Authors details Title Name Designation College : Financial Innovations And Derivative Markets : S.Pushpalatha M.B.A,M.H.R.M : Asst. Professor.

: Gayatri Vidya Parishad College for Degree and PG courses ( Autonomous) Department of Management Studies . Rushikonda , Visakhapatnam. Phone no E-mail : 9440223226 , 9160999226 : Pushpambagvp@yahoo.com

Financial Innovations and Derivative markets ABSTRACT

Financial innovations are advances over time in the financial instruments and payment systems used in the lending and borrowing of funds. These changes, which include innovations in technology , risk transfer and credit and equity generation, have increased available credit for borrowers and given banks new and less costly ways to raise equity capital. The financial markets have experienced a wide variety of financial instruments since 1980s creating nearly 60 securities innovations organized by wide variety of products .The present financial market is wide ,open and receptive to introduce new products and many products are continuously being introduced and accepted by market participants. Financial markets have continued to produce a multitude of new products, including many new forms of derivatives, alternative risk transfer products, exchange traded funds, and variants of taxdeductible equity. There is a tremendous innovation in exchange-traded derivatives, over-the-counter derivative contracts (such as the credit derivatives, equity swaps, weather derivatives and exotic over-the-counter options), new insurance contracts (such as alternative risk transfer contracts or contingent equity contracts), and new investment management products. This paper emphasizes on the financial innovations in the derivative markets traded in the Indian capital market , future trends of innovative derivative products , regulations and the their benefits and contributions towards customers in managing or reducing risks . The study is organised into two sections. Section I deals with the concept, definition, features and types of financial derivatives Section II has been devoted to a discussion of the growth of derivatives market, types of risks associated and regulation and policy development. Key words : Derivatives, Financial innovation, Regulations, Risk management .

Financial Innovations and Derivative Markets

The beauty of derivatives is that they self destruct every month and you get another commission Don Stone With the advent of liberalization, privatization and globalization in our Indian economy efforts are being made to strengthen the investors confidence. In this context financial services are witnessing a number of innovations . One such innovation is financial derivatives which initiated a number of changes in risk management activities. The new concept of derivative market trading mechanism has helped a lot in minimizing the risk factors to greater extent. The emergence of a well-functioning derivative market, with a wide range of trading mechanisms, is definitely a boost to all those perspective investors who are willingfully agreed to join the mainstream of investment business to meet with their own expectation of return on investment along with a support to structurise the economy in a new way. Financial Derivatives have recently been introduced in Indian capital markets and has grown tremendously in terms of variety of instruments available and their complexity and turnover. Innovations in the derivatives markets, 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. 1.1 Concept of derivative markets: Derivatives are products, whose values are gained from one or more primary variables, named bases that include- underlying assets, index or reference rate, all these are worked on a contractual manner. The underlying assets largely include the following: i. Commodities including grain, coffee beans, orange juice; ii. Precious metals like gold and 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; and vii. Over- the Counter (OTC) money market products such as loans or deposits. 1.2 Instruments in derivative markets Forwards: A forward contract is a contract between two parties to buy or sell an asset at a future date for a certain price that is pre-decided on the date of contract,. The future date is referred to as expiry date and the preecied price is referred to as forwar price. It may be noted that forwards are private contracts and their terms are determined by the parties involved . Forward contracts are traded only in the Over the counter(OTC market)and not in stock exchanges .

Futures: Futures are more standardised forms of forward contracts and mostly operate in organised markets. While it is possible to have a forward contract for any commercial transaction, futures are normally exchange-traded. Futures contracts are highly uniform contracts that specify the quantity and quality of the good that can be delivered, the delivery date(s), the method for closing the contract, and the permissible minimum and maximum price fluctuations permitted in a trading day. Options: The option provides the contracting parties only an option, not an obligation, to buy or sell a financial instrument or security at a pre-fixed price, called the strike price. An option is the right to either buy or sell something , at a set price , within a set period of time .Obviously, the option buyer will exercise the option only when he is in the money, that is, he gains by exercising the option. Two basic types of options are call options and put options. A call option is an option to call, that is, acquire a particular quantity and/or at particular strike price. A put option is just the reverse- the option to put or sell a particular quantity and/or at a particular strike price. Swaps: In a swap, both the parties exchange recurring payments with the idea of exchanging one stream of payments for another. A typical usage is a swap of fixed interest rates with floating rates, or rates floating with reference to one basis to another basis. In credit derivatives market, there are swaps based on the total return from a particular credit asset against total return on a reference asset. Caps, floor and collars: Caps, floors and collars are essentially options designed to shift the risk of an upward and/or downward movement in variables such as interest rates. These are normally linked to a notional amount and a reference rate. Swaption: A swaption is an option on a swap. The option provides the holder with the right to enter into a swap at a specified future date at specified terms. This derivative has characteristics of an option and a swap. 1.3 Arguments for Derivative markets:

A tool for hedging: Derivatives provides an excellent mechanism to hedge the future price risk. Think of a farmer, who doesn't know what price he is going to get for his crop at the time of harvest. He can sell his crop in the futures' market & lock in the price. If the future spot price is more than the futures price, he can take the off setting position & can get out of the market (with a marginal loss). Otherwise he will get the locked in price. Risk management: Derivatives provide an excellent mechanism to Portfolio Managers for managing the portfolio risk and to Treasury Managers for managing interest rate risk. The importance of index futures & Forward Rate Agreement (FRA) in this process can't be overstated. Better avenues for raising money: With the introduction of currency & interest rate swaps, Indian corporate will be able to raise finance from global markets at better terms. Price discovery: These derivative instruments make the spot price discovery more reliable using different models like Normal Backwardation hypothesis. These instruments will cause any arbitrage opportunities to disappear & will lead to better price discovery.

Increasing the depth of financial markets: When a financial market gets such sort of risk-management tools, its depth increases since the Institutional Investors get better ways of hedging their risks against unfavorable market movements. Derivatives market on Indian underlying elsewhere: These days, with the advent of technology, Indian prices are available globally on Reuters & Knight rider. Nothing prevents any foreign market from launching derivatives on these Indian underlying. This will put Indians in a disadvantageous position as they can't take the advantages of derivatives of securities or commodities traded in India but someone else can take. So we will have to move fast in this direction.

1.4 Arguments against derivatives:

Speculation: Many people fear that these instruments will unnecessarily increase the speculation in the financial markets, which can have far reaching consequences. The recent Barrings Bank incident is the classic case in point. Market efficiency: Many people fear that the Indian markets are not mature & efficient enough to introduce these instruments. These instruments require a well functioning & mature spot market. Like recently The Economic Times reported the strong correlation of Indian equity markets to the NASDAQ. Such type of market imperfections makes the functioning of derivatives market all the more difficult. Volatility: The increased speculation & inefficient market will make the spot market more volatile with the introduction of derivatives. Counter party risk: Most of the derivative intruments are not exchange traded. So there is a counter party default risk in these intruments. Again the same Barrings case, Barrings declared itself bankrupt when it faced huge losses in these instruments. Liquidity risk: Liquidity of a market means the ease with which one can enter or get out of the market. There is a continued debate about the Indian market's capability to provide enough liquidity to derivative trader.

2.1 History of Derivatives in Indian Capital Markets Due to growing instability of the financial markets the financial derivatives have gained prominence in post 1970 period and became very popular accounting for about two-thirds of the total transactions in variety of instruments available. Financial derivatives have changes the world of finance through creation of innovative ways to comprehend measure and manage risks. Indias tryst with equity derivatives began in the year 2000 on the NSE and BSE. The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmark S&P CNX Nifty Index. The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange to launch trading in options on individual securities from July 2, 2001. Futures on individual securities were introduced on November 9, 2001. Futures and Options on individual securities are available on 224 securities stipulated by SEBI.The Exchange has also introduced trading in Futures and Options contracts based on CNX-IT, BANK NIFTY, and NIFTY MIDCAP 50 indices. Index futures were introduced in June 2000, followed by index options in June 2001, and options and futures on individual securities in July 2001 and November 2001, respectively. As of 2005, the NSE trades futures

and options on 118 individual stocks and 3 stock indices. All these derivative contracts are settled by cash payment and do not involve physical delivery of the underlying product (which may be costly).
Table 1: Derivatives in India: A Chronology Date Progress 14 December 1995 18 November 1996 11 May 1998 7 July 1999 24 May 2000 25 May 2000 9 June 2000 12 June 2000 31 August 2000 June 2001 July 2001 November 9, 2002 June 2003 September 13, 2004 January 1, 2008 January 1, 2008 August 29,2008 October 2,2008 December 2008 September 2009 January 19,2010 : NSE asked SEBI for permission to trade index futures. SEBI setup L. C. Gupta Committee to draft a policy framework for index futures. L. C. Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps SIMEX chose Nifty for trading futures and options SEBI gave permission to NSE and BSE to do index futures trading. Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE. Trading of futures and options on Nifty to commence at SIMEX. Trading of Equity Index Options at NSE Trading of Stock Options at NSE Trading of Single Stock futures at BSE Trading of Interest Rate Futures at NSE Weekly Options at BSE Trading of Chhota(Mini) Sensex at BSE Trading of Mini Index Futures & Options at NSE Trading of Currency Futures at NSE Trading of Currency Futures at BSE S& P CNX Nifty Futures & Options Relaunch of IRF products Introducing additional currency pairs Sterling INR, Yen-INR, Euro-INR

Source: Complied from BSE and NSE

2.2 Growth of derivatives in Indian capital market. Today NSE is the largest derivative exchange both in terms of volume and turnover . Currently derivative contracts have a maximum of 3-month expiration cycles .Indias experience with the equity derivative markets has been extremely positive. India is one of the most successful developing countries in terms of a vibrant market for exchange traded derivatives.

Table : 2 Index futures Year

Stock futures

Index options

Stock options

Total

Turnover

Avg daily turnover

No. of No. of No. of contracts contracts contracts 21048317 24911828 118211728 2011-12 165023653 186041459 650638557 2010-11 178306889 145591240 341379523 2009-10 210428103 221577980 212088444 2008-09 156598579 203587952 55366038 2007-08 81487424 104955401 25157438 2006-07 58537886 80905493 12935116 2005-06 21635449 47043066 3293558 2004-05 17191668 32368842 1732414 2003-04 2126763 10676843 442241 2002-03 1025588 1957856 175900 2001-02 90580 2000-01 Source : Compiled from BSE and NSE. Table : 3 Volume of derivatives At NSE As on Jul 21, 2011 Product No. of contracts Traded Value (Rs crores) Index Futures 3,11,988 8,116.54 Stock Futures 4,45,896 12,903.23 Index Options 24,30,440 68,206.48 Stock Options 99,760 2,991.53 F&O Total 32,88,084 92,217.79 Source : www.nseindia.com

No. of contracts 4708637 32508393 14016270 13295970 9460631 5283310 5240776 5045112 5583071 3523062 1037529 -

No. of contracts 168880510 1034212062 679293922 657390497 425013200 216883573 157619271 77017185 56886776 16768909 4196873 90580

Turnover ( cr.) 4723637 29248221 17663664 11010482 13090477 7356242 4824174 2546982 2130610 439862 101926 2365

127665.87 115150.48 72392.07 45310.63 52153.30 29543 19220 10107 8388 1752 410 11

From Table - 2 and Table-3 it is evident that Indian derivative market has undergone tremendous increase in trading of derivative contracts since inception to till date. Trading in derivatives gained popularity soon after its introduction. Introduced in the year 2000, financial derivatives market in India has shown a remarkable growth both in terms of volumes and number of traded contracts. The introduction of derivatives has been well received by the stock market players. 2.3 Management of risk Derivatives can be used to hedge both credit and market risks . Credit risk represents the conventional counter party risks , market risk refers to all those market forces or variables which may adversely affect on institutions profit ability and economic value. Market risk is represented by price risk of all types like interest rate risk , exchange rate risk, commodity price risk, equity price risk etc. While credit and market risk are external , operational risks are those risks which are essentially internal to the organization. Where there are risks, there are derivatives to strip the risk and transfer it. As derivatives are essentially devices of transferring risks, their types and applications differ based

on the type of risk facing a business. Take, for instance, the following sources of risk and the derivatives to protect a business against such risks: Interest rate risk: Banks and financial institutions face the risk of changes in interest rates. If a bank has liabilities carrying floating costs and assets having fixed rates, it faces the risk of an adverse movement, that is, a decline in interest rates. This risk can be sheltered by writing an interest rate swap - that is, swapping the floating rate for fixed rates.Associated with interest rate movements is the basis risk, that is risk of unpredicted changes in the basis on which interest rates float. Let us say, a business has loans which are floating with reference to the LIBOR or EURIBOR, whereas the assets of the business are floating with reference to US treasuries. To cushion against this risk, the business may like to swap the basis by entering into a basis swap. Foreign exchange risk: If a business has assets or liabilities denominated in foreign currency, there is a risk of adverse changes in exchange rates. This risk is sheltered by foreign exchange futures or forward covers. Commodity risks: A business having any position on commodities faces risk of changes in commodity prices. Such risks are also sheltered by futures and forwards in commodities. Risk on capital market instruments: If someone holds equity shares, there is a risk that prices of equity shares will move up or down. To manage this risk, there are various futures and options available. Credit risk: Yet another risk in all financial transactions is credit risk. Credit derivatives are used to hedge against credit risk. Weather risk: Even something like risk of changes in weather is hedged and transferred. There is a variety of weather derivatives, that is, instruments that pay off based on weather changes. Investors must understand that investment in derivatives has an element of risk and is generally not an appropriate avenue for someone of limited resources/ limited investment and / or trading experience and low risk tolerance. An investor should therefore carefully consider whether such trading is suitable for him or her in the light of his or her financial condition. An investor must accept that there can be no guarantee of profits or no exception from losses while executing orders for purchase and / or sale of derivative contracts. 2.4 Regulations of derivative market: Derivative trading in India takes can place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self-Regulatory Organisation and SEBI acts as the oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment would have to be through a Clearing Corporation/House, which is independent in governance and membership from the Derivative Exchange/Segment. With the amendment in the definition of 'securities' under SC(R)A (to include derivative contracts in the definition of securities), derivatives trading takes place under the provisions of the Securities Contracts (Regulation) Act,

1956 and the Securities and Exchange Board of India Act, 1992. Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for derivative trading in India. SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House which lay's down the provisions for trading and settlement of derivative contracts. The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing Corporation/House have to be framed in line with the suggestive Bye-laws. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility conditions have been framed to ensure that Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading environment, safety & integrity and provide facilities for redressal of investor grievances.

Conclusion
Derivatives are risk management tools that help in effective management of risk by various stakeholders. Innovations of derivatives have redefined and revolutionized the landscape of financial industry across the world and derivatives have earned a well deserved and extremely significant place among all the financial products. References Gambhir, Neeraj and Manoj Goel, 2003, Foreign Exchange Derivatives Market in India---Status and Prospects, Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw-Hill Publishing Company Limited, New Delhi, India. P.Vijay Bhaskar, B. Mahapatra , 2003,Derivatives simplified An introduction to Risk management, Response Books, A division of sage publications, New Delhi. RobertA.Strong,2006, publications,Banglore. Derivatives an Introduction , Thomson South western

K.Seethapathi , 2005,The New World Of derivatives , ICFAI University Press , Hyderabad. Indian Securities Market, A Review (ISMR)-2008 available at: http://www.nseindia.com.(accessed on May 27, 2010) NCFM , Equity Derivatives: A Beginners Module www.nseindia.com