Derivatives

8/13/2019 Derivatives .

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DERIVATIVES

BACHELOR OF COMMERCE

BANKING & INSURANCE

SEMESTER V

(2012-2013)

SUBMITTED BY:

SHWETA SAWANT

ROLL NO. 83

PROJECT GUIDE:

PROF. SMITA DAYAL


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K.J.SOMAIYA COLLEGE OF ARTS & COMMERCE,

VIDHYAVIHAR (EAST), MUMBAI-400077

PROJECT ON:

DERIVATIVES

BACHELOR OF COMMERCE

BANKING & INSURANCE

SEMESTER V

(2012-2013)

SUBMITTED

In partial fulfillment of the requirements

For the award of the degree of

Bachelor of commerce- Banking & Insurance

By:

SHWETA SAWANT

ROLL NO.83


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K.J.SOMAIYA COLLEGE OF ARTS & COMMERCE,

VIDHYAVIHAR- (EAST), MUMBAI-400077

CERTIFICATE

This is to certify that MS.SHWETA SAWANT of B.COM. Banking &

Insurance Semester v (Academic Year) 2012-2013 has successfully

completed project on DERIVATIVESUnder the guidance of

PROF.SMITA DAYAL.

(Mrs. SMITA DAYAL) (Dr. SUDHA VYAS)

Course Coordinator Principal

Internal Examiner External Examiner

(Mrs. SMITA DAYAL)

Project Guide


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DECLARATION

I, Ms. SHWETA .C. SAWANT the student of B.COM-Banking &Insurance- Semester v (2012-2013) hereby declare that I have

completed project on DERIVATIVES.

Wherever the data/ information have been taken from any book or

other sources have been mentioned in bibliography.

The information submitted is true and original to the best of my

knowledge

Students Signature

SHWETA SAWANT

(Roll No. 83)


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ACKNOWLEDGEMENT

On the event of completion of my project DERIVATIVES.I take the

opportunity to express my deep sense of gratitude towards all those people

without whose guidance, inspiration, and timely help this project would have

never seen the light of day.

Heartily thanks to Mumbai University for giving me the opportunity to work on

this project. I would also like to thank our principal DR.MRS.SUDHA. VYAS for

giving us this brilliant opportunity to work on this project.

Any accomplishment requires the effort of many people and this project is not

different. I find great pleasure in expressing my deepest sense of gratitudetowards my project guide PROF. SMITA DAYAL, whose guidance & inspiration

right from the conceptualization to the finishing stages proved to be very

essential and valuable in the completion of the project. I would like to thank

Library staff, all my classmates, and friends for their invaluable suggestions and

guidance for my project work.

Lastly I would like to thank my parents without whose consent and support it

would have not been possible for me to complete this project.

Students Signature


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INDEX

SR NO TOPIC PAGE NO

1 SUMMARY 1-2

2 INTRODUCTION TO DERIVATIVES 3

3 ORIGIN OF DERIVATIVES 4

4 HISTORY OF DERIVATIVES 5-6

5 DEFINITION OF DERIVATIVES 7

6 FACTORS CONTRIBUTING TO THE GROWTH OF

DERIVATIVES

8-11

7 INDIAN DERIVATIVES MARKET 12-13

8 NEED FOR DERIVATIVES IN INDIA 14

9 TYPES OF DERIVATIVES 15-17

10 CONTRACT TYPES OF DERIVATIVES 18-19

11 ECONOMIC FUNCTION OF DERIVATIVES 20

12 USUAGE OF DERIVATIVES 21

13 BENEFITS OF DERIVATIVES 22-23

14 NATIONAL COMMODITY AND DERIVATIVE

EXCHANGE

24

15 WHAT BANKING SYSTEM HAS LEARNED ABOUT

DERIVATIVES- NOTHING AT ALL

25-29

16 DERIVATIVES- CAUTIOUS APPROACH TO

INNOVATION

30-34

17 BANK AND DERIVATIVES 35-37

18 INTEREST RATE SWAP AND SWAP POSITIONS 38-47

18 OPERATION OF DERIVATIVES IN BANK 48-51

20 DERIVATIVESUNREGULATED GLOBAL CASINO FOR

BANKS.

52-54


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CONTINUE..

21 DERIVATIVES RISK IN COMMERCIAL BANKING 55-58

22 HSBC - DERIVATIVES 59-63

23 BANK OF AMERICA - DERIVATIVES 64-66

24 DEUTSCHE BANKOTC DERIVATIVES 67-68

25 DERIVATIVES CLEARING- ICICI 69-70

26 STABILIZING ROLE IN BANKING SYSTEM IS CITED:DERIVATIVES THEIR DUE

71-72

27 BANK INCREASE HOLDINGS IN DERIVATIVES 73-75

28 BANKS AND DERIVATIVES: TOO BIG TO FAIL ANDTOO EXPOSED TO BE SAVED

76-77

29 STATISTICAL REPORT OF DERIVATIVES 78-80

30 CONCLUSION 81-82

31 RECOMMENDATIONS AND SUGGESTIONS 83

32 BIBLIOGRAPHY 84


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SUMMARY

Derivatives trading in the stock market have been a subject of enthusiasm of research in the field

of finance the most desired instruments that allow the market participants to manage risk in the

modern securities trading are known as derivatives. The derivatives are defined as the future

contracts whose value depends upon the underlying assets. If derivatives are introduced in the

stock market, the underlying asset may be anything as component of stock market like, stock

prices or market indices, interest rates, etc. The main logic behind derivative trading is that to

reduce the risk by providing an additional channel to invest with lower trading cost and it

facilitates the investors to extend their settlement through the future contracts.

Derivatives are assets, which derive their values from an underlying asset. The underlying assets

of derivatives are of various categories like

Commodities including grains, coffee beans, etc.

Precious metals like gold and silver.

Foreign exchange rates.

Equity and bonds including medium to long term negotiable debt.

Short term debt securities such as T-bills.

Over-the -counter (OTC) money market product such as loans and deposits.


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There are various derivatives products traded. They are:

1. Forwards.

2. Futures.

3. Options.

4. Swaps.

A Forward contract is a transaction in which the buyer and the seller agree upon a delivery of a

specific quality and quantity of asset usually a commodity at a specified future date. The price

may be agreed on in advance or in future.

A Future contract is a firm contractual agreement between a buyer and a seller for a specified as

on a fixed date in future. The contract price will vary according to the market place but it is fixed

when the trade is made. The contract also has a standard specification so both parties know

exactly what is being done.

An Options contract confers the rightbut not the obligation to buy or sell a specified underlying

instrument or asset at a specified price- the strike or exercised price up until or an specified

future date- the expiry date. The Price is called premium and is paid by buyer of the option to the

seller or writer of the option.

Swaps are transactions which obligates the two parties to the contract to exchange a series of

cash flows at specified intervals known as payment or settlement dates.


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INTRODUCTION

A derivative instrument is a contract between two parties that specifies conditions (especially the

dates, resulting values of the underlying variables, and notional amounts) under which payments

are to be made between the parties.

Under US law and the laws of most other developed countries, derivatives have special legal

exemptions that make them a particularly attractive legal form to extend credit. However, the

strong creditor protections afforded to derivatives counterparties, in combination with their

complexity and lack of transparency, can cause capital markets to under price credit risk. This

can contribute to credit booms, and increase systemic risks. Indeed, the use of derivatives to

mask credit risk from third parties while protecting derivative counterparties contributed to the

financial crisis of 2008 in the United States.

Derivatives can be used forspeculation ("bets") or tohedge ("insurance"). For example, a

speculator may selldeep in-the-moneynaked calls on a stock, expecting the stock price to

plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy

currency forwards in order to limit losses due to fluctuations in theexchange rate of two

currencies.
http://en.wikipedia.org/wiki/Speculationhttp://en.wikipedia.org/wiki/Hedge_%28finance%29http://en.wikipedia.org/wiki/Moneyness#ITM:_In_the_moneyhttp://en.wikipedia.org/wiki/Naked_callhttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Naked_callhttp://en.wikipedia.org/wiki/Moneyness#ITM:_In_the_moneyhttp://en.wikipedia.org/wiki/Hedge_%28finance%29http://en.wikipedia.org/wiki/Speculation


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ORIGIN OF DERIVATIVES

Derivatives have their roots in the agriculture-complex. From an historical context, it was

agricultural commodities futures (mainly grain) that first gained traction as viable financial

instruments. The genesis of these products dates back to the founding of the Chicago Board of

Trade (CBT) in the mid-eighteen hundreds.

Back in the eighteen hundreds large scale farming enterprises were difficult (risky) to bank.

The risk was embodied by the known costs associated with planting seed, fertilizing and

subsequent growth and harvest versus the often volatile, unpredictable final selling price of a

perishable commodity. Futures removedthis unknown from the banking/farming

relationship and transferred it to speculators for a nominal fee or cost.

From 1850 59, American agricultural exports were $189 million/year (81% of total exports).

With agriculture occupying such a huge percentage of exports and GDP it was only natural that

business of this scale (potential fees and profits) would and did attract the attention of the money

changers. The advent of futures and forward contracts in the agri-complex was productive:

giving a higher degree of predictability to farm income making the business of farming more

bankable.


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HISTORY

The history of derivatives is surprisingly longer than what most people think. Some texts even

find the existence of the characteristics of derivative contracts in incidents of Mahabharata.

Traces of derivative contracts can even be found in incidents that date back to the ages before

Jesus Christ .However, the advent of modern day derivative contracts is attributed to the need for

farmers to protect themselves from any decline in the price of their crops due to delayed

monsoon, or overproduction.

The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650.

These were evidently standardized contracts, which made them much like today's futures.

The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was

established in 1848 where forward contracts on various commodities were standardized around

1865. From then on, futures contracts have remained more or less in the same form, as we know

them today.

Derivatives have had a long presence in India. The commodity derivative market has been

functioning in India since the nineteenth century with organized trading in cotton through the

establishment of Cotton Trade Association in 1875. Since then contracts on various other

commodities have been introduced as well.


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Exchange traded financial derivatives were introduced in India in June 2000 at the two major

stock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges.

National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in

December 2003, to provide a platform for commodities trading.

The derivatives market in India has grown exponentially, especially at NSE. Stock Futures are

the most highly traded contracts on NSE accounting for around 55% of the total turnover of

derivatives at NSE, as on April 13, 2005.

Derivatives are generally used as an instrument to hedge risk, but can also be used

for speculative purposes. For example, a European investor purchasing shares of an American

company off of an American exchange (using U.S. dollars to do so) would be exposed to

exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase

currency futures to lock in a specified exchange rate for the future stock sale and currency

conversion back into Euros.


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DEFINITION

A derivative is security whose price is dependent upon or derived from one or more underlying

assets. The derivative itself is merely a contract between two or more parties. Its value is

determined by fluctuations in the underlying asset. The most common underlying assets

include stocks, bonds, commodities, currencies, interest rates and market indexes. Most

derivatives are characterized by high leverage.

With Securities Laws (Second Amendment) Act 1999, Derivatives has been included in

the definition of Securities. The term Derivative has been defined in Securities Contracts

(Regulations) Act, as:-

A Derivative includes: -

1. a security derived from a debt instrument, share, loan, whether secured or

unsecured, risk instrument 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;


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FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES

Factors contributing to the explosive growth of derivatives are price volatility, globalization of

the markets, technological developments and advances in the financial theories.

1. Price Volatility

A price is what one pays to acquire or use something of value. The objects having value may be

commodities, local currency or foreign currencies. The concept of price is clear to almost

everybody when we discuss commodities. There is a price to be paid for the purchase of food

grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is

called interest rate. And the price one pays in ones own currency for a unit of another currency

is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers have demand and

producers or suppliers have supply, and the collective interaction of demand and supply in the

market determines the price. These factors are constantly interacting in the market causing

changes in the price over a short period of time. Such changes in the price are known as price

volatility. This has three factors: the speed of price changes, the frequency of price changes and

the magnitude of price changes.


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The changes in demand and supply influencing factors culminate in market adjustments through

price changes. These price changes expose individuals, producing firms and governments to

significant risks. The breakdown of the BRETTON WOODS agreement brought and end to the

stabilizing role of fixed exchange rates and the gold convertibility of the dollars. The

globalization of the markets and rapid industrialization of many underdeveloped countries

brought a new scale and dimension to the markets. Nations that were poor suddenly became a

major source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of

1990s has also brought the price volatility factor on the surface. The advent of

telecommunication and data processing bought information very quickly to the markets.

Information which would have taken months to impact the market earlier can now be obtained in

matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates

rapidly.

This price volatility risk pushed the use of derivatives like futures and options increasingly as

these instruments can be used as hedge to protect against adverse price changes in commodity,

foreign exchange, equity shares and bonds. The original intended use of derivatives was to

manage risk (hedge); however, now they are often traded as investments whether hedged, un-

hedged or as component of a spread trading strategy. The diverse range of potential underlying

assets and pay-off alternatives leads to a wide range of derivatives contracts available to be

traded in the market.


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2) Globalization of the Markets

Earlier, managers had to deal with domestic economic concerns; what happened in other part of

the world was mostly irrelevant. Now globalization has increased the size of markets and as

greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods

at a lower cost. It has also exposed the modern business to significant risks and, in many cases,

led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of

our products vis--vis depreciated currencies. Export of certain goods from India declined

because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of

steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The

fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that

globalization of industrial and financial activities necessitates use of derivatives to guard against

future losses. This factor alone has contributed to the growth of derivatives to a significant

extent.

3) Technological Advances

A significant growth of derivative instruments has been driven by technological break through.

Advances in this area include the development of high speed processors, network systems and

enhanced method of data entry. Closely related to advances in computer technology are advances

in telecommunications. Improvement in communications allow for instantaneous world wide

conferencing, Data transmission by satellite.


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At the same time there were significant advances in software programmed without which

computer and telecommunication advances would be meaningless. These facilitated the more

rapid movement of information and consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the economy as a whole resources are

rapidly relocated to more productive use and better rationed overtime the greater price volatility

exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a

business which is otherwise well managed. Derivatives can help a firm manage the price risk

inherent in a market economy. To the extent the technological developments increase volatility,

derivatives and risk management products become that much more important.

4) Advances in Financial Theories

Advances in financial theories gave birth to derivatives. Initially forward contracts in its

traditional form, was the only hedging tool available. Option pricing models developed by Black

and Scholes in 1973 were used to determine prices of call and put options. In late 1970s, work

of Lewis Edeington extended the early work of Johnson and started the hedging of financial

price risks with financial futures. The work of economic theorists gave rise to new products for

risk management which led to the growth of derivatives in financial markets.


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INDIAN DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards a world instruments in India

gained momentum in the last few years due to liberalization process and Reserve Bank of Indias

(RBI) efforts in creating currency forward market.Derivatives are an integral part of

liberalization process to manage risk. NSE gauging the market requirements initiated the process

of setting up derivative markets in India. In July 1999, derivatives trading commenced in India.

Derivatives typically have a large notional value. As such, there is the danger that their use could

result in losses for which the investor would be unable to compensate. The possibility that this

could lead to a chain reaction ensuing in an economic crisis was pointed out by famed investor

Warren Buffett inBerkshire Hathaway's 2002 annual report. Buffett called them 'financial

weapons of mass destruction.' The problem with derivatives is that they control an increasingly

larger notional amount of assets and this may lead to distortions in the real capital and equities

markets. Investors begin to look at the derivatives markets to make a decision to buy or sell

securities and so what was originally meant to be a market to transfer risk now becomes a

leading indicator. Derivatives massively leverage the debt in an economy, making it ever more

difficult for the underlying real economy to service its debt obligations, thereby curtailing real

economic activity, which can cause a recession or even depression.
http://en.wikipedia.org/wiki/Warren_Buffetthttp://en.wikipedia.org/wiki/Berkshire_Hathawayhttp://en.wikipedia.org/wiki/Berkshire_Hathawayhttp://en.wikipedia.org/wiki/Warren_Buffett


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Chronology of development of Financial Derivatives markets in India.

1991 Liberalisation process initiated.

14 December 1995 NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L.C.Gupta committee to draft a policy

framework for index futures.

11May 1998 L.C. Gupta committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreements

(FRAs) and interest rate swaps.

24 May 2000 SIMEX choose Nifty for trading futures and options on an

Indian index.

25 May 2000 SEBI gave permission to NSE and BSE to do index futures

trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of nifty futures commenced at NSE.

25 September 2000 Nifty futures trading commenced at SGX.

2 June 2001 Individual stock options and derivatives.


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NEED FOR DERIVATIVES IN INDIA TODAY

In less than three decades of their coming into vogue, derivatives markets have become the most

important markets in the world. Today, derivatives have become part and parcel of the dayto

day life for ordinary people in major part of the world.

Until the advent of NSE, the Indian capital market had no access to the latest trading methods

and was using traditional out- dated methods of trading. There was a huge gap between the

investors aspirations of the markets and the available means of the trading. The opening of

Indian economy has precipitated the process of integration of Indias financial markets with the

international financial markets. Introduction of risk management instruments in India has gained

momentum in the last few years thanks to Reserve Bank of Indias efforts inallowing forward

contracts, cross currency options etc. which have developed into a very large market.

Derivatives increase speculation and do not serve any economic purpose. Derivatives are a low-

cost, effective method for users to hedge and manage their exposures to interest rates,

commodity prices or exchange rates. As the complexity of instruments increased many folds,

accompanying risk factors grew in gigantic proportions. This situation led to development

derivatives as effective risk management tools for the market participants.


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TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

National Stock Exchange Bombay Stock Exchange National commodity

and Derivative exchange.

Index future Index option stock option stock future


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Exchange-traded derivative

Are those derivatives instruments that are traded via specializedderivatives exchanges or other

exchanges. A derivatives exchange is a market where individuals trade standardized contracts

that have been defined by the exchange. A derivatives exchange acts as an intermediary to all

related transactions, and takes initial margin from both sides of the trade to act as a guarantee.

The world's largestderivatives exchanges (by number of transactions) are theKorea Exchange

(which listsKOSPI Index Futures & Options), and CME group (made up of the 2007 merger of

theChicago Mercantile Exchange and theChicago Board of Trade and the 2008 acquisition of

theNew York Mercantile Exchange). According to BIS, the combined turnover in the world's

derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of derivative

instruments also may trade on traditional exchanges. For instance, hybrid instruments such as

convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also,

warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash and various

other instruments that essentially consist of a complex set of options bundled into a simple

package are routinely listed on equity exchanges. Like other derivatives, these publicly traded

derivatives provide investors access to risk/reward and volatility characteristics that, while

related to an underlying commodity, nonetheless are distinctive.
http://en.wikipedia.org/wiki/Derivatives_exchangehttp://en.wikipedia.org/wiki/Korea_Exchangehttp://en.wikipedia.org/wiki/KOSPIhttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Board_of_Tradehttp://en.wikipedia.org/wiki/New_York_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Warrant_%28finance%29http://en.wikipedia.org/wiki/Warrant_%28finance%29http://en.wikipedia.org/wiki/New_York_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Board_of_Tradehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/KOSPIhttp://en.wikipedia.org/wiki/Korea_Exchangehttp://en.wikipedia.org/wiki/Derivatives_exchange


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Over The Counter Derivatives

Are contracts that are traded (and privately negotiated) directly between two parties without

going through an exchange or other intermediary. Products such asswaps,forward rate

agreements,exotic options - and otherexotic derivatives - are almost always traded in this way.

The OTC derivative market is the largest market for derivatives, and is largely unregulated with

respect to disclosure of information between the parties, since the OTC market is made up of

banks and other highly sophisticated parties, such ashedge funds.Reporting of OTC amounts are

difficult because trades can occur in private, without activity being visible on any exchange.

According to theBank for International Settlements,the total outstanding notional amount is

US$708 trillion (as of June 2011).Of this total notional amount, 67% areinterest rate contracts,

8% arecredit default swaps (CDS),9% are foreign exchange contracts, 2% are commodity

contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded

on an exchange, there is no central counter-party. Therefore, they are subject tocounter-party

risk, like an ordinarycontract,since each Counter- Party relies on the other to perform. The

problem is more acute as heavy reliance on OTC derivatives creates the possibility of systematic

financial events, which fall outside the more formal clearing house structures.
http://en.wikipedia.org/wiki/Swap_%28finance%29http://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Exotic_optionhttp://en.wikipedia.org/wiki/Exotic_derivativeshttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Interest_rate_derivativehttp://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Credit_risk#Counterparty_riskhttp://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Credit_risk#Counterparty_riskhttp://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Interest_rate_derivativehttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Exotic_derivativeshttp://en.wikipedia.org/wiki/Exotic_optionhttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Swap_%28finance%29


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CONTRACT TYPES OF DERIVATIVES

Some of the common variants of derivative contracts are as follows:

1. Forwards:A tailored contract between two parties, where payment takes place at a specific

time in the future at today's pre-determined price.

2. Futures:Are contracts to buy or sell an asset on or before a future date at a price specified

today. A futures contract differs from a forward contract in that the futures contract is a

standardized contract written by a clearing house that operates an exchange where the

contract can be bought and sold; the forward contract is a non-standardized contract written

by the parties themselves.

3. Options: Are contracts that give the owner the right, but not the obligation, to buy (in the

case of acall option)or sell (in the case of aput option)an asset. The price at which the sale

takes place is known as thestrike price,and is specified at the time the parties enter into the

option. The option contract also specifies a maturity date. In the case of a European option,

the owner has the right to require the sale to take place on (but not before) the maturity date;

in the case of anAmerican option,the owner can require the sale to take place at any time up

to the maturity date. If the owner of the contract exercises this right, the counter-party has the

obligation to carry out the transaction. Options are of two types:call option andput option.
http://en.wikipedia.org/wiki/Forward_contracthttp://en.wikipedia.org/wiki/Futureshttp://en.wikipedia.org/wiki/Contractshttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Clearing_house_%28finance%29http://en.wikipedia.org/wiki/Option_%28finance%29http://en.wikipedia.org/wiki/Call_optionhttp://en.wikipedia.org/wiki/Put_optionhttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/European_optionhttp://en.wikipedia.org/wiki/American_optionhttp://en.wikipedia.org/wiki/Call_optionhttp://en.wikipedia.org/wiki/Put_optionhttp://en.wikipedia.org/wiki/Put_optionhttp://en.wikipedia.org/wiki/Call_optionhttp://en.wikipedia.org/wiki/American_optionhttp://en.wikipedia.org/wiki/European_optionhttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/Put_optionhttp://en.wikipedia.org/wiki/Call_optionhttp://en.wikipedia.org/wiki/Option_%28finance%29http://en.wikipedia.org/wiki/Clearing_house_%28finance%29http://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Contractshttp://en.wikipedia.org/wiki/Futureshttp://en.wikipedia.org/wiki/Forward_contract


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The buyer of a Call option has a right to buy a certain quantity of the underlying asset, at a

specified price on or before a given date in the future, he however has no obligation whatsoever

to carry out this right. Similarly, the buyer of a Put option has the right to sell a certain quantity

of an underlying asset, at a specified price on or before a given date in the future, he however has

no obligation whatsoever to carry out this right.

4. Binary options :Are contracts that provide the owner with an all-or-nothing profit profile.

5. Warrants: Apart from the commonly used short-dated options which have a maximum

maturity period of 1 year, there exists certain long-dated options as well, known asWarrant

(finance).These are generally traded over-the-counter.

6. Swaps : Are contracts to exchange cash (flows) on or before a specified future date based on

the underlying value of currencies exchange rates, bonds/interest rates, commodities

exchange, stocks or other assets. Another term which is commonly associated to Swap is

Swaption which is basically an option on the forward Swap. Similar to a Call and Put option,

a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on one hand, in

case of a receiver Swaption there is an option wherein you can receive fixed and pay floating,

a payer swaption on the other hand is an option to pay fixed and receive floating.
http://en.wikipedia.org/wiki/Binary_optionhttp://en.wikipedia.org/wiki/Warrant_%28finance%29http://en.wikipedia.org/wiki/Warrant_%28finance%29http://en.wikipedia.org/wiki/Warrant_%28finance%29http://en.wikipedia.org/wiki/Swap_%28finance%29http://en.wikipedia.org/wiki/Commodities_exchangehttp://en.wikipedia.org/wiki/Commodities_exchangehttp://en.wikipedia.org/wiki/Swaptionhttp://en.wikipedia.org/wiki/Swaptionhttp://en.wikipedia.org/wiki/Commodities_exchangehttp://en.wikipedia.org/wiki/Commodities_exchangehttp://en.wikipedia.org/wiki/Swap_%28finance%29http://en.wikipedia.org/wiki/Warrant_%28finance%29http://en.wikipedia.org/wiki/Warrant_%28finance%29http://en.wikipedia.org/wiki/Warrant_%28finance%29http://en.wikipedia.org/wiki/Binary_option


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Economic function of the derivative market

Some of the salient economic functions of the derivative market include:

1. Prices in a structuredderivative market not only replicate the discernment of the market

participants about the future but also lead the prices ofunderlying to the professed future

level. The derivatives market relocates risk from the people who preferrisk aversion to

the people who have an appetite for risk.

2. The intrinsic nature of derivatives market associates them to the underlying Spot market.

Due to derivatives there is a considerable increase in trade volumes of the underlying

Spot market.The dominant factor behind such an escalation is increased participation by

additional players who would not have otherwise participated due to absence of any

procedure to transfer risk.

3. As supervision, reconnaissance of the activities of various participants becomes

tremendously difficult in assorted markets; the establishment of an organized form of

market becomes all the more imperative. Therefore, in the presence of an organized

derivatives market, speculation can be controlled, resulting in a more meticulous

environment.

4. A significant accompanying benefit which is a consequence of derivatives trading is that

it acts as a facilitator for newEntrepreneurs.
http://en.wikipedia.org/wiki/Derivative_markethttp://en.wikipedia.org/wiki/Underlyinghttp://en.wikipedia.org/wiki/Risk_aversionhttp://en.wikipedia.org/wiki/Spot_markethttp://en.wikipedia.org/wiki/Speculationhttp://en.wikipedia.org/wiki/Entrepreneurshttp://en.wikipedia.org/wiki/Entrepreneurshttp://en.wikipedia.org/wiki/Speculationhttp://en.wikipedia.org/wiki/Spot_markethttp://en.wikipedia.org/wiki/Risk_aversionhttp://en.wikipedia.org/wiki/Underlyinghttp://en.wikipedia.org/wiki/Derivative_market


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BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

1) RISK MANAGEMENT- Futures and options contract can be used for altering the risk of

investing in spot market. For instance, consider an investor who owns an asset. He will

always be worried that the price may fall before he can sell the asset. He can protect

himself by selling a futures contract, or by buying a put option. If the spot price falls, the

short hedgers will gain in the futures market. This will help offset their losses in the spot

market. Similarly, if the spot price falls below the exercise price, the put option can

always be excercised.

2) PRICE DISCOVERY- Price discovery refers to the market ability to determine true

equilibrium prices. Futures prices are believed to contain information about future spot

prices and help in disseminating such information. As we have seen, futures markets

provide a low cost trading mechanism. Thus information pertaining to supplu and

demand easily percolates into such markets. Accurate prices are essenatial for ensuring

the correct allocation of resources in a free market economy.

3) OPERATIONAL ADVANTAGES- As opposed to spot markets, derivatives markets

involve lower transactions costs. Secondly, they offer greater liquidity. Large spot

transactions can often lead to significant price changes. However, futures markets tend to

be more liquid than spot markets, because here in you can take large positions by

depositing relatively small margins.


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Consequently, a large position in derivatives markets is relatively easier to take and has

less of a price impact as opposed to a transaction of the same magnitude in the spot

market. Finally, it is easier to take a short position in derivatives markets than it is to sell

short in spot markets.

4) MARKET EFFICIENCY- The availability of derivatives makes markets more efficient

spot, futures and options markets are inextricably linked. Since it is easier and cheaper to

trade in derivatives, it is possible to exploit arbitrage opportunities quickly and to keep

prices in alignment. Hence these markets help to ensure that prices reflect true values.

5) EASE OF SPECULATION- Derivative markets provide speculators with a cheaper

alternative to engaging in spot transactions. Also, the amount of capital required to take a

comparable position is less in this cased. This is important because facilitation of

speculation is critical for ensuring free and fair markets. Speculators always take

calculated risks. A speculator will accept a level of risk only if he is convinced that the

associated expected return is commensurate with the risk that he is taking. Speculative

trading in derivatives gained a great deal of notoriety in 1995 whenNick Lesson,a trader

atBarings Bank,made poor and unauthorized investments in futures contracts. Through a

combination of poor judgment, lack of oversight by the bank's management and

regulators, and unfortunate events like the Kobe earthquake,Lesson incurred a US$1.3

billion loss that bankrupted the centuries-old institution.
http://en.wikipedia.org/wiki/Nick_Leesonhttp://en.wikipedia.org/wiki/Barings_Bankhttp://en.wikipedia.org/wiki/Kobe_earthquakehttp://en.wikipedia.org/wiki/Kobe_earthquakehttp://en.wikipedia.org/wiki/Barings_Bankhttp://en.wikipedia.org/wiki/Nick_Leeson


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National Commodity and Derivatives Exchange

National Commodity & Derivatives Exchange Limited (NCDEX) is an online multicommodity

exchange based in India. It was incorporated as a private limited company incorporated on 23

April 2003 under the Companies Act, 1956. It obtained its Certificate for Commencement of

Business on 9 May 2003. It has commenced its operations on 15 December 2003. NCDEX is a

closely held private company which is promoted by national level institutions and has an

independent Board of Directors and professionals not having vested interest in commodity

markets.

NCDEX is a public limited company incorporated on 23 April 2003 under the Companies Act,

1956. NCDEX is regulated byForward Market Commission (FMC) in respect of futures trading

in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies

Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other

legislations, which impinge on its working. On 3 February 2006, the FMC found NCDEX guilty

of violating settlement price norms and ordered the exchange to fire one of their executive.

NCDEX is located inMumbai and offers facilities in more than 550 centers in India. NCDEX

also offers as an information product, an agricultural commodity index. This is a value weighted

index, called DHAANYA and is computed in real time using the prices of the 10 most liquid

commodity futures traded on the NCDEX platform.
http://en.wikipedia.org/wiki/Commodity_exchangehttp://en.wikipedia.org/wiki/Commodity_exchangehttp://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/w/index.php?title=Forward_Market_Commission&action=edit&redlink=1http://en.wikipedia.org/wiki/Mumbaihttp://en.wikipedia.org/wiki/Mumbaihttp://en.wikipedia.org/w/index.php?title=Forward_Market_Commission&action=edit&redlink=1http://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/wiki/Commodity_exchangehttp://en.wikipedia.org/wiki/Commodity_exchange


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WHAT THE BANKING SYSTEM HAS LEARNED ABOUT

DERIVATIVES: NOTHING AT ALL.

Much of the crisis in the banking sector in 2008 was due to over-reaching in the trade of

derivatives. The invention of derivatives allowed banks to transcend their actual assets, and then

soar above them in layer after layer of speculation and counter-speculation. As we know, this

feat of financial levitation ended badly for all concerned, so you might think that the banks had

learned the lesson and scaled back their derivatives trading. Apparently not. This chart shows the

growth in the value of derivatives as a percentage of assets, for the three largest banks in the US.

Figure 1


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Both Citi and Bank of America have more liabilities than they did before the crash. And as the

Bank watch blog points out,those figures of 4,000% pale into insignificance when compared to

Goldman Sachs 33,823%. Our banks failed because finance had disappeared into a fantasy land,

a land they have refused to return from. Not only has government policy focused on a return to

business as usual, the financial sector is now more concentrated. With fewer, bigger players, any

crisis is a big crisis. The four largest banks in the US own 40% of the assets between them,

which is a vulnerable position to be in.

Derivatives are sophisticated financial products that are traded between banks. One of these that

has been in the news recently is the credit default swap, or CDS. Loans and mortgages are

bundled as a kind of package of future money, and sold on, as we now know. Company bonds

and national debt are other forms of banking assets, and anyone wanting a share of that income

as it rolls in can buy up that debt, with the associated risk that it carries. That makes sense. A

CDS however, allows you to invest the other way round. Rather than buy a share of the loans,

you pay the bank a fee, and the bank pays you if those loans default.

It sounds complicated, and it is, but it is essentially a form of insurance, a way of recouping costs

and minimizing risk. The difference is that we buy insurance to protect our own investments, but

an CDS can be taken out against other peoples. And thats where the potential for abuse quickly

becomes apparent. Imagine being able to take out insurance on your neighbours.
http://thebankwatch.com/2010/03/11/goldman-sachs-derivative-liability-33823-of-assets/http://thebankwatch.com/2010/03/11/goldman-sachs-derivative-liability-33823-of-assets/


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For example:

Wouldnt it be tempting to buy car insurance on the young and reckless driver at the end of the

road, since its only a matter of time before he has an accident. Or you could take out contents

insurance for the house that backs onto the alley, in the secret hope that it gets robbed. Although

they were originally devised to spread risk, CDSs are great for speculation of a rather insidious

kind.

For example, Goldman Sachs famously survived the financial crisis better than other banks,

partly because it had bought credit swaps against its rivals. In other words, says the Levy

Economics Institute,Goldman could hold risky securities, purchase insurance from AIG on

those securities, then make a bet that AIG would fail to honour that insuranceand thereby

seemingly protect itself from any risk.
http://www.levy.org/pubs/wp_587.pdfhttp://www.levy.org/pubs/wp_587.pdfhttp://www.levy.org/pubs/wp_587.pdfhttp://www.levy.org/pubs/wp_587.pdfhttp://www.levy.org/pubs/wp_587.pdf


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DERIVATIVES: BAILED-OUT BANKS STILL MAKING BILLIONS OFF

RISKY BETS

Derivatives drove the boom before 2008 by encouraging banks to make loans without adequate

reserves. They also worsened the panic last fall because they inherently tie institutions together.

Investors worried that the collapse of one bank would lead to big losses at others.


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Derivatives is one of the dirty words of the financial crisis. Though these often-risky bets were

blamed by many for helping fuel the credit crunch and the downfall of Lehman Brothers and

AIG, it seems that Wall Street has yet to learn its lesson.

U.S. commercial banks earned $5.2 billion trading derivatives in the second quarter of 2009, a

225 percent increase from the same period last year, according to the Treasury Department.

More than 1,100 banks now trade in derivatives, a 14 percent increase from last year. Four banks

control the market: JPMorgan Chase, Goldman Sachs, Bank of America and Citibank account

for 94 percent of the total derivatives reported to be held by U.S. commercial banks, according to

national bank regulator the Office of the Comptroller of the Currency.

The credit risk posed by derivatives in the banking system now stands at $555 billion, a 37

percent increase from 2008. "By any standard these [credit] exposures remain very high,"

Kathryn E. Dick, the OCC's deputy comptroller for credit and market risk, said in astatement.

The complex financial instruments, which take the form of futures, forwards, options and swaps,

derive their value from an underlying investment or commodity such as currency rates, oil

futures and interest rates. They are designed to reduce the risk of loss for one party from the

underlying asset.

Trading in an unregulated $600 trillion market, they were partly blamed for igniting the financial

crisis a year ago.The New York Times reported earlier this month.
http://topics.nytimes.com/top/reference/timestopics/subjects/d/derivatives/index.html?scp=1-spot&sq=derivatives&st=csehttp://occ.treas.gov/ftp/release/2009-114.htmhttp://www.nytimes.com/2009/09/12/business/12change.html?pagewanted=allhttp://www.nytimes.com/2009/09/12/business/12change.html?pagewanted=allhttp://occ.treas.gov/ftp/release/2009-114.htmhttp://topics.nytimes.com/top/reference/timestopics/subjects/d/derivatives/index.html?scp=1-spot&sq=derivatives&st=cse


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Derivatives | Cautious approach to innovation

One of the key reasons why the Indian financial system was not affected by the 2008 global

meltdown was the banking regulators conservatism. The central bank ring-fenced the Indian

banking system by imposing stringent criteria on various instruments, including trades in

permitted derivative products, and deferring the introduction of others, one

of which was blamed for sinking large global financial institutions.

The Reserve Bank of India (RBI) had proposed the introduction of credit

default swaps (CDS) a number of times since 2003, but drew up final

guidelines for them only this year.

Developments in the currency and interest rate derivatives markets show

RBI has only recently opened up the space. In 2010, it introduced currency

options though currency futures were launched just before the credit crisis in

2008. Both have garnered reasonable volume, but are nowhere close to their

volumes overseas.

Derivatives allow companies to hedge their currency risks and play a key

role in asset-liability management. It is a must-have for firms with most of

their inflows in dollars and costs in rupees.


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We live in a world where there is mismatch and we need certainty that the mismatch can be

bridged. Thats why we need various kinds ofderivatives, said Rostow Ravanan, chief financial

officer of software firm MindTree Ltd. Availability and access to a robust derivatives market is

what brings stability in the operation of a corporate.

As Indian firms gets connected to the world for their operations, the need for derivatives is on the

rise, say bankers. Derivatives are here to stay, said Ananth Narayan G., head of fixed income,

currencies and commodities at Standard Chartered Bank. Risk remains extremely high to stay

un-hedged. Clients risk-management needs will always be there, so will derivatives.

One critical derivative product introduced after the downturn is the cross-currency option,

launched on the exchanges in October 2010. RBI allowed options on four currency pairs: rupee-

dollar, rupee-yen, rupee-pound sterling and rupee-euro. Volume in this segment has crossed

$500 million on the National Stock Exchange, but is far below volumes in the currency forwards

market.

Volume in futures and options combined crossed Rs1 trillion in July, in a sign the currency

derivatives market is picking up pace. Average volume in exchange-traded currency derivatives

is Rs60000-80,000crore. Banks and retail investors dabble in the segment as speculators. Small

and medium enterprises enter the market for their simple needs, but big firms largely stay away

as their needs are complex and they need custom contracts that exchanges cannot provide.


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RBI governor D. Subbarao has indicated he believes in the dictum Festina lente -make haste

slowlywhen it comes to reforms. This, say bond market dealers, indicates RBI will be cautious

and ensure regulations are well entrenched before introducing more derivative products.

The central bank has been cautious regarding the introduction of new products. It issued four

draft discussion papers and guidelines before coming up with final guidelines on CDS in India.

There are two kinds of derivativestraded bilaterally over the counter (OTC) and exchange-

traded. Until a few years ago, most of the derivatives in India were of the OTC kind. Even

now, the size of the OTC currency market is larger than that of its exchange-traded counterpart.

The currency derivatives segment includes foreign currency forwards, currency swaps and

currency options. The interest rate derivatives segment includes interest rate swaps, forward-rate

agreements and interest rate futures (IRF). Then, there are products linked to the overnight

money markets, such as collateralized borrowing, lending obligations and overnight index swaps.

Overnight money market-linked products are overwhelmingly successful, but products that

involve a loan. In most developed nations, fixed-income markets compete with equity markets to

attract investors. In contrast, in India, the daily equity market volume is at least double that of the

debt market, including government and corporate bonds.


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A few large investors, mostly banks, control the bond market. Other investors include insurance

companies, a few mutual funds, and pension and provident funds. They are also the medium

through which RBI intervenes in the bond and currency markets.

Several committees have been formed to deliberate on measures to deepen the bond market and

introduce new products. The most influential was headed by R.H. Patil, chairman of National

Securities Depository Ltd and Clearing Corp. of India Ltd. The key recommendations of the

committee, submitted in 2005, are yet to be implemented despite the finance ministrys

acceptance of them.

The cautious attitude of the regulatorthat derivatives are used for hedging and not

speculationis helping to safeguard the financial system, but may be impeding the markets

growth. As the derivatives market will be dominated by hedging needs rather than speculation

purposes, currency derivatives will continue to outshine interest rate derivatives, say experts.

Many banks have significantly downsized or completely wound down their derivatives teams,

especially after RBI clamped down on exotic deals.

In a way, this indicates that the future of derivatives may be constrained by RBI if it continues

with its tough supervisory stance. There will not be many entities to make two-way quotes

available or extend liquidity in the market.


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In global markets, interest rate derivatives are the most popular

products, followed by currency derivatives. The volume in equity

derivatives is small in comparison. But in India, equity derivatives

have notched up large volumes compared with currency and interest

rate derivatives. In fact, currency derivatives are picking up well,

but interest rate derivatives, particularly interest rate futures, have

not been accepted. Experts say India has all the derivatives products

that make a market vibrant. New products, they say, may not be

needed to all

You dont need any fancy derivatives to make the market more

vibrant. You just need to have more participation of India forex and

simplification of rules, said Abhishek Goenka, chief executive officer of India Forex Advisors

Pvt. Ltd.

The main problem with the available derivatives is they are not traded in their current form and

RBI may have to eventually tweak them to make them more market-friendly. RBI may have to

introduce some amount of speculation and change the structure of the products.


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A large number of reports by government and trade organizations have been devoted to

studying derivatives. Such as:

Bank for International Settlements (1992),

Bank of England (1987, 1993),

Basle Committee on Banking Supervision (1993a, b, c, d),

Board of Governors of the Federal Reserve System et al. (1993),

Commodity Futures Trading Commission (1993),

Group of Thirty (1993a, b, 1994),

House Banking Committee Minority Staff (1993),

House Committee on Banking, Finance, and Urban Affairs (1993),

U.S. Comptroller of the Currency (1993A, B),

U.S. Government Accounting Office (1994).

Derivative securities are contracts that derive their value from the level of an underlying interest

rate, foreign exchange rate, or price. Derivatives include swaps, options, forwards, and futures.

At the end of 1992 the notional amount of outstanding interest-rate swaps was $6.0 trillion,and

the outstanding notional amount of currency swaps was $1.1 trillion (Swaps Monitor (1993)).

U.S. commercial banks alone held $2.1 trillion of interest rate swaps and $279 billion of foreign-

exchange swaps (Call Reports of Income and Condition). Moreover, derivatives are concentrated

in a relatively small number of financial intermediaries. For example, almost two-thirds of swaps

are held by only 20 financial intermediaries. Of the amount held by U.S. commercial banks,

seven large dealer banks account for over 75%.


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An interest-rate swap is a contract under which two parties exchange the net interest payments

on an amount known as the "notional principal." In the simplest interest-rate swap, at a series of

six-month intervals, one party pays the current interest rate (such as the six-month LIBOR) on

the notional principal while its counterparty pays a preset, or fixed, interest rate on the same

principal. The notional principal is never exchanged. By convention, interest rates in a swap are

set so that the swap has a zero market value at initiation. If there are unanticipated changes in

interest rates, the market value of a swap will change, becoming an asset for one party and a

liability for the counterparty

The key factor in determining the risk of a swap portfolio is the interest-rate sensitivity of the

portfolio. Swap value can be very volatile. If interest rates change slightly, the value of a swap

can change dramatically. Thus, monitoring the risks from swaps is difficult. Partially in response

to this, proposals for reforming swap reporting require institutions to reveal the interest-rate

sensitivity of their swap positions (as well as sensitivities to other factors such as foreign

exchange rates). Until institutions are required to report the interest-rate sensitivity of their swap

portfolios, swaps are an easy way to quickly and inexpensively alter the risk of a portfolio.

Starting in 1994, banks are required to report for interest rate, foreign exchange, equity, and

commodity derivatives the value of contracts that are liabilities as well as the value of contracts

that are assets.


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AN INTEREST-RATE SWAP

An interest-rate swap is a contract under which two parties agree to pay each other's interest

obligations. The cash flows in a swap are based on a "notional" principal which is used to

calculate the cash flow (but is not exchanged). The two parties are known as "counterparties."

Usually, one of the counterparties is a financial intermediary. At a series of stipulated dates, one

party (the fixed-rate payer) owes a "coupon" payment determined by the fixed interest rate set at

contract origination, in return, is owed a "coupon" payment based on the relevant floating rate.

For most swap contracts, LIBOR is used as the floating rate while the fixed rate is set to make

the swap have an initial value of zero. The fixed rate can be thought of as a spread over the

appropriate-maturity Treasury bond, where the spread can reflect credit risk.

A swap is a zero-sum transaction. While the initial value of a swap is zero, over the life of the

swap interest rates may change, causing the swap to become an asset to one party (the fixed-rate

payer if rates rise) or a liability (for the fixed-rate payer if rates fall); clearly, one party's gain is

the other's loss. For example, if the floating rate rises from rate to rate, then the difference check

received by the fixed-rate payer rises from (rt - rN)L to (r; - rN)L.


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Figure 2- SWAP EXAMPLES

Bank in Long Position: Pays Fixed and Receives Floating

Bank in Short Position: Pays Floating and Receives Fixed

COUNTERPARTY X BANK

7.15%

6- MONTH LIBOR

BANK COUNTER PARTY

Y

6- MONTH

LOBOR

7.25%

Figure 3


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Bank in Hedged Position

Figure 1 provides examples of a swap. We define a swap participant as "long" if the participant

pays a fixed rate and receives a floating rate. The top panel shows a bank with a long position.

The bank pays 7.15% to its counterparty and receives the six-month LIBOR rate. So, if the

notional principal is $1 million and payments are made every six months, then when LIBOR is

6.5%, the bank pays a net of $3250 to its counterparty [$1 million x (7.15% - 6.5%)/2]. When

LIBOR is 7.5%, on the other hand, the bank receives $1750. Thus, the bank gains when interest

rates rise.

COUNTER

PARTY X

BANK COUNTER PARTY

Y

6-MON

LIBOR

6-MON

LIBOR

7.15%

7.25%

Figure 4


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The middle panel shows the bank in a short position. Notice that we have implicitly assumed that

the bank is a dealer, since the fixed rate it pays is 10 basis points less than the fixed rate it

receives. This difference is the dealer fee. When a bank has a short position, it loses if interest

rates rise.

The last panel of Figure 1 shows the bank making both "legs" of a swap. The bank's position is

hedged, since no matter how interest rates

RISKS IN SWAPS

The major risks from swaps include those that are common to all fixed income securities.

Interest-rate risk exists because changes in interest rates affect the value of a swap. Also, credit

risk exists because a counter party may default. If a swap is a liability, then default by a counter

party is not costly. Also, notional principal is not exchanged in a swap, so the magnitude of

credit risk is reduced.

If the swap is an asset, however, then default means that the counterparty should be making

payments, but does not. The loss to the holder is equivalent to the value of the swap at that point.

The replacement cost of a swap is the loss that would be incurred if the counterparty defaulted.

Note that replacement cost is always nonnegative, since default by an asset holder implies a zero

loss to its counterparty.


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SWAP POSITIONS OF BANKS

If the swap is an asset, however, then default means that the counterparty should be making

payments, but does not. The loss to the holder is equivalent to the value of the swap at that point.

The replacement cost of a swap is the loss that would be incurred if the counterparty defaulted.

Note that replacement cost is always nonnegative, since default by an asset holder implies a zero

loss to its counterparty.

Table 1 presents a list of the top swap firms according to the notional value of interest-rate swap

positions. Most of these firms are commercial banks. Five of the top ten firms by notional value

are U.S. commercial banks, three are French state-owned banks, one is a British bank, and one is

a U.S. securities firm. Moreover, eighteen of the top twenty firms with the largest swap positions

are banks. These firms also tend to have large positions in other derivatives markets.

Within the U.S. banking system, swaps are concentrated in a few large banks


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Table 1 WORLD'SM AJORI NTEREST-RATE-SWAFIPR MS

(YEAR END 1992)

RANK FIRM OUTSTANDINGS

1 Chemical Bank $389.7

2 J.P. Morgan 367.7

3 Society General 345.9

4 Company Financier de Paribus 342.7

5 Credit Lyonnais 272.8

6 Merrill Lynch 265.0

7 Bankers Trust 255.7

8 Barclays Bank 247.4

9 Chase Manhattan 222.2

10 Citicorp 217.0

11 Bank of America 191.1

12 Credit Agricore 181.7

13 Banque Indosuez 174.1

14 Banque National de Paris 160.1

15 Westpac 147.8

16 Salomon Brothers 144.0

17 Cuisse des Depots 111.8

18 First Chicago 74.8

19 Bank of Nova Scotia 73.8

20 Banque Bruxelles Lambert 56.6


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Forms of credit default swaps had been in existence from at least the early 1990s,[48]with early

trades carried out byBankers Trust in 1991.

[49]

J.P. Morgan & Co. is widely credited with

creating the modern credit default swap in 1994. In 1997, JPMorgan developed a proprietary

product called BISTRO (Broad Index Securitized Trust Offering) that used CDS to clean up a

banks balance sheet.[50][52]The advantage of BISTRO was that it used securitization to split up

the credit risk into little pieces that smaller investors found more digestible, since most investors

lacked EBRD's capability to accept $4.8 billion in credit risk all at once. BISTRO was the first

example of what later became known as syntheticcollateralized debt obligations (CDOs).

J.P. Morgan losses:

In April 2012, hedge fund insiders became aware that the market in credit default swaps was

possibly being affected by the activities of Bruno Michel Isle, a trader for J.P. Morgan Chase &

Co., referred to as "the London whale" in reference to the huge positions he was taking. Heavy

opposing bets to his positions are known to have been made by traders, including another branch

of J.P. Morgan, who purchased the derivatives offered by J.P. Morgan in such high volume.

Major losses, $2 billion, were reported by the firm in May, 2012 in relationship to these trades.

The disclosure, which resulted in headlines in the media, did not disclose the exact nature of the

trading involved, which remains in progress. The item traded, possibly related to CDX IG 9, an

index based on the default risk of major U.S. corporations, has been described as a "derivative of

a derivative".
http://en.wikipedia.org/wiki/Credit_default_swap#cite_note-smithson-47http://en.wikipedia.org/wiki/Credit_default_swap#cite_note-smithson-47http://en.wikipedia.org/wiki/Credit_default_swap#cite_note-smithson-47http://en.wikipedia.org/wiki/Bankers_Trusthttp://en.wikipedia.org/wiki/Credit_default_swap#cite_note-FoolsGold-48http://en.wikipedia.org/wiki/Credit_default_swap#cite_note-FoolsGold-48http://en.wikipedia.org/wiki/J.P._Morgan_%26_Co.http://en.wikipedia.org/wiki/Credit_default_swap#cite_note-Philips-49http://en.wikipedia.org/wiki/Credit_default_swap#cite_note-Philips-49http://en.wikipedia.org/wiki/Credit_default_swap#cite_note-Philips-49http://en.wikipedia.org/wiki/Collateralized_debt_obligationshttp://en.wikipedia.org/wiki/Collateralized_debt_obligationshttp://en.wikipedia.org/wiki/Credit_default_swap#cite_note-Philips-49http://en.wikipedia.org/wiki/Credit_default_swap#cite_note-Philips-49http://en.wikipedia.org/wiki/J.P._Morgan_%26_Co.http://en.wikipedia.org/wiki/Credit_default_swap#cite_note-FoolsGold-48http://en.wikipedia.org/wiki/Bankers_Trusthttp://en.wikipedia.org/wiki/Credit_default_swap#cite_note-smithson-47


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Composition of the United States is 15.5 trillion US dollar CDS market at the end of 2008 Q2.

Green tints show Prime asset CDSs, reddish tints show sub-prime asset CDSs. Numbers followed

by "Y" indicate years until maturity.

Diagram 1


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Proportion of CDSs nominals (lower left) held by United States banks compared to all

derivatives, in 2008Q2. The black disc represents the 2008 public debt.

Diagram 2


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HOW DO BANK DERIVATIVES TRADING OPERATION WORK?

ORGANIZATION -Commercial banks and investment banks make up the foundation of the

OTC derivatives market. Their derivatives desk makes markets to customers, develops new

products, trade with one another in order to lay off risks and form the apparatus for much of the

industry's self-regulation. There are, of course, external regulators including the US Office of the

Comptroller of the Currency, the US Federal Reserve Board and the Canadian Office of the

Superintendent of Financial Institutions. However, the derivatives markets are so complex and

their evolution is so lightning-quick that regulators often have a difficult time keeping pace.

More often than not, large losses that might incur the curiosity of the regulator are attributable to

new cutting-edge products, the behavioral characteristics of which are different in actual practice

than they may have been thought to be beforehand.

These institutions engage in operations in up to five main asset classes:

Foreign Exchange

Interest Rates

Equities

Commodities

Credit


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ORGANIZATION BY ASSET CLASS

In this case, the bank sections its dealing room into five separate, vertically integrated groups

determined by asset class. Let's consider the case of the foreign exchange group, for ease of

argument.

In the vertically integrated foreign exchange group, the cash trader (i.e. the spot trader) will sit

next to the derivatives traders. This improves the flow of information among dealers specializing

in the same underlying market. It putatively reduces transaction costs for the derivatives dealers

since the forward and options traders are all part of one consolidated revenue pool. The spot

trader has an incentive to treat the options trader well, in order to get as much information about

the indirect implications of options market flows for the spot market.

Most importantly (and this is the key point), the spot trader knows that if the options trader does

well on the year, the available bonus pool for everyone is only going to be bigger.

Organizing along asset class lines also means that marketing is integrated for cash and

derivatives products as far as the customer is concerned. Marketing teams are directed to sell all

of the products in the asset class. They sell options to their clients and then they sell spot and

forwards to these clients in the dynamic management of these exposures.


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There are two problems with this approach to organization:

Difficulties arise when customers expect horizontally integrated products. For example, the

manager of a domestic money market fund might want to take advantage of his view on the

Canadian dollar exchange rate against the US dollar. Technically, he cannot take explicit foreign

exchange positions. However, he can buy a structured note that guarantees his principal while

simultaneously allowing him to take advantage of his view if it is correct.

There are also management issues that come into play in dealing rooms organized by asset class.

Because of their highly technical and specialized nature, derivative products themselves might be

considered a separate type of asset. If the bank chooses its asset class line managers from the

ranks of the cash trader or generalist salesperson, it is unfair to the manager and it is an

impediment to business. It is unfair to expect any individual to expect someone to be responsible

for products outside of their comprehension.

As difficult as this tenet is to accept for many people, having non-derivatives specialists in

charge of derivatives operations of any sort is like asking a bus driver to fly commercial aircraft.

It is terrifying for the manager who will have to explain any loss or other problem to his

superiors (or to answer their general questions) without any remotely sophisticated

comprehension of what is going on. The derivatives desks organized by asset class typically take

much less risk, win fewer deals, manage their risk as effectively or make as much money as

derivatives desks led by well-trained, experienced leaders.


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ORGANIZING BY FUNCTION:

The other type of organization is by function. Cash traders and salespeople work together,

dealing with clients who want cash products exclusively. They are also separated by asset class.

Cash foreign exchange people will not enter into transactions in cash bonds. Derivatives traders

and salespeople handle the sophisticated accounts, across all five asset classes (while usually

specializing in one or two of these asset classes).

What are the advantages of doing things this way?

Clients get seamless service across products. Instead of talking to five different contacts at a

bank for their various needs, they talk to one person. Instead of having five different kinds of

confirmation contract, they have one. It is easy for the bank to structure products that encompass

more than one asset class. Think of a cross-currency swap (an exchange of cash flows

denominated in different currencies) with an embedded currency option to hedge against

fluctuations in the cross-currency swap exchange rate. At the bank organized by function, the

customer talks to one salesperson, gets one integrated price and receives one easy-to-read

confirmation after dealing.

Hedging can be problematic. Because the bank has organized its dealing room along functional

lines, the cash trader has no interest or desire to see the derivatives desk do well. He does not

have to provide a competitive or even a market price for the internal transactions with the

derivatives desk.


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Derivatives: The Unregulated Global Casino for Banks.

The banks shown below hold a total of $228.72 trillion in Derivatives - Approximately 3 times

the entire A derivative is a legal bet (contract) that derives its value from another asset, such as

the future or current value of oil, government bonds or anything else. Ex- A derivative buys you

the option (but not obligation) to buy oil in 6 months for today's price/any agreed price, hoping

that oil will cost more in future. (I'll bet you it'll cost more in 6 months). Derivative can also be

used as insurance, betting that a loan will or won't default before a given date. So its a big betting

system, like a Casino, but instead of betting on cards and roulette, you bet on future values and

performance of practically anything that holds value. The system is not regulated what-so-ever,

and you can buy a derivative on an existing derivative.

Most large banks try to prevent smaller investors from gaining access to the derivative market on

the basis of there being too much risk. Deriv. market has blown a galactic bubble, just like the

real estate bubble or stock market bubble (that's going on right now). Since there is literally no

economist in the world that knows exactly how the derivative money flows or how the system

works, while derivatives are traded in microseconds by computers, we really don't know what

will trigger the crash, or when it will happen, but considering the global financial crisis this

system is in for tough times, that will be catastrophic for the world financial system since the 9

largest world economy. No government in world has money for this bailout.


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WELLS RARGO

MORGAN SATNLEY


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STATE STREET

BANK OF NEWYORK MILLON


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DERIVATIVES RISK IN COMMERCIAL BANKING

Derivatives activity at commercial banks, as measured by total notional values of over $56 trillion as of

December 31, 2002, continues to grow dramatically. Derivatives serve an essential role in the U.S. and

world economies but also present certain risks to the deposit insurance funds.

Derivatives: What They Are and the Role That They Have in the Economy

Derivatives are financial instruments or contracts with values that are linked to, or derived from,

the performance of underlying financial instruments, interest rates, currency exchange rates, or

indexes. In a simplified sense, a derivative links its holder to the risks and rewards of owning an

underlying financial instrument without actually owning the financial instrument.

Derivatives are important to the financial markets and the world economy because they provide a

means for companies to separate and trade various kinds of risks. The ability of participants in

the financial markets to adjust specific risk exposures enhances the efficiency of capital flows by

allowing companies to conduct business activities without amassing certain risks that would

otherwise attend that business. For instance, mortgage lenders that are comfortable with the

credit risk of mortgage lending may be less comfortable with the amount of exposure to interest

rate movements that accompany a large mortgage portfolio. A mortgage company can use

derivatives to lessen their exposure to the effect that interest rate movements might have on the

value of their business and continue to make mortgage loans.


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NATIONAL AMOUNTS MEASURE DERIVATIVES ACTIVITY NOT

RISK

At $56 trilliona dollar figure that is more than five times GDPthe notional amount of

derivatives outstanding can seem daunting. However, the notional amount of a derivative

contract is merely the reference point to the underlying instrument. It serves as the basis for

calculating cash flows under the contract. For example, a very typical derivative contract would

be to pay the 10-year Treasury rate on $1 million in return for a floating rate on the same

amount. The notional amount of the contract is $1 million. This amount does not change hands;

but for each payment period, the 10-year Treasury rate is multiplied by $1 million to calculate

the fixed-rate payment.

While the notional amount is a proxy for the amount of derivatives activity, it does not measure

the riskiness of the activity. The notional amount itself is seldom at risk of loss with derivatives.

Instead the derivatives investor is at risk of loss from changes in prices of or rates earned on the

physical or financial assets that the notional amount represents.

When the derivatives market as a whole is in view, it is important to consider that offsetting

positions that add to gross notional amounts do not necessarily add significantly to total market

risk.


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A RISK BANKING OF DERIVATIVES ACTIVITIES

The risk associated with hedging, dealing, or speculating varies substantially. While poorly

managed operational risk could lead to losses in any derivatives activity, a generalized rank

ordering of derivatives risk can be constructed. Generalizations about the rank ordering of risk

are helpful in understanding the nature and source of the risk inherent in the $56 trillion of

notionals outstanding. Diagram 1 provides a grid for considering the rank ordering of risk in the

derivatives market.

Diagram 3


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HONG KONG AND SHANGHAI BANKING CORPORATION-

DERIVATIVES

Getting started:

As far as derivatives are concerned, you may fit into either of these categories:

Beginner- completely new to derivatives

Expert- seek advanced derivative strategies to make the most of market opportunities


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If you belong to any of these categories, which is where almost everyone will, we have

something for you.

If you are a beginner, derivatives may seem like Greek and Latin to you to begin with. You may

come across people telling you that derivatives are complex to understand. Actually derivatives

can act as tools to hedge risk.

If you are an active trader and believe in making the most of market movements, our reports on

derivatives can be useful to you. As an advanced trader seeking information on futures, options

and derivative strategies, our advisory team can help you make informed investment decisions.

Why invest through us?


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With HSBC Invest Direct, your investment in derivatives will be easy and hassle free. As our

customer, you can avail of the following services:

Advisory Services

You can avail of the services of our advisory team and get access to derivative reports. For more

detailed information on derivative reports that we offer, please refer our detailed section on

Advisory services.

Relationship Manager

As an HSBC Invest Direct customer, you will have a dedicated Relationship Manager to help

you with queries on your trading account.

Trading Exposure

You can avail of trading exposure on your cash as well as demat holdings with us to invest in

derivatives.

Tele Trade

You can also access our central tele- trade desk over toll free numbers to place you the suspect.
http://www.hsbcinvestdirect.co.in/advservices/overview.jsphttp://www.hsbcinvestdirect.co.in/advservices/overview.jsp


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STRATEGIES

Using this section, you can try out various derivative strategies and test how each one would

work. Depending on your view of the market and the strategy that you wish to test, we have

developed parameters that will give you a fair idea of how each one would work.

OPTIONS

Active put calls, options movement, top traded quantity.


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FUTURES

TOOLS


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Bank of America Dumps $75 Trillion in Derivatives on U.S. Taxpayers With

Federal Approval

Bank of America has shifted about $22 trillion worth of derivative obligations from Merrill

Lynch and the BAC holding company to the FDIC insured retail deposit division. Along with

this information came the revelation that the FDIC insured unit was already stuffed with $53

trillion worth of these potentially toxic obligations, making a total of $75 trillion.

Derivatives are highly volatile financial instruments that are occasionally used to hedge risk, but

mostly used for speculation. They are bets upon the value of stocks, bonds, mortgages, other

loans, currencies, commodities, volatility of financial indexes, and even weather changes. Many

big banks, including Bank of America, issue derivatives because, if they are not triggered, they

are highly profitable to the issuer, and result in big bonus payments to the executives who

administer them. If they are triggered, of course, the obligations fall upon the corporate entity,

not the executives involved. Ultimately, by allowing existing gambling bets to remain in insured

retail banks, and endorsing the shift of additional bets into the insured retail division, the

obligation falls upon the U.S. taxpayers and dollar-denominated savers. Bank of America's

derivatives counter-parties will, as usual, be made whole, while the American people suffer. This

all has the blessing of the Federal Reserve, which approved the transfer of derivatives from

Merrill Lynch to the insured retail unit of BAC before it was done.


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In 2008, politicians in Washington D.C., and Trojan horse operatives within the financial organs

of our government, bailed out imprudent managements of big casino-banks. Bank executives not

only didn't need to go bankrupt, as they should have, but collected huge bonuses. Later, in

response to the abuse, Congress passed the Dodd-Frank legislation and the Volcker rule. These

were supposed to insure that such bailouts were not needed in the future. Supposedly, this would

prevent further abuse of the American taxpayer.

The most recent abuse-event, involving BAC, illustrates the uselessness of such laws. Bank of

America NA is FDIC insured, and has the blessing of the Federal Reserve, in spite of such a

transaction being prohibited by Section 23A of the Federal Reserve Act.

Specifically, the section reads in relevant part:

"A member bank and its subsidiaries may engage in a covered transaction with an affiliate only

if--

1. in the case of any affiliate, the aggregate amount of covered transactions of the member bank

and its subsidiaries will not exceed 10 per centum of the capital stock and surplus of the member

bank; and

2. in the case of all affiliates, the aggregate amount of covered transactions of the member bank

and its subsidiaries will not exceed 20 per centum of the capital stock and surplus of the member

bank ..."


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The Federal Reserve is an institution largely controlled by those who are probably the counter-

parties to the Merrill Lynch derivatives. No doubt, its approval of the transaction, in spite of the

prohibitions of section 23A arise out of a claim that Merrill is not a "bank" as defined under the

Act, and, therefore, not an affiliate.

But, the Act also provides that:

For purposes of applying this section and section 23B, and notwithstanding subsection (b)(2) of

this section or section 23B(d)(1), a financial subsidiary of a bank--

1. Shall be deemed to be an affiliate of the bank; and

2. Shall not be deemed to be a subsidiary of the bank.

So, Merrill Lynch is clearly an affiliate of Bank of America, and the Federal Reserve is clearly

violating the law by approving this particular transaction. But, here is the kicker. Congress has

given ultimate power to the Federal Reserve to ignore its own enabling Act legislation.

The counter-parties of Bank of America, both inside America and elsewhere around the world,

will be safely bailed out by the full faith and credit of the USA.


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DEUTSCHE BANK OTC DERIVATIVES

Deutsche Banks mission statement is: We compete to be the leading global provider of

financial solutions, creating lasting value for our clients, our shareholders, our people and the

communities in which we operate. The banks business model rests on two pillars: the

Corporate & Investment Bank (CIB) and Private Clients & Asset Management (PCAM).

Deutsche Bank is a leading provider of interest rate and inflation risk management solutions to

banks, corporations, money managers and public bodies globally. The Bank's OTC Derivatives

group is a major market maker in developed and developing derivative markets.

It is a priority to stay at the forefront of product development, market trends and regulatory

change so we can react quickly and efficiently to the changing requirements of the market and it

Documents

Derivatives