Contents1 Basics 5 Q1.1 What are derivatives? . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Q1.2 What is a forward contract? . . . . . . . . . . . . . . . . . . . . . . . 5 Q1.3 Why is forward contracting useful? . . . . . . . . . . . . . . . . . . . . 5 Q1.4 What are the problems of forward markets? . . . . . . . . . . . . . . 5 Q1.5 What is a futures contract? . . . . . . . . . . . . . . . . . . . . . . . . 5 Q1.6 Why is the cash market in India said to have futures-style settlement? 6 Q1.7 What is an option? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Q1.8 What are exotic" derivatives? . . . . . . . . . . . . . . . . . . . . . . 6 Q1.9 How are derivatives di erent from badla? . . . . . . . . . . . . . . . . 6 Q1.10 Why are derivatives useful? . . . . . . . . . . . . . . . . . . . . . . . 6 Q1.11 What are the instruments traded in the derivatives industry, and what are their relative sizes? . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Q1.12 Worldwide, what kinds of derivatives are seen on the equity market? 7 Q1.13 At the security level, are futures or options better? . . . . . . . . . . 7 Q1.14 Why have index derivatives proved to be more important than security derivatives? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Q1.15 Who uses index derivatives to reduce risk? . . . . . . . . . . . . . . 8 Q1.16 How will retail investors bene t from index derivatives? . . . . . . . 9 Q1.17 What derivatives exist in India today in the interest-rates area? . . 9 Q1.18 What derivatives exist in India today in the foreign exchange area? 9 Q1.19 What is the status in India in the area of commodity derivatives? . . 9 Q1.20 What is the present status of derivatives in the equity market? . . . 10 Q1.21 Why do people talk about starting derivatives in India if some derivatives already exist? . . . . . . . . . . . . . . . . . . . . . . . . . 10 Q1.22 What should the time to expiration of these contracts be? . . . . . . 102 Market Microstructure 11 Q2.1 How do derivatives trade? . . . . . . . . . . . . . . . . . . . . . . . . . 11 Q2.2 If a contract is just a relationship between long and short, how do we ensure contract performance? . . . . . . . . . . . . . . . . . . . . . . 11 Q2.3 What is the role of arbitrage in the derivatives area? . . . . . . . . . . 11 Q2.4 What happens if there are only a few arbitrageurs ready to function in the early days of the market? . . . . . . . . . . . . . . . . . . . . . . . 11 Q2.5 Isnt Indias cash market much too ine cient to support concepts like derivatives? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 1
2 CONTENTS Q2.6 What is the role of liquidity in enabling good derivatives markets? . . 12 Q2.7 What should a market index be? . . . . . . . . . . . . . . . . . . . . . 12 Q2.8 How does liquidity matter for market indexes? . . . . . . . . . . . . . 12 Q2.9 What is special about Nifty for use in index derivatives? . . . . . . . . 13 Q2.10 What is the impact cost seen in trading Nifty? . . . . . . . . . . . . 13 Q2.11 How does this low impact cost matter? . . . . . . . . . . . . . . . . . 13 Q2.12 Is the liquidity in India adequate to support well-functioning deriva- tives markets? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Q2.13 What kind of liquidity is expected on index derivatives markets? . . 13 Q2.14 How does spot-futures arbitrage a ect the cash market? . . . . . . . 14 Q2.15 Going beyond spot-futures arbitrage, how do derivatives in uence liq- uidity on the underlying market? . . . . . . . . . . . . . . . . . . . . . 14 Q2.16 What is the international experience in terms of how the underlying market is changed once derivatives start trading? . . . . . . . . . . . . 14 Q2.17 Program trading in the US is often accused of generating di culties. What does that mean for us? . . . . . . . . . . . . . . . . . . . . . . . 14 Q2.18 Will derivatives destabilise the stock market? Could this happen in extreme events? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Q2.19 Is there more or less of a natural monopoly in derivatives trading, as compared with the spot market? . . . . . . . . . . . . . . . . . . . . 15 Q2.20 What are the policy implications of this lack of a natural monopoly? 15 Q2.21 At the operational level, how do security contracts compare versus index-based contracts? . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 Derivatives Disasters 17 Q3.1 Why do we keep reading about disasters involving derivatives? . . . . 17 Q3.2 Why have we seen more disasters in the recent years? . . . . . . . . . 17 Q3.3 How much money has been lost in these derivatives disasters? . . . . 17 Q3.4 What happened in Barings? . . . . . . . . . . . . . . . . . . . . . . . 17 Q3.5 What should be done to minimise disasters with derivatives? . . . . . 174 Policy Issues 19 Q4.1 What emerging markets have already created derivatives markets? . . 19 Q4.2 What was Chinas experience in this area? . . . . . . . . . . . . . . . 19 Q4.3 What nancial markets in India are ready for derivatives today? . . . 19 Q4.4 Are derivatives in interest rates viable in India? . . . . . . . . . . . . 19 Q4.5 Why are commodity futures markets important? . . . . . . . . . . . . 19 Q4.6 What are the issues in the creation of commodity derivatives markets? 20 Q4.7 What can be done in derivatives on real estate? . . . . . . . . . . . . 21 Q4.8 Should foreigners be restricted in Indias derivatives markets as a mat- ter of policy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Q4.9 What would access to derivatives do to FII and FDI investment? . . . 21 Q4.10 Is India ready for derivatives today? . . . . . . . . . . . . . . . . . . 21 Q4.11 What are the costs and bene ts of delaying the onset of exchange- traded nancial derivatives in India? . . . . . . . . . . . . . . . . . . . 22 Q4.12 What international derivatives exchanges are working towards launch- ing products o underlyings in emerging markets? . . . . . . . . . . . 23
CONTENTS 3 Q4.13 What derivatives on Indian underlyings are currently trading abroad? 23 Q4.14 Would foreign derivatives markets be interested in launching trading on Indian underlyings? . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Q4.15 Is this a real threat? . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Q4.16 What are the implications of derivatives on Indian underlyings trading abroad? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Q4.17 But in the GDR market experience, the foreign market has hardly a ected order ow into India why are derivatives di erent? . . . . . 245 Regulatory Issues 25 Q5.1 What are the objectives of regulation? . . . . . . . . . . . . . . . . . . 25 Q5.2 What kinds of competition are possible in the nancial market scenario? 25 Q5.3 How does deviation from perfect competition or situations of market power arise on nancial markets? . . . . . . . . . . . . . . . . . . . . 25 Q5.4 How should regulation of exchanges work? . . . . . . . . . . . . . . . 25 Q5.5 What can regulation do to encourage competitiveness? . . . . . . . . 25 Q5.6 What should entry or eligibility requirements be for derivatives trading? 26 Q5.7 What is fraud? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Q5.8 How can regulation diminish the extent of fraud? . . . . . . . . . . . . 26 Q5.9 Should there be regulatory control over contract de nition? . . . . . . 26 Q5.10 Should the securities that are used in an index be required by regula- tion to be in depository mode? . . . . . . . . . . . . . . . . . . . . . . 27 Q5.11 Should regulation require that derivatives trading be organised at an exchange which is distinct from the spot market? . . . . . . . . . . . . 27 Q5.12 At an operational level, is it better to have the spot and futures market under one roof? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 5.1 Risk Management at Clearing . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Q5.13 Why is the clearinghouse central to derivatives markets? . . . . . . . 28 Q5.14 How should margining for derivatives work? . . . . . . . . . . . . . . 28 Q5.15 How is initial margin i.e. exposure limit calculated? . . . . . . . 28 Q5.16 How is daily mark to market MTM margin calculated? . . . . . . . 29 Q5.17 How does the slow payments system change these calculations? . . . 29 Q5.18 What are prospects for improvements of the banking system? . . . . 29 Q5.19 How does options margining work? . . . . . . . . . . . . . . . . . . . 30 Q5.20 What are the special di culties of margining options? . . . . . . . . 30 Q5.21 What constraints should regulation impose upon the time to expira- tion of these contracts? . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Q5.22 How does the margining system change the way people trade? . . . . 30 Q5.23 What are the policy issues in clearing corporation failure? . . . . . . 30 5.2 Other Aspects of the Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Q5.24 What are the risks that derive from usage of derivatives? . . . . . . . 31 Q5.25 What are the policy issues in individual risk? . . . . . . . . . . . . . 31 Q5.26 What about systemic risk, or risks to the economy? . . . . . . . . . . 32 Q5.27 How should the use of derivatives by mutual funds be regulated? . . 32 5.3 Market manipulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Q5.28 What are the issues in terms of manipulation in the context of deriva- tives markets in general? . . . . . . . . . . . . . . . . . . . . . . . . . . 32
4 CONTENTS Q5.29 What are the issues on short squeezes? . . . . . . . . . . . . . . . . . 32 Q5.30 What kinds of manipulation are found with index derivatives? . . . . 32 Q5.31 How do manipulators attack an index? . . . . . . . . . . . . . . . . . 33 Q5.32 What kinds of manipulation can take place on security options? . . . 33 Q5.33 Are individual securities in India liquid enough to support security options? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Q5.34 What would concerns about manipulation imply for the sequencing of index derivatives vs. security options? . . . . . . . . . . . . . . . . . . 34 Q5.35 Would a slow launch of security options harm the economy? . . . . . 34 Q5.36 What spot market should supply prices which are used for calculating payo s with cash settled security options? . . . . . . . . . . . . . . . 34 Q5.37 To what extent are these issues a regulatory issue? . . . . . . . . . . 34 5.4 In Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Q5.38 What does this discussion translate to in terms of speci c regulations in the derivatives area? . . . . . . . . . . . . . . . . . . . . . . . . . . 356 Derivatives and the Economy 37 Q6.1 What are the bene ts of derivatives to India? . . . . . . . . . . . . . . 37 Q6.2 How do index derivatives change the overall level of equity investment in the economy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Q6.3 How will index derivatives assist capital formation and growth in the economy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Q6.4 What is the evidence about derivatives and market liquidity and e - ciency? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Q6.5 What is the evidence about market quality and economic growth? . . 38 Q6.6 How do derivatives alter the exposure of di erent people in the economy? 38 Q6.7 How do derivatives alter the informational structure of the economy? 38
Chapter 1Basics go long on the forward market instead of the cashQ1.1: What are derivatives? market. The speculator would go long on the for-A: Derivatives, such as options or futures, are - ward, wait for the price to rise, and then take anancial contracts which derive their value o a reversing transaction. The use of forward marketsspot price time-series, which is called the under- here supplies leverage to the speculator.lying. For examples, wheat farmers may wishto contract to sell their harvest at a future date Q1.4: What are the problems of forward mar-to eliminate the risk of a change in prices by that kets?date. Such a transaction would take place through A: Forward markets worldwide are a icted by sev-a forward or futures market. This market is the eral problems: a lack of centralisation of trading, derivative market, and the prices on this mar- b illiquidity, and c counterparty risk.ket would be driven by the spot market price of In the rst two of these, the basic problem iswheat which is the underlying. The terms con- that of too much exibility and generality. Thetracts or products are often applied to denote forward market is like the real estate market inthe speci c traded instrument. that any two consenting adults can form contracts The world over, derivatives are a key part of the against each other. This often makes them de- nancial system. The most important contract- sign terms of the deal which are very convenienttypes are futures and options, and the most im- in that speci c situation, but makes the contractsportant underlying markets are equity, treasury non-tradeable. Also the phone market here isbills, commodities, foreign exchange and real es- unlike the centralisation of price discovery that istate. obtained on an exchange. Counterparty risk in forward markets is a sim-Q1.2: What is a forward contract? ple idea: when one of the two sides of the trans-A: In a forward contract, two parties agree to do action chooses to declare bankruptcy, the othera trade at some future date, at a stated price and su ers. Forward markets have one basic property:quantity. No money changes hands at the time the larger the time period over which the forwardthe deal is signed. contract is open, the larger are the potential price movements, and hence the larger is the counter-Q1.3: Why is forward contracting useful? party risk.A: Forward contracting is very valuable in hedging Even when forward markets trade standardisedand speculation. contracts, and hence avoid the problem of illiq- The classic hedging application would be that uidity, the counterparty risk remains a very realof a wheat farmer forward-selling his harvest at a problem. A classic example of this was the famousknown price in order to eliminate price risk. Con- failure on the Tin forward market at LME.versely, a bread factory may want to buy breadforward in order to assist production planning Q1.5: What is a futures contract?without the risk of price uctuations. A: Futures markets were designed to solve all the If a speculator has information or analysis three problems a, b and c listed in Question 1.4which forecasts an upturn in a price, then she can of forward markets. Futures markets are exactly 5
6 CHAPTER 1. BASICSlike forward markets in terms of basic economics. However, more complex contracts, often called ex- However, contracts are standardised and trad- otics, are used in more custom situations. For ex-ing is centralised, so that futures markets are ample, a computer hardware company may wanthighly liquid. There is no counterparty risk a contract that pays them when the rupee has de-thanks to the institution of a clearinghouse which preciated or when computer memory chip pricesbecomes counterparty to both sides of each trans- have risen. Such contracts are custom-builtaction and guarantees the trade. In futures mar- for a client by a large nancial house in whatkets, unlike in forward markets, increasing the is known as the over the counter derivativestime to expiration does not increase the counter- market. These contracts are not exchange-traded.party risk. This area is also called the OTC Derivatives In- dustry. Also see: ?. An essential feature of derivatives exchanges is contract standardisation. All kinds of wheat areQ1.6: Why is the cash market in India said not tradeable through a futures market, only cer-to have futures-style settlement? tain de ned grades are. This is a constraint for aA: In a true cash market, when a trade takes place farmer who grows a somewhat di erent grade oftoday, delivery and payment would also take place wheat. The OTC derivatives industry is an inter-today or a short time later. Settlement proce- mediary which sells the farmer insurance which isdures like T+3 would qualify as cash markets customised to his needs; the intermediary wouldin this sense, and of the equity markets in the in turn use exchange-traded derivatives to strip ocountry, only OTCEI is a cash market by this def- as much of his risk as possible.inition. For the rest, markets like the BSE or the NSE Q1.9: How are derivatives di erent fromare classic futures market in operation. NSEs eq- badla?uity market, for example, is a weekly futures mar- A: Badla is closer to being a facility for borrowingket with tuesday expiration. When a person goes and lending of shares and funds. Borrowing andlong on thursday, he is not obligated to do deliv- lending of shares is a functionality which is partery and payment right away, and this long position of the cash market. The borrower of shares pays acan be reversed on friday thus leaving no net obli- fee for the borrowing. When badla works withoutgations with the clearinghouse this would not be a strong marginning system, it generates counter-possible in a T+3 market. Like all futures mar- party risk, the evidence of which is the numerouskets, trading at the NSE is centralised, the futures payments crises which were seen in India.markets are quite liquid, and there is no counter- Options are obviously not at all like badla. Fu-party risk. tures, in contrast, may seem to be like badla to some. Some of the key di erences may be sum-Q1.7: What is an option? marised here. Futures markets avoid variabilityA: An option is the right, but not the obligation, of badla nancing charges. Futures markets tradeto buy or sell something at a stated date at a distinctly from the cash market so that each fu-stated price. A call option gives one the right tures prices and cash prices are di erent things into buy, a put option gives one the right to sell. contrast with badla, where the cash market and all Options come in two varieties european vs. futures prices are mixed up in one price. Futuresamerican. In a european option, the holder of the markets lack counterparty risk through the insti-option can only exercise his right if he should so tution of the clearinghouse which guarantees thedesire on the expiration date. In an american trade coupled with marginning, and this elimina-option, he can exercise this right anytime between tion of risk eliminates the risk premium that ispurchase date and the expiration date. embedded inside badla nancing charges, thus re- ducing the nancing cost implicit inside a futures Also see: ?, ?. price.Q1.8: What are exotic derivatives? Q1.10: Why are derivatives useful?A: Options and futures are the mainstream A: The key motivation for such instruments isworkhorses of derivatives markets worldwide. that they are useful in reallocating risk either
7 Badla Futures Expiration date unclear Expiration date known Spot market and di erent expiration dates are Spot market and di erent expiration dates all mixed up trade distinct from each other. Identity of counterparty often known Clearing corpn. is counterparty Counterparty risk present No counterparty risk Badla nancing is additional source of risk No additional risk. Badla nancing contains default-risk premia Financing cost at close to riskless thanks to counterparty guarantee Asymmetry between long and short Long and short are symmetric Position can breakdown if borrowing lending You can hold till expiration date for sure, if you proves infeasible want to Table 1.1: A Comparison of Futures and Badlaacross time or among individuals with di erent Derivatives are also very convenient in terms ofrisk-bearing preferences. international investment. For example, Japanese One kind of passing-on of risk is mutual insur- insurance companies fund housing loans in the USance between two parties who face the opposite by buying into derivatives on real estate in the US.kind of risk. For example, in the context of cur- Such funding patterns would be harder withoutrency uctuations, exporters face losses if the ru- derivatives.pee appreciates and importers face losses if therupee depreciates. By forward contracting in the Q1.11: What are the instruments traded indollar-rupee forward market, they supply insur- the derivatives industry, and what are theirance to each other and reduce risk. This sort of relative sizes?thing also takes place in speculative position tak- A: This information is summarised in Tables 1.2ing the person who thinks the price will go up and 1.3 which are drawn from ?.is long a futures and the person who thinks theprice will go down is short the futures. Another style of functioning works by a risk- Q1.12: Worldwide, what kinds of derivativesaverse person buying insurance, and a risk- are seen on the equity market?tolerant person selling insurance. An example of A: Worldwide, the most successful equity deriva-this may be found on the options market : an in- tives contracts are index futures, followed by indexvestor who tries to protect himself against a drop options, followed by security options.in the index buys put options on the index, and arisk-taker sells him these options. Obviously, peo- Q1.13: At the security level, are futures orple would be very suspicious about entering into options better?such trades without the institution of the clearing-house which is a legal counterparty to both sides A: The international experience is that at the se-of the trade. curity level, options markets are almost always In these ways, derivatives supply a method for more successful than futures markets.people to do hedging and reduce their risks. Ascompared with an economy lacking these facilities, Q1.14: Why have index derivatives proved toit is a considerable gain. be more important than security derivatives? The ultimate importance of a derivatives mar- A: Security options are of limited interest becauseket hence hinges upon the extent to which it helps the pool of people who would be interested say ininvestors to reduce the risks that they face. Some options on ACC is limited. In contrast, every sin-of the largest derivatives markets in the world are gle person in the nancial area is a ected by indexon treasury bills to help control interest rate risk, uctuations. Hence risk-management using indexthe market index to help control risk that is asso- derivatives is of far more importance than risk-ciated with uctuations in the stock market and management using individual security options.on exchange rates to cope with currency risk. This goes back to a basic principle of nan-
8 CHAPTER 1. BASICS 1986 1990 1993 1994 Exchange Traded 583 2292 7839 8838 Interest rate futures 370 1454 4960 5757 Interest rate options 146 600 2362 2623 Currency futures 10 16 30 33 Currency options 39 56 81 55 Stock Index futures 15 70 119 128 Stock Index options 3 96 286 242 Some of the OTC Industry 500 3450 7777 11200 Interest rate swaps 400 2312 6177 8815 Currency swaps 100 578 900 915 Caps, collars, oors, swaptions - 561 700 1470 Total 1083 5742 16616 20038 Table 1.2: The Global Derivatives Industry Outstanding Contracts, $ billioncial economics. Portfolio risk is dominated by the that the underwriter does in the bookbuild-market index, regardless of the composition of the ing process see ? for an exposition aboutportfolio. In other words, all portfolios of around bookbuilding.ten stocks or more have a pattern of risk where Similarly, a person who takes positions in in-80 or more of their volatility is index-related. In dividual stocks implicitly su ers index expo-such a world, investors would be more interested sure. A person who is long ITC is e ectivelyin using index based derivative products rather long ITC and long Index. If the index doesthan security-based derivative products. The ac- badly, then his long ITC position su ers.tual experience of derivatives markets worldwide A person like this, who is focussed on ITCis completely in line with this expectation. and is not interested in taking a view on the Also see: ?. Index would routinely measure the index ex- posure that is hidden inside his ITC expo- sure, and use index derivatives to eliminateQ1.15: Who uses index derivatives to reduce this risk. The NYSE specialist is a prime ex-risk? ample of intensive use of index derivatives inA: There are two important types of people who such an application.may not want to bear the risk of index uctua- A person who thinks Index uctuations aretions: painful An investor who buys stocks may like the A person who thinks Index uctuations are peace of mind of capping his downside loss. peripheral to his activity Put options on the index are the ideal form For example, a person who works in primary of insurance here. Regardless of the composi- market underwriting e ectively has index ex- tion of a persons portfolio, index put options posure if the index does badly, then the will protect him from exposure to a fall in the IPO could fail but this exposure has noth- index. To make this concrete, consider a per- ing to do with his core competence and in- son who has a portfolio worth Rs.1 million, terests which are in the IPO market. Such and suppose Nifty is at 1000. Suppose the a person would routinely use measure his in- person decides that he wants to never su er dex exposure on a day-to-day basis, and in- a loss of worse than 10. Then he can buy dex derivatives to strip o that risk. If full- himself Nifty puts worth Rs.1 million with edged bookbuilding becomes important in the strike price set to 900. If Nifty drops be- India, then there is a very important role for low 900 then his put options reimburse him index derivatives in the price stabilisation for his full loss. In this fashion, portfolio in-
9 1874 Commodity Futures 1972 Foreign currency futures 1973 Equity options 1975 T-bond futures 1981 Currency swaps 1982 Interest rate swaps; T-note futures; Eurodollar futures; Equity index futures; Options on T-bond futures; Exchange listed currency options 1983 Options on equity index; Options on T-note futures; Options on currency futures; Options on equity index futures; Interest rates caps and oors 1985 Eurodollar options; Swaptions 1987 OTC compound options; OTC average options 1989 Futures on interest rate swaps; Quanto options 1990 Equity index swaps 1991 Di erential swaps 1993 Captions; Exchange-listed FLEX options 1994 Credit default options Table 1.3: The Global Derivatives Industry: Chronology of Instruments surance through index options will greatly vestible lot on the index derivatives market is Rs.1 reduce the fear of equity investment in the million or so, then it will not be useful for retail country. investors. More generally, anytime an investor or a fund manager becomes uncomfortable, and does Q1.17: What derivatives exist in India to- not want to bear index uctuations in the day in the interest-rates area? coming weeks, he can use index futures or A: There are no derivatives based on interest rates index options to reduce or even eliminate in India today. his index exposure. This is far more con- venient than distress selling of the underly- Q1.18: What derivatives exist in India to- ing equity in the portfolio. Conversely, any- time investors or fund managers become op- day in the foreign exchange area? timistic about the index, or feel more com- A: India has a strong dollar-rupee forward market fortable and are willing to bear index uctu- with contracts being traded for one, two, .. six ations, they can increase their equity expo- month expiration. Daily trading volume on this sure using index derivatives. This is simpler forward market is around $500 million a day. In- and cheaper than buying underlying equity. dian users of hedging services are also allowed to In these ways, the underlying equity portfo- buy derivatives involving other currencies on for- lio can be something that is slowly traded, eign markets. and index derivatives are used to implement day-to-day changes in equity exposure. Q1.19: What is the status in India in the area of commodity derivatives? A: Futures markets exist on six commodities cas- tor seed, hessian, gur, potatoes, turmeric and pep-Q1.16: How will retail investors bene t from per. The pepper exchange, which is at Cochin, isindex derivatives? being upgraded to the status of an internationalA: The answer to this ts under People who nd pepper futures market, which will accept ordersIndex uctuations painful category in Question from all over the world. The Forward Markets1.15. Every retail investor in the economy who is Commission FMC oversees these markets.in pain owing to a downturn in the market index A high level of interest exists on futures mar-is potentially a happy user of index derivatives. kets for other commodities. In September 1994, One key requirement from the viewpoint of the the Kabra Committee recommended that fu-retail user is contract size. If the minimum in- tures trading should additionally be permitted
10 CHAPTER 1. BASICSin 17 commodities. These are a basmati rice, no exchange-traded nancial derivatives in In-b cotton, c kapas, d raw jute and jute dia today. Neither the dollar-rupee forward con-goods, e groundnut, its oil and cake, f rape- tract Question 1.18 nor the option-like contractsseed mustardseed, its oil and cake, g cotton Question 1.20 are exchange-traded. These mar-seed, its oil and cake, h sesame seed, its oil and kets hence lack centralisation of price discoverycake i sun ower, its oil and cake, j sa ower, its and can su er from counterparty risk. The nextoil and cake, k copra, coconut oil and its oilcake, step in these areas is institutionalisation, and al soyabean, its oil and cake, m ricebran oil, n broad-basing of access.castor oil and its oilcake, o linseed, p silver,and q onions. On 4 December 1996, the Cof- Q1.22: What should the time to expirationfee Board decided to recommend that a domestic of these contracts be?futures market for co ee should be setup. A: The time to expiration of these contracts On 28 February 1997, the nance minister an- should be whatever the market wants it to benounced that futures markets would be setup in if four-year contracts attract high trading vol-cotton and jute, and that an international futures ume, then four-year contracts should exist. Themarket would be created in castorseed and castor international experience is that most of the trad-oil. ing volume in index futures is concentrated in con- tracts which expire one, two, three and four quar-Q1.20: What is the present status of deriva- ters away. Limited interest is seen in contractstives in the equity market? which go upto two and three years out.A: As mentioned in Question 1.6, trading on the There is a widespread intuition in India, shaped spot market for equity has actually always been by decades of experience with clearinghouses thata futures market with weekly or fortnightly settle- do not guarantee trades, that longer time to expi-ment this is true of every market in the country ration is associated with higher counterparty risk.other than OTCEI. These futures markets fea- However, when daily mark-to-market margins areture the risks and di culties of futures markets, applied, the link between length of contract life andwithout the gains in price discovery and hedging counterparty risk is broken. A brand-new positionservices that come with a separation of the spot today is no di erent from an old position regard-market from the futures market. less of the history as long as the person has paid Indias primary market has experience with up his loss in full as of today. This is exactly whatderivatives of two kinds: convertible bonds and the mark-to-market margin does.warrants a slight variant of call options. Sincethese warrants are listed and traded, options mar-kets of a limited sort already exist. However, thetrading on these instruments is very limited. Therecent ICICI bond issue bundles a twelve-year ex-piration BSE Sensex warrant with the bond. Ifthis warrant is detached and traded, it would bean exchange-traded index derivative. A variety of interesting derivatives markets ex-ist in the informal sector. These markets tradecontracts like bhav-bhav, teji-mandi, etc. For ex-ample, the bhav-bhav is a bundle of one in-the-money call option and one in-the-money put op-tion. These informal markets stand outside themainstream institutions of Indias nancial systemand enjoy limited participation.Q1.21: Why do people talk about startingderivatives in India if some derivatives al-ready exist?A: It is useful to note here that there are
Chapter 2Market MicrostructureQ2.1: How do derivatives trade? Q2.3: What is the role of arbitrage in theA: In the cash market, the basic dynamic is that derivatives area?the issuer puts out paper, and people trade this A: All pricing of derivatives is done by arbitrage, and by arbitrage alone.paper. In contrast, in derivatives, there is no is- In other words, basic economics dictates a re-suer. The net supply of all derivatives contracts lationship between the price of the spot and theis 0. For each long, there is an equal and opposite price of a futures. If this relationship is violated,short. A contract is born when a long and a short then an arbitrage opportunity is available, andmeet on the market. when people exploit this opportunity, the price re- verts back to its economic value. There would be a clear contract cycle whichthe exchange de nes. For example, using quar- In this sense, arbitrage is basic to pricing of derivatives. Without arbitrage, there would be noterly contracts, we would have something like this: market e ciency in the derivatives market: pricesOn Jan 1, four contracts start trading. The near- would stray away from fair value all the time. In-est contract expires on 31 Mar. On 31 Mar, this deed, a basic fact about derivatives is that the rst contract ceases to exist, and the next 30June contract starts trading. market e ciency of the derivatives market is in- versely proportional to the transactions costs faced In the case of options, the exchange additionally by arbitrageurs in that market. When arbitrage isde nes the strike prices of the options which are uent and e ective, market e ciency is obtained,allowed to trade. which improves the attractiveness of the deriva- tives from the viewpoint of users such as hedgersQ2.2: If a contract is just a relationship or speculators.between long and short, how do we ensure contract performance? Q2.4: What happens if there are only a fewA: The key innovation of derivatives markets is arbitrageurs ready to function in the earlythe notion of the clearinghouse that guarantees days of the market?the trade. Here, when A buys from B, at a legal A: In most countries, there are bigger arbitragelevel the clearinghouse buys from B and sells to opportunities in the early days of the futures mar-A. This way, if either A or B fail on their obliga- ket. As larger resources and greater skills gettions, the clearinghouse lls in the gap and ensures brought into the arbitrage business, these oppor-that payments go through without a hitch. tunities tend to vanish. India is better placed in terms of skills in ar- The clearinghouse, in turn, cannot create such bitrage, as compared with many other countries,a guarantee out of thin air. It uses a system of thanks to years of experience with line opera-initial margin and daily mark-to-market margins, tors who are used to doing arbitrage betweencoupled with sophisticated risk containment, to exchanges. These kinds of traders would be eas-ensure that it is not bankrupted in the process of ily able to redirect their skills into this new mar-supplying this guarantee. ket. These line operators are uent with a host 11
12 CHAPTER 2. MARKET MICROSTRUCTUREof real-world di culties, such as di erent expira- fund managers to obtain excess returns throughtion dates on di erent exchanges, bad paper, etc. informed trading. The available evidence ? sug-Their skills are well-suited to index arbitrage. gests that three-quarters of Indian funds under- perform the index, after adjusting for the level of Also see: ?, ?, ?, ?. systematic risk adopted. This fraction is almost exactly the same as that seen in the US. ThisQ2.5: Isnt Indias cash market much too in- makes it di cult tomuch lessthe cient than those Indias markets are support e hypothesis thate cient to support concepts like derivatives? seen in OECD countries, after controlling for theA: There is no evidence to suggest that market levels of transactions costs.ine ciencies on the cash market make it di -cult to sustain derivatives markets. Many emerg- Also see: ?, ?, ?, ?.ing markets that have derivatives markets aremore primitive than India on the key determi- Q2.6: What is the role of liquidity in enablingnants of market e ciency, i.e. a high informa- good derivatives markets?tion availability, b high skills in keeping accounts A: The role of liquidity which is de ned as lowand reading accounting reports, c high popula- transactions costs is in making arbitrage cheaption of speculative traders and d low transac- and convenient. If transactions costs are low, thentions costs. Derivatives markets are successful if the smallest mispricings on the derivatives marketpeople face risks that they wish to hedge them- will be removed by arbitrageurs, which will makeselves against; market ine ciency on the underly- the derivatives market more e cient.ing market probably serves to increase the demandfor these hedging services. ? is a Ph.D. thesis which is devoted to an ex- Q2.7: What should a market index be?amination of BSE returns data from 1990 to 1995. A: A market index is a large, well-diversi ed port-This evidence supports the notion that the mar- folio which is an approximation to returns ob-kets are quite informationally e cient, given the tained in owning the overall economy. Portfoliohigh level of transactions costs that has prevailed diversi cation is a powerful means of stripping outin the past. One widely prevalant practise that rm- and industry-e ects, so that the returns onserves to interlink market prices and corporate the well-diversi ed portfolio re ect only economy-news is insider trading. Insider trading is unfair wide e ects, and are relatively insensitive to theand detrimental to market liquidity in a subtle speci c companies or industries in the index port-fashion, but it does serve to rapidly bring market folio. Market index returns time-series are cen-prices in line with corporate information. tral to modern nancial economics, and have enor- This research is carried further in ? which ex- mous value for a variety of real-world applications.amines the impact of automation and competition A good market index should be highly liquid toupon the functioning of the BSE. Here the evi- support products in the real world, it should havedence suggests that transactions costs have come a high hedging e ectiveness against a huge varietydown with automation, and exactly as predicted of real-world portfolios, and it should be hard toby economic theory, market e ciency has im- manipulate.proved as a consequence. One interesting piece of work in this area is Q2.8: How does liquidity matter for market?, where the publication of a research study was indexes?followed by a swift elimination of the market in- A: At one level a market index is used as a puree ciency which this research study documented. economic time-series. Liquidity a ects this appli-This is an example of how market e ciency any- cation via the problem of non-trading. If somewhere in the world works: pro t-maximising spec- securities in an index fail to trade today, then theulators detect mispricings on the market, and level of the market index obtained re ects the val-when they trade in exploiting these mispricings, uation of the macroeconomy today via securitiesthe ine ciency goes away. which traded today, but is contaminated with the The nal litmus test of market e ciency is mu- valuation of the macroeconomy yesterday via se-tual fund performance. If Indias markets were curities which traded yesterday. This is the prob-ine cient, it would be possible for professional lem of stale prices. By this reasoning, securities
13with a high trading intensity are best-suited forinclusion into a market index. As we go closer to applications of market in- 60dexes in the indexation industry such as index 12 Noonfunds, or sector-level active management, or index 1 PMderivatives, the market index is not just an eco- Basis Points 2 PMnomic time-series, but a portfolio which is traded. 40The key di culty faced here is again liquidity, orthe transactions costs faced in buying or sellingthe entire index as a portfolio. 20Q2.9: What is special about Nifty for use in 05 June ’96index derivatives?A: The methodology created for the NSE-50 index 0explicitly isolates a set of securities for which the 0 5 10 15 20 25market impact cost is minimised when buying or Rs. Millionselling the entire index portfolio. This makes Niftywell-suited to applications such as index funds, in-dex derivatives, etc. Nifty has a explicit method- Figure 2.1: Impact cost for Nifty for Variousology for regular maintenance of the index set. It Transaction Sizesis successful at expressing the market risk inherentin a wide variety of portfolios in the country. Also see: ?. vestors. High liquidity also immediately implies that the index is hard to manipulate, which helps engender public con dence.Q2.10: What is the impact cost seen in trad-ing Nifty?A: In calendar 1996, on average, the impact cost Q2.12: well-functioningin India adequate to support Is the liquidity derivatives markets?faced in buying Rs.5 million of the Nifty portfoliowas 0.25 or so. This means that if the index A: The one-way market impact cost faced by ar-level is 1000, then a buy order of Rs.5 million is bitrageurs working the NSE-50 is around 0.25.executed at 1002.5 and a sell order is executed at This is similar to that seen by arbitrageurs work-997.5. This is the lowest level of transactions costsing the SP 500. This suggests that market liq-seen in market indexes in India. uidity by itself will not be a serious constraint in An example of the impact cost analysis of Nifty the face of an index derivatives market in India.is shown in Figure 2.1, which uses data for 5 June It should be noted that market impact cost is1996, and shows how the impact cost in trades on not the only component of transactions costs thatNifty varies as the transaction size is increased. arbitrageurs face. It is true that post-trade costs are higher in India thanks to the small role that the book-entry trading plays as of today. How-Q2.11: How does this low impact cost mat- ever, market liquidity is not a constraint in index- based products based on Nifty.ter?A: As is the case in all areas of nance, in the con-text of index derivatives, there is a direct mapping Q2.13: What kind of liquidity is expected onbetween transactions costs and market e ciency. index derivatives markets?Index futures and options based on Nifty will ben- A: Impact cost on index derivatives markets ise t from a high degree of market e ciency because likely to be much smaller than that seen on thearbitrageurs will face low transactions costs when spot index. One thumb rule which is commonlythey eliminate mispricings. This high degree of used internationally is that the round trip costmarket e ciency on the index derivatives market i.e. twice the impact cost plus brokerage ofwill make it more attractive to pure users of the trades on index futures of around $0.5 million arederivatives, such as hedgers, speculators and in- around 0.01, i.e. the index futures are around
14 CHAPTER 2. MARKET MICROSTRUCTURE20 times more liquid than the spot index.1 High on the cash market. This reduces impact cost i.e.liquidity is the essential appeal of index deriva- increases liquidity on the cash market.tives. If trading on the spot market were cheap,then many portfolio modi cations would get done Q2.16: What is the international experiencethere itself. However, because transactions costson the cash market are high, using derivatives is in terms of how the underlying market isan appealing alternative. changed once derivatives start trading? A: The international experience is that market quality on the underlying market improves onceQ2.14: How does spot-futures arbitrage af- derivatives come to exist. Liquidity and marketfect the cash market? e ciency of the underlying market are increasedA: Spot-futures arbitrage increases the ow of once derivatives come to exist.market orders to the cash market. This increasesthe revenues obtained by day traders who place Q2.17: Program trading in the US is oftenlimit orders, and induces an increased supply of accused of generating di culties. What doeslimit orders. Limit orders are the ultimate sourceof liquidity on the market indeed, low impact cost that mean for us?is synonymous with a thick limit order book which A: Many post-mortems of the October 1987 crash concluded that program trading was related tois highly populated with limit orders. Hence the the crash. Some observers distorted this to pro-introduction of spot-futures arbitrage will improvethe liquidity on the cash market. gram trading caused the crash. A more accurate depiction of the sequence of events in October 1987 may be expressed as fol-Q2.15: Going beyond spot-futures arbitrage, lows:how do derivatives in uence liquidity on theunderlying market? A market drop commenced on overseas mar-A: There are also less direct channels of in uence kets before NYSE trading time and on thefrom derivatives to enhanced liquidity on the un- futures market which always shows marketderlying market. movements before the spot market, Day traders in individual stocks, who supply As is always the case, this led to a surgeliquidity in these stocks, will be able to use index of program trading orders as arbitrageursfutures to o set their index exposure, and hence rushed in to exploit the slight mispricings.be able to function at lower levels of risk. Forexample, the NYSE specialist makes phone calls to The communications system to the marketChicago almost every half an hour while trading makers overloaded and could not cope withis going on adjusting his index futures position as the orders.2a function of his inventory. Everytime a day trader This led to con rmations of many trades tak-is long security he will simultaneously be short ing over an hour.index futures to strip out his index exposure,and vice versa. This led to a panic selling on the part of Another aspect is rooted in security options traders across the world, which produced amarkets. When security options markets exist, major crash.speculators on individual securities tend to go Hence, it is correct to say that program trad-trade on the options market, and the focus of price ing had something to do with the October 1987discovery moves away from the cash market to the crash, but it is incorrect to blame the crash uponoptions market. More informed traders tend to program trading. The blame, if any, falls on thecluster on the options market, and less informed computer networking which links up the world toorders tend to go to the cash market. This reducesthe risk of trading against an informed speculator It should be noted that the biggest 50 to 100 2 stocks in the SP 500 were present in arbitrage trans- 1 For example, in the US, the SP 500 futures con- actions in quantities larger than 2100 shares, so thattract on the CME has spreads of around $100 on a program trading could not be done for these. Tradingminimum tradeable lot of around $400,000; i.e., the in these stocks involved a human runner carrying theone way impact cost is around 0.0125. order to the specialist post.
15the market maker, and on the basic methods of 1. Choice of indexfunctioning at the NYSE. 2. Choice of contract size i.e. multiplier In India, in any case, because the major marketsuse no market makers, the entire method of order 3. Choice of expiration datesmatching is quite di erent it consists of comput- 4. Choice of american vs. european optionsers directly talking to the central order-matchingcomputer. In this sense program trading i.e., 5. Choice of rules governing strike pricestrading by using computers is routine in India. 6. Choice of trading mechanism whether mar-The NYSE started out as a labour-intensive mar- ket makers, or order-matching market, etcket, and computerised communications with themarket maker was put in3 as a sideshow to the 7. Choice of time of day when market opens andmain processes of the market. In contrast, mar- closeskets in India are purely computer-driven, and their In the derivatives area, it is easier for exchangescomputer networking is less fragile. to di erentiate themselves, and nd subsets of the Also see: ?, ?, ?, ?. user population which require di erent features in the product. In the US, the experience of futures markets is that between 1921 and 1983, 180 dif-Q2.18: Will derivatives destabilise the stock ferent futures contracts had been launched, and amarket? Could this happen in extreme full 40 of these failed to survive four years. Suchevents? a steady process of entry and exit is extremely healthy in terms of the basic economics of compe-A: The available international evidence says that tition.market quality on the underlying market improves In this sense, the derivatives area is less of aonce derivatives come to exist. Derivatives im- natural monopoly than the cash market.prove liquidity on the underlying market for avariety of reasons outlined in Questions 2.14 and Also see: ?.2.15, and a more liquid market is one that is ableto absorb larger shocks for a smaller change in Q2.20: What are the policy implications ofprices. This would be the most useful in extremeevents it is in an extreme event that the liquidity this lack of a natural monopoly?of a market is taxed the most, and at such times a A: To the extent that a marketplace is competi-healthier cash market would be the most valued. tive, with a steady pace of entry and exit, the self- interest of exchanges will drive them to do things which their investors like. It will not be necessaryQ2.19: Is there more or less of a natural to force them to do these such competitive mar- The role for regulation in things via regulation.monopoly in derivatives trading, as com- kets is limited to the classic regulatory functions,pared with the spot market? i.e. health safety environment style regulation.A: In the spot market, the ability for exchanges todi erentiate their products is limited by the factthat they are all trading the same paper. This Q2.21: At the operational level, how do se-reduces the avenues for product di erentiation by curity contracts compare versus index-basedexchanges. In contrast, in the derivatives area, there are nu- contracts? fact is that index-based contractsmerous avenues for product di erentiation. Each A: Theabasic more substantial order- ow, whichexchange trading index options has to go through attract much tighter spreads i.e. greater liq- helps them havethe following major decisions: uidity. At a more basic economic level, we say 3 The Designated Order Turnaround system, that there is less asymmetric information in thewhich allows computers to communicate orders to index as opposed to securities, where insiders typ-market makers, was setup at NYSE in 1976 and up- ically know more than others, which helps index-graded to SuperDOT in 1984. As of October 1987, based trading have better liquidity.orders of smaller than 2100 shares could be sent elec- At settlement, in the case of security-options,tronically. there is the possibility of delivery, and in that
16 CHAPTER 2. MARKET MICROSTRUCTUREcase arises the question of depository vs. physi-cal delivery. Both alternatives are quite feasible.However, in index-based contracts, that questiondoes not arise since all index-based contracts arecash-settled. The index has much less volatility than individ-ual securities. That helps index options have lowerprices, and index futures can work with lower mar-gins. The most important di erence between the in-dex and individual securities concerns manipula-tion. Given that an index is carefully built withliquidity considerations in mind, it is much harderto manipulate the index as compared with the dif- culty of manipulating individual securities.
Chapter 3Derivatives Disasters 5. Japans nancial institutions are said toQ3.1: Why do we keep reading about disas- be sitting on $500 billion of nonperformingters involving derivatives? loans.A: Disasters involving derivatives make for goodreporting. In an multi trillion dollar worldwideindustry, some disasters are inevitable. Also see: ?.Q3.2: Why have we seen more disasters in Q3.4: What happened in Barings?the recent years? A: Mr. Nick Leeson, a trader for Barings FuturesA: As the derivatives industry grows, more dis- in Singapore, had positions on the Japanese Nikkeiasters would be observed. This is perhaps like 225 index worth $7 billion. In addition, he hadthe airline industry: when more planes y, more other positions on options and bond markets. Mr.planes will crash see Table 1.2 for the growth of Leeson was able to dodge internal corporate con-the global derivatives industry. trols and adopt these large positions unchecked. This was assisted by weak enforcement at the ex-Q3.3: How much money has been lost in changes in Singapore and Osaka, who did not gen- erate alerts to his large positions.these derivatives disasters?A: The cumulative losses from 1987 to 1995 addup to $16.7 billion. This is a tiny fraction of the Q3.5: What should be done to minimise dis-outstanding positions of the industry, which were asters with derivatives?around $50 trillion as of 1995. A: At the level of exchanges, position limits and Derivatives account for a small fraction of the surveillance procedures should be sound.overall picture of nancial disasters. Over this At the level of clearinghouses, margin require-same period, i.e. from 1987 to 1995, the nan- ments should be stringently enforced, even whencial industry has seen other large disasters: dealing with a large institution like Barings. At the level of individual companies with po- 1. Malaysias Central Bank lost $3 billion in sitions on the market, modern risk measurement 1992 and $2 billion in 1993 in taking posi- systems should be established alongside the cre- tions on the UK pound. ation of capabilities in trading in derivatives. The basic idea which should be steadfastly used when 2. In December 1993, the Bank of Spain took thinking about returns is that risk also merits over Spains fth biggest bank, which had measurement. $4.7 billion in hidden losses. Also see: ?. 3. In 1994, Credit Lyonnais the biggest state owned bank in France was kept a oat using a $10 billion subsidy from the government. 4. In the 1980s, the savings and loans indus- try of the US lost $150 billion. 17
Chapter 4Policy Issues In the case of the dollar-rupee exchange rate, aQ4.1: What emerging markets have already forward market already exists; it is just a matter ofcreated derivatives markets? formally institutionalising it at an exchange, andA: The status is summarised in Table 4.1, which turning it into a modern futures market.shows emerging markets that have derivativesmarkets today, and Table 4.2 which shows emerg- Q4.4: Are derivatives in interest rates viableing markets which are in the process of building in India?derivatives markets. A: In the case of interest-rate risk, derivatives in India are hindered by the poor liquidity on the Also see: ?. xed-income market. However, a few approaches towards designing interest-rate derivatives could commence. An ex-Q4.2: What was Chinas experience in this ample of this would be a futures contracts on trea-area?A: China had a mushrooming of derivatives ex- suryor sell which would give people the ability to bills,changes in the early 1990s. Many of these were a liquid and transparent in the future. The lack of buy treasury bills market for treasury bills,poorly run, and experienced signi cant episodes and constraints such as the inability to short-sellof market manipulation and counterparty risk. In treasury bills, would hurt the ability to do arbi-1994, the 50 exchanges were consolidated into 15. trage on this market. Hence, the market e ciencyIn 1995, Chinas futures markets did a trading vol- of the interest-rate futures market would be lim-ume of around $1.2 trillion for a comparison, In- ited.dias equity markets do an annual trading volume However, in an environment where economicof roughly $180 billion. agents are exposed to interest-rate risk and have Many observers have cited Chinas experience no alternative risk management facility, such con-with 50 exchanges as an example of how poorly tracts could still prove to be viable. If interest-rateregulated and hasty growth of derivatives mar- futures came about, they would generate greaterkets may be problematic. However, the other side order ow and improve market quality on theof the picture is now clear: the experience with xed-income market.these 50 exchanges got the Chinese markets o theground, and generated the necessary know-how Also see: ?.amongst exchange sta , regulators and users. Inthe end, Chinas derivatives exchanges has stolen Q4.5: Why are commodity futures marketsa march on their rivals: they now have signi canttrading volumes on a world scale. important? A: Indias farmers, and downstream industrial users of agricultural output, are exposed to ex-Q4.3: What nancial markets in India are tremely high risks. The creation of commodityready for derivatives today? derivatives markets will provide them with theA: In India, two areas are ripe for derivatives: the choice of obtaining insurance against price uctua-equity market and foreign exchange. tions. It will improve liquidity and price discovery 19
20 CHAPTER 4. POLICY ISSUES Table 4.1: Derivatives Exchanges in Emerging Markets Brazil BM F China SSE, SME, SHME, SCCFE Guatemala BDP Hungary BCE BSE Korea KSE Malaysia KLOFFE, KLCE, MME Philippines MIFE Portugal PSE Russia MICEX MCE Slovak Republic Bratislava Slovenia Ljubljana South Africa SAFEX Table 4.2: Emerging Markets Working Towards Derivatives Argentina Bulgaria Chile Colombia Costa Rica Czech Republic Greece India Indonesia Mexico Poland Taiwan Thailand Turkeyin the underlying spot markets. Once futures mar- the value of having commodity futures marketskets exist, the private sector will maintain bu er would become apparent, and the stage will be setstocks which will reduce spot price volatility, and for further expansion of commodity futures mar-the private sector will do this far more e ciently kets in India. If these markets experience a visiblethan government-sponsored e orts at maintaining episode of manipulation, or if they experience abu er stocks. In addition, the creation of these payments crisis, then it will be harder to estab-markets is consistent with the growth of skills in lish a consensus about the future of commodityIndias nancial industry in the area of derivatives. futures markets, and the development of Indias nancial system will be slowed. One serious weakness in India lies in the wayQ4.6: What are the issues in the creation of individual commodity futures markets are an out-commodity derivatives markets? growth of trading on individual spot markets. TheA: Like most traditional nancial markets in In- cotton trading community will create a cottondia, the commodity futures markets are weak in futures market, the jute trading community willterms of modern skills in how exchanges should create a jute futures market, etc. This is inef-be run. These markets are weak on a variety cient insofar as it does not foster the growthof issues: the use of modern market mechanisms of specialised skills which are common to all fu-such as the electronic limit order book market, tures markets and not speci c to one commodity.enforcement of contract standardisation, dealing For a well-functioning derivatives exchange, spe-with hetereogenous grades, the counterparty guar- cialised skills are required on the part of exchangeantee of the clearinghouse, calculation and en- and clearinghouse sta and on the part of tradingforcement of margins, and checks against market members. These skills are primarily in the deriva-manipulation. tives area, and they are easily transferable from The commodity markets which are now in the one commodity to another.spotlight are: the international pepper market, Ideally, a derivatives exchange should have a fo-the proposed markets in cotton and jute, and the cus on futures, options, and other derivatives re-proposed international castorseed market. Ideally, gardless of what the underlying is, and each fu-the management of these exchanges will be able to tures exchange should trade dozens of commodityfunction to international standards. In this case, futures contracts. This is similar to markets like
21CME and CBOT which trade derivatives on hun-dreds of commodities, and on a host of other un- Q4.9: What would access to derivatives doderlyings such as stock market indexes, treasury to FII and FDI investment?bills, foreign exchange, etc. A: Access to derivatives would increase the ow One useful alternative here is to involve main- of FII and FDI investment. The two importantstream nancial markets into the commodities kinds of risk that foreign investors are exposed toarea. Exchanges which have clearing corporations are currency risk and country risk. The rst wouldand can hence supply the counterparty guaran- be manageable using dollar rupee futures and op-tee can easily introduce cash-settled derivatives tions, and the second would be manageable usingon commodities. index futures and options. The details of usage would be subject to theQ4.7: What can be done in derivatives on individual requirements. For example, some FIIs might choose to completely eliminate their dollarreal estate? rupee exposure, coupled with portfolio insur-A: In the case of real estate, derivatives can ance to cap their downside exposure at no worseonly follow clear asset securitisation. Government than x. Other FIIs might choose to use indexshould work towards removing hurdles in the face derivatives as a liquid way to increase their equityof real estate asset securitisation, which would exposure. Similarly, investors in India throughthen enable derivatives on real estate to take place. FDI would be able to use dollar rupee futures toMutual funds which invest in real estate are an- control their risk of a currency devaluation, andother, easier, stepping stone towards derivatives use index futures to proxy for the overall successon real estate: markets could easily trade units of of Indias economy.such funds, and options on such units. This may These methods of controlling risk are quite rou-be a shorter route towards obtaining derivatives tine in the international nancial community.1 Ifon real estate. India had derivatives markets, then it would be a less risky environment and would better be ableQ4.8: Should foreigners be restricted in In- to attract foreign investment. While India lacks index derivatives as of to-dias derivatives markets as a matter of pol- day, there is a direct opportunity to make progressicy? on these issues via the dollar rupee forward mar-A: As in other areas of industry and commerce, ket. The constraints that are placed in the way ofthe key objective for policy in India should be to FIIs on using the dollar-rupee forward market areobtain the best quality of products and services for counterproductive. If the FII is allowed to obtainIndias economy, ensure conditions of intense com- insurance using this market, he will bring morepetition on the domestic market, and to employ money into India.Indian labour and Indian capital at the highestpossible levels of productivity. Given these objec- Q4.10: Is India ready for derivatives today?tives, the nationality of the ultimate owners of a A: There are four key aspects to this question. rm operating on Indian soil has little importance. Market Size In the case of all derivatives, foreigners should Derivatives markets need to work o a largebe allowed free access to trading and brokerage foundation of asset value that is traded onon Indias derivatives markets. This will help im- an underlying market. Indias debt marketprove the quality of Indias derivatives markets, has a total market capitalisation of aroundand help the dissemination of knowledge about the Rs.3 trillion, and Indias equity market has arisk management capabilities that these markets market capitalisation of around Rs.5 trillion.supply to the community of foreign investors. 1 See, for example, the article Investors Return to Hurdles to this level of liberalisation make it Latin America by Margaret Elliott, Derivatives Strat-di cult for us as a country to realise the full po- egy, May 1997, where Hari Hariharan of Santandertential of the investment that can be attracted into Investment is quoted as saying that 60 70 of FIIIndia given the level of development of our nan- investment into Latin America involves some use ofcial system. derivatives.
22 CHAPTER 4. POLICY ISSUES Indias foreign exchange market also has a that are required for derivatives might well considerable underlying market size. be in place in India. International experience and the success of In the context of the four points above, deriva- derivatives in many countries of much smaller tives on the debt market would be highly attrac- market size for example, the Johannesburg tive to investors who face interest rate risk, but futures market, and the Brazilian futures the debt market su ers from an illiquid under- markets shows that in India, each of the lying. The foreign exchange market is also an three markets mentioned above is ready for area where derivatives are clearly valuable; the derivatives. constraints faced there concern the sequencing of Liquidity liberalisation of this market. The Indian equity In India, NSE proposes to launch futures and market satis es all the four criterion laid out and options contracts on the NSE-50 index. The is the logical candidate to carry the rst exchange- market impact cost seen with Nifty is com- traded derivatives in India, with the index as the parable to some of the most liquid market underlying.2 indexes in the world e.g. the SP 500 of the US. Indias foreign exchange market also Q4.11: What are the costs and bene ts of possesses the low transactions costs to sup- delaying the onset of exchange-traded nan- port a healthy derivatives market. Indias cial derivatives in India? debt market might currently not ready for A: The costs are on two directions: trading derivatives since most of the key in- struments traded here are quite illiquid. 1. The most important cost is opportunity cost. Thus from the point of view of the liquidity of Indias investors will bene t from be- the market, two of Indias markets are ready ing able to access derivatives. Every for derivatives trading. investor who experiences pain owing to Clearing Corporation index uctuations could be happier if index derivatives existed. For derivatives markets to support large-scale use, it is important to have a clearing corpo- Indias markets will become more liq- ration which guarantees the trade. uid and e cient once derivatives are present. From July 1996 onwards, with NSCC guar- anteeing trades on the NSE, this prerequisite Indias nancial industry will grow for a derivatives market now exists in India. skills and capabilities through working The human capabilities that go into creating with derivatives which will help it come a clearing corporation can also be easily re- up to international standards. deployed to new markets, such as the foreign Each of these three developments is put o exchange market which has such a deep need further into the future when derivatives in for trading derivatives. India are delayed. Sophistication of traders 2. The second cost is the threat of foreign ex- Derivatives are complex. The payo s that changes creating derivatives markets on In- buyer and seller face, the risks that buyer dian underlyings. If this took place, it would and seller face, and the economic theory that make it harder for derivatives exchanges in is used for pricing derivatives: all these are India to succeed. considerably more di cult than that seen on the equity or the debt market. The apparent bene t of delay is the opportu- Indias nancial industry already has experi- nity to create a concerted e ort in training and ence with many kinds of derivatives. As com- improving skills as a preparation for the launch of pared with many emerging markets where a market. This bene t is illusory, for two reasons: derivatives exist, Indias nancial industry a a concerted e ort to pickup skills will not take possesses very strong human skills. It ap- 2 See Barclay 1996 for issues connected with In- pears that the foundations of human capital dias derivatives markets.
23place unless the market launch is imminent, andb the best form of training in derivatives is that Q4.14: Would foreign derivatives markets beobtained when actually using the instruments. See interested in launching trading on Indian un-Question 5.25 for a further treatment of this issue. derlyings? A: Internationally, derivatives trading is a ercely competitive area where exchanges are constantlyQ4.12: What international derivatives ex- trying to nd interesting new contracts based onchanges are working towards launching prod- which trading volume can be attracted. Hundredsucts o underlyings in emerging markets? of new contracts have been attempted in the lastA: The Chicago Mercantile Exchange CME, few years, only around half survive more than aChicago Board Of Trade CBOT, Chicago Board few years. In such an atmosphere of hectic innova-Options Exchange CBOE, American Stock Ex- tion in contract design, Indian currency and stockchange, Sydney Futures Exchange, Hong Kong index products constitute a glaring opportunity.Futures Exchange and Singapore InternationalMonetary Exchange SIMEX have all launchedemerging market initiatives, whereby they aim to Q4.15: Is this a real threat?trade derivatives o underlyings from emerging A: If India does not progress towards derivativesmarkets. swiftly enough, contracts based on Indian under- lyings will start trading on markets elsewhere inQ4.13: What derivatives on Indian underly- the world. The NSE-50 time series or the dollar-ings are currently trading abroad? rupee exchange rate are available on internationalA: Examples of contracts that exist abroad as of information services such as Reuters or Knight-today fall into the following categories: Ridder, and nothing prevents a foreign market from launching contracts on these.3 Many GDR issues are bundled with war- Such a scenario is not without precedent. Some rants option-like instruments, which are examples can be cited which show the forces in- then traded separately. For example, the volved: Hindalco issue done on 2 Nov 1995 bundled In 1989, regulatory errors in Japan led to every two shares with one warrant. Similar the market for derivatives based on Japans issues have taken place on Indias primary Nikkei 225 index moving o to Singapore and market the di erence here is that the war- partly to Chicago. Today, Japans markets rants are listed and traded, in contrast with feature a better set of regulations, but the Indias secondary market where the warrants market has not yet moved back to Japan. are not traded. Similarly, a large part of Swedens nancial Warrants on mutual fund paper such as the markets moved to London after the Govern- Lazard Birla India and Fleming Indian are ment imposed a tax on trading volume in listed in London. 1989. After the transactions tax was revoked, most of this volume did not return. Custom built OTC derivatives speci - cally, options and swaps on Indian market After prolonged delays in creating a deriva- indexes and baskets of Indian GDRs already tives market in Taiwan, derivatives on the exist on the international market. Essentially Taiwanese market index4 started trading in 100 of the OTC derivatives industry on In- Chicago and Singapre on 9 January 1997 ?, dian underlyings lies abroad. 3 Foreign markets would prefer to have the bene t of cooperation from the Indian owner of an index be- Restrictions upon access to the dollar-rupee fore using it for derivatives. But as the example of the forward market in India has led to the de- Nikkei-225 illustrates, this is not a binding constraint. velopment of the non-deliverable forward 4 Taiwans equity market remains relatively closed i.e., cash settled dollar-rupee market o - to foreign investment and has short trading hours. shore. Taiwans SEC tried unsuccessfully to prevent CME and SIMEX from introducing Taiwanese index futures, but interminable delays a icted e orts to get a lo-
24 CHAPTER 4. POLICY ISSUES Indias GDR market experience is a direct market inherently diminishes over time. This example of markets moving o o shore if the is not the case with derivatives. required facilities dont come about in India 2. In Indias GDR episode, GDRs were an alter- fast enough see Question 4.17, however. native in the face of a thriving Indian spot These examples suggest that the movement of market. It is always di cult to take awaymarkets indulging in regulatory arbitrage is not order ow from an existing market. In thejust a abstract possibility but a real alternative for case of derivatives, if foreign markets get es-investors seeking to meet their objectives. tablished rst, this will not be the case.Q4.16: What are the implications of deriva-tives on Indian underlyings trading abroad?A: As the Nikkei-225 experience suggests, oncea contract gets well-established at a market, itdoesnt easily move, even if the alternative des-tination proposed is the home country of the un-derlying. In this sense, Indias nancial industrycould then face an uphill struggle for order owif foreign markets are successful on establishingderivatives markets rst. This would have tworami cations: 1. As long as India lacks capital account con- vertibility, Indias citizens would be disad- vantaged by not being able to access deriva- tives while foreigners would be able to. This would generate increased incentives for In- dian citizens to use illegal channels through which positions would be adopted on foreign markets. 2. Such an event would be a setback for the de- velopment of skills and businesses in Indias nancial industry, and for the potential of Bombay as a world nancial centre.Q4.17: But in the GDR market experience,the foreign market has hardly a ected order ow into India why are derivatives di er-ent?A: In the case of the GDR market, two things weredi erent. 1. The GDR market is self-liquidating in the sense that GDRs gradually convert into un- derlying shares. Hence the size of the GDRcal derivatives exchange o the ground and CME andSIMEX chose to not wait for the local market to comeabout. Taiwans SEC initially prohibited local bro-kerage rms from trading on these contracts o shore.Later, the SEC announced that they may allow localorders to go to derivatives exchanges o shore.
Chapter 5Regulatory Issues spreads and brokerage fees above the level that isQ5.1: What are the objectives of regulation? found in perfect competition.A: There are three basic objectives of regulation: This implicit elevation can sometimes even become overt: prior to 1974, NYSE speci ed a el- to protect market integrity, evated brokerage commission schedule, and mem- to ensure erce levels of competition, and bers were required to not o er prices better than the de ned schedule. to prevent fraud. In addition to this form, every economy has some unusually large traders. This is another av- enue through which deviations from perfect com- Also see: ?, ?. petition are observed.Q5.2: What kinds of competition are possi- Q5.4: How should regulation of exchangesble in the nancial market scenario? work?A: There are many dimensions of competition: A: The most important intuition in regulation of exchanges is to view the exchange as a manufac- 1. The market should have a large number of turer of liquidity services. If exchanges do this traders. well, they will get satis ed customers. Exchanges that fail to do this well will fail to get business 2. There should be easy entry of new traders and go bankrupt. In India we have seen numerous and investors. industries and services where competition and the 3. No individual trader should be too large as steady process of entry and exit have proved to be compared with the size of the overall market, a great success in producing high quality and low i.e., no single individual trader or coalitions price. The area of trading services is no exception. of traders, should have market power. The key role for public policy is to keep en- try barriers low and therefore keep the competi- tive pressure upon the incumbents high. It should be easy to start new exchanges; even for businessQ5.3: How does deviation from perfect com- houses to start exchanges. It should be easy saypetition or situations of market power arise for CBOT to come to India and start an exchange.on nancial markets? That will serve to keep up competitive pressureA: One form of market power that is commonly and steadily improve the services and costs thatobserved in the world arises with an exchange end-users, the investors, face.which limits the supply of seats so as to increase Also see: ?.brokerage rates. This behaviour re ects itself inthe price of a seat on the exchange, or the seatprice. In an ideal economy, the seat price de- Q5.5: What can regulation do to encouragevoid of any real estate or other facilities should competitiveness?be close to 0. A high seat price implies bid-ask A: Brokerage fees are elevated as long as a re- 25