Title: Exploring factors affecting the proper use of derivatives: An empirical study with active users and controllers

of derivatives Author(s):Frank H. Bezzina, (Department of Management, University of Malta, Msida, Malta), Simon Grima, (Department of Banking and Finance, University of Malta, Msida, Malta) Citation: H. Bezzina, Simon Grima, (2012) "Exploring factors affecting the proper use of derivatives: An empirical study with active users and controllers of derivatives", Managerial Finance, Vol. 38 Iss: 4, pp.414 435 Keywords:Demographics, Derivative controllers, Derivative markets, Derivative users,Financial derivatives, Proper derivative handling, Risk managementArticle type:Research paperDOI:10.1108/03074351211207554 (Permanent URL) Publisher:Emerald Group Publishing

Limited Abstract: Purpose The purpose of this paper is to investigate factors that safeguard or hinder the proper use of derivatives, with evidence from active users and controllers of derivatives. Design/methodology/approach An online panel of 420 users and controllers of derivatives responded to a self-report questionnaire that was purposely designed for the present study. Exploratory factor analysis was used to guide scale construction and the resulting factor scores were examined overall and across four demographic variables (gender, experience, education, position held with firm). Findings Factor analysis provided support for the five hypothesised dimensions of proper derivative usage: Risk management controls; Misuse; Expertise; Perception; and Benefits. Summary statistics of the factor scores revealed that the respondents agree that: they are giving proper attention to risk management controls; factors such as greed, politics, inappropriate standards and inadequate controls encourage misuse; they are capable of dealing with derivatives even in complex situations; derivatives are valuable financial instruments; and they are aware of the benefits derivatives provide to firms, when properly handled. However, some respondents reported contrasting views while the respondents' education, position held and experience with derivatives produced a significant impact on the factor scores. The implications of the findings are discussed. Originality/value This study provides a better understanding and assessment of five factors that affect the proper use of derivatives and addresses practical recommendations aimed at ensuring that the true values and qualities of the derivative instrument are not obscured.

Literature Review

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 against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices.

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A)defines "equity derivative" to include -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. According to ROBERT L. MCDONALD A derivative is simply a financial instrument (or even more simply an agreement between two people) which has a value determined by the price of something else According to JOHN C. HUL A derivatives can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables.

As instruments of risk management, 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 in asset prices on the profitability and cash flow situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years.

The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products.

In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. By far the most significant event in finance during the past d e c a d e h a s b e e n t h e extraordinary development and expansion of financial deriva tivesThese instrumentsenhances the ability to differentiate risk and allocate it to those investors most able and willing to take it- a process that has undoubtedly improved national productivity growth and standards of livings. Alan Greenspan , Former Chairman US Federal Reserve bank

LITERATURE REVIEW The researchers all over the world have done research on derivative trading and were able to find out various facts about derivative and its trading. In this literature review efforts have been done to bring into the picture the research done about various issues throughout the world by the researchers. The literature review on the various issues is as follows: *Reader, GSIMR, DAVV, Indore **Lecturer, GSIMR, DAVV, Indore ***Lecturer, GSIMR, DAVV, Indore ****Lecturer, GSIMR, DAVV, Indore Bose, Suchismita conducted research on The Indian Derivatives Market Revisited in the year 2006. They found that Derivatives products provide certain important economic benefits such as risk management or redistribution of risk away from risk-averse investors towards those more willing and able to bear risk. Derivatives also help price

discovery, i.e. the process of determining the price level for any asset based on supply and demand. These functions of derivatives help in efficient capital allocation in the economy; at the same time their misuse also poses a threat to the stability of the financial sector and the overall economy.

Liquidity Routledge, Bryan and Zin, Stanley E of Carnegie Mellon University conducted research on Model Uncertainty and Liquidity in year 2001. Extreme market outcomes are often followed by a lack of liquidity and a lack of trade. This market collapse seems particularly acute for markets where traders rely heavily on a specific empirical model such as in derivative markets. In this paper we capture modeluncertainty explicitly using an Epstein-Wang (1994) uncertainty-averse utility function with an ambiguous underlying asset-returns distribution. To explore the connection of uncertainty with liquidity, we specify a simple market where a monopolist financial intermediary makes a market for a proprietary derivative security. The market-maker chooses bid and ask prices for the derivative, then, conditional on trade in this market, chooses an optimal portfolio and consumption. We explore how uncertainty can increase the bid-ask spread and, hence, reduces liquidity. In addition, "hedge portfolios" for the market-maker, an important component to understanding spreads, can look very different from those implied by a model without uncertainty. Our infinite-horizon example produces short, dramatic decreases in liquidity even though the underlying environment is stationary. Spot Future Relationship Dheeraj Mishra, R Kannan and Sangeeta D Mishra (2006), tried to find out the spot -future parity relationship in case of index futures in the Indian stock market. NSE Nifty has been chosen as underlying asset. It also aims at exploring different factors responsible for the violation of spot-future parity relationship. It was found that there exists a theoretical relationship between spot, futures and other relevant variables as dividend yield, maturity etc. the paper also aimed at finding out whether there exists an arbitrage profit due to violation of spot future. It was found that arbitrage profits are higher for far month future contracts than for near month future contracts. Arbitrage profits are more for undervalued future markets than overvalued future markets.

Volatility in the Market due to Derivative Trading Sen Shankar Som and Ghosh Santanu Kumar (2006) studied the relationship between stock market liquidity and volatility and risk. The paper also deals with time series data by applying Cochrane Orchid two step procedures. An effort has been made to establish a relation between liquidity and volatility in this paper. It has been found that there is a statistically significant negative relationship between risk and stock market liquidity. Finally it is concluded that there is no significant relationship between liquidity and trading activity in terms of turnover

Trading Volume of Stocks and Open Interest Shenbagraman (2004) reviewed the role of some non-price variables such as open interests, trading volume and other factors, in the stock option market for determining the price of underlying shares in cash market. The study covered stock option contracts for four months from Nov. 2002 to Feb. 2003 consisting 77 trading days. The study concluded that net open interest of stock option is one of the significant variables in determining future spot price of underlying share. The results clearly indicated that open interest based predictors are statistically more significant than volume based predictors in Indian context. The following exhibit gives the snapshot view of the results of studies on volatility effect of Stock Index Futures.

FII Trading All the existing studies found that the Equity return has a significant and positive impact on the FII (Agarwal, 1997; Chakrabarti, 2001; and Trivedi & Nair, 2003). But given the huge volume of investments, foreign investors could play a role of market makers and book their profits i.e., they can buy financial assets when the prices are declining thereby jacking-up the asset prices and sell when the asset prices are increasing (Gordon & Gupta, 2003). Hence, there is a possibility of bi-directional relationship between FII and the equity returns.

International Market and its Impact on Indian Derivative

Masih AM, Masih R, Quarterly Review of Economics and Finance, 2007, Volume: 37,Page: 859-885 Global Stock Futures: A Diagnostic Analysis of a Selected Emerging and Developed Markets with Special Reference to India , Tools used: correlation coefficients , grangers causality test, augmented Dicky Fuller test (ADF), Elliott, Rothenberg and Stock point optimal test. The Authors, through this paper, have tried to find out what kind of relationship exists between emerging and developed futures markets of selected countries.

Arbitrage Opportunities in Derivative Market Kumar Dr. R. & Chandra Abhijeet, Individual Investors Sentiments and Asset Pricing June2000. Individuals often invest in securities based on approximate rule of thumb, not strictly in tune with market conditions. Their emotions drive their trading behavior, which in turn drives asset (stock) prices. Investors fall prey to their own mistakes and sometimes others mistakes, referred to as herd behavior. Markets are efficient, increasingly proving a theoretical concept as in practice they hardly move efficiently. The purely rational approach is being subsumed by a broader approach based upon the trading sentiments of investors. The present paper documents the role of emotional biases towards investment (or disinvestment) decisions of individuals, which in turn force stock prices to move

Brokers awareness/ investors awareness Srivastava Sandeep, Yadav Surendra S, Jain P K, Derivative Trading in Indian Stock Market: Brokers Perception, September, 2008, Volume 20, Number 3 Review The authors conducted a survey of brokers in the recently introduced derivatives markets in India to examine the brokers' assessment of market activity and their perception of the benefits and costs of derivative trading. The need for such a study was felt as previous studies relating to the impact of derivative securities on the Indian stock market do not cover the perception of market participants who form an integral part of the functioning of derivative markets. The issues covered in the survey included: a) perception of brokers about the attractiveness of different derivative securities for clients; b) Profile of clients dealing in derivative securities; c) Popularity of a particular derivative security out of the total set;

d) Different purposes for which the clients are using these securities in order of preference; e) issues concerning derivative trading; f) Reasons for non usage of derivatives by some investors and g)pricing, liquidity and informational efficiency of the derivative market. Derivative securities have penetrated the Indian stock market and it emerged That investors are using these securities for different purposes, namely, risk Management, profit enhancement, speculation and arbitrage. High net worth individuals and proprietary traders account for a large proportion of broker turnover. Interestingly, some retail participation was also witnessed despite the fact that these securities are considered largely beyond the reach of retail investors (because of complexity and relatively high initial investment). Further, there is a need to popularize option instruments because they may prove to be a useful medium for enhancing retail participation in the derivative market.

Transactions Naresh Gopal, University of Madras, Views of the Market Participants on Trading, Regulations in the Derivatives Market, Indian Institute of Capital Markets 9th Capital Markets Conference Paper, January 25, 2006, The dynamic growth of the Derivatives market, particularly Futures & Options and the perceived risks to the financial sector, continue to stimulate debate on the proper regulation of these instruments. Even though this market was initially fuelled by various expert teams survey, regulatory framework, recommendations byelaws and rules there is still a debate on the existing regulations such as why is regulation needed? When and where regulation needed? What are reasonable and attainable goals of these regulations? Therefore this article critically examines the views of market participants on the existing regulatory issues in trading Derivative securities in Indian capital market conditions.

Future pricing Refet S. Gurkaynak , Bilkent University, Justin Wolfers University of Pennsylvania, Macroeconomic Derivatives: An Initial Analysis of Market-Based Macro Forecasts, Uncertainty and Risk, January 2006, Federal Reserve Bank of San Francisco Working Paper No. 2005-26, In September 2002, a new market in Economic Derivatives was launched allowing traders to take positions on future values of several macroeconomic data releases. We provide an initial analysis of the prices of these options. We find that market-based measures of expectations are similar to survey-based forecasts although the market-based measures somewhat more accurately predict financial market responses to surprises in data. These markets nalso provide implied probabilities of the full range of specific outcomes, allowing us to measure uncertainty, assess its driving forces, and compare this measure of uncertainty with the dispersion of point-estimates among individual forecasters (a measure of disagreement). Few of the behavioral anomalies present in surveys of professional forecasts survive in equilibrium, and that these markets are remarkably well calibrated. Finally we assess the role of risk, finding little evidence that risk-aversion drives a wedge between market prices and probabilities in this markets

Literature Review

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 against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices.

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A)defines "equity derivative" to include -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.

As instruments of risk management, 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 in asset prices on the profitability and cash flow situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations incommodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years.

The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products.

In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover

SEBI to introduce more currency derivatives product; Bhave. Chairman of the Indian securities board SEBI, C B Bhave, today said the market watchdog is planning to introduce more currency derivatives products, beginning with options, to give a wider choice to investors (The Econmic Times , April 16 2010) Indian raises trading limits in currency derivatives. Indias capital market regulator has allowed companies to increase their esposure to the currency derivatives market by raising position limits for clients and non-bank trading members. (Reuters, March 25, 2009)

Though several brokers and banks, such as State Bank of India (SEBI) and Axis Bank, offer the currency trading platform, the participation of retail investors is yet to pick up. currently, the awareness level is extremely low and currency futures are viewed as an asset class that is meant only for banks, traders and corporations. Worldwide, retail is very active in the forex market, but a lot of education is needed in India, says Narayanasami, (Business Today, Betting on the game, January 32, 2011)

ITERATURE REVIEWGOLD V/S COMMODITIES Gold is a unique asset based on few basic characteristics. First, it isprimarily a monetary asset, and partly a commodity. As much as two thirds of golds total accumulated holdings relate to store of value considerations. Holdings in this category include the central bank reserves, private investments, and high-cartage jewelry bought primarily in developing countries as a vehicle for savings. Thus, gold is primarily a monetary asset. Less than one third of golds total accumulated holdings can be considered a commodity, the jewelry bought in Western markets for adornment, and gold used in industry. The distinction between gold and commodities is important. Gold has maintained its value in after-inflation terms over the long run, while commodities have declined. Some analysts like to think of gold as a currency without a country. It is an internationally recognized asset that is not depends upon any governments promise to pay. This is an important feature when comparing gold to conventional diversifiers like T-bills or bonds, which unlike gold do have counter-party risk. Gold has three crucial attributes that, combined, set it apart from other commodities: firstly, assayed gold is homogeneous; secondly, gold is in destructible and fungible and thirdly, the inventory of aboveground stocks is astronomically large relative to changes in flow demand. One consequence of these attributes is a dramatic reduction in gestation lags, given low search costs and the well-developed leasing market. One would expect that the time required to convert bullion into producer inventory is short, relative to other commodities which may be less liquid and less homogenous that gold and may require longer time scales to extract and be converted into usable producer inventory, making them more vulnerable to cyclical price volatility. Of course because of the variability of demand, the price responsiveness of each commodity will depend impart on precautionary inventory holdings. There is low to negative correlation between returns on gold and those on stock markets, where as it is well known that stock and bond market returns are highly correlated with GDP. This is because, generally speaking, GDP is a leading indicator of productivity: during a boom, dividends can be expected to rise. On the other hand, the increased demand for credit, countercyclical monetary policy and higher expected inflation that characterize booms typically depress bond prices. The fundamental differences between gold and other financial assets and commodities give rise to the following hard line hypothesis: the impact of cyclical demand using as proxies

Literature review New ideas and innovations have always been the hallmark of progress made by mankind. At every stage of development, there have been two core factors that drive man to ideas and innovation. These are increasing returns and reducing risk, in all facet of life. The financial markets are no different. The endeavor has always been to maximize returns and minimize risk. A lot of innovation goes into developing financial products centered on these two factors. It has spawned a whole new area called financial Engineering. Derivatives are among the forefront of the innovations in the financial markets and a i m t o i n c r e a s e r e t u r n s a n d r e d u c e r i s k . T h e y p r o v i d e a n o u t l e t for investors to protect themselves from the vagaries of the financial markets. These instruments have been very p o p u l a r w i t h i n v e s t o r s a l l o v e r t h e w o r l d . I n d i a n f i n a n c i a l m a r k e t s h a v e b e e n o n t h e ascension and catching up with global standards in financial markets. The advent of screen b a s e d t r a d i n g , d e m a t e r i a l i z a t i o n , r o l l i n g s e t t l e m e n t h a s p u t our markets on par withinternational markets. As a logical step to t h e a b o v e p r o g r e s s , d e r i v a t i v e t r a d i n g w a s introduced in the country i n J u n e 2 0 0 0 . S t a r t i n g w i t h i n d e x f u t u r e s , w e h a v e m a d e r a p i d strides and have four types of derivative products - Index future, index option, stock future a n d s t o c k o p t i o n s . T o d a y, t h e r e a r e 3 0 s t o c k s o n w h i c h o n e c a n h a v e f u t u r e s a n d o p t i o n s , apart from the index futures and options. This market presents a tremendous opportunity for individual investors. The markets have performed smoothly over the last two years and have stabilized. The time is ripe for investors to make full use of the advantage offered by this market. We h a v e t r i e d t o present in a lucid and simple manner, the derivatives market, so t h a t t h e individual investor is educated and equipped to become a dominant player in the market.

LITERATURE REVIEW 2.1 Definition of Derivatives From the definition of Chance and Brooks (2009), derivative is defined as the financial instruments whose returns are derived from those of other financial instruments. That is, their performance depends on how other financial instruments perform. Derivatives serve a valuable purpose in providing a means of managing financial risk. By using derivatives, companies and individuals can transfer, for a price, any undesired risk to other parties who either have risks that offset or want to assume that risk. There are different types of derivatives such as forward contract, future contract, swap, option, equity derivative, foreign exchange derivative, interest rate derivative and commodity derivative. 2.2 The Use of Derivatives to Hedge Risk According to a survey from the International Swaps and Derivatives Association7, there were 94% of the worlds 500 largest companies in 2009 used the derivatives to manage and hedge their business and financial risks. The survey found that foreign exchange derivatives were the most widely used instruments which were 88 percent, followed by interest rate derivatives (83 percent) and commodity derivatives The risk that changes in the currency exchange rate will have an adverse effect on the companys revenue. It also known as currency risk. : Companies can hedge interest-rate risk in various ways. Consider a company wishes to sell a division in one year but the interest rate is expected to fall in the future, then it could purchase (or 'take a long position on') a Treasury futures

contract to lock in the interest rate by today. Thus, the company is effectively locking in the future interest rate. : This is the risk commonly faced by companies that are heavily sensitive to the price change of raw-material inputs or commodities. For example airline industry, it consumes lots of jet fuel. In the past, most airlines have given a great deal of consideration to hedging against crude-oil price increases.

L i t e r a t u r e r e v i e w T i t l e : c r e d i t r i s k m a n a g e m e n t s y s t e m o f c o m m e r c i a l b a n k s Citation : Evelyn Richard, Marcellina Chijoriga, Erasmus Kaijage, Christer Peterson,H a k a n B o h m a n , ( 2 0 0 8 ) " C r e d i t r i s k m a n a g e m e n t s ys t e m o f a c o m m e r c i a l b a n k " , International Journal of Emerging Markets, Vol. 3 Iss: 3, pp.323 - 332Abstract: Purpose The purpose of this paper is to develop a conceptual model to beused further in understanding credit risk management (CRM) system of commercial banks (CBs) in an economy with less developed financial sector. Design/methodology/approach T h e p a p e r r e v i e w s e x i s t i n g l i t e r a t u r e t h a t c o n s i s t s mostly evidence from developed countries. A study model is proposed with amendmentt o f i t Tanzania's environment. This is achieved through the u s e o f b o t h s e c o n d a r y (various relevant documents) and primary (interviews) information from a CB and keym a n a g e m e n t o f f i c i a l s d e a l i n g w i t h c r e d i t management. The selected CB is active inlending, has both foreign and l o c a l c h a r a c t e r i s t i c s i n i t s o p e r a t i o n s a n d h a s b e e n i n operation for a relatively longer period. Findings The main finding of this paper is that the components of CRM system differ in CBs operating in a less developed economy from those in a developed economy. Thisi m p l i e s t h a t t h e e n v i r o n m e n t w i t h i n w h i c h t h e b a n k o p e r a t e s i s a n i m p o r t a n t consideration for a CRM system to be successful. Originality/value Tanzania, a less developed economy, provides an excellent case for studying how CBs operating in economies with less developed financial sector managetheir credit

risk. The paper identifies issues to be studied further in order to establish a CRM system by CBs operating in Tanzania. Research methodology 1. Provide an assessment as to the quality of:the credit risks credit risk management processes collection process hedging solutions 2. Identify strengths and weaknesses within the credit risk management processes and propose improvements