Trading Risks: Contracts and Regulatory Issues of Derivative Transactions in India

Posted: 12 Sep 2009

See all articles by Tabrez Ahmad

Tabrez Ahmad

Maulana Azad National Urdu University (MANUU)

Reshma Sheerin Jaffrey

KIIT Law School, KIIT University

Sheetal Sahoo

KIIT University - KIIT School Of Law

Aman Chatterjee

KIIT University - KIIT School Of Law

Date Written: September 11, 2009

Abstract

Derivatives are the most modern financial instruments in hedging risks. The individuals and firm who wish to avoid or reduce risk with others who are willing to accept the risk for a price. As the financial products commonly traded in the derivative market are themselves not primary loans or securities but can be used to change the risk characteristics of underlying asset or liability position, they are referred to as ‘derivative financial instruments’ or ‘simply derivatives’. These instruments are so called because they don’t have any intrinsic value of their own. Forwards, futures, options, swaps, etc are some of commonly used derivatives. A derivative is a security or contract designed in such a way that its price is derived from the piece of an underlying asset. The term ‘risk’ is used in finance in two different but related ways: as the magnitude of (a) the potential loss or (b) the standard deviation of the potential revenue (or income) of a trading or investment portfolio over some period of time. Futures contracts typically deal in large volumes and thus pose significant risk in the case of default. The larger a futures transaction, the greater the risk of default. The counterparties to such large risks therefore tend to be corporations, financial institutions, investment banks or sovereign entities. The growth in the use of derivative instruments has led to the concentration of risk management in large financial institutions - one of the factors which has contributed to the set of circumstances leading to the current debate on the subject. Until the amendment to the RBI Act in 2006, there was some ambiguity in the legality of OTC derivatives which were cash settled. This has now been addressed through an amendment in the said Act. In the light of increasing use of structured products and to ensure that customers understand the nature of the risk in these complex instruments, RBI after extensive consultations with market participants issued comprehensive guidelines on derivatives in April 2007.

The paper analyses market risk and counterparty credit risk and almost exclusively focuses on risk as potential loss. The methods for measuring, in a specified context, the potential loss of economic value of a portfolio of financial contracts are also described. The context that needs to be specified includes the time frame over which the losses might occur, the confidence level at which the potential losses are measured and the types of loss that would be attributed to the risk being measured .This wider distribution of credit risks within the global financial system should in principle limit risk concentrations and reduce the risk of a systemic shock. Banks have fewer incentives to effectively screen and monitor borrowers. A systematic deterioration in lending and collateral standards would of course entail losses greater than historical experience of default and loss-given-default rates would indicate, and it is not clear that current risk management practices make enough allowance for this. Further the gap between the original borrower and the ultimate investors widened with a number of vehicles in between. Secondly, events may force banks to re-assume risks they had assumed transferred to other parties - either to preserve a bank’s reputation or to honour contingency liquidity/credit lines.

The derivatives market in India has been expanding rapidly and will continue to grow. The participation of private and public sector banks and corporates are dependent on development of skills, adapting technology and developing sound risk management practices. While derivatives are very useful for hedging and risk transfer, and hence improve market efficiency, it is necessary to keep in view the risks of excessive leverage, lack of transparency particularly in complex products, difficulties in valuation, tail risk exposures, counterparty exposure and hidden systemic risk. Clearly there is need for greater transparency to capture the market, credit as well as liquidity risks in off-balance sheet positions and providing capital therefore. From the corporate point of view, understanding the product and inherent risks over the life of the product is extremely important. Further development of the market will also hinge on adoption of international accounting standards and disclosure practices by all market participants, including corporates. The recent episode of financial turbulence has provoked debate about the measurement, pricing and allocation of risk by way of derivatives, which can have important lessons for India.

Keywords: Hedging, futures, options,derivatives,swaps, trading, risk

Suggested Citation

Ahmad, Tabrez and Jaffrey, Reshma Sheerin and Sahoo, Sheetal and Chatterjee, Aman, Trading Risks: Contracts and Regulatory Issues of Derivative Transactions in India (September 11, 2009). Available at SSRN: https://ssrn.com/abstract=1471698

Tabrez Ahmad (Contact Author)

Maulana Azad National Urdu University (MANUU) ( email )

Gachibowli
Hyderabad, IN Telangana 500032
India
+918755929751 (Phone)

HOME PAGE: http://www.manuu.ac.in

Reshma Sheerin Jaffrey

KIIT Law School, KIIT University ( email )

Bhubaneswar -751024
School of Computer Engineering
Bhubaneswar, IN Odisha 751024
India

HOME PAGE: http://www.kls.ac.in

Sheetal Sahoo

KIIT University - KIIT School Of Law ( email )

PATIA
P.O. KIIT
Bhubaneswar, Orissa 751024
India

Aman Chatterjee

KIIT University - KIIT School Of Law ( email )

P.O. KIIT
Orissa

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