Some of the oft-asked questions on the capital market these days are on derivatives. Strangers to the hitherto protected Indian market, these instruments have become popular options worldwide. The following is an extract from a recent text by Ajay Shah of the Indira Gandhi Institute of Development Research on the subject which answers some key queries.

Q: Why do we keep reading about disasters involving derivatives? How much money has been lost in these disasters?

Disasters involving derivatives make for good reporting. In a multi-trillion dollar worldwide industry, some disasters are inevitable. The cumulative losses from 1987 to 1995 add up to US $ 16.7 billion, a tiny fraction of the outstanding positions of the industry, which were around $50 trillion as of 1995. Also, derivatives account for a small fraction of the overall picture of financial disasters. Over this period there were other (less reported) larger disasters, though.

Q: Will the derivatives destabilise the stock market? Could this happen in extreme events?

International evidence says that market quality on the underlying market improves once derivatives come to exist. It improves liquidity on underlying cash market and a more liquid market is one that is able to absorb larger shocks for a smaller change in prices.

This would be the most useful in extreme events -- it is an extreme event that the liquidity of a market is taxed the most, and at such times a healthier cash market would be the most valued.

Q: What financial markets in India are ready for derivatives?

The equity and foreign exchange markets, though a forward market already exists in dollar-rupee exchange rate; it is just a matter of formal institutionalising it at an exchange and turning into a modern futures.

Q: How are derivatives different from badla?

Badla is closer to being a facility for borrowing and lending of shares and funds. Borrowing and lending of shares is a functionality which is part of the cash market. The borrowers of shares pays a fee for the borrowing. when badla works without a strong margining system, it generates counterparty risk, the evidence of which is the numerous payment crises which were seen in India. Options are obviously not at all like badla.

Futures, in contrast, may seem to be like badla to some, but is not so. Unlike in badla, the expiration date is known, clearing corporation eliminates counterparty risk and financing cost almost riskless and long short are symmetric.

Badla has asymmetry between long and short positions; positions can breakdown if borrowing/lending proves unfeasable. Futures markets avoid variability of badla financing charges.

Q: Why are derivatives useful?

The key motivation for such instruments is that they are useful in reallocation risk either across time or among individuals with different risk-bearing preferences.

One kind of passing-on risk is mutual insurance between two parties who face the opposite kind of risks. For example, in the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates.

By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This sort of thing also takes place in speculative position taking - the person who thinks the price will go up is xxxxxx a futures and the person who thinks the price will go down is short the futures.

The ultimate importance of a derivatives market hinges upon the extent to which it helps investors reduce the the risks that they face. some of the largest derivatives in the world are on treasury bills (to help control interest rate risk), the market index (to help control risk that is associated with fluctuations in the stock market and on exchange rates (to cope with currency risk).

Derivatives are also very convenient in terms of international investment. For example, Japanese insurance companies fund housing loans in the USA bu buying into derivatives on real estate in the USA. Such funding patterns would be harded without derivatives.

Q: How will retail investors benefit from index-based derivatives?

Derivatives are useful to all those who find index fluctuations painful. Every retail investor in the economy who is in pain owing to a down turn in the market index is potentially a happy user of index derivatives. One key requirement from the viewpoint of the retail user is contract size. If the minimum investible lot on the index derivatives market is Rs 1 million or so, then it will not be useful for retail investor.

Q: Is not India's cash market too inefficient to support a concept like derivative?

Many emerging markets that have derivatives markets are more primitive that Indian on the key determinants of the market efficiency like high information availability, high skills in keeping accounts and reading accounting reports, high population of speculative trades and low transaction costs.

A final litmus test of market efficiency is mutual fund performance. If India's markets were inefficiency, it would be possible for professional fund managers to obtain excess returns through informed trading.

Evidence suggests three quarters of Indian funds under perform the index, after adjusting for the level of systematic risk adopted. This fraction is almost the hypothesis that India's markets are much less efficient than those seen in OECD countries, after controlling for the levels of transaction cost.

Q: What would derivatives do to FDI and FII investments?

A: Access to derivatives would increase the flow of FII and FDI investments. The two important kinds of risks that foreign investors are exposed in are currency and country risk. The first would be manageable using dollar-rupee and options. If the FIIs are allowed to obtain insurance using this market, they will surely bring more money to India.

Q: Costs and benefits of delaying the onset of exchange-traded financial derivatives in India.

Opportunity cost is the most important one, the threat of foreign exchanges creating derivatives on Indian underlyings being the other. If this opportunity is lost, it would make it harder for derivatives exchanges in India to succeed, individuals and institutions will be devoid of taking risk cover and delay the improvement of financial markets in the country.

Q: What are specific regulatory steps required for safe play in derivatives market?

A: SEBI should not allow any exchange to function without a clearing house that guarantees the trade, introduce strict inspections to confirm that margin payments are calculated as claimed, and actually charged to members.

The surveillance department at SEBI should require, and possibly do an investigative follow-up on reports, of positions and trading activity of "large" players on the market -- large possibly meaning having an open position above Rs 100 crore or a one-day trading volume above Rs 50 crore.

Lastly, SEBI should be accessible to individual users of the market who would be able to complain about manipulative episodes where they have been hurt.

Copyright © 1997 Indian Express Newspapers (Bombay) Ltd.