Final Fdrm

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INNOVATIVE FINANCIAL PRODUCTS

IN INDIAN DERIVATIVES MARKET

PRESENTED TO

PROF. DR. REKHA KUMAR

PRESENTED BY

GROUP 6

PALLAVI JAISWAL

GAURAV AGRAWAL

SHIV SHANKAR

SANDEEP BABAJI

SAMEEKSHA SINGH

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DERIVATIVE MARKETS IN INDIA

Derivative means a forward, future, option or any other hybrid contract of pre determined

fixed duration, linked for the purpose of contract fulfilment to the value of a specified real

or financial asset or to an index of securities.

Derivatives have been included in the definition of Securities in The Securities Contracts

(Regulations) Act, as a security derived from a debt instrument, share, loan, whether

secured or unsecured, risk instrument or contract for differences or any other form of

security; a contract which derives its value from the prices, or index of prices, of

underlying securities.Derivatives include options and futures. Certain options are short-term in nature and are

issued by investors. These options may be long-term in nature and are issued by companies

in the process of financing their activities.

Derivative trading in India takes place either on a separate and independent Derivative

Exchange or on a separate segment of an existing Stock Exchange. DerivativeExchange/Segment function as a Self-Regulatory Organization (SRO) 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.

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In November 1996 L.C.Gupta Committee was set up and in 1998 the recommendations of

L.C.Gupta Committee was accepted by the Government. Subsequently in February 1999,Securities Contract (Amendment) Act was passed and definition of derivatives was

inserted in SCRA. In June 2000, the actual trading in Index Futures started on Bombay

Stock Exchange (BSE) and National Stock Exchange (NSE).

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.

Economic functions of a derivatives market:

The derivatives market performs a number of economic functions:It helps in transferring risks from risk averse people to risk oriented people.

It helps in the discovery of future as well as current prices.

It catalyze entrepreneurial activity.

It increase the volume traded in markets because of participation of risk averse people in

greater numbers.

It increase savings and investment in the long run.

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FINANCIAL INNOVATION

A payment system that advances altering or modifying the role of banks, and financial

institutions in general, as intermediaries between suppliers and users of funds. Technological

innovations, such as Electronic Funds Transfer (EFT) payments, replace checks with

electronic debits and credits. Risk transferring innovations, such as adjustable-rate mortgage

(ARM) , transfer credit risk from one party to another. Credit generating innovations, for example, home equity credit lines, give borrowers new ways to use financial assets,

increasing the supply of available credit. Equity generating innovations, such as trust

preferred stock, give banks a less costly way to raise equity capital than issuing new shares of

common stock.

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DERIVATIVE PRODUCT COMPANY (DPC)

A special-purpose entity created to be a counter-party to financial derivate transactions. A

derivative product company will often originate the derivative product to be sold; as well,

they may guarantee an existing derivative product or be an intermediary between two other

parties in a derivatives transaction.

These companies are involved mainly in credit derivatives, such as credit default swaps,

but may also transact in the interest rate, currency and equity derivatives markets.

Derivative product companies cater mainly to other businesses that are looking to hedge

risks that can include currency fluctuations, interest rate changes and contract defaults.

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SCOPE OF INNOVATIVE FINANCIAL PRODUCTS IN INDIAN

DERIVATIVES MARKET

Factors generally attributed as the major driving force behind growth of financial derivatives

are:

Increased Volatility in asset prices in financial markets.

Increased integration of national financial markets with the international markets.Marked improvement in communication facilities and sharp decline in their costs.

Development of more sophisticated risk management tools, providing economic agents a

wider choice of risk management strategies.

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.

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APPLICATIONS OF FINANCIAL DERIVATIVES

M anagement of risk: This is most important function of derivatives. Risk management is notabout the elimination of risk rather it is about the management of risk. Financial derivatives

provide a powerful tool for limiting risks that individuals and organizations face in the

ordinary conduct of their businesses. It requires a thorough understanding of the basic

principles that regulate the pricing of financial derivatives. Effective use of derivatives can

save cost, and it can increase returns for the organisations.

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 the 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 instrument in cash market.

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Speculation: This is not the only use, and probably not the most important use, of financialderivatives. Financial derivatives are considered to be risky. If not used properly, these can

leads to financial destruction in an organisation like what happened in Barings Plc. However,

these instruments act as a powerful instrument for knowledgeable traders to expose

themselves to calculated and well understood risks in search of a reward, that is, profit.

P rice discover: Another important application of derivatives is the price discovery whichmeans revealing information about future cash market prices through the futures market.

Derivatives 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.

P rice stabilization function: Derivative market helps to keep a stabilising influence on spot prices by reducing the short-term fluctuations. In other words, derivative reduces both peak

and depths and leads to price stabilisation effect in the cash market for underlying asset.

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INNOVATIVE FINANCIAL PRODUCTS IN DERIVATIVES MARKET

CREDIT DERIVATIVES

WEATHER DERIVATIVES

ENERGY DERIVATIVES ( CRUDE OIL, NATURAL GAS, ELECTRICITY)

INSURANCE DERIVATIVES

FREIGHT DERIVATIVES

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CREDIT DERIVATIVES ² INTRODUCTION

Banks: Major players in credit market.

C redit market: An inefficient market.

Banks and FIs have higher loan portfolios.( higher returns and higher credit risk)

MFs, Insurance Cos, PFs and HFs have bond portfolios.( low returns and lower risk)

P roblem: No credit protection for the banks and no access to these higher return earning

portfolios by other groups.

S olution: Credit Derivatives (banks are able to protect themselves from credit risk). These

could not only bridge this gap but also develop a much more efficient market for bank loans.

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SECURITIZATION VS CREDIT DERIVATIVES

S ecuritization

Credit risk is hedged by eliminating the credit products from the books of credit provider.

Banks need to sell the bad debt/loan in the market.

C redit Derivatives

Transfers the credit risk without actually selling the assets( off-balance sheet financial

instruments).

Banks can seek protection against this risk by retaining the loans intact in their books.

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CREDIT DERIVATIVES ² DEFINITION

Credit derivatives are usually defined as:

³off-balance sheet financial instruments that permit one party (beneficiary) to transfer credit

risk of a reference asset, which it owns, to another party (guarantor) without actually selling

the asset´.

For exam ple, a bank concerned that one of its customers may not be able to repay a loan

can protect itself against loss by transferring the credit risk to another party while keepingthe loan on its books.

It, therefore, ³ unbundles´ credit risk from the credit instrument and trades it

separately.

These are over the counter financial contracts.

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CREDIT DERIVATIVES - CHARACTERISTIC FEATURES

Contract between beneficiary and guarantor.

Beneficiary(protection buyer) pays premium to guarantor(protection seller).

Reference asset is pre-defined.

Credit event is pre-defined. It could be bankruptcy, insolvency, payment default.

Settlement can be cash settled or in terms of the physical financial asset.

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DIFFERENT CREDIT DERIVATIVES

In India the market comprises only foreign banks like Citi bank, HSBC and no Indian bank

operates due to legal restrictions.

Credit default swaps

Total return swaps

Collateralized debt obligations

Collateralized loan obligations

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NEED AND SCOPE OF CREDIT DERIVATIVES IN INDIA

Requirement of effective transmission mechanism.

A mechanism to provide long term financing without taking credit risk.

Additional yield for investors by taking on credit risk.

Benefits to banks and financial institutions

a) Transfer credit risk and hence free up capital.

b) Maintain client relationships (may not turn down a lucrative deal based on exposure

limits).

c) Can construct and manage a credit risk portfolio.

d) Credit risk gets diversified ( from banks to other players and lead to financial stability).

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CREDIT DERIVATIVES ² OTHER BENEFITS

Increase liquidity in the market.

No intermediation.

No substantial transaction costs.

Financial intermediaries can participate in credit linked returns.

Financial system is benefited due to increased usage of capital and more efficient pricing of

exposures.

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WEATHER DERIVATIVES ² INTRODUCTION

Weather derivatives are financial instruments that are utilized to manage weather (&

climate) related risk.

They are similar to conventional financial derivatives.

The basic difference lies in the underlying variables that determine the pay-offs.

These underlying assets include temperature, precipitation, wind, and heating (& cooling)

degree days.

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WEATHER DERIVATIVES ² SCOPE

Weather derivative as a measure of hedging risk against adverse weather conditions it can

also be used as the mode of trading in derivatives.

The most advantageous factor of weather derivatives is the fact that they can't be

manipulated by any means like insider trading as the raining patterns are natural and beyond the scope of humans.

However, there is growing awareness and signs of potential growth in the trading of

weather futures among agricultural firms, restaurants and companies involved in tourism

and travel.

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WEATHER DERIVATIVES ² BENEFICIARIES

Any company whose revenue is affected by weather has a potential need for weather

derivatives. Some of these industries include:

Agriculture

Soft drinks and confectionery retailers

Hotels and leisure industry Sports

Engineering and construction industry

Energy producers and distributors

Insurance, re-insurance companies

Banks and financial institutions

Breweries, pubs and restaurantsTransport and distribution companies

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COOLING AND HEATING DEGREE DAY (CDD/ HDD)

CDDs/HDD in a season is defined as the accumulated number of degrees the daily mean

temperature is above a base figure.

CDD/HDD is the difference between a baseline temperature and the average temperature

for a day in winters

This is a measure of the requirement for cooling and heating.

The baseline temperature is fixed; it is 65o Fahrenheit in the U.S and 18o Celsius in Europe

Example: If accumulated CDDs exceed ³the strike ,́ then the seller pays the buyer a certain

amount for each CDD above ³the strike .́

Specifying the C DD C all O ption

Strike: 400 CDDs.

$100 per CDD (> 400 CDDs).

If, at expiry, the accumulated CDDs > 400, the seller of the option pays the buyer $100 for

each CDD > 400.

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WEATHER DERIVATIVES ² EXAMPLE

Let's consider a farmer growingWheat in a village, usually produces 100 quintals of Wheat

in his farm.

This year, he thinks the production will drop to 80 quintals

The Minimum Support Price for Wheat is Rs. 1000 per quintal.

This means that the farmer fears losing Rs 20,000 this season due to poor rainfall.

If the farmer had access to weather derivatives, he could have bought or sold rain day

futures contracts today and entered into an equal but opposite contract at a later date,

making a profit on the transaction, thus offsetting the losses due to low volumes produced.

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ENERGY DRIVATIVES ² INTRODUCTION

A derivative instrument in which the underlying asset is based on energy productsincluding oil, natural gas and electricity, which trade either on an exchange or over-the

-counter. Energy derivatives can be options, futures or swap agreements, among others. The

value of a derivative will vary based on the changes of the price of the underlying energy

product.

Energy derivatives can be used for both speculation and hedging purposes. Companies,whether they sell or just use energy, can buy or sell energy derivatives to hedge against

fluctuations in the movement of underlying energy prices. Speculators can use derivatives

to profit from the changes in the underlying price and can amplify those profits through the

use of leverage.

The energy markets these are traded in New York NYMEX, in Tokyo TOCOM and on-linethrough the Intercontinental Exchange. A future is a contract to deliver or receive oil (in

the case of an oil future) at a defined point in the future. The price is agreed on the date the

deal/agreement/bargain is struck together with volume, duration, and contract index.

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The price for the futures contract at the date of delivery (contract expiry date) may be

different. At the expiry date, depending upon the contract specification the 'futures' owner

may either deliver/receive a physical amount of oil (this is a rare occurrence), they maysettle in cash against an expiration price set by the exchange, or they may close out the

contract prior to expiry and pay or receive the difference in the two prices. In futures

markets you always trade with a formal exchange, every participant has the same

counterpart.

There are 3 principal applications for the energy derivative markets:a) Risk Management ("Hedging")

b) Speculation ("Trading")

c) Investment Portfolio Diversification

Analysis and measurement of risks, both market price risk and credit (non-performance)

risk, have become central to all players, measured as Value at Risk, Capital at Risk,

Earnings at Risk or Cash at Risk. Deal structuring for regulated utilities and unregulated players will increasingly focus on trading around energy assets: generation, transmission,

and distribution in the power, natural gas and coal sectors; pipelines and wells for crude oil

and gas. This will bring to the forefront the proper application of financial products used in

trading and hedging: exchange-traded natural gas futures, crude oil futures, coal futures,

together with over-the-the counter swaps, basis trades, and options.

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ENERGY DERIVATIVES ² SCOPE

Growth of these contracts attracted a broader range of participants to the energy markets

and stimulated trading in an even wider variety of energy derivatives providing economic benefits.

The key attribute of these securities is their leverage, i.e., for a fraction of the cost of

buying the underlying asset, they create a price exposure similar to that of physical

ownership. They provide an efficient means of offsetting exposures among hedgers or

transferring risk from hedgers to speculators.

In addition, derivatives promote information dissemination and price discovery. The

leverage and low trading costs in these markets attract speculators, and as their presence

increases, so does the amount of information impounded into the market price.

These effects ultimately influence the underlying commodity price through arbitrageactivity, leading to a more broadly based market in which the current price corresponds

more closely to its true value.

Because this price influences production, storage, and consumption decisions, derivatives

markets contribute to the efficient allocation of resources in the economy.

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ENERGY DERIVATIVES - CRUDE OIL

It is one of the most important commodities in the world, with global demand amounting to

about 80 million barrels daily.

10 year fixed±price supply contracts have been common place in the over the counter

market for many years. There are swaps where oil at a fixed price is exchanged for oil at a

floating price.

In the over the counter market, virtually any derivative that is available on common stock/sindices is now available with oil as the underlying asset. Swaps, Forward contracts and

Options are popular.

Contracts sometimes require settlement in cash and sometimes require settlement in

physical delivery ( i.e., by delivery in of the oil)

Exchange- traded contracts are also popular. The New York Mercantile Exchange

(NYMEX) and The International Petroleum Exchange (IPE) trade a number of oil futures

and futures options contracts. Settled either in cash or in physical delivery.

NYMEX also trades popular contracts on two refined products: heating oil and gasoline.

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ENERGY DERIVATIVES - NATURAL GAS

The Natural Gas Industry throughout the world has been going through a period of deregulation and the elimination of the government monopolies.

The Supplier of natural gas is now not necessarily the same company as the producer of the

gas as the supplier faces the problem of meeting daily demand. The seller of the gas is

usually responsible for moving the gas through pipelines to the specified locations.

A typical over the counter contract is for the delivery of a specified amount of natural gas

at a roughly uniform rate over a month period. Forward contracts, options and swaps are

available in the over the counter market.

NYMEX trades a contract for the delivery of 10,000 million British Thermal units of

natural gas. The contract if not closed out, requires physical delivery to be made during thedelivery month at a roughly uniform rate to a particular specified location.

The IPE also trades a similar contract of natural gas in London.

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ENERGY DERIVATIVES ² ELECTRICITY

Unlike natural gas, electricity has also been going through a period of deregulation and theelimination of government monopolies. This has been accompanied by the development of

an electricity derivative market.

NYMEX now trades a future contract on the price of electricity and the is an active over

the counter market in forward contracts, options and swaps.

A typical contract ( exchange traded or over the counter) allows one side to receive a

specified number of megawatt-hours for a specified price at a specified location during a

particular month.

Options contracts have either daily exercise or monthly exercise. In the case of daily

exercise, the option holder can choose on each day of the month to receive the specifiedamount of power at the specified strike price. In case of the monthly exercise, a single

decision on whether to receive power for the whole month at a specified strike price is

made at the beginning of the month.

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An interesting contract under electricity is known as swing option or take-and-pay option.

In this contract a minimum and maximum for the amount of power that must be purchased

at a certain price by the option holder is specified for each day during a month and for the

month in total. The option holder can change the rate at which the power is purchased

during the month, but usually there is a limit on the total number of changes that can bemade.

In India contracts are traded on the MCX. These contracts are still benchmarked to the

NYMEX. All such contracts are only futures contracts. Although the volume of trade is low

right now but it is picking up and can become an important component of trading in the

Indian market in future.

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ENERGY DERIVATIVES - EXAMPLE

Asset scenario Asset scenario -- fixed low profit, low risk in normal operation, major exposure to outagefixed low profit, low risk in normal operation, major exposure to outage

Buy gas forward, generate power, sell power forward lock Buy gas forward, generate power, sell power forward lock- -in a profit in a profit

Generation Generation 12,000 MWh12,000 MWh

per day per day

Power Forward Power Forward sales contract sales contract

$25/MWh$25/MWh

Gas Forward Gas Forward purchase purchase contract contract

$18/MWh$18/MWh

CostCost

Buy Fixed Gas Buy Fixed Gas

RevenueRevenue

Sell Fixed Power Sell Fixed Power

Gross ProfitGross Profit

$ 216,000$ 216,000

$ 300,000$ 300,000

$84,000$84,000

Gas Forward Gas Forward purchase purchase contract contract

$18/MWh$18/MWh

Market scenarioMarket scenario variable higher profit, higher risk in normal operation, reduced exposure to outagevariable higher profit, higher risk in normal operation, reduced exposure to outage

Buy gas forward, sell spot gas buy spot power, sell power forward Buy gas forward, sell spot gas buy spot power, sell power forward

Buy Spot Buy Spot Power Power $30/MWh$30/MWh

Power Forward Power Forward sales contract sales contract

$25/MWh$25/MWh

**

Sell Spot Sell Spot Gas Gas

$50/$50/MWhMWh

No No Generation Generation

**

CostCost

Buy Fixed Gas Buy Fixed Gas

Buy Spot Power Buy Spot Power

RevenueRevenueSell Fixed Power Sell Fixed Power

Sell Spot Gas Sell Spot Gas

Gross ProfitGross Profit

$ 216,000$ 216,000

$ 360,000$ 360,000

$ 300,000$ 300,000

$ 600,000$ 600,000

$324,000$324,000

**

**

** at risk to market price movements at risk to market price movements

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INSURANCE DERIVATIVES - INTRODUCTION

A financial instrument that derives its value from an underlying insurance index or the

characteristics of an event related to insurance. Insurance derivatives are useful for

insurance companies that want to hedge their exposure to catastrophic losses due to

exceptional events, such as earthquakes or hurricanes.

Unlike financial derivatives, which typically use marketable securities as their underlying

assets, insurance derivatives base their value on a predetermined insurance-related statistic.

For example, an insurance derivative could offer a cash payout to its owner if a specific

index of hurricane losses reached a target level. This would protect an insurance companyfrom catastrophic losses if an exceptional hurricane caused unforeseen amounts of

damage.

In the context of catastrophic risk, the valuation of such derivatives proves to be more

problematic because of two reasons-

F irst, valuation based on arbitrage arguments makes sense only when all underlying assetsare explicitly denied. However, the current generation of catastrophe derivatives is based

on underlying loss indices that are not traded on the market.

S econd, stochastic jump sizes of the underlying index µcreate¶ an incomplete market. Both

problems are inherently related to the question whether unique price processes of insurance

derivatives exist solely on the basis of excluding arbitrage opportunities.

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INSURANCE DERIVATIVES ² SCOPE

F irst, insurance derivatives can be used by insurers and reinsurers to

buy standardized protection against catastrophic risk. Alternatively, gaps in

existing reinsurance contracts can be filled since financial protection can be

provided between a lower desired retention level and the attachment point

currently offered. In addition, these derivatives can offer an opportunity to

synthetically exchange one layer for another without the need to enter costly

negotiations.

S econd, securitization of catastrophic risk turns catastrophes into trade able

commodities. Investors thus have the opportunity to invest indirectly

in risk that traditionally has been addressed by the insurance industry only.

Since catastrophic risk should prove highly uncorrelated to any other financial

risk that underlies stock or bond price movements trading in catastrophes

provides an additional way to diversify the investors¶ portfolio.

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INSURANCE DERIVATIVES - EXAMPLE

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FREIGHT DERIVATIVE ² INTRODUCTION

Freight derivatives are financial instruments to be used by organizations or individuals as part of A risk management strategy to counter the negative economic affect of freight price

alterations that harm the financial prospect of A company.

The underlying asset is the freight rate for a specific physical trade route.

It serve as a means of hedging exposure to freight market risk by providing for the purchase

or sale of a freight rate (the µcontract rate¶) along a named voyage route (the µcontract

route¶) over a specified period of time (the µcontract period¶).

It is primarily for dry bulk carriers and tankers.

Freight derivatives are primarily used by ship owners and operators, oil companies, trading

companies and grain houses as tools for managing freight market risk.

Such instruments include exchange traded futures contracts and options on futures

contracts, plus OTC(over-the-counter) freight forward contracts like FFAS(forward freight

agreements) swaps and swap options.

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The BALTIC exchange is a major exchange for freight derivatives.

The multi commodity exchange of India Ltd (MCX), in strategic collaboration with the

BALTIC exchange, London, introduced freight futures contract for the first time in the

country on 25th November, 2009.

The large financial trading houses, including banks and hedge funds have entered the

market.

4 clearing houses for freight are NOS clearing, the London clearing house limited and clear

net, NY mercantile exchange and Singapore stock exchange.

The scope of this is to reduce the effect of freight charges due to which the company can

minimize the loss.

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FREIGHT DERIVATIVE ² EXAMPLE

Buying a Forward Freight Agreement @ at $30 per ton.

Time duration: 1 month

Quantity: 150,000 tons of Australian iron ore @ $90 at a fixed price.

Total price to be paid: $4.5 mn (150000*30)

S cenario 1

If spot rate is $32 per ton

Then the party who has taken contract need to pay $4.5 mn only.

The remaining amount has to be paid by the counter party i.e. the amount is $ 0.3

mn(150000*2).

S cenario 2

If spot rate is $28 per ton

Then the party who has taken contract has to pay $4.5 mn.

The remaining amount will be taken by the counter party i.e. the amount is $ 0.3

mn(150000*2).

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