Tuesday, April 19, 2005

All you wanted to know about derivatives!

April 19, 2005, www.rediff.com, Co-author-Vivek Kaul

'By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it - a process that has undoubtedly improved national productivity growth and standards of living.' -- Alan Greenspan, Chairman, Board of Governors of the US Federal Reserve System.
Understanding Derivatives
The primary objectives of any investor are to maximise returns and minimise risks. Derivatives are contracts that originated from the need to minimise risk.
The word 'derivative' originates from mathematics and refers to a variable, which has been derived from another variable. Derivatives are so called because they have no value of their own. They derive their value from the value of some other asset, which is known as the underlying.
For example, a derivative of the shares of Infosys (underlying), will derive its value from the share price (value) of Infosys. Similarly, a derivative contract on soybean depends on the price of soybean.
Derivatives are specialised contracts which signify an agreement or an option to buy or sell the underlying asset of the derivate up to a certain time in the future at a prearranged price, the exercise price.
The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date of commencement of the contract. The value of the contract depends on the expiry period and also on the price of the underlying asset.
For example, a farmer fears that the price of soybean (underlying), when his crop is ready for delivery will be lower than his cost of production.
Let's say the cost of production is Rs 8,000 per ton. In order to overcome this uncertainty in the selling price of his crop, he enters into a contract (derivative) with a merchant, who agrees to buy the crop at a certain price (exercise price), when the crop is ready in three months time (expiry period).
In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton. Now, the value of this derivative contract will increase as the price of soybean decreases and vice-a-versa.
If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will be more valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the contract becomes even more valuable.
This is because the farmer can sell the soybean he has produced at Rs .9000 per tonne even though the market price is much less. Thus, the value of the derivative is dependent on the value of the underlying.
If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold, silver, precious stone or for that matter even weather, then the derivative is known as a commodity derivative.
If the underlying is a financial asset like debt instruments, currency, share price index, equity shares, etc, the derivative is known as a financial derivative.
Derivative contracts can be standardized and traded on the stock exchange. Such derivatives are called exchange-traded derivatives. Or they can be customised as per the needs of the user by negotiating with the other party involved.
Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the example of the farmer above, if he thinks that the total production from his land will be around 150 quintals, he can either go to a food merchant and enter into a derivatives contract to sell 150 quintals of soybean in three months time at Rs 9,000 per ton. Or the farmer can go to a commodities exchange, like the National Commodity and Derivatives Exchange Limited, and buy a standard contract on soybean.
The standard contract on soybean has a size of 100 quintals. So the farmer will be left with 50 quintals of soybean uncovered for price fluctuations.
However, exchange traded derivatives have some advantages like low transaction costs and no risk of default by the other party, which may exceed the cost associated with leaving a part of the production uncovered.
Some of the most basic forms of Derivatives are Futures, Forwards and Options.
Futures and Forwards
As the name suggests, futures are derivative contracts that give the holder the opportunity to buy or sell the underlying at a pre-specified price some time in the future.
They come in standardized form with fixed expiry time, contract size and price. Forwards are similar contracts but customisable in terms of contract size, expiry date and price, as per the needs of the user.
Option contracts give the holder the option to buy or sell the underlying at a pre-specified price some time in the future. An option to buy the underlying is known as a Call Option.
On the other hand, an option to sell the underlying at a specified price in the future is known as Put Option.
In the case of an option contract, the buyer of the contract is not obligated to exercise the option contract. Options can be traded on the stock exchange or on the OTC market.
History of derivatives
The history of derivatives is surprisingly longer than what most people think. Some texts even find the existence of the characteristics of derivative contracts in incidents of Mahabharata. Traces of derivative contracts can even be found in incidents that date back to the ages before Jesus Christ.
However, the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, or overproduction.
The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardised contracts, which made them much like today's futures.
The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848 where forward contracts on various commodities were standardised around 1865. From then on, futures contracts have remained more or less in the same form, as we know them today.
Derivatives have had a long presence in India. The commodity derivative market has been functioning in India since the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Since then contracts on various other commodities have been introduced as well.
Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges.
National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in December 2003, to provide a platform for commodities trading.
The derivatives market in India has grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts on NSE accounting for around 55% of the total turnover of derivatives at NSE, as on April 13, 2005.
Risk Management Tools
Derivatives are powerful risk management tools. To illustrate, lets take the example of an investor who holds the stocks of Infosys, which are currently trading at Rs 2,096.
Infosys options are traded on the National Stock Exchange of India, which gives the owner the right to buy (call) shares of Infosys at Rs 2,220 each (exercise price), expiring on 30th June 2005. Now if the share price of Infosys remains less than or equal to Rs 2,200, the contract would be worthless for the owner and he would lose the money he paid to buy the option, known as premium.
However, the premium is the maximum amount that the owner of the contract can lose. Hence he has limited his loss. On the other hand, if the share price of Infosys goes above Rs 2,220, the owner of the call option can exercise the contract, buy the share at Rs 2,220 and make profits by selling the share at the market price of Infosys.
The upward gain can be unlimited. Say the share price of Infosys zooms to Rs .3,000 by June 2005, the owner of the call option can buy the shares at Rs 2,220, the exercise price of the option, and then sell it in the market for Rs 3,000.
Making a profit of Rs 780 less the premium that has been paid. If the premium paid to buy the call option is say Rs 10, the profit would be Rs 770.
Looking Forward
Derivatives are an innovation that has redefined the financial services industry and it has assumed a very significant place in the capital markets.
However, trading in derivatives is complicated and risky. The derivatives have been blamed for the loss of fortunes at many times in history. We will look at derivatives as a vehicle of investment available to investors, risks and returns associated with them, in our next article.

Wednesday, April 13, 2005

A guide to right investment

April 13, 2005, www. rediff.com, Co-author-Vivek Kaul

What would you prefer: Rs 10,000 right now or Rs 10,000 five years from now?
Common sense tells us that we should take Rs 10,000 today because we know that there is a certain time value of money. The Rs 10,000 received now provides us with an opportunity to put it to work immediately and earn a certain return on it.
A single rupee today is worth more than a single rupee a few years down the line. Given this, households that have surplus funds in the form of savings want to invest those funds so that the value of the funds over the years does not go down.
There are various forms of investments at the disposal of individuals. These include real assets like a house, a car, a television, or financial assets like stocks in companies, bonds, units of funds, et cetera.
Traditionally, term deposits in banks, post office savings schemes, bonds and common stocks are the most accessible forms of investments available to the investors. Term deposits, post office savings schemes and bonds give a fixed return over a period of time.
Risk and Return
Investors would typically want to invest in an asset, which gives them maximum return on their investment. However, life is not as simple as that. Different assets come with different risk profiles.
Risk in a practical way can be defined as the chance that the expected outcome may not happen and the actual outcome may not be as good as the expected outcome.
For example, the risk of driving a vehicle too fast may lead the driver getting a speeding ticket or it might even lead to an accident. The New Oxford Dictionary of English defines risk as 'a situation involving exposure to danger.' Thus risk is always looked at in negative terms.
In case of investments the definition of risk is much broader. Risk in case of investment can be defined as the likelihood that the investor will receive a return on his investment that is different from the return he expects to make.
So risk not only includes bad outcomes when the returns are lower than what was expected, but it also includes good outcomes when returns are more than expected.
When investors are making an investment they expect to earn a certain return over the period the investment is made. But their actual returns may be different from the expected return and this is the source of risk.
For example, an investor invests a certain amount in a fixed deposit for a period of one year and expects a return of 5% (i.e. the interest on a one year fixed deposit that the bank gives is 5%). At the end of one year when the investment matures the investor will get a return 5%. So this is a risk less investment.
Instead of investing in the fixed deposit, the investor decides to invest the same amount of money in a particular stock. The investor having done his research expects say a return of 25% in one year's time (dividend and capital gains).
The actual return over this period might turn out to be greater than 25% or lesser. The company may not pay the dividend on time or the price of the stock may not rise as much as was expected. Herein he carries the risk. The actual return is not guaranteed.
The figure 1 below shows the returns analysis of BSE Sensex over a period of 9 years, from 1997 to 2005. We can clearly see that the returns have varied from a negative 21% to positive 73% over these years. On the other hand, the returns on treasury bills (Treasury bills are securities with maturity period of less than or equal to one year. Issued by the government) just varied from about 13% to around 5% in 2004 (See figure 2).
So, treasury bills give a fixed return over a period of time but common stocks do not. So, investors demand a premium from the common stocks for taking on extra risk.
In India, the investors on an average demand a premium of around 10.5% above the risk free rate. The risk free rate is generally taken to be the rate of return on treasury bills, as they are considered virtually risk free.
Common stocks are riskier because of various reasons. For one, the companies are not obligated to pay a dividend to the common stock holders, and secondly, in the case of liquidation, shareholders are the last to get paid after all the other security holders have been paid.
Thus the decision to invest in an asset with maximum return becomes difficult, as high returns come with high risk. The task of investment becomes formidable for the investors who must balance the returns from and risk involved in an asset.
Alternative investments
A major part of the household savings gets channeled into the so called traditional investments like fixed deposits (FDs), post office saving schemes, Public Provident Fund (PPF), etc.
But since the mid-90s interest rates have come down considerably and investments like FDs have been giving lesser return than the existing rate of inflation, or just a few basis points above the rate of inflation.
For example, the current inflation rate prevailing in India is around 5.1%, whereas the largest bank of India, the State Bank of India offers a return of 5.00% on deposits for more than 182 days but less than 1 year.
The rate for deposits of more than 1 year but less than 3 years is 5.5%. Another disadvantage with such forms of investment is that the lock in period is considerably high.
However, many other forms of investments are available to investors. Exchange traded funds, derivatives, real estate, gold, art, are just a few of the alternatives. With the spread of technology, investing in some of these alternative investments has become comparatively easier than before.
These investments are also good means of diversification. Diversification refers to the act of reducing risk by spreading the total investment across many different investments.
The idea of diversification is very old. It has even been mentioned by Shakespeare as early as the 16th century in his one of the most celebrated plays, The Merchant of Venice:
'My Ventures are not in one bottom trusted,Nor to one place; nor is my whole estateUpon the fortune of this present year;Therefore, my merchandise makes me not sad.'-- Antonio in Merchant of Venice, Act I, Scene 1
This shows that merchants did realise the importance of not putting all their eggs in one basket early on.
Diversification and investment in alternative forms of investments have become more important in recent times when the stock markets have proven to be more volatile and the government bonds are barely able to match the inflation rate.
Investors are looking to put their money in assets which give decent returns even if the stock markets are tumbling. For example, the value of a piece of art may rise if the inflation is on the rise irrespective of the performance of stock markets.
Similarly, gold does well in time of global tension. In this way, even if the investor loses money in the stock market, it is offset by the gains in his alternative investments.
A lot of these alternative investments have consistently given a higher return than the traditional investment securities.
For example, the real estate investments in the National Capital Region of Delhi have consistently provided a return of more than 10% over the last three years, in both the commercial and residential segments.
This is much more than the 5-6% return provided by government bonds and fixed deposits. At the same time, the returns are not as volatile as that witnessed in the stock markets.
But many of these investment types still remain a mystery to the investors. This is a first in a series of articles through which we hope to explain the nature of various forms of such alternative investments that are available to the investors.
Figure 1: Returns of BSE Sensex over 9 years Source: The graph has been compiled from yearly closing price data on http://www.bseindia.com/ (The returns for 2005 is up to April 8th, 2005) Figure 2: Returns of Government of India Treasury Bills over 9 years Source: The graph has been compiled from the Bloomberg Data Terminal using Government of India Treasury Bills Index (The returns for 2005 is up to April 8th, 2005)

Monday, April 11, 2005

What Indian financial markets need

April 12, 2005, www.rediff.com

The series of financial crises that swept through many parts of the developing world during the 1990s and, more recently, the problems plaguing financial markets in the United States, the European Union and Japan have raised serious questions about the regulatory environment of the financial markets globally.
Unfortunate events of the decade of nineties and the beginning of the 21st century have led us to believe that regulators around the globe have failed to achieve their primary objectives of 'maintaining systemic stability' and 'protecting interests of the retail customer.' Be it the Brazilian, the Argentine or the East Asian crises; be it Enron, WorldCom or US-64; the retail investors have taken the brunt of it all. Economies have been wiped out.
The financial sector plays an important role in the economy of any nation. A well-regulated and well-developed financial sector is vital to achieving the most basic need of efficient allocation of scarce resources.
The main objectives of any regulator are to improve market efficiency, enhance transparency, and prevent unfair practices.
In the financial sector, the achievement of these objectives would mean increase in resource mobilisation, enhanced access to financial products and services, and sustained economic stability. The International Monetary Fund recognises the need for 'resilient, well-regulated financial systems for macroeconomic and financial stability in a world of increased capital flows.'
"The crises that have swept emerging market nations in recent years should have left no-one in any doubt about the importance of a strong and well-regulated financial sector, in dealing with capital flows that can be very large and reverse very quickly." -- IMF Managing Director, Stanley Fisher, June 2000.
I now look at a few events that shook the financial markets and the challenges they pose to the regulators.
The events and the challenges
In the aftermath of the East Asian crisis the regulators in many countries have been engaged in reforming the international financial architecture to deal with dangers facing the financial markets which have been enhanced due to globalisation and liberalisation of economies.
The dynamic growth in capital markets following the liberalization of financial markets in many countries occurred without domestic economy and financial weaknesses as well as the regulatory and supervisory frameworks being taken fully into account.
The events of September 11, 2001 too shook markets across the globe. The main financial market response was a flight to quality as investors' appetite for risks fell. All major stock markets experienced rapid, sharp price declines in the immediate aftermath of the event.
Insuring the investors against terrorism became another challenge for the regulators.
Investor confidence is a critical factor to the growth and success of the capital market, and on a larger scale, critical to economic stability. Confidence in some capital markets has deteriorated, partly because of corporate governance transgressions that have been under global scrutiny.
Accounting controls have been on the top of the mind of regulators since a series of accounting scandals such as ENRON, WorldCom and more recently, HealthSouth, in the USA. The European Union is also looking towards tighter accounting controls after the insolvency of dairy giant Parmalat due to irregular accounting practices.
The point to note here is that the accounting scandals in the US occurred at a time when the disclosure norms in the US were very stringent and well defined. According to Commissioner Paul Atkins of US Securities and Exchange Commission, these accounting scandals have resulted in the erosion of a staggering amount of $5 trillion from the capital markets.
Investors around the globe are asking the question, 'If it can happen in the US, why not elsewhere?' The challenge to the regulator is, therefore, to reassure investors that such abuse of the system will not be allowed to become the norm.
The need to implement and follow the rules not only by the letter, but also by the spirit is evident. Hence, corporate governance has become the most debated topic amongst the regulators recently.
The Indian scenario
The Indian stock markets are now amongst the best in the world in terms of modernisation and the technology. India was among the few countries, which was not badly effected by the contagion effects of the Asian crisis of 1997. Policy makers attribute this to the slow and cautious pace of capital account liberalisation.
However, it has also been a decade marred with scams, which were huge even by international standards, revealing the many gaps in our regulatory regime.
In 1991, a group of stockbrokers, headed by key trader 'Big Bull' Harshad Mehta artificially jacked up prices of worthless securities to rake in Rs 5,000 crore (Rs 50 billion). The Sensex came tumbling down after the scam story broke out on April 23, 1992. Fortunes were lost overnight. As a result, the ambit of the Securities Exchange Board of India, the stock exchanges and regulatory financial institutions was widened.
Nearly a decade later, after a 'dream budget' by Yashwant Sinha, the then finance minister, on February 28 2001, the Bombay Stock Exchange index rose initially but thereafter crashed. Nearly 700 points were lost in eight trading sessions leading to erosion in market capitalisation of Rs 146,000 crore (Rs 1,460 billion).
This erratic behaviour was once again traced to a handful of brokers, wishing to trap a leading 'bull', Ketan Parekh, who had manipulated prices of shares of a few select companies in information technology, communication and entertainment sector.
Units of US-64, the flagship scheme of Unit Trust of India --the largest public sector mutual fund in India, dropped from a peak of Rs 19 to Rs 5.81 in January 2002. Middle class people and retirees were the hardest hit because of the irregularities.
The recurrence of financial 'scams' periodically exhibits the helplessness of regulators, particularly the SEBI and the Reserve Bank of India. "It is easier to build a modern stock exchange from scratch than change century-old trading practices," says Jayanth Varma, a former board member at SEBI. Traders loathe any change in the market because many thrive on its imperfections.
Against this backdrop, the regulatory bodies are making endeavours to bring up the Indian market to international standards. It is working towards making India a global benchmark for capital market development.
The road ahead
Today-- with the 'feel good' factor about India in the global arena rising, increased confidence of the investors in the Indian market, Sensex looking more attractive than ever before, foreign exchange reserves at an all-time high of more than $140 billion -- is the most vulnerable period for the regulators of the Indian financial sector, particularly SEBI and RBI.
Major steps towards reforms, liberalisation and globalisation have been taken in the 1990s, now the hiccups need to be sorted out. Maintaining stability is of prime concern. The time seems ripe to address the gaps in the regulatory framework, when the times are relatively good and peaceful. Prevention is better than cure.
Some of the issues that need the regulators' attention and action in the Indian financial markets are:
Participation and education of retail investors: Encouraging and protecting the rights of retail investors is an important issue. In Indian markets it is a challenge to get these investors to participate in the securities markets.
Also, as new instruments like the derivatives are being introduced in the market, the emphasis on investor education should also be enhanced. Then the issue of providing a level playing field for these investors also remains so that there is continued confidence in the market.
Liquidity: Even though the shares of companies listed on major stock exchanges are fairly liquid, the options market suffers from illiquidity.
Enhancing liquidity in the options markets to facilitate trade at reasonable prices is required to encourage investors to hedge their portfolios and to facilitate companies to manage their risks.
Accounting and financial reporting norms: Financial disclosure requirements in India are not at par with international accounting practices in spite of attempts made by the Institute of Chartered Accountants of India. Good accounting and corporate standards need to be backed up by high moral and ethical standards by accounting and the corporate world.
Corporate governance: With sophistication in the marketplace, the demand for improved corporate governance by public companies will also increase. Ensuring high confidence of the investors in the business so as to improve investment levels through good corporate governance is a must.
Adopting a suitable framework of corporate governance and the extent of observing the framework in practice is an issue that requires to be addressed.
Technology: Regulators must keep up with the sophistication in market technology and new market structure. Enforcement cases will become more complicated as market manipulation and other misconduct are now also conducted on the Internet, making it more difficult to be detected.
A robust system ensuring good surveillance against cyber crime should be updated from time to time. Also, whether a demutualized exchange should be regulated as any other listed company, or as a utility, will be a challenge for the regulators.
Integration with other financial markets: The adoption of international best practices, sharing more information with the regulatory bodies globally and co-operation with international bodies is important. Global benchmarks should be adopted through education, assistance and advisory services to its members.
Organisations such as International Organization of Securities Commissions, the Bank of International Settlement, the Joint Forum and the Financial Stability Forum have led initiatives to introduce best practice or international benchmarks in regulation to counter global vulnerabilities such as weaknesses in market foundations, uncertain growth prospects, difficulties in surveillance and enforcement of financial conglomerates and increased investor risk aversion.
Former prime minister Atal Bihari Vajpayee summed up the requirement of the Indian financial markets, after the Ketan Parekh scam came to light. He told regulators to make markets safer for investors and called for more rigour in the market place.
"We need markets that are known for their safety and integrity. We need knowledgeable investors. And we need to build a sustainable, high-growth economy which will ensure better living conditions for our people, now and in the future," Vajpayee said.
"I urge all of you -- regulators, market intermediaries and investors -- to join hands to make our capital market the safest places to invest in the world," he had said. "While the technology and the regulatory framework of capital markets has improved, I am pained to say the standards of corporate governance have not kept pace. We have come across far too many instances of companies that have raised money from the market by creating hype and then defrauding their investors," he said.
Former finance minister Jaswant Singh added that more teeth recently given to SEBI offered it the legal right to impose sterner penalties on violators of stock market rules.
Investors will be the ultimate beneficiaries of all these changes in the marketplace. Investors will have more choices and information on investment products, easier accessibility to any market they wish to trade on, and better and cheaper services from intermediaries.
The new generation of investors will become increasingly sophisticated as market information becomes widely available. However, the complexity of the new markets also means that investors must know their own risk appetite before entering the market.