report liabilitymanagement

7/28/2019 Report Liabilitymanagement

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PROJECT REPORT

TITLED

LIABILITY MANAGEMENT AND DERIVATIVES AS A TOOL OFLIABILITY MANAGEMENT IN FINANCIAL INTERMEDIARIES

SUBMITTED BY:

MANISH SAINIENROLMENT NUMBER # 990046281

STUDY CENTRE # 0712REGIONAL CENTRE # 029

PROJECT PROPOSAL# 34918

SUBMITTED TO:

SCHOOL OF MANAGEMENT STUDIES

INDIRA GANDHI NATIONAL OPEN UNIVERSITYMAIDAN GARHI

NEW DELHI.


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CONTENTS

1.About IDBI

2.Introduction

3.Reasons for ALM Mismatch

4. Sources And Characteristics Of IRR

5.Measurement and management of IRS

6.Regulatory framework

7.ALM constraints

8.What are Derivatives

9. FRAs and IRS

10.What Does IRS Do?

11. Indian Scenario

12. Conclusion

13. References


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ABOUT IDBI

Industrial Development Bank of India (IDBI) was established in July 1964 by

Government of India under an act of Parliament, the Industrial Development

Bank of India Act, 1964(the IDBI Act). The IDBI Act governs the functions

and working of IDBI. Initially IDBI was set up as a wholly owned subsidiary

of the Reserve Bank of India (RBI) to provide credit and other facilities for

the development of industry. In 1976,the ownership of IDBI was transferred

to the Government of India and it was entrusted with the additional

responsibility of acting as the principal financial institution for coordinating

the activities of institutions engaged in financing, promotion or development

of industry.

In 1982, IDBI transferred its International Finance Division to export-import

Bank of India, which was established as a wholly owned corporation of the

Government of India under the export-import Bank of India Act, 1982.

In 1990,IDBI's portfolio relating to the small-scale industrial sector was

transferred to the Small Industries (SIDBI), which was established as a

wholly owned subsidiary of IDBI under Small Industries Development Bank

of India Act, 1989(SIDBI Act, 1989).

IDBI provided significant support in the development of the capital market

through setting up of Securities & Exchange Board of India, National Stock


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Exchange of India LTD, Credit Analysis and Research LTD, Stock Holding

Corporation of India LTD, Investor Services of India LTD, National Securities

Depository Ltd.

In 1999, entered into a JV agreement with the Principal Financial Group,

USA for participation in equity and management of IDBI Investment

Management Company Ltd., erstwhile a 100% subsidiary of IDBI.

In March 2000, set up IDBI Intech Limited as a subsidiary to undertake IT

related activities.

Functions

As a Development Bank, IDBI has financed and nurtured Indian industry

through its infancy to fulfill the national dream of a robust industrial and

financial structure in the country.

Over the last thirty years, IDBI's role as a catalyst to industrial development

has encompassed a broad spectrum of activities. IDBI can finance all types

of industrial concerns covered under the provisions of the IDBI Act,

irrespective of the size or the form of the organization. IDBI primarily

provides finance to large and medium industrial enterprises and is

authorized to finance all types of industrial concerns engaged in the

manufacture, processing of preservation of goods, mining, shipping,

transport, hotel industry, information technology, medical and health

services, leasing, generation and distribution of power, maintenance, repair,


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testing or servicing of vehicles, vessels and other types of industrial

machinery and the setting up of industrial estates. IDBI also assists

industrial concerns engaged in research and development of any process or

product or in the provision of special technical knowledge or other services

for promotion of industrial growth. In addition, floriculture, road construction

and the establishment and development of tourism related facilities including

amusement parks, cultural centers, restaurants, travel and transport

facilities and other tourist services and film industry have been recognized as

industrial activities eligible for finance from IDBI.

IDBI has been assigned a special role for co-coordinating the activities of

institutions engaged in financing, promoting or developing industries as also

provision of technical, legal and marketing assistance to industry and

undertaking market surveys, investment research as well as techno-

economic studies in connection with development of industries.

"We are envisaging the new Industrial Development Bank of India as a

central coordinating agency, which ultimately will be concerned, directly or

indirectly, with all the problems or questions relating to the long and

medium term financing of industry, and will be in a position, if necessary, to

adopt and enforce a system of priorities, in promoting future industrial

growth"

Extract of the then Union Finance Minister's address

to the Parliament on the setting up of IDBI in 1964


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IDBI's future strategy for business growth would be to further build upon its

area of core competence viz., project financing complemented with the

aggressive entry into other compatible business operations. Asset growth of

acceptable quality through client-driven business deals that would help

maintain IDBI's market shares along with enhanced profitability would be an

integral part of the strategy. IDBI's future strategy would be not only to

maintain its premier position in the Indian financial system but also to take a

position of prominence among top DFIs of the world.

Offices

IDBI has its Head Office at Mumbai and has an all India presence through its

branch network. It operates through the network of 5 Zonal offices; one

each in Calcutta, Chennai, Guwahati, Mumbai and New Delhi. Besides, IDBI

has 38 branch offices located in state capitals and major commercial centers

in India.

Government Holding

The IDBI Act was amended in October 1994, which, inter alia, permitted

IDBI to raise equity from the public subject to the holding of the

Government not falling below 51% of the issued capital. Pursuant to the

amendment, in July 1995,IDBI made its first initial public offering of equity

shares aggregating RS. 2184 crones. Simultaneously, the Government also

offered for sale a part of its holding of equity shares in the capital of IDBI


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aggregating Rs.187.5 crores (including premium of RS. 120 per share) to

the Indian public. On completion of the allotment of shares offered to the

public, the Government's shareholding in IDBI reduced to 72.14%. The

Government share holding has further come down to 57.76% with effect

from June 5,2000 as, the Government of India converted 24.7 crone equity

shares into 24.70 crone fully paid preference shares of Rs.10/- each

redeemable within 3 years and carrying a dividend @ 13% pa. However the

Government's holding has gone up to 58.5% with effect from August

25,2000.

Regulation and Supervision

The IDBI Act regulates the functions and business of IDBI. In addition it is a

financial institution subject to regulatory supervision by RBI. Section 45L of

RBI Act, 1934, empowers RBI, inter alia, to call for certain information

relating to the business of IDBI and give directions relating to conduct of its

business. RBI has also setup a Board of Financial Supervision under the

chairmanship of the Governor of RBI, which carries out periodical supervision

of IDBI.RBI also issues detailed guidelines on Asset Classification, Income

Recognition and Provisioning, Capital Adequacy, Asset Liability Management

etc. from time to time. IDBI adheres to all such guidelines and submits

necessary information to RBI as per guidelines.


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Corporate Governance

Presently corporate governance is administered through the Board and two

major committees, i.e. the Executive Committee and the Audit Committee.

However the primary responsibility of upholding the high standards of

corporate governance in its operations and providing necessary disclosures

within the framework of legal provisions and banking conventions with

commitment to enhance the shareholder's value, lies with the Board of IDBI.

The Board

The Board of Directors can have a maximum of 12 directors, consisting of a

Chairman and a Managing Director appointed by the Government of India, a

fulltime director appointed by the Government on the recommendations of

the Board, two Government nominees, three directors having special

knowledge in diverse fields nominated by Central Government and four

directors elected by the shareholders other than the Government of India.

Primary responsibilities of the Board include:

Maintaining high standard of corporate governance.

Shaping the policies and procedures of the Bank.

Monitoring the progress and shaping the future growth strategy.


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The Executive Committee

All directors of the Board are members of the Executive Committee, with the

CMD of IDBI being the committee chairman. This committee deals with

sanctions of assistance above certain threshold limits and also decides on

matters relating to Business Plans, Resource Mobilization, Investments,

Capital Expenditure etc.

Audit Committee

It comprises of five directors and is headed by an independent professional

director. This committee acts an interface between the management and the

statutory and internal auditors overseeing internal auditors.

Investor Grievances Committee

This committee consists of a Chairman and two members, who are Directors

of the Board and the Deputy Managing Director as a member. The

committee looks into redressal of shareholders and the investors' complaints

mainly relating to transfer of shares/bonds, on-receipt of annual accounts

and dividend, interest etc.


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OBJECTIVES


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RESEARCH METHODOLOGY


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LIMITATION


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INTRODUCTION

Asset and liability management is the management of total balance

sheet dynamics with regards to size and quality. It involves

quantification of risks.

Asset and Liability Management is the management of the structure of a

bank's balance sheet in such a way that interest related earnings are

maximized within the overall risk preference of the banks management.

Stated in this way, ALM is not new to bank management. No bank could

have survived over the years without paying attention to the risk/return

characteristics of its balance sheet. Asset and Liability management has

grown up as a response to the problem of managing modern banks dealing

in a wide range of diversified aspects, liabilities, and contingent liabilities at

a time of volatile interest rates, volatile exchange rates and, more generally

a continually changing economic environment.

Over the last few years the Indian financial markets have witnessed wide-

ranging changes at the fast pace. Intense competition for business involving

both the assets and liabilities, together with increasing volatility in the

domestic interest rates as well as foreign exchange rates has bought

pressure on the management of banks to maintain a good balance among

spreads, profitability and long term viability. These pressures call for


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structured and comprehensive measures and not just ad hoc action. The

management of banks has to base their business decisions on a dynamic and

integrated risk management system and process driven by corporate

strategy. Banks are exposed to several major risks in the course of their

business- credit risk, interest rate risk, foreign exchange risk, equity

commodity price risk, liquidity risk and operational risk.

The initial focus of the Asset Liability Management (ALM) function would be

to enforce the risk management discipline viz. managing business after

assessing the risks involved. The objective of good risk management

programs should be that these programs would evolve into a strategic tool

for bank management.

In the normal course, banks are exposed to credit and market risks in view

of the asset-liability transformation. With liberalization in Indian financial

markets over the last few years and growing integration of domestic markets

and with external markets, the risks associated with banks operations have

become complex and large, requiring strategic management. The interest

rates on bank investments in government and other securities are also now

market related. Intense competition for business involving both the assets

and liabilities, together with increasing volatility in the domestic interest

rates as well as foreign exchange rates, has brought pressure on the


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management of banks to maintain a good balance among spreads,

profitability and long-term viability. Imprudent liquidity management can put

bank earnings and reputation at great risk. These pressures call for

structured and comprehensive measures and not just ad hoc action.

The management of banks has to base their business decisions on a dynamic

and integrated risk management system and process, driven by corporate

strategy. Banks are exposed to several major risks in the course of their

business- credit risk, interest rate risk, foreign exchange risk,

equity/commodity price risk, liquidity risk and operational risk. It is,

therefore, important that banks introduce effective risk management

systems that address the issues related to interest rate, currency and

liquidity risks.

Banks can address these risks in a structured manner by upgrading their risk

management and adopting more comprehensive Asset-Liability Management

(ALM) practices that has been done hitherto.

Asset and Liability Management is the management of the structure of a

bank's balance sheet in such a way that interest related earnings are

maximized within the overall risk preference of the banks management.

Stated in this way, ALM is not new to bank management. No bank could

have survived over the years without paying attention to the risk/return


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characteristics of its balance sheet. Asset and Liability management has

grown up as a response to the problem of managing modern banks dealing

in a wide range of diversified aspects, liabilities, and contingent liabilities at

a time of volatile interest rates, volatile exchange rates and, more generally

a continually changing economic environment.


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REASONS FOR ASSET LIABILITY MISMATCH:

Prepayment / Payment Delays: The prepayment or payment delay

creates mismatch in the Asset - Liability structure when a borrower

does not fulfill his obligation or does not do so on time. There is

a fundamental connection between this problem and asset and liability

management, in that all asset management relies upon asset being of

good quality. The most direct influence of asset and liability

management on this problem has been the switch to variable rate

lending. This change designed to remove from banks much of the

interest rate risk involved in maturity transformation succeeded but

shifting the interest rate risk to the borrower, thus making his cash

flow less predictable and may be making him a worse credit risk. Of

course this will depend upon the variability of rates of interest, a

sudden fall in rates of interest will obviously help borrowers on

variable rate terms, rise will be to their disadvantage. Bad debts also

affects asset and liability management. They freeze assets and

convert short-term claims into long-term claims. Cash flows, which

were expected, are not received and this impacts on bank liquidity. If

bad debts are unusually large they affect outsiders perception of the

bank and in all probability reduce its creditworthiness, thereby

affecting the ease and/or cost of raising funds. And anything affecting

the perceived creditworthiness of a bank affects its ability to manage


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liabilities. While it is to be expected that bad debts will rise in time of

severe recession, the problems can be exacerbated by insufficient

diversification of the loan portfolio. With all lending whether by banks

or by financial institutions, concentration on individual lenders,

individual groups, and individual economic sectors can increase this

problem. Thus measuring and managing liquidity needs are vital

activities of commercial banks. By assuring a bank's ability to meet its

liabilities as they become due, liquidity management can reduce the

probability of an adverse situation developing.

In order to overcome this liquidity gap, commercial banks

undertake Credit Risk Management, which involves three key

principles: selection, limitation and diversification. The choice to

whom to lend is a first requirement. However discrimination is a bank's

credit management, there remains the risk of unforeseen changes in

the economic fortunes of companies, industries, of geographical areas

or even of whole countries; hence it is necessary to have a system of

limits in different ways and at different levels for amounts to be loaned

to any one borrower or group of connected borrower and to any one

industry or type of economic activity. The third principle of limitation-

avoiding concentration of lending. But over and beyond this minimum

implied diversification, the more a bank is able to spread its lending

over different types of borrower, different economic sectors and


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different geographical regions, the less likely is it to encounter credit

problems. Large banks are more able to diversify by geography by

economic sector than small banks.

Vulnerable Exchange Rate Movements: vulnerable exchange rate

movements creates Asset- Liability mismatch due to changes in

foreign exchange rates. Floating exchange rate arrangement has

bought in its wake pronounced volatility adding a new dimension to

the risk profile of bank balance sheets. The increased capital flows

across free economies following deregulation have contributed to

increase in the volume of transactions. Large cross border flows

together with the volatility has rendered the banks balance sheets

vulnerable to exchange rate movements. Dealing in different

currencies brings opportunities as also risks. If the liabilities in one

currency exceed the level of assets in the same currency, then the

currency mismatch can add value or erode value depending upon the

currency movements. For instance if dollar assets exceed dollar

liabilities a bank stands to gain from appreciation of the dollar and to

lose from depreciation. Banks undertake operations in foreign

exchange like accepting deposits, making loans and advances and

quoting prices for foreign exchange transactions. Irrespective of the

strategies adopted, it may not be possible to eliminate currency

mismatches altogether. Besides some of the institutions may take


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proprietary trading positions as a conscious business strategy. The

simplest way to avoid this is to ensure that mismatches, if any are

reduced to zero or near zero.

The management of currency positions like other aspects of asset

and liability management involves both short-run and long run

considerations. In the short run banks can transact in a range of

markets in orders to alter their asset/liability position in any given

currency. In the long run banks can choose to compete more or less

aggressively for business in particular currencies and they can vary their

long-term borrowing in particular currencies. If it accords with its other

long term plans, a bank can seek to develop retail banking operations in

other currencies in order to boost its resources in the currencies in

question.

Balance Sheet Activities: Banks have traditionally stood ready to

provide certain types of guarantee which involved underwriting the

obligations of a third party and which creates contingent liability for

the guarantor banks. In recent years contingent activities have

become more important as banks have increased off-balance sheet

business in search for fee income or for hedging purposes. The new

contingent risk are those arising from commitments to provide funds in

the future, from acting as counter party in currency or interest-rate


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swaps and from outstanding forward or futures commitment, and from

options granted.

Contingent activities should be taken seriously because they

being contingent as opposed to actual at times could be

underestimated.

Interest Rate Mismatches: Whenever rate-of-interest conditions

attaching to assets and liabilities diverge, then changes in market

interest rates will affect bank earnings. The regulatory restrictions on

banks greatly reduced many of the risks in the financial system. The

deposits were taken in at mandatory rates and loaned out at legally

established rates. Interest rates therefore remained unaffected by

market pressures.

Deregulation of the financial system in India has put in place a lot of

operational freedom to the financial institutions and the pricing of

major portion of assets and liabilities have been left to their

commercial judgement. The money that savings institutions historically

took in was primarily short-term deposit whereas the money they lent

out was primarily in the form of long-term loans. They failed in the

early 1980's when interest rate on deposit accounts rose sharply.

Because the mortgages used to pay interest on these accounts were

long-term instruments, the institutions were receiving lower rates than


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they were paying. Therefore their cost of funds rose much faster than

the yields on their assets. The resulting declines in spread and

profitability contributed to many failures.

For example, suppose ABC negotiated 10% with the borrower on 48-

month installment loan and a rate of 6% with the depositor on 90 days

CD. The spread would be 4%, which is favorable to ABC. Now the

depositor decides to renew the CD at the end of 90 days. If deposit

interest rates in ABC's market have risen during the 90 days since the

CD originally opened, ABC would be forced to pay higher rate when CD

renews. If local rate have risen by 2%, then ABC may be required to

pay 8% on renewal of CD. But because the 48-month installment loan

is fixed to maturity and 45 installments of the original 48 payments

will be still outstanding ABC will have 10% yield on the majority of the

loan and cost of fund will be 8%. The spread has dropped to 2% from

4%. As a result less money will be available to cover expenses. This

difference occurs because loan and deposit reprice at different times.

If rates had fallen during the 90 day period, cost of funds would drop

at renewal increasing ABC's profitability. The rapidly climbing cost of

funds in contrast to the sluggish movement in yields on earning assets

contributed to heavy losses.


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The earning of assets and the cost of liabilities are therefore

closely related to interest rate volatility.

Interest rate refers to potential impact of Net Interest Income (NII) or

Market Value of Equity (MVE) caused by unexpected changes in

interest rate. This unexpected change in the interest rates gives raise

to Interest Rate Risk.

While asset and liability management covers a much broader scope

than management of interest rate risk, this aspect of risk

management is one of the most important disciplines in asset

and liability management.


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SOURCES AND CHARACHTERISTIC OF INTEREST RATE RISK

The degree of interest rate risk that the institution must manage depends

upon the rate sensitivity of the financial instruments it uses to obtain funds

(deposits and borrowings) and invest funds (investment and loans).

Financial instruments rate sensitivity is the speed at which the interest rate

on the instrument responds to a change in market rates.

For example, suppose a customer opened a money market deposit account

(MMDA) at an interest rate of 5.5%. An MMDA is a saving account that is

designed to be directly equivalent to and competitive with money market

mutual funds. The institution can establish its own minimum deposit and

maintenance balance requirement to open the account to earn interest, the

MMDA contract specifies that whenever the institution changes its MMDA

rate, all MMDA customers automatically receive the new rate. If the

institution changes its rate to 5.75%, the customer who opened the MMDA

at 5.5% will immediately receive the higher rate. Because the interest rate

on the account might change immediately whenever there is a change in

market rates, the MMDA account can be extremely rate-sensitive. On the

other hand suppose a customer purchases a 2-year CD at a rate of 6.5%,

the CD contract specifies that the interest rate will be in effect for the life of

the instrument, 2 years. If the institution raises its rates on 2 years CD to

7%, the customer who already purchased it at 6.5% is locked in the older


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rate. Because a considerable length of time will elapse before the CD will

react to the change in market rates and because there are penalties for early

withdrawal, such CD is not considered to be very rate sensitive.

This shows rate sensitivity of a financial instrument depends upon certain

characteristics. These characteristics are: -

1. Length of term to maturity - the above example of the 2-year CD

showed the effect of maturity on rate sensitivity. Maturity is the point at

which an instrument becomes due and payable. The maturity of an

instrument represents an occasion to renegotiate the rate on the instrument.

Upon maturity of a 2 year CD the customer is free to take the funds and

seek the most favorable rate at which to reinvest. Thus, the shorter the term

of maturity, the more susceptible borrowers and lenders are to rate

sensitivity. Financial institution can replace maturing investments, loan, and

deposits on borrowings with other investments, loans, deposits or

borrowings. At the time of reinvestment, the financial institution is

vulnerable to the effect of changes in market interest rates. If rates have

gone up since the original instrument was first negotiated, the replacement

instrument will carry a higher interest rate. If rates have gone down, the

opposite occurs.


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2. Use of Amortization - an instrument is said to amortize when it calls for

payment of a portion of the instruments principal periodically over the life of

the instrument. For example, the typical mortgage loan has a 30-year life,

but each monthly payment includes interest on the outstanding balance plus

a reduction in the outstanding principal. As the institution receives these

principal payments it has the opportunity to lend the funds to other

customers at current market rates. This shows amortizing instrument is

more rate-sensitive than one that calls for a lump-sum payment. This is

because the principal payments represent re-pricing opportunities.

3. Prepayment - often a borrower or depositor does not adhere to the

principal repayment schedule specified in the contract. When a customer

prepays a loan early, the institution has the opportunity to reinvest those

funds at current market rates. When the customer negotiates an early

withdrawal on a CD, an institution replaces the funds withdrawn with funds

obtained at current market rates. Because prepayment causes a loan or CD

to reprice earlier than specified in the contract, in institution experiencing

frequent payment is more rate sensitive than an instrument that experiences

infrequent prepayments. Prepayments on loans vary based on demographic

and economic characteristics. E.g. a market with rapidly growing, healthy

economy experiences higher turnover in its housing stock than a market that

is stagnant, causing more frequent prepayments of mortgage loans. In an


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environment of falling rates, borrowers will have greater incentives to

refinance loans than when will rates are rising.

4. Contractual Repricing - timing the repricing of a financial instrument by

specifying it in the instruments contract is called contractual re pricing.

Earlier the timing of the re pricing of an instrument had been directly tied to

the timing of its principal flows. The reason re pricing was tied to these cash

flows is that until recently most instruments have carried an interest rate

that remained fixed until maturity? But then it was discovered that

guaranteeing a fixed rate for the term of the instrument could cause

considerable difficulty. Making the purchase of certain classes of assets

affordable to customers requires that the purchase be financed over

relatively long periods of time. Fixed rate term loans are not very rate

sensitive, as their balances do react to the changes in market rates. Because

customers like to keep their deposits in short term instruments, it is difficult

to find a source of deposit with rate sensitivity similar to that of an

institutions long-term mortgages. This problem of funding long term assets

with short-term liabilities is to separate instruments re pricing from the

terms of the contract.

E.g. while the typical adjustable rate mortgage has a term of 15 to 30 years,

its contract may allow the institution to change its interest rate annually

based on movements in market rates. Contractual modification of the re


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pricing characteristics affects the rate sensitivity of the instrument. Rather

than gradually re pricing over 15 o 30 years through amortization, the

instrument can re price annually.

Interest rate risk can be basically classified into:

Gap or mismatch risk

A gap risk arises from holding assets and liabilities with different principal

amounts, maturity or re pricing dates thereby creating exposure to

unexpected changes in the level of interest rates. The gap is the difference

between the amount of assets and liabilities on which the interest rates are

reset or re priced during a given period. In other words, when assets and

liabilities re price during different periods, they can create a mismatch. Such

a gap or mismatch may lead to gain or loss depending upon how interest

rates in the market tends to move. For example, if a bank has invested the

proceeds of a 91 days, 8% deposits in 91 days treasury bill earning 10% and

maturing on the same day as the deposit, the bank will have a matched gap.

Here there would be no interest rate risk. If the proceeds of the 91 day

deposit are re invested in the floating rate loan (re priced at monthly

interval) with an initial rate of 10%, the interest rate charged on the loan

will change twice during 91 days, while deposit rate remains unchanged.

Since the asset is repriced much more rapidly than the liability during this

period, the bank is more asset sensitive. The asset sensitive bank can


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produce a large NII if the interest rate rises in the market because interest

rate on floating loan moves higher during the 91 days period, while interest

rate being paid on the deposit remains at 8%. Conversely, asset sensitive

gap position will cause compression in NII as interest rate declines. If bank

uses 91 days 8% deposit to fund a 5 year fixed rate govt. stock at 10%, the

stock would continue to earn 10% while the deposit gets re priced at every

91 days interval. The bank is more liability sensitive because the interest

paid on deposit is reset more rapidly than the fixed coupon earned on the

stock. A rise or fall in the interest rate in a liability sensitive situation has the

opposite effect on the NII than on an asset sensitive bank. Any increase in

the interest rate will cause an erosion in the liability sensitive bank NII.

Basis risk

In a perfectly matched gap position, there is no timing difference between

the repricing dates; the magnitude of change in the deposit rate would be

exactly matched by the magnitude of change in the loan rate. However,

interest of two different instruments will seldom change by the same degree

during the give period of time. The risk that the interest rate of different

assets and liabilities may change in different magnitude is called basis risk.

The following table shows how the basis risk occurs.


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GAP Statement for ABC Bank

(Amount in million of Rs)

Repricing Assets Repricing liabilities

Call money 50 Saving Bank 50

Cash credit 40 Time deposits 50

90 100

The bank as a negative gap of Rs.10 million. In case the interest rate falls by

1% (assuming that the rates on all assets and liabilities change by 1%) will

improve the banks NII by Rs. 1 million.

Net Interest Position Risk

The banks net interest position also exposes the bank to an additional

interest rate risk. If a bank has more assets on which it earns interest than

its liabilities on which it pays interest, interest rate risk arises when interest

rate earned on assets changes while the cost of funding of the liabilities

remains at 0%. Thus, a bank with positive net interest position will

experience a reduction in NII as interest rate declines and expansion in NII

as interest rate rises. A large positive net interest position accounts for most

of the profit generated by many financial institutions.


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Embedded Option Risk

Large changes in the level of interest rate create a risk to banks profits by

encouraging pre payment of loans and/or withdrawal of deposits before the

stated maturity dates. In case where no penalty for pre payment of loans,

the borrower have a natural tendency to pay of their loan when a decline in

interest rate occurs. In such cases, the bank receive a lower NII for e.g.

suppose a bank disbursed a 90 days loan at the rate of 10% which is funded

through a 90 days CD at the rate of 8%. In case the rate of interest declines

to 9% after 30 days and the borrower repays his loan immediately, the bank

receives only 200 basis points NII or 30 days rather than the anticipated 90

days. In the remaining 60 days of the 90 days term, the NII will be only 100

basis points. When the interest rate rises, the NII will be exposed to same

embedded option risk in the liability side of the balance sheet. If there are

no substantial penalties for pre mature withdrawal, the depositor may

withdraw the term deposits before the contracted maturities so that the

funds can be re deposited in new deposit accounts at a higher rate of

interest. Thus, as interest rate rise and falls, the banks are exposed to some

degree of risk as customers exercise the embedded options inherent in their

loan and deposit contracts. The faster and higher the magnitude of changes

in the interest rate, the greater will be the embedded option risk. Banks

impose penalties for pre payment of loans and pre mature withdrawal of

deposits. However as customer resist paying large penalties bank have to


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reduce penalties to modest level as a competitive strategy to attract

additional business.

Yield Curve Risk

An yield curve is a line on a graph plotting the yield of all maturities of a

particular instrument. As the economy moves through business cycle, the

yield curve changes rather frequently. To illustrate how a change in the

shape of yield curve affects the banks NII, lets us assume that ABC bank use

three years floating rate fixed deposits for funding three year floating rate

loans (the deposits and loans are re priced at quarterly intervals). If the

bank pays 100 basis points above the 8.50%, 91 days treasury bills rate to

fixed deposits and basis points is produced. If the yield curve turns inverted

during the next repricing date with the 91 days TB's rate increasing to 10%

and 364 days TB's rate remaining at 9% and the spread relationship of

deposits and loans to TB's remains constant, the NII will be reduced to 100

basis points. Thus banks should base only the rate of single instruments for

pricing the assets and liabilities.


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Re-investment Risk

As one instrument matures and replaced with another, the funds being re

invested may bear a different rate than the funds in the initial instrument.

The risk that this will occur is called re-investment risk. As replacement

instruments take the place of original instrument on an institutions

statement of condition, the institutions interest income and interest expense

will rise or fall, depending on the whether the replacement bears a higher or

lower interest rates than the original instrument.

Liquidity Risk

Customers look to financial institution as a source of funds and a place to

deposit excess funds. A depositor expects to be able to withdraw deposited

funds as needed, so a financial institution needs to have funds available

when the customer asks for them. Borrower also expects that an institution

will be able to supply funds for loans. So, financial institutions seek to have

some degree of liquidity.

Liquidity is a measure of a business, individual or institution to convert

assets into cash at a particular time without significant loss of principal

value. In other words liquidity is the ability to meet commitments when due

and to undertake new transactions when desirable.

The liquidity of assets varies widely. Assets offering immediate liquidity


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Measurement and Management of Interest Rate Risk

Before risk can be managed, they must be identified and quantified. Unless

we measure the quantum of risk inherent in a bank's balance sheet is

measured it is impossible to measure the degree of risk the bank is exposed

to. It is equally impossible to develop effective risk management strategies.

Without being able to understand the correct risk position of the bank.

There are many analytical techniques to measure interest rate risk. The

most commonly used techniques are:

Maturity Gap Analysis

Duration Gap Analysis.

Simulation

Value At Risk.

While these methods highlight different facets of interest rate risk, banks in

combination that combine features of all the techniques can use these.

Maturity Gap Analysis

Gap analysis is a technique that shows how quickly an individual rate-

sensitive asset or liability reacts to change in market rate. In addition, gap


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analysis compares the rate sensitivity of assets and liabilities making up an

institution's portfolio and measures the imbalance between their respective

rate sensitivities at a particular time. It does this by breaking down future

cash flows by rate-sensitive asset or liability is scheduled to reprice. The gap

is the difference between the amounts of assets and liabilities repricing in a

rate-sensitivity period. A rate sensitivity is a period of time during which the

portion of a rate sensitve asset or liability is scheduled to reprise

The mismatch risk can be measured by calculating gaps over different time

intervals based on aggregate balance sheet data at a fixed point of time. An

institutions interest rate position is the cumulative result of thousands of

individual items of deposits, loans, investments etc. Each deposit, advance,

investment etc has its own cash flow characteristics. In order to fully

comprehend the risk inherent in banks balance sheet, each deposit,

borrowing, loan, cash credit etc. should be related to their cash flows and

repricing to a given change in general level of interest rate.

The gap report should be generated by grouping rate sensitive liabilities,

assets and off balance sheet positions into time buckets according to

residual maturity or next repricing period, whichever is earlier. The difficult

task in gap analysis is determining rate sensitivity. All investments,

advances, deposits, borrowings, purchased funds etc. that mature/re price

within a specified timeframe are interest rate sensitive. Similarly any


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principal repayment of loan is also rate sensitive if the bank expects to

receive within the time horizon. This includes final principal payment and

interim installments. Certain assets and liabilities are repriced at pre-

determined intervals and are rate sensitive at the time of repricing. While

the interest rate on term deposits are fixed during their currency the

advances portfolio of the banking system is basically floating. The interest

rates could be repriced any number of occasions, corresponding to the

changes in PLR.

Duration Gap Analysis

Matching the duration of assets and liabilities instead of matching the time

until repricing is another technique for interest rate measurement. Duration

gap model focuses on managing NII by recognizing the changes in the

market value of the assets and liabilities for a given change in the market

interest rate.

Duration is the weighted average of the time until expected cash flows from

a security will be received, relative to the current price of the security. The

weights are the present values of each cash flow divided by the current

price. Additional data required to calculate the duration gap are the current

market yields/cost of different categories of assets and liabilities.

The difference between duration of the asset structure and the duration of

the liability structure is the bank's net duration. If the net duration is


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positive (DA>DL), a decrease in market interest rate will increase the

market value of the bank. When the duration gap is negative, the market

value of the bank increases when rate of interest increases but decreases

when rate falls.

Simulation

Simulation is a technique to measure an institution's interest rate risk by

forecasting the effect of an interest rate change on the institution's

profitability and market value. All the asset-liability simulation models use a

basic three-step approach in running a computer simulation. First, the user

provides the computer simulation model with data. Then the computer

model uses the data to simulate the effect of the interest rate assumptions

and management policies on the institution profitability and market value.

Finally the model communicates its result using a variety of reports.

Value at Risk

VAR is a statistical measure of the risk that estimates the maximum loss

that may be experienced on a portfolio with a given level of confidence. VAR

always comes with a probability that says how likely it is that losses will be

smaller than the amount given. VAR is a monetary amount, which may be

lost over a certain specified period of time. The period of time is dependent

on the period the portfolio is considered to be held constant. The following is

the general formal definition of VAR:


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Value at risk is the maximum amount of money that may be lost on a

portfolio over a given period of time, with a given level of

confidence.

VAR is typically calculated for a one-day period - known as the holding

period - and is often calculated with 95% confidence. 95% confidence means

that there is (on average) a 95% chance of loss on the portfolio being lower

than the VAR calculated. Thus the typical definition of VAR becomes the

maximum amount of money that may be lost on a portfolio in 24 hours, with

95% confidence.

The holding period commonly used is one day. The longer the holding

period, the larger is the VAR. The confidence levels will only be true if VAR is

compared against the actual loss on the portfolio over a large number of

days. It is possible that at some point we will experience several days in a

row in which the actual loss on the portfolio is in excess of the var figure


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REQUIREMENT OF AN EFFECTIVE ALM FUNCTION - REGULATORY

FRAMEWORK.

ALM INFORMATION SYSTEM: -

The information necessary to support ALM decision- making can be from

internal and external sources. Internal information should contain all that is

necessary to determine the banks position, evaluate results of prior ALM

activity and apply the banks expertise. External information should enable

ALM to link historical, current and forecast developments in the bank's

economic environment (including institutional aspects such as regulation and

the structure of financial markets) to the development of desirable strategies

for managing the banks position.

ALM information requirements can differ enormously between banks. A

multi- center, risk-taking institution cannot be successful without a constant

stream of internal and external information to feed the decision making

process that controls its ALM and trading positions. Such an institution will

recognize the critical nature of relevant, reliable and timely information for

these processes because of the critical role they play in banks business. A

risk avoiding, single center bank on the other hand may approach the

subject of ALM information with much less effort and can still have

satisfactory process.


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The purpose of ALM information is to help ALM function understand the

dynamics and trends of the banks net interest income and the potential for

favorable and unfavorable change. Information should enable the bank to

design attractive strategies. In large banks ALM needs to deal with data

belonging to many different systems, often spread over many countries. The

ALM function needs to be intelligent and economic user of information, able

to improvise, estimate, negotiate access, it should not ask for more than it

strictly needs.

The basic information below shows a fairly long list of external items. The

economic forecast needs to focus on the economic development of the bank

service area. In many banking markets, change in transaction balances,

business and consumer saving, and borrowing activities are distributed

proportional to each banks overall market share. From there fairly accurate

and reliable forecast cane be made with regard to changes in many

balancesheet item. Also analysis of the short-term flow of funds and the

policy alternatives available to the monetary authorities to influence

developments often leads to practical results. It may be difficult for many

economists, unless they get much exposure to daily financial market activity

to develop an operational aspect to their forecasting in the are of interest

rates. As an alternative to the fundamental approach traditionally used by

economist to forecast interest rates and exchange rates, banks where trends


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are interpreted without too much concern about their causes adopt a

technical approach.

ALM Process gives weight to

Risk parameters

Risk identification

Risk measurement

Risk management

Risk policies and tolerance levels

We have already seen the different types of risk faced by banks and

strategies for measurement and management of interest rate and liquidity

risk.

ALM Organization

For implementing asset and liability management in an organization the

following steps need to be taken :

Organizing a planning team

Developing a strategic plan

Establishing an Asset Liability Committee


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Developing a process for reviewing performance relative to the

institutions profit and strategic plans.

By successfully completing these five steps, the institution builds a

foundation for integrating the key components of asset-liability

management.

The Planning Team

A banks planning team is responsible for developing the banks strategic plan

and setting planning process, assigns responsibilities for developing the

component parts of the banks overall plan, reviews the components and

recommends action regarding the plan to the board of directors. The

planning team periodically reviews the institution's performance relative to

the plan and recommends modifications.

Composition - The composition of the planning committee varies according

to the size, level of sophistication and philosophy of the institution. In small

institutions, the planning committee combines key managers and board

members. In large banks like IDBI, with full time planning staff, the planning

committee consists entirely of staff members. In addition the planning team

always consist of the chief executive officer of the bank. Team members

should include members who have a basic set of skills and knowledge. The

key member of the planning committee is the team leader. This person is

responsible for scheduling, organizing and conducting the committee


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meetings.

The Strategic Plan

Developing the strategic plan is the most crucial part of the planning

process. The strategic plan identifies the bank goals over the next few years,

examines the banks present position and determines the action necessary to

achieve the goals set forth in the mission statement. A strategic plan has

give key components.

Mission statement

Strategic financial goals

Situation analysis

SWOT analysis

Action plan supported by a financial plan.

Mission Statement

The financial institution begins the planning process by developing a basic

direction. It does this by preparing a basic mission statement, which

identifies the institutions, primary reason for being in business. The mission

will vary in accordance with the situation of the bank. The mission statement

should retain enough flexibility to allow the institution to react to internal

and external change. The economic, regulatory and competitive environment


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is certain to change over time, and the mission statement must be flexible

enough to that change. It should

1. Define line of business - the mission statement should first define the line

of business, its primary focus. By identifying the institutions primary

focus in the mission statement, manager can better direct their efforts

toward goals compatible with their institutions basic purpose.

2. Differentiates from competition - the mission statement should identify

the institutions uniqueness and strengths. One way is to define the

qualities that differentiate the institution from its competition.

3. Identify key values - the mission statement should spell out the

institutions key values. These might include commitment to community,

employees, stockholders and customers.

4. Identify present and prospective customers - the mission statement

should identify present and prospective customers. Here in identifying the

customers it should specify the institutions market area.

5. Spell out commitment to profitability - it should spell out the profit

orientation of the institution and its commitment to achieving its strategic

financial goals.


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Strategic Financial Goals

The mission statement serves as a basis for developing a set of strategic

financial goals. The strategic financial goals generally include objectives in

each of five crucial areas of financial performance. These areas are: -

Profitability

Growth

Capitalization

Investor compensation

Situation Analysis

The third step in the strategic planning process is to determine the

institutions current performance relative to its goals. An analysis of the

current situation will help build on institution strengths and correct its

weaknesses. Situation analysis begins with internal analysis. Management

evaluate financial trends within the institution, as well as its resources and

its management policies and procedures. After examining the institution

itself external analysis is done. The managers look at the institutions


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market, its performance in its market and the regulations that affect its

present and future operations.

SWOT Analysis

Here the most important issues identified in the situation analysis are

brought out. SWOT analysis is done in which the institution identifies and

sets priorities among its most important strengths, weakness, opportunities

and threats.

Action Plans

In the final step of the strategic planning process, a series of action plan is

developed. The action plans will take the institution from its present position,

as identified in the situation and SWOT analysis towards achievement of its

mission and strategic financial goals.

The Asset-Liability Management Committee

Once the strategic plan has been developed and is in place, the responsibility

for day to day administration of the components that affect financial

performance passes to the asset - liability committee (ALCO). While the

planning committee has a long-range perspective and meets infrequently the

ALCO has a much shorter-range perspective and meets more frequently.


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Composition and Responsibilities

The size of ALCO would depend on the size of each institution, business mix

and organizational complexity. To ensure commitment of the top

management and timely response to market dynamics, the CEO or the ED

head the committee. The chiefs of investment, credit, resource management

or planning funds management/treasury, international banking and

economic research can be members of the committee. In addition, the head

of the technology division should also be invitee for building up of MIS and

related computerization.

In its pricing role, the committee establishes and modifies on all the rate

sensitive assets and liabilities marketed by the institution in the retail

market. Pricing changes are designed to react to competitive and market

changes and to manipulate customer demand in managing the institutions

position with regard to interest rate, credit and liquidity risk.

The Budget or Profit Plan

A banks annual budget or profit plan is the tool that keeps the bank on track

towards achieving its strategic financial goals. The ALCO oversees the

development of the budget, recommends its implementation to the BOD and

monitors the banks performances under the plan.


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The Review System

An established system of reviewing the plan and modifying it where

necessary contributes significantly to the plan's success. When the plan is

written, the bank determines the frequency of its review, the types of

performance reporting and the method to use in modifying the plan. Banks

depend on effective plans with realistic targets. These plans enable the

managers to take action consistent with the banks short and long-range

goals.

ALM CONSTRAINS FACED BY BANKS

One of the essential requirements of ALM is the timely and accurate

collection of data. In India, considering the large network of branches,

it becomes difficult to collect and compile reliable data in absence of

computerized environment.

One of the major problems is the mismatch between relatively short-

term liabilities and the longer maturity assets held, particularly in the

SLR proportion of a bank portfolio.

The appropriate training of the staff for interpretation of data for ALM

is also one of the problems faced by the banks.


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In India, the market of off-balance sheet products viz. Swaps, FRA's,

option and futures have not been developed. These are not used for

hedging interest rate risk.

The deregulation of interest rate, though has made significant impact

on the management and performance of the banks, it lacks

professional approach and technique to interest rate forecasting.

Derivatives as a tool of liability management

One of the significant approaches used by banks to overcome the problem of

asset liability mismatch is to use various derivative instruments like futures,

options, swaps etc. all these instruments play a vital role in balancing the

balance sheets of the banks in a reasonable manner. Covering all these

aspects is one of the basic requirements of the banks. But to cover the

interest rate risk, the most effective instrument is Interest Rate Swaps.

Following pages of the report give a brief about the derivatives, their

presence in international and domestic market.

What are Derivatives?

Derivatives, the word, originate in mathematics and refers to a variable,

which has been derived from some other variable. For example, a measure

of weight in pounds can be derived from a measure of weight in kilograms


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by multiplying by 2.2.

Derivatives are financial contracts of pre-determined fixed duration, whose

values are derived from the value of an underlying primary financial

instrument, commodity or index, such as interest rates, exchange rates,

commodities, and equities. They are also known as contingent claims.

Without the underlying product and market it would not have any

independent existence. Someone may take an interest in the derivative

product without having an interest in the underlying product market; but the

two are always related and may therefore interact and affect each other,

similar to the way in which coffee prices may affect tea prices because both

are beverages.

If we look back at the world in the mid-sixties, price risk in financial markets

was fairly limited. This was an era when state interventions were much more

prevalent, the world over, and many kinds of risk were apparently absent

owing to price controls. For example, "interest rate risk" did not appear to be

present in India owing to direct state control over interest rates. Ever since

the early seventies, governments all over the world have steadily retreated

from overt price controls. This has been motivated by an increasing

realization that these stabilization programs involve enormous costs, upon

governments in particular and upon the economy in general through

distortions in resource allocation.


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The evolution of the four major financial markets of the economy - equity,

debt, foreign exchange, and commodities - has proceeded differently. In the

case of equity, direct government interventions have been absent in almost

all countries. In the case of foreign exchange, the first phase of elimination

of price controls took place in OECD countries in the early seventies, though

market interventions continued. From the early nineties onwards, there has

been a sense that government intervention in many currencies is infeasible

even when it is thought desirable. In the area of interest rates, there has

been a significant shift in monetary policy away from targeting nominal

interest rates. In the area of commodities, the breakdown of cartels like

OPEC, and the steady reduction of controls upon agricultural commodities,

has led to an increasing emphasis upon markets in determining commodity

prices.

The deregulation of these four financial markets has had many

consequences for productivity and economic growth. It has also generated

an upsurge of price volatility. The term "risk" is often interpreted, in

common parlance, as the probability of encountering losses. In the language

of modern economics, however, risk is defined as volatility, where

unexpected changes (whether in the positive or negative direction) are

viewed symmetrically. Volatility in major financial markets of the world rose

sharply in the early seventies. For a simple example, we can think of a


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commodity like cement in India, where price controls once existed. Under a

regime of price controls, the price apparently stayed constant for many

months at a time. However, the "true" price of cement did fluctuate. The

inflexibility of a controlled price generated risk for consumer (of shortages)

and producers (of gluts). A builder might apparently face no risk through a

clearly defined price, but the risk of actually obtaining cement might be quite

considerable if shortages exist. A cement manufacturer faced the opposite

risks. In an environment without price controls, it is the publicly visible price,

which fluctuates, and trading in cement is always possible at the market

price. The market-clearing price sends out meaningful signals to influence

the behavior of consumers and producers, and the risk is explicitly visible as

the volatility of cement prices.

Economic agents are uncomfortable when exposed to risk. Risk can inhibit

the use of efficient production processes, and hence productivity, in the

economy. Hence the management of risk has become important. There are

three major `technologies' through which economic agents can reduce the

risk that they are exposed to: diversification, insurance and hedging.

Diversification

It is obtained when economic agents spread their exposure over many

imperfectly correlated risks.


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Insurance

It is obtained by paying a fixed cost (the insurance premium) and

eliminating certain kinds of risk.

Hedging

Derivatives are risk-shifting instruments. The derivatives can also be

compared to an insurance policy. As you pay premium in advance to

an insurance company in protection against a specific event, the

derivatives products have a payoff contingent upon the occurrence of

some event for which you pay premium in advance. Initially, they were

used to reduce exposure to changes in foreign exchange rates, interest

rates, or stock indexes or commonly known as risk hedging. Hedging is

the most important aspect of derivatives and also its basic economic

purpose. There has to be counter party to hedgers and they are

speculators. Speculators don't look at derivatives as means of reducing

risk but it's a business for them. Rather he accepts risks from the

hedgers in pursuit of profits. Thus for a sound derivatives market, both

hedgers and speculators are essential. Now, derivative market can

stand on two pillars, but they will stand better if there were three

pillars. The third pillar represents arbitrageurs (judge in French).

These market participants look for mispricings and market mistakes,

and by taking advantage of them; they disappear and never become

too large.


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Risk management: Derivatives provide an excellent mechanism to

Portfolio Managers for managing the portfolio risk and to Treasury

Managers for managing interest rate risk. The importance of index

futures & Forward Rate Agreement (FRA) in this process can't be

overstated.

Price discovery: These derivative instruments make the spot price

discovery more reliable using different models like Normal

Backwardation hypothesis. These instruments will cause any arbitrage

opportunities to disappear & will lead to better price discovery.

Increasing the depth of financial markets: When a financial market

gets such sort of risk-management tools, its depth increases since the

Institutional Investors get better ways of hedging their risks against

unfavorable market movements.

Now these are some of the arguments against:

Speculation: Many people fear that these instruments will

unnecessarily increase the speculation in the financial markets, which

can have far reaching consequences. The Barrings Bank incident is the

classic case in point.

Market efficiency: Many people fear that the Indian markets are not

mature & efficient enough to introduce these instruments. These


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instruments require a well functioning & mature spot market. Like

recently The Economic Times reported the strong correlation of Indian

equity markets to the NASDAQ. Such type of market imperfections

makes the functioning of derivatives market all the more difficult.

Volatility: The increased speculation & inefficient market will make the

spot market more volatile with the introduction of derivatives.

So one can see that the pros of derivatives far outweigh the cons. And

moreover, by imposing margin requirements, by limiting the exposure one

can take and other measures like that, these vices of derivatives can be

controlled. The importance of derivatives for any financial market can't be

overstated.


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History and Development of Derivative Markets (Instruments):

A lot of people have this notion that derivatives are a completely new

phenomenon. They may have become popular now but their origin can be

traced back to Aristotle's writings.

Aristotle tells the story of Thanes; a poor philosopher who developed a

financial device, which he said, could be universally applicable. Thanes had

great skill in forecasting and predicting how good the harvest would be in

the autumn. Confident about his prediction, he made agreements with area

olive press owners to deposit what little money he had with them to

guarantee him exclusive use of their olive presses when the harvest was

ready. Thanes successfully negotiated low prices because the harvest was in

future and no one knew whether the harvest would be plentiful or pathetic

and because the olive press owners were willing to hedge against the

possibility of a poor yield -and these contracts were exercised some 2500

years ago!

This indicate that that derivatives are not a new concept at all, although, for

India it is still a relatively recent phenomenon.

The three modes of trade-spot transactions, forward/futures transactions

and options- have existed through the course of history, reaching the high of

sophistication in the late twentieth century. The concept of forward delivery,


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with contracts stating what is to be delivered for a fixed price at a specified

place at a specified date, existed in ancient Greece and Rome. Perhaps the

first organized commodity exchange on which forward contracts existed in

early 1700s in Japan. The first formal commodity exchange in the United

States for spot and forward trading was formed in 1848:the Chicago Board

of Trade (CBOT). Futures contracts began trading on CBOT in 1860s.The

Chicago Mercantile Exchange (CME) was formed in 1919,though it did exist

before that date under other names. Merton Miller, one of the winners of the

1990 Nobel Prize for economics, wrote in 1986,"my nomination for the most

significant financial innovation of the last twenty years is financial futures-

the futures exchange style of trading of financial instruments."

Options also have a long history. The concept of options existed in ancient

Greece and Rome. Options were used by speculators in the tulip craze of

seventeenth century Holland. Unfortunately, there was no mechanism to

guarantee the performance of the options' terms, and when the tulip craze

collapsed in 1636,many of the speculators were wiped out. In particular, the

put writers refused to take delivery of the tulip bulbs and pay high prices

they had originally agreed to pay. Puts and calls, mostly on agricultural

commodities were traded in nineteenth century England and in the United

States.

On the basis of underlying assets, derivatives are broadly of three types:

Financial Derivatives


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Commodity Derivatives

Index Derivatives

In commodity derivatives the underlying asset is commodity like gold or

could be any other raw material whereas in case of financial derivatives, the

underlying asset is some financial instrument like equity etc. In case of

Index derivative, the value is derived from the index of securities like S & P

500 or Sensex.

Also financial risks can arise due to following:

Due to inherent risk associated with each security and systematic risk

of the whole market of securities.

Due to fluctuations in Interest rates

Due to fluctuations in Exchange rates

Thus we can have 3 types of financial derivatives for all the above 3 cases.

Equity Derivative

Interest Rate Derivative

Currency Derivative


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In the equity derivatives we can have stock index futures, stock index

options, individual stocks options and individual stock futures.

Derivative markets in India

The Past: It's been fairly long since derivative trading started off on the

Indian Indexes. Activity has failed to really take off with low figures being

transacted in terms of Value and Volumes. The punters in the capital

markets but has not really brought about a wave so as to speak hailed the

introduction of derivatives trading. There are several factors, which impede

the growth of the derivatives markets in India. Of these factors the absence

of clear guidelines on tax-related issues and the high cost of transaction is

the most prominent.

The Bombay Stock Exchange decided to introduce a new index, which would

now substitute the BSE-30 in order to boost derivatives trading. The new

Index was to be narrower and more sensitive than the 30-share Sense. The

derivatives markets are generally a very volatile market and operators in

these markets would prefer a more volatile index than the Sense. It could be

said that the interest of the operators in derivatives trading would be directly

proportional to the volatility in the underlying security which would mean

that more the volatility, more the interest. BSE's developing the new index

suits the traders in the derivatives market.


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To elaborate more on this special index it needs to be clearly stated that this

index included several technology scrips that had not found a place in the

existing index. Apart from tracing in index futures, the bourse plans to

introduce trading in other products in the derivatives segment such as the

trading in stock options and futures. The new index is to be in place by April

2001. Trading in index options would begin with 30-50 scrips. These would

include scrips in the current Sensex and also some of the scrips on the Nifty

(NSE-50).

The criteria for the selection of these scrips would be liquidity and market

capitalization. The aspect that rolling settlement has been mandated for

nearly all the actively traded stocks, speculative activity is likely to switch to

the derivatives market. The derivatives market is expected to see a spurt in

activities by the end of this fiscal. The derivatives in India need to catch up

with other major bourses the world over wherein the turnover in the

derivatives segment far exceeds the cash segment.

The BSE recently introduced limited trading membership to investors in the

derivatives segment. This would involve an entrance fee of Rs. 1 lakh.

Initiatives have been taken in terms of a nationwide training program to

disseminate information on derivatives trading. The CEO of derivatives

segment of BSE, Manoj Vaish has stated explicitly that the volume of

derivatives trading in India was currently very low compared with the cash

volumes. The introduction of the limited trading membership (LTM) would


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enable members to taste the flavor of derivatives without having to accept

the liability of paying margin money to the exchange. The liability would be

borne out by the clearing member who would act on behalf of LTM.

However, an LTM would neither be entitled to hold any office of the

exchange neither have voting rights. The exchange would charge annually

an amount of Rs. 25,000 in addition to an initial fee of Rs. 3 lakh, out of

which Rs. 2 lakh would go to the investor protection fund and the balance to

trade guarantee fund. The LTM would have all the rights and privileges of a

trading member and have to be registered. All guidelines issued by the Stock

Exchange Board of India would apply to the LTM.

Other initiatives to spruce up derivatives trading are the plan to develop a

retail debt market and also bring about the participation of the bourse in the

wholesale debt market. Players in the derivatives markets could expect to

see some changes in the future and hope that the Indian derivative markets

take off without further snags.

Changes in the Market:

What will happen to Indian Financial market, when the derivatives will be

launched, is yet to be seen, but for the market and it's time now to say good

bye to Badla and all such deferral products like ALBM and BLESS. Come July

2, 2001, the Indian bourses will be ushering into an era of options finally. In

a move, which is bound to have far reaching implications, the market


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regulator SEBI has finally decided to put a ban on Badla and all deferral

products, effective July 2, 2001. The regulator has given time till September

3, 2001 to liquidate outstanding deferred positions as of the current

settlement worth close to Rs. 2,000 crore. It has said that any additional

deferred position taken after May 15 would have to be liquidated by July 2,

and no new deferred positions will be allowed from July 2. This gives a

breathing space to the players to square up their position and is expected to

ease the selling pressure. The fact that market has sustained the upward

momentum, post-ban announcement, vindicates that belief.

The regulator has further announced that 251 scrips will be put into rolling

settlement mode. This will be in addition to the 163 scrips, which are already

in the compulsory-rolling mode. These are the scrips, which form part of the

list of scrips where Badla or ALBM was allowed. SEBI has said that all scrips,

which do not form part of this list, will be brought within the ambit of rolling

settlements from January 2, 2002. In the interim period, however, the

regulator has decided to put in place a uniform settlement cycles for stocks,

which are not in rolling mode. This cycle would run from Monday to Friday

and would be followed across all the stock exchanges. This would effectively

lead to the closing of the door on menace of inter-exchange arbitrage, which

had been outlined as one of the reasons for the recent stock market scam.

In another bold initiative towards bringing the Indian capital market at par

with the global practices, SEBI has decided to do away with the price bands


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(circuit filters) for all stocks in the rolling mode. It sounds logical to give an

adequate exit opportunity to investors once the trading period is reduced to

a single day from five days. Though the price bands would continue to be in

place for other scrips, 95 percent of all trading volumes would be exempt

from any price bands. SEBI has also decided that the global practice of

having index-based circuit filters will be introduced. It means that while their

will be no price bands on individuals stocks, the market could be frozen if

the entire index itself swings sharply. The extent of the circuit filter would be

worked out shortly.

To keep a check on another malaise, insider trading, the regulator has

approved a code of conduct and a preventive framework. The regulator has

also paved the way for launch of options trading on individual stocks, though

it has deferred the launch of futures on individual stocks.

On this front, the BSE has recently entered into an agreement with Chicago

Mercantile Exchange (CME) to adopt its "Standard Portfolio Analysis of Risk"

(SPAN) system for calculating margin requirements and managing risk.

Introduced by the CME in 1988, SPAN has become an industry-standard,

adopted by more than 30 exchanges and clearing organizations worldwide

including Tokyo Stock Exchange, Singapore Exchange and Hong Kong

Futures Exchange. SPAN was the first futures industry performance bond

system ever to calculate requirements exclusively on the basis of overall

portfolio risk. SPAN is a portfolio-based system, which comprehensively


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evaluates the impact of specified market events on futures and options

portfolios. A key element of this process is granting credit for net long option

value, and assessing additional charges for net short option value. This long

option value credits and short option value charges comprise the premium

component of the overall, or "total", performance bond calculation. The

requirement assessed upon long options positions is designed to reflect the

fact that the holder of these long options may not be able to liquidate them

at their current market value. The difference between the current value of a

given long option position and its liquidation value under a "worst case

scenario" of market movement is derived as part of the scanning risk

calculation, and serves as a haircut against the option's full value to reflect

potential liquidation losses. The BSE has said that it will adopt CME's

standard portfolio analysis of risk management to compute margin

requirements for derivative products like options and futures. The exchange

has said that this will also be used for recognizing risk offsets between the

cash and the derivatives markets.

The market appears to be divided on the issue of ban on Badla. According to

one section of the market, as Badla has been around for a long time it

should have been allowed to continue, albeit with more stringent risk

measures such as upfront payment of margins. Another view is that so long

as Badla mechanism is available derivatives will never take off, as given a

choice between Badla and other derivatives, players would opt for a


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mechanism like Badla, which they have been used to for decades. Not

withstanding such never ending debates, the fact of the matter is that, we

need a market where rules of game are different for each discipline - be it

rugby or football. And, the writing on the wall is clear - it's time to clean

one's act or be ready for extinction, which could be just a few strokes away.

Financial Derivatives in India

Informal options markets

As in other countries, informal options markets have existed in India for

centuries. Today, they go by names like teji-mandi, bhav-bhav, etc. Lacking

formal market institutions, these markets are fairly small. The anachronistic

legal prohibition upon derivatives contracts in India has also served to

impede the growth and institutionalization of these markets.

Badla

On the equity market, many observers have noted that the institution of

Badla (on the Bombay Stock Exchange) and derivatives markets are similar

insofar as they are both vehicles for leveraged trading. This fact has been

widely, and incorrectly, mutated into the notion that "Badla is an indigenous

alternative to derivatives". This fact is incorrect insofar as Badla is not

indigenous (it has existed in stock markets in London, Paris and Milan). It is

also incorrect insofar as Badla does not achieve what either futures or

options markets achieve, which is hedging risk. Hence, Badla does not


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belong in the analysis of derivatives markets in India. (Badla is now

scrapped by SEBI since July 2001)

Futures and options markets

By May 1996, the National Stock Exchange (NSE) had substantially

completed the development of systems and software required to start

trading futures and options on the NSE-50 index. The commencement of

trading on this market has been awaiting approval from SEBI since then. In

November 1996, SEBI created the twenty-member L. C. Gupta Committee in

order to draft a policy framework governing derivatives markets. As of early

December 1997, the report of this committee is awaited.

Many of the fears about equity index derivatives as "highly leveraged

instruments" are essentially misplaced on the equity market. This is because

the distorted trading practices presently used on the spot market for equity

in India involve more leverage, and much more unsafe leverage, than what

is involved in the NSE index derivatives proposal. In this sense, the attempts

at formulating a stringent regulatory apparatus to govern the index

derivatives market are somewhat misplaced, and risk stifling the market in

its formative phase. A superior approach towards regulation would have

involved an early onset of equity index derivatives, coupled by a policy

initiative to diminish the leveraged trading, which is found on the spot


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market.


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Currency derivatives

In the report on capital account convertibility, the Tarapore Committee has

recommended that a dollar-rupee futures market should augment the

existing dollar-rupee forward market, and that a currency options market

should be created. These initiatives would give improved hedging methods

through which economic agents could reduce their exposure to currency

fluctuations, and improve market quality on the dollar-rupee spot market.

Market structure

3 essential classes of players drive the markets -

Hedgers: They seek to eliminate or reduce price risk to which they are

already exposed. They provide the economic substance to any fin

report liabilitymanagement

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