Page 13 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes highly leveraged institutions and their OTC derivative positions were the main cause of
turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to
market stability originating in features of OTC derivative instruments and markets.
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:

1. The management of counter-party (credit) risk is decentralized and located within
individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or margining,

3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and integrity, and
for safeguarding the collective interests of market participants, and

5. The OTC contracts are generally not regulated by a regulatory authority and the exchange's
self- regulatory organization, although they are affected indirectly by national legal
systems, banking supervision and market surveillance.
Some of the features of OTC derivatives markets embody risks to financial market stability. The
following features of OTC derivatives markets can give rise to instability in institutions, markets,
and the international financial system:
(i) the dynamic nature of gross credit exposures;
(ii) information asymmetries;

(iii) the effects of OTC derivative activities on available aggregate credit;
(iv) the high concentration of OTC derivative activities in major institutions; and
(v) the central role of OTC derivatives markets in the global financial system.
Instability arises when shocks, such as counter-party credit events and sharp movements in asset
prices that underlie derivative contracts occur, which significantly alter the perceptions of current
and potential future credit exposures. When asset prices change rapidly, the size and
configuration of counter-party exposures can become unsustainably large and provoke a rapid
unwinding of positions.

There has been some progress in addressing these risks and perceptions. However, the progress
has been limited in implementing reforms in risk management, including counter- party,
liquidity and operational risks, and OTC derivatives markets continue to pose a threat to
international financial stability. The problem is more acute as heavy reliance on OTC derivatives
creates the possibility of systemic financial events, which fall outside the more formal clearing
house structures. Moreover, those who provide OTC derivative products, hedge their risks
through the use of exchange traded derivatives. In view of the inherent risks associated with
OTC derivatives, and their dependence on exchange traded derivatives, Indian law considers
them illegal.

OTC Derivatives market Exchange trades
 1980s – Currency forwards  June, 2000 – Equity index futures
 1997 – Long term foreign currency-rupee swaps  June, 2001 – Equity index option
 July, 1999 – Interest rate swaps and FRAs  July, 2001 – Stock Option
 July, 2003 – FC-rupee options  June, 2003 – Interest rate futures

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