Sri Lanka mulls introducing derivatives contracts

Oct 16, 2007 (LBO) – Sri Lanka’s financial sector has been advised to exercise caution in launching derivatives which are yet new instruments in the island. Derivatives are useful financial instruments that help manage risks and give depth to financial markets, Indian experts said.

But designing and launching derivatives instruments can be tricky and two-thirds of launches the world over fail, said Ajay Shah, Senior Fellow, National Institute for Public Finance and Policy, New Delhi and a former consultant to Indian’s finance ministry.

He advised the financial sector to prepare thoroughly by building the systems and departments and training people before launching new instruments.

“The tragedy is that financial firms do not prepare enough, so they are not ready at the launch and then the contract dies,” said Shah.

Derivatives provide a valuable economic function, he told a meeting on the new financial instruments organized by the Colombo Stock Exchange.

The derivatives market has taken off in a big way in India with the trading volumes being five to 10 times that of the spot market, Susan Thomas, a former visiting scholar at the Indian School of Business and consultant to the Rand Corporation, told the meeting.

“But derivative do not have a life without the spot market,” she said. “It is like a giant system of side bets on economic and financial outcomes.”

Derivatives markets provide price certainty to producers irrespective of what the actual price for their product may at a future date

Instruments like options give even more flexibility allowing investors the freedom to decide whether or not to exercise the option depending on the prevailing price, Thomas said.

For farmers, it helps to remove all uncertainty about future earnings.

Derivatives prices are a good indication of the future price of physicals commodities, Thomas said.

Derivatives are used for hedging, speculation or arbitrage, she said, adding that “if finance is the brain of the economy, derivatives are the brain of finance.”

Hedging helps producers protect themselves against price fluctuations, Thomas said.

But she also warned that investors engaged in speculation could make or lose money.

Thomas acknowledged that there were concerns about the nature of the new instruments.

“Yes, it is gambling. But it is not only gambling because it performs an economic function.”

This was the hard work on researching the markets and prices – the economic function of analysis and information dissemination.

She said concerns about the speculative nature of the instruments were over-played.

“There’s no need to make a fuss about the difference between a hedger and a speculator, because the economic activity is the same – speculation.”

Counter-party credit risk was a concern in derivatives markets and forwards markets had failed in the past because of default and regulators were concerned this could create a domino effect, affecting other sectors.

But settlement systems of derivatives exchanges had largely eliminated this risk. .