Article on Derivatives

8/3/2019 Article on Derivatives

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Derivatives and its Risk management

Introduction:

The emergence of the market for derivative products, most notably forwards, futures and options,can be traced back to the willingness of risk-averse economic agents to guard themselves againstuncertainties arising out of fluctuations in asset prices. By their very nature, the financial marketsare marked by a very high degree of volatility. Through the use of derivative products, it ispossible to partially or fully transfer price risks by locking-in asset prices. As instruments of riskmanagement, these generally do not influence the fluctuations in the underlying asset prices.However, by locking in asset prices, derivative products minimize the impact of fluctuations inasset prices on the profitability and cash flow situation of risk-averse investors.

Derivative is a product whose value is derived from the value of one or more basic Variables,called bases (underlying asset, index, or reference rate), in a contractual manner. The underlyingasset can be equity, forex, commodity or any other asset. For example, wheat farmers may wishto sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such atransaction is an example of a derivative. The price of this derivative is driven by the spot priceof wheat which is the "underlying". In the Indian context the Securities Contracts (Regulation)Act, 1956 (SC(R)A) defines "derivative" to include-1. A security derived from a debt instrument, share, loan whether secured or unsecured, riskinstrument or contract for differences or any other form of security.2. A contract which derives its value from the prices, or index of prices, of underlying securities.

History of Derivatives:

Early forward contracts in the US addressed merchants' concerns about ensuring that there werebuyers and sellers for commodities. However 'credit risk" remained a serious problem. To dealwith this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT)in 1848. The primary intention of the CBOT was to provide a centralized location known inadvance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one stepfurther and listed the first 'exchange traded" derivatives contract in the US, these contracts werecalled 'futures contracts". In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, wasreorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange(CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed thetwo largest "financial" exchanges of any kind in the world today.

The first stock index futures contract was traded at Kansas City Board of Trade. Currently themost popular stock index futures contract in the world is based on S&P 500 index, traded onChicago Mercantile Exchange. During the mid eighties, financial futures became the most activederivative instruments generating volumes many times more than the commodity futures. Indexfutures, futures on T-bills and Euro-Dollar futures are the three most popular futures contractstraded today. Other popular international exchanges that trade derivatives are LIFFE in England,DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.


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ECONOMIC FUNCTION OF THE DERIVATIVE MARKET

Inspite of the fear and criticism with which the derivative markets are commonly looked at, thesemarkets perform a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market participants aboutthe future and lead the prices of underlying to the perceived future level. The prices ofderivatives converge with the prices of the underlying at the expiration of the derivative contract.Thus derivatives help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have them but may not like themto those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With theintroduction of derivatives, the underlying market witnesses higher trading volumes because ofparticipation by more players who would not otherwise participate for lack of an arrangement to

transfer risk.

4. Speculative trades shift to a more controlled environment of derivatives market. In the absenceof an organized derivatives market, speculators trade in the underlying cash markets. Margining,monitoring and surveillance of the activities of various participants become extremely difficult inthese kinds of mixed markets.

5. An important incidental benefit that flows from derivatives trading is that it acts as a catalystfor new entrepreneurial activity. The derivatives have a history of attracting many bright,creative, well-educated people with an entrepreneurial attitude. They often energize others tocreate new businesses, new products and new employment opportunities, the benefit of which

are immense.

In a nut shell, derivatives markets help increase savings and investment in the long run. Transferof risk enables market participants to expand their volume of activity.

Present scenario:

Market liquidity suffered in the year 2008 and general economic conditions worsened,resulting in escalated write-downs in legacy credit positions, including CDOs, leveraged loansand mortgage-related exposures. These write-downs flowed through trading revenues anddwarfed the underlying strength in trade profitability from wide bid-ask spreads. Trading results

in the fourth quarter also suffered due to an unfavorable combination of rising overall corporatecredit spreads and declining credit spreads for the bank dealers themselves. Rising counterpartycredit spreads increase the risk of derivatives receivables. Banks account for this increased riskby lowering the fair value of those receivables. Banks report the rising credit costs associatedwith a write-down of receivables values as trading losses. While these higher credit costs are apart of operating a derivatives business, they can (and in the fourth quarter did) mask otherwise profitable trading operations. Typically, when credit spreads increase, much of the negativeimpact on bank trading results from write-downs of receivables can be offset by write downs of


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derivatives payables. However, in the fourth quarter, government support for the bankingindustry resulted in lower bank credit spreads. As a result, the fair value of bank derivativespayables increased, and therefore banks reported additional trading losses.

The difficult trading environment in 2008 led to the first annual trading loss in the banking

industry as banks lost $836 million for 2008, compared to revenues of $5,489 million in 2007.While banks continue to suffer major losses in credit trading, the 2008 loss actually fell 1% to$12.6 billion. Foreign exchange revenues increased 63% to $11.4 billion, while commodityrevenues advanced 424% to $1.5 billion. The major change in 2008 trading performance waspoor performance in interest rate and equity contracts. Interest rate trading revenues fell 89%, or$7.0 billion, to $866 million. Banks incurred $2.0 billion in losses from equity contracts in 2008,a change of $5.0 billion from 2007.

TOTAL TRADING REVENUES

REVENUE IN MIO$


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Interest rate derivatives:

An interest rate derivative is a derivative where the underlying asset is the right to pay orreceive a (usually notional) amount of money at a given interest rate.

Commodity derivatives:

Trading in derivatives first started to protect farmers from the risk of the value of their cropgoing below the cost price of their produce. Derivative contracts were offered on variousagricultural products like cotton, rice, coffee, wheat, pepper, et cetera.

Equity derivatives:

An equity derivative is a class of financial instruments whose value is at leastpartly derivedfrom one or more underlying equity securities. Market participants trade equityderivatives in order to transfer or transform certain risks associated with the underlyingsecurity. Options are by far the most common equity derivative; however there are many other

types of equity derivatives that are actively traded.

Credit derivatives:

A credit derivative is an OTC derivative designed to transfer credit risk from one party toanother. By synthetically creating or eliminating credit exposures, they allow institutions to moreeffectively manage credit risks.

FOREX derivatives:

Derivatives based on currency exchange rates are forward contracts (or forward rateagreements); options and swaps and are popularly known as Forex derivatives.

FACTORS DRIVING THE GROWTH OF DERIVATIVES

Over the last three decades, the derivatives market has seen a phenomenal growth. A largevariety of derivative contracts have been launched at exchanges across the world. Some of thefactors driving the growth of financial derivatives are:1. Increased volatility in asset prices in financial markets,2. Increased integration of national financial markets with the international markets,3. Marked improvement in communication facilities and sharp decline in their costs,4. Development of more sophisticated risk management tools, providing economic agents awider choice of risk management strategies, and5. Innovations in the derivatives markets, which optimally combine the risks and returns over a

large number of financial assets leading to higher returns, reduced risk as well as transactionscosts as compared to individual financial assets.

Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almostthree hundred years. Financial derivatives came into spotlight in the post-1970 period due togrowing instability in the financial markets. However, since their emergence, these products


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have become very popular and by 1990s, they accounted for about two-thirds of totaltransactions in derivative products. In recent years, the market for financial derivatives hasgrown tremendously in terms of variety of instruments available, their complexity and alsoturnover.

USES

Derivatives offer good opportunities for the bank to improve the non-interest income. Theseproducts can be easily cross-sold to our existing clients who are normally exposed to great dealof market risks. Market risk is the risk of losses in On and Off Balance Sheet position arisingfrom movements in various variables, which determine market price of the On and Off Balancesheet items.

Corporates can undertake derivative transaction for hedging their balance sheet exposures only.They amount and period of the derivative transaction should not be in excess of their

underlying exposures. They are not allowed to undertake any derivative transaction for tradingand each derivative transaction should be backed by underlying assets or liabilities. Derivativesallow the users to unbundle the risks and facilitate transfer of specific risks to the ones who arewilling to assume and manage each risk component. This is a major function of derivatives byproviding a more efficient allocation of economic risks. They can also be used as means costreduction strategies and to alter cash flows.

Broadly, Derivatives with Interest Rates as the underlying are used for management of interestrate risks associated with loans, investments while derivatives with exchange rates as theunderlying are used for management of risks associated with foreign exchange risks.

As a part of the research there were some risks which mainly affect the derivatives market are:

y Credit Risk.

y Market Risk.

y Interest rate Risk.

Credit Risk:

Credit risk is a significant risk in bank derivatives trading activities. The notional amount of aderivative contract is a reference amount from which contractual payments will be derived, but itis generally not an amount at risk. The credit risk in a derivative contract is a function of anumber of variables, such as whether counterparties exchange notional principal, the volatility ofthe underlying market factors (interest rate, currency, commodity, equity or corporate referenceentity), the maturity and liquidity of contracts, and the creditworthiness of the counterparties.

Credit risk in derivatives differs from credit risk in loans due to the more uncertain nature of thepotential credit exposure. With a funded loan, the amount at risk is the amount advanced to the


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borrower. The credit risk is unilateral; the bank faces the credit exposure of the borrower.However, in most derivatives transactions, such as swaps (which make up the bulk of bankderivatives contracts), the credit exposure is bilateral. Each party to the contract may (and, if thecontract has a long enough tenor, probably will) have a current credit exposure to the other partyat various points in time over the contracts life. Moreover, because the credit exposure is a

function of movements in market rates, banks do not know, and can only estimate, how much thevalue of the derivative contract might be at various points of time in the future.

The first step in measuring credit exposure in derivative contracts involves identifying thosecontracts where a bank would lose value if the counterparty to a contract defaulted today. Thetotal of all contracts with positive value (i.e., derivatives receivables) to the bank is the grosspositive fair value (GPFV) and represents an initial measurement of credit exposure. The total ofall contracts with negative value (i.e., derivatives payables) to the bank is the gross negative fairvalue (GNFV) and represents a measurement of the exposure the bank poses to itscounterparties.

Source: unionbankofindia.com

For a portfolio of contracts with a single counterparty where the bank has a legally enforceablebilateral netting agreement, contracts with negative values may be used to offset contracts withpositive values. This process generates a net current credit exposure, as shown in the examplebelow


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A banks net current credit exposure across all counterparties will therefore be the sum of thegross positive fair values for counterparties lacking legally certain bilateral netting arrangements(this may be due to the use of non-standardized documentation or jurisdiction considerations)and the bilaterally netted current credit exposure for counterparties with legal certainty regardingthe enforceability of netting agreements.

Market Risk:

Banks control market risk in trading operations primarily by establishing limits against potential

losses. Value at Risk (VaR) is a statistical measure that banks use to quantify the maximum lossthat could occur, over a specified horizon and at a certain confidence level, in normal markets. Itis important to emphasize that VaR is not the maximum potential loss; it provides a loss estimateat a specified confidence level. A VaR of $50 million at 99% confidence measured over onetrading day, for example, indicates that a trading loss of greater than $50 million in the next dayon that portfolio should occur only once in every 100 trading days under normal marketconditions. Since VaR does not measure the maximum potential loss, banks stress test theirtrading portfolios to assess the potential for loss beyond their VaR measure.

To provide perspective on the market risk of trading activities, it is useful to compare the VaRnumbers over time and to equity capital and net income. As shown in the table above, marketrisks reported by the three largest trading banks, as measured by VaR, are small as a percentageof their capital.

To test the effectiveness of their VaR measurement systems, trading institutions track thenumber of times that daily losses exceed VaR estimates. Under the Market Risk Rule thatestablishes regulatory capital requirements for U.S. commercial banks with significant tradingactivities, a banks capital requirement for market risk is based on its VaR measured at a 99%confidence level and assuming a 10-day holding period. Banks back-test their VaR measure bycomparing the actual daily profit or loss to the VaR measure. The results of the back-testdetermine the size of the multiplier applied to the VaR measure in the risk-based capital


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calculation. The multiplier adds a safety factor to the capital requirements. An exceptionoccurs when a dealer has a daily loss in excess of its VaR measure. Some banks disclose thenumber of such exceptions in their published financial reports. Because of the unusually highmarket volatility and large write-downs in CDOs in the recent quarters, as well as poor marketliquidity, a number of banks experienced back-test exceptions and therefore an increase

in their capital multiplier.

Interest rate risk:

It is the risk (variability in value) borne by an interest-bearing asset, such as loan or a bond, dueto variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, andvice versa. Interest rate risk is commonly measured by the bonds duration.

Asset liability management is a common name for the complete set of techniques used to managerisk within a general enterprise risk management framework

Banks face 4 types of interest rate risk:

Basis risk:

The risk presented when the yield on the assets and cost on the liabilities are based on different bases, such as LIBOR Vs US prime rate. In some circumstances different bases will move atdifferent rates which can cause erratic changes in the revenues and expenses.


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Yield curve risk:

The risk presented by different long term and short term interest rates. Short term rates arenormally lower than long term rates and banks earn their profits by borrowing short term moneyat lower rates and investing in the long term assets at higher rates. But the relationship betweenshort and long term rates can shift quickly and dramatically.

Reprising risk:

This risk presented by assets and liabilities that reprice at different times and rates. For instance,a loan with a variable rate will generate more interest income when rates rise and less interestincome when rates fall. If the loan is funded with fixed rated deposits, the banks interest marginwill fluctuate.

Option risk:

It is presented by optionality ie embedde in some assets and liabilities. For instance, mortageloans present significant option risk due to prepayment speeds that change dramatically wheninterest rates rise and fall. Falling interest rates will cause many borrowers to refinance and repaytheir loans, leaving the bank with un invested cash when interest rates have declined. Alternately,rising interest rates cause mortagage borrowers to repay slower, leaving the bank with relativelymore loans based on prior, lower interest rates,. Option risk is difficult to measure and control.

More banks are asset sensitive, meaning interest rate changes impact asset yields more than theyimpact liability costs. This is because substantial amounts of bank funding are not affected, orare just minimally affected, by changes in interest rates. The average checking accounts pay no


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interest, or very little interest, so changes in interest rates do not produce notable changes ininterest expense. However banks have large concentrations of short term and/or variable rateloans, so changes in interest rates significantly impact interest income. In general, banks earnmore money when interest rates are high, and they earn less money vice versa. Large banks alsotend to maintain large concentrations of fixed rate loans, which further increase liability

sensitivity. Therefore, large banks earn high net interest income when rates are low.

Exchange-rate risk:

The central government assumes an exchange-rate risk on its foreign borrowing. The exchange-rate risk is the risk that the value of the debt will increase as a consequence of the developmentin exchange rates.

Since 1992 the exchange-rate risk on the debt has been subject to coordinated management withDan marks National banks foreign-exchange reserve. The background to the net management isas follows:

y Central-government foreign loans are raised to ensure an adequate foreign-exchangereserve. Exchange-rate losses and gains on the foreign-exchange reserve should thereforebe related closely to the equivalent gains and losses on the central government's currency-denominated debt.

y Exchange-rate gains and losses on the foreign-exchange reserve affect the size of theNational banks surplus and thereby also the National banks transfer of profit to thecentral government.

y

The work to prepare the assessment of the development in interest and exchange rates isidentical. Net management therefore eliminates duplicate work.


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And after a thorough research in the field of derivatives I found some new risks which werearising in trading. Of course they are not so high in volumes but its risk capacity is increasingand gaining importance in the international markets. They are like:

y Liquidity risky Volatility risk

y Operational risk

Liquidity risk:

In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough

in the market to prevent a loss (or make the required profit).

Types of liquidity risk:

1. Asset Liquidity - An asset cannot be sold due to lack of liquidity in the market -essentially a sub-set of market risk. This can be accounted for by:

1.Widening bid/offer spread

2.Making explicit liquidity reserves

3.Lengthening holding period for VaR calculations

2. Funding liquidity - Risk that liabilities:

1.Cannot be met when they fall due

2.Can only be met at an uneconomic price

3. Can be name-specific or systemic

Causes of Liquidity Risk

y Liquidity risk'arises from situations in which a party interested in trading an asset cannotdo it because nobody in the market wants to trade that asset. Liquidity risk becomesparticularly important to parties who are about to hold or currently hold an asset, since itaffects their ability to trade.

y Manifestation of liquidity risk is very different from a drop of price to zero. In case of adrop of an asset's price to zero, the market is saying that the asset is worthless. However,if one partycannot find another party interested in trading the asset, this can potentially be

only a problem of the market participants with finding each other. This is why liquidityrisk is usually found higher in emerging markets or low-volume markets.

y Liquidity risk is financial risk due to uncertain liquidity. An institution might loseliquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or someother event causes counterparties to avoid trading with or lending to the institution. Afirm is also exposed to liquidity risk if markets on which it depends are subject to loss ofliquidity.


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y Liquidity risk tends to compound other risks. If a trading organization has a position in anilliquid asset, its limited ability to liquidate that position at short notice will compound itsmarket risk. Suppose a firm has offsetting cash flows with two different counterparties ona given day. If the counterparty that owes it a payment defaults, the firm will have toraise cash from other sources to make its payment. Should it be unable to do so, it too

will default. Here, liquidity risk is compounding credit risk.y A position can be hedged against market risk but still entail liquidity risk. This is true in

the above credit risk examplethe two payments are offsetting, so they entail credit risk but not market risk. Another example is the1993 Metallgesellschaftdebacle. Futures were used to hedge an OTC obligation. It isdebatable whether the hedge was effective from a market riskstandpoint, but it was theliquidity crisis caused by staggering margin calls on the futures that forcedMetallgesellschaft to unwind the positions.

Accordingly, liquidity risk has to be managed in addition to market, credit and other risks.Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity

risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do notexist. Certain techniques of asset-liability management can be applied to assessing liquidity risk.A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any daythat has a sizeable negative net cash flow is of concern. Such an analysis can be supplementedwith stress testing. Look at net cash flows on a day-to-day basis assuming that an importantcounterparty defaults.

Analyses such as these cannot easily take into account contingent cash flows, such as cash flowsfrom derivatives or mortgage-backed securities. If an organization's cash flows are largelycontingent, liquidity risk may be assessed using some form of scenario analysis. A generalapproach using scenario analysis might entail the following high-level steps:

Construct multiple scenarios for market movements and defaults over a given period oftime

Assess day-to-day cash flows under each scenario.

Because balance sheets differ so significantly from one organization to the next, there is littlestandardization in how such analyses are implemented.


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Measures:

Liquidity gap:

The liquidity gap is the net liquid assets of a firm. The excess value of the firms liquid assetsover its volatile liabilities. A company with a negative liquidity gap should focus on their cash

balances and possible unexpected changes in their values.As a static measure of liquidity risk it gives no indication of how the gap would change with anincrease in the firms marginal funding cost.

Liquidity risk Elasticity:

It is nothing but change of net assets over funded liabilities that occurs the liquidity premium onthe banks marginal funding cost rises by a small amount as the liquidity risk elasticity. For thebanks this would be the measured as a spread over LIBOR.

Problems with it are like it assumes parallel changes in funding spread across all maturities andthat is only accurate for small changes in funding spreads

Volatility risk:

It is a risk in financial markets is the likelihood of fluctuations in the exchange rate of currencies.Therefore it is a probability measure of the threat that an exchange rate movement poses to aninvestors portfolio in a foreign currency. The volatility of the exchange rate is measured asstandard deviation over a dataset of exchange rate movements.

Consequences:

reduces volume of international trade

reduces long term capital flows

increases speculation

increases resources absorbed in risk management

economic policy making becomes difficult.

Operational risk:

The Basel Committee (2004) defines operational riskas

the risk of loss resulting from inadequate or failed internal processes, people and systems, orfrom external events.

Event-Type

Category

(Level 1)

DefinitionCategories

(Level 2)

Activities Examples

(Level 3)

Internal Fraud Loss due to acts of a type

intended to defraud,

misappropriate property or

Unauthorized Activity Transactions not reported

(intentional)

Transaction type


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circumvent regulations, the law or

company policy, excluding

diversity / discrimination events,

which involves at least one

internal party.

unauthorized (with monetary

loss)

Mismarking of position

(intentional)

Theft and Fraud Fraud / credit fraud /

worthless deposits

Theft / extortion /

embezzlement / robbery

Misappropriation of assets

Forgery

Check kiting

Smuggling

Account take-over /

impersonation, etc.

Tax non-compliance / evasion

(willful)

Bribes / kickbacks

Insider trading (not on firm's

account)

External Fraud Losses due to acts of a type

intended to defraud,

misappropriate property or

circumvent the law, by a third

party

Theft and Fraud Theft / robbery

Forgery

Check kiting

Systems Security Hacking damage

Theft of information (with

monetary loss)

Employment

Practices and

Workplace Safety

Losses arising from acts

inconsistent with employment,

health or safety laws or

agreements, from payment ofpersonal injury claims, or from

diversity / discrimination events.

Employee Relations Compensation, benefit,

termination issues

Organized labor activities

Safe Environment General liability (slips and

falls, etc.)

Employee health & safety

rules and events

Workers compensation

Diversity &

Discrimination

All discrimination types

Clients, Products &

Business Practice

Losses arising from an

unintentional or negligent failureto meet a professional obligation

to specific clients (including

fiduciary and suitability

requirements), or from the nature

or design of a product.

Suitability, Disclosure

& Fiduciary

Fiduciary breaches /

guideline violationsSuitability / disclosure issues

(KYC, etc.)

Retail consumer disclosure

violations

Breach of privacy

Aggressive sales

Account churning

Misuse of confidential


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information

Lender liability

Improper Business or

Market Practices

Antitrust

Improper trade / market

practice

Market manipulation

Insider trading (on firm's

account)

Unlicensed activity

Money laundering

Product Flaws Product defects

(unauthorized, etc.)

Model errors

Selection,

Sponsorship &Exposure

Failure t investigate client per

guidelinesExceeding client exposure

limits

Advisory Activities Disputes over performance

or advisory activities

Damage to Physical

Assets

Losses arising from loss or

damage to physical assets from

natural disaster or other events

Disasters and Other

Events

Natural disaster losses

Human losses from external

sources (terrorism, vandalism)

Business Disruption& Systems Failures

Losses arising from disruption ofbusiness or system failures

Systems HardwareSoftware

Telecommunications

Utility outage / disruptions

Execution, Delivery &

Process

Management

Losses from failed transaction

processing or process

management, from relations with

trade counterparties and vendors

Transaction Capture,

Execution &

Maintenance

Miscommunication

Data entry, maintenance or

loading error

Missed deadline or

responsibility

Model / system misoperation

Accounting error / entity

attribution errorOther task misperformance

Delivery failure

Collateral management

failure

Reference data maintenance

Monitoring & Failed mandatory reporting


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Reporting obligation

Inaccurate external report

(loss incurred)

Customer Intake &

Documentation

Client permissions /

disclaimers missed

Legal documents missing /

incomplete

Customer / Client

Account

Management

Unapproved access given to

accounts

Incorrect client records (loss

incurred)

Negligent loss or damage of

client assets

Trade Counterparties Non-client counterparty

misperformanceMisc. non-client counterparty

disputes

Vendors & Suppliers Outsourcing

Vendor disputes

Source: Basel Committee (2003)


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Methods of operational risk management:

Basel II and various supervisory bodies of the countries have prescribed various soundnessstandards for operational Risk Management for Banks and similar Financial institutions. Tocomplement these standards, Basel II has given guidance to 3 broad methods of capital forcalculation of this risk

Basic indicator approach- based on annual revenue of the financial institution.

Standardized approach- based on annual revenue of each of the broad business lines ofthe financial institution.

Advanced measurement approach- based on the internally developed risk measurementframework of the bank adhering to the standards prescribed.

In order to control these risks the financial intellectuals have invented some financialinstruments called the derivatives. They are as follows:

EQUITY DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are forwards, futures,options and swaps. We take a brief look at various derivatives contracts that have come to beused.

Forwards: A forward contract is a customized contract between two entities, where settlementtakes place on a specific date in the future at today's 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 forwardcontracts 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 theobligation to buy a given quantity of the underlying asset, at a given price on or before a givenfuture date. Puts give the buyer the right, but not the obligation to sell a given quantity of theunderlying 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 onoptions exchanges having a maximum maturity of nine months. Longer-dated options are calledwarrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These areoptions having a maturity of up to three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset isusually a moving average of a basket of assets. Equity index options are a form of basketoptions.


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Swaps: Swaps are private agreements between two parties to exchange cash flows in the futureaccording to a prearranged formula. They can be regarded as portfolios of forward contracts. Thetwo commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between theparties in the same currency.

Currency swaps: These entail swapping both principal and interest between the parties, with thecash flows in one direction being in a different currency than those in the opposite direction.

Stations: Stations are options to buy or sell a swap that will become operative at the expiry ofthe options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, theswaptions market has receiver swaptions and payer swaptions. A receiver swaption is an optionto receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date for a specifiedprice. One of the parties to the contract assumes a long position and agrees to buy the underlyingasset on a certain specified future date for a certain specified price. The other party assumes ashort position and agrees to sell the asset on the same date for the same price. Other contractdetails like delivery date, price and quantity are negotiated bilaterally by the parties to thecontract. The forward contracts are normally traded outside the exchanges.

The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration dateand the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party,which often results in high prices being charged.

Forward contracts are very useful in hedging and speculation. The classic hedging applicationwould be that of an exporter who expects to receive payment in dollars three months later. He isexposed to the risk of exchange rate fluctuations. By using the currency forward market to selldollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importerwho is required to make a payment in dollars two months hence can reduce his exposure toexchange rate fluctuations by buying dollars forward.If a speculator has information or analysis, which forecasts an upturn in a price, then he can golong on the forward market instead of the cash market. The speculator would go long on theforward, wait for the price to rise, and then take a reversing transaction to book profits.Speculators may well be required to deposit a margin upfront. However, this is generally arelatively small proportion of the value of the assets underlying the forward contract. The use offorward markets here supplies leverage to the speculator.


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LIMITATIONS OF FORWARD MARKETS

Forward markets world-wide are afflicted by several problems: Lack of centralization of trading, Illiquidity, and

Counterparty riskIn the first two of these, the basic problem is that of too much flexibility and generality. Theforward market is like a real estate market in that any two consenting adults can form contractsagainst each other. This often makes them design terms of the deal which are very convenient inthat specific situation, but makes the contracts non-tradable.

Counterparty risk arises from the possibility of default by any one party to the transaction. Whenone of the two sides to the transaction declares bankruptcy, the other suffers. Even when forwardmarkets trade standardized contracts, and hence avoid the problem of illiquidity, still thecounterparty risk remains a very serious issue.

Lets see the notional amount of derivative contracts by type:


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Interestrate derivatives:

An interest rate derivative is a derivative where the underlying asset is the right to pay orreceive a (usually notional) amount ofmoney at a given interest rate.


Trading in derivatives first started to protect farmers from the risk of the value of their crop

going below the cost price of their produce. Derivative contracts were offered on variousagricultural products like cotton, rice, coffee, wheat, pepper, et cetera.The first organizedexchange, the Chicago Board of Trade (CBOT) -- with standardized contracts on variouscommodities -- was established in 1848. In 1874, the Chicago Produce Exchange -- which is nowknown as Chicago Mercantile Exchange -- was formed (CME).CBOT and CME are two of thelargest commodity derivatives exchanges in the world.


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Equity derivatives:

An Equity derivative is a class of financial instruments whose value is at leastpartly derivedfrom one or more underlying equity securities. Market participants trade equityderivatives in order to transfer or transform certain risks associated with the underlyingsecurity. Options are by far the most common equity derivative, however there are many othertypes of equity derivatives that are actively traded.

Credit derivatives:

A credit derivative is an OTC derivative designed to transfer credit risk from one party toanother. By synthetically creating or eliminating credit exposures, they allow institutions to moreeffectively manage credit risks.

Currency derivatives:

Currency derivatives can be described as contracts between the sellers and buyers, whose values

are to be derived from the underlying assets, the currency amounts. These are basically riskmanagement tools in Forex and money markets. Those are meant to hedge interest rate risks andcash mismatches in different currencies such as currency swaps and options are known ascurrency derivatives.

FOREX derivatives:

Derivatives based on currency exchange rates are forward contracts (or forward rateagreements); options and swaps and are popularly known as Forex derivatives.


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Interest rate derivatives:

INTEREST RATE SWAPS (IRS)

IRS is a derivative instrument in which two parties exchange two streams of interest onnotional amount. Let us see how an Interest Rate Swap can be used in rising interest ratesscenario, where the customer has Term Loan Borrowings with floating rate of interest. Forunderstanding the mechanics of IRS, let us we assume that repayment of principal payment isbullet payment i.e. entire principal amount is payable at the end of 5th Year. He is exposed tointerest rate risks, as his interest liabilities will increase with each interest rate hike.

The customer enters into an agreement with the Bank, to pay fixed rate of interest say 9% on a

notional sum of equivalent to term loan borrowings say Rs. 100 Cr. And in turn the Bank paysfloating rate of interest rate. Floating rate will be linked to benchmark rate. Popularbenchmarks are INBMK, MIBOR, and LIBOR. Let us assume the bank agrees to pay INBMKwith six monthly reset. INBMK is one of the accepted benchmark, which mirrors G.Sec.Yield.

Pays 9% on Rs. 100 Cr

Customer

C

Bank pays Floating Rate INBMK Reset every six month

In the above illustration, let us assume that deal is concluded on 1 st January,2007 and INBMKrate is 7.00%. Interest will be settled at the end of six months and interest set on settlementdate will be applicable for the next six months.

On 1st July,2007, which is the first interest settlement date, the Bank will pay 2% p.a. (9%-7%) on Rs. 100 Cr and floating interest will be reset for the next six months period. Letassume, INBMK resets at 7.50%, which will be applicable for six months period effect from1st July,2007. Reset of floating interest and interest differential settlement continues till the

maturity of swap.

Thus, effectively customer has converted his floating interest liability into fixed interestliability and remains insulated from interest rate shocks. With IRS is in place, the customer isfully protected and increase in interest liability on underlying Term Loan on account ofinterest rate hikes, gets neutralized by receipt of difference between fixed and floating interestlegs under IRS and vice versa.

Customer

Bank


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Likewise, in falling rate scenario, the customer synthetically converted fixed interest liabilityinto floating interest liability for reducing cost of borrowings. However, this exposes him tointerest rate risk.

IRS is a hedging instrument. Through IRS you can convert your floating interest rate liabilities (or assets)

into fixed interest rate liabilities (or assets) and vice-versa. In case of rising interest rate scenario and if

you contracted a floating rate loan, you can protect yourself from paying more interest on your loan, bycrystallizing your liabilities into fixed interest through IRS.

Let us assume, the Company has taken Term Loan of Rs. 10 Crores with floating rate ofinterest. The company sees rate of interest going up in the near future. The company canhedge it by entering into Interest Rate Swaps.

The company concludes IRS Deal with Union Bank of India for Rs. 10 Crores for fiveyears. Union Bank of India to pay floating rate benchmarked to INBMK linked toGovt. Securities yield (more explanation given below) and the Company to pay fixed @

10.25%p.a. The interest payment/resetting frequency is one year and the tenor is 5 years.

Let us assume the interest rate moves upward as viewed by the Company.Date of payment Interest Payable Interest Receivable

Floating Fixed Difference

August,2007 9.90% 10.25% (-) 0.35 August,2008 10.50% 10.25% (+)0.25 August,2009 10.00% 10.25% (+)0.75 August,2010 10.25% 10.25% (+)1.00

August,2011 10.00% 10.25% (+)0.75Net gain _________________ (+)2.40 %

Thus, effectively the company reduces its interest burden by 2.40% provided the view turnscorrect.

However, it the view turns otherwise and interest rates come down, the company will be at loss in

derivative transaction. The loss will be neutralized by gains in underlying transactions due to reduction in

interest rate on the underlying the company will be paying less interest on underlying liabilities.

The above example explains in simple terms how the company can convert floating interest liabilities into

fixed interest liabilities. Likewise, the company can convert fixed interest liabilities into floating interestrate liabilities.

Any derivative as an instrument should be used cautiously as it may lead to offsetting the gains earned on

the underlying transactions. But at the same time it offers opportunities for genuine hedging transactions


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Foreign exchange derivatives:

Evolution of the forex derivatives market in India

This tremendous growth in global derivative markets can be attributed to a number of factors.

They reallocate risk among financial market participants, help to make financial markets morecomplete, and provide valuable information to investors about economic fundamentals.Derivatives also provide an important function of efficient price discovery and make unbundlingof risk easier.

In India, the economic liberalization in the early nineties provided the economic rationale for theintroduction of FX derivatives. Business houses started actively approaching foreign markets notonly with their products but also as a source of capital and direct investment opportunities. Withlimited convertibility on the trade account being introduced in 1993, the environment becameeven more conducive for the introduction of these hedge products. Hence, the development in theIndian forex derivatives market should be seen along with the steps taken to gradually reform the

Indian financial markets. As these steps were largely instrumental in the integration of the Indianfinancial markets with the global markets.

Rupee Forwards

An important segment of the forex derivatives market in India is the Rupee forward contractsmarket. This has been growing rapidly with increasing participation from corporates, exporters,importers, banks and FIIs. Till February 1992, forward contracts were permitted only againsttrade related exposures and these contracts could not be cancelled except where the underlyingtransactions failed to materialize. In March 1992, in order to provide operational freedom tocorporate entities, unrestricted booking and cancellation of forward contracts for all genuine

exposures, whether trade related or not, were permitted. Although due to the Asian crisis,freedom to re-book cancelled contracts was suspended, which has been since relaxed for theexporters but the restriction still remains for the importers.

Cross Currency Forwards

Cross currency forwards are also used to hedge the foreign currency exposures, especially bysome of the big Indian corporates. The regulations for the cross currency forwards are quitesimilar to those of Rupee forwards, though with minor differences. For example, a corporatehaving underlying exposure in Yen, may book forward contract between Dollar and Sterling.Here even though its exposure is in Yen, it is also exposed to the movements in Dollar vis a vis

other currencies. The regulations for rebooking and cancellation of these contracts are alsorelatively relaxed. The activity in this segment is likely to increase with increasing convertibilityof the capital account.


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Outlook: Currency Futures

As mentioned earlier, Indian forwards market is relatively illiquid for the standard maturitycontracts as most of the contracts traded are for the month ends only. One of the reasons for themarket makers reluctance to offer these contracts could be the absence of a well-developed term

money market. It could be argued that given the future like nature of Indian forwards market,currency futures could be allowed.

Some of the benefits provided by the futures are as follows:

y Currency futures, since they are traded on organized exchanges, also confer benefits fromconcentrating order flow and providing a transparent venue for price discovery, whileover-the-counter forward contracts rely on bilateral negotiations.

y Two characteristics of futures contract- their minimal margin requirements and the lowtransactions costs relative to over-the counter markets due to existence of a

clearinghouse, also strengthen the case of their introduction.

y Credit risks are further mitigated by daily marking to market of all futures positions withgains and losses paid by each participant to the clearinghouse by the end of tradingsession.

y Moreover, futures contracts are standardized utilizing the same delivery dates and thesame nominal amount of currency units to be traded. Hence, traders need only establishthe number of contracts and their price.

y Contract standardization and clearing house facilities mean that price discovery can

proceed rapidly and transaction costs for participants are relatively low.

However given the status of convertibility of Rupee whereby residents cannot freely transact incurrency markets, the introduction of futures may have to wait for further liberalization on theconvertibility front.

Options

Cross currency options

The Reserve Bank of India has permitted authorized dealers to offer cross currency options to the

corporate clients and other interbank counter parties to hedge their foreign currency exposures.Before the introduction of these options the corporates were permitted to hedge their foreigncurrency exposures only through forwards and swaps route. Forwards and swaps do remove theuncertainty by hedging the exposure but they also result in the elimination of potentialextraordinary gains from the currency position. Currency options provide a way of availing ofthe upside from any currency exposure while being protected from the downside for the paymentof an upfront premium.


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Exotic options

Options being over the counter products can be tailored to the requirements of the clients. Moresophisticated hedging strategies call for the use of complex derivative products, which go beyondplain vanilla options.

These products could be introduced at the inception of the Rupee vanilla options or in phases,depending on the speed of development of the market as well as comfort with competencies andRisk Management Systems of market participants.

Some of these products are mentioned below:

Simple structures involving vanilla European calls and puts such as range-forwards, bull andbear spreads, strips, straps, straddles, strangles, butterflies, risk reversals, etc. Simple exotic options such as barrier options, Asian options, Look back options and alsoAmerican options

More complex range of exotics including binary options, barrier and range digital options,forward-start options, etc

Some of the above-mentioned products especially the structure involving simple European callsand puts may even be introduced along with the options itself.

Foreign currency derivatives

There is some activity in other cross currency derivatives products also, which are allowed to be used tohedge the foreign currency liabilities provided these were acquired in accordance with the RBIregulations. The products that may be used are:

y Currency swapy Coupon Swap

y Interest rate swap

y Interest rate cap or collar (purchases)

y Forward Rate Agreement (FRA) contract.However the regulations require that:

y The contract should not involve rupee

y The notional principal amount of the hedge does not exceed the outstanding amount of theforeign currency loan, and

y

The maturity of the hedge does not exceed the un-expired maturity of the underlying loan

Outlook: Some proposed products

Finally some innovative products may be introduced which satisfy specific customer requirements. Theseare designed from the cash and derivative market instruments and offer complex payoffs depending onthe movement of various underlying factors. Some of the examples of these products areprovided below:


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y Accrual forward: With an accrual forward, for each of the daily fixing up to expiry that spotremains within the range, the holder gets longer 1 unit of USD/INR at the Forward Rate. Forexample, for each of the daily fixing up to expiry that spot remains within the range let us say48.50 to 48.60, the holder accrues 1 unit at the forward rate of 48.56.

y Enhanced accrual forward: Enhanced accrual forward is similar to accrual forward, but thiscontract has two forward rates, which apply for different ranges. For example, Accrue long 1 unitper fixing at forward rates of 48.56 (Range 1 - 48.50 to 48.60) or Long 1 unit per fixing at48.47(Range 2- below 48.50). So for each of the daily fixing up to expiry that spot remains withinthe 48.50 48.60 ranges the holder accrues 1 unit at 48.56. For each of the daily fixing up toexpiry that spot is below 48.50 the holder accrues 1 unit at 48.47. If spot is ever above 48.60 thennothing will be accrued on that day. Note that the two ranges do not overlap, so the holder willnever accrue more than 1 unit per fixing.

y Higher yield deposits: This product can be developed to offer a comparable higher yield than on atraditional Rupee money market deposit. Exercise price: 48.80 per 1 US$ In strike: 48.70 per 1US$

There are three possible scenarios at maturity:

y If spot never trades at or beyond the in strike before expiration, the investment plus interest atcertain rate r will be paid in rupee.

y If spot trades at or beyond the in strike before expiration and closes above the exercise price, theinvestor is paid the invested capital plus interest r paid in rupee.

But if spot trades at or beyond the instrike before expiration and closes below the exercise price, the

investor is paid in USD. The sum paid in USD corresponds to the amount of invested capital plus interest

of r converted at the exercise price

tions

Credit risk derivative:

A credit derivative is an OTC derivative designed to transfer credit risk from one party toanother. By synthetically creating or eliminating credit exposures, they allow institutions to moreeffectively manage credit risks. Credit derivatives take many forms.

Credit derivatives are over-the-counter contracts which allow the isolation and management ofcredit risk from all other components of risk.

Off-balance sheet financial instruments that allow end users to buy and sell credit risk

Uses of credit derivatives

To hedge against an increase in risk, or to gain exposure to a market with higher risk.

Creating customized exposure; e.g. gain exposure to Russian debts (rated below the managerscriteria per her investment mandate).


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Leveraging credit views - restructuring the risk/return profiles of credits. Allow investors to eliminate credit risk from other risks in the investment instruments.

Credit derivatives allow investors to take advantage of relative valueopportunities by exploiting inefficiencies in the credit markets

Definition of a credit derivative

1. Basedon intended useA derivative security that is primarily used to transfer, hedge or manage credit risk.

2. Basedonnature ofpayoff

A derivative security whose payoff is materially effected by credit risk.

Common types of credit derivatives

1. Credit default swaps

2. Asset swaps and total return swaps3. Credit spread options4. Credit linked notes5. Default correlation products:basket default swaps and collateralized debt obliga


Chequred HistoryThe history of organized commodity derivatives in India goes back to the nineteenth centurywhen the Cotton Trade Association started futures trading in 1875, barely about a decade afterthe commodity derivatives started in Chicago. Over time the derivatives market developed inseveral other commodities in India. Following cotton, derivatives trading started in oilseeds inBombay (1900), raw jute and jute goods in Calcutta (1912), wheat in Hapur (1913) and inBullion in Bombay (1920).However, many feared that derivatives fuelled unnecessary speculation in essential commodities,and were detrimental to the healthy functioning of the markets for the underlying commodities,and hence to the farmers. With a view to restricting speculative activity in cotton market, theGovernment of Bombay prohibited options business in cotton in 1939. Later in 1943, forwardtrading was prohibited in oilseeds and some other commodities including food-grains, spices,vegetable oils, sugar and cloth.

After Independence, the Parliament passed Forward Contracts (Regulation) Act, 1952 whichregulated forward contracts in commodities all over India. The Act applies to goods, which aredefined as any movable property other than security, currency and actionable claims. The Actprohibited options trading in goods along with cash settlements of forward trades, rendering acrushing blow to the commodity derivatives market. Under the Act, only those


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associations/exchanges, which are granted recognition by the Government, are allowed toorganize forward trading in regulated commodities. The Act envisages three-tier regulation:

(i) The Exchange which organizes forward trading in commodities can regulate trading on aday-to-day basis;

(ii) the Forward Markets Commission provides regulatory oversight under the powers

delegated to it by the central Government,(iii)the Central Government - Department of Consumer Affairs, Ministry of ConsumerAffairs, Food and Public Distribution - is the ultimate regulatory authority.

The already shaken commodity derivatives market got a crushing blow when in 1960s, followingseveral years of severe draughts that forced many farmers to default on forward contracts (andeven caused some suicides), forward trading was banned in many commodities consideredprimary or essential. As a result, commodities derivative markets dismantled and wentunderground where to some extent they continued as OTC contracts at negligible volumes. Muchlater, in 1970s and 1980s the Government relaxed forward trading rules for some commodities,but the market could never regain the lost volumes.

India is among the top-5 producers of most of the commodities, in addition to being a majorconsumer of bullion and energy products. Agriculture contributes about 22% to the GDP of theIndian economy. It employees around 57% of the labor force on a total of 163 million hectares ofland. Agriculture sector is an imposrtant factor in achieving a GDP growth of 8-10%. All thisindicates that India can be promoted as a major center for trading of commodity derivatives.

It is unfortunate that the policies of FMC during the most of 1950s to 1980s suppressed theverymarkets it was supposed to encourage and nurture to grow with times. It was a mistake otheremergingeconomies of the world would want to avoid. However, it is not in India alone thatderivatives were suspected of creating too much speculation that would be to the detriment of thehealthy growth of the markets and the farmers. Such suspicions might normally arise due to amisunderstanding of the characteristics and role of derivative product.

It is important to understand why commodity derivatives are required and the role they can playin risk management. It is common knowledge that prices of commodities, metals, shares andcurrencies fluctuate over time. The possibility of adverse price changes in future creates risk forbusinesses.Derivatives are used to reduce or eliminate price risk arising from unforeseen price changes. Aderivative is a financial contract whose price depends on, or is derived from, the price of anotherasset.

Two important derivatives are futures and options.(i) Commodity Futures Contracts: A futures contract is an agreement for buying or selling acommodity for a predetermined delivery price at a specific future time. Futures are standardizedcontracts that are traded on organized futures exchanges that ensure performance of the contractsand thus remove the default risk. The commodity futures have existed since the Chicago Boardof Trade (CBOT, www.cbot.com) was established in 1848 to bring farmers and merchantstogether. The major function of futures markets is to transfer price risk from hedgers tospeculators. For example, suppose a farmer is expecting his crop of wheat to be ready in two


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months time, but is worried that the price of wheat may decline in this period. In order tominimize his risk, he can enter into a futures contract to sell his crop in two months time at a price determined now. This way he is able to hedge his risk arising from a possible adversechange in the price of his commodity.

(ii) Commodity Options contracts: Like futures, options are also financial instruments usedfor hedging and speculation. The commodity option holder has the right, but not the obligation,to buy (or sell) a specific quantity of a commodity at a specified price on or before a specifieddate. Option contracts involve two parties the seller of the option writes the option in favour ofthe buyer (holder) who pays a certain premium to the seller as a price for the option. There aretwo types of commodity options: a call option gives the holder a right to buy a commodity at anagreed price, while a put option gives the holder a right to sell a commodity at an agreed priceon or before a specified date (called expiry date).

Booming Business: US$ 1 Trillion and Beyond

Since 2002 when the first national level commodity derivatives exchange started, the exchangeshave conducted brisk business in commodities futures trading. In the last three years, there hasbeen a great revival of the commodities futures trading in India, both in terms of the number ofcommodities allowed for futures trading as well as the value of trading. While in year 2000,futures trading was allowed in only 8 commodities, the number jumped to 80 commodities inJune 2004.


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Notional Amounts of Commodity and Equity Contracts

by MaturityAll Commercial Banks

Year-ends 1995 - 2007, Quarterly 2008


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Findings:

1.And after a thorough research I found some more derivatives which were also playing a major role

from the past few years and gaining recognition and now the banks and authorized dealers shouldconcentrate on these derivatives also for more risk management. They are like:

Fund derivatives:

A fund derivative is a financial structured product related to a fund, normally using the underlying fund

to determine the payoff. This may be a mutual fund or a hedge fund. Purchasers might want exposure to

a fund to get exposure to a star fund manager or management style as well as the asset class.

Typical fund derivatives might be a call option on a fund, a CPPI on a fund, or a leveraged note on a fund.

More complicated structures might be a guarantee sold to a fund that ensures it cannot fall in value by

more than a certain amount. Maturities might range from three to ten years. The big players in this field

are BNP Paribas, Societe Generale, Barclays, Deutsche Bank, Citigroup, Credit Suisse, etc.Fund derivatives have had explosive growth over the past 10 years but are still a major growth area.

New structures are constantly being developed to suit market and client opportunities.

Inflation derivatives:

A subclass of derivative that is used by individuals to mitigate the effects of potentially large levels of

inflation. The most common type of inflation derivatives are swaps, in which a counterparty's cash

flows are linked to a price index and the other counterparty is linked to a conventional fixed or floating

cash flow. Many investors prefer inflation protection from derivatives because unlike inflation-indexed

bonds, a significant amount of capital isn't required and it's more flexible. Inflation derivatives requirethe buyer to provide a small premium to the swap provider.

In most cases the Consumer Price Index (CPI) is used measure the differences in annual inflation.

Real estate derivatives:

The National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index (NPI) is the accepted

index created to provide an instrument to gauge the investment performance of the commercial real

estate market. Originally developed in 1982, the unleveraged index is made up of more than 5,000

properties worth a total of about $309 billion (as of 2008) from all the U.S. regions and real estate land

uses. Although this index has been in existence for more than 20 years, it is only recently that data has

become transparent enough to allow it to accurately and appropriately track the performance of equity

real estate. With real estate data becoming more transparent and transaction information becoming

easier and less costly to obtain, real estate indexes have become more relevant, leading to the creation

of an increasingly efficient derivatives market.


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Regulatory Arbitrage under Basel I

y High grade corporate: 100% risk weighty Speculative grade corproate 100% risk weight

y Well known perverse incentives of Basel I

y Can lend to high grade corporate buy a CDS, and if protection-seller is right type,reduce regulatory capital to 20% risk weight

y Or could sell high grade risk to non regulated sector (securitize)

y Or sell CDOs on high grade portfolio maintaining equity tranche (supervisorytreatments differ, must normally must reduce notional from capital)

y The claim is banks are net protection buyers, perhaps spurred by arbitraging Basel I typerules

y But, lack of information a serious concern.

That is there is huge risk in case of credit derivatives as per the data shown in credit risk columnie because of CDOs Collateral Debt Obligations the product which mainly leaded to presentGlobal Financial Crisis.

3.This is the shocking news and infact might not be believable but it is true about 90% only 5banks they are like :

y JPMC

y BANK OF AMERICA

y CITI BANK

y HSBC

y GOLDMAN SACHS


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Five Banks Dominate in DerivativesAll Commercial Banks, 2008


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CONCLUSION:

Derivatives are an instrument which are mainly used for the risk control and hence that should be

used in the same way but recently and now these derivatives are used for private purpose withwrong ratings which caused biggest ever financial crisis in the history. And the dealers must also

start trading the newly formed and establishing derivatives like Fund Derivatives, real estate

derivatives where the housing bubble has occurred, and inflation derivatives which was

becoming popular in the European areas starting its volumes in the Asian region especially in

India.


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Article on Derivatives