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Derivatives in An Emerging Market: A Study of Thailand: Jyoti P Gupta, I M Pandey and Tippawan Pinvanichkul
Derivatives in An Emerging Market: A Study of Thailand: Jyoti P Gupta, I M Pandey and Tippawan Pinvanichkul
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Journal of Foreign Exdiange and International Finance
II. Need for Derivative Market in of speed of contract execution and liquidity,
Thailand it will no longer serve the purpose efficiently
with the tremendous demand for
An emerging market simply reflects the derivatives.
pace of the economic development of a Although it is not possible to measure the
country. It is a key instrument to mobilise volume of demand exactly, our survey
the capital which is the driving force for the results show that there is a significant
country's economic development. The demand for futures and options trading for
following factors contribute to the need for the following reasons:
the development of the financial market in Firstly, among the leading commercial
Thailand. corporations, there is a high proportion of
Firstly, there is a pressure from the global activities in foreign currencies (e.g., foreign
and regional economic corporations such as currency debt, income and expenses
General Agreement on Tariff and Trade
(GATT), Asian Trade Agreement (AFTA)
included in their financial statements).
These corporations are not only exposed to
I
etc. These bring the closer integration of the volatility of foreign exchange rate but
country's financial market with the world also to interest rate fluctuations. Almost all
market. of them (93 per cent) do hedge their position
Secondly, the rapid modernisation of by using derivatives instruments such as
technology has made the country's financial forward contracts, interest rate swaps,
and trading conditions more compatible currency swaps, currency or interest rate
with external conditions. option, cap, collar and floor. The size or
Thirdly, the recent relative high growth volume of the contract varies from baht 10
rate of the country's economy which is million to baht 200 million per month. Some
expected to be sustained in future of them have not entered into the derivative
accentuates the need for investment. With a activities due to management policy of the
high growth rate, Thailand is one of the company. There is high potential for them
Asian emerging markets that provides to involve in derivative activities in the
much higher spectacular return (Kuczynski, future.
1994). This interest in investment may affect Secondly, as Thailand's capital market is
the market to be more costly and volatile. rapidly growing, discussions with portfolio
Fourthly, making baht a regional managers of security houses, mutual funds
currency induces a higher priority for the and other financial firms indicated that most
government to develop the financial of them are looking for the derivative
derivative market in Thailand. The country instruments like stock index options and
will enjoy some benefits if the baht is made individual stock options to improve and
a regional currency. As a result, there may facilitate the portfolio management. Several
be impacts on the movements of domestic investors had used futures and options
interest rate and the effectiveness of traded on the other exchanges abroad to
exchange rate policy of the country. hedge against the Stock Exchange of
Once introduced, the volume of Thailand (SET). However, this is not
derivative activities will significantly possible now as they are prohibited to invest
increase due to fast economic development in futures market.
and financial liberalisation. More Thirdly, discussions with some bankers
involvement in a derivative market can be who are the major derivatives traders
expected with the increased awareness (almost all foreign bank branches) show that
among public and private sectors towards the derivative tradings are about US $ 10
the necessity and benefits of, such market. million to US $ 200 million per day. These
As the present OTC market is weak in terms banks enroll either as dealers or
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Derivatives in an Emerging Market: A Study of Thailand
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Journal of Foreign Exchange and International Finance
50 per cent retail and 50 per cent the availability of a short selling
institutional. mechanism; and
In the Thai stock market, the major group the joint availability of stock index
of hedgers are mutual funds, pension funds futures and stock index options.
and insurance companies. But these
investing groups are still small compared to There is also another measure to
the individual investors who speculate in determine the potential for developing
the stock market. Figure 1 illustrates the derivatives market in a given financial
volume of transactions by groups of centre. This is known as "the derivatives
investors in the SET in July 1994. liquidity ratio (DLR)" and defined as the
In addition to the above factors, the ratio between the national value of traded
following macro-economic factors can be equity index derivatives and the cash
used to determine the readiness for the market turnover in a given year. This
creation of equity derivatives: indicator indicates that liquidity of the
derivatives market is a measure for its
- Capitalisation of the underlying cash success. Research has shown that a DLR
market before launching derivatives equal to 1 appears to be an important
trading. It was suggested by the dividing point. Markets have shown a
interviewees, viz., the potential tendency to remain consistently either
operators and market makers that a above or below 1 (OECD, 1994). At the
volume of around $ 20 billion appears to moment it is impossible to apply this
be a critical mass in the case of Thailand. criterion to Thailand but it may be useful in
- The turnover on the cash market, the future.
defined as the annual average over the In practice, a DLR higher than 1 does not
three years prior to launch. A 20 per always mean that the local derivatives
cent of market capitalisation appears to market is successful. The long delay in
be the breaking point. information dissemination can reduce the
A positive growth of the ratio between level of transparency which will not always
market capitalisation and GDP, which indicate a negative factor. For example, the
indicates that more and more assets are long delay in information dissemination of
equitised. This may be seen as an the London Stock Exchange has the
indication of greater risk awareness and advantage of attracting large block trading
management capability. to London. (OECD, 1994).
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Journal of Foreign Exchange and International Finance
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Derivatives in an Emerging Market: A Study ofTliailand
restrictions neither support nor promote the developed for a long time, derivatives
exchange. They are: instruments remain relatively unfamiliar to
- There are some limitations on the capital the general public and not properly
outflows of commercial banks and understood even by some segments of the
finance companies in Thailand. This financial community. The knowledge on
prevents them taking full advantage of derivative products and their use is lacking
the international market. in Thailand and which may cause to- hinder
The artificially regulated exchange rate the market development.
is another obstacle that may delay the The understanding of derivatives market
development of the exchange rate- by regulatory agencies needs to be
linked derivatives market. A considered. According to some reports,
prohibition of short-selling in the derivative markets can pose some specific
Stock Exchange is a major obstacle to the threats to the cash market and financial
introduction of individual stock futures system in countries where regulatory
and options. The availability of practices lag significantly behind
short-selling mechanism is one of the practitioners. For example, in Hong Kong
success factors for the creation of equity some types of financial institutions are
derivatives market. neither covered by bank regulators nor by
- Income tax laws are vague. There are security regulators. Similarly, regulatory
serious concerns about the stock option agencies that lack full understanding of
tax law among government and private derivative markets are likely to concentrate
sectors. The Revenue Department on probable harmful effects and risks rather
recently studied the ways to tax stock than the new value which such product can
options. The Government may lose tax bring.
revenue if the individual receivers enjoy As the understanding of the market
tax exemption when they sell the stocks mechanism is lacking in Thailand, the
of exercised options on the Exchange complex operations of the new market may
with no income tax. not be easy to grasp by its users. This may
- According to our survey, it was found prevent the efficient utilisation of the
that banks rarely sell the currency derivatives market.
option as the total amount of premium Customer-base is another important
before deducting any expense is criterion in the market participants related
subjected to tax (around 30 per cent). aspects, m Thailand, the foreign brokerage
firms are much more keen in dealing with
As far as the regulatory obstacles are financial derivatives than the local firms.
concerned, the sound and strong Therefore the brokerage firms which are
commitment of the government to relax or entering into the emerging markets may
remove these obstacles is another criterion help to stimulate the market development.
to determine the success of the market However, the size of the potential customer
operation. So far the government's attitude base will determine the foreign brokerage
towards the removal of these obstacles is firms' interest in entering into the emerging
quite strong. This may be another positive derivatives market.
factors for the introduction of derivatives
exchange in Thailand. Consequences of the Derivatives Market
Market Participants Related Aspects :
Among the other factors the traders' Generally, the purpose of the "exchange"
understanding of derivatives, activity is the is to provide an institutional framework as
most important. Even within the countries well as the place for the buyers and the
where derivatives markets have been sellers to meet and transact business without
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Journal of Foreign Exchange and International Finance
any default of trust and with financial By helping to solve costly contractual
integrity. However, an exchange brings to and informational problems.
the country both advantages and
disadvantages. Academic scholars have The economic efficiency gains from the
given various reasons for the recent growth use of derivatives are (Pyle, 1993):
in derivatives. The reason include (Pyle,
1993): Diverse functions as the enrichment - Lowering transaction costs
of securities of security firms; Regulatory Reducing agency costs
and tax avoidance; Economic efficiency - Helping to complete capital markets.
gains.
The household savings are channelised to
The discussion on the economic gains are the companies in the form of real investment
given by several economists and financial through the capital markets. The return on
experts. The exchange-based markets investments flows back to households for
provide valuable services and further investment or consumption. Capital
opportunities. Two well known economic markets help for households to select
functions of the exchange-based market are investments in accordance with the required
(Kilcollineffl/, 1993): risk - return profile and make funds
Price Discovery Function : Liquid markets available to the companies to carry out their
provide the economy with the valuable price operations. Derivatives help to strengthen
discovery function. Active trading provides this saving-investment link.
a constant reassessment of true market Derivatives, by enlarging the scope of
valuation of products. This mechanism thus investment and financing, could help in
provides the economy with an accurate and saving costs, enhancing returns and
up-to-date valuation of exchange traded reducing risks. They may also strengthen
products. the financial institutions by reinforcing
Transfer of Risk : Corporations can use existing operations of the clients and by
these markets to offset the risk of holding creating diversified credit portfolios (Group
assets or liabilities. Such risk is often of Thirty, 1993).
transferred to firms and individuals whose The futures and options market is
expertise and efforts are aimed at expected to contribute to Thailand in the
speculation. following ways:
- Enhancing the competitiveness of the
Other functions of exchange-based Thai economy. This market will
market are operational standardisation and provide a wide range of risk
liquidity and depth of the relative cash management tools; for example, the risk
market. Merton and Miller (1992) identified from currency, interest rate and price
three ways in which derivatives products volatility could be hedged or shifted by
improve economic performance: using derivatives instruments.
- Encouraging financial innovation for
- By meeting investors and issuer the Thai financial industry. The Thai
demands for new securities and other financial industry currently has been
financial products, expanding the most attractive to those who are
opportunities for risk-sharing, brilliant, creative and well educated.
risk-pooling, hedging and Together with the derivative activities,
inter-temporal or spatial transfers of new inventions in the form of new
resources. business, new products, or even new
- By lowering transaction costs or knowledge (e.g., mathematical model)
increasing the liquidity of the markets. would be possible to emerge.
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Derivatires in an Emerging Market: A Study ofTlutiland
- Providing the risk management tools to making the market more competitive and
the corporations and individuals. efficient. One of the government's most
Allowing corporations to improve their important actions towards this end is the
ability for assets and liability creation of financial reform policies. A
management at a lower cost. comprehensive financial reform plan should
- Enhancing the existing scope, encompass the following major areas
magnitude of services and bring new (Chodechai and Vachira, 1993) :
services to the business of banks and Deregulation and liberalisation; Improving
other financial institutions. supervision of the financial system;
- Acting as a income stabiliser. This may Development of financial instruments and
help to improve the Thai's saving status services; and Development of payment
and will reduce the country's reliance system.
on foreign capital. These policies if effectively implemented
will open the Thai financial market to the
The useful social functions of this market world market (free market). For example,
should also be considered. As stated by Cox the abolition of interest rate ceiling allows
and Rubinstein (1985), the market enables to the local interest rate to move more in line
allocate individual wealth, firm resources with the world interest rates. But this
and provide information. exposes the entrepreneurs to the interest rate
The most probable disadvantages of risk. However, financial deregulation will
derivative activities are the impacts on the increase the competition among banks and
cash market and the fear of high speculation. financial firms. As a result, these
Studies by OECD (1994) have shown the organisations will have to improve their
following impact of derivative activities on existing service lines and need to create new
the related cash market: businesses.
Trading in stock index futures, stock As discussed earlier, our survey has
options and warrants have an shown that there is high potential to
insignificant impact on the underlying introduce organised derivatives exchange in
cash marker volatility. Thailand in the near future. The
- The introduction of derivatives trading Government and private sector have shown
improves the informational efficiency of a strong commitment to remove or ease the
the underlying stocks. barriers (e.g. lack of professional ethics,
- The volatility of stocks and futures price good understanding of derivatives
do not significantly differ on expiration activities, market mechanisms, some
dates as compared to other dates. regulations which will not allow derivatives
- The greater the imperfection of the cash activity to be misused, etc.) which may
market, the more significant is the lead obstruct the operation of the derivatives
lag relationship observed between the exchange. However, according to the
futures market and the cash market. Securities' Exchange Commission and Bank
The efficiency of the cash market needs of Thailand, steps are being taken to
to be improved to make the two markets introduce this exchange by forming
move in tandem. If the markets lose regulations and processes and may be
efficiency, more speculation will occur. possible within two years time.
The Thai government has to play a major The products which may have more
role in order to encourage, promote and potential to be listed on the Thai exchange
support the private sector. This may lead to are equity-linked futures and options
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Journal of Foreign Exchange and International Finance
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Derivatives in an Emerging Market: A Study ofTliailanii
same and are generally used by almost all quickly amenable to the regulations. (Blank
exchanges. They are discussed below. efa/1991).
Market Independence: In an exchange, only In the case of options trading, most
futures or options or both futures and options exchanges in the world have market
options or in some cases, both derivatives makers to facilitate trading. This ensures
contracts and stocks are traded : liquidity since buying and selling orders can
- From the cost perspective, the aggregate always be executed at some price without
market would reduce the resources any delays.
required to develop and operate the
market. Regulatory Framework
From the human resources perspective,
at present human resources in the There is a controversy whether Thailand
financial industry, specifically in should have a single derivatives market
derivatives, are in short supply. A with both financial and commodity
single exchange may be adequate for the derivative products or not.
derivative tradings in Thailand. The "bipolar" regulatory structure which
- Liquidity is the most important criterion is used by many western countries has two
to operate a derivative exchange different agencies who are responsible for
efficiently. However, aggregate market regulation of commodity markets and
may dilute the demand and number of financial markets separately. Kilcollin and
trading transactions in each exchange. Frankel (1993) highlighted that this
As a result, number of transactions and structure may provide the same tension and
traders will not be adequate to achieve uncertainty as commodity futures and
market liquidity. options. It is evident that the growth of the
western markets have been hampered by
Trading System: The "open outcry trading uncertainty. The other rationales to support
system" has been proven to be exceedingly a single derivatives market are :
successful in promoting the market's
economic functions such as price discovery According to the past experience, many
and liquidity, transparency, etc., in the countries have suffered from the
developed markets. Open outcry relies on a regulatory measures such as
regulatory system where merchants agree to overlapping of rules and the
certain trading rules and their trades are bureaucratic system in multi-derivative
guaranteed by the clearing organisation. markets (for example, Japan and the
As many exchanges are now moving into USA)
the international tradings, the electronic Regulations are needed to be modified
trading system is out performing the open when the current regulations are not
outcry system. With the modern able to promote the efficiency of the
telecommunication and computer exchange. The dual regulatory agencies
technology, electronic trading system system will create the extra cost as well
allows the markets to increase their trading as the redundancy works.
time to 24 hours per day and expand their
tradings to the international market. Implementation
Computer technology offers the
opportunity to store large volumes of At present, it seems that the local financial
trading information as well as to improve industry is developing at a faster rate than
the ability to detect fraud. However, the the other industries (particularly the
potential abuse in electronic trading cannot manufacturing industry). As a result, the
be ruled out. This trading system is now gap of the growth between financial and
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Jaunui of Foreign Exchange and international Finance
other industries is becoming wider. products since there are always new
However, the development of derivatives products being introduced to the market.
exchange is one of tine government efforts to It may be impossible for the government
modernise and liberalise the country's to make complete regulations to control
financial market. The effective handling of the derivative market. It is also
financial market will in turn support the necessary to introduce regulations
country's manufacturing and trading to control the unscrupulous traders.
domain. Therefore it is clear that there This is essential to build the
should be a balanced development between confidence of operators and derive the
financial and other industries to support the desired objectives of the derivatives
country's economy in a meaningful way. market.
On the other hand, there is also a gap In addition to the regulations, the
between country's savings and investments. professional ethics of the market players
It appears that the Government does not and other parries should also be
encourage saving as it charges a tax of 15 per developed. The factors such as the
cent on saving. Since the existing understanding of different kinds of
saving/investment gap is large, the derivatives, their operations, operation
Government has to rely on foreign capital of the market mechanism and the
inflows to cover the huge public and private recognition -of risks in utilising
investment needs. It was revealed that these derivatives will determine the efficiency
capital inflows are of short-term nature and of the regularity.
carry the pressure on the economy as there Sound internal control system needs to
is a risk of quick reversals. This may be introduced.. The internal control
increase the risk of volatility and hinder the system of derivative traders (especially
operation of derivatives market. Even dealers) should be improved in order to
though derivatives are used to hedge the control or limit losses that may occur to
risk, there is no way to eliminate them the firms. One good example of losses
completely. resulted from the weak internal control
is the case of Barings pk. Among the
V. Conclusions other currency-linked contracts the
baht/DM and baht/yen currency
The following recommendations are contracts should be listed first in the
made based on a study of the existing market.
derivatives markets in the developed A single exchange is more suitable to the
countries and our survey regarding the local conditions as the separate markets
potential for the development of a cannot be justified on the ground of
derivatives exchange in Thailand.. They efficiency at the initial stage of operations.
may also be found relevant in the context of The futures and options exchange in
other emerging markets in Asia: Thailand may operate with open outcry
trading system and the market maker
- Regulators must play an effective role in system can be utilised to ensrire the
many areas (e.g., establish the standard market liquidity.
of the traders, promote transparency of A single regulatory agency should be
these markets, introduce measures such preferred.
as circuit breakers, higher margin The organised exchange should be
requirements, approval of new product introduced when the gaps between
innovation, etc.). So far, no one knows growth of finance and other industries
exactly the size of the derivative market and saving and investment have
and number of existing derivative reduced to a significant level.
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Derivatives in an Emerging Market: A Study of Tltailand
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