Description
In practice, derivatives are a contract between two parties that specify conditions (especially the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the notional amount) under which payments are to be made between the parties.
“ STUDY ON DERIVATIVES”
PROJECT REPORT Submitted to the
SCHOOL OF MANAGEMENT
In partial fulfillment of the requirements for the award of the degree of
MASTER OF BUSINESS ADMINSTRATION
By
RENUKA CHANDRAWAL REG NO: 3510910640
Under the guidance of
Ms. R. SHENBAGAVALLI, Asst. Professor
SRM SCHOOL OF MANAGEMENT SRM UNIVERSITY KATTANKULATHUR 603 203
MAY 2011
RENUKA CHANDRAWAL 3510910640 SRM School of Management SRM University SRM Nagar, Kattankulathur - 603 203, Kancheepuram District, Tamil Nadu.
DECLARATION
I hereby declare that the project report entitled “STUDY ON DERIVATIVES” submitted to SRM School of Management in partial fulfillment of the requirement for the award of the Degree of Master of Business Administration, is a record of the original research work done under the supervision and guidance of Ms. R. SHENBAGAVALLI, Asst. Professor, SRM School of Management, SRM University, Chennai and that it has not formed the basis for the award of any degree / associate ship / fellowship of other similar title to any candidate of any university.
Place: Kattankulathur Date: RENUKA CHANDRAWAL
SRM School of Management SRM University SRM Nagar, Kattankulathur - 603 203, Kancheepuram District, Tamil Nadu.
Bonafide certificate
Certified that this project report titled “STUDY ON DERIVATIVES” is the Bonafide work of Ms. RENUKA CHANDRAWAL (3510910640) who carried out the research under my supervision. Certified further, that to the best of my knowledge the work reported herein does not from part of any other project report or dissertation on the basis of which a degree or award was conferred on an earlier occasion on this or any other candidate.
Submitted for the viva-voce examination held on -----------------------
-------------------------------Ms. R. SHENBAGAVALLI Asst. Professor (Project Guide)
----------------------------Dr. JAYSHREE SURESH (Dean, MBA)
-----------------------------------External Examiner
ACKNOWLEDGEMENT
I take this opportunity to thank Dr. C. Muthumizhchelvan, Director (Engineering & Technology), SRM University for providing us with an excellent infrastructure and conducive atmosphere for developing our projects. I express my profound gratitude to my mentor, Mrs. R. Shenbagavalli, Assistant Professor , SRM School of Management, who has been a constant source of encouragement and support for guiding me through the course of the project work. My heartfelt thanks to Dr. Jayshree Suresh, Dean, SRM School of Management, SRM University, for the support and advice she has given us throughout our project and also for the opportunity she has given us to undergo the Internship Training. I also wish to thank the managers and staffs of IND BANK , Chennai for their timely help and cooperation. I also express our gratitude to the Faculty, Attendants and Fellow Students of the Department of Business Administration, School of Management Studies for their needy and continuous support and technical assistance given throughout the duration of the course and the project. Last but not least, I would also like to thank my family and friends for all their love and support.
TABLE OF CONTENT
SL NO. 1 2
INDEX Introduction Industrial profile
PAGE NO 01 02 08
3 Company profile 4 Product profile 5 Scope of study 6 Objectives of study 7 Usage of future and option for hedging 8 Review of literature 9 Research methodology 10 Data analyze and interpretation 11 Finding 12 Suggestion 13 Conclusion 14 Limitations of study 15 Questionnaire 16 Bibliography
13 18 31 40 41 46 51 54 62 66 69 75 76
TABLE OF TABLES
SLNO. 1 INDEX Respondents who deal in shares , mutual fund, bonds, commodities. Durations of respondents in investment. 2 Respondents view on meaning of hedging. 3 4 Respondents view on awareness about future and options as a tool of hedging. Respondents use future and options as a tool of hedging. 5 Respondents limit on investment in future and options. 6 7 Respondents view on current market scenario, what would they prefer most……??? 60 61 59 57 58 56 PAGE NO 55
TABLE OF CHART
SL NO. 1 INDEX PAGE NO 55
Respondents who deal in shares , mutual fund, bonds, commodities. Durations of respondents in investment. Respondents view on meaning of hedging. Respondents view on awareness about future and options as a tool of hedging. Respondents use future and options as a tool of hedging. Respondents limit on investment in future and options. Respondents view on current market scenario, what would they prefer most……???
2 3 4
57 58 59
5 6 7
60 61 62
ABSTRACT
The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. My study in this topic deals with meaning of derivatives , types of derivatives .In later part of study I have done the survey which tells how many . Lack of awareness has been the prior reason why the trading in derivatives has been low in volume. Hence for creating awareness about derivatives among investors, stock exchanges have to conduct awareness programmes at free of or at minimal charges. people invest in different types of securities and whether they are aware of the hedging tools available.
CHAPTER-1
INTRODUCTION
INDUSTRIAL PROFILE
STOCK EXCHANGE The stock exchange of secondary market is a highly organized market for the purchase and the sale of second hand quoted of listed securities. The securities contracts (Regulation) Act 1956 defines a stock exchange as “an association, organization or not, established for the purpose of assisting, regulating and controlling business in buying, selling and dealing in securities”. Of all the modern service institution, stock exchange plays a crucial agents and facilitators of entrepreneurial progress. After the industrial resolution, as the size of the business enterprises grew, it was no longer possible for individual person or even partnerships to raise such huge amount for undertaking these ventures. Such huge requirements of capital can be met only by large number of individuals
DEVELOPMENT OF DERIVATIVES MARKET IN INDIA. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (amendment) ordinance, 1995, which withdrew the prohibitation on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. Securities Exchange Board of India (SEBI) set up a committee (consisting of 24 members) under Chairmanship of Dr. L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirements and real time monitoring requirements.
2
The Securities Contracts (Regulation) Act 1956 (SCRA) was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework were developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding over the counter (OTC) derivatives. The government also rescinded in March 2000, the three decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2009. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE ,and their clearing house/ corporation to commence trading and settlement in approval derivatives contracts. To begin with, SEBI approved trading index futures contracts based on S&P CNX Nifty and BSE30 (Sensex) index. This was followed by approval for trading in index options commenced in June 2001 and trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. Trading and settlement in derivative contracts is done in accordance with the rules byelaws and regulations of the respective exchanges and their clearing house corporation duly approved by SEBI and notified in the official gazette. Though the derivative market has been developed and much of people deal in derivative market they are not aware of advantage of the dealing in various derivative instruments.
3
BOMBAY STOCK EXCHANGE AND SENSEX: BSE is the first stock exchange in the country which obtained permanent recognition (in 1956) from the Government of India under the Securities Contracts (Regulation) Act 1956. BSE's pivotal and pre-eminent role in the development of the Indian capital market is widely recognized. It migrated from the open outcry system to an online screen-based order driven trading system in 1995B. The BSE Index, SENSEX, is India's first stock market index that enjoys an iconic stature , and is tracked worldwide. It is an index of 30 stocks representing 12 major sectors. The SENSEX is constructed on a 'free-float' methodology, and is sensitive to market sentiments and market realities. Apart from the SENSEX, BSE offers 21 indices, including 12 sectoral indices.
NATIONAL STOCK EXCHANGE: The Organisation The National Stock Exchange of India Limited has genesis in the report of the High Powered Study Group on Establishment of New Stock Exchanges, which recommended promotion of a National Stock Exchange by financial institutions (FIs) to provide access to investors from all across the country on an equal footing. Based on the recommendations, NSE was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the country.
On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The Capital Market (Equities) segment commenced operations in November 1994 and operations in Derivatives segment commenced in June 2000.
NIFTY: The National stock exchange has an index called the Nifty( officially called S&P CNX nifty). This name can be credited to the 50 stocks that comprise its index. 4
VARIOUS PRODUCTS AVAILABLE FOR TRADING IN FUTURES AND OPTIONS SEGMENT AT NSE: Futures and options contracts are traded on Indices and on Single stocks. The derivatives trading at NSE commenced with futures on the Nifty 50 in June 2000. Subsequently, various other products were introduced and presently futures and options contracts on the following products are available at NSE: 1. Indices : Nifty 50 CNX IT Index, Bank Nifty Index, CNX Nifty Junior, CNX 100 , Nifty Midcap 50, Mini Nifty and Long dated Options contracts on Nfity 50. 2. Single stocks – 228
BUSINESS GROWTH IN DERIVATIVES SEGMENT FROM 2008-2009
Index Futures Month
Stock Futures
Index Options
Stock Options
Total
No. of al / Year No. of Turnov No. of Turnove No. of Turnove contrac er (Rs. contract r (Rs. contract contract Turnov r (Rs. ts cr.) s cr.) s s er (Rs. cr.) cr.) Mar2009 Feb2009 Jan204971 276676 1018402 289361.7 3144808 444099.1 52 .50 8 0 5 6
Notional
Notion No. of contr acts Turnover (Rs. cr.)
966542
29793. 6309580 12 7
1039930.49
157507 205679 1715683 185121.0 2147520 305599.0 67 .16 8 0 1 3
1361770
15971.1 5574457 0 6
712370.28
176955 234140 2281433 215830.3 2121567 309271.3 1777120 18876.2 6350266
778118.35
5
2009 Dec2008 Nov2008 Oct2008 Sep2008 Aug2008 Jul2008 Jun2008 May2008 Apr2008
42
.51
2
0
1
3
3
5
200078 269997 2226278 230465.5 2115877 313615.4 95 .31 5 7 9 2
1364307
15087.9 6479376 6 6 5814537 8
829166.28
194713 256949 1794927 187211.2 1992092 292134.3 67 .74 0 6 4 3
803817 9060.80
745356.12
216494 324961 1985840 239263.8 2073738 364509.6 45 .66 9 5 1 2
889593
12911.0 6313482 6 8
941646.17
193323 380197 2007613 332728.5 2139843 461622.6 43 .75 8 2 0 6
1304655
23323.4 6211156 3 6
1197872.36
144339 300448 1759421 324010.8 1383564 312101.6 84 .85 6 6 2 9
1029701
20883.4 4689354 0 3
957444.84
204231 395379 2223222 382600.8 1688970 357208.5 39 .96 7 0 4 8
1252290
24984.6 6079736 8 0
1160174.01
179418 377939 1915494 375986.7 1356443 308708.6 70 .01 6 1 6 3 129066.5 3 133564.8 6
939877
21429.9 5160112 3 9
1084064.27
111614 267640 1669326 380160.6 27 .70 0 5
5078960
906408
21040.4 3384005 5 5
797908.39
120631 280100 1560153 336900.9 72 .25 1 0
5365231
699890
15864.6 3372982 5 4
766430.64
6
CHAPTER-2
COMPANY PROFILE
7
COMPANY PROFILE
INDBANK MERCHANT BANKING SERVICES LIMITED was established as a subsidiary of Indian bank, in 1989. Indbank is a SEBI registered merchant banker and was one among the few merchant banking subsidiaries to be formed by a Nationalized Bank. Indbank is also one of the early corporate entrants in the field of stock broking, being the first institutional member of Madras Stock Exchange since 1991. Indbank provides financial services. The services includes 1. Merchant banking and Corporate advisory services
2. Stock Broking
3. Online Trading
4. Depository Participant activities
5. Distribution of Mutual funds and other Investment products
6. Websites
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1. MERCHANT BANKING AND CORPORATE ADVISORY SERVICES
Indbank is a category 1 merchant banker registered with Security Exchange Board of India (SEBI) undertaking assignments. Indbank has identified the major areas of services and has assigned specialist personnel to each.
• • • • •
Management of Equity and Debt issues Corporate Advisory services Mergers and Acquisitions Loan Syndication Project Counseling
2. STOCK BROKING
Indbank is a SEBI registered member of National Stock Exchange of India (NSE), Madras Stock Exchange (MSE) and Over the Counter Exchange of India (OTCEI). Indbank is an
empanelled broker for major financial institutions and banks. Indbank undertakes trading in the BSE as sub-broker of Madras Stock Exchange where Indbank is an Institutional members.
3. ONLINE TRADING
To enable the customer to trade from anywhere under the internet based trading system, Indbank has recently launched a powerful and user- friendly Online trading facility, which is completely safe and secure. Indbank Merchant Banking Services Limited has entered into an agreement with Indian Bank for the customers of Indian Bank for the provision of online trading facilities to the
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customers of Indian Bank. For availing this facility the customer has to open a Net Banking Account and DEMAT Account with Indian Bank and Online Trading Account with Indian Banking Services Limited.
4. DEPOSITORY PARTICIPANT ACTIVITIES
Indbank is a SEBI registered Depository participant with National Securities and Depository participant with National Securities and Depositories Limited (NSDL), since 1998, and is governed by the Depositories Act 1996 and circulars issued by SEBI regulations, 1996 and circulars issued by SEBI and NSDL from time to time. DEMAT is a safe and convenient way to hold securities eliminating the risks associated with physical certificates like bad deliveries, fake securities, delays, thefts etc., facilitating faster transactions. Indbank Offers a DEMAT services through its network of offices
5. DISTRIBUTION OF MUTUAL FUNDS AND OTHER INVESTMENT PRODUCTS
Indbank distributes Mutual Funds and investment products and is registered with the Association of Mutual Fund of India (AMFI) for distribution of Mutual Funds of products. Indbank offer this services through its network offices.
6. WEBSITES
Indbank has launched its website www.indbankonline.com in the current year. The website provides host of market information like quotes, indices, economy, industry and corporate news and provides facilities for Creating your own portfolio, posting your queries etc.
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CHAPTER-3
PRODUCT PROFILE
11
PRODUCT PROFILE
INDBANK MERCHANT BANKING SERVICES LIMITED (IBMBS Ltd) was established as a subsidiary of Indian bank, in 1989. Indbank, under one roof, offers a truly comprehensive range of financial services by way of one-stop shop through a cream of professionals drawn from various disciplines, who are ably supported by a team of experienced personnel from Indian bank offices, backed by the most sophisticated communication network for instant access to information and constant updates. The services include: ¾ Merchant banking and Corporate Advisory Services ¾ Stock Broking ¾ Online Trading ¾ Depository Participant Activities ¾ Distribution of Mutual Funds and other Investment product.
1. Merchant banking and Corporate Advisory Services Indbank is a category 1 Merchant Banker registered with Securities Exchange Board of India (SEBI). Merchant banking today has become so complex and sophisticated in nature that it’s truly multi-faced. Indbank has identified the major areas of services and has assigned specialist personnel to each. • Management of Equity & Debt issues ¾ Rights/Public Issues ¾ IPO s/Offer for sale of equity-through fixed price/book building routes, ¾ obtaining clearances for the same and drafting prospectus ¾ Compliances with Pre and Post issue requirements ¾ Underwriting, Liason with the brokers and bankers ¾ ESOP/ESOS issues
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¾ Private placement of debt for banks, FIIs, industrial houses ¾ Venture Capital Tie- ups
•
Corporate Advisory Services ¾ Valuation of shares and other financial instruments ¾ Capital structuring and restructuring ¾ Delisting ¾ Buyback ¾ Efficiency improvement studies
•
Mergers and Acquisitions ¾ Identification of opportunities ¾ Evaluation of prospects ¾ Negotiations and working out of mechanics ¾ Documentation ¾ Managing open offers
•
Loan Syndication ¾ Identification of finance sources ¾ Detailed project Appraisals ¾ Application for assistance ¾ Negotiations of terms and documentati
•
Project Counseling ¾ Collaboration arrangements ¾ Detailed Project Appraisal
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¾ Assistance in project implementation ¾ Financial closure
2. Stock Broking
Indbank is a SEBI registered member of National Stock Exchange of India (NSE), Madras Stock Exchange (MSE) and Over the Counter Exchange of India(OTCEI).Indbank currently operates in the cash, derivatives & wholesale Debt Market Segments of NSE for both retail and institutional investors. Indbank is one amongst very few subsidiaries of nationalized banks that have entered into Stock Broking activity. Indbank is an empanelled broker for major financial institutions and banks. Indbank undertakes trading in BSE as sub-broker of Madras Stock Exchange where Indbank is an Institutional member. The website of Indbank is www.indbankonline.com , which provides a host of market information like quotes, indices, economy, industry and corporate news, and provides facilities for creating client’s own portfolio, posting client’s queries etc.
3. Online Trading To enable the customer to trade from anywhere under the Internet based trading system, Indbank had recently launched a powerful and user-friendly Online trading facility, which is completely safe and secure. The facility is designed to provide the clients an expedient and
paperless trading experience through their website, “www.indbankonline.com->online trading>login”. Indbank uses robust software, which utilizes highest levels of encryption standards to guard against intrusion. The software has many user friendly features to enable the Indbank Online Trading Clients perform several functions over the internet, including: ¾ View the market information ¾ Enter/Modify/Cancel their orders ¾ View order and trade status
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¾ View their portfolio and cash balance information ¾ View their transaction history ¾ Use of information and price ticker ¾ Online alerts for their activities ¾ Hyperlinks to other services such as market historical information, exchange websites, news, charting and a host of other value added features ¾ Access to digital contracts for trades that are executed and to back office accounts. ¾ Online Alerts for client’s activities
Indbank Merchant Baking services Limited has entered into an agreement with Indian Bank for provision of Online trading facilities to the customers of Indian Bank. For availing this facility the customers has to open a net banking account with Indian Bank, a demat account either with Indian Bank or with Indbank and online trading account IBMBS Ltd. This will benefit all the customers having accounts with CBS branches of Indian Bank for undertaking stock market operations. Incidentally it may be mentioned here that all branches of Indian Bank are now under CBS system.
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CHAPTER-4
SIGNIFICANCE OF PROBLEM
16
Significance of the problem
In India there are two types of markets. First is equity market or cash market and second one is derivative market. Normally people invest in cash market. Cash market is that market where investors have to pay full amount for there transactions; where as derivative market is that market where investors can invest by paying some partial money instead of full payment. Both the markets involve risk in terms of fluctuation in prices. An investor who is investing in equity market (cash market) can not estimate that in which direction market would go, whether upward or downward. Big investors can tolerate risk but small and medium investors can not. More than 80% investors belong to small and medium category and they may avoid investing in market, which can hamper the growth of our country. But the study tells the interrelationship of both the markets and tells how risk can be minimized with the help of hedging in derivative market. Focus of study is whether the investors are aware about the right meaning of risk and a tool available to reduce it.
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CHAPTER-5
INTRODUCTION TO STUDY
18
Conceptualization
Derivatives The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the `to arrive' contract that permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. These were eventually standardized, and in 1925 the rest futures clearing house came into existence. Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.
Definition A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, FOREX, commodity or any other asset. A derivatives market is any market for a derivative security that is a contract which specifies the right or obligation to receive or deliver future cash flows based on some future event such as the price of an independent security or the performance of an index. The main types of derivatives are futures, forwards, options and swaps.
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Types of Derivatives
Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way that they are traded in market: ¾ Over-the-counter (OTC) derivatives: Over the counter derivatives are contracts that are traded directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivatives market is huge. According to the Bank for International Settlements, the total outstanding national amount is USD 248 trillion at the end of December 2004.
¾ Exchange-traded derivatives: Exchange-traded derivatives are those derivatives products that are traded via derivatives exchanges. A derivatives exchange acts as an intermediary to all transactions, and takes initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), Chicago Mercantile Exchange and the Chicago Board of Trade Participants in the Derivative Market ¾ Hedgers- Hedgers are participants who face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk.
¾ Speculators- Speculators are participants who wish to bet on future movements in the price of an asset. Futures and options contracts can give them leverage; that is, by putting in small amounts of money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses.
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¾ Arbitragers- Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit.
Risk
Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome .more specifically, most investors are concerned about the actual outcome being less than the expected outcome .the wider the range of possible outcomes the greater the risk. Stock Market Stock market is place where the stocks or shares are purchased and sold .stock exchange is an organized market where securities are traded .these securities are issued by the government, semi-government, public sector undertakings and companies for borrowing funds and raising resources. securities are defined as any monetary claims and includes stock ,shares, debentures ,bonds etc .if these securities are marketable as in the case of government stocks; they are transferable by endorsement and are like moveable property .they are tradable on the stock exchange. Exchanges are located all over the world with the most famous one being the New York stock exchange. The NYSE annually traded almost 14 trillion dollars worth of capital thousands of stocks are listed on this exchange. When you buy a stock you will need to learn which exchanges list it other than locating quote in the news paper with online trading and the automation of order system ,there is very little reason to determine where the stock trades from the customers viewpoint.
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There are 22 stock exchanges in India, the first being the Bombay Stock Exchange (BSE), which began formal trading in 1875, making it one of the oldest in Asia. Over the last few years, there has been a rapid change in the Indian securities market, especially in the secondary market. Advanced technology and online-based transactions have modernized the stock exchanges. In terms of the number of companies listed and total market capitalization, the Indian equity market is considered large relative to the country’s stage of economic development. The number of listed companies increased from 5,968 in March 1990 to about 20,000 by May 2006 and market capitalization has grown almost 11 times during the same period. The debt market, however, is almost nonexistent.
BSE and NSE
For the premier Stock Exchange that pioneered the stock broking activity in India, 128 years of experience seems to be a proud milestone. A lot has changed since 1875 when 318 persons became members of what today is called "The Stock Exchange, Mumbai" by paying a princely amount of Re1. Since then, the country's capital markets have passed through both good and bad periods. The journey in the 20th century has not been an easy one. Till the decade of eighties, there was no scale to measure the ups and downs in the Indian stock market. The Stock Exchange, Mumbai (BSE) in 1986 came out with a stock index that subsequently became the barometer of the Indian stock market. SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. First compiled in 1986, SENSEX is a basket of 30 constituent stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100. The index is widely reported in both domestic and international markets through print as well as electronic media. 22
Well, the National Stock Exchange has an index called the Nifty (officially called S&P CNX Nifty). This name can be credited to the 50 stocks that comprise its index. The Nifty has 50 stocks covering 24 sectors, as against 30 stocks and 13 sectors for the Sensex. In case if one is shaking your head about 50 also being too small a number, these 50 stocks account for around 60 percent of the market capitalisation.
S&P CNX Nifty S&P CNX Nifty is a well diversified 50 stock index accounting for 22 sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds. S&P CNX Nifty is owned and managed by India Index Services and Products Ltd. (IISL), which is a joint venture between NSE and CRISIL. IISL is India's first specialized company focused upon the index as a core product. IISL have a consulting and licensing agreement with Standard & Poor's (S&P), who are world leaders in index services. Prices of every stock increases or decreases due to following reasons: News about the company, like a product launch, closure of a factory, the government providing tax or duty exemptions to the sector so more profits expected, a feud among the company's top bosses, etc. This will be stock specific news. News about the country, like testing a nuclear bomb, a terrorist attack, a budget announcement, etc. This will be called index news. The job of an index is mainly to capture the news about the country. This will reflect the movement of the stock market as a whole.
Future Contract It is an agreement between two parties to exchange an asset at a certain date in future at a certain price. It is a standardized forward contract that is traded on an exchange. The standardized items in a 23
futures contract are: • • • • Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change
Futures were originally introduced as an insurance mechanism for farmers and manufacturers who wanted to fix a price for crops at a future date. The farmer wanted to be able to make plans knowing the price he would get for his crops. For the manufacturer, fixing the price meant that he could ensure consistency in the prices he charged. Quite simply, a future is an agreement (obligation) to buy or sell a given quantity of a particular asset, at a specified future date, at a pre-agreed price. Futures contracts have standard delivery dates, trading units, terms and conditions. Futures can be based on any number of underlying assets. In addition to offering futures and options based on individual shares and stock market indices, LIFFE also offers futures and options based on bonds, interest rates and soft and agricultural commodities. You can "open" a futures position by either buying or selling a future. You can "close" your futures position by doing the opposite - either selling or buying the same future. In practice, most futures contract positions are "closed out" before they expire. If you hold a view that the underlying asset will rise, you could buy futures - known as a Long futures position - which commits you to take delivery of the underlying shares, or equivalent cash value, at a pre-arranged price and by a certain date. If your view is that the share prices for the underlying asset will fall, you could sell futures known as a Short futures position - which commits you to deliver the underlying shares, or equivalent cash value, at a prearranged price and by a certain date.
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Potential Risks and Rewards There is no way of knowing for sure the direction of the prices of the underlying asset or the price of futures in advance. Therefore, like many investments, futures carry a risk that market prices may go in the opposite direction of the view held. Futures can be used in different market conditions. Let's consider equity futures. Remember that equity futures are financial instruments whose price movements are derived from the price movements of an underlying share price or index. Two distinctive benefits of trading equity futures are as follow:
•
You can earn profit in a falling market as well as a rising market: Normally, when investing in shares, you would go by the rule of buy low and sell high in order to profit from market prices. In the futures market, you have the opportunity to sell futures, known as going short. So, if a view is held that a share price will fall, consider selling futures. If the view materialises and the price of the future price falls in line with the underlying share price, the position can be closed by buying back the future for less in order to make a gain.
•
Cost efficiency: An additional benefit of trading equity futures as opposed to trading shares is the lower commission structure. Futures trading commissions typically represent a third of the costs for those to trade the underlying market and cash-settled futures contracts. In addition, profits from futures do not incur any stamp duty.
Pricing of the Futures Futures prices are calculated in a structured way. When you look at a futures price you will see two prices: Bid Price is the price at which a trader is willing to buy a futures contract Offer Price is the price at which a trader is willing to sell a futures contract The futures price should be equal to the cost of financing the purchase of the underlying asset and the cost of holding (or storing) it until expiry of the futures contract.
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LIFFE's range of equity futures are derived from share prices and indices. So, in this case, the total cost of buying shares and holding them until expiry of the future contract is made up to three main elements:
• • •
The price of the underlying shares Any interest income foregone by holding shares rather than cash Any dividends paid to the holder of the shares before the expiry of the future
This can be calculated by using formula as under: Fair equity futures price = today's share price + interest costs - dividends received Futures on equity indices are priced on a cost of carry basis. The fair value of the index futures contract is determined by adjusting the current cash index price by the net cost of carry of the underlying basket of shares replicating the index. Cost of carry reflects the cash flow considerations of a seller of futures over the life of the contract as (s)he holds the underlying basket of shares. The cost of borrowing for the financing of the index basket is the main factor, but the income generated from holding the underlying basket of shares must also be taken into consideration. The cost of carry can therefore be defined as the difference between the cost of financing the holding of the basket of shares comprising the index and the income earned on these stocks in the form of dividends (dividend yield). Futures and options are products that can transform your trading and investment activity; increasing profit potential and giving you the means to control risk too. LIFFE is committed to bringing this world of trading and investing opportunities to the private investor, both through education and through a continuous process of product enhancement and development. In conjunction with education supplier Trade Basics, LIFFE is pleased to bring you a series of interactive education modules in The Learning Centre. The prices for LIFFE's range of equity futures and options can be viewed at http://www.liffedata.com. Here you will see 15 minute delayed price data. In addition, free live prices for LIFFE's Universal Stock Futures are also available.
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History of futures exchanges Though the origins of futures trading can be supposedly traced to Ancient Greek or Phoenician times, the history of modern futures trading begins in Chicago, United States in the early 1800s. Chicago is located at the base of the Great Lakes, close to the farmlands and cattle country of the U.S. Midwest, making it a Natural centre for transportation, distribution and trading of agricultural produce. Gluts and shortages of these products caused chaotic fluctuations in price. This led to the development of a market enabling grain merchants, processors, and agriculture companies to trade in "to arrive" or "cash forward" contracts to insulate them from the risk of adverse price change. In 1848, the Chicago Board of Trade (CBOT), the world's first futures exchange, was formed. Trading was originally in forward contracts; the first contract (on corn) being written on March 13, 1851. In 1865, standardized futures contracts were introduced. The Chicago Produce Exchange was established in 1874, renamed in 1898 the Chicago Mercantile Exchange (CME). In 1972 the International Monetary Market (IMM), a division of the CME, was formed to offer futures contracts in foreign currencies: British pound, Canadian dollar, German Mark, Japanese yen, Mexican peso, and Swiss franc. Later in the 1970s saw the development of the financial futures contracts, which allowed trading in the future value of interest rates. These (in particular the 90-day Eurodollar contract introduced in 1981) had an enormous impact on the development of the interest rate swap market. Options Contract: Today, the futures markets have far outgrown its agricultural origins. With the addition of The New York Mercantile Exchange (NYMEX) and The American Energy Exchange(AMENX) the trading and hedging of financial products using futures dwarfs the traditional commodity markets, and plays a major role in the global financial system trading over 1.5 trillion U.S. dollars per day in Option. In finance, an option is a contract whereby one party (the holder or buyer) has the right but not the obligation to exercise a feature of the contract (the option) on or before a future date (the exercise
27
date or expiry). The other party (the writer or seller) has the obligation to honour the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium. Four major factors affecting the Option premium: • • • • Price of Underlying Time to Expiry Exercise Price Time to Maturity Volatility of the Underlying
And two less important factors: • • Short-Term Interest Rates Dividends
An option simply gives the holder the right, but not the obligation, to buy (call), or sell (put), a specified underlying asset at a pre-agreed price on or before a given date. Example Imagine there is a plot of land next to where you live. The owner of the land knows that it is only worth selling if he obtains planning permission. But the owner needs some funds now so he offers you the option to buy that land at an agreed amount during a fixed period of time. You know that you want the land but only if there is planning permission so you agree to pay him a fee for the option to buy the land. The fee is just a small percentage of the amount agreed. In time, the planning permission is granted and you exercise the option and buy the land. If planning permission had not been granted during the agreed period of time, you would not exercise your option and would have only lost the fee you had paid - but you would have safeguarded against anyone else buying that land.
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There are two types of options: Call: The buyer of a Call option acquires the right, but not the obligation, to buy the underlying asset at a fixed price. Call options generally rise in value if the price of the underlying asset rises. Put: The buyer of a Put option acquires the right, but not the obligation to sell the underlying asset at a fixed price. Put options generally rise in value if the price of the underlying asset falls. The buying of options involves limited risk - that is to say you cannot lose any more than the premium paid at outset. It is also possible to write or sell options. The writing of call options, although having a wide range of uses, is a potentially high-risk strategy requiring a high degree of product knowledge. Since exercise can involve the writer in a substantial financial commitment, option writers are required to deposit margin with the broker to ensure the obligations of the contract can be met in full if required. An option can be granted over many assets - including soft and agricultural commodities, bonds, shares and share indices. Equity options are financial instruments whose price movements are derived from the price movements of an underlying share price or index and hold a host of investment opportunities as a private investor. Whilst options on individual equities allow investors to gain exposure to specific shares, index options allow investors to gain exposure to the UK stock market in one transaction. In both the US and the Netherlands, private investors account for over 60% of the equity options traded. In these countries, private investors view investing in options and investing in the underlying shares or indices as being quite similar.
29
Potential Risks and Rewards Options can be used in a variety of different market conditions. Let's consider equity options. Remember equity options are financial instruments whose price movements are derived from the price movement of the underlying share price or index. Two distinctive benefits of trading equity options are as follow:
•
Buying equity options: limited risk and unlimited potential profit: This is obviously quite different to buying shares. When a investor buy either a call or put option, the risk is limited to the premium he/she pays. If the share price does not go in the direction of anticipation, simply leave the option to expire without exercising it. There is only loss of premium paid.
•
With equity options you can enhance the return on your existing equity portfolio: If you hold shares and do not expect the price to move very much over the next few months, you may consider writing, or selling, a call option against this shareholding. This is known as selling a Covered Call. In return, you will receive a premium from the buyer. You retain this premium in all circumstances. If, as you anticipated, the share price does not change significantly by expiry, the option will expire worthless and the premium received has enhanced your shareholding during static market conditions.
If however investors view is incorrect, the option holder may choose to exercise the option and he will be obliged to sell his shares. • Note that since exercise can involve the writer in substantial financial commitment, option writers are required to deposit margin with their broker to ensure the obligation of the contract can be met. • • The risk associated with options largely depends on how they are used. The buying of options involves a limited risk. That is to say that the maximum loss is limited to the price paid for the option (the premium) and therefore is known at the outset.
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The writing i.e. selling of options, although having a wide range of uses, is a potentially high-risk strategy requiring a high degree of product knowledge. Investors should consider very carefully the risks of writing options and ensure they hold the requisite number of shares or cash equivalent (margin) to lodge with the broker. Since exercise can involve the writer in substantial financial commitment, option writers are required to deposit margin with their broker to ensure the obligation of the contract can be met. This is known as "covered" option writing. Option Exchanges and Contracts Most of the exchanges that trade financial futures also trade financial options. There are also exchange that trade option but not futures, such as the European options exchange (EOE-located in Amsterdam) and the Marche des options negociables de Paris (MONEP).
How is Equity Option Priced? The value of an equity option contract is influenced by several factors. A mathematical formula is applied to these factors in order to achieve the option price. Table is on the next page.
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Factor Underlying share price
Explanation The underlying share price, together with the option's exercise price, determines the "intrinsic value" of an option. For example, if the share price exceeds the exercise price of a call option by 20p, the options is said to have 20p worth of intrinsic value and to be 20p "in-the-money". In the case of a put option, the reverse is true. A put option is "in-the-money" when the exercise price exceeds the underlying share value.
Exercise price or strike price
The term "exercise" refers to taking up the right to buy or sell the underlying asset. The price is fixed at the outset. When an option holder exercises their option, a randomly selected writer is notified of this and is required to deliver or take delivery of the underlying asset .
Time to expiry
Time has a value since the longer the option has to go until expiry, the more opportunity there is for the share price, and hence the option price, to move. Generally the further away the expiry day, the higher an option's time value. This is true for both calls and puts.
Volatility
Time value is also affected by the past and/or future volatility of the underlying share. More volatile shares attract higher time value as profit opportunities for option holders and hence risks for option writers are greater than for shares and more stable prices.
Dividends
Dividends are paid to shareholders, but not to holders of options. Since the share price tends to fall by the amount of the dividend after it has been announced, it follows that the price of an option will reflect the value of any expected dividend payments.
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Interest Rates
Interest rates also affect the price of equity options. However, changes in interest rates have a relatively small effect on option premiums
HEDGING:
Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta.
Beta is the measure of a fund's volatility relative to the market. A beta of greater than 1.0 indicates that the fund is more volatile than the market, and less than 1.0 is less volatile than the market. Assuming you have a portfolio of Rs. 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs. 1.2 mn of S&P CNX Nifty futures. Risk management strategy used in limiting or offsetting probability of loss from
fluctuations in the prices of commodities, currencies, or securities. In effect, hedging is a transfer of risk without buying insurance policies. It employs various techniques but, basically, involves taking equal and opposite positions in two different markets (such as cash and futures markets).
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Steps 1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1.
2. Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings.
Therefore in the above scenario we have to short sell 1.2 * 1 million = 1.2 million worth of Nifty.
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CHPTER-6
SCOP OF STUDY
35
Scope of the Study
In the today’s volatile market nobody can predict to which way market will move i.e. either upward or downward. So it is considered as an enigma by the small investors and they try to be away from the market due to fear of losses. Focus of study is to identify the interrelationship of both the equity and derivative markets and tell the usage of derivative market for the purpose of hedging, so that the risk can be minimized.
Usefulness of the study
The study can help in the following ways: ¾ Provide complete knowledge of future and option. ¾ Usage of future and option as a tool of hedging. ¾ Motivate investors to use this tool by asking some questions regarding it. ¾ Interrelationship of equity and derivative market.
36
CHAPTER-7
OBJECTIVES OF STUDY
37
Objective of The Study
Objectives of the study are: ¾ To study the history and benefits of financial derivatives. ¾ To show how to hedge with future and option. ¾ To know the awareness of investors towards hedging. ¾ To identify the future scenario of derivative Market for hedging in india.
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USAGE OF FUTURE & OPTION FOR HEDGING
39
How can Futures be used for Hedging?
Futures contracts can be used in many different ways depending on investment objectives. Here are two examples:
•
To safeguard or "hedge" the existing underlying assets if price will fall in near future: Consider opening a futures position to protect the existing assets (e.g. your share
portfolio) in the event of a down turn in prices. As a holder of the asset, you can sell futures against equity portfolio to avoid making a loss and without having to incur the costs associated with selling assets. To "close" the futures position by buy the equivalent amount of futures in the market. Losses in the underlying asset can therefore be compensated by profit made on the futures position.
•
To profit from volatile market conditions: Futures provide the opportunity to profit from the upward and downward turns in the
prices of underlying assets. For a view that market prices will raise, consider buying futures (remember this is a Long futures position). Conversely, for a view that market prices will fall, consider selling futures (remember this is a Short futures position). If the view held materialises, the position can be closed by undertaking an equal and opposite position in the same market in order to profit from the price difference. Remember to close a long position you would sell futures and to close a short position you would buy futures. Futures can transform trading and investment activity of an investor, by increasing profit potential and giving the means to control risk. There is no way of knowing for sure the direction of the prices of the underlying asset or the price of futures in advance. Therefore, like many investments, futures carry a risk that market prices may go in the opposite direction of the view held.
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How can Options be used for Hedging?
Options are extremely flexible instruments that can be used in a variety of different ways either as a way to gain profit from short term market movements or as a part of longer-term investment strategies. Here are two:
•
As a form of insurance against a fall in the price of the underlying asset: Imagine Mr. Ramesh hold a particular asset and intend to sell it at a date in the future. If
his view is that the price of the asset will fall, he could consider buying a put option which gives the right, but not the obligation, to sell the underlying asset at a fixed price by a certain date in the future. If his view is correct, he could exercise his put option and sells the underlying asset for more than the prevailing market value.
•
To participate in price movements of the underlying asset without buying or selling the underlying asset: If view is that the price of the underlying asset will rise, then consider buying a call
option which gives the right, but not the obligation, to buy the underlying asset at a fixed price by a certain date in the future. If the view is accurate, the value of call option will increase. To realise profit, close out your position by selling the call option back to the market. Conversely, if view is that the price of the underlying asset will fall, you could buy a put option which gives the right, but not the obligation, to sell the asset at a fixed price. If the view is accurate, the value of your put option will increase. To realise your profit, close the position by selling the put option back to the market. Futures and options are products that can transform trading and investment activity of an investor; increasing profit potential and giving the means to control risk too. LIFFE is committed to bringing this world of trading and investing opportunities to the private investors, through education and a continuous process of product enhancement and development.
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The Option Contract For the option purchaser (also called the holder or taker), the option: • offers the right (but imposes no obligation), ? ? ? ? to buy (call option) or sell (put option) a specific quantity (e.g. 1 contract= 100 shares) of a given financial underlying (e.g. shares) at an agreed price (exercise or strike price), or calculable value. For example the value can be calculated based on a reference rate or something else such as the average price of an underlying asset, as measured at agreed-upon intervals during the life of a contract, i.e. the Asian option. ? on one or more call dates
•
In exchange for a premium (option price).
•
The counterparty (option writer / seller) has an obligation to fulfil the contract if the option holder exercises the option. In return, the option seller receives the option price or premium.
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Types of Options
? European Option
o Can be exercised only on the expiration date
? American Option
o Can be exercised any time on or before the expiration date
Call Option A call option gives the buyer, the right to buy specified quantity of the underlying asset at the set strike price on or before expiration date. The seller (writer) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. The risk for the option holder is limited: he cannot lose more than the premium paid as he can "abandon the option". His potential gain is theoretically unlimited. The buyer assumes a long position, and the writer a corresponding short position.
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CHAPTER- 8
REVIEW OF LITERATURE
44
HOW ARE DERIVATIVES DEFINED
Derivatives may be defined as “ A security or contract designed in such a way that its price is derived from the price of an underlying asset”. Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate). In a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such transaction is a example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”. Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset. Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions contrary to what the investor currently has. The main purpose of speculation, on the other hand, is to profit from betting on the direction in which an asset will be moving.
WHAT IS THE DIFFERENCE BETWEEN HEDGING AND SPECULATION
HEDGERS reduce their risk by taking an opposite position in the market to what they are trying to hedge. The ideal situation in hedging would be to cause one effect to cancel out another. For example, assume that a company specializes in producing jewelry and it has a major contract due in six months, for which gold is one of the company's main inputs. The company is worried about the volatility of the gold market and believes that gold prices may increase substantially in the near future. In order to protect itself from this uncertainty, the company could buy a six-month futures contract in gold. This way, if gold experiences a 10% price increase, the futures contract will lock in a price that will offset this gain. As you can see, although hedgers are protected from any losses, they are also restricted from any gains. Depending on a company's policies and the type of business it runs, it may choose to hedge against certain business operations to reduce fluctuations in its profit and protect itself from any downside risk. 45
SPECULATORS make bets or guesses on where they believe the market is headed. For example, if a speculator believes that a stock is overpriced, he or she may short sell the stock and wait for the price of the stock to decline, at which point he or she will buy back the stock and receive a profit. Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risky. (To learn more, check out the Short Selling tutorial.)
Overall, hedgers are seen as risk averse and speculators are typically seen as risk lovers. Hedgers try to reduce the risks associated with uncertainty, while speculators bet against the movements of the market to try to profit from fluctuations in the price of securities.
A BULL MARKET This is when the market showing is confidence. Indicators of confidence are prices going up. Number of shares traded is also high and even the number of companies entering the stock market show that the market is confident.A bull market is a rise in value of the market of at least 20%. A BEAR MARKET
A bear market is the opposite to a bull. If the markets fall by more than 20% then we have entered a bear market. A bear market is a market showing a lack of confidence. Prices hover at the same price then go down, indices fall too and volumes are stagnant. In a bear market people are waiting for the bulls to start driving the prices up again. However, a bear is a very tentative bull or a bull that is asleep.
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VARIOUS DERIVATIVE INSTUMENTS There are two types of derivatives instruments traded on NSE; namely Futures and Options : 1. FUTURES : A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. All the futures contracts are settled in cash at NSE. 2. OPTIONS: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.
Options are of two types - Calls and Puts options : "Calls" give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. "Puts" give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date. All the options contracts are settled in cash. Further the Options are classified based on type of exercise. At present the Exercise style can be European or American.
I. AMERICAN OPTION - American options are options contracts that can be exercised at any time upto the expiration date. Options on individual securities available at NSE are American type of options.
II. EUROPEAN OPTIONS
- European options are options that can be exercised only on the
expiration date. All index options traded at NSE are European Options. Options contracts like futures are Cash settled at NSE.
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CHAPTER- 9
RESEARCH METHODOLOGY
48
Research Design
The research is of Diagnostic cum Descriptive type; it is so because it establishes relationship between equity market and derivative market and shows how securities of equity market can be hedged with the help of future and option in derivative market. Moreover secondary data is used to give description of available observations so this way it is also a descriptive kind of study.
Universe of the Study
Universe of the survey are investors in share market of CHENNAI City through indbank.
Survey Population
Population of the survey is 40 people who invest in share market.
Technique of selecting the Sample
The technique of selecting the sample is Random in Nature.
Data Collection
Data is collected from two sources i.e. Primary & Secondary. Primary data is collected from the investors by the method of questionnaire and it is further used for analysis. Secondary data is collected from books and internet. Analysis Pattern For analysis of the answers of the questionnaire bar diagrams and pie charts are used. With the help of these further recommendations are given.
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CHAPTER- 10
DATA PRESENTATION AND ANALYSIS
50
1 You deal in
Shares Mutual Fund Bonds Commodities
40 24 12 14
45 40 35 30 25 20 15 10 5 0
Series1
51
The above graph shows that
¾ Shares occupied a predominant place in the financial market. ¾ Mutual fund was also very popular among the investors since 60% of the sample invested
in it.
¾ 35 % of the sample invested in commodities ¾ Only 30% of the sample invested in bonds.
2. How long have you been investing?
Below 2 yrs 2-5 yrs 5-10 yrs Above 10 yrs
16 8 10 6
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18 16 14 12 10 8 6 4 2 0 Below 2 yr 2-5 yrs 5-10 yrs Above 10 Yrs Series1
The above graph shows that
¾ 15% of the sample was in the financial market for more than 10 years. ¾ 10% of the sample was in the financial market for 5-10 years. ¾ 20% of the sample was in the financial market for 2-5 years. ¾ 40% of the sample was in the financial market for less than 2 years.
3. What do you understand by hedging?
Risk minimization Profit maximization Both None
18 8 10 4
53
20 18 16 14 12 10 8 6 4 2 0 Risk Minimization Profir Maximisation Both None Series1
The above graph shows that
¾ 45% of the sample knew the meaning of hedging as risk minimization. ¾ 20% of them thought hedging as a tool of profit maximization. ¾ 25% of them comprehended hedging as a tool of risk minimization as well as profit
maximization.
¾ 10% of the sample didn’t know what is meant by hedging.
4. Are you aware of future and options as a tool of hedging?
Fully Partially Not at all
8 26 6
54
Not at all 15%
Fully 20%
Partially 65%
The above graph shows that
¾ 20% of the sample says that they were fully aware of future and options as a tool of
hedging.
¾ Majority of the sample i.e. 65% of them were partially aware of future and options as a
tool of hedging.
¾ 15% of them were not at all aware of future of options as a tool of hedging.
5. Do you use future and options as a tool of hedging?
Yes No
18 22
55
No 55%
Yes 45%
Interpretation: It was found that 45% of the sample used future and options as a tool of hedging. It also included those people who were partially aware of it and those who didn’t know the exact meaning of hedging. They used it with the help of their brokers. 55% of the sample surveyed didn’t use future and options as a tool of hedging.
6.What is the limit of your investment in future and options?
Below 1 lakh 1- 10 lakh 10-20 lakh Above20 lakh
11 6 1 0
56
12 10 8 6 4 2 0 Below 1 Lakh 1-10 Lakhs 10-20 Lakhs Above 20 Lakhs Series1
The above graph shows that
¾ 27.5% of the sample has their investment below 1 lakh. ¾ 15% of the sample has their investment between 1-10 lakh. ¾ 1% of the sample has their investment between 10-20 lakh. ¾ None of the sample surveyed had their investment above 20 lakh.
7. According to current market scenario, what would you prefer most?
Call Option Put option Both None
16 4 6 14
57
None 35%
Call Option 40%
Both Put Option 15% 10%
The above graph shows that
¾ 40% of the sample prefers call option. ¾ 10% of the sample prefers call option. ¾ 15% of the sample has a fluctuating view on the market. ¾ 35% of the sample does not want to invest in the market due to its volatility.
58
CHAPTER-11
FINDINGS
59
Findings of the Study ? During the study it was found that people didn’t know the right meaning of risk. Most
of them thought that risk is there only when losses are incurred but there is no risk when profit is earned in future.
? Study shows that investors can earn profits in both bullish and bearish market by
using futures and options.
? 15% of the sample didn’t know anything about future and options as a tool of
hedging.
? 65% of the sample is partially aware of future and options as a tool of hedging so they
fear using it.
? It was found that most of the clients followed what their brokers specified. The
knowledge of the public about the financial market is average.
? There is a great scope for future and options as a tool of hedging in coming years as
55% of sample surveyed still don’t use future and options as a tool of hedging.
60
CHAPTER-12
SUGESSTIONS
61
SUGGESTIONS:
? Trading in derivatives was started with the objective of reducing the volatility prevailing in the stock market. Lack of awareness has been the prior reason why the trading in derivatives has been low in volume. Hence for creating awareness about derivatives among investors, stock exchanges have to conduct awareness programmes at free of or at minimal charges. ? The market lot is a barrier for trading both options and futures. Reducing the lot size may increase volume of trade. There is need to reduce transaction cost also, which will increase the number and volume of transactions. ? Investors should take his own decisions after analyzing all those factors like Fundamental analysis and Technical analysis and risk involved before entering into the stock and derivative market. ? Investors should know their markets, they should remember their positions, to avoid more losses. ? Buy when the markets comes down and sell when the market goes up. Average the shares when the price of the share comes down. ? Instead of investing the whole amount in single scrip, we can diversify the amount into several scrips. ? Investors should observe and study the strategies used by others in the market and select his/ her strategy, otherwise it may lead to big market moves, unstable market and large looses for the market participant. ? Investors should observe whether the market is bullish or bearish and use right strategy. When the market is bullish covered call writing is right strategy. On the contrary if the market looks like bearish covered put is the right strategy. But when the market is normal position writing straddles and strangles are right strategies. ? Always put stop loss orders after taking positions to reduce the risk to maximum loss. Its better to trade in high volume counters. ? Delivery facility which is in cash maket if implemented here, will increase volume of trade.
62
CHAPTER-13
CONCLUTION
63
CONCLUSION
In the current scenario, investing in stock markets is a major challenge ever for professionals. Derivatives are important products of on india’s financial markets. They help in risk management. Derivatives acts as a major tool for reducing the risk involved in investing in stock markets for getting the best result out of it. The investors should be aware of various hedging and speculation strategies, which can be used for reducing their risk. Awareness about the various uses of derivatives can help investors to reduce risk and increase profits. Though the stock market is subjected to high risk, by using derivative products like forwards, futures, options and swaps loss can be minimized to an extent.
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CHAPTER-14
LIMITATIONS
65
Limitations
Main limitations of the study are: ¾ Shortage of time was a very big constraint due to which less information has been included in the study. ¾ As there are number of players dealing in derivative markets but focus is on only small investors so limits the scope of the study. ¾ There are four types of derivatives market: future, forward, swap and option but in this study only future and option are considered. ¾ Though every - "precaution has taken due to large data and complex calculations, there may be chances of error. ¾ Being a student; there is lack of practical knowledge regarding future and option as a tool of hedging. . ¾ Data is collected at random basis so chances of biasness are always there. ¾ Due to shortage of time, sample has been taken of just 40 investors. That might not represents the accurate picture of investors’ knowledge.
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CHAPTER-15
QUESTIONNAIRE
67
QUESTIONNAIRE
Study of hedging based on Derivative
You deal In shares Shares Mutual Fund Bonds Commodities How long have you been investing? Below 2 yrs 2-5 yrs 5-10 yrs Above 10 yrs What do you understand by hedging? Risk minimization Profit maximization Both None
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Are you aware of future and options as a tool of hedging? Fully Partially Not at all
Do you use future and options as a tool of hedging? Yes No
What is the limit of your investment in future and options? Below 1 lakh 1- 10 lakh 10-20 lakh Above20 lakh
According to current market scenario, what would you prefer the most? Call Option Put option Both None
Personal Information Name…………… Place…………… Occupation…………… Contact No……………
69
CHAPTER-16
BIBLIOGRAPHY
70
BIBLIOGRAPHY
1. Www.indbankonline.com 2. Investor.sebi.gov.in 3. en.wikipedia.org/.../Securities_and_Exchange_Board_of_India 4. www.sebi.gov.in 5. www.hedging.com 6. www.investopedia.com
71
doc_865784900.pdf
In practice, derivatives are a contract between two parties that specify conditions (especially the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the notional amount) under which payments are to be made between the parties.
“ STUDY ON DERIVATIVES”
PROJECT REPORT Submitted to the
SCHOOL OF MANAGEMENT
In partial fulfillment of the requirements for the award of the degree of
MASTER OF BUSINESS ADMINSTRATION
By
RENUKA CHANDRAWAL REG NO: 3510910640
Under the guidance of
Ms. R. SHENBAGAVALLI, Asst. Professor
SRM SCHOOL OF MANAGEMENT SRM UNIVERSITY KATTANKULATHUR 603 203
MAY 2011
RENUKA CHANDRAWAL 3510910640 SRM School of Management SRM University SRM Nagar, Kattankulathur - 603 203, Kancheepuram District, Tamil Nadu.
DECLARATION
I hereby declare that the project report entitled “STUDY ON DERIVATIVES” submitted to SRM School of Management in partial fulfillment of the requirement for the award of the Degree of Master of Business Administration, is a record of the original research work done under the supervision and guidance of Ms. R. SHENBAGAVALLI, Asst. Professor, SRM School of Management, SRM University, Chennai and that it has not formed the basis for the award of any degree / associate ship / fellowship of other similar title to any candidate of any university.
Place: Kattankulathur Date: RENUKA CHANDRAWAL
SRM School of Management SRM University SRM Nagar, Kattankulathur - 603 203, Kancheepuram District, Tamil Nadu.
Bonafide certificate
Certified that this project report titled “STUDY ON DERIVATIVES” is the Bonafide work of Ms. RENUKA CHANDRAWAL (3510910640) who carried out the research under my supervision. Certified further, that to the best of my knowledge the work reported herein does not from part of any other project report or dissertation on the basis of which a degree or award was conferred on an earlier occasion on this or any other candidate.
Submitted for the viva-voce examination held on -----------------------
-------------------------------Ms. R. SHENBAGAVALLI Asst. Professor (Project Guide)
----------------------------Dr. JAYSHREE SURESH (Dean, MBA)
-----------------------------------External Examiner
ACKNOWLEDGEMENT
I take this opportunity to thank Dr. C. Muthumizhchelvan, Director (Engineering & Technology), SRM University for providing us with an excellent infrastructure and conducive atmosphere for developing our projects. I express my profound gratitude to my mentor, Mrs. R. Shenbagavalli, Assistant Professor , SRM School of Management, who has been a constant source of encouragement and support for guiding me through the course of the project work. My heartfelt thanks to Dr. Jayshree Suresh, Dean, SRM School of Management, SRM University, for the support and advice she has given us throughout our project and also for the opportunity she has given us to undergo the Internship Training. I also wish to thank the managers and staffs of IND BANK , Chennai for their timely help and cooperation. I also express our gratitude to the Faculty, Attendants and Fellow Students of the Department of Business Administration, School of Management Studies for their needy and continuous support and technical assistance given throughout the duration of the course and the project. Last but not least, I would also like to thank my family and friends for all their love and support.
TABLE OF CONTENT
SL NO. 1 2
INDEX Introduction Industrial profile
PAGE NO 01 02 08
3 Company profile 4 Product profile 5 Scope of study 6 Objectives of study 7 Usage of future and option for hedging 8 Review of literature 9 Research methodology 10 Data analyze and interpretation 11 Finding 12 Suggestion 13 Conclusion 14 Limitations of study 15 Questionnaire 16 Bibliography
13 18 31 40 41 46 51 54 62 66 69 75 76
TABLE OF TABLES
SLNO. 1 INDEX Respondents who deal in shares , mutual fund, bonds, commodities. Durations of respondents in investment. 2 Respondents view on meaning of hedging. 3 4 Respondents view on awareness about future and options as a tool of hedging. Respondents use future and options as a tool of hedging. 5 Respondents limit on investment in future and options. 6 7 Respondents view on current market scenario, what would they prefer most……??? 60 61 59 57 58 56 PAGE NO 55
TABLE OF CHART
SL NO. 1 INDEX PAGE NO 55
Respondents who deal in shares , mutual fund, bonds, commodities. Durations of respondents in investment. Respondents view on meaning of hedging. Respondents view on awareness about future and options as a tool of hedging. Respondents use future and options as a tool of hedging. Respondents limit on investment in future and options. Respondents view on current market scenario, what would they prefer most……???
2 3 4
57 58 59
5 6 7
60 61 62
ABSTRACT
The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. My study in this topic deals with meaning of derivatives , types of derivatives .In later part of study I have done the survey which tells how many . Lack of awareness has been the prior reason why the trading in derivatives has been low in volume. Hence for creating awareness about derivatives among investors, stock exchanges have to conduct awareness programmes at free of or at minimal charges. people invest in different types of securities and whether they are aware of the hedging tools available.
CHAPTER-1
INTRODUCTION
INDUSTRIAL PROFILE
STOCK EXCHANGE The stock exchange of secondary market is a highly organized market for the purchase and the sale of second hand quoted of listed securities. The securities contracts (Regulation) Act 1956 defines a stock exchange as “an association, organization or not, established for the purpose of assisting, regulating and controlling business in buying, selling and dealing in securities”. Of all the modern service institution, stock exchange plays a crucial agents and facilitators of entrepreneurial progress. After the industrial resolution, as the size of the business enterprises grew, it was no longer possible for individual person or even partnerships to raise such huge amount for undertaking these ventures. Such huge requirements of capital can be met only by large number of individuals
DEVELOPMENT OF DERIVATIVES MARKET IN INDIA. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (amendment) ordinance, 1995, which withdrew the prohibitation on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. Securities Exchange Board of India (SEBI) set up a committee (consisting of 24 members) under Chairmanship of Dr. L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirements and real time monitoring requirements.
2
The Securities Contracts (Regulation) Act 1956 (SCRA) was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework were developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding over the counter (OTC) derivatives. The government also rescinded in March 2000, the three decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2009. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE ,and their clearing house/ corporation to commence trading and settlement in approval derivatives contracts. To begin with, SEBI approved trading index futures contracts based on S&P CNX Nifty and BSE30 (Sensex) index. This was followed by approval for trading in index options commenced in June 2001 and trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. Trading and settlement in derivative contracts is done in accordance with the rules byelaws and regulations of the respective exchanges and their clearing house corporation duly approved by SEBI and notified in the official gazette. Though the derivative market has been developed and much of people deal in derivative market they are not aware of advantage of the dealing in various derivative instruments.
3
BOMBAY STOCK EXCHANGE AND SENSEX: BSE is the first stock exchange in the country which obtained permanent recognition (in 1956) from the Government of India under the Securities Contracts (Regulation) Act 1956. BSE's pivotal and pre-eminent role in the development of the Indian capital market is widely recognized. It migrated from the open outcry system to an online screen-based order driven trading system in 1995B. The BSE Index, SENSEX, is India's first stock market index that enjoys an iconic stature , and is tracked worldwide. It is an index of 30 stocks representing 12 major sectors. The SENSEX is constructed on a 'free-float' methodology, and is sensitive to market sentiments and market realities. Apart from the SENSEX, BSE offers 21 indices, including 12 sectoral indices.
NATIONAL STOCK EXCHANGE: The Organisation The National Stock Exchange of India Limited has genesis in the report of the High Powered Study Group on Establishment of New Stock Exchanges, which recommended promotion of a National Stock Exchange by financial institutions (FIs) to provide access to investors from all across the country on an equal footing. Based on the recommendations, NSE was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the country.
On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The Capital Market (Equities) segment commenced operations in November 1994 and operations in Derivatives segment commenced in June 2000.
NIFTY: The National stock exchange has an index called the Nifty( officially called S&P CNX nifty). This name can be credited to the 50 stocks that comprise its index. 4
VARIOUS PRODUCTS AVAILABLE FOR TRADING IN FUTURES AND OPTIONS SEGMENT AT NSE: Futures and options contracts are traded on Indices and on Single stocks. The derivatives trading at NSE commenced with futures on the Nifty 50 in June 2000. Subsequently, various other products were introduced and presently futures and options contracts on the following products are available at NSE: 1. Indices : Nifty 50 CNX IT Index, Bank Nifty Index, CNX Nifty Junior, CNX 100 , Nifty Midcap 50, Mini Nifty and Long dated Options contracts on Nfity 50. 2. Single stocks – 228
BUSINESS GROWTH IN DERIVATIVES SEGMENT FROM 2008-2009
Index Futures Month
Stock Futures
Index Options
Stock Options
Total
No. of al / Year No. of Turnov No. of Turnove No. of Turnove contrac er (Rs. contract r (Rs. contract contract Turnov r (Rs. ts cr.) s cr.) s s er (Rs. cr.) cr.) Mar2009 Feb2009 Jan204971 276676 1018402 289361.7 3144808 444099.1 52 .50 8 0 5 6
Notional
Notion No. of contr acts Turnover (Rs. cr.)
966542
29793. 6309580 12 7
1039930.49
157507 205679 1715683 185121.0 2147520 305599.0 67 .16 8 0 1 3
1361770
15971.1 5574457 0 6
712370.28
176955 234140 2281433 215830.3 2121567 309271.3 1777120 18876.2 6350266
778118.35
5
2009 Dec2008 Nov2008 Oct2008 Sep2008 Aug2008 Jul2008 Jun2008 May2008 Apr2008
42
.51
2
0
1
3
3
5
200078 269997 2226278 230465.5 2115877 313615.4 95 .31 5 7 9 2
1364307
15087.9 6479376 6 6 5814537 8
829166.28
194713 256949 1794927 187211.2 1992092 292134.3 67 .74 0 6 4 3
803817 9060.80
745356.12
216494 324961 1985840 239263.8 2073738 364509.6 45 .66 9 5 1 2
889593
12911.0 6313482 6 8
941646.17
193323 380197 2007613 332728.5 2139843 461622.6 43 .75 8 2 0 6
1304655
23323.4 6211156 3 6
1197872.36
144339 300448 1759421 324010.8 1383564 312101.6 84 .85 6 6 2 9
1029701
20883.4 4689354 0 3
957444.84
204231 395379 2223222 382600.8 1688970 357208.5 39 .96 7 0 4 8
1252290
24984.6 6079736 8 0
1160174.01
179418 377939 1915494 375986.7 1356443 308708.6 70 .01 6 1 6 3 129066.5 3 133564.8 6
939877
21429.9 5160112 3 9
1084064.27
111614 267640 1669326 380160.6 27 .70 0 5
5078960
906408
21040.4 3384005 5 5
797908.39
120631 280100 1560153 336900.9 72 .25 1 0
5365231
699890
15864.6 3372982 5 4
766430.64
6
CHAPTER-2
COMPANY PROFILE
7
COMPANY PROFILE
INDBANK MERCHANT BANKING SERVICES LIMITED was established as a subsidiary of Indian bank, in 1989. Indbank is a SEBI registered merchant banker and was one among the few merchant banking subsidiaries to be formed by a Nationalized Bank. Indbank is also one of the early corporate entrants in the field of stock broking, being the first institutional member of Madras Stock Exchange since 1991. Indbank provides financial services. The services includes 1. Merchant banking and Corporate advisory services
2. Stock Broking
3. Online Trading
4. Depository Participant activities
5. Distribution of Mutual funds and other Investment products
6. Websites
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1. MERCHANT BANKING AND CORPORATE ADVISORY SERVICES
Indbank is a category 1 merchant banker registered with Security Exchange Board of India (SEBI) undertaking assignments. Indbank has identified the major areas of services and has assigned specialist personnel to each.
• • • • •
Management of Equity and Debt issues Corporate Advisory services Mergers and Acquisitions Loan Syndication Project Counseling
2. STOCK BROKING
Indbank is a SEBI registered member of National Stock Exchange of India (NSE), Madras Stock Exchange (MSE) and Over the Counter Exchange of India (OTCEI). Indbank is an
empanelled broker for major financial institutions and banks. Indbank undertakes trading in the BSE as sub-broker of Madras Stock Exchange where Indbank is an Institutional members.
3. ONLINE TRADING
To enable the customer to trade from anywhere under the internet based trading system, Indbank has recently launched a powerful and user- friendly Online trading facility, which is completely safe and secure. Indbank Merchant Banking Services Limited has entered into an agreement with Indian Bank for the customers of Indian Bank for the provision of online trading facilities to the
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customers of Indian Bank. For availing this facility the customer has to open a Net Banking Account and DEMAT Account with Indian Bank and Online Trading Account with Indian Banking Services Limited.
4. DEPOSITORY PARTICIPANT ACTIVITIES
Indbank is a SEBI registered Depository participant with National Securities and Depository participant with National Securities and Depositories Limited (NSDL), since 1998, and is governed by the Depositories Act 1996 and circulars issued by SEBI regulations, 1996 and circulars issued by SEBI and NSDL from time to time. DEMAT is a safe and convenient way to hold securities eliminating the risks associated with physical certificates like bad deliveries, fake securities, delays, thefts etc., facilitating faster transactions. Indbank Offers a DEMAT services through its network of offices
5. DISTRIBUTION OF MUTUAL FUNDS AND OTHER INVESTMENT PRODUCTS
Indbank distributes Mutual Funds and investment products and is registered with the Association of Mutual Fund of India (AMFI) for distribution of Mutual Funds of products. Indbank offer this services through its network offices.
6. WEBSITES
Indbank has launched its website www.indbankonline.com in the current year. The website provides host of market information like quotes, indices, economy, industry and corporate news and provides facilities for Creating your own portfolio, posting your queries etc.
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CHAPTER-3
PRODUCT PROFILE
11
PRODUCT PROFILE
INDBANK MERCHANT BANKING SERVICES LIMITED (IBMBS Ltd) was established as a subsidiary of Indian bank, in 1989. Indbank, under one roof, offers a truly comprehensive range of financial services by way of one-stop shop through a cream of professionals drawn from various disciplines, who are ably supported by a team of experienced personnel from Indian bank offices, backed by the most sophisticated communication network for instant access to information and constant updates. The services include: ¾ Merchant banking and Corporate Advisory Services ¾ Stock Broking ¾ Online Trading ¾ Depository Participant Activities ¾ Distribution of Mutual Funds and other Investment product.
1. Merchant banking and Corporate Advisory Services Indbank is a category 1 Merchant Banker registered with Securities Exchange Board of India (SEBI). Merchant banking today has become so complex and sophisticated in nature that it’s truly multi-faced. Indbank has identified the major areas of services and has assigned specialist personnel to each. • Management of Equity & Debt issues ¾ Rights/Public Issues ¾ IPO s/Offer for sale of equity-through fixed price/book building routes, ¾ obtaining clearances for the same and drafting prospectus ¾ Compliances with Pre and Post issue requirements ¾ Underwriting, Liason with the brokers and bankers ¾ ESOP/ESOS issues
12
¾ Private placement of debt for banks, FIIs, industrial houses ¾ Venture Capital Tie- ups
•
Corporate Advisory Services ¾ Valuation of shares and other financial instruments ¾ Capital structuring and restructuring ¾ Delisting ¾ Buyback ¾ Efficiency improvement studies
•
Mergers and Acquisitions ¾ Identification of opportunities ¾ Evaluation of prospects ¾ Negotiations and working out of mechanics ¾ Documentation ¾ Managing open offers
•
Loan Syndication ¾ Identification of finance sources ¾ Detailed project Appraisals ¾ Application for assistance ¾ Negotiations of terms and documentati
•
Project Counseling ¾ Collaboration arrangements ¾ Detailed Project Appraisal
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¾ Assistance in project implementation ¾ Financial closure
2. Stock Broking
Indbank is a SEBI registered member of National Stock Exchange of India (NSE), Madras Stock Exchange (MSE) and Over the Counter Exchange of India(OTCEI).Indbank currently operates in the cash, derivatives & wholesale Debt Market Segments of NSE for both retail and institutional investors. Indbank is one amongst very few subsidiaries of nationalized banks that have entered into Stock Broking activity. Indbank is an empanelled broker for major financial institutions and banks. Indbank undertakes trading in BSE as sub-broker of Madras Stock Exchange where Indbank is an Institutional member. The website of Indbank is www.indbankonline.com , which provides a host of market information like quotes, indices, economy, industry and corporate news, and provides facilities for creating client’s own portfolio, posting client’s queries etc.
3. Online Trading To enable the customer to trade from anywhere under the Internet based trading system, Indbank had recently launched a powerful and user-friendly Online trading facility, which is completely safe and secure. The facility is designed to provide the clients an expedient and
paperless trading experience through their website, “www.indbankonline.com->online trading>login”. Indbank uses robust software, which utilizes highest levels of encryption standards to guard against intrusion. The software has many user friendly features to enable the Indbank Online Trading Clients perform several functions over the internet, including: ¾ View the market information ¾ Enter/Modify/Cancel their orders ¾ View order and trade status
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¾ View their portfolio and cash balance information ¾ View their transaction history ¾ Use of information and price ticker ¾ Online alerts for their activities ¾ Hyperlinks to other services such as market historical information, exchange websites, news, charting and a host of other value added features ¾ Access to digital contracts for trades that are executed and to back office accounts. ¾ Online Alerts for client’s activities
Indbank Merchant Baking services Limited has entered into an agreement with Indian Bank for provision of Online trading facilities to the customers of Indian Bank. For availing this facility the customers has to open a net banking account with Indian Bank, a demat account either with Indian Bank or with Indbank and online trading account IBMBS Ltd. This will benefit all the customers having accounts with CBS branches of Indian Bank for undertaking stock market operations. Incidentally it may be mentioned here that all branches of Indian Bank are now under CBS system.
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CHAPTER-4
SIGNIFICANCE OF PROBLEM
16
Significance of the problem
In India there are two types of markets. First is equity market or cash market and second one is derivative market. Normally people invest in cash market. Cash market is that market where investors have to pay full amount for there transactions; where as derivative market is that market where investors can invest by paying some partial money instead of full payment. Both the markets involve risk in terms of fluctuation in prices. An investor who is investing in equity market (cash market) can not estimate that in which direction market would go, whether upward or downward. Big investors can tolerate risk but small and medium investors can not. More than 80% investors belong to small and medium category and they may avoid investing in market, which can hamper the growth of our country. But the study tells the interrelationship of both the markets and tells how risk can be minimized with the help of hedging in derivative market. Focus of study is whether the investors are aware about the right meaning of risk and a tool available to reduce it.
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CHAPTER-5
INTRODUCTION TO STUDY
18
Conceptualization
Derivatives The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the `to arrive' contract that permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. These were eventually standardized, and in 1925 the rest futures clearing house came into existence. Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.
Definition A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, FOREX, commodity or any other asset. A derivatives market is any market for a derivative security that is a contract which specifies the right or obligation to receive or deliver future cash flows based on some future event such as the price of an independent security or the performance of an index. The main types of derivatives are futures, forwards, options and swaps.
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Types of Derivatives
Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way that they are traded in market: ¾ Over-the-counter (OTC) derivatives: Over the counter derivatives are contracts that are traded directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivatives market is huge. According to the Bank for International Settlements, the total outstanding national amount is USD 248 trillion at the end of December 2004.
¾ Exchange-traded derivatives: Exchange-traded derivatives are those derivatives products that are traded via derivatives exchanges. A derivatives exchange acts as an intermediary to all transactions, and takes initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), Chicago Mercantile Exchange and the Chicago Board of Trade Participants in the Derivative Market ¾ Hedgers- Hedgers are participants who face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk.
¾ Speculators- Speculators are participants who wish to bet on future movements in the price of an asset. Futures and options contracts can give them leverage; that is, by putting in small amounts of money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses.
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¾ Arbitragers- Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit.
Risk
Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome .more specifically, most investors are concerned about the actual outcome being less than the expected outcome .the wider the range of possible outcomes the greater the risk. Stock Market Stock market is place where the stocks or shares are purchased and sold .stock exchange is an organized market where securities are traded .these securities are issued by the government, semi-government, public sector undertakings and companies for borrowing funds and raising resources. securities are defined as any monetary claims and includes stock ,shares, debentures ,bonds etc .if these securities are marketable as in the case of government stocks; they are transferable by endorsement and are like moveable property .they are tradable on the stock exchange. Exchanges are located all over the world with the most famous one being the New York stock exchange. The NYSE annually traded almost 14 trillion dollars worth of capital thousands of stocks are listed on this exchange. When you buy a stock you will need to learn which exchanges list it other than locating quote in the news paper with online trading and the automation of order system ,there is very little reason to determine where the stock trades from the customers viewpoint.
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There are 22 stock exchanges in India, the first being the Bombay Stock Exchange (BSE), which began formal trading in 1875, making it one of the oldest in Asia. Over the last few years, there has been a rapid change in the Indian securities market, especially in the secondary market. Advanced technology and online-based transactions have modernized the stock exchanges. In terms of the number of companies listed and total market capitalization, the Indian equity market is considered large relative to the country’s stage of economic development. The number of listed companies increased from 5,968 in March 1990 to about 20,000 by May 2006 and market capitalization has grown almost 11 times during the same period. The debt market, however, is almost nonexistent.
BSE and NSE
For the premier Stock Exchange that pioneered the stock broking activity in India, 128 years of experience seems to be a proud milestone. A lot has changed since 1875 when 318 persons became members of what today is called "The Stock Exchange, Mumbai" by paying a princely amount of Re1. Since then, the country's capital markets have passed through both good and bad periods. The journey in the 20th century has not been an easy one. Till the decade of eighties, there was no scale to measure the ups and downs in the Indian stock market. The Stock Exchange, Mumbai (BSE) in 1986 came out with a stock index that subsequently became the barometer of the Indian stock market. SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. First compiled in 1986, SENSEX is a basket of 30 constituent stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100. The index is widely reported in both domestic and international markets through print as well as electronic media. 22
Well, the National Stock Exchange has an index called the Nifty (officially called S&P CNX Nifty). This name can be credited to the 50 stocks that comprise its index. The Nifty has 50 stocks covering 24 sectors, as against 30 stocks and 13 sectors for the Sensex. In case if one is shaking your head about 50 also being too small a number, these 50 stocks account for around 60 percent of the market capitalisation.
S&P CNX Nifty S&P CNX Nifty is a well diversified 50 stock index accounting for 22 sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds. S&P CNX Nifty is owned and managed by India Index Services and Products Ltd. (IISL), which is a joint venture between NSE and CRISIL. IISL is India's first specialized company focused upon the index as a core product. IISL have a consulting and licensing agreement with Standard & Poor's (S&P), who are world leaders in index services. Prices of every stock increases or decreases due to following reasons: News about the company, like a product launch, closure of a factory, the government providing tax or duty exemptions to the sector so more profits expected, a feud among the company's top bosses, etc. This will be stock specific news. News about the country, like testing a nuclear bomb, a terrorist attack, a budget announcement, etc. This will be called index news. The job of an index is mainly to capture the news about the country. This will reflect the movement of the stock market as a whole.
Future Contract It is an agreement between two parties to exchange an asset at a certain date in future at a certain price. It is a standardized forward contract that is traded on an exchange. The standardized items in a 23
futures contract are: • • • • Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change
Futures were originally introduced as an insurance mechanism for farmers and manufacturers who wanted to fix a price for crops at a future date. The farmer wanted to be able to make plans knowing the price he would get for his crops. For the manufacturer, fixing the price meant that he could ensure consistency in the prices he charged. Quite simply, a future is an agreement (obligation) to buy or sell a given quantity of a particular asset, at a specified future date, at a pre-agreed price. Futures contracts have standard delivery dates, trading units, terms and conditions. Futures can be based on any number of underlying assets. In addition to offering futures and options based on individual shares and stock market indices, LIFFE also offers futures and options based on bonds, interest rates and soft and agricultural commodities. You can "open" a futures position by either buying or selling a future. You can "close" your futures position by doing the opposite - either selling or buying the same future. In practice, most futures contract positions are "closed out" before they expire. If you hold a view that the underlying asset will rise, you could buy futures - known as a Long futures position - which commits you to take delivery of the underlying shares, or equivalent cash value, at a pre-arranged price and by a certain date. If your view is that the share prices for the underlying asset will fall, you could sell futures known as a Short futures position - which commits you to deliver the underlying shares, or equivalent cash value, at a prearranged price and by a certain date.
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Potential Risks and Rewards There is no way of knowing for sure the direction of the prices of the underlying asset or the price of futures in advance. Therefore, like many investments, futures carry a risk that market prices may go in the opposite direction of the view held. Futures can be used in different market conditions. Let's consider equity futures. Remember that equity futures are financial instruments whose price movements are derived from the price movements of an underlying share price or index. Two distinctive benefits of trading equity futures are as follow:
•
You can earn profit in a falling market as well as a rising market: Normally, when investing in shares, you would go by the rule of buy low and sell high in order to profit from market prices. In the futures market, you have the opportunity to sell futures, known as going short. So, if a view is held that a share price will fall, consider selling futures. If the view materialises and the price of the future price falls in line with the underlying share price, the position can be closed by buying back the future for less in order to make a gain.
•
Cost efficiency: An additional benefit of trading equity futures as opposed to trading shares is the lower commission structure. Futures trading commissions typically represent a third of the costs for those to trade the underlying market and cash-settled futures contracts. In addition, profits from futures do not incur any stamp duty.
Pricing of the Futures Futures prices are calculated in a structured way. When you look at a futures price you will see two prices: Bid Price is the price at which a trader is willing to buy a futures contract Offer Price is the price at which a trader is willing to sell a futures contract The futures price should be equal to the cost of financing the purchase of the underlying asset and the cost of holding (or storing) it until expiry of the futures contract.
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LIFFE's range of equity futures are derived from share prices and indices. So, in this case, the total cost of buying shares and holding them until expiry of the future contract is made up to three main elements:
• • •
The price of the underlying shares Any interest income foregone by holding shares rather than cash Any dividends paid to the holder of the shares before the expiry of the future
This can be calculated by using formula as under: Fair equity futures price = today's share price + interest costs - dividends received Futures on equity indices are priced on a cost of carry basis. The fair value of the index futures contract is determined by adjusting the current cash index price by the net cost of carry of the underlying basket of shares replicating the index. Cost of carry reflects the cash flow considerations of a seller of futures over the life of the contract as (s)he holds the underlying basket of shares. The cost of borrowing for the financing of the index basket is the main factor, but the income generated from holding the underlying basket of shares must also be taken into consideration. The cost of carry can therefore be defined as the difference between the cost of financing the holding of the basket of shares comprising the index and the income earned on these stocks in the form of dividends (dividend yield). Futures and options are products that can transform your trading and investment activity; increasing profit potential and giving you the means to control risk too. LIFFE is committed to bringing this world of trading and investing opportunities to the private investor, both through education and through a continuous process of product enhancement and development. In conjunction with education supplier Trade Basics, LIFFE is pleased to bring you a series of interactive education modules in The Learning Centre. The prices for LIFFE's range of equity futures and options can be viewed at http://www.liffedata.com. Here you will see 15 minute delayed price data. In addition, free live prices for LIFFE's Universal Stock Futures are also available.
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History of futures exchanges Though the origins of futures trading can be supposedly traced to Ancient Greek or Phoenician times, the history of modern futures trading begins in Chicago, United States in the early 1800s. Chicago is located at the base of the Great Lakes, close to the farmlands and cattle country of the U.S. Midwest, making it a Natural centre for transportation, distribution and trading of agricultural produce. Gluts and shortages of these products caused chaotic fluctuations in price. This led to the development of a market enabling grain merchants, processors, and agriculture companies to trade in "to arrive" or "cash forward" contracts to insulate them from the risk of adverse price change. In 1848, the Chicago Board of Trade (CBOT), the world's first futures exchange, was formed. Trading was originally in forward contracts; the first contract (on corn) being written on March 13, 1851. In 1865, standardized futures contracts were introduced. The Chicago Produce Exchange was established in 1874, renamed in 1898 the Chicago Mercantile Exchange (CME). In 1972 the International Monetary Market (IMM), a division of the CME, was formed to offer futures contracts in foreign currencies: British pound, Canadian dollar, German Mark, Japanese yen, Mexican peso, and Swiss franc. Later in the 1970s saw the development of the financial futures contracts, which allowed trading in the future value of interest rates. These (in particular the 90-day Eurodollar contract introduced in 1981) had an enormous impact on the development of the interest rate swap market. Options Contract: Today, the futures markets have far outgrown its agricultural origins. With the addition of The New York Mercantile Exchange (NYMEX) and The American Energy Exchange(AMENX) the trading and hedging of financial products using futures dwarfs the traditional commodity markets, and plays a major role in the global financial system trading over 1.5 trillion U.S. dollars per day in Option. In finance, an option is a contract whereby one party (the holder or buyer) has the right but not the obligation to exercise a feature of the contract (the option) on or before a future date (the exercise
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date or expiry). The other party (the writer or seller) has the obligation to honour the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium. Four major factors affecting the Option premium: • • • • Price of Underlying Time to Expiry Exercise Price Time to Maturity Volatility of the Underlying
And two less important factors: • • Short-Term Interest Rates Dividends
An option simply gives the holder the right, but not the obligation, to buy (call), or sell (put), a specified underlying asset at a pre-agreed price on or before a given date. Example Imagine there is a plot of land next to where you live. The owner of the land knows that it is only worth selling if he obtains planning permission. But the owner needs some funds now so he offers you the option to buy that land at an agreed amount during a fixed period of time. You know that you want the land but only if there is planning permission so you agree to pay him a fee for the option to buy the land. The fee is just a small percentage of the amount agreed. In time, the planning permission is granted and you exercise the option and buy the land. If planning permission had not been granted during the agreed period of time, you would not exercise your option and would have only lost the fee you had paid - but you would have safeguarded against anyone else buying that land.
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There are two types of options: Call: The buyer of a Call option acquires the right, but not the obligation, to buy the underlying asset at a fixed price. Call options generally rise in value if the price of the underlying asset rises. Put: The buyer of a Put option acquires the right, but not the obligation to sell the underlying asset at a fixed price. Put options generally rise in value if the price of the underlying asset falls. The buying of options involves limited risk - that is to say you cannot lose any more than the premium paid at outset. It is also possible to write or sell options. The writing of call options, although having a wide range of uses, is a potentially high-risk strategy requiring a high degree of product knowledge. Since exercise can involve the writer in a substantial financial commitment, option writers are required to deposit margin with the broker to ensure the obligations of the contract can be met in full if required. An option can be granted over many assets - including soft and agricultural commodities, bonds, shares and share indices. Equity options are financial instruments whose price movements are derived from the price movements of an underlying share price or index and hold a host of investment opportunities as a private investor. Whilst options on individual equities allow investors to gain exposure to specific shares, index options allow investors to gain exposure to the UK stock market in one transaction. In both the US and the Netherlands, private investors account for over 60% of the equity options traded. In these countries, private investors view investing in options and investing in the underlying shares or indices as being quite similar.
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Potential Risks and Rewards Options can be used in a variety of different market conditions. Let's consider equity options. Remember equity options are financial instruments whose price movements are derived from the price movement of the underlying share price or index. Two distinctive benefits of trading equity options are as follow:
•
Buying equity options: limited risk and unlimited potential profit: This is obviously quite different to buying shares. When a investor buy either a call or put option, the risk is limited to the premium he/she pays. If the share price does not go in the direction of anticipation, simply leave the option to expire without exercising it. There is only loss of premium paid.
•
With equity options you can enhance the return on your existing equity portfolio: If you hold shares and do not expect the price to move very much over the next few months, you may consider writing, or selling, a call option against this shareholding. This is known as selling a Covered Call. In return, you will receive a premium from the buyer. You retain this premium in all circumstances. If, as you anticipated, the share price does not change significantly by expiry, the option will expire worthless and the premium received has enhanced your shareholding during static market conditions.
If however investors view is incorrect, the option holder may choose to exercise the option and he will be obliged to sell his shares. • Note that since exercise can involve the writer in substantial financial commitment, option writers are required to deposit margin with their broker to ensure the obligation of the contract can be met. • • The risk associated with options largely depends on how they are used. The buying of options involves a limited risk. That is to say that the maximum loss is limited to the price paid for the option (the premium) and therefore is known at the outset.
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The writing i.e. selling of options, although having a wide range of uses, is a potentially high-risk strategy requiring a high degree of product knowledge. Investors should consider very carefully the risks of writing options and ensure they hold the requisite number of shares or cash equivalent (margin) to lodge with the broker. Since exercise can involve the writer in substantial financial commitment, option writers are required to deposit margin with their broker to ensure the obligation of the contract can be met. This is known as "covered" option writing. Option Exchanges and Contracts Most of the exchanges that trade financial futures also trade financial options. There are also exchange that trade option but not futures, such as the European options exchange (EOE-located in Amsterdam) and the Marche des options negociables de Paris (MONEP).
How is Equity Option Priced? The value of an equity option contract is influenced by several factors. A mathematical formula is applied to these factors in order to achieve the option price. Table is on the next page.
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Factor Underlying share price
Explanation The underlying share price, together with the option's exercise price, determines the "intrinsic value" of an option. For example, if the share price exceeds the exercise price of a call option by 20p, the options is said to have 20p worth of intrinsic value and to be 20p "in-the-money". In the case of a put option, the reverse is true. A put option is "in-the-money" when the exercise price exceeds the underlying share value.
Exercise price or strike price
The term "exercise" refers to taking up the right to buy or sell the underlying asset. The price is fixed at the outset. When an option holder exercises their option, a randomly selected writer is notified of this and is required to deliver or take delivery of the underlying asset .
Time to expiry
Time has a value since the longer the option has to go until expiry, the more opportunity there is for the share price, and hence the option price, to move. Generally the further away the expiry day, the higher an option's time value. This is true for both calls and puts.
Volatility
Time value is also affected by the past and/or future volatility of the underlying share. More volatile shares attract higher time value as profit opportunities for option holders and hence risks for option writers are greater than for shares and more stable prices.
Dividends
Dividends are paid to shareholders, but not to holders of options. Since the share price tends to fall by the amount of the dividend after it has been announced, it follows that the price of an option will reflect the value of any expected dividend payments.
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Interest Rates
Interest rates also affect the price of equity options. However, changes in interest rates have a relatively small effect on option premiums
HEDGING:
Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta.
Beta is the measure of a fund's volatility relative to the market. A beta of greater than 1.0 indicates that the fund is more volatile than the market, and less than 1.0 is less volatile than the market. Assuming you have a portfolio of Rs. 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs. 1.2 mn of S&P CNX Nifty futures. Risk management strategy used in limiting or offsetting probability of loss from
fluctuations in the prices of commodities, currencies, or securities. In effect, hedging is a transfer of risk without buying insurance policies. It employs various techniques but, basically, involves taking equal and opposite positions in two different markets (such as cash and futures markets).
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Steps 1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1.
2. Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings.
Therefore in the above scenario we have to short sell 1.2 * 1 million = 1.2 million worth of Nifty.
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CHPTER-6
SCOP OF STUDY
35
Scope of the Study
In the today’s volatile market nobody can predict to which way market will move i.e. either upward or downward. So it is considered as an enigma by the small investors and they try to be away from the market due to fear of losses. Focus of study is to identify the interrelationship of both the equity and derivative markets and tell the usage of derivative market for the purpose of hedging, so that the risk can be minimized.
Usefulness of the study
The study can help in the following ways: ¾ Provide complete knowledge of future and option. ¾ Usage of future and option as a tool of hedging. ¾ Motivate investors to use this tool by asking some questions regarding it. ¾ Interrelationship of equity and derivative market.
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CHAPTER-7
OBJECTIVES OF STUDY
37
Objective of The Study
Objectives of the study are: ¾ To study the history and benefits of financial derivatives. ¾ To show how to hedge with future and option. ¾ To know the awareness of investors towards hedging. ¾ To identify the future scenario of derivative Market for hedging in india.
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USAGE OF FUTURE & OPTION FOR HEDGING
39
How can Futures be used for Hedging?
Futures contracts can be used in many different ways depending on investment objectives. Here are two examples:
•
To safeguard or "hedge" the existing underlying assets if price will fall in near future: Consider opening a futures position to protect the existing assets (e.g. your share
portfolio) in the event of a down turn in prices. As a holder of the asset, you can sell futures against equity portfolio to avoid making a loss and without having to incur the costs associated with selling assets. To "close" the futures position by buy the equivalent amount of futures in the market. Losses in the underlying asset can therefore be compensated by profit made on the futures position.
•
To profit from volatile market conditions: Futures provide the opportunity to profit from the upward and downward turns in the
prices of underlying assets. For a view that market prices will raise, consider buying futures (remember this is a Long futures position). Conversely, for a view that market prices will fall, consider selling futures (remember this is a Short futures position). If the view held materialises, the position can be closed by undertaking an equal and opposite position in the same market in order to profit from the price difference. Remember to close a long position you would sell futures and to close a short position you would buy futures. Futures can transform trading and investment activity of an investor, by increasing profit potential and giving the means to control risk. There is no way of knowing for sure the direction of the prices of the underlying asset or the price of futures in advance. Therefore, like many investments, futures carry a risk that market prices may go in the opposite direction of the view held.
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How can Options be used for Hedging?
Options are extremely flexible instruments that can be used in a variety of different ways either as a way to gain profit from short term market movements or as a part of longer-term investment strategies. Here are two:
•
As a form of insurance against a fall in the price of the underlying asset: Imagine Mr. Ramesh hold a particular asset and intend to sell it at a date in the future. If
his view is that the price of the asset will fall, he could consider buying a put option which gives the right, but not the obligation, to sell the underlying asset at a fixed price by a certain date in the future. If his view is correct, he could exercise his put option and sells the underlying asset for more than the prevailing market value.
•
To participate in price movements of the underlying asset without buying or selling the underlying asset: If view is that the price of the underlying asset will rise, then consider buying a call
option which gives the right, but not the obligation, to buy the underlying asset at a fixed price by a certain date in the future. If the view is accurate, the value of call option will increase. To realise profit, close out your position by selling the call option back to the market. Conversely, if view is that the price of the underlying asset will fall, you could buy a put option which gives the right, but not the obligation, to sell the asset at a fixed price. If the view is accurate, the value of your put option will increase. To realise your profit, close the position by selling the put option back to the market. Futures and options are products that can transform trading and investment activity of an investor; increasing profit potential and giving the means to control risk too. LIFFE is committed to bringing this world of trading and investing opportunities to the private investors, through education and a continuous process of product enhancement and development.
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The Option Contract For the option purchaser (also called the holder or taker), the option: • offers the right (but imposes no obligation), ? ? ? ? to buy (call option) or sell (put option) a specific quantity (e.g. 1 contract= 100 shares) of a given financial underlying (e.g. shares) at an agreed price (exercise or strike price), or calculable value. For example the value can be calculated based on a reference rate or something else such as the average price of an underlying asset, as measured at agreed-upon intervals during the life of a contract, i.e. the Asian option. ? on one or more call dates
•
In exchange for a premium (option price).
•
The counterparty (option writer / seller) has an obligation to fulfil the contract if the option holder exercises the option. In return, the option seller receives the option price or premium.
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Types of Options
? European Option
o Can be exercised only on the expiration date
? American Option
o Can be exercised any time on or before the expiration date
Call Option A call option gives the buyer, the right to buy specified quantity of the underlying asset at the set strike price on or before expiration date. The seller (writer) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. The risk for the option holder is limited: he cannot lose more than the premium paid as he can "abandon the option". His potential gain is theoretically unlimited. The buyer assumes a long position, and the writer a corresponding short position.
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CHAPTER- 8
REVIEW OF LITERATURE
44
HOW ARE DERIVATIVES DEFINED
Derivatives may be defined as “ A security or contract designed in such a way that its price is derived from the price of an underlying asset”. Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate). In a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such transaction is a example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”. Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset. Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions contrary to what the investor currently has. The main purpose of speculation, on the other hand, is to profit from betting on the direction in which an asset will be moving.
WHAT IS THE DIFFERENCE BETWEEN HEDGING AND SPECULATION
HEDGERS reduce their risk by taking an opposite position in the market to what they are trying to hedge. The ideal situation in hedging would be to cause one effect to cancel out another. For example, assume that a company specializes in producing jewelry and it has a major contract due in six months, for which gold is one of the company's main inputs. The company is worried about the volatility of the gold market and believes that gold prices may increase substantially in the near future. In order to protect itself from this uncertainty, the company could buy a six-month futures contract in gold. This way, if gold experiences a 10% price increase, the futures contract will lock in a price that will offset this gain. As you can see, although hedgers are protected from any losses, they are also restricted from any gains. Depending on a company's policies and the type of business it runs, it may choose to hedge against certain business operations to reduce fluctuations in its profit and protect itself from any downside risk. 45
SPECULATORS make bets or guesses on where they believe the market is headed. For example, if a speculator believes that a stock is overpriced, he or she may short sell the stock and wait for the price of the stock to decline, at which point he or she will buy back the stock and receive a profit. Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risky. (To learn more, check out the Short Selling tutorial.)
Overall, hedgers are seen as risk averse and speculators are typically seen as risk lovers. Hedgers try to reduce the risks associated with uncertainty, while speculators bet against the movements of the market to try to profit from fluctuations in the price of securities.
A BULL MARKET This is when the market showing is confidence. Indicators of confidence are prices going up. Number of shares traded is also high and even the number of companies entering the stock market show that the market is confident.A bull market is a rise in value of the market of at least 20%. A BEAR MARKET
A bear market is the opposite to a bull. If the markets fall by more than 20% then we have entered a bear market. A bear market is a market showing a lack of confidence. Prices hover at the same price then go down, indices fall too and volumes are stagnant. In a bear market people are waiting for the bulls to start driving the prices up again. However, a bear is a very tentative bull or a bull that is asleep.
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VARIOUS DERIVATIVE INSTUMENTS There are two types of derivatives instruments traded on NSE; namely Futures and Options : 1. FUTURES : A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. All the futures contracts are settled in cash at NSE. 2. OPTIONS: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.
Options are of two types - Calls and Puts options : "Calls" give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. "Puts" give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date. All the options contracts are settled in cash. Further the Options are classified based on type of exercise. At present the Exercise style can be European or American.
I. AMERICAN OPTION - American options are options contracts that can be exercised at any time upto the expiration date. Options on individual securities available at NSE are American type of options.
II. EUROPEAN OPTIONS
- European options are options that can be exercised only on the
expiration date. All index options traded at NSE are European Options. Options contracts like futures are Cash settled at NSE.
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CHAPTER- 9
RESEARCH METHODOLOGY
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Research Design
The research is of Diagnostic cum Descriptive type; it is so because it establishes relationship between equity market and derivative market and shows how securities of equity market can be hedged with the help of future and option in derivative market. Moreover secondary data is used to give description of available observations so this way it is also a descriptive kind of study.
Universe of the Study
Universe of the survey are investors in share market of CHENNAI City through indbank.
Survey Population
Population of the survey is 40 people who invest in share market.
Technique of selecting the Sample
The technique of selecting the sample is Random in Nature.
Data Collection
Data is collected from two sources i.e. Primary & Secondary. Primary data is collected from the investors by the method of questionnaire and it is further used for analysis. Secondary data is collected from books and internet. Analysis Pattern For analysis of the answers of the questionnaire bar diagrams and pie charts are used. With the help of these further recommendations are given.
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CHAPTER- 10
DATA PRESENTATION AND ANALYSIS
50
1 You deal in
Shares Mutual Fund Bonds Commodities
40 24 12 14
45 40 35 30 25 20 15 10 5 0
Series1
51
The above graph shows that
¾ Shares occupied a predominant place in the financial market. ¾ Mutual fund was also very popular among the investors since 60% of the sample invested
in it.
¾ 35 % of the sample invested in commodities ¾ Only 30% of the sample invested in bonds.
2. How long have you been investing?
Below 2 yrs 2-5 yrs 5-10 yrs Above 10 yrs
16 8 10 6
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18 16 14 12 10 8 6 4 2 0 Below 2 yr 2-5 yrs 5-10 yrs Above 10 Yrs Series1
The above graph shows that
¾ 15% of the sample was in the financial market for more than 10 years. ¾ 10% of the sample was in the financial market for 5-10 years. ¾ 20% of the sample was in the financial market for 2-5 years. ¾ 40% of the sample was in the financial market for less than 2 years.
3. What do you understand by hedging?
Risk minimization Profit maximization Both None
18 8 10 4
53
20 18 16 14 12 10 8 6 4 2 0 Risk Minimization Profir Maximisation Both None Series1
The above graph shows that
¾ 45% of the sample knew the meaning of hedging as risk minimization. ¾ 20% of them thought hedging as a tool of profit maximization. ¾ 25% of them comprehended hedging as a tool of risk minimization as well as profit
maximization.
¾ 10% of the sample didn’t know what is meant by hedging.
4. Are you aware of future and options as a tool of hedging?
Fully Partially Not at all
8 26 6
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Not at all 15%
Fully 20%
Partially 65%
The above graph shows that
¾ 20% of the sample says that they were fully aware of future and options as a tool of
hedging.
¾ Majority of the sample i.e. 65% of them were partially aware of future and options as a
tool of hedging.
¾ 15% of them were not at all aware of future of options as a tool of hedging.
5. Do you use future and options as a tool of hedging?
Yes No
18 22
55
No 55%
Yes 45%
Interpretation: It was found that 45% of the sample used future and options as a tool of hedging. It also included those people who were partially aware of it and those who didn’t know the exact meaning of hedging. They used it with the help of their brokers. 55% of the sample surveyed didn’t use future and options as a tool of hedging.
6.What is the limit of your investment in future and options?
Below 1 lakh 1- 10 lakh 10-20 lakh Above20 lakh
11 6 1 0
56
12 10 8 6 4 2 0 Below 1 Lakh 1-10 Lakhs 10-20 Lakhs Above 20 Lakhs Series1
The above graph shows that
¾ 27.5% of the sample has their investment below 1 lakh. ¾ 15% of the sample has their investment between 1-10 lakh. ¾ 1% of the sample has their investment between 10-20 lakh. ¾ None of the sample surveyed had their investment above 20 lakh.
7. According to current market scenario, what would you prefer most?
Call Option Put option Both None
16 4 6 14
57
None 35%
Call Option 40%
Both Put Option 15% 10%
The above graph shows that
¾ 40% of the sample prefers call option. ¾ 10% of the sample prefers call option. ¾ 15% of the sample has a fluctuating view on the market. ¾ 35% of the sample does not want to invest in the market due to its volatility.
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CHAPTER-11
FINDINGS
59
Findings of the Study ? During the study it was found that people didn’t know the right meaning of risk. Most
of them thought that risk is there only when losses are incurred but there is no risk when profit is earned in future.
? Study shows that investors can earn profits in both bullish and bearish market by
using futures and options.
? 15% of the sample didn’t know anything about future and options as a tool of
hedging.
? 65% of the sample is partially aware of future and options as a tool of hedging so they
fear using it.
? It was found that most of the clients followed what their brokers specified. The
knowledge of the public about the financial market is average.
? There is a great scope for future and options as a tool of hedging in coming years as
55% of sample surveyed still don’t use future and options as a tool of hedging.
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CHAPTER-12
SUGESSTIONS
61
SUGGESTIONS:
? Trading in derivatives was started with the objective of reducing the volatility prevailing in the stock market. Lack of awareness has been the prior reason why the trading in derivatives has been low in volume. Hence for creating awareness about derivatives among investors, stock exchanges have to conduct awareness programmes at free of or at minimal charges. ? The market lot is a barrier for trading both options and futures. Reducing the lot size may increase volume of trade. There is need to reduce transaction cost also, which will increase the number and volume of transactions. ? Investors should take his own decisions after analyzing all those factors like Fundamental analysis and Technical analysis and risk involved before entering into the stock and derivative market. ? Investors should know their markets, they should remember their positions, to avoid more losses. ? Buy when the markets comes down and sell when the market goes up. Average the shares when the price of the share comes down. ? Instead of investing the whole amount in single scrip, we can diversify the amount into several scrips. ? Investors should observe and study the strategies used by others in the market and select his/ her strategy, otherwise it may lead to big market moves, unstable market and large looses for the market participant. ? Investors should observe whether the market is bullish or bearish and use right strategy. When the market is bullish covered call writing is right strategy. On the contrary if the market looks like bearish covered put is the right strategy. But when the market is normal position writing straddles and strangles are right strategies. ? Always put stop loss orders after taking positions to reduce the risk to maximum loss. Its better to trade in high volume counters. ? Delivery facility which is in cash maket if implemented here, will increase volume of trade.
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CHAPTER-13
CONCLUTION
63
CONCLUSION
In the current scenario, investing in stock markets is a major challenge ever for professionals. Derivatives are important products of on india’s financial markets. They help in risk management. Derivatives acts as a major tool for reducing the risk involved in investing in stock markets for getting the best result out of it. The investors should be aware of various hedging and speculation strategies, which can be used for reducing their risk. Awareness about the various uses of derivatives can help investors to reduce risk and increase profits. Though the stock market is subjected to high risk, by using derivative products like forwards, futures, options and swaps loss can be minimized to an extent.
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CHAPTER-14
LIMITATIONS
65
Limitations
Main limitations of the study are: ¾ Shortage of time was a very big constraint due to which less information has been included in the study. ¾ As there are number of players dealing in derivative markets but focus is on only small investors so limits the scope of the study. ¾ There are four types of derivatives market: future, forward, swap and option but in this study only future and option are considered. ¾ Though every - "precaution has taken due to large data and complex calculations, there may be chances of error. ¾ Being a student; there is lack of practical knowledge regarding future and option as a tool of hedging. . ¾ Data is collected at random basis so chances of biasness are always there. ¾ Due to shortage of time, sample has been taken of just 40 investors. That might not represents the accurate picture of investors’ knowledge.
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CHAPTER-15
QUESTIONNAIRE
67
QUESTIONNAIRE
Study of hedging based on Derivative
You deal In shares Shares Mutual Fund Bonds Commodities How long have you been investing? Below 2 yrs 2-5 yrs 5-10 yrs Above 10 yrs What do you understand by hedging? Risk minimization Profit maximization Both None
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Are you aware of future and options as a tool of hedging? Fully Partially Not at all
Do you use future and options as a tool of hedging? Yes No
What is the limit of your investment in future and options? Below 1 lakh 1- 10 lakh 10-20 lakh Above20 lakh
According to current market scenario, what would you prefer the most? Call Option Put option Both None
Personal Information Name…………… Place…………… Occupation…………… Contact No……………
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CHAPTER-16
BIBLIOGRAPHY
70
BIBLIOGRAPHY
1. Www.indbankonline.com 2. Investor.sebi.gov.in 3. en.wikipedia.org/.../Securities_and_Exchange_Board_of_India 4. www.sebi.gov.in 5. www.hedging.com 6. www.investopedia.com
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doc_865784900.pdf