Effectiveness of derivatives regulation in India

Abstract

A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic, underlying variables. Very often the variables underlying derivatives are the prices of traded assets. Derivatives transactions have evolved in the past twenty years to cover a broad range of "underlying" including exchange rates, interest rates, commodities, and equities. Derivatives trading commenced in India in June 2000 after framing of the regulatory framework by the SEBI based on the Gupta and Varma Reports. The main thrust of any Derivatives Regulation would be on 1) protection of investors 2) ensuring that markets are fair, efficient and transparent and 3) reduction of systemic risk. First two requirements are achieved by regulation on Accounting Disclosure, and Reporting. It is widely recognized that accounting standards and disclosure practices for derivatives play an important role in ensuring investor protection and also fairness, efficiency, and transparency in the markets. Reduction of systemic risk requires regulatory prescription of Capital and Margin Requirements- Adequate capitalization is viewed by most regulators as a necessary condition for participation in derivatives activities for mitigating the risk. The research question proposed is Whether the current regulatory frame work for Derivatives with regard to Value at Risk (VaR) margins has been effective in managing the risk in the Capital market? To investigate the research question Back testing will be under taken in respect of the National Stock Exchange (NSE)Nifty index futures for the period June 12, 2000 (starting date of Nifty index futures)to October 30, 2009. This period covers several extremely volatile days such as May14 and 17, 2004. This study also intends to examine the suitability coherent risk measures such as Expected Shortfall (ES), which is becoming popular among risk managers and regulators. Extreme Value Theory will be used to compute the ES measure to take care fat tail behaviour of Financial Time Series. Based on the above study appropriate policy recommendations with regard to risk management of derivatives exchanges will be made.