Risk dynamics. Last 3 decades has witnessed

Risk is almost synonyms for business enterprise and capital market. Variation in prices ofsecurities, commodities, business operations is induced by ever changing and evolving economicenvironment dynamics. Last 3 decades has witnessed the robust growth of innovative financialinstruments to mitigate or hedge the risk to certain extent. Financial Derivatives are one suchwonderful product of financial engineering that has transformed & re-energized the financialmarkets by offering innovative and inventing ways of trading & risk management in moderntime. In India the exchange traded derivative market started in June 2000, since then thelandscape of derivative trading has altered exponentially with the introduction of new products,higher volumes, newer contracts and advanced framework.The paper is an attempt to study genesis of plain vanilla and exotic derivative instruments’development ; growth in India. Paper discusses the relevant factors for the growth of exchangetraded ; exotic derivative in the country. The report also highlights the trends and currentposition of derivative asset class in terms of turnover and notional value in India and othereconomies of the world. It is interesting here to know the paradigm shift over time in the role ofderivative participants as end user or cross assets speculator.Keyword: OTC Derivative market, Exchange traded derivatives, Exotic derivatives, Financialinnovation,Introduction:Derivatives are the financial instruments to mitigate risks associated with fluctuation in theprices of the underlying. In other words, users of derivatives can hedge against fluctuations inexchange and interest rates, equity and commodity prices, as well as credit worthiness.Derivatives transactions are now familiar among a broad range of entities, including bankingfirms, financial institutions, central banks, mutual fund and pension fund managers, insurer,other NBFI and non-financial corporations. Participants in derivatives markets are oftenclassified as either “hedgers” or “speculators”. A number of financial reforms and fundamentalchanges in global financial markets have contributed to the strong growth in derivative markets.But derivatives like any other financial instruments are inherently risky. They are double edgedsword as they are highly leveraged transactions. Regulators have a role in the market to ensurethat besides economic benefits of financial derivatives trading activities remain on the efficientrisk return frontier. In this context the study of current scenario and trend of derivativeinstruments and market participation is important and contextual.Objective of the study:? To study the growth and development of plain vanilla and exotic derivative productsacross different asset class.? To discuss the relevant factors which lead to the growth of exotic derivatives in thecountry.? To study present position of Indian derivative market with respect to other economies ofthe world.? To observe the shift in recent years in the role of derivative participants as end user orcross asset speculator.Literature ReviewData for this study was generated by referring text books, trade journals, articles fromnewspapers and internet websites.A historical roots of derivatives trading was analysed byAshutosh Vashistha ; Satish Kumar in his paper 'development of financial derivatives market inIndian. In NSE research paper Gopala C Nath has studied the behaviour of market volatility afterderivatives. In 2013 Dr Kamlesh Gokhar ;Ms Mattu analysed the trading issue and bottlenecksfor derivatives in India2010.MethodologyThe research is a descriptive explanatory type as it attempts to explore and explain currentscenario in derivative market in more detail, filling in missing part and expanding understanding.The paper is designed in four sections. Section I deals with the concept, definitions and relevantfactors for the growth of derivative products. Section II discusses trend and growth of theseinstruments in Indian market in terms of turnover ; also role of participants. Section IIIdiscusses the data and positional information of Indian derivative market in respect of globalderivative exchanges. Lastly, section IV specifies the summary and conclusion.SECTION IDerivatives indicate financial contracts that have no independent value but derive its value fromunderlying assets. Any underlying asset that is subject to market volatility and price fluctuationis a good candidate for being the basis for a financial derivative. Be it indices, equity, interestrate, currency, commodity, weather or inflation. In financial world plain vanilla derivatives is todescribe such instruments that has no additional embedded features or any hidden condition.Vanilla is jargon for things that are simple. The standardized form of financial derivatives isgenerally referred as plain vanilla derivatives. This form constitutes the basic form of derivativewithout any complex specification relating to underlying, type of calculation or payoff like Indexfuture and options, equity future ; option, forward contracts, interest rate derivatives contacts,currency futures and options etc.Exotic derivatives instruments refer to the products which can be characterized by not commonlyused underlying, a complex payoff determination or low trade volume. Currently exotic couldinclude weather derivative- where underlying is heating degree days (HDD) or cooling degreedays (CDD), freight derivative- where underlying is future freight rates or may be inflationderivative- where underlying is inflation rate. Most exotic derivatives are traded in over thecounter (OTC) market as they are customized to individual customer specific requirements.Common exotic instruments are digital options, barrier options, basket options, options on theaverage and many other innovative instruments depending upon the requirements of market.With time when there is an increase in market demand of a particular exotic derivative or if theunderlying becomes more common and at the same time there is a simplification of relatedworking model of an exotic instrument then these instruments qualifies to become mainstreamplain vanilla derivative instruments.Derivative can broadly be classified into two categories on the basis of market where they aretraded- exchange traded derivatives (ETD) ; over the counter (OTC). OTC derivativesconstitutes the greater proportion of derivatives in existence, they are less regulated andcustomized contracts whereas ETD are standardized. OTC derivative generally have greater riskfor counterparty then do standardized derivatives. Most common derivative contracts areFutures ; Forwards, Options and Swaps. Generally product innovation ; exotic products in thismarket are initially introduced in OTC market as it offers better condition due to more liberalregulatory framework and lower initial investment.Players in derivative market are risk hedgers, speculators or arbitragers. Hedgers are those whoprotect themselves from the risk associated with the price volatility of an assets throughderivative instruments. They are the end users as corporate/individuals/institutions who areexposed to financial risk. Speculators or traders bet on the future movement in the price of anasset and not interested in actual owning. Arbitragers are the persons who attempt to profit fromthe price inefficiencies in different market.The relevant factors which lead to the development of derivative markets in the India can beenumerated as follows:? Globalisation and financial sector reforms? Participants’ requirement –both end user and cross asset trader.? Risk taking capabilities and analytical skills? Physical infrastructure- India equity market moves towards satellite connectivityfacilitating trading and liquidity facilities now from anywhere. There is robustadvancement in the technology which is evidenced from the fact that in spite ofsignificant increase in volume and quotes the execution time of transaction in BSE hasgone down to 6 micro seconds.? Liquidity in underlying? Clearing house for most trades.SECTION IIThe volume of both exchange-traded and OTC derivative markets have grown sharply in recentyears. Options of various kinds (called Teji, Mandi & Fatak) in unorganized market were tradedas early as in 1900 in Mumbai. However they were banned since independence but with openingup of the economy this ban was removed in 1995 by RBI when it permitted currency derivativesto hedge exchange rate risk. RBI has permitted options, interest rate swaps, currency swaps andother risk reduction OTC derivatives products. Advancement in trading electronic platform haschange the trading process in Indian OTC market. This only replicates the multilateral tradingthat is hallmark of an exchange but only for direct participants.The Bank for International Settlements statistics on OTC derivatives markets showed thatnotional amounts outstanding totaled $693 trillion at the end of June 2013.There is nocomprehensive source for assessing the total volume of transactions carried out on the IndianOTC derivatives market. Therefore, the information presented for interest rate derivatives andforeign currency derivatives on RBI portal is the basis to show the growth of these OTCinstruments in Indian context. Total derivative contracts as per RBI source shows a growth of17% from 2007 to 2009 and this growth rate is expected to sustain & increase in the future. Theactivity in the forex derivative markets can also be assessed from the positions outstanding in thebooks of the banking system. As of December 2009, total forex contracts outstanding in thebanks’ balance sheet amounted to INR 36,142 billion (USD 774.25 billion), of which over 86%were forwards and rest options.Exchange traded derivative in India made debut with the introduction of stock index future in2000. In that year the number of contracts were 90580 with turnover of Rs 2356 Cr. In 2016-17total contract traded in this stock rose many fold to 66535070 with turnover of Rs 4335940 Cr.Table 2.1 shows the participants for derivatives. It is evidenced from the table that currentlylarge number of participants is natural hedgers. Participants in IRS, CDS, FX are investmentbanks and NBFI. BIS triennial central bank survey 2013 concluded that NBFI accounted formore than half of foreign exchange and interest rate trading in the global market.

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