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AKNOWLEDGMENT
The felling of gratitude when expressed in words is only a fraction of
acknowledgement. I am sincerely very thankful to Dr. Kapil Sharma,
for giving me the opportunity.
My deepest gratitude toward my project guide Dr. Kapil Sharma
who gave his valuable time and provided me with useful suggestion
with the help of which, I could complete my term paper work
successfully.
I am also very thankful to my friend without whom I could not have
completed my term paper.
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DECLERATION
I, Mr. ABHISHEK MEVAFAROSH hereby declare that student ofmaster of business administration (Financial Administration),
Institute of management studies, DAVV, Indore has completed this
term paper on USE OF DERIVATIVES BY BANK/INDIAN BANK
in the academic year 2011-12. The information submitted is true
and original to the best of my knowledge.
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Introduction of derivatives market
The word derivatives comes from the verb to derive it indicates that it has no
independent value. A derivative is a contract whose value is derived from the value
of another asset, known as underlying asset, which could be a share, a stock market
index, an interest rate, a commodity or a currency. When the prise of this underlying
changes, the value of the derivative also changes. Without an underlying, derivative
do not having any meaning.
Exam: - The value of a gold future contract derives from the value of the underlying asset (gold).
Introduction of banking system
The baking system is the fuel injection system which spurs economic efficiency by
mobilising saving and allocating them to high return investment. Research confirms
that countries with a well-developed banking system grow faster than those with a
weaker one. The banking sector is dominant in India as it accounts for more than
half the assets of the financial sector.
Use of financial Derivatives by Bank
Banks typically participate in derivatives markets because their traditional lending
and borrowing activities expose them to financial market risk. Interest rate risk, or
market risk, is, in general, the potential for changes in rates to reduce a banks
earnings or value. As financial intermediaries, banks encounter interest rate risk in
several ways. The primary source of interest rate risk stems from timing differences
in the reprising of bank assets, liabilities, and off-balance-sheet instruments. These
reprising mismatches are fundamental to the business of banking and generallyoccur from either borrowing short term to fund long-term assets or borrowing long
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term to fund short-term assets. Financial derivatives provide banks with an effective
way to manage interest rate risk without incurring additional capital charges.
Derivatives can be used to hedge asset and liability positions by allowing banks to
take a position in the derivatives market that is equal and opposite to a current or
planned future position in the spot or cash market.
It has been argued that federal
deposit insurance held by banks provides an incentive to use derivatives in a
speculative manner in order to increase the value of shareholder equity by
expanding into activities that shift risk onto the deposit insurer. Speculating with
derivatives involves gambling on the future performance of the underlying assets in
an attempt to reap trading profits.
The acceleration of derivative by Bank
Use of derivative e by bank begins from the late 1970s and 1980s, when banks
market risk exposure proved fatal to many institutions. During this period, interest
rates were extremely volatile-mortgage rates rose to over 15% while the prime rate
surpassed 20%. Banks found themselves in a more vulnerable position. Many banks
experienced a dramatic drop in their market values, and as a result 1000 insured
banks with approximately $92 billion in deposits failed over the decade. Because of
the rapidly rising number of bank failures during the 1980s, the Federal Regulatory
Agencies became concerned about the amount of capital held by commercial banks.
At the time capital requirements for a bank were based solely on its total assets. No
consideration was given to the risk embedded in the assets. The Committee
assigned to investigate the problem formulated the Federal Deposit Insurance
Corporation Improvement Act (FDICIA), passed in 1991. In an effort to develop
formal capital charges that conformed more closely to banks true risk exposure
regulators implemented risk-based capital requirements through FDICIA in
accordance with the Basel Accord of 1988. The new risk-based capital requirements
took into account the amount of credit risk of the assets held by a particular bank in
determining the level of capital required for that bank. The requirements called for
assets to be divided into four categories according to their riskiness. Cash and its
equivalents, including short term Treasury securities, were assigned a zero weight,
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municipal general obligation bonds and mortgage-backed securities a 20% weight.
Moderate risk assets and assets in a banks loan portfolio, including residential
mortgages, carried a 50% weight and commercial loans, loans made to developing
countries (LDC loans) and corporate bonds held a 100% weight. A required
minimum ratio of total capital to risk-weighted assets was established at 7.25%.The
risk-based capital requirements discussed above are based solely on credit risk;
however, in developing FDICIA, regulators realized the need to establish guidelines
for protecting banks against interest-rate risk as well. From the regulatory
perspective in a risk-based capital environment, interest-rate risk should be
incorporated into existing capital requirements as well as credit risk. Thus, as
outlined in FDICIA, regulators set out to incorporate interest rate risk into capital
charges based on the interest rate sensitivity of the assets and liabilities of the bank.
Specifically, assets, liabilities and off-balance sheet instruments are divided into
seven maturity groups: 0 to 3 months; 3 months to 1 year; 1 year to 3 years; 3 to 5
years; 5 to 10 years; 10 to 20 years; and more than 20 years. Each group is then
assigned a duration based on a benchmark instrument representative of the assets
and the liabilities in that group. Duration is the measure of the approximate change in
the value of an asset or liability for a change of 100 basis points in interest rates.
Once the durations are computed, they are multiplied by the balances in each of the
respective groups, and the net balance sheet duration is calculated. The results
provide an estimate of the amount by which the surplus or equity position, (the
difference between a banks assets and liabilities) is expected to change as a result
of a given change in interest rates. According to the proposal, if the surplus changes
by more than one percent of assets, the bank must hold additional capital in an
amount equal to the excess.
Development of Derivative Markets in India
Derivatives markets have been in existence in India in some form or other for a long
time. In the area of commodities, the Bombay Cotton Trade Association started
futures trading in 1875 and, by the early 1900s India had one of the worlds largest
futures industry. In 1952 the government banned cash settlement and options
trading and derivatives trading shifted to informal forwards markets. In recent years,government policy has changed, allowing for an increased role for market-based
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pricing and less suspicion of derivatives trading. The ban on futures trading of many
commodities was lifted starting in the early 2000s, and national electronic commodity
exchanges were created.
In the equity markets, a system of trading called badla
involving some elements of forwards trading had been in existence for decades.6
However, the system led to a number of undesirable practices and it was prohibited
off and on till the Securities and Exchange Board of India (SEBI) banned it for good
in 2001. A series of reforms of the stock market between 1993 and 1996 paved the
way for the development of exchange-traded equity derivatives markets in India. In
1993, the government created the NSE in collaboration with state-owned financial
institutions. NSE improved the efficiency and transparency of the stock markets by
offering a fully automated screen-based trading system and real-time price
dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE
sent a proposal to SEBI for listing exchange-traded derivatives. The report of the L.
C. Gupta Committee, set up by SEBI, recommended a phased introduction of
derivative products, and bi-level regulation (i.e., self-regulation by exchanges with
SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma
Committee in 1998, worked out various operational details such as the margining
systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was
amended so that derivatives could be declared securities. This allowed the
regulatory framework for trading securities to be extended to derivatives. The Act
considers derivatives to be legal and valid, but only if they are traded on exchanges.
Finally, a 30-year ban on forward trading was also lifted in 1999.
The economic liberalization of the early
nineties facilitated the introduction of derivatives based on interest rates and foreign
exchange. A system of market-determined exchange rates was adopted by India in
March 1993. In August 1994, the rupee was made fully convertible on current
account. These reforms allowed increased integration between domestic and
international markets, and created a need to manage currency risk. Figure 1 shows
how the volatility of the exchange rate between the Indian Rupee and the U.S. dollar
has increased since 1991.7 The easing of various restrictions on the free movement
of interest rates resulted in the need to manage interest rate risk.
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Derivatives Instruments Traded in India
In the exchange-traded market, the biggest success story has been derivatives on
equity products. Index futures were introduced in June 2000, followed by index
options in June 2001, and options and futures on individual securities in July 2001
and November 2001, respectively. As of 2005, the NSE trades futures and options
on 118 individual stocks and 3 stock indices. All these derivative contracts are
settled by cash payment and do not involve physical delivery of the underlying
product (which may be costly).
Derivatives on stock indexes and individual stocks
have grown rapidly since inception. In particular, single stock futures have become
hugely popular, accounting for about half of NSEs traded value in October 2005. In
fact, NSE has the highest volume (i.e. number of contracts traded) in the single stock
futures globally, enabling it to rank 16 among world exchanges in the first half of
2005. Single stock options are less popular than futures. Index futures are
increasingly popular, and accounted for close to 40% of traded value in October
2005. NSE launched interest rate futures in June 2003 but, in contrast to equity
derivatives, there has been little trading in them. One problem with these instruments
was faulty contract specifications, resulting in the underlying interest rate deviatingerratically from the reference rate used by market participants. Institutional investors
have preferred to trade in the OTC markets, where instruments such as interest rate
swaps and forward rate agreements are thriving. As interest rates in India have
fallen, companies have swapped their fixed rate borrowings into floating rates to
reduce funding costs.10 Activity in OTC markets dwarfs that of the entire exchange-
traded markets, with daily value of trading estimated to be Rs. 30 billion in 2004.
Foreign exchange derivatives are less active than interest rate derivatives in India,even though they have been around for longer. OTC instruments in currency
forwards and swaps are the most popular. Importers, exporters and banks use the
rupee forward market to hedge their foreign currency exposure. Turnover and
liquidity in this market has been increasing, although trading is mainly in shorter
maturity contracts of one year or less In a currency swap, banks and corporations
may swap its rupee denominated debt into another currency (typically the US dollar
or Japanese yen), or vice versa. Trading in OTC currency options is still muted.
There are no exchange-traded currency derivatives in India.
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Exchange-traded
commodity derivatives have been trading only since 2000, and the growth in this
market has been uneven. The number of commodities eligible for futures trading has
increased from 8 in 2000 to 80 in 2004, while the value of trading has increased
almost four times in the same period. However, many contracts barely trade and, of
those that are active, trading is fragmented over multiple market venues, including
central and regional exchanges, brokerages, and unregulated forwards markets.
Total volume of commodity derivatives is still small, less than half the size of equity
derivatives.
Use of derivatives in India by financial institution/Banks
The use of derivatives varies by type of institution. Financial institutions, such as
banks, have assets and liabilities of different maturities and in different currencies,
and are exposed to different risks of default from their borrowers. Thus, they are
likely to use derivatives on interest rates and currencies, and derivatives to manage
credit risk. In contrast to the exchange-traded markets, domestic financial institutions
and mutual funds have shown great interest in OTC fixed income instruments.Transactions between banks dominate the market for interest rate derivatives, while
state-owned banks remain a small presence Corporations are active in the currency
forwards and swaps markets, buying these instruments from banks. Credit and
interest rate risks are two core risks all banks accept and hope to profit from. Foreign
currency (price) risk accepted by banks varies widely across the four categories.
Commodity (price) risk accepted by banks is limited to gold price risk in respect of
gold deposits accepted by five banks under their schemes framed under RBI
guidelines on the Gold Deposit Scheme 1999 announced in the union budget for the
year 1999-2000. Equity (price) risk accepted by banks again is limited to their direct
or indirect (through MFs) exposure to equities under the RBI prescribed 5 % capital
market instruments limit (of total outstanding advances as at previous year-end).
Some banks may have further equity exposure on account of equities collaterals
held against loans in default.
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Derivatives instrument which is used by bank
1 Credit derivatives:-
Credit derivatives are bilateral financial contracts
with payoffs linked to a credit related event such as non-payment of interest, a credit
downgrade, or a bankruptcy filing. A bank can use a credit derivative to transfer
some or all of the credit risk of a loan to another party or to take on additional risks.
In principle, credit derivatives are tools that enable banks to manage their portfolio of
credit risks more efficiently. The promise of these instruments has not escaped
regulators and policymakers. In various speeches as the head of the Federal
Reserve System, Alan Greenspan concluded that credit derivatives and other
complex financial instruments have contributed to the development of a far more
flexible, efficient, and hence resilient financial system than existed just a quarter-
century ago.. The largest sector of the credit derivatives market is the credit default
swap market where the most liquid individual names on which credit derivatives are
written are large US investment grade firms, foreign banks, and large multinational
firms, but much of the most recent growth of the market has been in index
derivatives.
Perhaps, the following evolution in the corporate credit markets in India
could pave way to a credit derivatives market:
1. Presence of a liquid corporate bond market is essential for a term structure of
corporate credit spreads over the sovereign curve to emerge.
2. Insurance sector which is a seller of credit derivatives in other markets would need
evolve on the sell side of the credit derivatives market.
3. RBI guidelines on guarantees and co-acceptances2 presently preclude banks
from issuing guarantees favouring other lending agencies, banks or FIs for loans
extended by them. This restriction would need to go if banks are to sell or write credit
derivatives.
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4. There is no RBI guideline permitting use of credit derivatives by banks and FIs to
reduce regulatory capital on their respective balance sheet. This is one of the best
uses of credit derivatives internationally.
(A) Swap:-
A swap is an agreement between two parties to exchange sequences
of cash flows for a set period of time. Usually, at the time the contract is
initiated, at least one of these series of cash flows is determined by a
random or uncertain variable, such as an interest rate, foreign
exchange rate, equity price or commodity price. Conceptually, one may
view a swap as either a portfolio of forward contracts, or as a longposition in one bond coupled with a short position in another
bond. This article will discuss the two most common and most basic
types of swaps:
(I) Plain Vanilla Interest Rate Swap:-
The most common and simplest swap is a "plain vanilla" interest rate
swap. In this swap, Party A agrees to pay Party B a predetermined,fixed rate of interest on a notional principal on specific dates for a
specified period of time. Concurrently, Party B agrees to make
payments based on a floating interest rate to Party A on that same
notional principal on the same specified dates for the same specified
time period. In a plain vanilla swap, the two cash flows are paid in the
same currency. The specified payment dates are called settlement
dates, and the time between are called settlement periods. Because
swaps are customized contracts, interest payments may be made
annually, quarterly, monthly, or at any other interval determined by the
parties.
(II) Plain Vanilla Foreign Currency Swap:-
The plain vanilla currency swap involves exchanging
principal and fixed interest payments on a loan in one currency for principal and fixed
interest payments on a similar loan in another currency. Unlike an interest rate swap,
the parties to a currency swap will exchange principal amounts at the beginning and
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end of the swap. The two specified principal amounts are set so as to be
approximately equal to one another, given the exchange rate at the time the swap is
initiated.
2 Interest-Rate Derivatives:-
A financial instrument based on an
underlying financial security whose value is affected by changes in interest rates.
Interest-rate derivatives are hedges used by institutional investors such as banks to
combat the changes in market interest rates. Individual investors are more likely to
use interest-rate derivatives as a speculative tool - they hope to profit from their
guesses about which direction market interest rates will move. The RBI is yet topermit banks to write rupee (INR) interest rate options. Indeed, for banks to be able
to write interest rate options, a rupee interest rate futures market would need to first
exist, so that the option writer can deltahedge the risk in the interest rate options
positions. And, according to one school of thought, perhaps the policy dilemma
before RBI is: how to permit an interest rate futures market when the current
framework does not
permit short selling of sovereign securities. Further, even if short selling of sovereignsecurities were to be permitted, it may be of little consequence unless lending and
borrowing of sovereign securities is first permitted.
3 Foreign currency derivatives:-
An agreement to make a
currency exchange between two foreign parties. The agreement consists of
swapping principal and interest payments on a loan made in one currency for
principal and interest payments of a loan of equal value in another currency. The
Federal Reserve System offered this type of swap to several developing countries in
2008.
Derivative markets worldwide have witnessed explosive growth in recent past.
According to the BIS Triennial Central Bank Survey of Foreign Exchange and
Derivatives Market Activity as of April 2007 was released recently and the OTCderivatives segment, the average daily turnover of interest rate and non-traditional
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foreign exchange contracts increased by 71 % to $2.1 trillion in April 2007 over April
2004, maintaining an annual compound growth of 20 per cent witnessed since 1995.
Turnover of foreign exchange options and cross-currency swaps more than doubled
to $0.3 trillion per day, thus outpacing the growth in 'traditional' instruments such as
spot trades, forwards or plain foreign exchange swaps. The traditional instruments
also show an unprecedented rise in activity in traditional foreign exchange markets
compared to 2004. Average daily turnover rose to $3.2 trillion in April 2007, an
increase of 71% at current exchange rates and 65% at constant exchange rates.
Relatively moderate growth was recorded in the much larger interest rate segment,
where average daily turnover increased by 64 per cent to $1.7 trillion. While the
dollar and euro clearly dominate activity in OTC interest rate derivatives, their
combined share has fallen by nearly 10 percentage points since the 2004 survey, to
70 per cent in April 2007, as turnover growth in several non-core markets outstripped
that in the two leading currencies. RBI is yet to permit authorized dealers to write
FCY:INR options. Interestingly, domestic corporates with rupee liabilities may also
enter into FCY:INR swaps with authorized dealers to hedge their long-term interest
rate exposures. (This enables corporates to benchmark their rupee liability servicing
costs to foreign currency yield curve). There is now an active Over-The-Counter
(OTC) foreign currency derivatives market in India. However, the activity of most
PSB majors in this market is limited to writing FCY derivatives contracts with their
corporate customers on fully covered back-to-back basis. And, most PSBs do not
run an active foreign currency derivatives trading book, on account of the
impediments enumerated earlier that need to be overcome at their end. RBI is yet to
permit authorized dealers to write FCY:INR options. Interestingly, domestic
corporates with rupee liabilities may also enter into FCY:INR swaps with authorized
dealers to hedge their long-term interest rate exposures. (This enables corporates to
benchmark their rupee liability servicing costs to foreign currency yield curve). There
is now an active Over-The-Counter (OTC) foreign currency derivatives market in
India. However, the activity of most PSB majors in this market is limited to writing
FCY derivatives contracts with their corporate customers on fully covered back-to-
back basis. And, most PSBs do not run an active foreign currency derivatives trading
book, on account of the impediments enumerated earlier that need to be overcome
at their end.
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4 Mutual funds:-
(I) Equity derivatives:-
Mutual Funds ought to be natural players in the equity derivatives
market. SEBI (MF) Regulations also authorize use of exchange traded equity
derivatives by mutual funds for hedging and portfolio re-balancing purposes. And,
being tax exempt, there are also no tax issues relating to use of equity derivatives by
them. However, most mutual funds (whether managed by Indian or foreign owned
asset management companies) are not yet active in use of equity derivatives
available on the NSE or BSE. The following impediments seem to hinder use of
exchange trade equity derivatives by mutual funds:
1. SEBI (Mutual funds) regulations restrict use of exchange traded equity
derivatives to hedging and portfolio rebalancing purposes. The popular view
in the mutual fund industry is that this regulation is very open to interpretation;
and the trustees of mutual funds do not wish to be caught on the wrong foot!
The mutual fund industry therefore wants SEBI to clarify the scope of this
regulatory provision.
2. Inadequate technological and business process readiness of several players
in the mutual fund
industry to use equity derivatives and manage related risks.
3. The regulatory prohibition on use of equity derivatives for portfolio
optimization return
enhancement strategies, and arbitrage strategies constricts their ability to use
equity derivatives.4. Relatively insignificant investor interest in equity funds ever since exchange
traded options and futures were launched in June 2000 (on NSE, later on
BSE).
(II) Fixed income derivatives:-
SEBI (MF) regulations are silent about use of IRS and FRA
by mutual funds. Evidently, IRS and FRA transactions entered into by mutual fundsare not construed by SEBI as derivatives transactions covered by the restrictive
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provisions which limit use of derivatives by mutual funds to exchange traded
derivatives for hedging and portfolio balancing purposes. MFs are emerging as
important users of IRS and FRA in the Indian fixed income derivatives market. At
least a few mutual funds actively use IRS to optimize yield and reduce the duration
of their bond scheme portfolios, by paying fixed rate and receiving floating rate. It is
understood that some of these IRS are benchmarked to MIFOR as well. (Needless
to add, given the open-ended nature of most bond schemes of mutual funds, such
MIFOR linked IRS have the potential of generating noticeable basisrisk, besides the
liquidity risk in the underlying bond asset of longer maturity.)
(III) Foreign currency derivatives:-
In September 1999 Indian mutual funds
were allowed to invest in ADRs/GDRs of Indian companies in the overseas market
within the overall limit of US$ 500 million with a sub-ceiling for individual mutual
funds of 10 percent of net assets managed by them (at previous year-end), subject
to maximum of US$ 50 million per mutual fund. Several mutual funds had obtained
the requisite approvals from SEBI and RBI for making such investments. However,
given that most ADRs/GDRs of Indian companies traded in the overseas market at a
premium to their prices on domestic eq-uity markets, this facility has remained
largely unutilized. Therefore, the question of using FCY:INR forward cover or swap
did not much arise. However, recently, from 30 March 2002 domestic mutual funds
have been permitted to invest in foreign sovereign and corporate debt securities
(AAA rated by S&P or Moody or Fitch IBCA) in countries with fully convertible
currencies within the overall market limit of US$ 500 million, with a sub-ceiling for
individual mutual funds of four percent of net assets managed by them as on 28
February 2002, subject to a maximum of US$ 50 million per mutual fund. Several
mutual funds have now obtained the requisite SEBI and RBI approvals for making
these investments. Once investment in foreign debt securities pick-up, mutual funds
ought to emerge as active users of FCY:INR swaps to hedge the foreign currency
risk in these investments.
(IV) Commodity derivatives:-
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Under SEBI (MF) regulations, mutual funds can invest
only in transferable financial securities. In absence of any financial security linked to
commodity prices, mutual funds cannot offer a fund product that entails a proximate
exposure to the price of any commodity. Therefore, the issue of they using
commodity derivatives (whether in the overseas or Indian market) does not arise.
However, interestingly, one of the players in the mutual fund industry proposes to
offer an exchange traded gold fund that would invest solely in transferable gold
receipts/certificates issued by one or more of the 13 bullion banks which have been
authorized by RBI to accept gold deposits under the Gold Deposit Scheme 1999.
The draft offer document of the scheme is awaiting SEBI clearance. This product
aspires to offer investors the ability to hold gold as an asset class (with its attendant
risks and rewards) in the form of a financial asset, with the prospect of also getting
some regular income in the form of interest on the gold receipts/certificates held by
the fund.
Bank Participant in Indian derivatives market
Name of the Organisation Name of the Officer / Designation
1. State Bank of India Shri A. Ghosh, General Manager, Credit
Policy and Procedures Department
2. ICICI Bank Ms. Vishakha Mulye, Joint General Manager
3. Citibank Shri Ravi Savur, Vice President
4. HSBC Shri Anand Krishnamurthy, Deputy Head
Interest Rates
5. Bank of America Shri Joydeep Sengupta, Vice PresidentHead
Derivative Advisory
6. General Insurance Corpn. Smt. M.M. Parkhi, Manager
7. Reserve Bank of India, Department ofBanking Supervision Shri Amrendra Mohan, General Manager
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8. Reserve Bank of India, Exchange Control
Department
Shri R.N. Kar, Deputy General Manager
9. Reserve Bank of India, Industrial & Export
Credit Department
Ms. Rose Mary Sebastian, General Manager
10. Reserve Bank of India, Department of
Banking Operations & Development
Shri B. Mahapatra, General Manager
(Convenor)
Establishment years of derivatives product
1874 Commodity Futures1972 Foreign currency futures1973 Equity options1975 T-bond futures1981 Currency swaps1982 Interest rate swaps; T-note futures; Eurodollar futures;
Equity index futures; Options on T-bond futures;Exchange{listed currency options
1983 Options on equity index; Options on T-note futures;Options on currency futures; Options on equity indexfutures; Interest rates caps and oors
1985 Eurodollar options; Swaptions1987 OTC compound options; OTC average options1989 Futures on interest rate swaps; Quanto options1990 Equity index swaps1991 Di_erential swaps1993 Captions; Exchange-listed FLEX options1994 Credit default options
AnalysisThis paper argues that banks use derivatives to minimize risk exposure, assuming
that banks
maximize profits subject to a risk constraint. In theory, a banks exposure to interest
rate risk should have an effect on the size of its derivative holdings if the financial
instruments are used for hedging purposes. Furthermore, it is argued that derivative
use will vary according to bank size, balance sheet composition, total risk exposure,
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profitability and appetite for assuming risk. I will discuss each of these characteristics
below.
A. Risk Exposure
Interest Rate Risk Exposure
In theory, banks can benefit from derivative markets because derivatives, like
insurance, can be used to hedge against risk. Carefully chosen derivative deals can
reduce interest rate risk inherent in banking activities because the preexisting
interest
rate risk can sometimes be offset by a counterbalancing derivative risk. Therefore, if
derivatives are used to hedge against interest rate risk, then the volume of
derivatives held by a bank should be negatively related to the current interest rate
risk experienced by the bank.
Credit Risk Exposure
The ratios of loan loss reserves to loans and noncurrent loans to loans are
indications of the quality of assets held by a bank. Each bank must maintain an
allowance for loan and lease losses that is adequate to absorb estimated credit
losses associated with its loan and lease portfolio. A bank with relatively risky assets
would be required to hold a relatively larger loan loss reserve balance. Loans are
considered non-current if they are 90 days or more past due or if they are in non-
accrual status. Thus a bank with a relatively greater proportion of non-current loans
would be considered relatively riskier. It can be argued that investors would view a
bank with a relatively high loan loss reserve or a bank with a relatively high balance
of non-current loans as one of high risk. Thus the bank might have a difficult time
raising additional capital as needed to manage interest rate risk in the traditional
manner. Furthermore, a riskier loan portfolio may be an indication of managements
predilection for risk that might be carried over into derivative dealings. If
management has greater tendencies towards risk then they might be more likely to
assume the risk involved in speculating
with derivatives. Banks in either situation would theoretically be more likely to use
derivatives. However, it would be difficult to discriminate among those that are using
derivatives prudently to manage interest rate risk and those that are speculating. On
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the other hand, it has been argued that banks that hold a relatively risky portfolio of
assets would avoid using derivatives in order to avoid regulatory scrutiny. Therefore,
the direction of the relationship between derivative use and bank credit risk is
ambiguous.
B. Balance Sheet Characteristics
Capitalization
Banks are required to hold a percentage of capital based on the risk embedded in
their asset holdings. Profit maximizing banks have an incentive to increase their
assets given the size of
their capital balance. Such banks would tend to purchase assets until their capital to
asset ratio reaches its minimum as required by regulators. Once in that position, the
banks are better off using derivatives to manage interest rate risk because they do
not require additional capital. Therefore, a negative relationship should exist between
derivative use and the banks risk weighted capital to asset ratio.
Size of Asset Portfolio
In theory, large banks are more likely to be involved in derivative use for several
reasons. First, derivatives are very complex instruments and require careful
management and analysis. Smaller banks may not have the resources to devote to
understanding the complexities of these instruments. Furthermore, transaction fees
involved in trading derivatives decrease with increased volume of purchases. Thus
larger banks that can afford to make larger transactions pay relatively smaller
transactions fees. Finally, larger banks are more likely to have greater exposure to
market risk particularly because of the differences in their borrowing sources. Large
banks tend to use instruments, such as jumbo CDs, whose price and yields vary with
the market on a day-to-day basis. Therefore, the relationship between derivative use
and asset size is expected to be positive.
C. Other CharacteristicsBank Profitability
Recalling the work of Deshmukh, Greenbaum, and Kanatas (1983), banks who can
manage interest rate risk using derivatives will be less constrained in their lending
activities and will thus be able to invest in higher risk/higher yielding assets.Derivatives free banks from the restrictions imposed by traditional internal hedging
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by allowing the bank to separate its choice of assets or sources of funding from
considerations of market risk. Therefore, derivative use is expected to have a
positive relationship with bank profitability.
8/4/2019 jai shri ganesh
20/21
8/4/2019 jai shri ganesh
21/21
References
1 Indian Financial System B bharti pathak PEARSON EDUCAION 2nd
edition
2 http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=18465
3 www.iwu.edu/economics/PPE07/katie.pdf
4 citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.121.886&rep.
5 www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdf
http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=18465http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=18465http://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdfhttp://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdfhttp://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdfhttp://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdfhttp://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdfhttp://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=18465