In recent years, derivatives markets have grown by leaps and bounds in emerging economics. Given the high level of economic and financial risks faced by market participants and investors in emerging countries, derivatives contribute to a country's economic development by making these risks manageable. For the deepening reform of market economy, modernizing it and making it compatible, Bangladesh should embrace the international normal practice and develop derivatives mechanism to promote healthy growth of commercial banks.
A derivative is an investment instrument that consists of a contract between parties whose value derives from and depends on the value of an underlying financial asset. Among the most common derivatives traded are futures, options, contracts for difference, and swaps. Some market analysts estimate the derivatives market at more than 10 times the size of the total world gross domestic product (GDP). Numerous derivatives are available on virtually every possible type of investment asset, including equities, commodities, bonds and foreign currency exchange. However, some other analysts challenge such estimates and maintain the size of the derivatives market has been vastly overstated.
Determining the actual size of the derivatives market depends on what a person considers part of the market, and therefore what figures go into the calculation. The larger estimates of the market come from adding up the notional value of all available derivatives contracts. But analysts, who disagree with the large estimates of the market, argue that such a calculation vastly overstates the reality of derivatives contracts, that the notional value of underlying assets does not accurately reflect the actual market value of derivative contracts based on those assets.
According to 2017 data from the Bank for International Settlements (BIS), it is estimated that the total notional amounts outstanding for contracts in the derivatives market was $542.4 trillion. Meanwhile, they report the gross market value of all contracts to be significantly less at approximately $12.7 trillion.
An example that illustrates the vast difference between notional value and actual market value can be found in a popularly traded derivative, interest rate swaps. The large principal amounts of the underlying interest rate instruments, although usually included in the calculation of total swaps value, never actually change hands in derivatives trading. The only money actually traded in an interest rate swap is the vastly smaller interest payment amounts - sums that are only a fraction of the principal amount. When actual market value of derivatives (rather than notional value) is the focus, the estimate of the size of the derivatives market changes dramatically. However, by any calculation, the derivatives market is quite sizable and significant in the overall picture of worldwide investments.
Before making a proper assumption about derivatives, investors have to determine the risks associated with the projected derivatives. The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks.
Market risk refers to the general risk in any investment. Investors make decisions and take positions based on assumptions, technical analysis or other factors that lead them to certain conclusions about how an investment is likely to perform. An important part of investment analysis is determining the probability of an investment being profitable and assessing the risk/reward ratio of potential losses against potential gains.
Counterparty risk, or counterparty credit risk, arises if one of the parties involved in a derivatives trade, such as the buyer, seller or dealer, defaults on the contract. This risk is higher in over-the-counter, or OTC, markets, which are much less regulated than ordinary trading exchanges. A regular trading exchange helps facilitate contract performance by requiring margin deposits that are adjusted daily through the mark-to-market process. The mark-to-market process makes pricing derivatives more likely to accurately reflect current value. Traders can manage counterparty risk by only using dealers they know and consider trustworthy.
Liquidity risk applies to investors who plan to close out a derivative trade prior to maturity. Such investors need to consider if it is difficult to close out the trade or if existing bid-ask spreads are so large as to represent a significant cost. Besides, Interconnection risk refers to how the interconnections between various derivative instruments and dealers might affect an investor's particular derivative trade. Some analysts express concern over the possibility that problems with just one party in the derivatives market, such as a major bank that acts as a dealer, might lead to a chain reaction or snowball effect that may threaten the stability of financial markets overall.
Last but not least, investors who look to protect or assume risk in a portfolio can employ long, short or neutral derivative strategies that seek to hedge, speculate or increase leverage. The use of a derivative only makes sense if the investor is fully aware of the risks and understands the impact of the investment within a broader portfolio strategy.
Sk. Shamim Iqbal serves in R&D Division of a leading commercial bank.
