Why Indian companies’ love affair with derivatives soured

There is other data to show that Indian banks and companies have been having an intensifying love affair with derivatives. BIS tracks the growth of derivative markets around the world through a triennial survey of central banks. The 2007 survey shows that daily trading in over-the-counter derivatives—those that are privately negotiated between two parties and are not traded on public exchanges—has grown at explosive rates in India since 2001.

Daily turnover is an indication of market liquidity rather than the size of the local derivatives market or the amount of risk in the system.

Average daily turnover shot up from $2 billion in 2001 to $4 billion in 2004 to $27 billion in 2007, according to BIS. Foreign exchange derivatives have led the charge, going up from $2 billion in 2001 to $3 billion in 2004 to $24 billion in 2007. The rest comes from interest rate derivatives. Should we worry? Not necessarily. To understand why this is so, it is useful to know what these numbers are really all about.

Chidambaram was referring to the nominal value of derivatives outstanding in the investment books of banks operating in India. BIS explains in its notes to the 2007 triennial survey of central banks that nominal amounts outstanding is a measure of market size, and not of risk. “Nominal amounts outstanding provide useful information on the structure of the OTC derivatives market but should not be interpreted as a measure of riskiness of these positions,” says BIS. For example, a bank may hold two types of currency derivatives. One will make money if the dollar zigs while the other will make money if it zags. The overall risk could be low in such as “hedged position”. Yet, both derivatives will be added to calculate a bank’s total exposure.

“Neither notional amounts nor gross market values are good measures for the risks transferred through derivatives. Notional amounts can be far larger than the amounts actually transferred through derivatives, in particular in the case of interest rate contracts. Gross market values give a snapshot on how much it would cost to replace all existing contracts at prevailing market prices at a given point in time. They, thus, refer to the “mark-to-market” of these contracts, which is quite independent from the potential exposures that could arise if prices were to move further. Ideally, we would like to have some measure of potential future exposures, but there is no accepted methodology for computing this,” says Christian Upper, head (monetary policy and exchange rates) of the monetary and economics department at BIS, in an e-mailed response to a Mint questionnaire.

In short, there is little correlation between the size of the nominal amounts of derivatives outstanding (which is the oft-quoted number) and the risk in the system (which is the primary worry about derivatives).