The World of Derivatives

Derivatives are specialized contracts which marks an agreement or an option to buy or sell its underlying's up to pre-choreographed time in the future at a prearranged price,which is know as the exercise price. The word “derivatives” originated from mathematics and signify the variables, these variables are derived from another variable-they have no value of their own and they derive their value from the value of some other asset, that’s commonly known as underlying.
Not in modern sense,though the history of derivatives is surprisingly longer and could be traced back since the age of Mahabharata,albeit advent of modern day’s derivatives contracts can be attributed to the need for farmers to protect themselves from any decline in the price of their corps due to delayed monsoon or over production.

The first “futures” contracts can be traced to the “Yadoya” rice market in Osaka {Japan} around 1650-those were the explicitly standardized contracts which resembled very close to today’s futures contracts. The Chicago Board of Trade {CBOT}, the largest derivative exchange in the world was established in 1848 where forward contracts on various commodities were standardized around 1865-aftetwards, futures {contracts}have remained more or less in the same form, as we know them in modern understanding.
In Indian case too-derivatives have a long standing presence; the commodity derivative market has been operationalizing in India since the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875, since than contracts on various other commodities have been introduced as well.

Indian market is in growing phase with seven-eight years of operation in exchange traded financial derivatives, those were introduced in India in June 2000 at the two major stock exchanges-NSE and BSE.Further National Commodity &Derivatives Exchange Limited {NCDEX} started its operation in December 2003, to provide a platform for commodities trading-with slew of measures, the derivatives market in India has grown exponentially over the years, especially at NSE.
Stock futures are the highest traded contracts on NSE accounting for around 55% of the total turnover in derivatives trade at NSE, as on April13, 2005. Broadly derivatives can be categorized in three orders-I. Simple derivatives {plane Vanilla products}, II.Complex derivatives {exotic products} and III.Very complex products designed and suitable to particular client only.

Indian banks remains mostly untouched with the last two products as RBI doesn’t permit too much open positions on foreign exchange; many Indian banks did the deals and in turn entered into back to back understanding with the foreign banks-it was so because Indian banks didn’t have those exotic products, they bought it from foreign banks and sold them to corporates.Thanks to our regulators, who never believed in “greed is good” principle like the protagonist of 1987 released Hollywood blockbuster {Wall Street} or its real executioner{bankers} at Wall Street…we also can’t ignore the wise saying of grand old man of investment, Mr. Warren Buffet, who in aggrieved state pronounced on the wake of deep recession in 2008, derivatives as “Financial Weapons of Mass Destruction”.
Indeed he wasn’t wrong as longer as he saw its bad outcome by the acts of its maligners {greedy bankers from Wall Street} otherwise, a financial product even derivative can’t stand so destructively on their own foot-these potential outside push is the real threat behind the entire web of derivative trading.

A single derivative product known Credit Default Swaps {CDS} has alone fuelled the matter for more than six dozens bank failure, alone in U.S.A since the break out of recession in 2007-wrong doings are still far from being over as another giant from Wall Street {Goldman Sachs}is badly tapped in its wave of unethical handling.Derivatives as a financial product is very useful until its bounded with an ethical conscience and incentive for mass enrapture otherwise its repercussions can be easily ransack the entire order…proper regulatory execution and shared vision of institutions involved in this field can lead to a sustainable way-out.
Atul Kumar Thakur
April24th 2010, Saturday, New Delhi
atul_mdb@rediffmail.com

Myopic Routes of Finance (Sovereign Wealth Funds& Participatory Notes)

Amidst the ongoing crisis; it will be quite interesting to see and visualize the scale of losses…what we have actually lost in recent months, which have been in our possession through a considerable time. A lot of debate and writing has been stuffed about the potential causes of financial failure and diminishing market sentiments in past few months.
There could be many reasons behind the present financial chaos; among them, inflated treatment of stock markets best be attributed because the unprecedented growth till the crisis broke out largely caused by the unrestricted financial routes which don’t even canopied under the regulation of SEBI. So, no one can exactly traced the investors as their business dealt through intermediaries, even those middlemen’s never required to follow Know Your Customers (KYC) Norms.
These myopic investment roots may be considered to progenitor and nurturer of speculative finance. Two most prolific among them are: -

Sovereign Wealth Funds (SWF): -
Some SWF own by the State Governments of countries to handle with its idle assets for its maximization of value. SWF is not a fresh concept since its genesis can be traced back to 1950’s, then their size worldwide was $300billion.The current level now reached to $2 trillion to $3 trillion, the size may be cross $10trillion by 2010.
At present more than twenty countries have set up these funds. A dozen more have expressed willingness in establishing them. More than half of assets are possessed by oil exporting countries. Ranging from Norway to Trinidad, including Australia, China and Singapore. Still the holding are mostly concentrated with the top five funds, accounting for more than 70% of total assets under management.

Like hedge funds, SWF are also not governed by any single authority except the Singapore. SWF also operates through hedge funds, Private Equity for high return. So,it requires great care in fund management.SWF have a positive tendency to go long on securities that means to say, they buy and hold it invested for longer periods. This creates some establishing influence on stock markets.
But this establishing factor of SWF is highly disproportionate with its destablishing factor. Since it creates more place for irresponsible transaction. Overall SWF are immensely surrounded with chances of risk and failures, so neither it’s a meticulous route of investments nor it is good for just and equitable society.

Participatory Notes (PN): -
PN is an investment root by Foreign Institutional Investor (FII), through Offshore Derivatives Instrument (ODI); Such as Equity linked Notes and Participatory Return Notes have created storm in stock markets.
Basically FII issues PN to funds for companies whose identity is not known to the authorities. The PN is discriminatory as it promotes unethical investments; further it creates harmful effects on domestic companies. PN having very firm presence in India, as its proportion lies around 15-20% of stock of the top 1,000 companies. They have almost ruling influence on the market.PN outstanding by middle of 2007 was 3,53,484crores(51.6% of Asset under custody of all FII Sub Accounts). The value of outstanding ODI with underlying derivatives currently stands at Rs.1, 17,071crores, which is approx to 30% of total PN outstanding.

Users Of PN Route: -

1.Regular funds whose twin objectives are returns and more returns
2.Prodigal money returning
3.Foreign Governments/Entities who would like to acquire/control Indian entities by tracking them over.

PN investors channelizes their investment through the FII, but despite playing the role of intermediary, FII are not required to reveal their face. This situation further become more mysterious when regulators like SEBI simply let PN to escape from registration, which set them free from any regulation. Such allowances, promotes Indian financiers to enter in Indian Financials to enter in Indian Financial Markets.
Overall producers of PN transaction violates know Your Customers Norms, lastly, National Security Advisor cautioned against terror financing through stock market channels. Rising concerns of Indian authorities are very genuine, because unprecedented rise as well as fall are misleading the Indian growth story.

Two major constraints, which can lessen the impacts, are: -
1.A Special Purpose Vehicle (SPV), can be created which would be dollar dominated to hold these funds at attractive rates and which are countered over a period of time to minimize the followed impacts.
2.Generally these are two types of PN- Spot based and Derivatives/Future based (ODI). The latter accounts for around 32-33 percent of all PN. FII and their sub accounts shall not issue/renew ODI with underlying as derivatives with immediate effect .It should also mean that the hedge funds ,which has been fairly responsible for the steep rise in the markets, might exit the market because SEBI will never let them register as FII.

On such proposals, due consideration was given by SEBI to cope with threats of PN. Ultimately SEBI allowed 18 months to wind up outstanding PN in late 2007, now the proposed ceiling is near end, which means ends of the unauthorized PN.Decision taken by the SEBI was in very right directions. Since its timely implementation optimized and lessen many future losses. Some such more measure are imperative to check irregularities in financial markets.
Authorities have to play catalyst role in such initiatives. Investors should have also rationalize their paramounting expectations from financial markets and now must start to keep faiths in realistic rewards.
Atul Kumar Thakur
New Delhi
March12,2009
atul_mdb@rediffmail.com

From Wall Street to Main Street(On Financial Meltdown)

The year 2008 must be remembered as watershed year in the financial history as it shattered the confident tone of financial management which has generated through the
recent successes especially from the credit bubble of post 2003-04.Since the year 1987 crash, there have been many financial upsets –the 1997 –98 Asian financial crises, failure of the hedge funds long term capital management in 1998,the puffing Of the stock bubble in 2000,and now the sub prime ‘Mortgage debacle ‘.None has turned into a full-fledged panic, So all three mishappening formed a temptation that we have got mastership over these occurring problems .
Unfortunately situation this time is much grave than initial speculation…gravity of problems recognized very late which deepens the fear of loss and insecurity among both the participant and regulators. The main reasons for the financial mess seem to be the allocation of large funds with U.S Banks and the structural products developed to pass on the risk to investors.

Through January the United State saw on average the loss of over 800 jobs every hour, or 17000 every day since the meltdown began in September ; Off course here in India, too things are shipping but the lessons remain unlearnt .Even in such gloomious atmosphere ,corporate kleptocracy kept very profoundly as Citi group spent $50million on a corporate jet. Now the disgraced CEO of Merrill Lynch, John Thain, spent $1.22million on redecorating his office in early 2008,All that was happening when he prepared to cut thousands of jobs. The amount included purchase of an antique “Commode on legs”.
Even more top bankers from wall street didn’t felt even a bit of reluctance to acquire the hefty amount of perks and bonuses until the U.S President curb such extravagant practices in present troubled phase ,he also barred the maximum compensation to $50,000.No such initiative made from the top notch professional circle except the Citi group chief Mr. Vikram Pandit who voluntary abandoned any fees for his service till the recovery of reputation of his banks .No doubt ,it is suffice to acknowledge the lacking of corporate ethics, among the professional especially who possessed top notch authority.


DID IVY LEAGUE KILL WALL STREET?

When wall street was run by individuals without exotic degrees from Ivy Leagues, they had proper skepticism towards fancy models and managed their risk with a great deal of humility and caution.Indeed they create conducive atmosphere for the practice of “Charuvaka Economics (From the epic MAHABHARATA)”, Which expected from people to borrow, spend and live happily without bothering of repayment of debt and not feel guilty if unable to pay it back .
In same manner, the US financial system consciously pushed sub-prime loans to put cash in the hands of gullible and not creditworthy borrowers and make them splurge at shopping malls, so that wealth shifted from Individuals to corporates; And when things fall apart it was also at the cost of the global community.All credit crises having the same origins. They are spotted in buoyant economic growth that promotes over-optimism, excessive risk taking and extreme demands on liquidity. Some of the typical cases are:-

#.1907:BANKERS PANIC-Run on U.S banks and trust companies what J P Morgan did in 1907?At quarter five on a November morning, Mr Morgan presented assembled bankers a documents telling them what they showed through the kitty to restore confidence. The bankers meekly signed, and the crises was over.

#.1909:WALL STREET CRASH-Stock prices plummet for there years following rampant speculation taking almost twenty five years – Until 1954 to regain pre 1929 value.

#.1973: OIL CRISES-Oil embargo and international withdrawal from Breton Woods agreement trigger stock crash.

#.1987:BLACK MONDAY-Panic leads to 22%drop in single day.

#.2000:DOTCOM CRASH-Teach stock bubble bursts.

#.2008:CREDIT CRUNCH-Defaulters on Sub prime mortgage leads to liquidity problems for financial institution worldwide.

ANATOMY OF A MELTDOWN-

#.Collateral Debt Obligations (CDO)-Late1970’s:-Mortgage were packaged together and sold to investors as CDO’s.

#.Mortgaged-Backed Security (MBS): -1983;Larry fink pioneers MBS market while leading bond department at first Boston Corporation .MBS divides package at Mortgages into different tranches of risk. Softest investment grade bonds receive interest rate while riskiest tier-so called toxic dept-is paid 2-3%higher. Investor is now induced for accepting risk, not for lending money.

#.Sub-Prime Mortgages:-In 1990’s demands for MBS results in lenders lowering interest rates and offering 100% Sub prime Mortgage to individuals with questionable ability to pay. Rising house prices protect these borrowers from defaulting.

#.Credit Default Swaps (1997):-Invented by Blythe Masters at Investment Bank J.P Morgan Chase. CD’S or credit swaps are Insurance like contracts intended to remove risk from companies balance sheets. Presently International Swap and Derivative Association regulate Swaps.

#.Shadow Banking System (Late1990’s):-Swaps now used to package everything from Mortgages ,business card, credit card debt, and even education loans are brought by unregulated speculators and hedge funds on behalf of insurance companies and pension funds worldwide value for global CDs market rose from $1trillion in 2001 to $62.1trillion in 2007 and lastly fall to $28trillion in January 2009.

#.Credit Crunch(2006):-Interest rate rises to 5.25%;Housing market begins to confront defaulter –one in five U.S borrowers falls behind on mortgage payments.

#.2007-08:-Banks worldwide suffer huge losses and stop lending despite massive bailouts by taxpayers.

BAD ASSETS:-

Even before the Bernard Madoff’s scam may other Ponzi scam –In August 2007;the process of price discovery began a long time back when Bear Sterns declares that investment in one of its hedge funds set up to invest in mortgage tracked securities had lost all its value and there is a second such fund were valued at nine cents for every dollar of original investments. Being an interconnected institution holding assets valued at $395.4 billion dollar in November 2007 on an equity base of just $11.8billion,despite having such portfolio, its came under the severe pressure which concluded only with the life support from J.P Morgan Chase at huge loss of share prices.
Normally banking sector considered as the core of financial sector; The equity base of more banks are relatively small even when they follow Basel norms with regard to capital adequacy. Despite such allocation of trenches Banks having considerable derivative exposure.

Citi Group and Bank of New York Mellon estimated to have an exposure to the institution (Derivatives) that was placed at upward of staggering $155billion.In same manner fourth largest bank of Wall street Lehman Brothers came under the severe losses through the Derivative exposure and bad lending, ultimately came to the table with request for support, but it was refused the same. The refusal of the state sends out a strong message.
In a surprise move Bank Of America that was being spoken to as a potential buyer of Lehman Brothers was persuaded to acquire Merrill Lynch instead. But even that deal was not taken place properly and before any move from Bank of America, Black Rock acquired major arms of Merrill Lynch, consequently bringing down two of the iconic and major independent investment bank on Wall street.

In its update to the Financial Stability Report for 2008,issued on January 28,2009,the IMF has estimated the losses incurred by U.S and European Banks from bad assets that originated in the U.S at $2.2trillion.Barely two months back it had placed the figure at $1.4 trillion. So scale of severity can be easily measured since the late 1940s.U.S. has suffered to recessions, joblessness, 6.1% in September, would have to rise spectacularly to match post second world war highs .
The great depression, that followed the stock market collapse in october1929 was a different beast. By the low point in July 1932,Stock was dropped almost 90% from their peak .The accompanying devastation. Bankruptcies, foreclosures, breadlessness lasted a decade. Even in 1940s unemployment was almost 15%,it was the onset of second world war that boosted spending and bailed out the economy.

The deregulation of Banking was crucial for this transaction that was made possible by the process of deregulation that began in the 1980s and culminated in the Gramm-Leach-Billey Financial Modernization Act of 1999,which completely dismantled the regulation structure and the restriction on cross-sector activity put in place by Glass-Steagall in the 1930s.It is noteworthy that Glass-Steagalll’s own conception that there is less profitability In regulatory regime itself bounded with a deep inner contradiction in the system which set up pressure for deregulation .
Those pressure gained strength during the inflationary years in the 1970s when right monetary policies pushed up interest rates elsewhere but not in the banks .But such any claim deregulation is not justifiable in present circumstances, even the policy maker’s like Allan Greenspan who even facing a staunch liberalist, stressed on need for temporary regulation .This is need of hour, even U.S newly president elect Barack Obama ,not stop to saying that U.S should have the privately held banking system regulated by government.
Bank of Ireland and Allied Irish Banks and in the U.K whose Royal Bank of Scotland and Lloyds group are now under dominant public control, and others are expected to follow. The U.S and the U.K now have what India called the social control of banks. While in India bankers and policy makers are not stopping to encourage riskier loans by banks, In the U.S and U.K, the objectives are exactly opposite .In present circumstances India and rest economy of the world can learn a lot of tracts from Latin America where the first time in a century ,Latin America has managed to atleast partially “cushioned” itself from the seismic waves of economic turmoil in the U.S and Europe.
Even this partial success comes through the balanced monetary policies which undertaken to boost peoples development instead of fascinating merely towards numerical growth.
According to Hayek ,if monetary tightening is undertaken after the upper turning point of inflationary cycle is passed ,the downturn is accelerated. This useful concept is however anathema to Indian policy makers, who’s main focus now is on spurring higher growth. But such measures will add to the suffering of the poor. Now it is quite imperative to think about the falling purchasing capacity at mass level while prices at staple goods are reached at record high up 50%,in the last six months ,global food stocks are reached to historic lows. So, the poor can’t afford the food in present mechanism.
In present circumstances, if there is one enduring idea from Friedman, that central bankers in China and India would be well advised to heed, it is the” Monetarist Paradox” that almost every rate cut leads one time to a higher interest rate. And tightening moves such as raising the CRR do not necessarily ensure that policy has tightened, Reading Friedman tends to be a revelation .

It may interesting to note that popular rhetoric exaggerates damage done by recessions; but recessions have often overlooked benefits too. They moderate inflationary tendencies and punish reckless financial speculation and poor corporate practices like bad instruments, irresponsible lending etc. These effects contribute to an economy’s long term strength .
So, it is imperative to take some very impeccable measures to heed from ongoing downward movement of financial world, International Monetary Fund (IMF)s Global Financial Stability Report (April2008),suggested some very vital policy options to sub-prime crises:-
#IN SHORT TERM:-
1.Disclosure
2.Bank balance sheet repair
3. Management of compensation structure
4. Consistency of treatment
5.More intense supervision
6.Early action to resolved institutional maladies
7. Public plans for impaired assets.

#IN THE MEDIUM TERM:-

1.Standardization of some components of structured finance products.
2.Transparency at origination & subsequently.
3.Reform of rating system.
4.Transparency & disclosure.
5.Paying greater attention to applying fair value accounting results.
6.Reexamining incentives to set up Special Investment Vehicles{SIV} and its conducts.
7.Tightening oversight of mortgage originators.

Some of these recommendation are really very close to the solution, its judicious formulation may heed the problem to an extent. Apart from this, countries must understand what was lost in 1944 (Bretton Woods Conference) one of the reasons for financial crises is the imbalance of trade between nations. Countries accumulate debt partly as a result of sustaining a trade deficit.
They can easily destined to trapped in vicious circle; the bigger their debt, the harder it is to generate a trade surplus. International debt wracks peoples development, trashes the environment and threatens the global system with periodic crises. There have been more than a dozen financial crises since the beginning of 20th century. The aftermath of each was transitory, and markets rebounded rather quickly.

The current may be different, it will usher in profound and lasting structural behaviour and regulatory changes .In present troubled time a fresh approach is needed on overall policy matters and its implementation to curb occurring such mishappening. For restoration of confidence in financial markets a new look on corporate governance is quite imperative, this is the measure area where a lot of work have to be done in near future, personally I think governance is a biggest determinant in shaping of an administrative order, whatever we have seen in back times may be termed as failure of governance ðical work style.
It would be quite nice to see a new financial world free from such wrong practices, but before this, indeed we have to pass through a long wait…. like the Samuel Backetts Waiting For Godot….
Atul Kr Thakur
New Delhi,March 2,2009
atul_mdb@rediffmail.com