The latest buzzword ready to hit Indian financial markets is Derivative. Derivatives are wasting assets, which derive their values from an underlying asset. These underlying assets are of various categories like equity, bonds, commodities etc. For example, a dollar Forward is a derivative contract, which gives the buyer a right & an obligation to buy dollars at some future date. The prices of the derivatives are driven by the spot prices of these underlying assets.

There is a debate going on in the Indian financial circles on the issue of introduction of derivatives. World over, in developed financial markets, these instruments have been in vogue for quite sometime now. The arguments in favor are as follows:

• A tool for hedging: Derivatives provides an excellent mechanism to hedge the future price risk. Think of a farmer, who doesn’t know what price he is going to get for his crop at the time of harvest. He can sell his crop in the futures’ market & lock in the price. If the future spot price is more than the futures price, he can take the off setting position & can get out of the market (with a marginal loss). Otherwise he will get the locked in price.

• Risk management: Derivatives provide an excellent mechanism to Portfolio Managers for managing the portfolio risk and to Treasury Managers for managing interest rate risk. The importance of index futures & Forward Rate Agreement (FRA) in this process can’t be overstated.

• Better avenues for raising money: With the introduction of currency & interest rate swaps, Indian corporate will be able to raise finance from global markets at better terms.

• Price discovery: These derivative instruments make the spot price discovery more reliable using different models like Normal Backwardation hypothesis. These instruments will cause any arbitrage opportunities to disappear & will lead to better price discovery.

• Increasing the depth of financial markets: When a financial market gets such sort of risk-management tools, its depth increases since the Institutional Investors get better ways of hedging their risks against unfavorable market movements.

• Derivatives market on Indian underlying elsewhere: These days, with the advent of technology, Indian prices are available globally on Reuters & Knightrider. Nothing prevents any foreign market from launching derivatives on these Indian underlying. This will put Indians in a disadvantageous position as they can’t take the advantages of derivatives of securities or commodities traded in India but someone lese can take. So we will have to move fast in this direction.

• Empirical evidence: There is strong empirical evidence from other countries that after derivative markets have come about, the liquidity and market efficiency of the underlying market has improved.

Now taking a look at arguments against :-

• Speculation: Many people fear that these instruments will unnecessarily increase the speculation in the financial markets, which can have far reaching consequences. The recent Barrings Bank incident is the classic case in point.

• Market efficiency: Many people fear that the Indian markets are not mature & efficient enough to introduce these instruments. These instruments require a well functioning & mature spot market. Like recently The Economic Times reported the strong correlation of Indian equity markets to the NASDAQ. Such type of market imperfections makes the functioning of derivatives market all the more difficult.

• Volatility: The increased speculation & inefficient market will make the spot market more volatile with the introduction of derivatives.

• Counter party risk: Most of the derivative intruments are not exchange traded. So there is a counter party default risk in these intruments. Again the same Barrings case, Barrings declared itself bankrupt when it faced huge losses in these instruments.

• Liquidity risk: Liquidity of a market means the ease with which one can enter or get out of the market. There is a continued debate about the Indian market’s capability to provide enough liquidity to derivative trader.

So one can see that the pros of derivatives far outweigh the cons. And moreover, by imposing margin requirements, by limiting the exposure one can take and other measures like that, these vices of derivatives can be controlled. The importance of derivatives for any financial market can’t be overstated.