derivatives

Topics: Derivative, Derivatives, Futures contract Pages: 74 (13995 words) Published: December 5, 2013
Derivatives in Financial Market
Development
Rangarajan K. Sundaram

New York University (contact: rsundara@stern.nyu.edu)
(contact: )

February 2013

Derivatives in Financial Market Development
Rangarajan K. Sundaram
Stern School of Business, New York University
http://pages.stern.nyu.edu/ rsundara
13 September 2012

Contents
Executive Summary

ii

1 Introduction

2

2 The World Derivatives Market

2

2.1

Basic Derivative Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2

2.2

Market Size and Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4

2.3

Emerging Markets versus Advanced Economies . . . . . . . . . . . . . . . . . .

7

3 Uses of Derivatives

9

4 The Potential Risks in Derivatives Usage

14

4.1

Barings Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15

4.2

Metallgesellschaft . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16

4.3

Amaranth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16

4.4

Aracruz Cellulose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17

4.5

AIG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

18

4.6

Heeding the Lessons? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

19

5 Derivatives in the Indian Context: Some Comments

20

6 Regulation and its Challenges

26

A Derivatives Instruments

30

A.1 Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

A.2 Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

31

A.3 Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

32

A.4 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

32

A.5 Credit Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

33

1

Executive Summary
Derivatives are financial instruments whose payoffs derive from other, more primitive financial variables such as a stock price, a commodity price, an index level, an interest rate, or an exchange rate. The world market for derivatives is an immense one. The notion amount outstanding in the over-the-counter (OTC) derivatives market worldwide exceeds $640 trillion, with a collective gross market value of over $27 trillion. The exchange-traded market has another $60 trillion in outstanding notional. The growth of derivatives usage over the last two decades has been rapid in both advanced economies and emerging markets; in both OTC contracts and those that are exchange-traded; and across all underlying classes, including interest-rate, currency, equity, and the most recent addition, credit.

Derivatives are enormously useful instruments in the management of risk. They can be used to hedge an existing market exposure (forwards and futures), to obtain downside protection to an exposure even while retaining upside potential (options), to transform the nature of an exposure (swaps), and to obtain insurance against events such as default (credit derivatives). For corporations and financial institutions looking to manage exchange-rate risk, input costs, financing costs, or credit exposures, these are invaluable features, and explain to a considerable extent the rapid growth of the derivatives market as globalization and global interlinkages have grown.

Derivatives are also highly levered instruments, and this has its own implications. On the one hand, the leverage makes derivatives attractive to speculators (those who wish to bet on price direction). In itself, this is not a bad thing, since speculators add considerable liquidity to the market and, by taking the opposite side, facilitate the positions hedgers want to take. However, leverage magnifies the effect of price moves, so sharp unfavorable price moves can...
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