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.

DECLERATION
I, Mr. ABHISHEK MEVAFAROSH hereby declare that student of master 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.

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 generally occur from either borrowing short term to fund long-term assets or borrowing long

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,

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

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.

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 deviating erratically 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 exchangetraded 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.

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.

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 quartercentury 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.

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 long position 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

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 to permit 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 delta hedge 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 sovereign securities 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 OTC derivatives segment, the average daily turnover of interest rate and non-traditional

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-toback 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.

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 funds are not construed by SEBI as derivatives transactions covered by the restrictive

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 basis risk, 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:-

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 1. State Bank of India 2. ICICI Bank 3. Citibank 4. HSBC 5. Bank of America 6. General Insurance Corpn. 7. Reserve Bank of India, Department of Banking Supervision

Name of the Officer / Designation Shri A. Ghosh, General Manager, Credit Policy and Procedures Department Ms. Vishakha Mulye, Joint General Manager Shri Ravi Savur, Vice President Shri Anand Krishnamurthy, Deputy Head Interest Rates Shri Joydeep Sengupta, Vice President Head Derivative Advisory Smt. M.M. Parkhi, Manager Shri Amrendra Mohan, General Manager

8. Reserve Bank of India, Exchange Control Department 9. Reserve Bank of India, Industrial & Export Credit Department 10. Reserve Bank of India, Department of Banking Operations & Development

Shri R.N. Kar, Deputy General Manager Ms. Rose Mary Sebastian, General Manager Shri B. Mahapatra, General Manager (Convenor)

Establishment years of derivatives product

1874 1972 1973 1975 1981 1982 Commodity Futures Foreign currency futures Equity options T-bond futures Currency swaps Interest rate swaps; T-note futures; Eurodollar futures; Equity index futures; Options on T-bond futures; Exchange{listed currency options Options on equity index; Options on T-note futures; Options on currency futures; Options on equity index futures; Interest rates caps and oors Eurodollar options; Swaptions OTC compound options; OTC average options Futures on interest rate swaps; Quanto options Equity index swaps Di_erential swaps Captions; Exchange-listed FLEX options Credit default options

1983

1985 1987 1989 1990 1991 1993 1994

Analysis
This 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,

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 nonaccrual 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

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

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.

References 1 Indian Financial System B bharti pathak PEARSON EDUCAION 2nd edition 2 3 4 5 http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=18465
www.iwu.edu/economics/PPE07/katie.pdf citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.121.886&rep. www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdf