Review of Scholarly articles on Derivative Markets

Table of contents:

Content Page Numbers

Article 1 - Credit derivatives: international 3-4

developments and lessons for India

Article 2: Spot market and derivative segment of

equity in India 5-6

Article 3: The development of equity derivative 7-9

markets

References and links to articles 10

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 Article 1: Credit derivatives: international developments and lessons for
India

Introduction of Credit derivatives:

Credit derivatives have been popular instruments for hedging of credit risks by banks and
financial institutions. The notional value outstanding of credit default swap contracts, a type
of credit derivative most in use, increased from US$6.4 trillion in December 2004 to
US$57.89 trillion in December, 2007. However, this instrument, which was once ‘apple of
the eye’ of market players, lost its sheen in the wake of the sub-prime crisis when it was
perceived to have played a major role in igniting the crisis and spreading it across the global
financial system. This article presents how this came about and the afterthought of the
regulators of developed countries in regulating these instruments. It then looks at what
lessons India can draw from the experience of the Western nations before considering
introduction of credit derivatives in the Indian markets.

Global market trends of Credit derivatives:

The first credit derivatives transactions are recorded to have occurred in the early 1990s.
However, a liquid market emerged only after the ISDA produced standardized documentation
of these transactions in 1999. According to the Bank for International Settlements (BIS), the
notional value of credit derivatives outstanding increased over six times between 2001 and
2004, from only US$695 billion in June 2001 to US$ 4.5 trillion in June 2004. The BIS
started collecting and disseminating data on CDS contracts since 2005. The growth in
notional amount outstanding and gross market value of CDS contracts over 2004 to 2008. As
is evident, the notional value outstanding of CDS contracts has increased from US$6.4
trillion in December 2004 to US$57.89 trillion in December 2007. Thereafter it has witnessed
a fall to US$41.87 trillion in December 2008. This contraction was against the background of
severely strained credit markets and increased multilateral netting of offsetting positions by
market participants.

Policy responses for OTC derivatives, including credit derivatives at G-20

commitments:

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The leaders of Group of 20 nations met in Washington in November 2008, amid serious
challenges to the world economy and financial markets following the events listed above. In
its declaration the Group called upon its member countries to strengthen the resilience and
transparency of credit derivatives and other OTC derivatives markets. In the action plan
drawn up following this Washington declaration, supervisors and regulators of the G-20
countries were urged to speed efforts to reduce the systemic risks of CDS and OTC
derivatives transactions; insist that market participants support exchange traded or electronic
trading platforms for CDS contracts; expand OTC derivatives market transparency; and
ensure that the infrastructure for OTC derivatives can support growing volumes.

Financial regulatory reform: a new foundation

The document recommends that government regulation of the OTC derivatives markets
should be designed to achieve four broad objectives:

(1) preventing activities in these markets from posing risk to the financial system;

(2) promoting the efficiency and transparency of these markets;

(3) preventing market manipulation, fraud, and other market abuses; and

(4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated
parties.

The document has further urged national authorities to promote standardization and improved
oversight of credit derivative and other OTC derivative markets, in particular through the use
of central counter-parties, along the lines of the G-20 commitment, and to advance these
goals through international coordination and cooperation. It reports that market participants
within the US have already created standardized contracts for use in North America that meet
the G-20 commitment and that several central counter-parties have also been established
globally to clear credit derivatives.

Conclusion:

Financial innovation with inappropriate regulatory oversight can, in a sense, be regarded as

the root cause of the crisis. However, the solution for the regulators is not to stop innovation
all together but to give it a direction and a helping hand while ensuring market stability and
keeping in mind the larger interests of consumers. What shape the regulatory framework for

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OTC products, such as credit derivatives, would take in the developed countries following
certain proposals mooted by the regulators, remains to be seen.

Article 2: Spot market and derivative segment of equity in India

Introduction to the article:

The foremost objective of the manuscript is to predict the volatility and causality between
spot and derivative segment of equity in India and also to determine long run relationship
between the two. Monthly time-series data of 15 years have been taken, from 2003 to 2019
(pre- and post-financial crisis 2008). The unit root test, GARCH model, Granger Causality
test under VECM framework have been smeared to infer the volatility and causality between
the spot Nifty and Nifty futures. Johansen co-integration test and VECM have been used to
determine the long and short run relationship between the two-time series. Regression has
been applied to determine the impact of spot market on Stock Futures. The outcomes depict
that the two variables have positive impact and statistically significant in the short and long
run. There exist fluctuations, volatility and lead lag relationship between the two which will
help investors and policymakers to take well-formed decisions.

Literature review:

This article discusses the verifiable studies which have been done about the derivatives
market, including its size, unpredictability and volatility, and the relationship between the
spot and futures markets in India as well as around the world. it was required that an
experimental examination be conducted to research the volatility and relationship between
the spot and futures markets in India, regardless of whether the day-by-day changes of futures
value lists established data as significant with the pattern that follows the financial exchange,
or changes in the cash market comprise an instrument to foresee a pattern of costs in the
market of future contracts traded on the NSE of India

Data and research methodology:

The daily closing prices of spot Nifty were collected from the authorized website of the NSE.
Additionally, a data set composed of time-series data of the closing price of Nifty futures was
also collected from the NSE website. The statistics and numbers were examined from a

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period of about 15 years, from 2003 to 2019. Nine stocks – the top nine stocks according to
Mcap 100 – were taken into consideration for the study. Thus, the stock futures and index
future statistics and numbers were compiled from the approved website of the NSE. The
study aimed to derive the dynamic relationship between the futures (stock and index) and the
spot Nifty.

The strategies, models, systems used in the research are: Measures of central tendency, Test
for stationariness of data, Tests for long-term and short-run association of data, GARCH
model, Granger causality test.

The study of descriptive statistics reveals that there is no major gap between the performance
of the spot and future markets. The high Jarque–Bera test statistics indicate the non-normality
of the data.

Major findings:

 As capital market instability is successfully portrayed with the assistance of GARCH

class models, the estimations of the GARCH (1,1) models have been performed in
order to deliver the proof of time-differing unpredictability, which shows bunching,
high diligence and consistency, and reacts symmetrically to positive and negative
shocks.
 It has been concluded that price or other changes in the stock futures influence the
spot Nifty. The independent variables that are significant can explain the dependent
variable. Thus, there is an association and positive relationship between the individual
stocks of the future contract and the spot Nifty.
 There is a necessity to predict the association of macroeconomic variables with the
volatility in the derivatives market to allow both investors and policymakers to make
their investment and policy decisions. The spot and futures markets share a
bidirectional relationship with the stock market in India. It cannot be ascertained
which variable will predict the other class. But any extreme volatile behaviour in one
variable can help predict the price performance of the other.
 Be that as it may, any outrageous, unpredictable conduct in one variable can help
forecast the value execution of the other. In any case, the direction of the relationship
between the spot and futures market can be reversed. Thus, futures can be support for
the equity market.

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 Article 3: The development of equity derivative markets

Introduction to the article:

Amid benign monetary policy in mature market countries and high liquidity-induced demand,
lower risk premia have encouraged risk diversification into alternative asset classes outside
the scope of conventional investment. The development of derivative markets in emerging
economies plays a special role in this context as more institutional money is managed on a
global mandate, with more and more capital being dedicated to emerging market equity. This
paper aims to focus on these issues.

Current situation of equity derivative markets in emerging Asia:

Global trading in equity futures and options at derivatives exchanges more than tripled over
the last three years from about US$56.0 trillion in 2002 to US$174.9 trillion in terms of
notional amounts (on 7.3 billion contracts) by end-2006 (Figures 1 and 2) – by comparison
the USA GDP was about US$13.3 trillion in 2006. Measured by notional value, global
turnover of equity futures and options surged by 103.9 and 93.4 percent, respectively, since
end-2004, with the combined figure for futures and options having shown explosive growth
at an annualized rate of more than 30 percent over the last five years. During the same time,
options have become slightly more popular than futures, whose relative share in global
trading declined from 50.9 to 46.1 percent.

In general, equity derivatives have flourished on Asia’s exchanges and have witnessed the
most rapid growth of all traded derivative products (foreign exchange, interest rate, equity,
commodities, and credit derivatives). Equity derivative trading in emerging Asia, which
concentrates mostly on options, has mushroomed from US$16.9 trillion in 2002 to US$54.2
trillion in 2006, and now represents 31.0 and 38.9 percent of worldwide equity derivatives
turnover by notional value and number of trades, respectively.

Countries with formalized and regulated exchanges are leading the growth in Asian
derivative markets, which can be divided into three categories:

(1) fully demutualized exchanges (Hong Kong and Singapore), which offer a wide range of
derivative products;

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(2) partially demutualized exchanges, which have specialized in equity futures (India and
Malaysia) and index products (Korea and Taiwan); and

(3) derivative markets with no or marginal exchange-based and limited OTC derivative
trading (China, Indonesia, Philippines, and Thailand).

Challenges to the further development of equity derivative markets in emerging Asia:

 Over-the-counter (OTC) vs exchange-traded derivatives (ETD) – the most salient

differences Derivative markets are generally distinguished by the degree of contract
flexibility and the organization of trading activity. While exchange-traded derivatives
(ETD) are standardized products traded on the floor of organized exchanges, over-the-
counter (OTC)-traded derivatives are privately negotiated, bilateral agreements
transacted off organized exchanges. ETDs have rigid structures compared to OTC
derivatives, which are subject to a lengthy and costly process of rigorous regulatory
evaluation and approval. Conversely, OTC derivatives are customized to other
financial transactions and can involve any underlying asset, index, and payoff
structure.
 Prudential measures in OTC to curb risks to financial stability The flexibility of
contract structures in OTC markets cuts both ways. While OTC trading can be
efficiency enhancing as participants deliberately choose the upside potential of lower
transaction cost over the downside risk of contract failure in bilateral transactions, it is
also prone to induce financial instability given lightly and only indirectly regulated
trading. Derivatives trading without CCP, the mutualization of risk and full disclosure
requirements of participants increase potential vulnerabilities and may trigger system-
wide failures. That said, the benefit of OTC depends on how market participants
manage some of the most acute risks from unregulated trading to market stability,
such as
(i) difficulties in the complete elimination of confirmation backlogs,
(ii) deficient post-default settlement protocols and automated trade processing,
and
(iii) the prospect of market risk from multiple defaults that could overwhelm the
existing settlement infrastructure and undermine the efficacy of risk transfer in
general.

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 Requirements for the development of well-functioning and stable derivative markets:
Derivatives are financial contracts, whose value derives from underlying reference
assets, such as securities, commodities, market indices, interest rates or foreign
exchange rates. Derivatives offer gains from risk transfer at low transaction cost. They
improve market liquidity, aid price formation, and complete financial markets by
facilitating the unbundling, transformation and diversification of financial risks,
which can be customized to the risk preferences and tolerances of agents, improving
the capacity of the financial system overall to bear risk and intermediate capital

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References:
Cite of article 1: Anuradha Guru (2010) Credit derivatives: international developments and lessons
for India, Macroeconomics and Finance in Emerging Market Economies, 3:1, 147-155, DOI:
10.1080/17520840903498263

Cite of article 2: Dheeraj Sharma, Shweta Ahalawat, Archana Patro & Patanjal Kumar (2022) Spot
market and derivative segment of equity in India, Applied Economics, 54:3, 326-339, DOI:
10.1080/00036846.2021.1962509

Cite of article 3: BIS (2006b), Regular OTC Derivatives Market Statistics – OTC Derivatives Market
Activity in the First Half of 2006, Bank for International Settlements, Monetary and Economic
Department, Basel, November 17.

Link to articles:
Link to this article 1: https://doi.org/10.1080/17520840903498263

Link to this article 2: https://doi.org/10.1080/00036846.2021.1962509

Link to this article 3: www.emeraldinsight.com/1746-8809.htm