Basics

What are derivatives?
Derivatives, such as options or futures, are financial contracts which derive their value off a spot price time-series, which is called “the underlying". For examples, wheat farmers may wish to contract to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction would take place through a forward or futures market. This market is the “derivative market", and the prices on this market would be driven by the spot market price of wheat which is the “underlying". The terms “contracts" or “products" are often applied to denote the specific traded instrument.

The world over, derivatives are a key part of the financial system. The most important contract types are futures and options, and the most important underlying markets are equity, treasury bills, commodities, foreign exchange and real estate.

What is a forward contract?
In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed.

Why is forward contracting useful?
Forward contracting is very valuable in hedging and speculation.

The classic hedging application would be that of a wheat farmer forward-selling his harvest at a known price in order to eliminate price risk. Conversely, a bread factory may want to buy bread forward in order to assist production planning without the risk of price fluctuations.

If a speculator has information or analysis which forecasts an upturn in a price, then she can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction. The use of forward markets here supplies leverage to the speculator.

What are the problems of forward markets?
Forward markets worldwide are afflicted by several problems: (a) lack of centralisation of trading, (b) illiquidity, and (c) counterparty risk.

In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like the real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradeable. Also the \phone market" here is unlike the centralisation of price discovery that is obtained on an exchange.

Counterparty risk in forward markets is a simple idea: when one of the two sides of the transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic property: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counterparty risk.

Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, the counterparty risk remains a very real problem. A classic example of this was the famous failure on the Tin forward market at LME.

What is a futures contract?
Futures markets were designed to solve all the three problems (a, b and c listed in Question 1.4) of forward markets. Futures markets are exactly like forward markets in terms of basic economics.

However, contracts are standardised and trading is centralised, so that futures markets are highly liquid. There is no counterparty risk (thanks to the institution of a clearinghouse which becomes counterparty to both sides of each transaction and guarantees the trade). In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counterparty risk.

Why is the cash market in India said to have futures-style settlement?
In a true cash market, when a trade takes place today, delivery and payment would also take place today (or a short time later). Settlement procedures like T+3 would qualify as “cash markets" in this sense, and of the equity markets in the country, only OTCEI is a cash market by this definition.

For the rest, markets like the BSE or the NSE are classic futures market in operation. NSE's equity market, for example, is a weekly futures market with tuesday expiration. When a person goes long on thursday, he is not obligated to do delivery and payment right away, and this long position can be reversed on friday thus leaving no net obligations with the clearinghouse (this would not be possible in a T+3 market). Like all futures markets, trading at the NSE is centralised, the futures markets are quite liquid, and there is no counterparty risk.

What is an option?
An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price. A “call option" gives one the right to buy, a “put option" gives one the right to sell.

Options come in two varieties - european vs. american. In a european option, the holder of the option can only exercise his right (if he should so desire) on the expiration date. In an american option, he can exercise this right anytime between purchase date and the expiration date.

What are “exotic" derivatives?
Options and futures are the mainstream workhorses of derivatives markets worldwide. However, more complex contracts, often called exotics, are used in more custom situations. For example, a computer hardware company may want a contract that pays them when the rupee has depreciated or when computer memory chip prices have risen. Such contracts are “custom-built" for a client by a large financial house in what is known as the “over the counter" derivatives market. These contracts are not exchange-traded. This area is also called the “OTC Derivatives Industry".

An essential feature of derivatives exchanges is contract standardisation. All kinds of wheat are not tradeable through a futures market, only certain defined grades are. This is a constraint for a farmer who grows a somewhat different grade of wheat. The OTC derivatives industry is an intermediary which sells the farmer insurance which is customised to his needs; the intermediary would in turn use exchange-traded derivatives to strip off as much of his risk as possible.

How are derivatives different from badla?
Badla is closer to being a facility for borrowing and lending of shares and funds. Borrowing and lending of shares is a functionality which is part of the cash market. The borrower of shares pays a fee for the borrowing. When badla works without a strong marginning system, it generates counterparty risk, the evidence of which is the numerous payments crises which were seen in India.

Options are obviously not at all like badla. Futures, in contrast, may seem to be like badla to some. Some of the key differences may be summarised here. Futures markets avoid variability of badla financing charges. Futures markets trade distinctly from the cash market so that each futures prices and cash prices are different things (in contrast with badla, where the cash market and all futures prices are mixed up in one price). Futures markets lack counterparty risk through the institution of the clearinghouse which guarantees the trade coupled with marginning, and this elimination of risk eliminates the “risk premium" that is embedded inside badla financing charges, thus reducing the financing cost implicit inside a futures price.

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

One kind of passing-on of risk is mutual insurance between two parties who face the opposite kind of risk. For example, in the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This sort of thing also takes place in speculative position taking {the person who thinks the price will go up is long a futures and the person who thinks the price will go down is short the futures.

Another style of functioning works by a risk-averse person buying insurance, and a risk-tolerant person selling insurance. An example of this may be found on the options market : an investor who tries to protect himself against a drop in the index buys put options on the index, and a risk-taker sells him these options. Obviously, people would be very suspicious about entering into such trades without the institution of the clearinghouse which is a legal counterparty to both sides of the trade.

In these ways, derivatives supply a method for people to do hedging and reduce their risks. As compared with an economy lacking these facilities, it is a considerable gain.

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

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

What are the instruments traded in the derivatives industry, and what are their relative sizes?
This information is summarised in Tables 1.2 and 1.3 which are drawn from ?.

Worldwide, what kinds of derivatives are seen on the equity market?
Worldwide, the most successful equity derivatives contracts are index futures, followed by index options, followed by security options.

At the security level, are futures or options better?
The international experience is that at the security level, options markets are almost always more successful than futures markets.

Why have index derivatives proved to be more important than security derivatives?
Security options are of limited interest because the pool of people who would be interested (say) in options on ACC is limited. In contrast, every single person in the financial area is affected by index fluctuations. Hence risk-management using index derivatives is of far more importance than risk-management using individual security options.
 

	1986	1990	1993	1994
Exchange Traded	583	2292	7839	8838
Interest rate futures	370	1454	4960	5757
Interest rate options	146	600	2362	2623
Currency futures	10	16	30	33
Currency options	39	56	81	55
Stock Index futures	15	70	119	128
Stock Index options	3	96	286	242
Some of the OTC Industry	500	3450	7777	11200
Interest rate swaps	400	2312	6177	8815
Currency swaps	100	578	900	915
Caps, collars, floors, swaptions	-	561	700	1470
Total	1083	5742	16616	20038

This goes back to a basic principle of financial economics. Portfolio risk is dominated by the market index, regardless of the composition of the portfolio. In other words, all portfolios of around ten stocks or more have a pattern of risk where 80% or more of their volatility is index-related. In such a world, investors would be more interested in using index-based derivative products rather than security-based derivative products. The actual experience of derivatives markets worldwide is completely in line with this expectation.

Who uses index derivatives to reduce risk?
There are two important types of people who may not want to \bear the risk" of index fluctuations:

• A person who thinks Index fluctuations are peripheral to his activity
  For example, a person who works in primary market underwriting effectively has index exposure - if the index does badly, then the IPO could fail { but this exposure has nothing to do with his core competence and interests (which are in the IPO market). Such a person would routinely use measure his index exposure on a day-to-day basis, and index derivatives to strip off that risk. If full-fledged bookbuilding becomes important in India, then there is a very important role for index derivatives in the “price stabilisation" that the underwriter does in the bookbuilding process (see ? for an exposition about bookbuilding).
  
  Similarly, a person who takes positions in individual stocks implicitly suffers index exposure. A person who is long ITC is effectively long ITC and long Index. If the index does badly, then his “long ITC" position suffers. A person like this, who is focussed on ITC and is not interested in taking a view on the Index would routinely measure the index exposure that is hidden inside his ITC exposure, and use index derivatives to eliminate this risk. The NYSE specialist is a prime example of intensive use of index derivatives in such an application.

•  person who thinks Index fluctuations are painful
  An investor who buys stocks may like the peace of mind of capping his downside loss. Put options on the index are the ideal form of insurance here. Regardless of the composition of a person's portfolio, index put options will protect him from exposure to a fall in the index. To make this concrete, consider a person who has a portfolio worth Rs.1 million, and suppose Nifty is at 1000. Suppose the person decides that he wants to never suffer a loss of worse than 10%. Then he can buy himself Nifty puts worth Rs.1 million with the strike price set to 900. If Nifty drops below 900 then his put options reimburse him for his full loss. In this fashion, “portfolio insurance" through index options will greatly reduce the fear of equity investment in the country.

1874	Commodity Futures
1972	Foreign currency futures
1973	Equity options
1975	T-bond futures
1981	Currency swaps
1982	Interest rate swaps; T-note futures; Eurodollar futures; Equity