Publication - Working Paper
Derivatives are financial instruments whose payoffs derive from other, more primitive financial variables such as a stock price, a commodity price, an index level, an interest rate, or an exchange rate. The world market for derivatives is an immense one. The notion amount outstanding in the over-the-counter (OTC) derivatives market worldwide exceeds $640 trillion, with a collective gross market value of over $27 trillion. The exchange-traded market has another $60 trillion in outstanding notional. The growth of derivatives usage over the last two decades has been rapid in both advanced economies and emerging markets; in both OTC contracts and those that areexchange-traded; and across all underlying classes, including interest-rate, currency, equity, and the most recent addition, credit. Derivatives are enormously useful instruments in the management of risk. They can be used to hedge an existing market exposure (forwards and futures), to obtain downside protection to an exposure even while retaining upside potential (options), to transform the nature of an exposure (swaps), and to obtain insurance against events such as default (credit derivatives). For corporations and financial institutions looking to manage exchange-rate risk, input costs, financing costs, or credit exposures, these are invaluable features, and explain to a considerable extent the rapid growth of the derivatives market as globalization and global interlinkages have grown. Derivatives are also highly levered instruments, and this has its own implications. On the one hand, the leverage makes derivatives attractive to speculators (those who wish to bet on price direction). In itself, this is not a bad thing, since speculators add considerable liquidity to the market and, by taking the opposite side, facilitate the positions hedgers want to take. However, leverage magnifies the effect of price moves, so sharp unfavourable price moves can easily spell disaster to the derivatives portfolio and thence to the larger business entity. Indeed, the annals of financial history are littered with stories of corporations and financial institutions which collapsed when a deterioration in market conditions led to massive losses in the derivatives portfolio – occasionally, even in cases where the derivatives were being used to hedge existing exposures. The potentially lethal cocktail of leverage and volatility makes it vital that users understand fully the risks of the instruments, and regulators the systemic impact of volatility spikes. India’s derivatives markets, both OTC and exchange-traded, have seen rapid growth over the last decade, and with relatively few sputters. The successes are visible and real – several Indian exchanges rank among the world’s top exchanges in terms of number of derivatives contracts traded (though the gures are exaggerated by the small size of Indian contracts compared to the major international exchanges); and there have been no large scale derivatives disasters of the sort that have roiled the advanced economies. But problems lurk not far beneath the surface. This paper peels away the layers and discusses the role of derivatives in financial markets and their development.