INTRODUCTION
Current problem statement
In the late 20th century, a significant trend in financial innovation led to the rapid growth of the global derivatives market, which has become essential to the development of both the global financial and stock markets Despite economic volatility, the derivatives market continues to thrive in both exchange-traded and over-the-counter segments, primarily due to the effectiveness of derivatives as risk hedging instruments that enable market participants to mitigate potential losses from market fluctuations.
Vietnam has a long history of using derivatives related to commodities and currencies, driven by investors' need for protection against fluctuations in asset prices, such as rice and coffee Despite 15 years of operation, the Vietnamese stock market lacks diversity, primarily offering common stocks and a limited number of investment fund certificates To address this gap and fulfill the demand for risk management amid market volatility, the establishment of a derivatives market in Vietnam is crucial In 2014, Prime Minister Nguyen Tan Dung approved a project to develop a centralized and regulated derivatives market, moving away from a spontaneous market structure Subsequently, the government issued Decree No 42/2015/NĐ-CP and the Ministry of Finance launched Circular 11 in January 2016, providing a legal framework for the establishment of Vietnam's first derivatives market.
The derivatives market is quite new to Vietnam, so it is undeniable that developing a State-controlled centralized derivatives market following international technical
The establishment of standards for Vietnam's derivatives market presents both opportunities and challenges that necessitate thorough research into market development conditions As Vietnam prepares to operate its derivatives market in 2016, it is essential to outline strategies for its growth alongside the stock market up to 2020 Understanding the opportunities and challenges in creating a formal derivatives market is crucial, and Vietnam can benefit from the successful experiences of regional leaders such as Japan, China, and Singapore in this field.
Objective and research questions
This study aims to explore various types of derivatives instruments, focusing on their characteristics, roles, and trading markets, while examining the features of the derivatives market and its participants It is crucial to analyze the development of the global derivatives market and the current state of derivatives usage in Vietnam, comparing it with other countries The primary objective is to provide a comprehensive overview of the potential and challenges in developing Vietnam's derivatives market for authorities, securities companies, and market participants Ultimately, the thesis seeks to offer recommendations to address existing issues in the market.
The thesis should be able to answer the following questions:
What are the features and roles of derivatives?
What is the derivatives market development roadmap in Vietnam?
What conditions do the market participants need to enter into the market?
What opportunities and challenges for authorities and market participants?
What can Vietnam learn from other countries’ experiences?
What should be done to deal with the problem?
This research focuses on the global derivatives market and the development of the derivatives market in Vietnam, while also examining the operations of derivatives markets in several Asian countries However, due to time constraints and limited knowledge, the study does not offer a comprehensive analysis of all related aspects.
The thesis primarily relies on secondary sources, including published books, articles, expert discussions, online content, previous research, and various media outlets Additionally, it incorporates data from the World Federation of Exchanges' annual report and the Bank for International Settlements statistics This information is instrumental in analyzing the current state of Vietnam's financial derivatives market in comparison to regional counterparts, ultimately providing valuable international insights for Vietnam.
2.1 An overview of derivative securities
2.1.1 A brief history of derivatives and derivatives markets
The derivatives were derived from medieval times to meet a demand for insuring agricultural products’ prices
The history of derivatives provides evidence that an option-type agreement known as a precursor of an options contract was launched around the 6th century B.C
The first official exchange for trading contracts as forward delivery, the Royal
Exchange (which later became the London Commodity Exchange), was formed in
In 1570, a significant hub for metal traders emerged, paving the way for organized trading The late 17th century saw the establishment of a formal futures exchange in Japan's rice markets This concept evolved further with the founding of the Chicago Board of Trade (CBOT) in 1848, which aimed to connect farmers and merchants Additionally, the first forward contract in the United States marked a pivotal moment in the development of trading practices.
1851 After that, the New York Cotton Exchange and the New York Coffee Exchange were set up in 1870 and in 1885, respectively
The development of modern derivatives markets
The Chicago Mercantile Exchange (CME) initiated the trading of the first futures contracts in 1972, marking a significant development in financial markets Similarly, options have gained immense popularity, with the Chicago Board Options Exchange (CBOE) launching call option contracts on 16 stocks in 1973, soon followed by the introduction of put option contracts.
1977 The first swap agreements were executed by the Salomon Brothers in London in
1986, while equity derivatives based on underlying stock indices began to emerge in the late 1980s In 2007, the CBOT and the CME merged to form the CME Group In
Tran Thi Giang 5 15A7510048 recent years, the derivative instruments based on a wide range of underlying assets have been traded globally
“The Oxford dictionary defines a derivative as something derived or obtained from another, coming from a source; not original” ( Michael Chui, “Derivatives markets, products and participants: an overview”)
In financial economics, a derivative is a financial instrument whose value is derived from underlying assets For instance, a stock option is a type of derivative that relies on the price of a specific stock.
Underlying assets are categorized into two primary types: real assets and financial assets Real assets encompass commodities such as food, agricultural products, precious and industrial metals, and energy products, including pork bellies, live cattle, sugar, wool, lumber, copper, aluminum, gold, and tin In contrast, financial assets consist of stock indices, equity derivatives, Treasury bonds, foreign currencies, exchange rates, debt instruments, interest rates, and other derivative securities The values of derivative contracts can fluctuate based on the performance of the underlying assets.
A derivatives market is the financial market which trades derivatives like futures contracts or options, forwards or swaps, which are derived from other forms of assets
The market can be divided into two segments, including exchange-traded market (ETD) or the on-exchange segment and over-the-counter market (OTC) or the off- exchange segment
+) Characteristics of the derivatives markets may be listed as follows:
First, trading value in the derivatives markets is very huge
Second, the derivatives markets are so flexible compared with other ones
Third, the derivatives instruments are diverse on the market (Types of Derivatives)
Fourth, the derivatives markets are affected by fluctuation in commodities’ market prices because the derivatives contracts’ value depends on the original assets’ prices in the market
The derivatives markets draw a diverse range of traders, including banks, investment firms, insurance companies, and corporations, due to the significant roles that derivative products play in financial strategies.
+) Classification of the derivatives markets
The below table gives comparison between ETD market and OTC market, two parts of the derivatives markets
Table 2.1 Exchange-traded versus Over-the-counter (OTC) Market
Exchange Traded Market Over – the – counter Market
- ETD market is a physical place traders implement standardized contracts determined by derivatives exchanges
- Removing counterparty risk, trade obligations guaranteed =>safer place for individuals to trade
- Both parties have to do their transactions through a clearing house, register to participate and have a maintenance margin in their account
- High transaction cost due to the exchange fees and commissions
- Trading volume and market price is very visible and transparent
- OTC market is a less formal market which traders do their transactions through Internet, telephone, network…
- There is no barrier to enter into the market
=> Easier for fraudulent firms to enter, both parties face with counterparty risk
- Only the two market participants directly observe the quotes or execution
=> bilateral trading Financial institutions usually pay a role as market makers so that financial instruments are transacted easily
- Lower transaction cost compared to Exchange market
- Trading volume and market price is not transparent
- Heavy price competition, transactions are completely determined by the market
Derivatives can be used for some purposes.
Derivatives primarily serve as a tool for risk management, particularly in reducing risk through a process known as hedging, which protects against price fluctuations of underlying assets While derivatives cannot entirely eliminate risk, they enable traders and investors to make strategic investments that can offset potential losses from other investments.
Corporations and financial institutions utilize derivatives as a strategic tool to hedge against fluctuations in raw material prices, exchange rates, and interest rates These derivative products act as a form of insurance against unfavorable price movements, helping to stabilize cash flow volatility This stabilization leads to more accurate forecasting, reduced capital requirements, and enhanced capital productivity Consequently, a significant number of companies globally are adopting derivatives to effectively manage their price risks.
Hedging involves the simultaneous buying and selling of two comparable assets, anticipating profits from their differing price movements over time Typically, these assets share all characteristics except for their maturity dates.
Second, several marketparticipants could enter into a derivative contract with the aim of seeking profits from speculation and arbitrage
“Arbitrage is the simultaneous purchase and sale of equivalent assets at prices which guarantee a fixed profit at the time of the transactions”
“ Speculation is the purchase or sale of an asset in the expectation of a gain from changes in the price of that asset”.
Some individuals and institutions exploit price fluctuations in underlying assets to achieve short-term profits, often without the intention of engaging in direct asset transactions For instance, speculators enter derivative contracts to purchase an asset at a predetermined low price, allowing them to sell it immediately in the market for profit when future prices rise.
The derivatives market offers a high degree of financial leverage, allowing speculators to achieve significant profits from minimal initial investments; however, this potential for high returns is accompanied by a correspondingly high level of risk.
Leverage refers to the ability of a small change in the underlying asset's value to significantly impact the value of a derivative Financial leverage indicates the extent to which a company utilizes fixed-income securities like debt and preferred equity; greater reliance on debt financing results in higher financial leverage However, elevated financial leverage leads to increased interest payments, which can adversely affect the company's earnings per share.
Arbitrage opportunities arise when similar assets are priced differently, allowing investors to capitalize on these discrepancies for risk-free profits By selling an asset in an overpriced market while simultaneously purchasing it in a cheaper market, investors can limit their initial investment This practice leads to an increase in the price of the cheaper asset and a decrease in the price of the more expensive one, continuing until market equilibrium is achieved.
In general, derivatives have some important features making them quite attractive to all institutions, investors and traders
Derivatives can be classified along three main dimensions
+) Based on types of derivatives and market place, derivatives can be traded bilaterally OTC (mostly individually customized contracts) or multilaterally on exchanges (standardized contracts)
LITERATURE REVIEW
2.1 An overview of derivative securities
2.1.1 A brief history of derivatives and derivatives markets
The derivatives were derived from medieval times to meet a demand for insuring agricultural products’ prices
The history of derivatives provides evidence that an option-type agreement known as a precursor of an options contract was launched around the 6th century B.C
The first official exchange for trading contracts as forward delivery, the Royal
Exchange (which later became the London Commodity Exchange), was formed in
In 1570, a significant gathering place for metal traders emerged, laying the groundwork for future trading practices The late 17th century saw the establishment of a formal futures exchange in Japan's rice markets This evolution continued with the founding of the Chicago Board of Trade (CBOT) in 1848, which aimed to connect farmers and merchants Notably, the first forward contract in the United States was also initiated during this period, marking a pivotal moment in the history of trading.
1851 After that, the New York Cotton Exchange and the New York Coffee Exchange were set up in 1870 and in 1885, respectively
The development of modern derivatives markets
In 1972, the Chicago Mercantile Exchange (CME) introduced the first futures contracts, marking a significant development in financial trading Following this trend, options gained immense popularity, with the Chicago Board Options Exchange (CBOE) launching call option contracts on 16 stocks in 1973, soon after introducing put option contracts.
1977 The first swap agreements were executed by the Salomon Brothers in London in
1986, while equity derivatives based on underlying stock indices began to emerge in the late 1980s In 2007, the CBOT and the CME merged to form the CME Group In
Tran Thi Giang 5 15A7510048 recent years, the derivative instruments based on a wide range of underlying assets have been traded globally
“The Oxford dictionary defines a derivative as something derived or obtained from another, coming from a source; not original” ( Michael Chui, “Derivatives markets, products and participants: an overview”)
In financial economics, a derivative is a financial instrument whose value is contingent upon the values of other assets, known as underlying assets For instance, a stock option is a type of derivative that derives its value from the price of a specific stock.
Underlying assets are categorized into two primary types: real assets and financial assets Real assets encompass commodities such as food, agricultural products, precious metals, industrial metals, and energy products, including pork bellies, live cattle, sugar, wool, lumber, copper, aluminum, gold, and tin In contrast, financial assets include a diverse range of instruments like stock indices, equity derivatives, Treasury bonds, foreign currencies, exchange rates, debt, interest rates, and various derivative securities The values of derivative contracts are subject to fluctuations based on the performance of their underlying assets.
A derivatives market is the financial market which trades derivatives like futures contracts or options, forwards or swaps, which are derived from other forms of assets
The market can be divided into two segments, including exchange-traded market (ETD) or the on-exchange segment and over-the-counter market (OTC) or the off- exchange segment
+) Characteristics of the derivatives markets may be listed as follows:
First, trading value in the derivatives markets is very huge
Second, the derivatives markets are so flexible compared with other ones
Third, the derivatives instruments are diverse on the market (Types of Derivatives)
Fourth, the derivatives markets are affected by fluctuation in commodities’ market prices because the derivatives contracts’ value depends on the original assets’ prices in the market
The derivatives markets attract a diverse range of traders, including banks, investment firms, insurance companies, and corporations, due to the significant roles that derivative products play in financial strategies.
+) Classification of the derivatives markets
The below table gives comparison between ETD market and OTC market, two parts of the derivatives markets
Table 2.1 Exchange-traded versus Over-the-counter (OTC) Market
Exchange Traded Market Over – the – counter Market
- ETD market is a physical place traders implement standardized contracts determined by derivatives exchanges
- Removing counterparty risk, trade obligations guaranteed =>safer place for individuals to trade
- Both parties have to do their transactions through a clearing house, register to participate and have a maintenance margin in their account
- High transaction cost due to the exchange fees and commissions
- Trading volume and market price is very visible and transparent
- OTC market is a less formal market which traders do their transactions through Internet, telephone, network…
- There is no barrier to enter into the market
=> Easier for fraudulent firms to enter, both parties face with counterparty risk
- Only the two market participants directly observe the quotes or execution
=> bilateral trading Financial institutions usually pay a role as market makers so that financial instruments are transacted easily
- Lower transaction cost compared to Exchange market
- Trading volume and market price is not transparent
- Heavy price competition, transactions are completely determined by the market
Derivatives can be used for some purposes.
Derivatives primarily serve the purpose of risk management, specifically in reducing risks associated with price fluctuations of underlying assets, a strategy often referred to as hedging While derivatives cannot completely eliminate risks, they enable traders and investors to make strategic investments that can offset potential losses from other investments.
Corporates and financial institutions utilize derivatives to hedge against fluctuations in raw material prices, exchange rates, and interest rates These derivative products act as a powerful insurance mechanism against undesirable price changes, helping to stabilize cash flows and enhance forecasting accuracy As a result, companies can lower their capital requirements and improve capital productivity Consequently, a significant number of businesses globally are adopting derivatives to effectively manage their price risks.
Hedging involves the concurrent buying and selling of two assets, anticipating profit from their differing future price movements Typically, these assets are similar in all aspects except for their maturity dates.
Second, several marketparticipants could enter into a derivative contract with the aim of seeking profits from speculation and arbitrage
“Arbitrage is the simultaneous purchase and sale of equivalent assets at prices which guarantee a fixed profit at the time of the transactions”
“ Speculation is the purchase or sale of an asset in the expectation of a gain from changes in the price of that asset”.
Some individuals and institutions may exploit price fluctuations of underlying assets for short-term gains, rather than engaging in actual asset transactions For instance, speculators enter into derivative contracts to purchase an asset at a lower future price, allowing them to sell it immediately in the market for a profit when the future market price rises.
The derivatives market offers a high degree of financial leverage, allowing speculators to achieve significant profits from minimal initial investments; however, this potential for high returns is accompanied by an equally high level of risk.
Leverage refers to the ability of a small change in the underlying asset's value to result in a significant impact on the derivative's value Financial leverage indicates the extent to which a company utilizes fixed-income securities, like debt and preferred equity Increased debt financing leads to higher financial leverage, resulting in elevated interest payments that can adversely affect the company's earnings per share.
Arbitrage opportunities arise when similar assets are priced differently, allowing investors to capitalize on these discrepancies for risk-free profits By selling an asset in an overpriced market while simultaneously purchasing it in a cheaper market, investors can limit their initial investment This activity tends to equalize prices, as the cheaper asset's price increases and the overpriced asset's price decreases, continuing until market equilibrium is achieved.
In general, derivatives have some important features making them quite attractive to all institutions, investors and traders
Derivatives can be classified along three main dimensions
+) Based on types of derivatives and market place, derivatives can be traded bilaterally OTC (mostly individually customized contracts) or multilaterally on exchanges (standardized contracts)
There are six primary types of derivatives based on their underlying assets: fixed-income derivatives, foreign exchange derivatives, credit risk derivatives, equity derivatives, equity indices derivatives, and commodities derivatives.
There are four primary types of financial derivatives: forwards, futures, options, and swaps Each of these instruments varies in its reliance on the price movements of the underlying asset.
Table 2.2: Examples of Common Derivatives
Exchange traded options OTC swap OTC forward OTC option
-Option on Eurodollar future -Option on Euribor future
-Interest rate cap and floor -Swaption -Basis swap
Bonds Bond future Option on Bond future n/a Repurchase agreement Bond option
Single-share option Equity swap Repurchase agreement
-Stock option -Warrant -Turbo warrant Foreign exchange FX future Option on FX future
Currency swap FX forward FX option
(Source: http://www.hedgefund-index.com/)
The thesis will take a first look at forward, futures, and options contracts in the next parts
A forward contract is a financial agreement between two parties to buy or sell an asset at a predetermined price on a specified future date This type of contract differs from a spot contract, which involves the immediate exchange of an asset at the current market price.
There are two parties engaged in a forward contract
RESEARCH METHODOLOGY AND DATA ANALYSIS
3.1 Overview of global derivatives markets in recent years
The global derivatives market is a vital component of the international financial system and economy, with the OTC derivatives market reaching approximately $493 trillion in notional amounts outstanding as of December 2015.
It is easy to notice that global derivatives trading volume has been increased over many years, consisting of trading volume on the OTC and ETD market
Figure 3.1: Global derivatives trading volume
Source: BIS (The Bank for International Settlements)
The line graph illustrates the size of the global derivatives market over the period of 6 years (1998-2004)
Overall, the trading volume on the derivatives market worldwide increased significantly during this period
There was a slight growth by around $10 trillion, from over $70 trillion in June
From 1998 to June 2001, the global OTC derivatives market surged to approximately $100 trillion, while the trading volume in the exchange-traded derivatives market remained relatively stable at around $20 trillion during the same timeframe.
The global OTC derivatives market experienced significant growth, doubling from 2001 to 2004 and reaching approximately $230 trillion In parallel, the global exchange-traded derivatives market also saw a steady increase, rising to around $60 trillion by June 2004.
The global derivatives market has shown significant growth over time, establishing itself as one of the most active markets worldwide.
World Bank definition: “Market capitalization (also known as market value) is the share price times the number of shares outstanding It is a measure of the size of
Tran Thi Giang 23 15A7510048 discusses the stock market in the country, highlighting its significance by reporting its size as a percentage of GDP This approach allows for an effective evaluation of the stock market's scale in relation to the overall economy.
The global stock market capitalization peaked at the end of economic development cycles, with notable highs of over $35 trillion in 2000 and $58.5 trillion in 2008 However, following these peaks, the market experienced a significant decline, with capitalization dropping to $27 trillion in 2009—more than half of the 2008 figure The stock market then began to recover post-global economic crisis, reaching $70.4 trillion at the start of 2015, although it saw a slight decrease of 1.3% by the end of that year, settling at $67 trillion.
In 2015, global Exchange Traded Derivatives (ETD) volumes surged by 11.6% compared to 2014, primarily driven by a rise in trading activity for commodity and currency derivatives.
(Source: CME Group, Unit: US$ billion – ETD derivatives revenue)
The bar graph illustrates the changes in exchange-traded derivatives turnover across various global regions from 2010 to 2015 Notably, there was significant growth in the global derivatives exchange value during this period Among the regions analyzed, North America consistently recorded the highest turnover in both years presented.
The ETD derivatives revenue in North America increased considerably from over
$5 billion to over $10 billion over the 5 recent years Especially, the figure for Asia in
By 2015, the exchange-traded derivatives market in Asia surged to over $7 billion, nearly five times its value in 2010, establishing the region as the second largest market globally, following North America.
Like a wise, there was a considerable rise in the revenue of ETD derivatives in both Latin America and Europe from 2010 to 2015 The figures were $3 billion and $4 billion, respectively in 2015
Between 2010 and 2015, the Asian market experienced significant growth in exchanged-traded derivatives revenue, establishing itself as the second-highest region globally for trading derivatives on exchanges.
Figure 3.4:Total volume of Derivatives on Global exchange-traded derivatives market
(Source: World Federation of Exchanges)
From 2012 to 2015, the line graph illustrates fluctuating trends in the trading volume of options and futures in the global exchange-traded derivatives market, showcasing both increases and decreases during this period.
In early 2012, the global ETD market saw approximately 900 million options traded, significantly surpassing the 300 million futures contracts By 2015, the number of futures traded had doubled compared to the previous figures, highlighting a notable shift in market dynamics.
2012 Thus, the futures contracts are increasingly traded widely around the world
Global OTC derivatives markets saw a considerable decline in both notional principal and gross market value over the period from 2013 to 2015
Source: BIS (The Bank for International Settlements)
Between June 2013 and June 2014, the notional amount of outstanding OTC derivatives contracts in US dollar terms remained steady at approximately $700 trillion However, this figure experienced a continuous decline until the end of 2015, dropping to below $500 trillion Exchange rate fluctuations further exacerbated the reduction of positions in currencies other than the US dollar during this period, indicating that the notional amount of countries' outstanding OTC derivatives contracts in 2015 was lower than in the previous year when converted to USD.
Source: BIS (The Bank for International Settlements)
The gross market value of outstanding derivatives contracts represents the cost of replacing all existing contracts at current market prices on the reporting date This value experienced fluctuations, declining from $20.2 trillion at the end of June 2013 to $14.5 trillion by the end of December 2015, marking the lowest level since 2007.
To conclude, global derivatives market has increasingly developed with larger scale and diverse derivatives products According to statistics, trading operations on both ETD and OTC market have grown strongly
3.2 Reality of developing derivatives market in Vietnam
3.2.1 Reality of using derivatives products in Vietnam
Derivatives are a widely recognized and effective risk hedging tool globally; however, their development in Vietnam has been quite limited The introduction of commodity and currency derivatives in Vietnam dates back to the late 1990s, with significant advancements beginning in 2005.
2006, derivatives transactions based on some agricultural products (rice, coffee…)
RECOMMENDATIONS AND CONCLUSIONS
First, providing information and advising on derivatives for investors
The successful deployment of derivatives markets globally highlights that a significant number of interested investors is crucial for enhancing market liquidity Consequently, prioritizing training and disseminating knowledge for investors is essential and should be initiated promptly before launching the derivatives market This can be achieved through various channels, including the Internet, mass media, and newspapers, to ensure comprehensive information dissemination and investor education.
Establishing investment consulting center on derivatives to train, offer certificates and give advice on investors
Second, develop a modern and stable technology background
The Government needs to develop a modern and stable technology background so that members and investors on the derivatives market could control risks and fasten trading processes
To stimulate the growth of derivatives in Vietnam, it is essential to promote investment in advanced equipment and synchronize information technology solutions, including transaction, surveillance, information announcement, and clearing and settlement systems These systems should be developed with a modern design that adheres to international standards.
Third, enhancing human resources quality
The SSC need build a training plan to popularize knowledge for staff in detail according to the derivatives market development timeline
Authorities also conduct training basic knowledge about derivatives, and then intensive training, offering professional practice certificates for staff
Training may organize according to centralized training or updated training through television, newspapers, mass media…
In Vietnam, institutional investors dominate trading volume, and attracting them can instill confidence in individual investors, thereby boosting market liquidity To encourage participation from foreign investors with expertise in derivatives trading, it is crucial to lower entry barriers such as capital requirements and stringent legal regulations Additionally, enhancing the legal framework for derivatives markets is vital to ensure transparency of information These measures could lead to a substantial increase in trading volume, further improving market liquidity.
The Government also needed to develop a modern and stable technology background so that members and investors on the derivatives market could control risks and fasten trading processes
In context of increasingly intensive international integration as well as Vietnamese
The emergence of the derivatives market in Vietnam is a crucial development to support the growth of the country's financial market While derivatives have been successfully utilized globally for years, they remain relatively new in Vietnam This market offers significant economic advantages, including effective risk management tools and the ability to raise capital at lower and more diversified costs.
Recognizing the importance of derivatives to Vietnamese financial market, March
In 2014, Prime Minister Nguyen Tan Dung approved a project aimed at establishing a state-controlled centralized derivatives market, alongside a comprehensive restructuring of the securities market in Vietnam Although derivatives transactions have existed in the country for some time, their trading volume has remained low due to restrictive market management practices To foster a sustainable derivatives market, Vietnam must draw on international experiences Additionally, the initial development of this market will inevitably face challenges, necessitating effective solutions from both authorities and investors to overcome these obstacles.