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Derivatives In India A Retail Investor's Perspective

Myths and Reality a perspective of Retail investor from India

An interesting research to capture the perception of Retail investor is carried out by Dr. Shaik Abdul Majeeb Pasha from Professor, College of Business and Economics, Arba Minch University, Ethiopia. In this the author has sampled 500 investors from Andhra Pradesh state (Telengana, Andhra and Rayalseema regions) and asked them 10 questions to understand what they think of Derivatives.

Results have shown consistently whether in India ( where derivative markets have been developing) or in America (where derivative markets are developed) retail investors have hold similar thoughts towards investing and using derivatives.

Now looking at the results

  1. DERIVATIVES ARE NEW, COMPLEX, HIGH-TECH FINANCIAL PRODUCTS: Among Investors who are mostly trading stocks, bonds and mutual funds more than 2/3rd of them think these products are new. One reason could be that these products are relatively young compared to other products.

History of Derivatives in India

Derivatives have come into vogue in India after 2000. Derivatives markets in India have been in existence in one form or the other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. In 1952, the Government of India banned cash settlement and options trading. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges, NSE (National Stock Exchange) and BSE (Bombay Stock Exchange), and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Initially, SEBI approved trading in index futures contracts

based on various stock market indices such as, S&P CNX, Nifty and Sensex. Subsequently, index-based trading was permitted in options as well as individual securities

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX.

Introduction of Derivatives have provided various market players hedging tools.

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Now I see similar kind of reactions from variety of financial market professionals in Americas. People tend to think derivatives are too complex, risky and they have caused the financial turmoil and meltdown of 2008 great financial crisis.

  1. DERIVATIVES ARE Speculative and levered: Most market participants think that these products are speculative in nature when they see how these products are created out of nowhere. This reminds to me a story from a Chinese official who was asked by the China central party leader, what is a Derivative? After the great financial crisis of 2008. This official answered back with wit saying, if you have two mirrors facing each other with a needle placed at the center. The reflection you see on the mirror is nothing but Derivative.

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Without speculators, Hedgers and Arbitrageurs markets do not exist. Likewise, derivative markets are provide investors tools to safeguard their investments not to endanger their life time savings. On this note there is huge activity happens in the structured note derivative market. This market packages derivative and a bond for the individual investor. So the myth of Derivatives being highly speculative is not true.

  1. ONLY LARGE ORGANIZATIONS / INVESTORS HAVE A PURPOSE FOR USING DERIVATIVES

According to the survey whooping 50% of the participants think Derivatives are only for large corporations and banks. This kind of misconception arises due to the fact that transaction sizes happen in millions of dollars. Retail investors with their low capital outlays are clearly out of the game. In riposte to this SEBI has launched. Chhota (mini) SENSEX7 was launched on January 1, 2008. With a small or 'mini' market lot of 5, it allows for comparatively lower capital outlay, lower trading costs, more precise hedging and flexible trading. Currency futures were introduced on October 1, 2008 to enable participants to hedge their

Currency risks through trading in the U.S. dollar-rupee future platforms.

So it is matter of awareness and having tools to be able to transact in these products.

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  1. FINANCIAL DERIVATIVES ARE SIMPLY THE LATEST RISK - MANAGEMENT FAD

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50% of surveyed investors thought Derivatives are more like a new product with sizzle and will go away after some time. Global investment banks have built their franchises around this product. Derivatives have become major source of trading revenues to these banks. Most importantly big corporations have got huge hedging benefits. Only one thing has changed in this market after financial crisis is that these markets have become more transparent. Investors are able to look at transactions and their prices in a seamless manner that was not possible earlier. Due to this these products will become more ingrained in the investor risk management toolkit. Now once investors get full access to the derivatives through structured note markets these products will gain clear utility status.

  1. DERIVATIVES TAKE MONEY OUT OF PRODUCTIVE PROCESSES AND NEVER PUT BACK ANYTHING

Another common point from most of the folks who have not understood these derivatives are that they are weapons of mass destruction has no economic benefits. It is easy to get swayed by this notion when you think how an option or future is going to help economy to grow compared to growing a bushel of corn. One should not forget the price of a bushel cannot be determined in air and it will get its price agreed on the market place. Derivative to a larger extent perform he function of the price setting. In doing so, Derivatives actually bring an order into the markets rather than chaos.

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  1. ONLY RISK SEEKING ORGANIZATIONS/INVESTORS SHOULD USE DERIVATIVES

Again 50% of investors thought that Derivatives are for risk takers. This is another big myth that clearly goes against the financial wisdom. Risk averse investors buy insurance to protect them from life and property damages. If so then investors who want to protect their investments should also have these derivatives as insurance to craft the risk and returns of their portfolios.

Financial derivatives can be used in two ways: to hedge against unwanted risks or to speculate by taking a position in anticipation of a market movement. Organizations / Investors today can use financial derivatives to actively seek out specific risks and speculate on the direction of market price movements, or they can use derivatives to hedge against unwanted risks. Hence, it is not true that only risk - seeking institutions use derivatives. Indeed, organizations should use derivatives as part of their overall risk - management strategy for keeping those risks that they are comfortable managing and selling those that they do not want to others who are more willing to accept them. Even conservatively managed institutions can use derivatives to improve their cash-flow management to ensure that necessary funds are available to meet objectives. One could argue that organizations that refuse to use financial derivatives are at greater risk than those who use them.

When using financial derivatives, however, organizations / investors should be careful to use only those instruments that they understand and that fit best with their risk - management objectives. It may be prudent to stay away from the more exotic instruments, unless the risk / reward tradeoffs are clearly understood by the firm's senior management / investor. Exotic contracts should not be used unless there is some obvious reason for doing so.

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  1. THE RISKS ASSOCIATED WITH FINANCIAL DERIVATIVES ARE NEW AND UNKNOWN

Financial risks are never new. They have existed all along and only our understanding of them has evolved. This kind of evolution with the help of advancements in Risk measuring techniques using finance engineering tools has changed entire landscape of financial risk management. Corporations funding their cashflow needs can create structured notes products and investors seeking customized risk profile can supply their capital at market price.

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  1. DERIVATIVES TRADING UNSAFE AND RISKY: Most of the investors unanimously felt that Derivatives are unsafe.

In general, every investment is risky. There is no strategy which is 100% risk - free, whether you invest on spot or derivatives market. It is not that derivatives are risky, but the strategy used for them might be risky; just as many share strategies are risky. For example, car driving can be either safe or risky, depending on who is driving. The majority of accidents are caused by drivers and not by the cars themselves. The danger comes from how a driver drives the car. It is the same with derivatives; intrinsically, derivatives are neither unsafe nor risky.

But in reality, derivatives also help to improve market efficiencies because risks can be isolated and sold to those who are willing to accept them at the least cost. Using derivatives breaks risk into piece that can be managed independently. Investors can keep the risks they are most comfortable managing and transfer those they do not want to others who are more willing to accept them. From a market-oriented perspective, derivatives offer the free trading of financial risks.

The viability of financial derivatives rests on the principle of comparative advantage, that is, the relative cost of holding specific risks. Whenever comparative advantages exist, trade can benefit all parties involved. Financial derivatives allow for the free trading of individual risk components.

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  1. DERIVATIVES TRADING INCREASES SYSTEMATIC RISKS

During the financial crisis, regulators and politicians have blamed financial derivatives to destabilize the system after bailing out AIG (American insurance group) and other large systemically important institutions. Main issue has been lack of transparency in the over the counter derivatives markets. Most banks do book keeping of their inventory bilaterally and hence it is difficult imagine with accuracy how much is being traded and at what price.

After the latest Dodd frank act, derivatives trading DTCC's SDR provides players with transaction prices and size of transaction. Atleast investors can guage the risk getting on the market. Derivative trading do not lead to build up in risk.

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  1. BECAUSE OF THE RISKS ASSOCIATED WITH DERIVATIVES, REGULATORS SHOULD BAN THEIR USE

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The survey found that 25% of the small investors are of the opinion that because of the risks associated with derivatives, regulators should ban their use. 55% of the respondents are of the opinion that because of the risks associated with derivatives, regulators should not ban their use. The remaining 20% of investors answered that they could not say./ it is good to see that more than 50% respondents did not believe in this myth and opposed the ban of derivatives. Even though most of the investors are not familiar with the use of derivatives, and think that derivatives are complex and risky, they oppose a ban on derivatives. The problem is not derivatives but, it is the responsibility of a user to ensure that risks are effectively controlled and limited to levels that do not pose a serious threat to their investment position.

Regulation is an ineffective substitute for sound risk management at the individual firm / user level. However, it is likely that derivatives have become so enmeshed in modern life that it is impossible to go back and remove them. The ban on any derivatives is unreasonable, ignorant of realities of the futures market, and possibly disastrous for the futures trade.

Regulators should emphasize more disclosure of derivatives positions in financial statements and be certain that institutions trading huge derivatives portfolios have adequate capital. In addition, because derivatives could have implications for the stability of the financial system, it is important that users maintain sound risk-management practices. Regulators should educate the investors to overcome their misconception on derivatives. Securities and Exchange Board of India, which is a powerful regulatory authority in India, has taken steps to create awareness, but it is not reaching the small retail investors effectively. It should issue guidelines that firms with substantial trading or derivatives activity should follow

Conclusion:

Based on these 10 myths, one can clearly imagine, lack of awareness, education and knowledge has become main source of all perceptions. Regulators should develop guidelines for expanding the knowledge of these derivatives to various investors on the market.