Excel and VBA as Modeling Tools

Even in the mid- to late 1990s, Excel was not considered a powerful enough tool for
serious financial modeling, in part because the PCs available at the time had speed and
memory limitations. With advances in PCs and improvements in Excel itself, the table has
now turned completely: Excel has become the preferred tool for creating all but the largest and
most computationally intensive financial models. The advantages of Excel for financial
modeling are so obvious that it is not necessary to go into them. However, for those who have
not worked with other programs or programming languages for modeling, it is worthwhile to
point out that one of the important advantages of Excel is that with Excel you can create
excellent output with very little work. You should learn to take full advantage of Excel’s
power in this respect. If Excel is so good, then, why bother with VBA? VBA is a
programming language, and if you do not know anything about programming languages, it
will be difficult for you to appreciate the advantages of VBA at this point. Let me touch on
only a few key reasons here, and I will answer the question in greater detail when we discuss
modeling with VBA. Despite its power, Excel has many limitations, and there are many
financial models—some even relatively simple ones—that either cannot be created in Excel or
will be overly complex or cumbersome to create in Excel. What’s more, when you create a
highly complex model in Excel, it can be difficult to understand, debug, and maintain. VBA
generally offers a significant edge in all these respects.

The problem that most people have with VBA is that it is one more thing to learn, and they are
somehow afraid of trying to learn a programming language. The reality is that if you follow
the right method, learning a programming language is not particularly difficult—especially if
you selectively learn what you will really use (as we will do in this book) and not let yourself
get lost in all the other things you can do with VBA but probably never will. The truth is that
you do not need to learn all that much to be able to create very useful and powerful financial
models with VBA. What you will need is a lot of practice, which you will get as you go
through this book. VBA offers you the best of both worlds: you can take advantage of all the
powers of Excel including its ability to easily create excellent outputs, and supplement them
with VBA’s additional tools and flexibility
FINANCIAL DERIVATIVES

A derivative is a financial instrument that derives or gets it value from some real good or stock. It is in its
most basic form simply a contract between two parties to exchange value based on the action of a real good or
service. Typically, the seller receives money in exchange for an agreement to purchase or sell some good or
service at some specified future date.

The largest appeal of derivatives is that they offer some degree of leverage. Leverage is a financial term that
refers to the multiplication that happens when a small amount of money is used to control an item of much
larger value. A mortgage is the most common form of leverage. For a small amount of money and taking on
the obligation of a mortgage, a person gains control of a property of much larger value than the small amount
of money that has exchanged hands.

Derivatives offer the same sort of leverage or multiplication as a mortgage. For a small amount of money, the
investor can control a much larger value of company stock then would be possible without use of derivatives.
This can work both ways, though. If the investor purchasing the derivative is correct, then more money can be
made than if the investment had been made directly into the company itself. However, if the investor is
wrong, the losses are multiplied instead.

Derivatives made the news in 1995 when rogue trader Nick Leeson single-handedly caused the failure of the
Barings bank of England. Nick Leeson was a derivatives trader whose trades did not work out, and due to the
enormous leverage of the trades used, the losses became so large that the bank was bankrupt when the results
of his trades become due. Warren Buffet, a much revered and very successful investor, has stated in one of his
annual reports that he is very much against the use of derivatives and he expects that they will lead to eventual
failure for anyone who uses them. In spite of all this negative press, derivatives have long been a normal part
of business and investing and are likely to be so for many more years.
Uses

Hedging

Derivatives allow risk about the value of the underlying asset to be transferred from one party to another. For
example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for
a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the
uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no
wheat will be available due to causes unspecified by the contract, like the weather, or that one party will
renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all
derivatives are insured against counterparty risk.

From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the
futures contract: The farmer reduces the risk that the price of wheat will fall below the price specified in the
contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby
losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the
price of wheat will fall below the price specified in the contract (thereby paying more in the future than he
otherwise would) and reduces the risk that the price of wheat will rise above the price specified in the
contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counterparty is the
insurer (risk taker) for another type of risk.

Hedging also occurs when an individual or institution buys an asset (like a commodity, a bond that has
coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual
or institution has access to the asset for a specified amount of time, and then can sell it in the future at a
specified price according to the futures contract. Of course, this allows the individual or institution the benefit
of holding the asset while reducing the risk that the future selling price will deviate unexpectedly from the
market's current assessment of the future value of the asset.
Speculation and arbitrage

Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and
institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that
the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want
to be able to buy an asset in the future at a low price according to a derivative contract when the future market
price is high, or to sell an asset in the future at a high price according to a derivative contract when the future
market price is low.

Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an
asset falls below the price specified in a futures contract to sell the asset.

Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at
Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor
judgment, lack of oversight by the bank's management and by regulators, and unfortunate events like the
Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution.[1]
Types of derivatives

OTC and exchange-traded

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way
they are traded in market:

• Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly
between two parties, without going through an exchange or other intermediary. Products such as
swaps, forward rate agreements, and exotic options 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 as hedge funds. Reporting of OTC amounts are difficult because
trades can occur in private, without activity being visible on any exchange. According to the Bank for
International Settlements, the total outstanding notional amount is $684 trillion (as of June 2008)[2]. Of
this total notional amount, 67% are interest rate contracts, 8% are credit 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 counterparty. Therefore,
they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the
other to perform.

• Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized
derivatives exchanges or other exchanges. 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
largest[3] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists
 KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as
interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago
Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York
Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges
totalled 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 xPRTs 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.

Common derivative contract types

There are three major classes of derivatives:

1. Futures/Forwards 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, while a forward contract is a non-standardized contract written by the parties themselves.

2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call
option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as
the strike 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 an American 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 counterparty has the obligation to carry out the transaction.

3. 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, stocks or other
assets.
More complex derivatives can be created by combining the elements of these basic types. For example, the
holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future
date.

Examples

Some common examples of these derivatives are:

CONTRACT TYPES

UNDERLYING
Exchange- Exchange-traded
OTC swap OTC forward OTC option
traded futures options

DJIA Index Option on DJIA

future Index future
Equity Index Equity swap Back-to-back n/a
NASDAQ Index Option on NASDAQ
future Index future

Option on Eurodollar Interest rate cap

Eurodollar future future Interest rate Forward rate and floor
Money market
Euribor future Option on Euribor swap agreement Swaption
future Basis swap

Option on Bond Total return Repurchase

Bonds Bond future Bond option
future swap agreement

Stock option
Single-stock Repurchase
Single Stocks Single-share option Equity swap Warrant
future agreement
Turbo warrant
 Credit Credit default
Credit n/a n/a n/a
default swap option

Other examples of underlying exchangeables are:

• Property (mortgage) derivatives

• Economic derivatives that pay off according to economic reports [1] as measured and reported by
national statistical agencies

• Energy derivatives that pay off according to a wide variety of indexed energy prices. Usually
classified as either physical or financial, where physical means the contract includes actual delivery of
the underlying energy commodity (oil, gas, power, etc.)

• Commodities

• Freight derivatives

• Inflation derivatives

• Insurance derivatives[citation needed]

• Weather derivatives

• Credit derivatives

Cash flow

The payments between the parties may be determined by:

• the price of some other, independently traded asset in the future (e.g., a common stock);
 • the level of an independently determined index (e.g., a stock market index or heating-degree-days);

• the occurrence of some well-specified event (e.g., a company defaulting);

• an interest rate;

• an exchange rate;

• or some other factor.

Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future
for a predetermined price. If the price of the underlying security or commodity moves into the right direction,
the owner of the derivative makes money; otherwise, they lose money or the derivative becomes worthless.
Depending on the terms of the contract, the potential gain or loss on a derivative can be much higher than if
they had traded the underlying security or commodity directly.

Valuation

Total world derivatives from 1998-2007[4] compared to total world wealth in the year 2000[citation needed]
Market and arbitrage-free prices

Two common measures of value are:

• Market price, i.e. the price at which traders are willing to buy or sell the contract

• Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts; see
rational pricing

Determining the market price

For exchange-traded derivatives, market price is usually transparent (often published in real time by the
exchange, based on all the current bids and offers placed on that particular contract at any one time).
Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it
difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to
collate and disseminate prices.

Determining the arbitrage-free price

The arbitrage-free price for a derivatives contract is complex, and there are many different variables to
consider. Arbitrage-free pricing is a central topic of financial mathematics. The stochastic process of the price
of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the Black–
Scholes formula, which is based on the assumption that the cash flows from a European stock option can be
replicated by a continuous buying and selling strategy using only the stock. A simplified version of this
valuation technique is the binomial options model.

Criticisms

Derivatives are often subject to the following criticisms:

Possible large losses

See also: List of trading losses

The use of derivatives can result in large losses due to the use of leverage, or borrowing. Derivatives allow
investors to earn large returns from small movements in the underlying asset's price. However, investors could
lose large amounts if the price of the underlying moves against them significantly. There have been several
instances of massive losses in derivative markets, such as:

• The need to recapitalize insurer American International Group (AIG) with $85 billion of debt provided
by the US federal government[5]. An AIG subsidiary had lost more than $18 billion over the preceding
three quarters on Credit Default Swaps (CDS) it had written.[6] It was reported that the recapitalization
was necessary because further losses were foreseeable over the next few quarters.

• The loss of $7.2 Billion by Société Générale in January 2008 through mis-use of futures contracts.

• The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in
September 2006 when the price plummeted.

• The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.

• The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U.S. history. On
December 6, 1994, Orange County declared Chapter 9 bankruptcy, from which it emerged in June
1995. The county lost about $1.6 billion through derivatives trading. Orange County was neither
bankrupt nor insolvent at the time; however, because of the strategy the county employed it was
unable to generate the cash flows needed to maintain services. Orange County is a good example of
what happens when derivatives are used incorrectly and positions liquidated in an unplanned manner;
had they not liquidated they would not have lost any money as their positions rebounded.[citation needed]
Potentially problematic use of interest-rate derivatives by US municipalities has continued in recent
years. See, for example:[7]

• The Nick Leeson affair in 1994

Counter-party risk

Derivatives (especially swaps) expose investors to counter-party risk.

For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only
offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a
fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the
first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it
is possible that the first business may be adversely affected, because it may not be prepared to pay the higher
variable rate.

Different types of derivatives have different levels of risk for this effect. For example, standardized stock
options by law require the party at risk to have a certain amount deposited with the exchange, showing that
they can pay for any losses; Banks who help businesses swap variable for fixed rates on loans may do credit
checks on both parties. However in private agreements between two companies, for example, there may not
be benchmarks for performing due diligence and risk analysis.

Unsuitably high risk for small/inexperienced investors

Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Because derivatives
offer the possibility of large rewards, they offer an attraction even to individual investors. However,
speculation in derivatives often assumes a great deal of risk, requiring commensurate experience and market
knowledge, especially for the small investor, a reason why some financial planners advise against the use of
these instruments. Derivatives are complex instruments devised as a form of insurance, to transfer risk among
parties based on their willingness to assume additional risk, or hedge against it.

Large notional value

• Derivatives typically have a large notional value. As such, there is the danger that their use could
result in losses that the investor would be unable to compensate for. The possibility that this could lead
to a chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren
Buffett in Berkshire Hathaway's 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.

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real
economy to service its debt obligations and curtailing real economic activity, which can cause a recession or
even depression.[8] In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November, 1934
to February, 1948, too high a level of debt was one of the primary causes of the 1920s-30s Great Depression.
(See Berkshire Hathaway Annual Report for 2002)

Benefits

Nevertheless, the use of derivatives also has its benefits:

• Derivatives facilitate the buying and selling of risk, and thus have a positive impact on the economic
system. Although someone loses money while someone else gains money with a derivative, under
normal circumstances, trading in derivatives should not adversely affect the economic system because
it is not zero sum in utility.

• Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the
use of derivatives has softened the impact of the economic downturn at the beginning of the 21st
century.

Definitions

• Bilateral netting: A legally enforceable arrangement between a bank and a counter-party that creates a
single legal obligation covering all included individual contracts. This means that a bank’s obligation,
in the event of the default or insolvency of one of the parties, would be the net sum of all positive and
negative fair values of contracts included in the bilateral netting arrangement.

• Credit derivative: A contract that transfers credit risk from a protection buyer to a credit protection
seller. Credit derivative products can take many forms, such as credit default swaps, credit linked
notes and total return swaps.

• Derivative: A financial contract whose value is derived from the performance of assets, interest rates,
currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial
contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors,
collars, forwards and various combinations thereof.
• Exchange-traded derivative contracts: Standardized derivative contracts (e.g. futures contracts and
options) that are transacted on an organized futures exchange.

• Gross negative fair value: The sum of the fair values of contracts where the bank owes money to its
counter-parties, without taking into account netting. This represents the maximum losses the bank’s
counter-parties would incur if the bank defaults and there is no netting of contracts, and no bank
collateral was held by the counter-parties.

• Gross positive fair value: The sum total of the fair values of contracts where the bank is owed money
by its counter-parties, without taking into account netting. This represents the maximum losses a bank
could incur if all its counter-parties default and there is no netting of contracts, and the bank holds no
counter-party collateral.

• High-risk mortgage securities: Securities where the price or expected average life is highly sensitive to
interest rate changes, as determined by the FFIEC policy statement on high-risk mortgage securities.

• Notional amount: The nominal or face amount that is used to calculate payments made on swaps and
other risk management products. This amount generally does not change hands and is thus referred to
as notional.

• Over-the-counter (OTC) derivative contracts : Privately negotiated derivative contracts that are
transacted off organized futures exchanges.

• Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on
one or more indices and/or have embedded forwards or options.

• Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common
shareholders equity, perpetual preferred shareholders equity with non-cumulative dividends, retained
earnings, and minority interests in the equity accounts of consolidated subsidiaries. Tier 2 capital
consists of subordinated debt, intermediate-term preferred stock, cumulative and long-term preferred
stock, and a portion of a bank’s allowance for loan and lease losses.
 Financial Derivatives Market and its Development in India

Financial markets are, by nature, extremely volatile and hence the risk factor is an

important concern for financial agents. To reduce this risk, the concept of derivatives

comes into the picture. Derivatives are products whose values are derived from one or more

basic variables called bases. These bases can be underlying assets (for example forex,

equity, etc), bases or reference rates. For example, wheat farmers may wish to sell their

harvest at a future date to eliminate the risk of a change in prices by that date. The

transaction in this case would be the derivative, while the spot price of wheat would be the

underlying asset.

Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading with one
another. Forward contracting dates back at least to the 12th century, and may well have

been around before then. Merchants entered into contracts with one another for future

delivery of specified amount of commodities at specified price. A primary motivation for

pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to

lessen the possibility that large swings would inhibit marketing the commodity after a

harvest.

The need for a derivatives market

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk averse people to risk oriented people

2. They help in the discovery of future as well as current prices

3. They catalyze entrepreneurial activity

4. They increase the volume traded in markets because of participation of risk averse

people in greater numbers

5. They increase savings and investment in the long run

The participants in a derivatives market

• Hedgers use futures or options markets to reduce or eliminate the risk associated
with price of an asset.

• Speculators use futures and options contracts to get extra leverage in betting on

future movements in the price of an asset. They can increase both the potential

gains and potential losses by usage of derivatives in a speculative venture.

• Arbitrageurs are in business to take advantage of a discrepancy between prices in

two different markets. If, for example, they see the futures price of an asset getting

out of line with the cash price, they will take offsetting positions in the two markets

to lock in a profit.

Types of Derivatives

Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a

certain time in the future at a certain price. Futures contracts are special types of forward

contracts in the sense that the former are standardized exchange-traded contracts

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the

obligation to buy a given quantity of the underlying asset, at a given price on or before a

given future date. Puts give the buyer the right, but not the obligation to sell a given

quantity of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of upto one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated options are

called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are

options having a maturity of upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying

asset is usually a moving average or a basket of assets. Equity index options are a form of

basket options.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the

future according to a prearranged formula. They can be regarded as portfolios of forward

contracts. The two commonly used swaps are :

• Interest rate swaps: These entail swapping only the interest related cash flows

between the parties in the same currency.

• Currency swaps: These entail swapping both principal and interest between the

parties, with the cashflows in one direction being in a different currency than those

in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap. Rather than have

calls and puts, the swaptions market has receiver swaptions and payer swaptions. A

receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.

Factors driving the growth of financial derivatives

1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international markets,

3. Marked improvement in communication facilities and sharp decline in their costs,

4. Development of more sophisticated risk management tools, providing economic agents a

wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and returns

over a large number of financial assets leading to higher returns, reduced risk as well as

transactions costs as compared to individual financial assets.

Development of derivatives market in India

The first step towards introduction of derivatives trading in India was the promulgation of

the Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition on

options in securities. The market for derivatives, however, did not take off, as there was no

regulatory framework to govern trading of derivatives. SEBI set up a 24–member

committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop

appropriate regulatory framework for derivatives trading in India. The committee submitted

its report on March 17, 1998 prescribing necessary pre–conditions for introduction of

derivatives trading in India. The committee recommended that derivatives should be

declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’

could also govern trading of securities. SEBI also set up a group in June 1998 under the

Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in

derivatives market in India. The report, which was submitted in October 1998, worked out

the operational details of margining system, methodology for charging initial margins,

broker net worth, deposit requirement and real–time monitoring requirements.

The Securities Contract Regulation Act (SCRA) was amended in December 1999 to

include derivatives within the ambit of ‘securities’ and the regulatory framework was

developed for governing derivatives trading. The act also made it clear that derivatives

shall be legal and valid only if such contracts are traded on a recognized stock exchange,

thus precluding OTC derivatives. The government also rescinded in March 2000, the three–

decade old notification, which prohibited forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the final

approval to this effect in May 2001. SEBI permitted the derivative segments of two stock

exchanges, NSE and BSE, and their clearing house/corporation to commence trading and

settlement in approved derivatives contracts. To begin with, SEBI approved trading in

index futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was

followed by approval for trading in options based on these two indexes and options on

individual securities.
The trading in BSE Sensex options commenced on June 4, 2001 and the trading in

options on individual securities commenced in July 2001. Futures contracts on individual

stocks were launched in November 2001. The derivatives trading on NSE commenced with

S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced

on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001.

Single stock futures were launched on November 9, 2001. The index futures and options

contract on NSE are based on S&P CNX

Trading and settlement in derivative contracts is done in accordance with the rules,

byelaws, and regulations of the respective exchanges and their clearing house/corporation

duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors

(FIIs) are permitted to trade in all Exchange traded derivative products.

The following are some observations based on the trading statistics provided in the NSE

report on the futures and options (F&O):

• Single-stock futures continue to account for a sizable proportion of the F&O

segment. It constituted 70 per cent of the total turnover during June 2002. A

primary reason attributed to this phenomenon is that traders are comfortable with

single-stock futures than equity options, as the former closely resembles the

erstwhile badla system.

• On relative terms, volumes in the index options segment continues to remain poor.
This may be due to the low volatility of the spot index. Typically, options are

considered more valuable when the volatility of the underlying (in this case, the

index) is high. A related issue is that brokers do not earn high commissions by

recommending index options to their clients, because low volatility leads to higher

waiting time for round-trips.

• Put volumes in the index options and equity options segment have increased since

January 2002. The call-put volumes in index options have decreased from 2.86 in

January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the

traders are increasingly becoming pessimistic on the market.

• Farther month futures contracts are still not actively traded. Trading in equity

options on most stocks for even the next month was non-existent.

• Daily option price variations suggest that traders use the F&O segment as a less

risky alternative (read substitute) to generate profits from the stock price

movements. The fact that the option premiums tail intra-day stock prices is

evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day.

If calls and puts are not looked as just substitutes for spot trading, the intra-day

stock price variations should not have a one-to-one impact on the option premiums.
Commodity Derivatives

Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking,

castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18

commodity exchanges located in various parts of the country. Futures trading in other

edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new

commodities, especially in edible oils, is expected to commence in the near future. The

sugar industry is exploring the merits of trading sugar futures contracts.

The policy initiatives and the modernisation programme include extensive training,

structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and

the thrust towards the establishment of a national commodity exchange. The Government

of India has constituted a committee to explore and evaluate issues pertinent to the

establishment and funding of the proposed national commodity exchange for the

nationwide trading of commodity futures contracts, and the other institutions and

institutional processes such as warehousing and clearinghouses.

With commodity futures, delivery is best effected using warehouse receipts (which are like

dematerialised securities). Warehousing functions have enabled viable exchanges to

augment their strengths in contract design and trading. The viability of the national

commodity exchange is predicated on the reliability of the warehousing functions. The

programme for establishing a system of warehouse receipts is in progress. The Coffee

Futures Exchange India (COFEI) has operated a system of warehouse receipts since 1998.

Exchange-traded vs. OTC (Over The Counter) derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few years,

which has accompanied the modernization of commercial and investment banking and

globalisation of financial activities. The recent developments in information technology

have contributed to a great extent to these developments. While both exchange-traded and

OTC derivative contracts offer many benefits, the former have rigid structures compared to

the latter. It has been widely discussed that the highly leveraged institutions and their OTC

derivative positions were the main cause of turbulence in financial markets in 1998. These

episodes of turbulence revealed the risks posed to market stability originating in features of

OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange-traded
derivatives:

1. The management of counter-party (credit) risk is decentralized and located within

individual institutions,

2. There are no formal centralized limits on individual positions, leverage, or margining,

3. There are no formal rules for risk and burden-sharing,

4. There are no formal rules or mechanisms for ensuring market stability and integrity, and

for safeguarding

the collective interests of market participants, and

5. The OTC contracts are generally not regulated by a regulatory authority and the

exchange’s self-regulatory organization, although they are affected indirectly by national

legal systems, banking supervision and market surveillance.

Accounting of Derivatives :

The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on

accounting of index futures contracts from the view point of parties who enter into such

futures contracts as buyers or sellers. For other parties involved in the trading process, like
brokers, trading members, clearing members and clearing corporations, a trade in equity

index futures is similar to a trade in, say shares, and does not pose any peculiar accounting

problems

Taxation

The income-tax Act does not have any specific provision regarding taxability from

derivatives.The only provisions which have an indirect bearing on derivative transactions

are sections 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a

speculative business carried on by the assessee, shall not be set off except against profits

and gains, if any, of speculative business. In the absence of a specific provision, it is

apprehended that the derivatives contracts, particularly the index futures which are

essentially cash-settled, may be construed as speculative transactions and therefore the

losses, if any, will not be eligible for set off against other income of the assessee and will

be carried forward and set off against speculative income only up to a maximum of eight

years .As a result an investor’s losses or profits out of derivatives even though they are of

hedging nature in real sense, are treated as speculative and can be set off only against

speculative income.

10 Myths About Financial Derivatives

Executive Summary
In our fast-changing financial services industry, coercive regulations intended to restrict banks' activities will
be unable to keep up with financial innovation. As the lines of demarcation between various types of financial
service providers continues to blur, the bureaucratic leviathan responsible for reforming banking regulation
must face the fact that fears about derivatives have proved unfounded. New regulations are unnecessary.
Indeed, access to risk-management instruments should not be feared but, with caution, embraced to help firms
manage the vicissitudes of the market.

In this paper 10 common misconceptions about financial derivatives are explored. Believing just one or two of
the myths could lead one to advocate tighter legislation and regulatory measures designed to restrict derivative
activities and market participants. A careful review of the risks and rewards derivatives offer, however,
suggests that regulatory and legislative restrictions are not the answer. To blame organizational failures solely
on derivatives is to miss the point. A better answer lies in greater reliance on market forces to control
derivative-related risk taking.

Financial derivatives have changed the face of finance by creating new ways to understand, measure, and
manage risks. Ultimately, financial derivatives should be considered part of any firm's risk-management
strategy to ensure that value-enhancing investment opportunities are pursued. The freedom to manage risk
effectively must not be taken away.

Introduction

Remember the bankruptcy of Orange County, California, and the Barings Bank due to poor investments in
financial derivatives? At that time many policymakers feared more collapsed banks, counties, and countries.
Those fears proved unfounded; prudent use, not government regulation, of derivatives headed off further
problems. Now, however, the Financial Accounting Standards Board, the Federal Reserve, and the Securities
and Exchange Commission are debating the merits of new rules for derivatives. But before adopting
regulations, policymakers need to separate myths about those financial instruments from reality.

The tremendous growth of the financial derivatives market and reports of major losses associated with
derivative products have resulted in a great deal of confusion about those complex instruments. Are
derivatives a cancerous growth that is slowly but surely destroying global financial markets? Are people who
use derivative products irresponsible because they use financial derivatives as part of their overall risk-
management strategy? Are financial derivatives the source of the next U.S. financial fiasco--a bubble on the
verge of exploding?
Those who oppose financial derivatives fear a financial disaster of tremendous proportions--a disaster that
could paralyze the world's financial markets and force governments to intervene to restore stability and
prevent massive economic collapse, all at taxpayers' expense. Critics believe that derivatives create risks that
are uncontrollable and not well understood. [1] Some critics liken derivatives to gene splicing: potentially
useful, but certainly very dangerous, especially if used by a neophyte or a madman without proper safeguards.

In this paper 10 myths, or common misconceptions, about financial derivatives are explored. Financial
derivatives have changed the face of finance by creating new ways to understand, measure, and manage
financial risks. Ultimately, derivatives offer organizations the opportunity to break financial risks into smaller
components and then to buy and sell those components to best meet specific risk-management objectives.
Moreover, under a market-oriented philosophy, derivatives allow for the free trading of individual risk
components, thereby improving market efficiency. Using financial derivatives should be considered a part of
any business's risk-management strategy to ensure that value-enhancing investment opportunities can be
pursued.

Myth Number 1: Derivatives Are New, Complex, High-Tech Financial Products Created by Wall Street's
Rocket Scientists

Financial derivatives are not new; they have been around for years. A description of the first known options
contract can be found in Aristotle's writings. He tells the story of Thales, a poor philosopher from Miletus
who developed a "financial device, which involves a principle of universal application." [2] People reproved
Thales, saying that his lack of wealth was proof that philosophy was a useless occupation and of no practical
value. But Thales knew what he was doing and made plans to prove to others his wisdom and intellect.

Thales had great skill in forecasting and predicted that the olive harvest would be exceptionally good the next
autumn. Confident in his prediction, he made agreements with area olive-press owners to deposit what little
money he had with them to guarantee him exclusive use of their olive presses when the harvest was ready.
Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the
harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge against the
possibility of a poor yield.

Aristotle's story about Thales ends as one might guess: "When the harvest-time came, and many [presses]
were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of
money. Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of
another sort." [3] So Thales exercised the first known options contracts some 2,500 years ago. He was not
obliged to exercise the options. If the olive harvest had not been good, Thales could have let the option
contracts expire unused and limited his loss to the original price paid for the options. But as it turned out, a
bumper crop came in, so Thales exercised the options and sold his claims on the olive presses at a high profit.

Options are just one type of derivative instrument. Derivatives, as their name implies, are contracts that are
based on or derived from some underlying asset, reference rate, or index. Most common financial derivatives,
described later, can be classified as one, or a combination, of four types: swaps, forwards, futures, and options
that are based on interest rates or currencies.

Most financial derivatives traded today are the "plain vanilla" variety--the simplest form of a financial
instrument. But variants on the basic structures have given way to more sophisticated and complex financial
derivatives that are much more difficult to measure, manage, and understand. For those instruments, the
measurement and control of risks can be far more complicated, creating the increased possibility of
unforeseen losses.

Wall Street's "rocket scientists" are continually creating new, complex, sophisticated financial derivative
products. However, those products are all built on a foundation of the four basic types of derivatives. Most of
the newest innovations are designed to hedge complex risks in an effort to reduce future uncertainties and
manage risks more effectively. But the newest innovations require a firm understanding of the tradeoff of
risks and rewards. To that end, derivatives users should establish a guiding set of principles to provide a
framework for effectively managing and controlling financial derivative activities. Those principles should
focus on the role of senior management, valuation and market risk management, credit risk measurement and
management, enforceability, operating systems and controls, and accounting and disclosure of risk-
management positions. [4]

Myth Number 2: Derivatives Are Purely Speculative, Highly Leveraged Instruments

Put another way, this myth is that "derivatives" is a fancy name for gambling. Has speculative trading of
derivative products fueled the rapid growth in their use? Are derivatives used only to speculate on the
direction of interest rates or currency exchange rates? Of course not. Indeed, the explosive use of financial
derivative products in recent years was brought about by three primary forces: more volatile markets,
deregulation, and new technologies.
The turning point seems to have occurred in the early 1970s with the breakdown of the fixed-rate international
currency exchange regime, which was established at the 1944 conference at Bretton Woods and maintained
by the International Monetary Fund. Since then currencies have floated freely. Accompanying that
development was the gradual removal of government-established interest-rate ceilings when Regulation Q
interest-rate restrictions were phased out. Not long afterward came inflationary oil-price shocks and wild
interest-rate fluctuations. In sum, financial markets were more volatile than at any time since the Great
Depression.

Banks and other financial intermediaries responded to the new environment by developing financial risk-
management products designed to better control risk. The first were simple foreign-exchange forwards that
obligated one counterparty to buy, and the other to sell, a fixed amount of currency at an agreed date in the
future. By entering into a foreign-exchange forward contract, customers could offset the risk that large
movements in foreign-exchange rates would destroy the economic viability of their overseas projects. Thus,
derivatives were originally intended to beused to effectively hedge certain risks; and, in fact, that was the key
that unlocked their explosive development.

Beginning in the early 1980s, a host of new competitors accompanied the deregulation of financial markets,
and the arrival of powerful but inexpensive personal computers ushered in new ways to analyze information
and break down risk into component parts. To serve customers better, financial intermediaries offered an ever-
increasing number of novel products designed to more effectively manage and control financial risks. New
technologies quickened the pace of innovation and provided banks with superior methods for tracking and
simulating their own derivatives portfolios.

From the simple forward agreements, financial futures contracts were developed. Futures are similar to
forwards, except that futures are standardized by exchange clearinghouses, which facilitates anonymous
trading in a more competitive and liquid market. In addition, futures contracts are marked to market daily,
which greatly decreases counterparty risk--the risk that the other party to the transaction will be unable to
meet its obligations on the maturity date.

Around 1980 the first swap contracts were developed. A swap is another forward-based derivative that
obligates two counterparties to exchange a series of cash flows at specified settlement dates in the future.
Swaps are entered into through private negotiations to meet each firm's specific risk-management objectives.
There are two principal types of swaps: interest-rate swaps and currency swaps.
Today interest-rate swaps account for the majority of banks' swap activity, and the fixed-for-floating-rate
swap is the most common interest-rate swap. In such a swap, one party agrees to make fixed-rate interest
payments in return for floating-rate interest payments from the counterparty, with the interest-rate payment
calculations based on a hypothetical amount of principal called the notional amount.

Myth Number 3: The Enormous Size of the Financial Derivatives Market Dwarfs Bank Capital, Thereby
Making Derivatives Trading an Unsafe and Unsound Banking Practice

The financial derivatives market's worth is regularly reported as more than $20 trillion. That estimate dwarfs
not only bank capital but also the nation's $7 trillion annual gross domestic product. Those often-quoted
figures are notional amounts. For derivatives, notional principal is the amount on which interest and other
payments are based. Notional principal typically does not change hands; it is simply a quantity used to
calculate payments.

While notional principal is the most commonly used volume measure in derivatives markets, it is not an
accurate measure of credit exposure. A useful proxy for the actual exposure of derivative instruments is
replacement-cost credit exposure. That exposure is the cost of replacing the contract at current market values
should the counterparty default before the settlement date.

For the 10 largest derivatives players among U.S. bank holding companies, derivative credit exposure
averages 15 percent of total assets. The average exposure is 49 percent of assets for those banks' loan
portfolios. In other words, if those 10 banks lost 100 percent on their loans, the loss would be more than three
times greater than it would be if they had to replace all of their derivative contracts.

Derivatives also help to improve market efficiencies because risks can be isolated and sold to those who are
willing to accept them at the least cost. Using derivatives breaks risk into pieces that can be managed
independently. Corporations can keep the risks they are most comfortable managing and transfer those they
do not want to other companies that are more willing to accept them. From a market-oriented perspective,
derivatives offer the free trading of financial risks.

The viability of financial derivatives rests on the principle of comparative advantage--that is, the relative cost
of holding specific risks. Whenever comparative advantages exist, trade can benefit all parties involved. And
financial derivatives allow for the free trading of individual risk components.

Myth Number 4: Only Large Multinational Corporations and Large Banks Have a Purpose for Using
Derivatives
Very large organizations are the biggest users of derivative instruments. However, firms of all sizes can
benefit from using them. For example, consider a small regional bank (SRB) with total assets of $5 million
(Figure 1). [5] The SRB has a loan portfolio composed primarily of fixed-rate mortgages, a portfolio of
government securities, and interest-bearing deposits that are often repriced. Two illustrations of how SRBs
can use derivatives to hedge risks follow.

First, rising interest rates will negatively affect prices in the SRB's $1 million securities portfolio. But by
selling short a $1 million Treasury-bond futures contract, the SRB can effectively hedge against that interest-
rate risk and smooth its earnings stream in a volatile market. If interest rates went higher, the SRB would be
hurt by a drop in value of its securities portfolio, but that loss would be offset by a gain from its derivative
contract. Similarly, if interest rates fell, the bank would gain from the increase in value of its securities
portfolio but would record a loss from its derivative contract. By entering into derivatives contracts, the SRB
can lock in a guaranteed rate of return on its securities portfolio and not be as concerned about interest-rate
volatility (Figure 2).

The second illustration involves a swap contract. As in the first illustration, rising interest rates will harm the
SRB because it receives fixed cash flows on its loan portfolio and must pay variable cash flows for its
deposits. Once again, the SRB can hedge against interest-rate risk by entering into a swap contract with a
dealer to pay fixed and receive floating payments.
 Figure 1
Sample Balance Sheet of a Small Regional Bank

Assets Liabilities

Loans $3 million Deposits

Securities $1 million - Interest-bearing $3 million

Cash and premises $1 million - Noninterest-bearing $1 million

Equity $1 million

Total assets $5 million Total liabilities and equity $5 million

 Figure 2
Effect of Interest Rates on Securities Earnings of a Small Regional Bank

Figure 3
Effect of Interest Rates on Net Interest Margin of a Small Regional Bank

Rates Drop No Change Rates Rise

300 bps in Rates 300 bps

Asset Yield (Loans) 7.00% 7.00% 7.00%

Liability Yield (Deposits) -1.00% -4.00% -7.00%

Net Margin (w/o Swap) 6.00% 3.00% 0.00%

 Fixed Swap Outflow -4.50% -4.50% -4.50%

Floating Swap Inflow 0.50% 3.50% 6.50%

Net Swap Flow -4.00% -1.00% 2.00%

Net Margin (w/Swap) 2.00% 2.00% 2.00%

Say the SRB currently receives a 7 percent fixed rate from its loan portfolio and pays a variable rate for its
deposits that approximates the three-month T-bill rate. The top portion of Figure 3 shows the SRB's net
interest margin under three scenarios, all of which assume that the T-bill rate is currently at 4 percent: (1)
rates falling 300 basis points, (2) rates unchanged, and (3) rates rising 300 basis points. [6] The SRB's net
interest margin would decline with rising rates and increase with falling rates.

To hedge that interest-rate risk, the SRB can negotiate with a swaps dealer to pay 4.5 percent fixed interest in
exchange for T-bill minus 0.5 percent (Figure 4). The net swap flow is shown in Figure 3 under the same
three scenarios. In this case, the value of the swap increases with rising rates because the SRB receives
floating-rate cash flows and pays fixed rates.

As shown on the bottom of Figure 3, the swap provides an effective hedge against interest-rate risk. With the
swap, the bank has a guaranteed 200-basis-point spread, no matter what happens to interest rates. Without the
swap, the SRB could get badly burned by rising interest rates.
 Figure 4
Effect of Interest-Rate Swap on a Small Regional Bank

The economic benefits of derivatives are not dependent on the size of the institution trading them. The
decision about whether to use derivatives should be driven, not by the company's size, but by its strategic
objectives. The role of any risk-management strategy should be to ensure that the necessary funds are
available to pursue value-enhancing investment opportunities. [7] However, it is important that all users of
derivatives, regardless of size, understand how their contracts are structured, the unique price and risk
characteristics of those instruments, and how they will perform under stressful and volatile economic
conditions. A prudent risk-management strategy that conforms to corporate goals and is complete with market
simulations and stress tests is the most crucial prerequisite for using financial derivative products.

Myth Number 5: Financial Derivatives Are Simply the Latest Risk-Management Fad

Financial derivatives are important tools that can help organizations to meet their specific risk-management
objectives. As is the case with all tools, it is important that the user understand the tool's intended function and
that the necessary safety precautions be taken before the tool is put to use.

Builders use power saws when they construct houses. And just as a power saw is a useful tool in building a
house--increasing the builder's efficiency and effectiveness--so financial derivatives can be useful tools in
helping corporations and banks to be more efficient and effective in meeting their risk-management
objectives. But power saws can be dangerous when not used correctly or when used blindly. If users are not
careful, they can seriously injure themselves or ruin the project. Likewise, when financial derivatives are used
improperly or without a plan, they can inflict pain by causing serious losses or propelling the organization in
the wrong direction so that it is ill prepared for the future.
When used properly, financial derivatives can help organizations to meet their risk-management objectives so
that funds are available for making worthwhile investments. Again, a firm's decision to use derivatives should
be driven by a risk-management strategy that is based on broader corporate objectives.

The most basic questions about a firm's risk-management strategy should be addressed: Which risks should be
hedged and which should remain unhedged? What kinds of derivative instruments and trading strategies are
most appropriate? How will those instruments perform if there is a large increase or decrease in interest rates?
How will those instruments perform if there are wild fluctuations in exchange rates?

Without a clearly defined risk-management strategy, use of financial derivatives can be dangerous. It can
threaten the accomplishment of a firm's long-range objectives and result in unsafe and unsound practices that
could lead to the organization's insolvency. But when used wisely, financial derivatives can increase
shareholder value by providing a means to better control a firm's risk exposures and cash flows.

Clearly, derivatives are here to stay. We are well on our way to truly global financial markets that will
continue to develop new financial innovations to improve risk-management practices. Financial derivatives
are not the latest risk-management fad; they are important tools for helping organizations to better manage
their risk exposures.

Myth Number 6: Derivatives Take Money Out of Productive Processes and Never Put Anything Back

Financial derivatives, by reducing uncertainties, make it possible for corporations to initiate productive
activities that might not otherwise be pursued. For example, an Italian company may want to build a
manufacturing facility in the United States but is concerned about the project's overall cost because of
exchange-rate volatility between the lira and the dollar. To ensure that the company will have the necessary
cash available when it is needed for investment, the Italian manufacturer should devise a prudent risk-
management strategy that is in harmony with its broader corporate objective of building a manufacturing
facility in the United States. As part of that strategy, the Italian firm should use financial derivatives to hedge
against foreign-exchange risk. Derivatives used as a hedge can improve the management of cash flows at the
individual firm level.

To ensure that productive activities are pursued, corporate finance and treasury groups should transform their
operations from mundane bean counting to activist financial risk management. They should integrate a clear
set of risk-management goals and objectives into the organization's overall corporate strategy. The ultimate
goal is to ensure that the organization has the necessary funds at its disposal to pursue investments that
maximize shareholder value. Used properly, financial derivatives can help corporations to reduce
uncertainties and promote more productive activities.

Myth Number 7: Only Risk-Seeking Organizations Should Use Derivatives

Financial derivatives can be used in two ways: to hedge against unwanted risks or to speculate by taking a
position in anticipation of a market movement. The olive-press owners, by locking in a guaranteed return no
matter how good or bad the harvest, hedged against the risk that the next season's olive harvest might not be
plentiful. Thales speculated that the next season's olive harvest would be exceptionally good and therefore
paid an up-front premium in anticipation of that event.

Similarly, organizations today can use financial derivatives to actively seek out specific risks and speculate on
the direction of interest-rate or exchange-rate movements, or they can use derivatives to hedge against
unwanted risks. Hence, it is not true that only risk-seeking institutions use derivatives. Indeed, organizations
should use derivatives as part of their overall risk-management strategy for keeping those risks that they are
comfortable managing and selling those that they do not want to others who are more willing to accept them.
Even conservatively managed institutions can use derivatives to improve their cash-flow management to
ensure that the necessary funds are available to meet broader corporate objectives. One could argue that
organizations that refuse to use financial derivatives are at greater risk than are those that use them.

When using financial derivatives, however, organizations should be careful to use only those instruments that
they understand and that fit best with their corporate risk-management philosophy. It may be prudent to stay
away from the more exotic instruments, unless the risk/reward tradeoffs are clearly understood by the firm's
senior management and its independent risk-management review team. Exotic contracts should not be used
unless there is some obvious reason for doing so.

Myth Number 8: The Risks Associated with Financial Derivatives Are New and Unknown

The kinds of risks associated with derivatives are no different from those associated with traditional financial
instruments, although they can be far more complex. There are credit risks, operating risks, market risks, and
so on.

Risks from derivatives originate with the customer. With few exceptions, the risks are man-made, that is, they
do not readily appear in nature. For example, when a new homeowner negotiates with a lender to borrow a
sum of money, the customer creates risks by the type of mortgage he chooses--risks to himself and the lending
company. Financial derivatives allow the lending institution to break up those risks and distribute them
around the financial system via secondary markets. Thus, many risks associated with derivatives are actually
created by the dealers' customers or by their customers' customers. Those risks have been inherent in our
nation's financial system since its inception.

Banks and other financial intermediaries should view themselves as risk managers--blending their knowledge
of global financial markets with their clients' needs to help their clients anticipate change and have the
flexibility to pursue opportunities that maximize their success. Banking is inherently a risky business. Risk
permeates much of what banks do. And, for banks to survive, they must be able to understand, measure, and
manage financial risks effectively.

The types of risks faced by corporations today have not changed; rather, they are more complex and
interrelated. The increased complexity and volatility of the financial markets have paved the way for the
growth of numerous financial innovations that can enhance returns relative to risk. But a thorough
understanding of the new financial-engineering tools and their proper integration into a firm's overall risk-
management strategy and corporate philosophy can help turn volatility into profitability.

Risk management is not about the elimination of risk; it is about the management of risk: selectively choosing
those risks an organization is comfortable with and minimizing those that it does not want. Financial
derivatives serve a useful purpose in fulfilling risk-management objectives. Through derivatives, risks from
traditional instruments can be efficiently unbundled and managed independently. Used correctly, derivatives
can save costs and increase returns.

Myth Number 9: Derivatives Link Market Participants More Tightly Together, Thereby Increasing
Systemic Risks

Financial derivative participants can be divided into two groups: end-users and dealers. As end-users, banks
use derivatives to take positions as part of their proprietary trading or for hedging as part of their asset/liability
management. As dealers, banks use derivatives by quoting bids and offers and committing capital to satisfy
customers' needs for managing risk.

In the developmental years of financial derivatives, dealers, for the most part, acted as brokers, finding
counterparties with offsetting requirements. Then dealers began to offer themselves as counterparties to
intermediate customer requirements. Once a position was taken, a dealer immediately either matched it by
entering into an opposing transaction or "warehoused" it--temporarily using the futures market to hedge
unwanted risks--until a match could be found.
Today dealers manage portfolios of derivatives and oversee the net, or residual, risk of their overall position.
That development has changed the focus of risk management from individual transactions to portfolio
exposures and has substantially improved dealers' ability to accommodate a broad spectrum of customer
transactions. Because most active derivatives players today trade on portfolio exposures, it appears that
financial derivatives do not wind markets together any more tightly than do loans. Derivatives players do not
match every trade with an offsetting trade; instead, they continually manage the residual risk of the portfolio.
If a counterparty defaults on a swap, the defaulted party does not turn around and default on some other
counterparty that offset the original transaction. Instead, a derivatives default is very similar to a loan default.
That is why it is important that derivatives players perform with due diligence in determining the financial
strength and default risks of potential counterparties.

For banking supervisors in the United States, probably the most important question today is, What could go
wrong to engender systemic risk--the danger that a failure at a single bank could cause a domino effect,
precipitating a banking crisis? Because financial derivatives allow different risk components to be isolated
and passed around the financial system, those who are willing and able to bear each risk component at the
least cost will become the risk holders. That clearly reduces the overall cost of risk bearing and enhances
economic efficiency.

Furthermore, a major shock that would jolt financial markets in the absence of derivatives would also affect
financial markets in which the use of derivatives was widespread. But because the holders of various risks
would be different, the impact would be different and presumably not as great because the holders of the risks
should be better able to absorb potential losses.

Myth Number 10: Because of the Risks Associated with Derivatives, Banking Regulators Should Ban
Their Use by Any Institution Covered by Federal Deposit Insurance

The problem is not derivatives but the perverse incentives banks have under the current system of federal
deposit guarantees. Deposit insurance and other deposit reforms were first introduced to address some of the
instabilities associated with systemic risk. Through federally guaranteed deposit insurance, the U.S.
government attempted to avoid, by increasing depositor confidence, the experience of deposit runs that
characterized banking crises before the 1930s.

The current deposit guarantee structure has, indeed, reduced the probability of large-scale bank panics, but it
has also created some new problems. Deposit insurance effectively eliminates the discipline provided by the
market mechanism that encourages banks to maintain appropriate capital levels and restrict unnecessary risk
taking. Therefore, banks may wish to pursue higher risk strategies because depositors have a diminished
incentive to monitor banks. Further, federal deposit insurance may actually encourage banks to use derivatives
as speculative instruments to pursue higher risk strategies, instead of to hedge, or as dealers.

Since federal deposit insurance discourages market discipline, regulators have been put in the position of
monitoring banks to ensure that they are managed in a safe and sound manner. Given the present system of
federal deposit guarantees, regulatory proposals involving financial derivatives should focus on market-
oriented reforms as opposed to laws that might eliminate the economic risk-management benefits of
derivatives. [8]

To that end, banking regulators should emphasize more disclosure of derivatives positions in financial
statements and be certain that institutions trading huge derivatives portfolios have adequate capital. In
addition, because derivatives could have implications for the stability of the financial system, it is important
that users maintain sound risk-management practices.

Regulators have issued guidelines that banks with substantial trading or derivatives activity should follow.
Those guidelines include

• active board and senior management oversight of trading activities;

• establishment of an internal risk-management audit function that is independent of the trading

function;

• thorough and timely audits to identify internal control weaknesses; and

• risk-measurement and risk-management information systems that include stress tests, simulations, and
contingency plans for adverse market movements.

It is the responsibility of a bank's senior management to ensure that risks are effectively controlled and limited
to levels that do not pose a serious threat to its capital position. Regulation is an ineffective substitute for
sound risk management at the individual firm level.
 Should My Company Use Derivatives?

Financial derivatives should be considered for inclusion in any corporation's risk-control arsenal. Derivatives
allow for the efficient transfer of financial risks and can help to ensure that value-enhancing opportunities will
not be ignored. Used properly, derivatives can reduce risks and increase returns.

Derivatives also have a dark side. It is important that derivatives players fully understand the complexity of
financial derivatives contracts and the accompanying risks. Users should be certain that the proper safeguards
are built into trading practices and that appropriate incentives are in place so that corporate traders do not take
unnecessary risks.

The use of financial derivatives should be integrated into an organization's overall risk-management strategy
and be in harmony with its broader corporate philosophy and objectives. There is no need to fear financial
derivatives when they are used properly and with the firm's corporate goals as guides.

What Should Regulators Do?

Believing the 10 myths presented here, indeed, believing just one or two of them, could lead one to advocate
legislative and regulatory measures to restrict the use of derivatives. [9] Derivatives-related disasters, such as
the Orange County bankruptcy and the collapse of Barings, have led to questions about the ability of
individual derivatives participants to internally manage their trading operations. In addition, concerns have
surfaced about regulators' ability to detect and control potential derivatives losses.

But regulatory and legislative restrictions on derivatives activities are not the answer, primarily because
simple, standardized rules most likely would only impair banks' ability to manage risk effectively. A better
answer lies in greater reliance on market forces to control derivatives-related risk taking, together with more
emphasis on government supervision, as opposed to regulation.

The burden of managing derivatives activities must rest squarely on trading organizations, not the
government. Such an approach will promote self-regulation and improve organizations' internal controls
through the discipline of market mechanisms. Government guarantees will serve only to strengthen moral-
hazard behavior by derivatives traders.

The best regulations are those that guard against the misuse of derivatives, as opposed to those that severely
restrict, or even ban, their use. Derivatives-related losses can typically be traced to one or more of the
following causes: an overly speculative investment strategy, a misunderstanding of how derivatives reallocate
risk, an ineffective internal risk-management audit function, and the absence of systems that simulate adverse
market movements and help develop contingency solutions. To address those concerns, supervisory reforms
should focus on increasing disclosure of derivatives holdings and the strategies underlying their use,
appropriate capital adequacy standards, and sound risk-management guidelines.

For the most part, however, policymakers should leave derivatives alone. Derivatives have become important
tools that help organizations manage risk exposures. The development of derivatives was brought about by a
need to isolate and hedge against specific risks. Derivatives offer a proven method of breaking risk into
component pieces and managing those components independently. Almost every organization--whether a
corporation, a municipality, or an insured commercial bank--has inherent in its business and marketplace a
unique risk profile that can be better managed through derivatives trading. The freedom to manage risks
effectively must not be taken away.