OTC vs. Exchange Traded Derivatives

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  • 1. A Report:Exchange Traded CurrencyDerivatives vs. OTC MarketWhy the Exchange Traded Currency Options have pick up so well in comparison to theOTC Market?The Foreign Exchange market is a global, worldwide decentralized, over-the-counter financial market for tradingcurrencies. Across the world the Financial Centers functions as bridge to serve the varied buyers and the sellers.Exchange Traded Derivatives are preferred over the OTC Derivatives. The reasons being: Market Liquidity,Transparency, Lower Impact Cost etc.Submitted To: Mr. Vikas Bajaj, (Business Head Currency Derivatives, Kotak Securities Ltd.)Submitted By: Sukant Arora, (Student, Jindal Global Business School)Dated: May 27, 2011

2. ACKNOWLEDGEMENTThis Report was produced by Sukant Arora, a student Of Jindal Global Business School at KotakSecurities Ltd. I would like to thank Mr. Vikas Kr Bajaj, Business Head, Currency Derivatives, KotakSecurities Ltd. who provided me with support and encouragement during writing of this report.Without his guidance and persistent help this dissertation would not have been possible.I would like to express my sincere appreciation to Mr. Anindya Banerjee, Mr. Ratushtra Merchant, Mr.Nikhil Garg, Mr. Manish Maisheri, Mr. VinodHolani and Mr. Ankit Parekhwho supported me allthrough my summer training and guided me all the way.I would like to give full acknowledgement to the outstanding help by the staff of Kotak Securities Ltd. Ihope that this report will helpful to the readers. 3. Executive SummaryThe Foreign Exchange market is a global, worldwide decentralized, over-the-counter financial marketfor trading currencies. Across the world the Financial Centers functions as bridge to serve the variedbuyers and the sellers. The foreign exchange market works round the clock except for the weekendsand it determines the relative value of global currencies.Foreign exchange market serves many purposes but the primary purpose of the market is to giveassistance to investment and international trade, by allowing businesses to convert one currency tothe other. For example it promotes a British business to import Chinese goods and pay Chinese Yuan,even though the income of the business is in Pound Sterling.The financial derivatives market in India have evolved through a reform process over the last twodecades, witnessed in its growth in terms of size, product profile, nature of participants and thedevelopment of market infrastructure.The OTC derivative markets in India, unlike the developed financial markets where these marketsepitomized complex, unregulated financial innovations, have evolved within a regulated space. Theprocess of evolution needs to be seen in perspective of the boundary conditions imposed by thebroader macroeconomic framework for the development of the financial sector.After interaction with large corporates & industry specialist it has come in to the point that they stillprefer to trade in the OTC market over the exchanges because of many reasons but during the recenttimes exchanges are even attracting them as the exchanges are also up to the mark on fulfilling thedemands of the large corporate.On the other hand when a large corporate is trading in the options he prefers to trade more throughthe exchanges and there are the few reasons why the currency options have pickup so well in theexchanges during recent times. 4. Table of Contents1. Foreign Exchange Market: Global Scenario.1-22. Foreign Exchange Market: Indian Scenario..3-43. Over The Counter Market.5-84. Evolution of Over the Counter Derivatives in India.8-95. Exchange Traded Currency Derivatives106. Issues with the Over the Counter Market in India11-127. Findings..13-14 5. 1.) Foreign Exchange Market: Global ScenarioThe Foreign Exchange market is a global, worldwide decentralized, over-the-counter financial marketfor trading currencies. Across the world the Financial Centers functions as bridge to serve the variedbuyers and the sellers. The foreign exchange market works round the clock except for the weekendsand it determines the relative value of global currencies.Foreign exchange market serves many purposes but the primary purpose of the market is to giveassistance to investment and international trade, by allowing businesses to convert one currency tothe other. For example it promotes a British business to import Chinese goods and pay Chinese Yuan,even though the income of the business is in Pound Sterling.Foreign Exchange Market also facilitates the Carry Trade and supports Speculation, (in which investorscan lend high-yielding currencies and borrow low-yielding currencies.)In a typical foreign exchange market an investor or speculator purchases a specific quantity of onecurrency by paying a specific quantity of another currency.The modern foreign exchange market came into light around mid-1970s when gradually all thecountries switched to Floating exchange rates from the previous regime which was followed.Firms specializing in foreign exchange market say that the daily turnover of the foreign exchangemarket is over$ 4 Trillion presently, but, according to the Bank for International Settlements, as ofApril 2010, the average daily turnover of the foreign exchange market globally is estimated at $ 3.98Trillion, and have seen a growth of around 20% as compared to the daily turnover in 2007 which wasaround $ 3.21 trillion.Breakdown of the Daily Turnover:$ 1.765 Trillion in foreign exchange swaps$ 1.49 Trillion in spot transactions$ 475 Billion in outright forwards$ 43 Billion in currency swaps$ 207 Billion in options and other products 1 6. The foreign exchange market is a unique market and the reasons behind its uniqueness are:It has a huge volume i.e. $ 3.98 Trillion daily and therefore it leads to the high liquidity in themarket.The low margins of relative profit as compared with the other markets.Its continuous operation and its geographical dispersion.The variety of factors that affect exchange rates.The use of leverage to enhance the profit margins with respect to account size.2 7. 2.) Foreign Exchange Market: Indian ScenarioThe origins of the Indian foreign exchange market can be traced to 1978 when banks were permittedto undertake intra-day trading in foreign exchange. However, the market started growing only afterthe liberalization process picked up in 1992. The continuous improvement in market infrastructurehas had its impact in terms of the enhanced depth, liquidity and efficiency of the foreign exchangemarket. The turnover in the Indian foreign exchange market has grown significantly in both the spotand derivatives segments in the recent past. The daily average turnover saw a substantial pick upfrom about $5 billion during 1997-98 to $18 billion during 2005-06. The turnover has risen further to$45billion during 2011.The growth of the Indian Foreign exchange market owes to the tremendous growth of the Indianeconomy in the last few years. Today India holds a significant position in the Global economic scenarioand it is considered to be one of the emerging economies in the World. The steady growth of theIndian economy and diversification of the industrial sectors in India has contributed significantly tothe rapid growth of the Indian Foreign exchange market.During the year 2008 that Indian Foreign exchange market has seen a great advancement that tookthe Indian Foreign exchange trading at par with the global Foreign exchange markets. It is theintroduction of future derivative segment in Foreign exchange trading through the largest stockexchange in country National Stock Exchange and MCX-SX. This step not only increased the IndianForeign exchange market volume too many folds also gave the individual and retail investor a chanceto trade at the Foreign exchange market, that was till this time remained a forte of the banks andlarge corporate.The importance of the exchange rate to the Indian economy has also beengreater than ever before.While the government has explicitly adopted a flexible exchange rateregime, in practice the rupee isone of most efficient trackers of the US dollar. The rupees deviationsfromCovered Interest Parity(withrespect tothe dollar) exhibit relatively long-lived swings. An inevitable side-effect of the Indianexchangerate policy has been the ballooning of foreign exchange reserves to well over a hundredbilliondollars. In an unprecedented move, the government is considering using part of these reservestofinance infrastructure investments in the country.3 8. The foreign exchange market is divided into two segments:OTC (which includes spot, forwards and swaps) andExchange traded currency futures & options.In April2011, the size of Indias foreign exchange market was estimated to have a turnover of $45billion per day.Of this, the OTC foreign exchange market was estimated to have a daily turnover of $34 billion whilethe exchange-traded currency futures market was estimated to have a daily turnover of $11 billion.4 9. 3.) Over The Counter MarketFirstly it is important to understand what an OTC market is and how it functions.A security traded in some context other than on a formal exchange such as the NYSE, NSE, and BSEetc. The phrase "over-the-counter" can be used to refer to stocks that trade via a dealer network asopposed to on a centralized exchange. It also refers to debt securities and other financial instrumentssuch as derivatives, which are traded through a dealer network. In the same way currency is alsotraded in Over the Counter Market.Amongst the Financial Markets, the Foreign Exchange market is the most liquid Financial Market inthe world. The average daily turnover in the global foreign exchange and related markets iscontinuously growing. Foreign exchange trading increased by 20% between April 2007 and April 2010and has more than doubled since 2004. The increase in turnover is due to a number of factors:Growing importance of foreign exchange as an asset class.Emergence of retail inv