Derivatives - Prospects in Bangladesh
Derivatives - Prospects in Bangladesh
On
Derivatives: Prospects in Bangladesh
Submitted to
Roushanara Islam
Assistant Professor
Department of Finance
Faculty of Business Studies
Jagannath University, Dhaka
Submitted By
Anisur Rahman
ID:M190203023
Course code: FIN-5111
10th Batch
Department of Finance
Jagannath University, Dhaka
The financial industry in third world countries has started introducing financial derivative products to
enlarge the market base as well as protect firms and investors from the exposition to the risks that arise
from different sources. Stock Exchanges in Bangladesh – both CSE and DES have taken a primary initiative
to introduce exchange-traded financial derivative products within the shortest possible time. BSEC being
a regulator has started undertaking programs like the establishment of a clearinghouse to facilitate the
development of the derivatives market in Bangladesh. Being new innovative products, financial derivative
products, and their usage are not familiar with the parties to the stock exchanges. The present paper is
an attempt to highlight some important aspects of derivative markets for end-users of financial
derivatives.
What is a derivative?
The Oxford dictionary defines a derivative as something derived or obtained from another, coming from
a source; not original. In the field of financial economics, a derivative security is generally referred to as a
financial contract whose value is derived from the value of an underlying asset or simply underlying. A
derivative derives its value from the value of some other financial asset or variable. For example, a stock
option is a derivative that derives its value from the value of a stock. An interest rate swap is a derivative
because it derives its value from an interest rate index. The asset from which a derivative derives its value
is referred to as the underlying asset. The price of a derivative rises and falls by the value of the underlying
asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates,
and market indexes. Like other contracts, derivatives represent an agreement between two parties; the
terms of the agreement are highly flexible and the contract has a fixed beginning and ending date.
Derivatives transactions are now common among a wide range of entities, including commercial banks,
investment banks, central banks, fund managers, insurance companies, and other non-financial
corporations. Key points to remember about derivatives:
In general, the payoff from a long position in a forward contract on one unit of an asset is
=St-K
Where (St) is the spot price of the asset at maturity of the contract and (K) is the delivery price.
Future Contract
Like a forward contract, a futures contract is an agreement to buy or sell an asset at a certain time in the
future for a certain price. However, unlike forwarding contracts, futures contracts are normally traded on
an exchange. To make trading possible, the exchange specifies certain standardized features of the
contract. As the two parties to the contract do not necessarily know each other, the exchange also
provides a mechanism that gives the two parties a guarantee that the contract will be honored (Hull,
1998). The largest exchanges on which futures are traded include the Chicago Board of Trade (CBOT), the
Chicago Mercantile Exchange (CME), and the South Africa Futures Exchange (SAFEX). Futures contracts on
currency are contracts specifying a standard volume of a particular currency to be exchanged on specific
settlement date. Thus, currency futures contracts are similar to forwarding contracts in terms of their
obligation but differ from forwarding contracts in the way they are traded. They are commonly used by
MNCs to hedge their foreign currency positions. In addition, they are traded by speculators who hope to
capitalize on their expectations of exchange rate movements. A buyer of a currency futures contract locks
in the exchange rate to be paid for a foreign currency at a future point in time. Alternatively, a seller of a
currency futures contract locks in the exchange rate at which a foreign currency can be exchanged for the
home currency. The fundamental difference between futures and forwards is that futures are traded on
exchanges and forwards trade OTC (Over the Counter) market. Besides, the followings are the notable
differences in the two instruments:
I. Futures are standardized instruments transacted through brokerage firms. The terms of a futures
contract – including delivery places and dates, volume, technical specifications, and trading and
credit procedures – are standardized for each type of contract. Like an ordinary stock trade, two
parties will work through their respective brokers, to transact a futures trade. An investor can
only trade in the futures contracts that are supported by each exchange. In contrast, forwards are
entirely customized and all the terms of the contract are privately negotiated between parties.
They can be keyed to almost any conceivable underlying asset or measure. The settlement date,
the notional amount of the contract, and settlement form (cash or physical) are entirely up to the
parties to the contract. That means in the case of forwarding contracts all the terms and
conditions are privately negotiated but in the case of futures contracts, we can’t do that. For
example, if a company needs the delivery of a certain specified amount of currency after 33days
later it may not find exactly such a contract in an organized exchange. In such a case it should
make a forward contract instead of buying a futures contract.
II. Forwards are riskier than futures. Forwards entail both market risk and credit risk. Those who
engage in futures transactions assume exposure to default by the exchange’s clearinghouse. For
OTC derivatives, the exposure is to default by the counterparty who may fail to perform on a
forward. The profit or loss on a forward contract is only realized at the time of settlement, so the
credit exposure can keep increasing.
III. With futures, credit risk mitigation measures, such as regular mark-to-market and margining, are
automatically required. The exchanges employ a system whereby counterparties exchange daily
payments of profits or losses on the days they occur. Through these margin payments, a futures
contract’s market value is effectively reset to zero at the end of each trading day. This system
effectively eliminates credit risk.
IV. Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the
end). Forwards are settled at the forward price agreed on at the trade date (i.e. at the start).
V. In the case of physical delivery, the forward contract specifies to whom the delivery should be
made. The counterparty on a futures contract is chosen randomly by the exchange.
VI. In a forward, there are no cash flows until delivery, whereas in futures there are margin
requirements for marking to market and periodic margin calls.
Options Contracts
Options are traded both on an organized exchange and in the OTC market. There are two basic types of
options such as; call options and put options. The basic difference between the options and the two other
derivatives explained above is that in the case of options the holders have rights to exercise but in the
case of forwards and futures they have obligations to do that. A call option gives the holder the right to
buy the underlying asset at a certain date for a certain price, specified on the date of making the contract.
The party with the long position (buyer) can exercise the contract or not. A put option gives the holder
the right to sell the underlying asset by a certain date for a certain price, also specified on the date of
making the contract. The party with the short position (seller) should exercise the contract if asked to do
so. The date specified in the contract is known as the expiration date or the maturity date. The price
specified in the contract is the exercise price or the strike price. Options are either American or European,
a distinction that has nothing to do with geographical location. American options can be exercised at any
time to the expiration date, whereas European options can be exercised only on the expiration date itself
(Hull, 1998).
Swap Contracts
A swap is an agreement between two parties to exchange cash flows in the future. The agreement defines
the dates when the cash flows will be paid. The cash flows are calculated over a notional principal amount,
which is not usually exchanged between counterparties (Hull, 1998). Examples of swaps are currency
swaps, interest rate swaps, and commodity swaps. An interest rate swap is an agreement between two
parties to exchange interest obligations or receipts in the same currency on an agreed amount of notional
principal for an agreed period. A currency swap is an agreement between two parties to exchange
payments or receipts in one currency for payments in another. Commodity swaps are hedging
instruments; one party (commodity user/buyer) agrees to pay a fixed price for a designated quantity of a
commodity to the counterparty (commodity producer/seller), who in turn pays the first party a price
based on the prevailing market price for the same quantity (Daniel Ekerumeh,2010).
On the other hand, the derivatives markets can be divided into two that for exchange-traded derivatives
and that for over-the-counter derivatives. The legal nature of these products is very different as well as
the way they are trading. Some common examples of these derivatives are the followings:
(i) Arbitrageurs if placed on a risk spectrum are the risk-averse participants who take positions in
two or more instruments to lock in a profit. For example, if the price of the same product is
different in two markets, the arbitrageur will simultaneously buy in the lower-priced market and
sell in the higher-priced one. They always try to find out the gap of prices between the two
markets, if find then take the benefit from trading. Thus, they help to make such markets more
efficient.
(ii) Speculators are positioned at the risk-taking end of the risk spectrum; they bet on movements in
the market and try to lock in a profit by using the leverage created by derivatives contracts.
(iii) Hedgers are risk-neutral participants who use derivatives to reduce their exposure to risk from
future price movement in a commodity, financial security, or currency market. This is done by
undertaking forward or futures contracts or purchases of the commodity security or currency in
the OTC forward or the organized futures market (ibid,15).
The array of derivative products that have been developed in recent years has enhanced economic
efficiency. Derivatives have become an integral part of the financial system in the world’s leading
economies. “Efficient markets lead to tighter bid-ask spreads, higher volumes of trading, and greater
market liquidity. And for making a capital market more effective, sophisticated, viable, and adaptable to
the modern rapidly changing competitive world, the introduction of derivative securities is essential.
Because today’s risks in the business arena are more complicated than it was fifty-sixty years ago. It has
been maybe for the introduction of freely floating exchange rate systems in the 1970s and rapid growth
in international trade capitalizing on the benefit of modern transportation and telecommunication
technologies. So if an economy wants to cope with the so much changing competitive world, it should
think about financial stability, risk-sharing, and market efficiency; here the introduction of the derivatives
market may be proven as a vital decision. Derivatives help to improve market efficiencies in various ways
such as by reducing the risk for farmers, oil companies, interest rate risk for banks, etc. They allow users
to meet the demand for cost-effective protection against risks associated with movements in the prices
of the underlying assets. In other words, users of derivatives can hedge against fluctuations in exchange
and interest rates, equity, and commodity prices. It is such a mechanism through which parties easily can
transfer the risks associated with their underlings to others. Specifically, derivative transactions involve
transferring those risks from entities less willing or able to manage them to those more willing or able to
do so. Derivatives transactions are now common among a wide range of entities, including commercial
banks, investment banks, central banks, fund managers, insurance companies, and other non-financial
corporations.
Capital market watchers urge the authority that the introduction of derivatives would help increase
liquidity flow in the stock market. Derivatives, a financial instrument, will also help cut investor risks and
create a new investment opportunity.
Professionals of the stock market also point out that, "The introduction of derivatives will push the
liquidity of the equity market. But awareness among investors, journalists, and professionals are
essential," Referring to Indian experience, they address that the total volume of trade in derivatives is
much higher than equity products on the National Stock Exchange of India.
The authorities are well informed about the new demand and say that "We are trying to create a friendly
environment through diverse products. We are very much optimistic that our capital market will cope
with derivatives very soon," They also inform that the Chittagong Stock Exchange already has submitted
its proposal for derivatives trade to authorities. They add that the desire to achieve sustained
development would be a far cry without a strong, predictable, and accountable capital market with
diversified products.
From the Investors point of View:
As it has been said earlier that, investors are willing to have more options for their investment, Derivatives
Market can be the solution for them. Different aspects regarding this matter discussed below:
• Like anyone (investor) who invested both in a stock exchange and an indexed market of
securities. It’s hedging based on an index. So, now the investor may incur a loss in the share market but
he can gain in the hedging for that product market.
• Countries that have unstable economical conditions like Bangladesh Derivatives contract can be
useful. Because of an unstable economy price fluctuation is common in our country. Future and Forward
Market can reduce problems that arise due to unpredictable price conditions.
• Derivatives Market is a place for all kinds of investors. Those, who want to take the risk
(Speculators), who want to avoid risks (Hedgers), and who want to utilize short-term price fluctuations
(Arbitragers).
To allow the economy to grow it is essential to spread out different branches to create new investment
opportunities. Stock markets and other derivatives market of any country is one kind of indicator which
tells the strength of that country’s economy. It is also desired for Bangladesh. As the economy is going
besides stock exchange the country will also look for other investment opportunities. This will leads to the
concept of establishing a Derivatives Market in Bangladesh.
Firstly, we need lots of professionals who can design and control the market. We know this is a very new
concept for almost all of the people of our country. Because there is no such market in Bangladesh and
due to this there is a few numbers of professionals and expertise in here. Lesser number of graduates we
are having regarding this subject from our universities and institutions who can work for this kind of
project. Lesser number of researchers we are having in our country. To establish a Derivatives Market, we
need to hire professionals and expert people from overseas countries and which is expensive.
Secondly, in our country investors are not that much educated who can understand Derivatives Market
scenarios and activities. It will take time to get educated or understand the market. At this time a group
of people might want to enjoy extra benefits which are unwanted. Some fundamental problems
contribute to derivatives’ negative image:
Stories in the press of our country tend to focus on the illegitimate abuse of derivatives rather
than how they are used legitimately.
Investors’ misinformed perceptions and uninformed opinions.
Improper suitability is given an investor’s resources and temperament.
Thirdly, for a Derivatives Market, we need a huge number of investors which we are currently lacking off.
As a developing nation, we do not have enough investors who are having a bulk amount of monetary
reserve. Whereas a Derivatives Market needs a strong number of investors whose investment will run as
the blood of the market and keep it alive.
Another thing is that when the investors are doing their business in the Derivatives Market they are
ensured by the market about the quality of their underlining product. Where in Bangladesh there is some
risk in this kind of matter or activities. It is said that some of the derivatives are too complicated. Investors
also may not understand that some derivatives, such as futures and options, by definition, are contract
markets. Besides these, derivatives are purely speculative and highly leveraged. This objection relates
directly to the use vs. abuse problem. When hedge vehicles are used as a primary investment, they
become extremely risky businesses. The problem is that much of the investing public in our country may
not appreciate that when properly used, derivatives can mitigate risk, rather than exacerbate it. Last but
not the least, political instability is another big issue for this kind of business. Problems that arise due to
political instability can be a drawback for the Derivatives Market. Many agricultural assets might get
unusable if it kept for a longer time or might the cost increases due to the long-time preservation of stock.
I. Interest Rate Risk: This arises from changes in interest rates. This affects the firms/ individuals
borrowing or investing. Interest Rate changes because of changes in demand for funds and supply
of funds, term structure of interest rate, inflation rate, etc. Financial Futures and Swaps are
instrumental to transfer interest rate risk to the counterparties.
II. Exchange Rate Risk: This arises from changes in exchange rates. This affects the financial
intuitions, MNCs, Firms, and Individuals involved in exchanges of foreign currencies. Exchange
rate changes because of changes in differential growth in GDP, Inflation, and other macro-
economic parameters. This risk is often subdivided into transaction risk, where currency
fluctuations affect the proceeds from the day-to-day transaction; and translation risk, which
affects the value of assets & liabilities and revenue, costs, and expenditure of MNCs.
III. Equity Risk: This risk arises from the unexpected movement of prices of equity security. A financial
institution risks loss (a) when the prices decline and it has long positions due to agency-related or
principal trading or (b) when prices rise and the institution has short positions.
IV. Commodity Risk: This risk arises from changes in prices of commodities ranges from soft to hard
commodities. A financial institution risks loss (a) when the prices decline and it has long positions
due to agency-related or principal trading or (b) when prices rise and the institution has short
positions.
V. Other Market Risk: There are many residual market risks, which come under this heading. Among
these are volatility risks. Volatility risk relates to the difference between expected and actual
volatility in prices. Such a divergence results in gains or losses depending on the degree of
underestimation or overestimation of volatility.
VI. Liquidity Risk: This arises from the likely inability to pay financial obligations as and when they
are due. All new financial products which involve capital commitments are carefully analyzed to
assess their liquidity ramifications and their impact on overall liquidity. An important component
of this analysis involves the firm’s ability to hedge the instruments through direct offsets or trades
in underlying debt or equity markets.
VII. There are different sources of risks associated with the financial derivatives market. All risks fall
into two categories as Product Market Risks and Capital Market Risks. Financial Engineering has
to consider these categories of risks while developing financial derivative products or
restructuring existing products with more desirable properties for hedging risk to maximizing
shareholder’s wealth.
Recommendations
The following recommendations are required to consider:
(i) As it is the very first time to establish a derivative market in Bangladesh, an advisory
committee can be formed to conduct a feasibility study. This committee may be represented
by all stakeholders and analysts. The committee may further analyze the probable benefit of
the derivative market in Bangladesh, current and required capital market structure, and
prepare a comprehensive roadmap for a successful introduction.
(ii) For an efficient derivatives market, a liquid financial market is required. The government must
take necessary steps to make the financial market of Bangladesh highly liquid.
(iii) Restructuring of (BSEC) Bangladesh Security Exchange Commission is required. A
comprehensive inspection of the activities of this organization is required.
(iv) The opinion of stakeholders and making them aware of the derivative instruments are
essential. Seminars, workshops, training, etc. may be arranged to make such awareness of
stakeholders such as speculators, hedgers, regulators, and others.
(v) Deepening of the capital market is required. It can be done by increasing participants,
numbers of shares in the market, attracting more people in the market, proper governance,
ensuring scientific price, stopping corruption and manipulation, etc.
(vi) Ensuring proper coordination between BSEC and secondary and other markets and ensuring
strong regulations.
(vii) Up-gradation of infrastructure and sophistication is required. The easy movement of capital
between different markets and currencies is essential to eliminate price discrepancies and
the efficient functioning of the market.
(viii) Former economist of the World Bank Oliver Fratzscher (2006) identified three critical
issues that must be considered before the introduction of derivatives in his paper titled
‘Emerging Derivative Market in Asia’. These are: (i) a deep liquid cash market supported
by market-determined prices, (ii) how much regulation is needed in derivative markets and
(ix) What infrastructure is necessary? The authority must analyze these three crucial issues deeply
before proceed.
11.0 Conclusion
Financial derivatives provide risk management tools as well as alternative investment opportunities to
market participants. Financial derivatives have a long history of use. It has started its journey in the 12th
century in Venice. But after the inception of the freely floating exchange rate in 1971, the usage of such
instruments overwhelmingly increased. At present, the growth of the derivatives market in the world is
highest comparing all of the financial market segments. The derivatives market can play a pivotal role to
strengthen the effect of monetary policy and absorb foreign capital into a country as it helps in bringing
stability in the overall financial markets. It can contribute to make an efficient capital structure and
increase the profit-making ability of commercial banks. The derivatives market contributes to deepening
the capital market by its innate mechanism of risk-shifting and increasing the number of participants. As
after the catastrophic fall of the capital market of Bangladesh in 2010 it can’t recover yet, rapidly declining
FDI and scarcity of innovative and versatile financial products such as derivative securities are prevailing
in Bangladesh, the establishment of a financial derivatives market may be a proper decision for this
country as soon as possible. On the other hand, if the country can’t establish such a market its a backward
pacethen the other comparables in the world of competition may be inevitable. Hence, Bangladesh should
take steps now to establish a financial derivatives market but that must be slowly in phase by phase.
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