jai shri ganesh

8/4/2019 jai shri ganesh

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AKNOWLEDGMENT

The felling of gratitude when expressed in words is only a fraction of

acknowledgement. I am sincerely very thankful to Dr. Kapil Sharma,

for giving me the opportunity.

My deepest gratitude toward my project guide Dr. Kapil Sharma

who gave his valuable time and provided me with useful suggestion

with the help of which, I could complete my term paper work

successfully.

I am also very thankful to my friend without whom I could not have

completed my term paper.


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DECLERATION

I, Mr. ABHISHEK MEVAFAROSH hereby declare that student ofmaster of business administration (Financial Administration),

Institute of management studies, DAVV, Indore has completed this

term paper on USE OF DERIVATIVES BY BANK/INDIAN BANK

in the academic year 2011-12. The information submitted is true

and original to the best of my knowledge.


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Introduction of derivatives market

The word derivatives comes from the verb to derive it indicates that it has no

independent value. A derivative is a contract whose value is derived from the value

of another asset, known as underlying asset, which could be a share, a stock market

index, an interest rate, a commodity or a currency. When the prise of this underlying

changes, the value of the derivative also changes. Without an underlying, derivative

do not having any meaning.

Exam: - The value of a gold future contract derives from the value of the underlying asset (gold).

Introduction of banking system

The baking system is the fuel injection system which spurs economic efficiency by

mobilising saving and allocating them to high return investment. Research confirms

that countries with a well-developed banking system grow faster than those with a

weaker one. The banking sector is dominant in India as it accounts for more than

half the assets of the financial sector.

Use of financial Derivatives by Bank

Banks typically participate in derivatives markets because their traditional lending

and borrowing activities expose them to financial market risk. Interest rate risk, or

market risk, is, in general, the potential for changes in rates to reduce a banks

earnings or value. As financial intermediaries, banks encounter interest rate risk in

several ways. The primary source of interest rate risk stems from timing differences

in the reprising of bank assets, liabilities, and off-balance-sheet instruments. These

reprising mismatches are fundamental to the business of banking and generallyoccur from either borrowing short term to fund long-term assets or borrowing long


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term to fund short-term assets. Financial derivatives provide banks with an effective

way to manage interest rate risk without incurring additional capital charges.

Derivatives can be used to hedge asset and liability positions by allowing banks to

take a position in the derivatives market that is equal and opposite to a current or

planned future position in the spot or cash market.

It has been argued that federal

deposit insurance held by banks provides an incentive to use derivatives in a

speculative manner in order to increase the value of shareholder equity by

expanding into activities that shift risk onto the deposit insurer. Speculating with

derivatives involves gambling on the future performance of the underlying assets in

an attempt to reap trading profits.

The acceleration of derivative by Bank

Use of derivative e by bank begins from the late 1970s and 1980s, when banks

market risk exposure proved fatal to many institutions. During this period, interest

rates were extremely volatile-mortgage rates rose to over 15% while the prime rate

surpassed 20%. Banks found themselves in a more vulnerable position. Many banks

experienced a dramatic drop in their market values, and as a result 1000 insured

banks with approximately $92 billion in deposits failed over the decade. Because of

the rapidly rising number of bank failures during the 1980s, the Federal Regulatory

Agencies became concerned about the amount of capital held by commercial banks.

At the time capital requirements for a bank were based solely on its total assets. No

consideration was given to the risk embedded in the assets. The Committee

assigned to investigate the problem formulated the Federal Deposit Insurance

Corporation Improvement Act (FDICIA), passed in 1991. In an effort to develop

formal capital charges that conformed more closely to banks true risk exposure

regulators implemented risk-based capital requirements through FDICIA in

accordance with the Basel Accord of 1988. The new risk-based capital requirements

took into account the amount of credit risk of the assets held by a particular bank in

determining the level of capital required for that bank. The requirements called for

assets to be divided into four categories according to their riskiness. Cash and its

equivalents, including short term Treasury securities, were assigned a zero weight,


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municipal general obligation bonds and mortgage-backed securities a 20% weight.

Moderate risk assets and assets in a banks loan portfolio, including residential

mortgages, carried a 50% weight and commercial loans, loans made to developing

countries (LDC loans) and corporate bonds held a 100% weight. A required

minimum ratio of total capital to risk-weighted assets was established at 7.25%.The

risk-based capital requirements discussed above are based solely on credit risk;

however, in developing FDICIA, regulators realized the need to establish guidelines

for protecting banks against interest-rate risk as well. From the regulatory

perspective in a risk-based capital environment, interest-rate risk should be

incorporated into existing capital requirements as well as credit risk. Thus, as

outlined in FDICIA, regulators set out to incorporate interest rate risk into capital

charges based on the interest rate sensitivity of the assets and liabilities of the bank.

Specifically, assets, liabilities and off-balance sheet instruments are divided into

seven maturity groups: 0 to 3 months; 3 months to 1 year; 1 year to 3 years; 3 to 5

years; 5 to 10 years; 10 to 20 years; and more than 20 years. Each group is then

assigned a duration based on a benchmark instrument representative of the assets

and the liabilities in that group. Duration is the measure of the approximate change in

the value of an asset or liability for a change of 100 basis points in interest rates.

Once the durations are computed, they are multiplied by the balances in each of the

respective groups, and the net balance sheet duration is calculated. The results

provide an estimate of the amount by which the surplus or equity position, (the

difference between a banks assets and liabilities) is expected to change as a result

of a given change in interest rates. According to the proposal, if the surplus changes

by more than one percent of assets, the bank must hold additional capital in an

amount equal to the excess.

Development of Derivative Markets in India

Derivatives markets have been in existence in India in some form or other for a long

time. In the area of commodities, the Bombay Cotton Trade Association started

futures trading in 1875 and, by the early 1900s India had one of the worlds largest

futures industry. In 1952 the government banned cash settlement and options

trading and derivatives trading shifted to informal forwards markets. In recent years,government policy has changed, allowing for an increased role for market-based


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pricing and less suspicion of derivatives trading. The ban on futures trading of many

commodities was lifted starting in the early 2000s, and national electronic commodity

exchanges were created.

In the equity markets, a system of trading called badla

involving some elements of forwards trading had been in existence for decades.6

However, the system led to a number of undesirable practices and it was prohibited

off and on till the Securities and Exchange Board of India (SEBI) banned it for good

in 2001. A series of reforms of the stock market between 1993 and 1996 paved the

way for the development of exchange-traded equity derivatives markets in India. In

1993, the government created the NSE in collaboration with state-owned financial

institutions. NSE improved the efficiency and transparency of the stock markets by

offering a fully automated screen-based trading system and real-time price

dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE

sent a proposal to SEBI for listing exchange-traded derivatives. The report of the L.

C. Gupta Committee, set up by SEBI, recommended a phased introduction of

derivative products, and bi-level regulation (i.e., self-regulation by exchanges with

SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma

Committee in 1998, worked out various operational details such as the margining

systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was

amended so that derivatives could be declared securities. This allowed the

regulatory framework for trading securities to be extended to derivatives. The Act

considers derivatives to be legal and valid, but only if they are traded on exchanges.

Finally, a 30-year ban on forward trading was also lifted in 1999.

The economic liberalization of the early

nineties facilitated the introduction of derivatives based on interest rates and foreign

exchange. A system of market-determined exchange rates was adopted by India in

March 1993. In August 1994, the rupee was made fully convertible on current

account. These reforms allowed increased integration between domestic and

international markets, and created a need to manage currency risk. Figure 1 shows

how the volatility of the exchange rate between the Indian Rupee and the U.S. dollar

has increased since 1991.7 The easing of various restrictions on the free movement

of interest rates resulted in the need to manage interest rate risk.


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Derivatives Instruments Traded in India

In the exchange-traded market, the biggest success story has been derivatives on

equity products. Index futures were introduced in June 2000, followed by index

options in June 2001, and options and futures on individual securities in July 2001

and November 2001, respectively. As of 2005, the NSE trades futures and options

on 118 individual stocks and 3 stock indices. All these derivative contracts are

settled by cash payment and do not involve physical delivery of the underlying

product (which may be costly).

Derivatives on stock indexes and individual stocks

have grown rapidly since inception. In particular, single stock futures have become

hugely popular, accounting for about half of NSEs traded value in October 2005. In

fact, NSE has the highest volume (i.e. number of contracts traded) in the single stock

futures globally, enabling it to rank 16 among world exchanges in the first half of

2005. Single stock options are less popular than futures. Index futures are

increasingly popular, and accounted for close to 40% of traded value in October

2005. NSE launched interest rate futures in June 2003 but, in contrast to equity

derivatives, there has been little trading in them. One problem with these instruments

was faulty contract specifications, resulting in the underlying interest rate deviatingerratically from the reference rate used by market participants. Institutional investors

have preferred to trade in the OTC markets, where instruments such as interest rate

swaps and forward rate agreements are thriving. As interest rates in India have

fallen, companies have swapped their fixed rate borrowings into floating rates to

reduce funding costs.10 Activity in OTC markets dwarfs that of the entire exchange-

traded markets, with daily value of trading estimated to be Rs. 30 billion in 2004.

Foreign exchange derivatives are less active than interest rate derivatives in India,even though they have been around for longer. OTC instruments in currency

forwards and swaps are the most popular. Importers, exporters and banks use the

rupee forward market to hedge their foreign currency exposure. Turnover and

liquidity in this market has been increasing, although trading is mainly in shorter

maturity contracts of one year or less In a currency swap, banks and corporations

may swap its rupee denominated debt into another currency (typically the US dollar

or Japanese yen), or vice versa. Trading in OTC currency options is still muted.

There are no exchange-traded currency derivatives in India.


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Exchange-traded

commodity derivatives have been trading only since 2000, and the growth in this

market has been uneven. The number of commodities eligible for futures trading has

increased from 8 in 2000 to 80 in 2004, while the value of trading has increased

almost four times in the same period. However, many contracts barely trade and, of

those that are active, trading is fragmented over multiple market venues, including

central and regional exchanges, brokerages, and unregulated forwards markets.

Total volume of commodity derivatives is still small, less than half the size of equity

derivatives.

Use of derivatives in India by financial institution/Banks

The use of derivatives varies by type of institution. Financial institutions, such as

banks, have assets and liabilities of different maturities and in different currencies,

and are exposed to different risks of default from their borrowers. Thus, they are

likely to use derivatives on interest rates and currencies, and derivatives to manage

credit risk. In contrast to the exchange-traded markets, domestic financial institutions

and mutual funds have shown great interest in OTC fixed income instruments.Transactions between banks dominate the market for interest rate derivatives, while

state-owned banks remain a small presence Corporations are active in the currency

forwards and swaps markets, buying these instruments from banks. Credit and

interest rate risks are two core risks all banks accept and hope to profit from. Foreign

currency (price) risk accepted by banks varies widely across the four categories.

Commodity (price) risk accepted by banks is limited to gold price risk in respect of

gold deposits accepted by five banks under their schemes framed under RBI

guidelines on the Gold Deposit Scheme 1999 announced in the union budget for the

year 1999-2000. Equity (price) risk accepted by banks again is limited to their direct

or indirect (through MFs) exposure to equities under the RBI prescribed 5 % capital

market instruments limit (of total outstanding advances as at previous year-end).

Some banks may have further equity exposure on account of equities collaterals

held against loans in default.


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Derivatives instrument which is used by bank

1 Credit derivatives:-

Credit derivatives are bilateral financial contracts

with payoffs linked to a credit related event such as non-payment of interest, a credit

downgrade, or a bankruptcy filing. A bank can use a credit derivative to transfer

some or all of the credit risk of a loan to another party or to take on additional risks.

In principle, credit derivatives are tools that enable banks to manage their portfolio of

credit risks more efficiently. The promise of these instruments has not escaped

regulators and policymakers. In various speeches as the head of the Federal

Reserve System, Alan Greenspan concluded that credit derivatives and other

complex financial instruments have contributed to the development of a far more

flexible, efficient, and hence resilient financial system than existed just a quarter-

century ago.. The largest sector of the credit derivatives market is the credit default

swap market where the most liquid individual names on which credit derivatives are

written are large US investment grade firms, foreign banks, and large multinational

firms, but much of the most recent growth of the market has been in index

derivatives.

Perhaps, the following evolution in the corporate credit markets in India

could pave way to a credit derivatives market:

1. Presence of a liquid corporate bond market is essential for a term structure of

corporate credit spreads over the sovereign curve to emerge.

2. Insurance sector which is a seller of credit derivatives in other markets would need

evolve on the sell side of the credit derivatives market.

3. RBI guidelines on guarantees and co-acceptances2 presently preclude banks

from issuing guarantees favouring other lending agencies, banks or FIs for loans

extended by them. This restriction would need to go if banks are to sell or write credit

derivatives.


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4. There is no RBI guideline permitting use of credit derivatives by banks and FIs to

reduce regulatory capital on their respective balance sheet. This is one of the best

uses of credit derivatives internationally.

(A) Swap:-

A swap is an agreement between two parties to exchange sequences

of cash flows for a set period of time. Usually, at the time the contract is

initiated, at least one of these series of cash flows is determined by a

random or uncertain variable, such as an interest rate, foreign

exchange rate, equity price or commodity price. Conceptually, one may

view a swap as either a portfolio of forward contracts, or as a longposition in one bond coupled with a short position in another

bond. This article will discuss the two most common and most basic

types of swaps:

(I) Plain Vanilla Interest Rate Swap:-

The most common and simplest swap is a "plain vanilla" interest rate

swap. In this swap, Party A agrees to pay Party B a predetermined,fixed rate of interest on a notional principal on specific dates for a

specified period of time. Concurrently, Party B agrees to make

payments based on a floating interest rate to Party A on that same

notional principal on the same specified dates for the same specified

time period. In a plain vanilla swap, the two cash flows are paid in the

same currency. The specified payment dates are called settlement

dates, and the time between are called settlement periods. Because

swaps are customized contracts, interest payments may be made

annually, quarterly, monthly, or at any other interval determined by the

parties.

(II) Plain Vanilla Foreign Currency Swap:-

The plain vanilla currency swap involves exchanging

principal and fixed interest payments on a loan in one currency for principal and fixed

interest payments on a similar loan in another currency. Unlike an interest rate swap,

the parties to a currency swap will exchange principal amounts at the beginning and


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end of the swap. The two specified principal amounts are set so as to be

approximately equal to one another, given the exchange rate at the time the swap is

initiated.

2 Interest-Rate Derivatives:-

A financial instrument based on an

underlying financial security whose value is affected by changes in interest rates.

Interest-rate derivatives are hedges used by institutional investors such as banks to

combat the changes in market interest rates. Individual investors are more likely to

use interest-rate derivatives as a speculative tool - they hope to profit from their

guesses about which direction market interest rates will move. The RBI is yet topermit banks to write rupee (INR) interest rate options. Indeed, for banks to be able

to write interest rate options, a rupee interest rate futures market would need to first

exist, so that the option writer can deltahedge the risk in the interest rate options

positions. And, according to one school of thought, perhaps the policy dilemma

before RBI is: how to permit an interest rate futures market when the current

framework does not

permit short selling of sovereign securities. Further, even if short selling of sovereignsecurities were to be permitted, it may be of little consequence unless lending and

borrowing of sovereign securities is first permitted.

3 Foreign currency derivatives:-

An agreement to make a

currency exchange between two foreign parties. The agreement consists of

swapping principal and interest payments on a loan made in one currency for

principal and interest payments of a loan of equal value in another currency. The

Federal Reserve System offered this type of swap to several developing countries in

2008.

Derivative markets worldwide have witnessed explosive growth in recent past.

According to the BIS Triennial Central Bank Survey of Foreign Exchange and

Derivatives Market Activity as of April 2007 was released recently and the OTCderivatives segment, the average daily turnover of interest rate and non-traditional


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foreign exchange contracts increased by 71 % to $2.1 trillion in April 2007 over April

2004, maintaining an annual compound growth of 20 per cent witnessed since 1995.

Turnover of foreign exchange options and cross-currency swaps more than doubled

to $0.3 trillion per day, thus outpacing the growth in 'traditional' instruments such as

spot trades, forwards or plain foreign exchange swaps. The traditional instruments

also show an unprecedented rise in activity in traditional foreign exchange markets

compared to 2004. Average daily turnover rose to $3.2 trillion in April 2007, an

increase of 71% at current exchange rates and 65% at constant exchange rates.

Relatively moderate growth was recorded in the much larger interest rate segment,

where average daily turnover increased by 64 per cent to $1.7 trillion. While the

dollar and euro clearly dominate activity in OTC interest rate derivatives, their

combined share has fallen by nearly 10 percentage points since the 2004 survey, to

70 per cent in April 2007, as turnover growth in several non-core markets outstripped

that in the two leading currencies. RBI is yet to permit authorized dealers to write

FCY:INR options. Interestingly, domestic corporates with rupee liabilities may also

enter into FCY:INR swaps with authorized dealers to hedge their long-term interest

rate exposures. (This enables corporates to benchmark their rupee liability servicing

costs to foreign currency yield curve). There is now an active Over-The-Counter

(OTC) foreign currency derivatives market in India. However, the activity of most

PSB majors in this market is limited to writing FCY derivatives contracts with their

corporate customers on fully covered back-to-back basis. And, most PSBs do not

run an active foreign currency derivatives trading book, on account of the

impediments enumerated earlier that need to be overcome at their end. RBI is yet to

permit authorized dealers to write FCY:INR options. Interestingly, domestic

corporates with rupee liabilities may also enter into FCY:INR swaps with authorized

dealers to hedge their long-term interest rate exposures. (This enables corporates to

benchmark their rupee liability servicing costs to foreign currency yield curve). There

is now an active Over-The-Counter (OTC) foreign currency derivatives market in

India. However, the activity of most PSB majors in this market is limited to writing

FCY derivatives contracts with their corporate customers on fully covered back-to-

back basis. And, most PSBs do not run an active foreign currency derivatives trading

book, on account of the impediments enumerated earlier that need to be overcome

at their end.


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4 Mutual funds:-

(I) Equity derivatives:-

Mutual Funds ought to be natural players in the equity derivatives

market. SEBI (MF) Regulations also authorize use of exchange traded equity

derivatives by mutual funds for hedging and portfolio re-balancing purposes. And,

being tax exempt, there are also no tax issues relating to use of equity derivatives by

them. However, most mutual funds (whether managed by Indian or foreign owned

asset management companies) are not yet active in use of equity derivatives

available on the NSE or BSE. The following impediments seem to hinder use of

exchange trade equity derivatives by mutual funds:

1. SEBI (Mutual funds) regulations restrict use of exchange traded equity

derivatives to hedging and portfolio rebalancing purposes. The popular view

in the mutual fund industry is that this regulation is very open to interpretation;

and the trustees of mutual funds do not wish to be caught on the wrong foot!

The mutual fund industry therefore wants SEBI to clarify the scope of this

regulatory provision.

2. Inadequate technological and business process readiness of several players

in the mutual fund

industry to use equity derivatives and manage related risks.

3. The regulatory prohibition on use of equity derivatives for portfolio

optimization return

enhancement strategies, and arbitrage strategies constricts their ability to use

equity derivatives.4. Relatively insignificant investor interest in equity funds ever since exchange

traded options and futures were launched in June 2000 (on NSE, later on

BSE).

(II) Fixed income derivatives:-

SEBI (MF) regulations are silent about use of IRS and FRA

by mutual funds. Evidently, IRS and FRA transactions entered into by mutual fundsare not construed by SEBI as derivatives transactions covered by the restrictive


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provisions which limit use of derivatives by mutual funds to exchange traded

derivatives for hedging and portfolio balancing purposes. MFs are emerging as

important users of IRS and FRA in the Indian fixed income derivatives market. At

least a few mutual funds actively use IRS to optimize yield and reduce the duration

of their bond scheme portfolios, by paying fixed rate and receiving floating rate. It is

understood that some of these IRS are benchmarked to MIFOR as well. (Needless

to add, given the open-ended nature of most bond schemes of mutual funds, such

MIFOR linked IRS have the potential of generating noticeable basisrisk, besides the

liquidity risk in the underlying bond asset of longer maturity.)

(III) Foreign currency derivatives:-

In September 1999 Indian mutual funds

were allowed to invest in ADRs/GDRs of Indian companies in the overseas market

within the overall limit of US$ 500 million with a sub-ceiling for individual mutual

funds of 10 percent of net assets managed by them (at previous year-end), subject

to maximum of US$ 50 million per mutual fund. Several mutual funds had obtained

the requisite approvals from SEBI and RBI for making such investments. However,

given that most ADRs/GDRs of Indian companies traded in the overseas market at a

premium to their prices on domestic eq-uity markets, this facility has remained

largely unutilized. Therefore, the question of using FCY:INR forward cover or swap

did not much arise. However, recently, from 30 March 2002 domestic mutual funds

have been permitted to invest in foreign sovereign and corporate debt securities

(AAA rated by S&P or Moody or Fitch IBCA) in countries with fully convertible

currencies within the overall market limit of US$ 500 million, with a sub-ceiling for

individual mutual funds of four percent of net assets managed by them as on 28

February 2002, subject to a maximum of US$ 50 million per mutual fund. Several

mutual funds have now obtained the requisite SEBI and RBI approvals for making

these investments. Once investment in foreign debt securities pick-up, mutual funds

ought to emerge as active users of FCY:INR swaps to hedge the foreign currency

risk in these investments.

(IV) Commodity derivatives:-


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Under SEBI (MF) regulations, mutual funds can invest

only in transferable financial securities. In absence of any financial security linked to

commodity prices, mutual funds cannot offer a fund product that entails a proximate

exposure to the price of any commodity. Therefore, the issue of they using

commodity derivatives (whether in the overseas or Indian market) does not arise.

However, interestingly, one of the players in the mutual fund industry proposes to

offer an exchange traded gold fund that would invest solely in transferable gold

receipts/certificates issued by one or more of the 13 bullion banks which have been

authorized by RBI to accept gold deposits under the Gold Deposit Scheme 1999.

The draft offer document of the scheme is awaiting SEBI clearance. This product

aspires to offer investors the ability to hold gold as an asset class (with its attendant

risks and rewards) in the form of a financial asset, with the prospect of also getting

some regular income in the form of interest on the gold receipts/certificates held by

the fund.

Bank Participant in Indian derivatives market

Name of the Organisation Name of the Officer / Designation

1. State Bank of India Shri A. Ghosh, General Manager, Credit

Policy and Procedures Department

2. ICICI Bank Ms. Vishakha Mulye, Joint General Manager

3. Citibank Shri Ravi Savur, Vice President

4. HSBC Shri Anand Krishnamurthy, Deputy Head

Interest Rates

5. Bank of America Shri Joydeep Sengupta, Vice PresidentHead

Derivative Advisory

6. General Insurance Corpn. Smt. M.M. Parkhi, Manager

7. Reserve Bank of India, Department ofBanking Supervision Shri Amrendra Mohan, General Manager


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8. Reserve Bank of India, Exchange Control

Department

Shri R.N. Kar, Deputy General Manager

9. Reserve Bank of India, Industrial & Export

Credit Department

Ms. Rose Mary Sebastian, General Manager

10. Reserve Bank of India, Department of

Banking Operations & Development

Shri B. Mahapatra, General Manager

(Convenor)

Establishment years of derivatives product

1874 Commodity Futures1972 Foreign currency futures1973 Equity options1975 T-bond futures1981 Currency swaps1982 Interest rate swaps; T-note futures; Eurodollar futures;

Equity index futures; Options on T-bond futures;Exchange{listed currency options

1983 Options on equity index; Options on T-note futures;Options on currency futures; Options on equity indexfutures; Interest rates caps and oors

1985 Eurodollar options; Swaptions1987 OTC compound options; OTC average options1989 Futures on interest rate swaps; Quanto options1990 Equity index swaps1991 Di_erential swaps1993 Captions; Exchange-listed FLEX options1994 Credit default options

AnalysisThis paper argues that banks use derivatives to minimize risk exposure, assuming

that banks

maximize profits subject to a risk constraint. In theory, a banks exposure to interest

rate risk should have an effect on the size of its derivative holdings if the financial

instruments are used for hedging purposes. Furthermore, it is argued that derivative

use will vary according to bank size, balance sheet composition, total risk exposure,


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profitability and appetite for assuming risk. I will discuss each of these characteristics

below.

A. Risk Exposure

Interest Rate Risk Exposure

In theory, banks can benefit from derivative markets because derivatives, like

insurance, can be used to hedge against risk. Carefully chosen derivative deals can

reduce interest rate risk inherent in banking activities because the preexisting

interest

rate risk can sometimes be offset by a counterbalancing derivative risk. Therefore, if

derivatives are used to hedge against interest rate risk, then the volume of

derivatives held by a bank should be negatively related to the current interest rate

risk experienced by the bank.

Credit Risk Exposure

The ratios of loan loss reserves to loans and noncurrent loans to loans are

indications of the quality of assets held by a bank. Each bank must maintain an

allowance for loan and lease losses that is adequate to absorb estimated credit

losses associated with its loan and lease portfolio. A bank with relatively risky assets

would be required to hold a relatively larger loan loss reserve balance. Loans are

considered non-current if they are 90 days or more past due or if they are in non-

accrual status. Thus a bank with a relatively greater proportion of non-current loans

would be considered relatively riskier. It can be argued that investors would view a

bank with a relatively high loan loss reserve or a bank with a relatively high balance

of non-current loans as one of high risk. Thus the bank might have a difficult time

raising additional capital as needed to manage interest rate risk in the traditional

manner. Furthermore, a riskier loan portfolio may be an indication of managements

predilection for risk that might be carried over into derivative dealings. If

management has greater tendencies towards risk then they might be more likely to

assume the risk involved in speculating

with derivatives. Banks in either situation would theoretically be more likely to use

derivatives. However, it would be difficult to discriminate among those that are using

derivatives prudently to manage interest rate risk and those that are speculating. On


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the other hand, it has been argued that banks that hold a relatively risky portfolio of

assets would avoid using derivatives in order to avoid regulatory scrutiny. Therefore,

the direction of the relationship between derivative use and bank credit risk is

ambiguous.

B. Balance Sheet Characteristics

Capitalization

Banks are required to hold a percentage of capital based on the risk embedded in

their asset holdings. Profit maximizing banks have an incentive to increase their

assets given the size of

their capital balance. Such banks would tend to purchase assets until their capital to

asset ratio reaches its minimum as required by regulators. Once in that position, the

banks are better off using derivatives to manage interest rate risk because they do

not require additional capital. Therefore, a negative relationship should exist between

derivative use and the banks risk weighted capital to asset ratio.

Size of Asset Portfolio

In theory, large banks are more likely to be involved in derivative use for several

reasons. First, derivatives are very complex instruments and require careful

management and analysis. Smaller banks may not have the resources to devote to

understanding the complexities of these instruments. Furthermore, transaction fees

involved in trading derivatives decrease with increased volume of purchases. Thus

larger banks that can afford to make larger transactions pay relatively smaller

transactions fees. Finally, larger banks are more likely to have greater exposure to

market risk particularly because of the differences in their borrowing sources. Large

banks tend to use instruments, such as jumbo CDs, whose price and yields vary with

the market on a day-to-day basis. Therefore, the relationship between derivative use

and asset size is expected to be positive.

C. Other CharacteristicsBank Profitability

Recalling the work of Deshmukh, Greenbaum, and Kanatas (1983), banks who can

manage interest rate risk using derivatives will be less constrained in their lending

activities and will thus be able to invest in higher risk/higher yielding assets.Derivatives free banks from the restrictions imposed by traditional internal hedging


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by allowing the bank to separate its choice of assets or sources of funding from

considerations of market risk. Therefore, derivative use is expected to have a

positive relationship with bank profitability.


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References

1 Indian Financial System B bharti pathak PEARSON EDUCAION 2nd

edition

2 http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=18465

3 www.iwu.edu/economics/PPE07/katie.pdf

4 citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.121.886&rep.

5 www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdf
http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=18465http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=18465http://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdfhttp://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdfhttp://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdfhttp://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdfhttp://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdfhttp://www.iwu.edu/economics/PPE07/katie.pdfhttp://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=18465

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