Doctoral Programme in Management

Six Months Progress Report

(Sept. 2009 to Feb. 2010)

ON

“ROLE OF DERIVATIVES IN THE GROWTH OF

MICRO SMALL AND MEDIUM
ENTERPRISES
IN INDIA”

Under Supervision of: Submitted by:

Dr. P.V. Rajeev Ram Mohan Mishra
Associate Professor Research Scholar

Faculty of Management Studies

Banaras Hindu University
Varanasi 221005
INTRODUCTION:

"We view them as time bombs both for the parties that deal in them and the
economic system ... In our view ... derivatives are financial weapons of mass
destruction, carrying dangers that, while now latent, are potentially lethal."

- Warren Buffett
Derivatives, the financial weapons of mass destruction as famously said by the legendry
investor Warrren Buffett are seen as the major culprit in the financial market by many
experts but at the same time these are also compared with fire, which can be used to cook
food and at the same time can be used for suicide. Despite the differences in views, the
necessity and importance of derivatives in world economy cannot be overlooked which is
the largest segment of the global financial market surpassing the staggering estimated
limit of $596 trillion(http://www.slate.com/id/2202263) . By contrast, the value of the
world's financial assets—including all stock, bonds, and bank deposits—was pegged at
$167 trillion in 2007 by McKinsey.
When derivatives becoming a standardized key to unbundling and
managing risk in banking, investment, capital, insurance and in other
markets around the world, it is inevitable that they would also need to
be established in India. In a globalizing world there is no other choice.
These products or contracts are like double edged sword, which if not used wisely and
competitively can seriously hamper the user itself as happened in the case of MICRO
SMALL AND MEDIUM ENTERPRISES during the regime of appreciating rupee versus
dollar(2007-2008) where MSMEs (especially the exporters) suffered huge losses in their
currency derivative contracts. The MSME export sector which has limited knowledge of
forex derivatives suffered huge losses on fluctuations in the value of rupee, Subhash
Mittal, Convenor, Federation of Indian Export Organisations (FIEO) Committee on
IT&EP said. Mittal said this at a Workshop organized by FIEO with Religare
Commodities Limited at New Delhi in 2008. With the rupee breaching the barrier of 46
to a dollar, quite a few exporters had booked their export receivables in the forward
market for 42/43 to a dollar. While some exporters would gain in terms of profitability,
the depreciation of the rupee vis-à-vis dollar definitely impacted the overall
competitiveness of the MSME export sector.

It is easy to recall that since 2006 the US dollar had been depreciating against most global
currencies. In April 2007 the rupee, keeping in line with its global peers, too began to
appreciate significantly against the dollar. And as the rupee appreciated, exporters began
to lose both their top-line and bottom-line. In this situation, banks (mostly private and
foreign, but also some nationalised ones) took advantage of the situation to sell exotic
derivative products. Innocent exporters, mostly MSMEs, whose dealings with banks
hitherto were based only on trust, believed the words of the banks and signed several
derivative contracts without realizing the potential risk and unaware of the fact that those
contracts are only speculative in nature.

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It is important to highlight that these products were sold in utter disregard to Indian
Contract Act. Contracts without genuine underlying exposure are a speculative wager,
which under the Indian contract law, is void. What is appalling to note that one of the
fundamental requirements to contract under the Indian contract law is that the parties to
the contract must be 'competent.' If even learned Chartered Accountants are incompetent
to understand these instruments, how does one expect exporters to understand them,
especially when the persons explaining the risks too were no experts.
This sheer misunderstanding and incompetence to understand the risk associated with the
currency derivatives resulted in the huge losses to the involved enterprises, while these
contracts were meant to save them with the same and ultimately invited the probe against
the involving banks in this episode including some public sector banks.
Worldwide, the micro small and medium enterprises (MSMEs) have been accepted as the
engine of economic growth and for promoting equitable development. The major
advantage of the sector is its employment potential at low capital cost. The labour
intensity of the MSME sector is much higher than that of the large enterprises. The
MSMEs constitute over 90% of total enterprises in most of the economies and are
credited with generating the highest rates of employment growth and account for a major
share of industrial production and exports. In India too, the MSMEs play a pivotal role in
the overall industrial economy of the country. In recent years the MSME sector has
consistently registered higher growth rate compared to the overall industrial sector. With
its agility and dynamism, the sector has shown admirable innovativeness and adaptability
to survive the recent economic downturn and recession. As per available statistics (4th
Census of MSME Sector), this sector employs an estimated 59.7 million persons spread
over 26.1 million enterprises. It is estimated that in terms of value, MSME sector
accounts for about 45% of the manufacturing output and around 40% of the total export
of the country, which clearly emphasize the pivotal role of MSMEs in the development of
Indian economy.
Majority of available studies on derivatives are mainly aberreted towards their use by big
corporates and financial institutions, while there is no any concrete study related with the
use of derivatives by the MSMEs .Given the importance of MSMEs in economy and
inevitable role of derivatives in the business present study aims to explore the role of
derivatives in the business of MSMEs in India and would try to find out the problems and
prospects associated with the derivative business (financial + commodity) of MSMEs to
get the better insite about it.

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REVIEW OF LITERATURE:

There are plenty of literatures available on the various aspects of derivatives and their
uses by financial institution and by the corporates, but MSME sector till now is to some
extent neglected. There are no specific and concrete studies on the use of derivatives by
the Micro Small and Medium Enterprises in India. Some useful literature/studies are
discussed here-
1: Marston, Richard C., discusses in their paper, 1995 Wharton survey of derivatives
usage by US non-financial firms discusses the use of derivatives by US non-financial
firms in which one of the primary objectives of the survey is the development of a
database on risk management practices suitable for academic research.Study touches
various aspects of derivative uses which includes subjects like Derivatives Usage by Size
and Industry, Use of Derivatives in Risk Management, Objectives of Derivatives Use in Risk
Management, Concerns about Derivatives Usage, Foreign Exchange Exposure Management,
Impact of a Market View on Foreign Currency Derivatives Use, Market Risk Assessment,
Impact of Accounting Issues on Derivatives Use, Non-Use of Derivatives among others.
Concluding remark of study includes-‘Derivatives usage among non-financial firms
appears to be a fact of modern financial life. Despite the derivatives "train wrecks" of
1994, the evidence suggests that the percentage of firms using derivatives has not
dropped off from 1994 levels. Currently less than half of all non-financial firms use
derivatives, although usage is tilted heavily towards larger firms in the commodity and
manufacturing sectors.’
2: Henk Berkman, Michael E. Bradbury, 1996 in his paper Empirical evidence on the
corporate use of derivatives studies the derivatives uses by corporates in New Zealand.
Theory indicates that hedging can increase firm value by reducing expected taxes,
expected costs of financial distress, and other agency costs. Prior research, based on
survey data, has found only weak evidence consistent with theory. This study provides
evidence on the corporate use of derivative instruments from the 1994 audited financial
statements of 116 firms. Researchers use the fair and contract values scaled by the market
value of each firm to measure the extent of derivatives usage. Data were collected from
audited financial statements. Study find that derivative use increases with leverage, size,
the existence of tax losses, the proportion of shares held by directors, and the payout
ratio. The corporate use of derivatives decreases with interest coverage and liquidity.
Only when we use fair value as the measure of hedging activity, do we find support for
the hypothesis that derivative use is positively related to the value of a firm’s growth
options.
3: Danijela MILOŠ SPRČIĆ, Ph.D., in paper ‘The use of Derivatives as Financial Risk
Management Instruments: The case of Croation and Slovenian Non –Financial
Companies’, analyses financial risk management practices and derivative usage in large
Croatian and Slovenian non-financial companies and explores if the decision to use
derivatives as risk management instruments in the analysed companies is a function of
several firm’s characteristics that have been proven as relevant in making financial risk
management decisions. On the basis of the research results it can be concluded that

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forwards and swaps are by far the most important derivative instruments in both
countries.
4: Asani Sarkar, 2006 in Indian Derivative Markets, talks about the rise of derivatives,
definition and uses of derivatives, development of derivative markets in India, derivatives
instruments traded in India and derivative users. He further states that in terms of the
growth of derivatives markets, and the variety of derivatives users, the Indian market has
equalled or exceeded many other regional markets.13 While the growth is being
spearheaded mainly by retail investors, private sector institutions and large corporations,
smaller companies and state-owned institutions are gradually getting into the act. Foreign
brokers such as JP Morgan Chase are boosting their presence in India in reaction to the
growth in derivatives. The variety of derivatives instruments available for trading is also
expanding.
5: Rajendra P. Chitale in Use of Derivatives by India’s Institutional Investors: Issues
and Impediments after discussing various issues related with the financial and commodity
derivatives, he concludes that derivative markets in equities, fixed income, and
foreign currency are at their nascent stage of evolution in India, but have significant
growth potential. For this potential to be realized, as discussed in the sections of paper he
suggests the issues or impediments would have to be overcome and resolved
which touches various regulatory and technological and talent related issues.
6: Neeraj Gambhir and Manoj Goel, (2003) in his paper Foreign
Exchange Derivatives Market in India - Status and Prospects, states
that The Indian forex derivatives market is still in a nascent stage of
development but offers tremendous growth potential. The
development of a vibrant forex derivatives market in India would
critically depend on the growth in the underlying spot/forward markets,
growth in the rupee derivative markets along with the evolution of a
supporting regulatory structure. Factors such as market liquidity,
investor behavior, regulatory structure and tax laws will have a heavy
bearing on the behavior of market variables in this market. Increasing
convertibility on the rupee and regulatory impetus for new products
should see a host of innovative products and structures, tailored to
business needs. The possibilities are many and include INR options,
currency futures, exotic options, rupee forward rate agreements, both
rupee and cross currency swaptions, as well as structures composed of
the above to address business needs as well as create real options. A
further development in the derivatives market could also see
derivative products linked to commodities, weather, etc which would
add great value in an economy where a substantial section is still
agrarian and dependent on the vagaries of the monsoon.
7: Susan Thomas in his article The Jaggery Futures Market at
Muzaffarnagar: Status and Policy Recommendations he states about
the importance of commodity futures and further concludes that
Commodities futures markets are strength of Indian agriculture that
has been neglected over the last four decades. While the importance
of agriculture has been dropping in the Indian economy, it still forms a
significantly large part in relation to other economic sectors, that focus

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and attention in this area can achieve a considerable impact on the
growth of the country.
8: Narender L. Ahuja, 2006, in his paper Commodity Derivatives
Market in India: Development, Regulation and Future Prospects says
that Since 2002, the commodities futures market in India has experienced an
unprecedented boom in terms of the number of modern exchanges, number of
commodities allowed for derivatives trading as well as the value of futures trading in
commodities. However, there are several impediments to be overcome and issues to be
decided for sustainable development of the market. This paper attempts to answer
questions such as thee importance and the sustainability of the commodity derivative
markets in India.
9: The Economic Times India MSME summit, 13thFeb 2009, talks about the various issues
faced by the MSMEs in India like Payments Delay, Protectionism through Tariff and
non-tariff barriers, Government/ Public Procurement, Impediments in Exports, Exports
through MSMEs, Working Capital shortages, Commodity Crash, Access to funds for new
projects/ start-ups, Interest Rates and service charges, Losses due to Exotic Forex
Derivatives and Forward Contracts, taxation, environmental concerns and other related
issues, and suggests various measures to overcome or reduce the burden of MSMEs to
help them to prosper.
THE NEED OF DERIVATIVES MARKET:
The derivatives market performs a number of economic functions:
1. They help in transferring risks from risk adverse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk adverse
people in greater numbers
5. They increase savings and investment in the long run.

ECONOMIC FUNCTION OF THE DERIVATIVE MARKET

In spite of the fear and criticism with which the derivative markets are commonly looked
at, these markets perform a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market participants

about the future and lead the prices of underlying to the perceived future level. The prices
of derivatives converge with the prices of the underlying at the expiration of the
derivative contract. Thus derivatives help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have them but may not
like them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets.
With the introduction of derivatives, the underlying market witnesses’ higher trade
volumes because of participation by more players who would not otherwise participate
for lack of an arrangement to transfer risk.

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4. Speculative trades shift to a more controlled environment of derivatives market. In the
absence of an organized derivatives market, speculators trade in the underlying cash
markets. Margining, monitoring and surveillance of the activities of various participants
become extremely difficult in these kinds of mixed markets.

5. An important incidental benefit that flows from derivatives trading is that it acts as a
catalyst for new entrepreneurial activity. The derivatives have a history of attracting
many bright, creative, well-educated people with an entrepreneurial attitude. They often
energize others to create new businesses, new products and new employment
opportunities, the benefit of which are immense. In a nut shell, derivatives markets help
increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity.
RESEARCH METHODOLOGY:

Objectives of the study-The primary and secondary objectives of the study are discussed
as under-
Primary objective:
1: To study the current situation of derivatives uses by the Micro Small and Medium
Enterprises in India.
2: To find out the role of derivatives in the growth of MSMEs.
Secondary objective:
1: To find out the best practices in the use of derivatives among MSMEs.
2: To study the objective of the use of derivatives by MSMEs.
3: To study the role of derivatives in hedging practices of MSMEs.
4: To find out the problem and prospects of derivative uses by MSMEs in India.
5: To help the MSMEs in their decision making process regarding the use of derivatives
based on the research findings.
6: To help the various regulatory authorities while drafting the policies regarding the
derivative uses by the MSMEs in India.

Research Design: The research design is exploratory till identification of current status of the
derivative uses by MSMEs. Later it becomes descriptive when it comes to the evaluation of the
role of derivatives in the growth of MSMEs.

Research Sample: The sample would be taken from various different MSMEs from the
different parts of the country to provide a large scope to the study.

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COURSE WORK:

1: Seminar attended-

International Conference on Strategic Management of Energy, Environment &

Disaster for Sustainable Development, (11-15 January 2010) in Banaras Hindu University.

2: QIP (Quality Improvement Programme) Attended:-

1. “Micro Finance: Issues and Perspective” organized by Faculty of Management

Studies, B.H.U. Varanasi, 28 December 2009 to 2 Jan 2010.

2. "Corporate Social Responsibility" organized by Faculty of Management

Studies, B.H.U. Varanasi, 11-16 January 2010.

3. “Creating Value through innovations” organized by Faculty of Management

Studies, B.H.U. Varanasi, 25-30 January 2010.

4. “Effectiveness in Teaching through Ethics & Soft Skills” organized by Faculty

of Management Studies, B.H.U. Varanasi, 1-6 February 2010.

5. "Re-engineering in financial Markets" organized by Faculty of Management

Studies, B.H.U. Varanasi,8-13 February 2010.

6. “Value Chain Analysis” organized by Faculty of Management Studies, B.H.U.

Varanasi, 8-13 February 2010.

7. "Research Methods in Management" organized by Faculty of Management

Studies, B.H.U. Varanasi, 15-20 February 2010.

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 8. "Women Studies in Management education" organized by Faculty of
Management Studies, B.H.U. Varanasi, 22-27 February 2010.

3: Books Read-
1: A Mathetnatician Plays the Stock Market by John Allen Paulos Published by
Basic Books (2003).

2: The Ascent of Money; A Financial History of the World by Niall Ferguson

(Penguin Press; 2008)

REFERANCES:
Books-
1: Mistry Percy S., (Preface & Overview), Derivatives Markets in India (2002)
2: Gregoriou Greg N., (2007), Advances in Risk Management, PALGRAVE
MACMILLAN publication, New Yark.
3: Chandra Prasanna , Security Analysis and Portfolio Management(2008), Tata Mcgraw
Hills publication, New Delhi.
4: Hull John C., Options Futures and Other Derivatives, 6e, Prentice Hall of India Pvt.
Ltd., New Delhi.
5: Parmeshwaran Sunil K., Futures and Options-Concept and Application, Tata Mcgraw
Hills publication, New Delhi.
Articles & Research Papers-
1: Marston, Richard C., 1995 Wharton survey of derivatives usage by US non-financial
firms, Financial Management, 1996, page no 1-5.
2: Henk Berkman, Michael E. Bradbury, Empirical evidence on the corporate use of
derivatives, Financial Management (Financial Management Association), Summer,
1996,page no.1-3.
3: Asani Sarkar, Kaushik Basu, INDIAN DERIVATIVES MARKETS, Oxford
University Press, New Delhi,2006, page no. 5-10.
4: Susan Thomas and Ajay Shah, Equity derivatives in India: The state of the art, page
no.1-2, 8.
5: Susan Thomas, The Jaggery Futures Market at Muzaffarnagar: Status and Policy
Recommendations, page no.1-5, 18.
6: Neeraj Gambhir and Manoj Goel, Foreign Exchange Derivatives Market in India -
Status and Prospects, page no 207-219.
7: Rajendra P. Chitale, Use of Derivatives by India’s Institutional Investors: Issues and
Impediments, page no. 264-275.
8: Neeraj Gambhir and Manoj Goel, Foreign Exchange Derivatives Market in India -
Status and Prospects, page no.206-215.
9: S.M. Lokare, Commodity Derivatives and Price Risk Management: An Empirical
Anecdote from India, Reserve Bank of India Occasional Papers Vol. 28, No. 2, Monsoon
2007, page no.27-38.

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10: Narender L. Ahuja, Commodity Derivatives Market in India: Development,
Regulation and Future Prospects, International Research Journal of Finance and
Economics,2006,page no.153-160.
11: Percy S. Mistry, Derivatives Markets in India (2002), Preface & Overview.
12:T.S.Jagadharini & Raghavan Putran, Issues Before A National Multi
Commodity Exchange,page no.2-5.

Signature of supervisor: Research scholar

Dr. P.V. Rajeev Ram Mohan Mishra

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