Sudip Bandyopadhyay

Derivatives are useful financial instruments.  No Financial market can
function without speculation & derivatives too are necessary for market
efficiency.  However, it is important  that all concerned do  understand
the nature of the instrument before participating.  Derivatives feed on
leverage, and leverage feeds on greed. A combination of these leads to
complexities in derivatives.  When Bear Stearns ideated credit derivative
swaps it may not have imagined its destructive potential.  It saw the
market in credit derivatives swaps as a place to make money.  The
instrument became so complex that, at one point, few understood who was
taking the credit risk and this led to a mis-pricing of risk.  But complex
derivatives helped make more money and puff up the bottom line, and earn
more bonuses.  No one could  &  did object. The resultant devastation &
destruction is now there for all of us to see & suffer.

As yet in India we do not have complex derivatives or complex structured
products based on securitisation.  Nor has the securitisation market picked
up.  But there are a variety of derivative instruments in the stock market
(index-based and stock-based futures and options) and exchange-traded
currency futures have been introduced in the currency market.  But even
these simple derivatives could cause severe risk-management problems unless
one is careful. In equity derivatives segment  stock futures have gained
popularity  in our market in comparison to anywhere else in the world.  It
could be that stock futures closely resemble the erstwhile carry-forward
system which the market is familiar with; and it is possible that brokers
and clients have found a way of using stock futures in a manner similar to
the carry-forward system,  This large market for stock futures could also
be the reason why the short selling  & borrowing-lending of shares hasn’t
not picked up in our markets.

Alan Greenspan in his book The Age of Turbulence commented that ‘Fear is an automatic response in all of us to threats to our deepest inbred propensities. It is also the basis of many of our economic responses. It is difficult for investors to imagine when markets veer from rational to irrational, from euphoria to fear and back again’ The stock market is ruled by powerful emotions and desires – greed, fear, hope, uncertainty which control the behaviour of stock markets and investors.At the start of the year there was talk of a Great Depression. By March, that had become the End of the World. In April, however, the global economy faced merely a stiff recession. May has now ushered forth expectations of a self-sustaining recovery. At this rate the boom will be back by summer. The Bernanke, Fed Chairman, now expects to see a recovery by the year’s end, albeit a weak one.

The strong rally in global equity markets continues to confuse and surprise most market participants. A continuing stream of better than expected economic data is forcing investors & fund managers to reposition portfolios, and this act of repositioning is driving up markets to levels that may no longer seem attractive from a valuation perspective. Having gone through a very tough 12 months, investors are naturally worried about not taking further losses, and are thus loath to chase this rally. Fund managers are damned if they do and damned if they don’t. If they buy now and the markets fall, they are bound to get asked questions on chasing the market, and if they do not participate they will be questioned on underperformance. India is currently part of this global rally, and for us to break out on either side we will have to wait for the election results. Markets will cheer the emergence of any stable political structure post the elections. Such structure will assure that the reforms agenda of the central government will proceed without any major setbacks.

The economic reform agenda of the new government amongst others should include large scale reforms in the Commodity space. Financial markets have witnessed reforms regularly and to a great extent our capital market systems are world class and robust. However, unfortunately the Commodity Trading space, both Spot and Derivatives including the related infrastructure haven’t yet received the required attention. Organised development of the Commodity business will surely create a virtuous cycle which will significantly benefit the farmers, manufacturers, users and consumers across the country. Commodity market needs a strong regulator and this needs to be addressed urgently either by empowering FMC or creating a single regulator for the markets

.From the point of view of commodity markets competition is important among exchanges. But to compete efficiently, they must have products which differ in features and benefits or even if these parameters are the same, they must be distinguishable in service quality. Without any product differentiation, the market gets segmented, leading to efficiency losses when the same product is traded on more than one exchange.

The Indian capital market in the last week remained buoyant largely on the back of aggressive FII buying in the cash segment. Despite high volatility in the week gone by, both benchmark Indices Nifty and the Sensex registered hefty gains. The current trend suggests that the economic data is likely to keep improving slowly on tle margin as restocking of inventories begins and confidence creeps back among corporates.The results of the U.S. government’s stress tests for Banks were in line with expectations. However, 10 out of the 19 banks under review will need to raise further capital of about $75 billion by end of CY2010. On the domestic front, Inflation rate witnessed a mild jump for the third straight week to 0.70% from 0.57% earlier due to a large increase in prices of food articles.

In the coming week markets are likely to decouple from global developments and would be eyeing political developments more closely. FIIs have already turned cautious. With elections results slated for end of the week, markets may witness extremely high volatility and may see some unwinding of positions. With the political scenario post election still cloudy, fresh build up of positions and sustained upmove looks unlikely.