Derivatives Rupali.docx

ASSIGNMENT ON FINANCIAL DERIVATIVES

SUBMITTED TO

SUBMITTED

BY MR. AKHILESH MISHRA

RUPALI SONI ROLL

170122

NO.

Ques no.1 HOW DEVELOPED ARE THE DERIVATIVES MARKET IN INDIA? COMMENT. Derivatives are financial contracts whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities. Derivatives include a wide assortment of financial contracts, including forwards, futures, swaps, and options. The International Monetary Fund defines derivatives as "financial instruments that are linked to a specific financial instrument or indicator or commodity and through which specific financial risks can be traded in financial markets in their own right. The value of financial derivatives derives from the price of an underlying item, such as asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues." While some derivatives instruments may have very complex structures, all of them can be divided into basic building blocks of options, forward contracts or some combination thereof. Derivatives allow financial institutions and other participants to identify, isolate and manage separately the market risks in financial instruments and commodities for the purpose of hedging, speculating, arbitraging price differences and adjusting portfoliorisks. The emergence of the market for derivatives products, most notable forwards, futures, options and swaps can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets can be subject to a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, derivatives products generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivatives products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Factors generally attributed as the major driving force behind growth of financial derivativesare (a)

Increased

Volatility

in

asset

prices

in

financial

markets,

(b) Increased integration of national financial markets with the international markets, (c) Marked improvement in communication facilities and sharp decline in their costs, (d) Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and (e) Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets. Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and May well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. DERIVATIVE MARKET IN INDIA Derivatives markets have had a slow start in India. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendments) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr. L.C. Gupta on 18th November 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee recommended that derivatives should be declared as 'securities' so that regulatory framework applicable to trading of 'securities' could also govern trading of securities. SEBI was given more powers and it starts regulating the stock exchanges in a professional manner by gradually introducing reforms in trading. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval in May 2000. SEBI permitted the derivative segments of two stock exchanges, viz NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivative contracts.

Ques. 2 Why derivatives are called Weapons of mass destruction? Discuss with reference to global crisis of 2008. As financial markets remain volatile, Warren Buffet's description of derivatives as 'weapons of mass destruction' is turning out to be more and more apt for banks and their corporate clients. As for the former, in the last few weeks alone Deustche Bank has reported a loss of $400 million on equity derivatives; and Caissed' Epargne, a French bank, has sustained a loss of euro 600 million, also in trading equity derivatives. This is the third major trading loss reported by a French bank this year, the earlier two being Societe Generale (euro 4.9 billion) and Credit Agricole (euro 250 million). In 2008 the world economy faced its most dangerous Crisis since the Great Depression of the 1930s. The contagion, which began in 2007 when sky-high home prices in the United States finally turned decisively downward, spread quickly, first to the entire U.S. financial sector and then to financial markets overseas. The casualties in the United States included a) the entire investment banking industry, b) the biggest insurance company, c) the two enterprises chartered by the government to facilitate mortgage lending, d) the largest mortgage lender, e) the largest savings and loan, and f) two of the largest commercial banks. The carnage was not limited to the financial sector, however, as companies that normally rely on credit suffered heavily. The American auto industry, which pleaded for a federal bailout, found itself at the edge of an abyss. Still more ominously, banks, trusting no one to pay them back, simply stopped making the loans that most businesses need to regulate their cash flows and without which they cannot do business. Share prices plunged throughout the world—the Dow Jones Industrial Average in the U.S. lost 33.8% of its value in 2008—and by the end of the year, a deep recession had enveloped most of the globe. In December the

National Bureau of Economic Research, the private group recognized as the official arbiter of such things, determined that a recession had begun in the United States in December 2007, which made this already the third longest recession in the U.S. since World War II. Each in its own way, economies abroad marched to the American drummer. By the end of the year, Germany, Japan, and China were locked in recession, as were many smaller countries. Many in Europe paid the price for having dabbled in American real estate securities. Japan and China largely avoided that pitfall, but their export-oriented manufacturers suffered as recessions in their major markets— the U.S. and Europe—cut deep into demand for their products. Less-developed countries likewise lost markets abroad, and their foreign investment, on which they had depended for growth capital, withered. With none of the biggest economies prospering, there was no obvious engine to pull the world out of its recession, and both government and private economists predicted a rough recovery.