Emerging derivative products - can India adopt them?

Abstract

Derivatives are instruments that are increasingly being used to hedge against volatility involved in the underlier. The most common of them are financial and commodity derivatives. But the need to hedge against various other risks faced by industries has given birth to products for which underlier is not a financial instrument. We call these products as emerging derivatives. Examples of such derivatives are electricity, weather and emission derivatives. Electricity derivatives were developed when many countries started deregulating their electricity production, giving rise to volatility in price. The major participants in them are electricity distribution companies and industries which are heavily depended on electricity for their operations. Similarly weather derivatives also have their roots in deregulation of electricity sector. Variability of weather conditions have its effect on electricity consumption by households and pose a risk in front of utilities companies, hence a demand to hedge against them. Emission derivatives are expected to gain popularity with the implementation of the Kyoto Protocol and the pollution control regimes getting stricter. These derivatives are being perceived as better than some traditional forms of hedging such as insurance. Moreover, these derivatives provide hedge against unique types of risks that present instruments cannot offer. These derivatives are currently not traded in India but the risks against which they hedge are relevant in the Indian context too. India is also experimenting with deregulation of its electricity sector and faces similar environmental risks as the economies where these emerging derivative products are being traded. Thus, there is a need to study the viability of a potential market for these derivatives in India. This will be determined by unique hedging capability, ease of understanding, development of sophisticated pricing models and policy support by regulators for these derivatives. Most of these emerging derivatives may look attractive when evaluated on above mentioned parameters. There is a need to investigate and identify those few derivatives that would provide hedge against risks that have the maximum impact on the Indian economy and thus, would eventually be successful over the long run.