Although Indian market is far from being complete in an academic sense(in terms of implementation of measures for risk mitigation), we have already initiated some steps in that direction. OTC rupee derivatives in the form of Forward rate Agreements / Interest Rate swaps were introduced in India in July, 1999. Since the introduction of FRAs / IRS transactions have recorded substantial increase. In terms of number of contracts and outstanding notional principal amount, IRS contracts have jumped from about 200 contracts amounting to Rs 4000 crore in March, 2000 to 6500 contracts for Rs 150,000 crore in December 2002.Though in a majority of these contracts , the market players have used NSE-MIBOR as the benchmark rate, they have also been using other benchmarks as Mumbai Inter bank Forward Offered Rate (MIFOR) , Mumbai Inter bank Offered Currency Swaps (MIOCS), Mumbai Inter bank Overnight Index swaps (MIOIS) , primary auction treasury bill rates etc. In order to give a further fillip to the market, you are aware that an Working Group on OTC Rupee derivatives under the Chairmanship of Shri Jaspal Bindra, CEO, Standard Chartered Bank (Indian Region) has submitted its report to the Deputy Governor on 30 January, 2003. As and when derivatives both Over the Counter type as well as Exchange traded ones get enabled, this will open up a range of possibilities for efficient pricing, hedging and managing of interest rate risks. But it also raises a set of new issues like counter party risks, liquidity risks etc., which, although not unfamiliar, but will be important in this altered milieu. I have a feeling that, for optimizing the capital charges, the clearing and settlement of contracts should increasingly be through a centralized counterparty. Such arrangements not only reduce counter party risk but also considerably simplify documentation and settlement operations which reduce operational risk and settlement costs.

In June 2000, derivatives have been allowed on stock exchanges also (at NSE and BSE). The available products are : Index futures and options, basket futures and options, stock futures and options. As between, Index/basket derivatives and stock derivatives, stock derivatives are more popular. Further, as between futures and options, futures are more popular. As between stock exchanges, derivatives have large volumes on NSE. The market for stock futures is growing very fast. During 2001-02, 43 lakh contracts for a total amount of Rs.1,03,848 crore were traded on the exchanges. NSE accounted for 98% of the volume, while the remaining 2% by BSE. The volumes have shown fast growth from month to month : Rs.320 crore in April 2001, Rs.840 crore in June 2001, Rs.5,680 crore in September 2001, Rs.13,005 crore in December 2001 and Rs.20,538 crore in March 2002.

There is a misconception that derivatives are used for speculation. While speculators can use, and do use, derivatives, they can also be used - and are used - by businessmen and investors to hedge their risks.

There can be a variety of uses of derivatives. We can discuss a few of them. I am using simple examples for an easy understanding of the subject. Please excuse me for any error because of my limited knowledge of the subject.

Suppose, a manufacturer has received order for supply of his products after six months. Price of the product has been fixed. Production of goods will have to start after four months. He fears that, in case the price of raw material goes up in the meanwhile, he will suffer a loss on the order. To protect himself against the possible risk, he buys the raw material in the 'futures' market for delivery and payment after four months at an agreed price, say, Rs. 100 per unit. Let us take the case of another person who produces the raw material. He does not have advance orders. He knows that his produce will be ready after four months. He roughly knows the estimated cost of his produce. He does not know what will be the price of his produce after four months. If the p-rice goes down, he will suffer a loss. To protect himself against the possible loss, he makes a 'future' sale of his produce, at an agreed price, say, Rs. 100 per unit. At the end of four months, he delivers the produce and receives payment at the rate of Rs. 100 per unit of contracted quantity. The actual price may be more or less than the contracted price at the end of contracted period. A businessman may not be interested in such speculative gains or losses. His main concern is to make profits from his main business and not through rise and fall of prices. He wants to work with peace of mind and some assurance.

Let us take another example. Suppose a person is going to retire after one year. He wants to invest a part of his retirement dues to be received after one year, in shares. He feels that share prices ruling at present are quite reasonable, and after one year the prices might go up. He enters a 'futures' contract for one year to buy the shares at an agreed price of, say, Rs. 100 per share. After one year, he will make payment at the contracted rate and will receive the shares. There is another person who holds investments in shares. He desires to sell his investments after one year, for use for his daughter's marriage. He is afraid that if prices of his investments fall after one year, he will suffer a loss. He cannot sell them now as he has pledged them with a bank as security for a loan. He hedges the risk by selling his investments through a 'futures' contract for one year at a contracted price of, say, Rs. 100 per share.

In the above two examples, at the end of one year, ruling price may be more than Rs. 100 or less than Rs. 100. If the price is higher(say, Rs. 125), the buyer is gainer for he pays Rs. 100 and gets shares worth Rs. 125, and the seller is the loser for he gets Rs.100 for shares worth Rs. 125 at the time of delivery. On the other hand, in case the price is lower (say, Rs.75), the purchaser is loser; and the seller is the gainer There is a method to cut a part of such loss by buying a 'futures ' contract with an 'option', on payment of a fee. The option gives a right to the buyer/seller to walk out the 'futures' contract. Naturally, a person will exercise option only if beneficial. In the above example, suppose the option fee is Rs. 10, and the price of shares at the time of exercise is Rs. 75, it will be advantageous for the buyer of shares to exercise the option. Thus, if he directly buys shares in the spot market, his cost will be only Rs. 85(Rs.75+Rs.10 fee) as against Rs. 100 which he had to pay under the 'futures' contract. In case the current price at the time of delivery is higher (say, Rs.125) than the contracted price (Rs. 100) plus option fee, the seller of shares will be similarly benefited in opting out of the futures contract, for he can realize a higher price in the spot market.

We have noticed from the earlier discussion that one's gain is another's loss. That is why derivatives are a 'zero sum game'. The mechanism helps in distribution of risks among the market players.

The above retiring gentleman also wants to invest a part of his retirement dues in bonds. He is quite comfortable with the present level of yield. He hedges the risk of fall in yield by entering into a 'forward rate agreement' of one year at an agreed rate. At the time of actual investment after one year, he will get the contracted yield on his investment.

Let us see one of the uses of 'interest rate swap'. Suppose a financial institution has some floating rate liabilities, but all its assets are on fixed rate basis. In case the floating rate goes up, it will be a loser. The institution can protect its position by swapping (exchanging) floating rate on its liabilities with fixed rate. There may be another person holding floating rate assets. He fears that the floating rate may go down in future. He may exchange his floating rate receipts with fixed rate receipts.

I would like to give an example of 'currency swap'. Suppose a person is holding one million Dollars. He does not need them now. But, he will need them after six months for purchase of machinery. His calculation is that he can earn a better return on his funds by investing in Rupee bonds. What he does is that he sells the Dollars in spot market for Rupees. Simultaneously, he buys Dollars 'forward' for delivery after six months. At the end of six months, he sells his Rupee bonds and takes delivery of Dollars against payment of Rupees. He makes payment for the machine in Dollars. (The difference between 'forwards' and 'futures' is that while the former take place between two counter parties in the OTC market, the latter are transacted on stock exchanges.)

It is also possible to hedge the risk of default on a bond/loan through a 'credit derivative'.

So far, we have seen examples of derivatives for hedging business/investment risks. Derivatives can also be undertaken for speculation. Speculators, as you know, are of two types. One type is of optimistic variety, and sees a rise in prices in future. He is known as 'bull'. The other type is a pessimist, and he sees a fall in prices, in future. He is known as 'bear'. They undertake 'futures' transactions with the intention of making gains through difference in contracted prices and future prices. If, in future, their expectations turn out to be true, they gain. If not, they lose. Of course, they may limit their losses through options.