derivatives segment of the NSE soon overtook the turnover in the capital markets segment of the exchange. As per the latest data for the period April 08 to Nov 08, the turnover in the derivatives segment of the NSE was around 3.8 times that on its capital markets segment. This speaks aloud on the way derivative instruments have been accepted by the market participants in India. Overtime, the number of contracts available for trading in the derivatives segment of the exchanges has increased. On the NSE, as at end November 2008, 42,218 contracts were available for trading. To expand the universe of risk hedging products available to the market, Interest rate futures were launched in June, 2003. However, the product did not pick up as the design of the product had some flaws and also banks were not permitted to take trading positions in these instruments. 4

The product was now been reintroduced and RBI has permitted banks to take trading positions in October, 2008. SEBI set up a Derivatives Market Review Committee, in March 2007, to look into the developments in derivatives market in India and also suggest future possibilities and course of action. The Committee, in December 2007, recommended introduction of certain new derivative instruments based on global experience and the perceived appetite for new products in the Indian markets. These included mini contract in equity indices; long term option contracts, options on futures; exchange traded currency futures and Exchange-traded Products Involving Different Strategies. Based on these recommendations the new products that have been launched by the NSE in 2008 are the mini Nifty contracts, long tenure options and exchange traded currency futures. As per the Futures Industry Association (FIA) Annual Volume Survey, more than 15 billion futures and options contracts were traded during 2007 on the 54 exchanges that report to the FIA, an increase of 28% from the previous year. The growth rates were 19% in 2006, 12% in 2005, and 9% in 2004. As regards the position of derivatives trading in India, among the top derivatives exchanges worldwide, the National Stock Exchange of India (NSE) ranked 9th in 2007 in terms of futures and options volume with 379 mn contracts being traded in 2007 (Source: FIA). In terms of trading volumes in single stock futures, while the NSE was ranked first (1st) in terms on number of contracts traded in 2006, it has shifted to second position as the Johannesburg Stock Exchange (JSE) overtook NSE with a 265.49 million contracts traded in 2007 at the JSE as against 179.33 contracts on the NSE. While we are yet to see how these derivative instruments are received by the market, there are still many more milestones to cross in terms of expanding the universe of derivative products available to the market participants. The following table shows, what kind of asset classes are covered by derivative contracts globally and what is the position in India. Table 1 REST OF THE WORLD

Table 1 shows that in the rest of the world, new and innovative derivative products are being traded. These include, weather derivatives, Volume futures/options, Energy derivatives, Credit derivatives etc. In future the policy makers think about expanding the universe of available hedging instruments in the form of derivatives. The regulators in India need to encourage financial innovation. The LCGC also recognized that: 5

"While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology." One important product that has been in the offing for a long time now, but has not been introduced as yet is the credit derivatives. In the year 2003 the RBI issued the first draft on guidelines on credit derivatives trading. It released another draft guideline in May, 2007. Between March 2003 and May 2007, four years have lapsed and the credit derivatives market has not yet started functioning. Various apprehensions have been expressed about the preparedness of Indian markets for this product in terms of risk management infrastructure and comprehension of the product itself. These apprehensions of the market regulators have been aggravated further in the light of the present global financial crisis Thus, this product has for the present been kept on hold for the Indian markets. Besides the issue of expanding the universe of derivative instruments available in the Indian markets, two important policy issues that confront the markets are the choice between cash and physical settlement and the choice between exchange traded and OTC derivative markets. These are elaborated below:Cash vs Physical settlement There has been much controversy about the two modes of settlement that are available for derivative contracts, viz. cash and physical settlement, comparing the two on the basis of their vulnerability to speculation and manipulation. Physical settlement, it is argued, provides the link to the real markets of the underlying securities. However it is susceptible to distortions such as "short squeezes" Cash settlement, on the other hand, provides the benefits of avoiding the problem of delivery costs and lowering the effectiveness of market manipulations such as cornering and squeezing. Presently, all derivative contracts in India are cash settled. Looking at the debate on cash vs physical settlement of derivatives in India, we find that the LCGC Report took it for granted that physical settlement would be used for derivative contracts on individual stocks. It noted that: "In the case of individual stocks, the positions which remain outstanding on the expiration date will have to be settled by physical delivery. This is an accepted principle everywhere. The futures and the cash market prices have to converge on the expiration date. Since Index futures do not represent a physically deliverable asset, they are cash settled all over the world on the premise that the index value is derived from the cash market. This, of course, implies that the cash market is functioning in a reasonably sound manner and the index values based on it can be safely accepted as the settlement price. However, when single stock derivatives were introduced in India, it was decided to use cash settlement to begin with because the exchanges did not then have the software, legal framework and administrative infrastructure for physical settlement. It was proposed that cash settlement would be replaced by physical settlement as the exchanges developed the capabilities to achieve physical settlement efficiently. In April 2002, SEBI's Advisory Committee on Derivatives (ACD) proposed a broad framework for physical settlement presenting the risks and benefits of physical settlements along with 6

possible risk containment measures. The ACD noted the following as the principal issues involved in physical settlement: In the absence of a vibrant mechanism for securities lending and borrowing, physical settlement of stock specific derivative contracts, especially stock options, may raise concerns on the possibility of a short squeeze. Globally, cash settlement is cheaper than physical settlement, but the economics may be less clear cut in India where the modernization of the payment system has lagged that of the securities settlement system. Speculators on the other hand would find cash settlement beneficial since they do not (by definition) have an offsetting cash market position and cash settlement saves them the burden of operating in two markets. Physical settlement of derivative contract helps hedgers and arbitragers avoid basis risk while imposing some additional costs on speculators.

SEBI approved of this recommendation and was of the view that it would be desirable to have a vibrant system of margin-trading and securities lending and borrowing in the cash market, before allowing physical settlement. Both the schemes were permitted by SEBI in March, 2004. The margin-trading scheme was not successful as the market did not perceive the scheme to be attractive or efficient. The ACD again deliberated on this issue and reiterated that physical settlement is dependent on a vibrant securities lending and borrowing mechanism. In this context, it would be instructive to ask if the physical settlement is an end in itself or a means to something. If the objective is the efficient and liquid market where futures price converges with the spot price on expiration, then cash settlement is equally effective, if not more. We look at some evidence on the process of price discovery and market manipulation under the physical and cash settlement system. An "efficient" price discovery process happens when the private information embodied in the future market participants seamlessly percolates to the spot market. Presented here are certain empirical studies on efficiency of cash vis--vis physically settled derivative contracts. While the first two studies deal with commodity markets, the implications would be even more pertinent in markets with financial under lyings. A theoretical model of futures pricing with delivery option is used to simulate futures prices with different terms of construct cash indices. Results suggest that cash settlement provides slightly higher levels of hedging effectiveness than any type of multiple physical deliveries. Donald Lien and Yiu Kuen Tse (2002) investigate the effects of the switch from physical delivery to cash settlement on the behavior of the cash and futures prices of the feeder cattle contract traded on the Chicago Mercantile Exchange. The results show the following: Volatility of the futures prices (but not the cash prices) declined after physical delivery was replaced by cash settlement. In terms of futures hedging, cash settlement led to smaller and more stable hedge ratios. 7

The variance of the hedged portfolio also decreased substantially.

The evidence suggests that cash settlement is beneficial to the feeder cattle futures market. There is, thus, no fundamental difference on price discovery and it is always possible to obtain convergence of futures price to the spot price on expiration date, both under physical as well as cash settlement, because this convergence depends upon arbitrage and it is perfectly feasible to do arbitrage under cash settlement.

OTC vs Exchange Traded Derivatives Derivatives trading can be organized in two ways. The first way is through bi-lateral agreement between counterparties, called the `over the counter' or `OTC derivatives' transactions. Another way is through the anonymous order matching platform of the stock exchange. Exchange-traded contracts are standardized, with regard to maturity date, contract size and delivery terms, whereas OTC contracts are custom-tailored to the client's needs. Worldwide there is has been a phenomenal increase in OTC transactions, as indicated from the table below: Table 2 Global Exchange traded Derivatives volume by Category (in USD)

The growth in this market has been led by the innovations happening in structured finance and other customized derivatives products. These innovations are driven by the investor's demands and them competition among the institutional brokers to cater to these demands. Some of the advantages of OTC contracts are: Buyers and Sellers can negotiate the contracts as per their respective needs to come with customized products. Transaction costs can be reduced. The fees like exchange fees, clearing fees can be eliminated. OTC derivatives market can be used for executing bulk orders without the risk of market impact. Table :- 3 Derivatives transaction on Organized Exchange and OTC Markets 8

The above table 3 presents the derivative transactions on organized exchanges vis--vis those happening in the OTC markets. As is evident from the data, while both exchange traded and OTC derivative transactions are increasing, the rate of growth of amounts outstanding of exchange traded derivative instruments was 14% over Dec-06 to Dec-07 vis--vis 43.5% growth in OTC derivations over the same period. Over the period Dec-07 to June-08, the rate of growth of outstanding OTC derivative transactions was 15% as against 5% growth in amounts outstanding on exchange traded derivative transactions. Though OTC transactions have certain benefits as mentioned above, they are generally held to be faced with problems of inefficient price discovery and large counterparty risk as they are privately negotiated, devoid of novation which a clearing corporation offers. However, there is another aspect of this debate which argues that we are presently witnessing an increasingly diminishing boundaries between the exchange traded and OTC derivatives markets. Some are as follows: Exchange-traded contracts are generally thought of as having been standardized (with regard to maturity date, contract size and delivery terms), whereas OTC contracts are customtailored to the client's needs. Some exchanges, however, have introduced derivative instruments that can provide a significant degree of customization.

Also, in practice, OTC markets may follow certain simplifying market conventions that provide a certain degree of standardization. For example, most interest rate swaps in Canada are fairly standardized, typically involving the exchange of cash flows on a contract's notional value based on 1-month or 3-month bankers' acceptances (floating interest rate) for 2- to 5-year Government of Canada bonds (fixed rate). The general perception about OTC markets is that they have high counterparty risk. However, the Bank for International Settlement's Committee on Payment and Settlement Systems (CPSS), in a report on "New developments in clearing and settlement arrangements for OTC derivatives", published in March 2007, based on a survey of 35 large OTC dealers, noted the following:

1. Expanded use of collateral now significantly mitigates counterparty credit risks, and the legal and operational risks associated with reliance on collateral have been reduced by changes in national law and enhancements to dealers' collateral management systems. 9

2. The use of Central Counterparties (CCPs) has expanded in financial markets generally, spurred by increasing use of electronic trading systems. Some CCPs have also developed services that enable products traded over the counter to be submitted for clearing. In most instances, the OTC products are converted into equivalent exchange-traded contracts to facilitate clearing and to allow for offsetting with exchange-traded products. Examples include: A trade information warehouse has been created by the Depository Trust & Clearing Corporation (DTCC) and launched in November 2006. The Trade Information Warehouse ("Warehouse"), as the market's central registry and industry-recognized postconfirm infrastructure for credit derivatives, is optimally equipped to support any and all CCPs that are established in the CDS market. Virtually all dealers and buy-side participants along with 15 third-party service providers in the global CDS market are already linked to the Warehouse and utilize its functionality.

The Present Scenario in India Economic entities in India currently have a menu of OTC products. In respect of forex derivatives involving rupee, residents have access to foreign exchange forward contracts, foreign currency-rupee swap instruments and currency options - both cross currency as well as foreign currency-rupee. For derivatives involving only foreign currency, a range of products such as IRS, FRAs, option are allowed. The rupee interest rate derivatives presently permissible are Forward Rate Agreements (FRA), Interest Rate Swaps (IRS) and Interest Rate Futures (IRF). Table below indicates the activity in the OTC markets in India in April 2007 on Daily average turnover basis. Table 4 :- OTC Derivatives turnover in April 2007 ( in USD)

The corresponding activity on the derivatives segment of the largest derivatives exchange, the National Stock exchange, in the month of April 2007 was Rs 30,8143 mn (or USD 7463 mn) of average daily turnover. Thus, in line with international trend, the OTC derivatives markets in India are far larger than the exchange traded market for derivatives. The debate on choice between the two ways of trading in derivative, viz. on exchange and OTC, in India is on the same lines as the international debate. It is recognized that OTC trading, while 10

permitting unlimited flexibility in the contract, suffers from non-transparency, inefficient price discovery and generally involves counterparty risk. However, there are some benefits of OTC markets, as pointed out by Prof J.R.Varma, who argues for the creation of an OTC equity derivative market in India18. He is of the view that competition between OTC markets and exchanges forces each market to lower costs and to adopt the best practices of the other market. He further holds that standardized and highly liquid contracts are best traded in organized exchanges because of the enhanced transparency and lower systemic risk. However new contracts are often best incubated in OTC markets until they achieve a critical mass of liquidity and widespread participation at which point they can be moved to the exchange traded format. Long dated equity options are today best incubated in OTC markets. Role of OTC in Decision system On the other hand, on the role of exchange-traded vs OTC derivatives, the recent report of Government appointed High Powered Expert Committee on Making Mumbai an International Financial Centre has stressed on a greater role for exchange-traded derivatives in an Indian International Financial Center, for the following reasons: 1. The present OTC market in India largely trades plain vanilla products for which exchange traded platform is a better option as it provides transparency and liquidity at no cost in flexibility. 2. In an environment where India's regulatory and supervisory capacity in the derivatives markets in still nascent but evolving, exchange traded markets are easier to regulate than the opaque OTC markets which make greater demand upon regulation and governance. 3. Exchange traded markets fit better with non-institutional customers who are not able to access the telephone network through which OTC trading takes place. 4. Exchange traded derivatives trading plays to India's strengths in running exchange institutions. Our two national exchanges (BSE and NSE) and clearing corporations (NSCCL and CCIL) are a strong set of institutions who can compete in the global market for exchange traded derivatives. The report, on this issue, concludes that India needs both exchange traded derivatives and OTC derivatives. However, based on the above arguments, it is desirable to lay special focus on obtaining world-class liquidity on the exchange platform, after which OTC market can spring up based on utilization of the prices and liquidity produced on this platform. Conclusion One has seen a significant growth of OTC derivatives market world over. Internationally, the problems of technology solutions and risk management are increasingly being addressed by new developments in the market like introduction of electronic trading and confirmation systems, CCP clearing the trades etc. With these developments happening, analysts have argued that it is actually leading to unification of the organized exchange market and the OTC market. There are other sets of analysts who feel both the exchange and OTC derivatives market will co-exist as they cater to needs of different user. However, there is a renewed debate on the level of transparency and counterparty risk in the OTC markets kindled by the sub prime mortgage crisis in the US and the need to regulate OTC 11

transactions effectively, as also mentioned in the introduction of this article. This throws up important issues which, at best, may need to be handled separately. For the present, one could say that these markets, viz. exchange traded and OTC, are two competing market and each have unique characteristics. Due to this reason we can say that OTC and cash effects the decision system of derivatives in India. References Bontis, N. (1998). Intellectual Capital: an exploratory study that develops measures and models. Management Decision, 36(2), 63-76. Chen, J., Zhu, Z. & Xie, H. (2004) Measuring Intellectual capital: a new model and empirical study. Journal Intellectual Capital, 5(1), 195-212. Donald Lien and Yiu Kuen Tse, Physical delivery versus cash settlement: an empirical study on the feeder cattle contract, Journal of Empirical Finance, November 2002. Donald Lien and Li Yang, Alternative settlement methods and Australian individual share futures contracts, Journal of International Financial Markets, Institutions and Money December 2004. Nabil Chaherli and Robert Hauser, Delivery Systems versus Cash Settlement in Corn and Soybean Futures Contracts, SSRN working paper. February 1995. Stolowy, H. & Jenny-Cazavan, A. (2001). International accounting disharmony: the case of intangibles. Accounting, Auditing and Accountability Journal, 14(4), 477-496. Wang, W.Y. & Chang, C. (2005). Intellectual capital and performance in causal models: Evidence from the information technology industry in Taiwan. Journal Intellectual Capital, 6(2), 222-236. IMF Working Paper: Counterparty Risk in the Over-The-Counter Derivatives Market by Miguel A. Segoviano and Manmohan Singh, November 2008. The Microstructure of Financial Derivatives Markets: Exchange-Traded versus Over-theCounter by Brenda Gonzlez-Hermosillo, Bank of Canada (March 1994) www.nscindia.com www.google.co.in

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