Financial Derivatives in Bangladesh Perspectives

S.M. Masudur Rahman

Student, MBA, Finance Department , University Of Rajshahi.
Email. bablahru2018@gmail.com
Abstract
Financial Derivative is used to shift the risk. Gradually derivatives use broadly raised . Many
articles has been written on this topic nationally and internationally. In this article, mainly
focused on Bangladeshi issues for derivative as still has not derivative market in Bangladesh. In
Bangladesh , there have many sectors like, national Fruits, Flower plantation, Fishery, Cotton etc
which are very potential for derivative market. As we know derivative market firstly main focus
was on domestic product. As well as , In capital market of Bangladesh has a great opportunity to
use of derivative instrument through which investor can shift their risk to others. In this paper is
also focus on the importance of derivative market in Bangladesh. And finally give some
essential recommendation for derivative market of Bangladesh .

In this study, Firstly, we provided introduction of derivative market. Secondly, showed the
literature review. Thirdly theoretical aspects of derivatives .Fourthly, Derivatives in Bangladesh
perspectives (how to establishment of financial derivative market in Bangladesh, analyze the
potential benefits & barrier of the establishment of a financial derivative market in Bangladesh ,
derivatives of other countries and its growth and it takes assess for Bangladesh) . And gradually
come several importance topic and finally conclusion remark.
Key Words : Financial derivative market, Forward contract, Future contract, Option contract,
Swap contract, underlying instruments; derivative instruments; functions of financial market,
players of market.

1.Introduction :

It is widely believed in financial world that the most significant milestone in financial
innovation is achieved with the issuance and trading of derivatives. Along with this positive
element, the proponents of derivatives also admit that this term arouses more controversies and
most people look at them with suspicion and few would believe that they do contribute to the
society’s welfare. But the matter of fact is that derivatives are a standard risk management tool
that enables risk-sharing and facilitates the efficient allocation of capital to productive
investment activities. Derivatives are the most actively traded financial instruments for ensuring
efficiency and depth of capital market. Establishment of a financial derivative market improves
the capital structure and profit making ability of commercial banks. Hedgers can easily use
derivative as safeguard against the risks associated with their assets. Derivative market can play
a pivotal role to strengthen the effect of monetary policy and absorb the foreign capital into a
country as it helps bring stability in the overall financial markets. After the catastrophic fall of
capital market of Bangladesh in 2010, it hasn’t yet recovered yet; causing rapid decline of FDI
and scarcity of innovative and versatile financial products .As derivative securities are prevailing
in Bangladesh, the establishment of financial derivative market may be a proper decision for the
country.

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2.0 Literature Review
Md. Habibur Rahman1, Bijoy Chandra Das (2015), In this article , They have been tried to
explain in detail the theoretical framework of various types of derivative and their potential
usage in strengthening capital market, capital structure of commercial banks, against the
fluctuation of major import(petroleum) and export(RMG) sectors, and thus turning Bangladesh
economy into a strong global one.
Saif Rahman1 and M. Kabir Hassan2, (2011), They have provided clear examples of how
derivative securities can strengthen capital market of Bangladesh, both in terms of risk mitigation
and creating alterative investment vehicles as well as reduce burden on our major import and
export sectors. Furthermore, we have also looked into the prerequisite of setting up a derivative
markets in Bangladesh and provided a clear roadmap. In view of recent turmoil in the equity
markets, we need to be circumspect and foresighted in our approach; a standardized exchange
traded derivative market with phase-by-phase introduction of product has been recommended.

Ashutosh Vashishtha & Satish Kumar(2010). They showed that in India the emergence and
growth of derivatives market is relatively a recent phenomenon. Since its inception in June 2000,
derivatives market has exhibited exponential growth both in terms of volume and number of
traded contracts. The market turn-over has grown from Rs.2365 crore in 2000-2001 to Rs.
11010482.20 crore in 2008-2009. Within a short span of eight years, derivatives trading in
India has surpassed cash segment in terms of turnover and number of traded contracts. The
present study encompasses in its scope an analysis of historical roots of derivative trading,
types of derivative products, regulation and policy developments, trend and growth, future
prospects and challenges of derivative market in India.

Dr. Shree Bhagwat, Ritesh More & Deepak Chand (2012), In this article they tried to draw In
India, the emergence and growth of derivatives market is relatively a recent phenomenon. Since
its inception in June 2000, derivatives market has exhibited exponential growth both in terms of
volume and number of contract traded. The market turnover has grown from Rs.2365 Cr. in
2000-2001 to Rs.16807782.22 Cr. in 2012-13. Within a short span of twelve years, derivatives
trading in India has surpassed cash segment in terms of turnover and number of traded contracts.

Li Tian(2005). This article objective is to establish derivative market will improve the capital
structure and profit-making ability of our commercial banks, strengthen the effect of our
monetary policies and absorb more international capital into our country, thus accelerating
Chinese economy’s future growth.

Gordon de Brouwer(2002). In this paper, he focus on that s there is a clear role for regional
cooperation among policymakers in building capacity in, and links between, financial markets in
East Asia, as well as in encouraging stable speculation and the participation of nonresident and
institutional investors in domestic financial markets. ASEAN+3 is an important and welcome
advance in regional cooperation, but its membership does not span the depth of experience in
financial markets and institutions that exists in East Asia.

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Eli M. Remolona (1992-1993). This article identifies four developments giving rise to such
demands: sustained shifts and temporary surges in market volatility, the emergence of important
but relatively illiquid cash markets for government bonds, new inducements for financial
institutions and nonfinancial firms to deal with interest rate risks, and the international
diversification of institutional equity portfolios.

Ayrin Sultana1, Abu Sayed Mohammod Nazmul Haque2, Mohammad Jashim Uddin3(2014).
The paper explains the essence of derivatives and identifies the different types of that exist. The
article examines the technologies of credit derivatives application in the financial markets,
especially the most common ones, credit default swaps. Both positive and negative aspects of
their application to risk management have been revealed. And this paper briefly explains how
derivative activity level can be monitored and then takes a look at the benefits, risks and
opportunities of derivative in Bangladesh.

Donald Lien and Mei Zhang(2008). This paper summarizes theoretical and empirical research on
the roles and functions of emerging derivatives markets and the resulting implications on policy
and regulations. He showed , There is a consensus that derivatives are seldom the cause of a
financial crisis but they could amplify the negative effects of the crisis and accelerate contagion .
Empirical results from a few emerging countries suggest a price discovery function of emerging
futures markets. The findings on the price stabilization function of emerging derivatives markets
are mixed. Finally, recent research has documented that constructive development of derivatives
markets in emerging market economies needs to be supported by sound macroeconomic
fundamentals as well as updated financial policies and regulations.

3. 0 Theoretical analysis.
3.1 What is Derivative?
The Oxford dictionary defines a derivative as something derived or obtained from another,
coming from a source; not original. In the field of financial economics, a derivative security is
generally referred to a financial contract whose value is derived from the value of an underlying
asset. A derivative derives its value from the value of some other financial asset or variable.
D.G. Gardener defined the derivatives as “A derivative is a financial product which has been
derived from market for another product”. For example, a stock option is a derivative that
derives its value from the value of a stock. An interest rate swap is a derivative because it derives
its value from an interest rate index. The asset from which a derivative derives its value is
referred as the underlying asset. The price of a derivative rises and falls in accordance with the
value of the underlying asset. Key points to remember about derivative:

 Derivatives are contracts between buyers and sellers.

 They are referred as "wasting" assets because they have a defined and limited life with a
set initiation and expiration date. The value of a derivative decreases as it gets closer to
the expiration date.
 Generally, payoff is determined or made at the expiration date, although this is not true in
all cases.
 Sometimes no money is exchanged at the beginning of the contract.

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3.2 Underlying asset in a derivatives contract
As defined above, its value is entirely derived from the value of the underlying asset. The
underlying asset can be securities, commodities, bullion, currency, livestock or anything else. In
other way the underlying asset may assume many forms:
(i) Commodities including grain, coffee beans, orange juice;
(ii) Precious metals like gold & silver;
(iii) Foreign exchange rates or currencies;
(iv) Bonds of different types, including medium to long term negotiable debt, securities issued by
governments, companies etc;
(v) Shares and share warrants of companies traded on recognized stock exchanges and stock
index;
(vi) Short term securities such as T-bills;
(vii) Over the counter (OTC) money market products such as loans or deposits.

3.3 Uses of financial derivatives

Derivatives are generally used to hedge risk, but it can also be used for speculative purposes.
And its have some other uses that are followed
1.Management of risk : One of the most important services provided by the derivatives is to
control, avoid, shift and manage efficiently different types of risk through various strategies like
hedging, arbitraging, spreading etc. Derivative assist the holders to shift or modify suitable the
risk characteristics of the portfolios. These are specifically useful in highly volatile financial
conditions like erratic trading, highly flexible interest rates, volatile exchange rates and monetary
chaos. .

2.Measurement of Market: Derivatives serve as the barometers of the future trends in price
which result in the discovery of new prices both on the spot and future markets. They help in
disseminating different information regarding the future markets trading of various commodities
and securities to the society which enable to discover or form suitable or correct or true
equilibrium price in the markets. As a result, they assets in appropriate and superior allocation of
resources in the society.
3. Efficiency in trading: Financial derivatives allow for free trading of risk components and that
leads to improving market efficiency. Traders can use a position in one or more financial
derivatives as a substitute for a position in underlying instruments. In many instances, traders
find financial derivatives to be a more attractive instrument than the underlying security. This is
mainly because of the greater amount of liquidity in the market offered by derivatives as well as
the lower transaction costs associated with trading a financial derivative as compared to the costs
of trading the underlying instruments in cash market.

4. Price discovery : The important application of financial derivatives is the price discovery
which means revealing information about future cash market prices through the future market.
Derivative markets provide a mechanism by which diverse and scattered opinions of future are
collected into one readily discernible number which provides a consensus of knowledgeable
thinking.

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5. Hedging : Hedge or mitigate risk in the underlying, by entering into a derivative contract
whose value moves in the opposite direction to their underlying position and cancels part or all
of it out. Hedging also occurs when an individual or institution buys an asset and sells it using a
future contract.

6. Price stabilization function : Derivative market helps to keep a stabilizing influences on spot
prices by reducing the short term fluctuations. In other words, derivatives reduces both peak and
depths and lends to price stabilization effect in the cash market for underlying asset.

7. Develop the complete markets : It is observed that derivative trading develop the market
towards “complete markets” complete market concept refers to that situation where no particular
investors be better of than others, or patterns of returns of all additional securities are spanned by
the already existing securities in it, or there is no further scope of additional security.

8. Encourage competition : The derivatives trading encourage the competitive trading in the
market, different risk taking preference at market operators like speculators, hedgers, traders,
arbitrageurs etc. resulting in increase in trading volume in the country. They also attract young
investors, professionals and other experts who will act as catalysts to the growth of financial
market.

9. Liquidity and reduce transaction cost : As we see that in derivatives trading no immediate
full amount of the transaction is required since most of them are based on margin trading. As a
result, large number of traders, speculators, arbitrageurs operates in such markets. So, derivatives
trading enhance liquidity and reduce transaction cost in the markets of underlying assets.

3.4 The major players of Derivatives Market.

There are three major players in the financial derivatives trading:

1. Hedgers: Hedgers are traders who use derivatives to reduce the risk that they face from
potential movements in a market variable and they want to avoid exposure to adverse movements
in the price of an asset. Majority of the participants in derivatives market belongs to this
category.

2. Speculators: Speculators are traders who buy/sell the assets only to sell/buy them back
profitably at a later point in time. They want to assume risk. They use derivatives to bet on the
future direction of the price of an asset and take a position in order to make a quick profit. They
can increase both the potential gains and potential losses by usage of derivatives in a speculative
venture.

3. Arbitrageurs: Arbitrageurs are traders who simultaneously buy and sell the same (or
different, but related) assets in an effort to profit from unrealistic price differentials. They
attempts to make profits by locking in a riskless trading by simultaneously entering into
transaction in two or more markets. They try to earn riskless profit from discrepancies between
futures and spot prices and among different futures prices.

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3.5 Types and classification of derivatives
There are many ways in which the derivatives can be categorized based on the markets where
they trade, based on the underlying asset and based on the product feather etc. some ways of
classification are following:

(1) On the basis of financial and non-financial: On the basis of this classification the
derivatives can be classified into two category namely financial derivatives and non-financial
derivatives.

(a) Financial derivatives: Those derivatives which are of financial nature are called financial
derivatives. They are following:
(i) Forwards
(ii) Futures
(iii) Options
(iv) Swaps
The above financial derivatives may be credit derivatives, forex, currency fixed-income, interest,
insider trading and exchange traded.
(b) Non-financial derivatives: Those derivatives which are not of financial nature are called
non-financial derivatives. They are following:
(i) Commodities
(ii) Metals
(iii) Weather
(iv) Others

(2) On the basis of market where they trade : On the basis of this classification, the
derivatives can be classified into three categories namely; OTC traded derivatives, exchange-
traded derivative and common derivative.

(a) Over-the-counter (OTC) traded derivative : These derivative contracts are traded (and
privately negotiated) directly between two parties, without going through an exchange or other
intermediary. The OTC derivative market is the largest market for derivatives and largely
unregulated with respect to disclosure of information between parties. They are following: (i)
Swaps
(ii) Forward rate agreements
(iii) Exotic options
(iv) Other exotic derivative

(b) Exchange traded derivative: Those derivatives instrument that are traded via specialized
derivatives exchange of other exchange. A derivatives exchange is a market where individual
trade standardized contracts that have been defined by the exchange. A derivative exchange act
as an intermediary to all related transactions and takes initial margin from both sides of the trade
to act as a guarantee. They may be followings:
(i) Futures
(ii) Options

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(iii) Interest rate
(iv) Index product
(v) Convertible
(vi) Warrants

3.5 .1 Forward Contract

The forward contract is relatively simple derivative - it is an agreement between two parties to
buy or sell an asset at a certain future time at a certain price. The party that has agreed to buy has
a long position while the party that has agreed
to sell has a short position. The forward contracts are normally traded Over-the-Counter (OTC)
are not dealt with on an exchange. This agreement puts an obligation to both counterparts to
fulfill their contracts at the specified time. This is basically a contract between two (or more)
parties who agree to engage in a transaction at a later date and at a specific price, which is given
at the start of the contract.
It is contract for delivering the goods. These transactions are spot transactions. It is also known
as “specific delivery contract”. One of the parties to a forward contract assumes a long position
(buyer) and agrees to buy the underlying asset at a certain future date for a certain price. The
other party to the contract known as seller assumes a short position and agrees to sell the asset on
the same date for the same price. The specified price is referred to as the deliver price.
The basic features of a contract are given in brief here as under:
1. Forward contracts are bilateral contracts, and hence, they are exposed to the counter party
risk. There is risk of non-performance of obligation either of the parties, so these are
riskier than to futures contracts.
2. Each contract is custom designed, and hence, is unique in terms of contract size,
expiration date, the asset type, quality etc.
3. In forward contract, one of the parties takes a long position by agreeing to buy the asset
at a certain specified future date. The other party assumes a short position by agreeing to
sell the same asset at the same date for the same specified price.

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 4. In the forward contract, derivative asset can often be contracted from the combination of
underlying assets; such assets are often known as synthetic assets in the forward market.
5. In a forward contract, covered party or cost of carry relations are relation between the
prices of forward and underlying assets. Forward contract are very popular in foreign
exchange market as well as interest rate bearing instruments.
Virtually all large MNCs use forward contracts. These contracts normally are not used by
consumers or small firms. In cases when a bank does not know corporation well or fully trust it,
the bank may request that the corporation make an initial deposit to assure that it will fulfill its
obligation. Such a deposit is called a compensating balance and typically does not pay interest.
The most common forward contracts are for 30, 60, 90, 180, and 360 days.

Payoffs from Forward Contracts

In general, the payoff from a long position in a forward contract on one unit of an asset is=St-K
Where (St) is the spot price of the asset at maturity of the contract and (K) is the delivery price.

3.5 .2 Future Contract

Like a forward contract, a futures contract is an agreement to buy or sell an asset at a certain time
in the future for a certain price. However, unlike forward contracts, Future contracts are normally
traded on an exchange. To make trading possible, the exchange specifies certain standardized
features of the contract. As the two parties do not necessarily know each other, the exchange also
provides a mechanism that gives the two parties a guarantee that the contract will be honored
(Hull, 2006). The largest exchanges on which futures are traded include the Chicago Board of
Trade (CBOT), the Chicago Mercantile Exchange (CME) and the South Africa Futures
Exchange (SAFEX).

The features of a futures contract may be specified as follows:

1. Futures are traded only in organized exchanges.
2. Futures contract required to have standard contract terms.
3. Futures exchange has associated with clearing house.
4. Futures trading required margin payment and daily settlement.
5. Futures positions can be closed easily.
6. Futures markets are regulated by regulatory authorities like SEBI.
7. The futures contracts are executed on expiry date.
8. The futures prices are expressed in currency units, with a minimum price movement called a
tick size.

The quality of positive economic theory explains about its ability with precision clarity and
simplicity. The main characteristics of futures explained by a good economic theory are as
follows:
1. There is a limited number of actively traded products with futures contracts.
2. The trading unit is large and indivisible.
3. It has no more than maturity of 3 months.
4. The success ratio of new contract is about 25% in the world financial markets.
5. Futures are seldom used by farmers.

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6. There are both commercial and non-commercial users of futures contract in interest rates and
foreign exchange.
7. The main use of the future by the commercial users is to hedge corresponding cash and
forward positions.
8. The positions of the non-commercial users almost entirely speculative positions.

The followings are the important types of financial futures contract:

1. Stock future or equity futures
2. Stock index futures .

3.5 .3 Options contract

Options are derivative contract that give the right, but not the obligation to either buy or sell a
specific underlying security for a specified price on or before a specific date. The person who
buys an option is normally called the buyer or holder. Conversely, the seller is known as the
seller or writer. Again we can say “An option is a particular type of a contract between two
parties where one person gives the other person the right to buy or sell a specific asset at a
specified price within a specified time period.”
The main characteristics of options are following:
1. Options holders do not receive any dividend or interest.
2. Option yield only capital gains.
3. Options holder can enjoy a tax advantages.
4. Options are traded on OTC and in all recognized stock exchanges.
5. Options holders can control their rights on the underlying assets.
6. Options create the possibility of gaining a windfall profit.
7. Options holder can enjoy a much wider risk-return combinations.
8. Options can reduce the total portfolio transaction costs.etc

Options are traded both on an organized exchange and in the OTC market. There are two basic
types of options such as; call options and put options. Actually the basic difference among the
options and the two other derivative explained above is that, in case of options the holders have
rights to exercise but in case of forwards and futures they have obligations to do that. A call
option gives the holder the right to buy the underlying asset at a certain date for a certain price,
specified on the date of making the contract. The party with the long position (buyer) has the
ability to exercise the contract or not. A put option gives the holder the right to sell the
underlying asset by a certain date for a certain price, also specified on the date of making the
contract. The party with the short position (seller) has the obligation to
exercise the contract if asked to do so. The date specified in the contract is known as the
expiration date or the maturity date. The price specified in the contract is the exercise price or the
strike price. Options(Hull, 2006).

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3.5 .4 Swap Contracts.
A swap is an agreement between two parties to exchange cash flows in the future. The agreement
defines the dates when the cash flows will be paid. The cash flows are calculated over a notional
principal amount, which is not usually exchanged between counterparties (Hull, 2006). Examples
of swaps are currency swaps, interest rate swaps and commodity swaps. An interest rate swap is
an agreement between two parties to exchange interest obligations or receipts in the same
currency on an agreed amount of notional principal for an agreed period of time. A currency
swap is an agreement between two parties to exchange payments or receipts in one currency for
payments in another. Commodity swaps are hedging instruments; one party (commodity
user/buyer) agrees to pay a fixed price for a designated quantity of a commodity to the counter
party (commodity producer/seller), who in turn pays the first party a price based on the
prevailing market price for the same quantity (Daniel Ekerumeh,2010).
On the other hand the derivative markets can be divided into two that for exchange traded
derivative and that for over the- counter derivative. The legal nature of these products is very
different as well as the way they are trade. Some common examples of these derivatives are the
followings:

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4.0 Derivatives scenario of Bangladesh
Bangladesh has not any formal or organized derivatives markets. This derivative market is very
needed for Bangladesh we will talk about that in why needed derivative market in Bangladesh
But in Bangladesh has done derivative transaction regularly under subconsciously that we don’t
know . Now we will talk about some of that transactions.

4.1 Derivatives in Some national Fruits ( Mango, Litchi, Jackfruit etc)

In Bangladesh in summer times get some special fruits like Mango, Litchi, Jackfruit etc mainly
and in winter season get plum orange etc. Very interesting fact is before this seasons to come the
owner of that fruits give lease to the other party who are the buyer or business man. The owner
does it because he want to shift the risk of unfavorable situation against of this fruits . In the
time of the maturity of this fruits it faces many unfavorable factors like storms, chance to steal
of this fruits , decrease the prices of this fruits , decrease the demand of this fruits , import from
other country etc . This problems will fall the owner under loss . For avoiding this situation or
loss the owner of the fruits give lease of those .

As this transaction occur before the strike time with party . At the time of the leasing before the
actual season the owner lock the price through the leasing contract and the owner will not take
any risk after that . When the fruit will mature and then price of those fruits are higher than the
lock price then owner face loss and if price below the locking price then the owner will face
profit . As the owner lock the price then he would not take any risk that’s mean he shifts his risk
that’s time .

This is actually derivative transaction on fruits or physical goods. And we know derivative
mainly work for shifting the risk above we can see the owner of the fruits shifts the risk through
the leasing of this. We can say as a example of our Rajshai University campus Mango tree ,
Litchi tree . The administration give lease these tree before getting fruits at a certain rate .through
this lease administration avoid different risk of that fruits like student will eat the fruits , different
natural problem fruits will come good or not etc .Administration get benefits of that before
contract . So on this national fruits in our country available the derivative . That’s in front of our
open eyes.

4.2 Derivatives in Flower plantation

In our country produce different kinds flower likes Rose, Carnation Sunflower, Daffodil etc . As
the climate of Bangladesh specially in Jeshore very useful f lower plantation . we know flower is
very demandable in our country and worldwide also . Flower is very sensitive . As in Bangladesh
sometimes affect by the various natural calamity that’s very harmful for flower . Price of flower
high and volatile also .

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 So thing is the flower producer face these kinds of problems for this generally the flower
producer before getting the bloom of flower he give lease of his land of flower plant to other
party who are ready to get and who know and have assessment about future . Through this
contract the flower plant owner shifts his risk to the others. So here the derivative of the flower is
natural calamity , price and thief of the flower. So through this lease contract get benefits of
avoiding risk . But in selling time of flower if has not occurred any unfavorable situation then
price will be raise than the locking price then the owner face loss but if price will lower than the
locking price then the owner face profit . But the flower plant owner shifts his risk of the flower.

So we can see here in our flower plantation available the derivative .But for this trading we have
not any formal market that we can see easily . but these trading occur face to face . And after
specific time the buyer give the owner the locking price whether he face loss or profit .

In flower plantation we use derivative for shifting the risk . This derivative available in our
Bangladesh . Its use very frequently in this plantation and the owner become encourage to
produce flower more as the need not to take risk at all and contribute on country economy .This
flower also export outside of Bangladesh also . Flower leasing transaction in Jeshore “Godagari”

Year Tk. Year Tk

2017 5.10cr 2018 7.cr

4.3 Derivatives in Fishery in Bangladesh

In Bangladesh, Fishing contribute on economy largely through export or trade within country .
Most of fishes come from Khulna , Shatkhira ,Bagerhat etc. Especially these places produce
different kind of fishes like Magor/Shing, Common carp, Grass carp , Kalibaus ,Katla ,Koi,
Pangas , Rui // Rohu ,Silver carp ,Telapia etc. For making high profit on fishing their have a
good reason that is the fishery owner can avoid the risk regarding the fish and fishery like
natural calamity, Volatility price of fish, Volatility import and export of fish etc .

We need to know how the fishery owner avoid the risk . Their have a good technique that apply
. That is leasing the fishery to the other party . when the fishery give lease then trough this
contract they fix or lock the price of fishes . After specific time the buyer party pay the amount
that was fixed. When the fishery enter into the contract from than the owner will not take the
above risk he will just will take the specific amount after specific time. So through this leasing
contract the owner shifts his risks to other party. From this opportunity the owner get
encouragement to produce more the fishes. But thing is here after specific time when the amount
of money will be paid that’s if the price of fishes above the lock price then the owner will
realize loss(buyer party will realize the profit ) or if the prices will below the lock price then the
owner will realize the profit ( the buyer party will realize the loss).

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However in Bangladesh regularly in Fishery occur this kind of transaction that’s we can say
derivative transaction that we can not realize but it is. So through this derivative make very
helpful to develop this side for development .

Division wise Fish production

This is the total fish production that largely contribute on our economy . That’s mostly done by
leasing contract as it help the fishery owner shifts the risk. This is work likely derivatives.

4.4 Derivatives in Cotton In Bangladesh

In Bangladesh RMG sector play big role in economy . This RMG sector need cotton as a raw
martial .This cotton also use in “Tat shilpo” to produce Langue , Shari ,Towel etc. In this cotton
production also use derivative as risk shifter . How it is work here right . in this cotton
production producer may face many problems that may affect the value if the cotton in future
like natural calamity , price volatility, demand of cotton and import the cotton etc . these reasons
are called underling factor that may affect the price. So producer want to shift the risk. Cotton
producer give lease his land for producing cotton and lock the price for specific time .After
specific time the producer will receive that locking money and the producer will not take any
kind of risk of that contact all risk will bear the contractual party . But thing is here the producer
may face loss if the strike price of that cotton will be higher than the locking price or the
producer will face profit if the strike price of the cotton will be lower than the locking price.

Cotton produce in our country and the producer get braveness to produce more as they can
easily shifts the risk regarding the cotton production also .

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5.0 Emerging Derivative Markets

5.1 Recent growth in Asia-Pacific

The Asia-Pacific has overtaken North America as the world’s biggest derivatives market amid
increasing demand for futures and options contracts in the region’s fast-growing economies.
According to Washington-based Futures Industry Association (FIA), Derivatives contracts traded
in Asia-Pacific accounted for 38 percent of the global total in the six months to June 2010, while
North America stands at 33percent.

Below exhibits shows global derivative volume by region and percentage change for first six
month of both year 2009 and 2010 and Asia Pacific region now the largest in terms of volume.

5.2 The size and structure of derivatives markets in EMEs

According to BIS Quarterly Review (Dec 2010), daily turnover in derivatives in of Emerging
Market Economics (EME) has expanded four times over the past decade, to over 6% of emerging
market GDP7. The derivatives in emerging markets are traded in almost equal proportions over
the counter and on exchanges and unlike in advanced economies, Foreign Exchange derivatives
are still the most traded derivatives in EMEs (50% of total turnover), while interest rate
derivatives remain underdeveloped (probably due to pegged interest rates).
Average daily turnover of derivatives in EMEs was $1.2 trillion in April 2010 (6.2% of those
economies’ GDP), compared to $13.8 trillion (36% of GDP) in advanced economies. However,
the small derivatives markets in EMEs have expanded rapidly with an average daily turnover
increase of 300% since 2001, and 25% over the past three years, despite the crisis in 2008–09
(Exhibit 2, left-hand panel)8. This was higher than the growth of turnover in advanced
economies (250% since 2001, and 22% since 2007).

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OTC foreign exchange derivatives
The turnover of OTC foreign exchange derivatives in EMEs – $535 billion per day in April 2010
(Table 1) – increased 24% between 2007 and 2010. This represents a slowdown compared to the
previous three-year period, when turnover almost doubled, but was much faster than the growth
in advanced economies (just 5.6%). No doubt the recent financial crisis has taken some of the
shine off the use of OTC foreign currency derivatives in advanced economies, particularly FX
swap markets, where growth over the entire three year period was only 0.3%. At the same time,
the financial crisis had a relatively small impact on FX derivatives markets in emerging market
economies.

15
OTC interest rate derivatives
The interest rate derivatives markets in EMEs are much smaller than the FX markets, with total
daily turnover of $90 billion in April 2010 (Table 3). In sharp contrast to the FX derivatives
market, turnover of interest rate derivatives decreased by 8% since 2007. Meanwhile, in
advanced economies interest rate derivatives turnover increased by 24%. Note, however, that the
decrease in turnover in emerging markets represents one exceptional case rather than a trend – a
major dealer, which accounted for 40–50% of interest rate derivatives trading in emerging Asia
in 2007, shifted its trading desk out of the region during the crisis. Net of trades by that desk,
turnover of interest rate derivatives in emerging markets nearly tripled, which compares with
growth in the previous three-year period.

16
5.3 Driving factors for growth of derivative market (Globally and in Asia)

First, an intrinsic characteristic of derivatives instruments is that they are designed to transfer
risk, whereas equity or fixed income securities are designed to be an explicit claim on the stream
of cash flows generated from the ownership of a financial asset in a certain jurisdiction. Traders
trading in derivatives markets form expectations about underlying asset prices and are better
placed to manage the risks.

The second driver is the rate of development of financial innovations and new derivatives
instruments. Advances in information technology, coupled with financial institutions’ drive to
enhance returns and expand their global reach, have facilitated the financial intermediaries (and,
to some extent, their clients, particularly hedge funds) to continuously introduce and/or embrace
new derivatives instruments and advances in risk-management techniques.

The main & final driving factors for derivative markets in various economies of Asia have been
the immense benefits from risk sharing in more complete capital markets, corporate demand for
hedging tools, institutional needs for enhanced liquidity in an environment of large cross-border
flows and trade integration, as well as rapidly declining transaction costs in electronic trading. At
present, most of the derivative markets in Asia offer multiple products for different user
requirement associated with price changes.

17
Finally, equity derivatives have usually reduced volatility and strengthened liquidity in equity
markets, enhanced returns to institutional investors such as mutual or pension funds, and reduced
the cost of equity listings for firms.

5.4 Indian derivative markets – a roadmap for future derivative emerging markets.

India over the years has developed a robust derivatives market. In the year 2000, National Stock
Exchange (NSE) started its operation in derivatives contracts and introduced futures contracts on
the Nifty and Sensex index. This was followed by Options contracts on Nifty and Sensex
(European Style), Option contracts on stocks (American style) and Futures contracts on stocks in
June, July and November 2001, respectively.

Derivatives in India : A chronology

18
The number of underlying stocks and indexes has increased over the years (Exhibit 4)

Since its inception, the derivative markets in India (Both NSE and BSE) have experienced steady
growth in Turnover. During 2001-02, turnover on NSE was Rs. 1019,250 million and during
2007-08 it was Rs. 130,904,780 million. Likewise, during 2001-02, turnover on BSE was Rs.
19,170 million and during 2007-08 it was Rs. 2423,080 million (Exhibit 5).

19
Regulation of Derivatives trading in India

The regulatory frame work in India is based on L.C. Gupta Committee report and J.R. Varma
Committee report. It is mostly consistent with the international organization of securities
commission (IUSCO). The L.C. Gupta Committee report provides a perspective on division of
regulatory responsibility between the exchange and SEBI. It recommends that SEBI’s role
should be restricted to approving rules, bye laws and regulations of a derivatives exchange as
also to approving the proposed derivatives contracts before commencement of their trading. It
emphasizes the supervisory and advisory role of SEBI. It also suggests establishment of a
separate clearing corporation.

5.5 Failure of derivative market – Lessons from China

China experienced major obstacles in the early 1990s and closed out 27 of its 30 exchanges, and
currently only allows commodity future trading which is expanding rapidly. During early 1990s,
the Shanghai Stock Exchange and Shenzhen Stock Exchanges traded bond futures in very high
volumes. Unfortunately, risk management procedures were not very adequate – margins were as
little as one per cent of contract price in early 1995. This situation became acute when a scandal
involving chaotic trading of bond futures contracts in the Shanghai Stock Exchange. The
Shanghai derivatives failure has been a lesson for exchanges. In order to develop a strong
derivative market there has to be a strong and liquid money market where the volatility of a well

20
designed derivative is within acceptable limits. There has to be transparent legal and regulatory
structures which must guide market participants and well established clearing house mechanism
to ensure negligible counter party risk. Finally, if market elements are not market determined
then derivative markets can create systematic risk. If macro factors of any economy are
artificially restricted, derivative markets will not flourish.

6.0 For establishment derivative in Bangladesh building blocks for a Well-

Functioning Derivatives Market.
The derivatives market is very dynamic and has rapidly developed into the most important
segment of the financial market. Whether access to derivative market is through a specific
exchange or over-the-counter, derivative markets add substantial value to institutional or retail
investors or corporate stakeholders. Due to this rapid growth of derivative markets, there has
been consistent research by academics and policy makers in determining a set of prerequisites for
developing new market for derivative securities.

6.1 Economic rationale of a derivative market

Derivatives accomplish a critical economic need by facilitating risk management, and enabling
price discovery. Price discovery occurs when an asset is traded and new information about its
value is incorporated into its price. The economic benefits that organized derivatives exchanges
provide in developed countries are well documented. In one such significant article, Peck (1985)
demonstrates both theoretically and empirically the direct impact futures markets have on
commodity prices, and their indirect impact on production, consumption and storage decisions.
She also provides empirical evidence that seasonal and annual commodity prices are more stable
in economies with futures markets. Her results demonstrate that futures markets fulfill an
economic role by decreasing price volatility. Silber (1985) provides a sound explanation for the
economic contribution of financial futures and indicates that increased liquidity and risk
reduction facilities available to portfolio managers and other investors reduce the cost of capital
to businesses, which ultimately translates into greater capital formation for the economy as a
whole. Baluch and Ariff (2007) studied 11 countries, including 5 developed and 6 emerging
markets, and their derivative exchanges to empirically test the economic contribution of
derivative markets in the development process of countries, both developed and emerging.

6.2 Reason for concern

However, derivatives have its fair share of criticism. Some analysts have even called derivative
as “Destructive”. Recent subprime mortgage crisis is an example how over exposure in security
and derivative market without substantial collateral can lead to a chain of global havoc. Concerns
arise especially in the areas of accounting and transparency and in presence of appetite for higher
leverage and speculation, lack of corporate governance, as well as on counterparty and potential
systemic risks in unregulated markets. These concerns are valid but can be successfully
eradicated with an appropriate legal and regulatory environment and a sound market
infrastructure.

21
6.3 Prerequisite of a derivative market

Research pertaining to launching derivatives exchanges in emerging markets consists primarily

of country specific feasibility reports or study conducted by using different emerging markets as
model. Such studies have been performed on countries such as Korea, India, Pakistan, Malaysia
and Turkey. However, a limited number of empirical studies, which generally focus on one
specific derivatives contract, exist. Bricheux, Savre and Tachon (1992) describe the important
factors for developing a successful futures contract and future market:

(i) Conditions for creating a futures market (legal, regulatory, political and economic).

(ii) Conditions for creating a futures contract (price volatility, underlying asset's risk, large cash
market, maturity of the spot market, and existence as well as involvement of dealer community).

(iii) Conditions for futures contract success (futures market environment, well-designed contract,
and exchange perseverance).

Fratzscher (2006) identified three critical policy issues that need to be carefully considered
before derivatives markets can be successfully developed: (i) a deep liquid cash markets
supported by market determined prices, (ii) how much regulation is needed in OTC and ETD
derivative markets; and (iii) what infrastructure is necessary. Market participants, policy makers
and regulators should support each-other to ensure these prerequisites are satisfied.

The next major requirement for a sound derivative market is stringent regulation to monitor and
ensure the credibility and efficiency of derivative markets. There must be sound risk
management mechanisms in place to ensure depositors are protected in financial distress and
integrity of the payment systems need to be secured to ensure transparency and efficient
transaction processing. Hedging is a pivotal practice in derivatives market, it at its core deals
with risk minimization to attract investments which has played a vital role in the recent
popularity of derivatives in financial markets, emerging economies promote derivatives and the
risk free side of it to create stability in their markets and enable it to grow.

However in a country like Bangladesh dominated by naïve investors with limited knowledge of
global investment products, along with improving governance of market participants and for self
regulation of the exchanges, there must be vigilant regulatory oversight over derivatives to
maintain financial stability.

Fratzscher (2006) emphasized on three additional considerations that regulators have to weigh in
order to establish an even playing field for derivative markets: First, an adequate legal
framework for enforcement and the adoption of IFRS accounting rules (incl. IAS 39) are critical

22
prerequisites for sound derivative markets. Second, capital rules for banks operating in OTC
derivative markets need to be aligned with margin rules that are effective in ETD derivative
markets.

Finally, the single most important risk management tool for derivative markets is to reduce
exposure through close-out netting arrangements, ideally with a central counterparty (CCP). The
most common means of mitigating counterparty risk are netting and collateralization of
counterparty risk exposures. In the OTC segment, these lead to the theoretic regulatory capital
required being reduced by around 70 percent11.

Based on information of major exchanges of Asia, Fratzscher (2006) determined an index of

major infrastructure requirements for a derivative market (Exhibit 6). Surprisingly, there appears
to be a strong correlation between existing derivatives products in Asia we found-out in Exhibit
3 as markets with adequate infrastructure have experienced higher growth in turnover and
product line.

23
 7.0 The efficiency of markets and derivatives:
The array of derivative products that has been developed in recent years has enhanced economic
efficiency. Derivatives have become an integral part of the financial system in the world's
leading economies. “Efficient markets lead to tighter bid-ask spreads, higher volumes of trading,
and greater market liquidity. In an efficient market, all information relevant for determining the
value of a product is reflected in the current market price. Financial derivative represent some of
the basic tools necessary in the mechanics of efficient capital markets. if an economy wants to
cope with the so much changing competitive world, it should think about the financial stability,
risks sharing and market efficiency; here introduction of derivative market may be proven as
vital decision. Derivative help to improve market efficiencies in various ways such as by
reducing the risk for farmers, oil companies, interest rate risk for banks.

Li Tian (2005) in his article named “Research on necessity of the establishment of financial
derivative market in China”, described some key facts that indicated the crucial need of
derivative market for the financial stability and economic growth.

7.1 Establishment of Financial Derivative Market for Strengthening Financial

Market Functions

A deep financial market is considered as a nucleus of an economy. It is a matter of great regret

that after more than four decades of our liberation, we are still in the nascent stage regarding the
development of an efficient financial market. In Bangladesh the money market is not well
developed. Again the there is no separate bond market here. Just very few bonds are traded in the
secondary market. On the other hand, the condition of capital market is so volatile in nature. It is
sometimes called as one of the worse markets in the world. In this regard, the establishment of a
financial derivative market might be helpful in some ways, such as: the risk-shifting mechanism
innately owned by the derivative instruments, can enhance the distributing function of the
financial market of Bangladesh.

7.2 Establishment of Financial Derivative Market for Eluding Risks of

Participators

We need hedgers who want to shift their risks to the others. The market needs speculators, and it
wants to make profit by taking the risks.”(Li Tian, 2005). Many economists believe that, proper
speculations can generally decrease the risk of whole market instead of increasing. So for sound
development of financial market, contribution of hedgers and speculators are very important. We
know the derivative such as: forward, futures, options and swaps inherently own the risk-shifting
characteristics. Yet, we haven’t such instruments that would provide the participators with proper
mechanism of eluding risks. According to the realistic requirements of market and its

24
participators, Bangladesh should set up a financial derivative market as soon as possible to meet
the objective rules of market development.

7.3 Establishment of a Derivative Market for the Requirement of

Financial Market Development
The capital market of Bangladesh is still in primary stage in respect of development. This market
is so much volatile in nature. Big traders can easily manipulate the market with forming
syndicate. Two major collapses, one in 1996 and another in 2010-2011, according to reports of
prove-committee, were the evidence of such syndication and manipulation. The lack of
deepening of market, which might be with increasing the substantial number of instruments and
participators, is the prime cause of syndication, manipulation and ultimate. So for deepening of
financial market of Bangladesh, there is no alternative to increase the number of financial
instruments as well as participators in the market. If general investors find the derivative
instruments to shift their risk, they will obviously be interested to
come in the market with their small amount of savings. Actually people want to come in the
market. But Bangladesh hasn’t able to make a good platform to motivate the small investors,
who can be called as the nucleus of the financial
market like ours. So the establishment of a financial derivative market would bring some new
instruments in the market such as: forward, futures, options and swaps that innately own the risk-
shifting characteristics. In this way, the number of instruments as well as the participators would
be increased substantially. That would ultimately deepen the market.

7.4 Establishment of Financial Derivative Market for Deepening Reforms Financial

Business of Bangladesh
The deepening reforms of financial business of Bangladesh require the support of financial
derivative market. Establishment of financial derivative market will promote the optimization of
commercial banks’ capital structure and improve commercial banks’ profit-making ability. If the
derivative market had been founded, more bounds instruments and trade-patterns would have
been promoted through the effects of derivative means in securitizations, thus the goal of capital
structure optimization would have been achieved” (Li Tian, 2005).Bangladesh has also similar
problem in respect of capital structure. It has serious problem in the case of bad-loan, total
capital and capital liquidity. Especially in state-owned banks, this condition is more serious. This
country has experienced two major debacles within three-four years. One is in the case of Hall-
mark and another is the case of Basic bank. The unprecedented malpractices were observed in
both of the cases. We got information from a recent speech of honorable Finance Minister in the
Parliament that the total amount of default loans of 56 banks operating in Bangladesh is over Tk
546.57 billion. Minister said that the state owned Agrani Bank, Janata Bank, Rupali Bank and
Sonali Bank had accumulated.

On the other hand, we have a volatile capital market which is still in a recovery phase after the
2010-11 stock market crash. Before the crash, the market experienced an astonishing growth
which was not in line with the growth in real
sector of the economy. As a result, the market went for a huge correction at that time and many
small investors were affected badly. Even after years, investors still lack confidence in the
market. Many economists think that, if the country wants to rebuild its market, where

25
participants will came back with their full confidence level, establishment of financial derivative
market might be an effective decision. Again, it is believed that, establishing financial derivative
market strengthens the effect of monetary policies by providing the central bank with ample and
effective information through its scientific pricing mechanism, enough operation instruments and
rational expectations about markets. On the other hand, the abundance of derivative variety can
effectively improve the conductive accuracy of monetary policies.

7.5 Establishment of Financial Derivative Market for the

Globalization of Economy
For attracting foreign capital investment, establishment of financial derivative market is
essential. Because without the strong financial viability, risk-shifting opportunities and stability
in the market (that are considered as main obstacles of an economy to turn into a global one), an
economy generally doesn’t able to catch the eyes of the foreign investors. Report of Bangladesh
bank shows that the total amount of FDIs were $913.3million (in2010);$1136.35million(in
2011);$1292.54million(in 2012); $1599.14 million(in 2013) and $1833.87million(in
2015).Though this data showing an upward trend, economists believe that these are very small
amount than the expectation. The most important
problems for what the capital market of Bangladesh can’t able to attract the foreign investors
may be the lack of necessary market mechanisms and varieties of instruments for shifting risk.
Again, some foreign investors do not think it is O.K. to enter the Bangladesh’s market,
considering the issues of safety and capital liquidity. Because of the lack of necessary trade-
means being as the guarantee, our work is irrational in the structure of currencies, time-period,
rate and market in absorbing capital thus it is decreasing the efficiency and effect of absorbing
the foreign capital. Thus if Bangladesh can establish a derivative market few advantages it can
get. Such as, the risk-shift mechanism in the derivative market may make foreign capital entering
Bangladesh’s market in the state of low-risk and help to meet its safety requirements. And
meanwhile, the abundant varieties of derivative instruments will provide foreign investors with
more choice of ways of entering and withdrawal to improve the liquidity and profit. That will
help much foreign capital float into Bangladesh. On the other hand, the financial globalization
requires ample financial market. However, the present situation in Bangladesh cannot meet such
a requirement, and the key to this issue is that we do not have a derivative market with abundant
instruments. So, establishing derivative market will not only make Bangladesh possess the basic
conditions of financial globalization, but also help this country promote the economy
development in the
wave of international capital.

8.0 Why Bangladesh needs a derivative market ?

8.1 Reduction of Volatility in the Capital Market

The capital market of Bangladesh is so much volatile in nature. In their study (Syed A. Basher,
M. Kabir Hassan, and Anisul M. Islam,2007) empirically examines the time-varying risk return
relationship and the impact of institutional factors such as circuit breaker on volatility for the
emerging equity market of Bangladesh [namely The Dhaka Stock Exchange (DSE)] using daily
and weekly stock returns. The DSE equity returns showed negative skewness, excess kurtosis
and deviation from normality. The returns display significant serial correlation suggesting stock

26
market inefficiency. The results also show a significant relationship between conditional
volatility and stock returns, but the risk-return parameter is found to be sensitive to choice of
samples and frequencies of data. Overall, the coefficient of the risk-return parameter is negative
and statistically significant. In a study (Mohammad Nayeem Abdullah, Kamruddin Parvez,
Moslehuddin Khaled) studied prices of 17 actively companies in the DSE from 2006 to 2010 and
used three valuation ratios with an explicit corporate sector along with overall market index data
and found that the Stock Market is overvalued. Syed Golam Shahjarul Alam in his study named
“Recent trends in capital market of Bangladesh: critical evaluation of regulation” in 2012 made a
comparison of volatility of DSE with other market in the following way and showed that the
returns of DSE in comparison with Bombay stock exchange and SET index of Thailand is highly
less within the time period (Dec’10-Jan’12), whereas the standard deviation (a measure of
volatility) of DSE were very high in that time.

27
We can also observe from the above graphs, the nature of volatility of indexes (from Jan’10-
Jan’12)of DSE with Bombay stock exchange and SET index of the Thailand. We see that the
general index of DSE is more fluctuating than the other two. Besides that, we have seen two
major collapses one is in 1996 and another in 2010. The collapse of 2010 was more dangerous.
Millions of investors lost their money and came down to the street. They invested their money
and finally lost everything when the bubble started to burst in December, 2010 that had started to
grow from the year 2009. This time Benchmark index came down to 3616 points in early
February 2012 from its highest point 8918 in December 2010.

8.2 Implication of perfect portfolio

Actually in Bangladesh’s financial market is still in very nascent stage of development. Here,
alternative financial instruments are rare to find. There is no separate bond market. Money
market is also not well-established. Investors can’t apply any hedging strategy through risk-
shifting instruments like derivative while they are buying risky assets. Suppose, at the time of
buying a stock if a purchaser simultaneously could buy futures or options from the same
marketplace to protect his investment, the perfect implication of portfolio (comprising of risky
assets and risk-free assets) could have been possible.

8.3 The possible way of protection using derivative

We have seen that the nature of volatility in DSE is very high than some other comparables. If a
derivative market can be established in this country, an investor could easily be protected himself
from potential loss. Suppose in December 10 a purchaser has bought 1000 stock of Beximco Ltd.
with BDT40 each. The investor is concerned about a possible share price decline in two months
from now and wants protection. The investor can buy February 10 put option contracts pricing of
each BDT1 on Beximco Ltd. with a strike price BDT43. This would give the investor a right to
sell the stocks with the strike price. Now if the price of stock on the maturity date is lower than
the strike price the investor can exercise the contract by selling each with BDT43.Net profit
would be(43-40)×1000=3000-(contract’s buying cost,1000×1)=BDT2000. But if the market
price on the maturity date is higher than the strike price, investor would not exercise the contract.
His loss is BDT1000(contract’s buying cost).Like options the investors can use some others

28
derivative instruments to protect themselves against losing their investment occurring from the
market volatility.

8.4 Protection in Major Export Sector (Especially RMG) Sector

The readymade garments industry acts as the backbone of our economy and as a catalyst for the
development of our country. We take pride in the sector that has been fetching billions of dollars
as export earnings and creating jobs for
millions of people (especially women) in the country. The country with its limited resources has
been maintaining 6% annual average GDP growth rate. This has been possible with the top-most
contribution of RMG sector. Now we envision Bangladesh achieving the middle-income country
status by 2021. We firmly believe that our dream will come true within the stipulated time and
the RMG industry will certainly play a crucial role in materializing the dream. RMG industry is
now the single biggest export earner for Bangladesh. The sector accounts for 81% of total export
earnings of the country. When the jute industry started losing its golden days, it is the RMG
sector that replaced it. The apparel industry of Bangladesh started its journey in the 1980s and
has come to the position it is in today. Despite the epic growth of our RMG industry, and its
bright prospects, challenges are still there. One of the biggest challenges currently faced by our
RMG industry is to ensure workplace safety and better working conditions for the millions of
garment workers. Two major accidents, the Tazreen fire and the Rana Plaza collapse, have
brought the issue of workplace safety to the fore and led all stakeholders to act accordingly.
However, the RMG sector is export oriented in Bangladesh. Its export of final products as well
as import of raw materials both are susceptible to exchange rate fluctuation. The incomes and
costs of RMG sector changes highly due to the changes in exchange rate. In this context, the
owners of
garments can’t protect themselves through hedging or other such strategy using any instrument
like derivative which
have innate characteristics of risk-shifting. Though, to mitigate exchange rate risk RMG
exporting companies
historically using two tools like selling the rights of Letter of Credit (LC) and forward contract
over the exchange rate,
these have some problems. “The transfer of LCs has its own disadvantage of high processing
fees that can amount from
3% to 5% of the total LC amount. Again, forward contract on the foreign exchange often become
hassling due to the
rigidity of regulation of the central bank”.(Saif Rahman and M.Kabir Hassan, 2011).They
showed an example of how
exporter can use the range forward contract to protect themselves against exchange rate risks.

29
Suppose a Range Forward Booking processed in order to hedge the exchange rate risk during the
period January to May 2015 for an amount of USD0.5 million. The amount is a limit and design
of the contract allows exercising the right of converting certain amount of US dollar at the floor
rate on exercise dates as long as the cumulative amount doesn’t exceed 0.5 million. The table
shows that the company using Ranged Forward Contract has been able to avoid loss of
BDT13000, which could have been much higher depending on the nature of volatility in the rate
of exchanges. Hence derivative can act as a protection in any major swing exchange rates.

8.5 Protection in Major Import Sector (Import of Petroleum) Sector

Being a country with higher import needs than the capacity of exporting, Bangladesh has been
experiencing growing negative balance in its current account27. Especially in 2008, the trade
deficit took a leap from around BDT 268 billion to BDT 511 billion, almost twice as it used to be
in the preceding fiscal years28. This unusual doubling of trade deficit was apparently caused by
the increase in the import volume in taka in some major commodities like rice, wheat, fertilizer,
cotton, staple fiber and most importantly the edible oil29. The global political unrest and the
financial crisis in 2007-08 contributed a great deal to the boost in price in the international
market, especially the price of the edible oil and the petroleum products30 (both crude and
refined form). Hence, the government must take actions and look into modern financial tools to
mitigate the risks due to the price instability and volatility in the exchange rate against major
currencies.
Petroleum Products in National Import
Petroleum is a principal commodity for Bangladesh, the national demand of which is met
entirely by import (National Accounting Wing, BBS, 2010, p. 24). Bangladesh’s petroleum
imports mainly consist of the refined oil products and comparatively a very little crude oil is
imported as the country doesn’t have an established industry of oil refining (Islam, 2006).
Considering the entire national import of any given year, the petroleum products as well as the
machinery and equipments are the highest contributors in the whole import amount. Exhibit 16
provides a year-by-year contribution of petroleum and petroleum related products on the total
import of Bangladesh. The petroleum import is entirely dealt by the government and afterwards
supplied throughout the country and distributed among different sectors, private and public. The

30
total import volume for petroleum in BDT has increased from 43.41 billion to 178.66 billion in
2009, in just 5 years.

But interestingly enough, the total import quantity has come down from 10.24 million metric ton
to 6.51 million metric ton during these years excluding the year 200531 and the price paid for
petroleum and related product has grown to staggering level (Exhibit 16).

31
Use of derivatives in Petroleum Import
Petroleum commodities are highly price inelastic and the supply-demand paradigm doesn’t
usually intervene to force back the price towards the equilibrium in this particular market. This
inherent volatility results in rapid price swings of petroleum products without being fueled by
almost any global macro-economic change.

8.6 Demand for alternative source of investments

In light of our scrutiny of the volatility and the return vs. risk assessment of the two capital
markets of Bangladesh, we can confer that moderate volatility level of the markets does not pose
any threat of market collapse while ensuring that there is enough fluctuation to serve the purpose
of hedging. As the investors are being offered by the market a fair return against the risk, the
market capitalization is increasing at a bull rate being much higher than the supply of securities.
This eventually poses potential threat of the market losing its efficiency and also the volatility
increasing in the long run. In order to make sure that the market doesn’t face the above
mentioned dilemma, the regulatory authority must ensure a boost in the supply of new and good-
quality securities. Now, derivatives securities can play a vital role in this regard besides the new
stocks and bonds. An important aspect for capital market is reflection of fair value of scrips. This
is not adequately present in the current scenario, and due to this reason the market is not
receiving the attention of an important segment of investors, both foreign and local. Although
DSE experienced impressive growth in liquidity in recent years with Average Daily Turnover
increased from US$ 24mm in 2007 to US$ 75mm in 2009, FDI has actually declined by 36
percent between 2008 and 2009. In an equity centric market and in absence of a solid bond
market, investors are looking for an alternative class of instruments and derivative can be the
ideal solution to this problem as coming-up with innovative derivatives will be much easier than
to issue fundamentally strong new company’s IPO.

9.0 Risks of Derivatives in Bangladesh

Certainly in Bangladesh there are some drawbacks as well as danger to set up a derivatives
market. Our country have a tendency to center of interest on how they are used legitimately the

32
illegitimate abuse of derivatives alternatively contribution to derivatives poor image there are
some necessary issues that stories in the press. Investors’ are uninformed opinion and s
misinformed perceptions. Who are having bulk amount of financial reserve as a developing
nation that do no longer have sufficient consumers. The market and keep it alive where as a
derivatives market needs whose funding will run as blood of a sturdy extensive range of traders.

10.0Recommendation for Introducing Derivatives in Bangladesh

The value of derivative securities is undeniable for a financial market. The capital market of
Bangladesh has recently witnessed extra-ordinary volatility and the recent periodic crashes at
Dhaka Stock Exchange (DSE) has illustrated our lack of knowledge and tools to combat this
aggravating market volatility.

One of the major reasons for such high volatility of our capital market is the lack of hedging
instruments that could protect the investors, both individuals as well as institutions. For last two
decades, emerging markets namely Korea, Malaysia, Brazil and India have innovatively and
judiciously used a vibrant derivative market for risk mitigation and also yielded substantial
benefits in terms of market expansion and overall economic growth. In view of the
overwhelmingly positive outcome in similar markets of the world, the introduction of derivatives
market in Bangladesh should have a salient effect on the country’s capital market and the overall
economy. The following set of recommendations will address both the preparatory evaluation
need and also relevant building blocks of creating an efficient derivative exchange.

Recommendation 1: Establishing an Advisory Committee

First and foremost, the Security and Exchange Commission should form an advisory committee
for preparing a comprehensive report on the feasibility of introducing exchange traded
derivatives market in Bangladesh.
Our policy makers and regulators can take cue from India’s Dr. L.C. Gupta led highly successful
feasibility committee and create an advisory committee comprising of representatives of
regulatory institution (SEC, Bangladesh Bank), DSE, CSE, financial institutions (ex: private
bank, merchant bank, investment bank, brokerage, credit rating agency), academics, legal
experts, consultants (local and/or international with relevant experience in derivatives) and
ministry of finance. The committee should be headed by a senior official of local and
international pedigree. The mandate of the committee can be as follows-

(i) Study and recommend whether trading of exchange-traded

derivatives is suitable for the capital market in Bangladesh in its present form. The research
should address (but not confined to) aspects concerning market infrastructure, systems, risks,
transparency, investor interest and education, users of the derivatives products.
33
(ii) Specify the probable and likely benefits for the capital market of Bangladesh by introducing
or trading of exchange-traded derivative products (based on the progress achieved by the
emerging and developed markets after the introduction of exchange-traded derivatives).

(iii) Prepare a list of legal amendments and regulatory reform required for derivatives.

(iv) Prepare a comprehensive roadmap (if required) for successful introduction of exchange-
traded derivatives for the capital market of Bangladesh.

Recommendation 2: Build-up public awareness and deduce stakeholder’s opinion

The concept and usage of derivatives is still quite vague to our major stakeholders such as
regulators, financial institutions and export/import entities. Such limited understanding of
derivatives trading on the part of major players can become a hindrance to the development of
the market. Hence, the initial process of creating a derivative market should involve sending
customized leaflets and questionnaire to major stakeholders to educate them on the various
derivatives available in global markets and also ascertain their requirement of derivative
instruments. Such comprehensive market survey can be an interactive method of sharing ideas,
concerns and suggestions for going forward.

Recommendation 3: Implementing stringent training and licensing mechanism

Derivative products by nature are complex and success of a derivative market is coherent with
the knowledge and expertise of the participants. The recent stock market probe clearly identified
the lack of basic understanding of risk and dynamics of a capital market of many of the
representative of financial institutions and investors and oversight of the regulators as a key
contributory factor of collapse of the exchanges33. Given the high level of economic and
financial risks faced by market participants and investors in emerging countries, such inadequacy
in knowledge and skill set may lead to substantial increase in systematic risk of the market. The
pricing of derivatives products and management risk models require brokers/dealers, regulators
and end-users to have sufficient educational training in finance and quantitative methods used for
asset pricing. Thus, it is essential professionals attend specialized courses in financial
management and derivatives. SEC in consultation with domestic/international experts,
Bangladesh Bank, Ministry of Finance and market players should introduce a compulsory
training and certification program. The National Certification for Financial Markets (NCFM) of
India can be an ideal guideline for preparing the content and means of offering such training.

Recommendation 4: Derivative Exchange is the way to go, not over-the-counter market

Derivatives, introduced both via exchanges and OTC have enjoyed global recognition and
appreciation primarily as effective instrument for hedging. They ensure depth and liquidity to the
capital markets and hence encourage trading. However, choice of exchange versus OTC depends
on the sophistication and prudence of capital market. The recent stock market manipulation in
Bangladesh has severely questioned the integrity and effectiveness of the regulatory bodies and

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also demonstrated the facile manner syndicates can eat into the core fundamentals of the market.
Under the circumstances, an OTC market which by nature is not strongly regulated will create
havoc in already feeble governance framework. There is strong recommendation in stock market
probe report for restricting the main regulatory body SEC and demutualization of the main
exchanges DSE and CSE. If government is sincere in its effort to revamp our financial market
and regulatory structure, such actions can also indirectly create an environment where derivative
exchange market can flourish. Besides it would be easier for traders, investors and brokers to
move up the learning curve by trading standardized products of exchange derivative market,
rather than exotic derivative of OTC which usually combines attributes of several derivatives
instruments and are, therefore, more complex than their exchange traded counterparts. Such
initial standardization is not only beneficial from the trader’s perspective but also from the
perspective of the regulators who need to understand the dynamics and magnitude of the risks
associated with the products before being able to design sustainable measures to alleviate
systematic risk. Therefore, introduction of Exchange-Traded Derivatives in Bangladesh will be
pragmatic and efficient.

Recommendation 5: Development of existing infrastructure and new system

Once the advisory committee has successfully completed its feasibility analysis and provided a
regulatory framework, focus should shift on upgrading infrastructure to accommodate derivative
trading. A deep and liquid market for the underlying (initially only DSE and CSE traded stocks)
is necessary for the development of an efficient derivative market. The easy movement of capital
between different markets and currencies is essential to eliminate pricing discrepancies and
efficient functioning of the markets. The stock market probe report highlighted the crying need
of restructuring main regulatory body SEC and also strengthening of key institutions such as
Central Depository Bangladesh Ltd. (CDBL) and clearing house. Such actions should be taken
on a priority basis, both for improving our stock market and creating a platform for a derivative
exchange. In order to increase investor confidence, derivative exchange must set-up on-line
screen-based systems for all trades in financial derivatives, and an independent and automated,
real-time market surveillance systems to identify market abuses.
A specific sub-group of the advisory committee comprised of mathematicians, analysts and
derivative exchange consultants should be in charge of preparing all rules pertaining to trading,
clearing, settlement, margin maintenance and membership eligibility criteria.

Recommendation 6: Establish a Central Counterparty (CCP)

In order to maintain the efficiency and transparency of derivative security exchange, clearing and
settlement of derivatives products should be executed through a central counterparty (CCP) with
multilateral multi-product close-out netting arrangements.
Clearinghouses can be organized in a wide variety of forms: some are organized as departments
of their affiliated exchanges (vertically integrated) while others are independent legal entities.
In present scenario, all transactions are settled by clearing house which is part of DSE and
settlement is based on category of shares (Such as A, B, N, G, Z category). The settlement
classifications are: T+0 (Day settlement), T+3 (Normal settlement) and T+9 (Prohibitory

35
settlement). Central Depository Bangladesh Ltd. (CDBL), on the other hand, acts as a record
keeper by electronically recording and maintaining securities accounts and registering transfer of
securities. However modern concept of clearing house for a derivative exchange is much more
vivid. A CCP acts as a buyer to all sellers and a seller to all buyers and assumes the
responsibility of guarantor to both parties. The CCP establishes different tools for conducting its
monitoring activities, such as, daily compensation of losses (and gains), liquidation of open
positions when a trading party is in default, collateralization of maximum expected daily losses,
a clearing fund, support from a highly rated guarantor and finally the clearing house’s equity
capital. Bangladesh should establish an independent clearing corporation/clearing house for
proposed derivative exchange, which should become counter party for all trades or alternatively
guarantee the settlement of all trades.

11.0 Concluding Remarks

In summary, financial derivatives provide risk management tools as well as alternative
investment opportunities to market participants. Emerging economies in which index futures and
options have been introduced have experienced significant gains in both stock market
capitalization and trading volume. There is no denying of the fact that our existing institutional
set up and regulatory framework might not be adequate for sophisticated instruments like
derivatives. However, the recent catastrophic fall of our stock market, rapidly declining FDI and
scarcity of investment opportunities in an equity centric economy, is crying out for an innovative
and versatile financial product for hedging and market expansion. The importance of the
development of institutional infrastructure and human capital cannot and should not be
overlooked; however if the capital market of Bangladesh want to be competitive with other
emerging economies of India, China, Malaysia or Singapore, the process of progressive policy
making cannot wait indefinitely for our market players to catch up with their counterparts in
more developed financial markets. Hence, our policy makers and regulators must initiate a
process for introducing derivative securities in Bangladesh within 3-5 years.
In view of recent turmoil in the equity markets, we need to be circumspect and foresighted in our
approach; a standardized exchange traded derivative market with phase-by-phase introduction of
product has been recommended. We are confident, adequate legal and regulatory reform, and
governance infrastructure and oversight will pave the way for successful introduction of
derivative securities in Bangladesh and provide the perfect fillip to our stagnant investment
climate. Financial derivative mainly shift the risk so in Bangladesh it will work for investor who
are face highly risk in investment.

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