banking regulations cap banks ’ exposure to the equity markets. 15. when we come to foreign exchange and interest rate derivative markets, the perspective changes significantly. it is to be appreciated that interest rate and exchange rates are important macro - economic variables with economy - wide implications. the reserve bank of india has responsibility in regard to both the rates and is statutorily mandated to ensure sound functioning of these markets. therefore, its approach to development the cash as well as derivative segments of these markets has been characterised by what one can call as cautious gradualism. i shall elaborate on the issues involved in these markets. foreign exchange derivatives 16. the backdrop for the foreign exchange market is provided by several factors following the balance of payment crisis we faced in 1991. full current account convertibility since 1994, increasing openness on the capital accounts, a persistent and sometimes rapidly increasing current account deficit, the instability in autonomous capital flows, the investment needs of an expanding economy and globalization aspirations of indian corporates are some of them. our stated objective is to maintain orderliness in the foreign exchange market even as the exchange rate is market determined without any target level or band. the other factor one has to reckon with is the so - called impossible trinity where an independent monetary policy, a fixed exchange rate and an open capital account are impossible to simultaneously attain. since no economy of india ’ s size and complexity can sacrifice its independence in monetary policy, the inevitable consequence is an eclectic combination of some capital account openness and some flexibility in the exchange rate. 17. how does all this influence the development of the foreign exchange derivatives market? our approach to development of the foreign exchange derivatives market has been largely biased by the use of these products as instruments of hedging for individuals and real sector firms with a pre - existing foreign exchange exposure. take for example an exporter who has a foreign exchange receivable at a future date and any adverse movement is likely to adversely affect her expected rupee revenue and therefore her balance sheet. a derivative product like a forward sale or a put option is designed to remove all or some bis central bankers ’ speeches uncertainty of the exporter ’ s expected revenue and thereby impart stability to its balance sheet. 18. but a derivative product also is an instrument for expressing a view on the future path of the price of the underlying. thus if you expect the rupee to fall in value at a future date, you can sell it in the forward or futures market or buy a put option. this has

in derivatives and underscoring the need for further regulating the market. immediate aftermath of a crisis was not a good time to take a balanced view, and now that much of the dust has, somewhat settled down, we can perhaps look at the problem dispassionately. financial sector & the derivatives 3. before we go to the theme of derivatives, it is necessary to briefly discuss the financial sector as such so as to provide a backdrop, as it were. it has been generally accepted that a financial sector is a necessary precondition for economic growth and progress. economists like john hicks, walter bagehot and joseph schumpeter have held that the development of financial sector helped mobilize the resources necessary for “ the immense work ” that constituted the industrial revolution. of course, like everything else in economics, this also has a contrary view point. economists joan robinson and robert lucas have expressed scepticism about the emphasis given to the financial sector. extensive research in recent years goes to show that a well developed financial sector may be neither a necessary nor a sufficient condition for economic growth but the absence of an efficient financial sector can surely retard growth. 4. the financial sector essentially enables inter - temporal transfer of income and smoothens the consumption over the life time of an individual. on the other side, it also pools the surplus and allocates it to various socially productive projects which require an upfront outlay with the potential of generating a surplus at the end of the production cycle. it involves parting of money from the one who has the surplus to the one who needs it. but it could be a bis central bankers ’ speeches dangerous proposition. it is for nothing that polonius counsels his son laertes in shakespeare ’ s hamlet, “ neither a borrower nor a lender be ”. the legal - financial system that has evolved over the centuries has developed an elaborate architecture to ensure that the trust of the people is maintained in the financial system and they lend and borrow their requirement freely and safely. the financial sector has basically two kinds of problems. the first relates to information asymmetry inasmuch as one party to the transaction, the borrower or the investee, always knows more than the other party, the lender or the investor. this is a large topic in itself which i do not intend to deal with here, except that it also lays the ground for the second problem in financial transactions, that is, the risk of default or