Project-Equity, Commodity n Currency Derivatives
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A REPORT ON “USAGE OF DERIVATIVES TO HEDGE EQUITY STOCK, COMMODITY AND CURRENCY PRICE RISK” By Ramakant Thakral 11BSPHH010650 (SHAREKHAN LIMITED)
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detailed study about commodity equities and derivatives
Transcript of Project-Equity, Commodity n Currency Derivatives
A
REPORT
ON
“USAGE OF DERIVATIVES TO HEDGE EQUITY
STOCK, COMMODITY AND CURRENCY PRICE RISK”
By Ramakant Thakral
11BSPHH010650
(SHAREKHAN LIMITED)
1
A REPORT
ON
“USAGE OF DERIVATIVES TO HEDGE
EQUITY STOCK, COMMODITY AND
CURRENCY PRICE RISK”
BY
RAMAKANT THAKRAL
11BSPHH010650
SHAREKHAN LIMITED
A report submitted in partial fulfilment of the requirements of
MBA Program Of
IBS Hyderabad
Submitted to Date of Submission
Prof. Hariprasad R. Soni 4th
June, 2012
Faculty – IBS Hyderabad
Mr. Mohammad Rafee
(Branch Manager-Gurgaon)
Sharekhan Limited
2
AUTHORIZATION
The report on “Usage of Derivatives to hedge Equity Stock, Commodity and Currency Price
Risk” is prepared in partial fulfilment of the Summer Internship Program of the MBA
program of Class 2013 at ICFAI Business School, Hyderabad; under the guidance of
company guide Mr MOHAMMAD RAFEE, Senior Branch Manager, Sharekhan Limited and
Faculty Guide Prof. HARIPRASAD R. SONI, ICFAI Business School, Hyderabad.
3
ACKNOWLEDGEMENTS
I would like to express my earnest gratitude to Mr. Tarun Shah, CEO Sharekhan Limited
for providing me a chance to conduct my internship in Sharekhan Ltd.
I would like to express my deep sense of hearty and special gratitude to Mr. Mohammad
Rafee, Senior Branch Manager, Sharekhan Limited for giving me an opportunity to work on
the project, “Usage of Derivatives to hedge Equity Stock, Commodity and Currency Price
Risk”.
I would like to further extend my heartiest gratitude towards Mr. Tarsem Verma,
Relationship Manager, Sharekhan Limited for providing me valuable inputs for shaping up
this project for what it is now. He always inspired me towards learning and gaining
knowledge and also helped me at all the stages of the project by spending his invaluable time
and efforts.
I would also like to thank and appreciate Prof. Hariprasad R. Soni, faculty guide, IBS
Hyderabad for providing the regular guidance and support throughout the duration of
internship. His regular directions during the internship were very much valuable for the
successful completion of the project.
It has indeed been a great learning experience both professionally and personally by working
in this project at Sharekhan Limited.
Ramakant Thakral
11BSPHH010650
4
INDEX
S.NO PARTICULARS PAGE NO.
1. Authorisation 2
2. Acknowledgement 3
3. Executive Summary 4
4. Company Profile 7
5. Analysis of Indian Economy 11
6. Analysis of Aluminum Industry 14
Economy Industry Analysis
7. Company Analysis (Hindalco Industries Ltd.) 17
8. Introduction to Derivatives 20
9. Indian Derivative Market 28
10. Equity Derivatives 31
11. Hedging Strategies using Equity Derivatives 38
12. Commodity Derivatives 68
Aluminium 73
13. Currency Derivatives 86
USD/INR 88
14. Project Analysis 93
Findings
15. Appendix 96
16. References 99
5
EXECUTIVE SUMMARY
Organisation profile: Sharekhan Ltd. is one of the leading retail brokerage firms in the
country. It is the retail Broking arm of the Mumbai-based Sharekhan Group, which has over
eight decades of experience in the stock broking business. Sharekhan offers its customers a
wide range of equity related services including trade execution on BSE, NSE, Derivatives,
depository services, online trading, investment advice, portfolio management service etc.
Report: The report “Usage of Derivatives to hedge Equity Stock, Commodity and Currency
price risk” aims at understanding the various strategies used for different derivatives under
different market conditions and to understand the inter-linkages between the equity stock
price, commodity price and the currency rate. To make this report more practical primary
data is used. For equity derivatives prices of equity derivative of Hindalco Industries Ltd. is
used, for commodity Aluminium May future prices is used, and for currency current spot
exchange rate and future rate of USD/INR is used. Secondary data is also used from various
sources to make this report more knowledge enriching.
The report also includes analysis of Hindalco Industries Ltd. and aluminium sector in India.
The analysis is done to select the stock and then to establish a relation between the prices of
commodity future and stock prices as well as of equity derivative.
From the report it can be concluded that an investor or a hedger can hedge his risk using
derivatives, which also help in price discovery of the underlying item (stock/equity/currency).
The usage of derivatives is increasing which is evident from the fact that 71% of the trade on
NSE is done in derivatives. Still various investors keep themselves away from the derivatives
because of their complex nature. With the increasing products on exchanges the confusion
and complexity is increasing therefore, the employee of the company (Sharekhan Ltd.) should
keep themselves and their clients updated.
Methodology: The main objective behind the project is to understand the functioning of
derivative market and to study the various strategies used for equity derivatives, commodity
derivatives and for currency derivatives to hedge the risk. The project consists of theoretical
approach and practical approach. The theoretical approach tries to explain the basic
6
understanding of derivative market whereas the practical approach shows the theory in
practice. The project contains analysis of aluminium industry and the analysis of Hindalco
Industries Ltd. to explain the usage of derivative particular to this company and industry. The
project also explains the interrelation of USD-INR rate with Hindalco Industries Ltd. stock
prices and the usage of strategy accordingly.
7
COMPANY PROFILE
(Sharekhan Limited)
Sharekhan is one of the top retail brokerage houses in India with a strong online trading
platform. The company offers to its client’s services like portfolio management; trade
execution in equities; futures and options; commodities; distribution of mutual funds,
insurance and structured products; etc. It has one of the largest networks in the country with
over 1529 outlets serving 950000 customers across 450 cities. It also has international
presence through its branches in the UAE and Oman. It was the first company to provide end
to end investment solution through its online portal www.sharkhan.com. It is a member of
major stock indices in India like National Stock Exchange (NSE), Bombay Stock Exchange
(BSE), National Commodity and Derivative Exchange Ltd. (NCDEX) and Multi Commodity
Exchange of India Ltd. (MCX). It is also registered as a depository participant with National
Securities Depository Ltd. (NSDL) and Central Depository Service Ltd. (CDSL)
Sharekhan was established by Morakhia family 8thFebruary 2000 and it continues to remain
the largest shareholder, the other shareholders include General Atlantic Partners, Intel Capital
and HSBC Private Equity. It is the retain brokerage arm of Mumbai based SSKI (S.S.Kantilal
Ishwarlal) Group which caters to foreign and domestic institutional investors. SSKI
Corporate Finance focuses on M&A, Infrastructure Advisory and Financing, Venture Capital
and Private Equity.
Sharekhan is known for its jargon free and investor friendly online trading portal. Its
regularly provides its clients quality investment advices based on fundamental, technical and
market analysis. It is also involve in conducting seminars for non-residents through its “India
First” Initiative to bring in the foreign investment into the system.
Sharekhan Products
1. Sharekhan First Step is a program designed for the first time investors. The
programs aims at educating the investor about the basics of the stock market,
understand the research products in detail and trade online with as little as Rs.5000
8
2. Trade Tiger is single advanced trading software which provides multiple exchange
facilities like NSE and BSE (Cash and Futures & Options); MCX; NCDEX; IPO and
Mutual Funds. The software provides 24 hours access to both domestic and
international markets. The clients can analyze the scripts through graph studies which
include Average, Band- Bollinger, Know Sure Thing, MACD, RSI, etc. The software
further provides tools to gauge the markets such as Tick Query, Ticker, Market
Summary, Action Watch, Option Premium Calculator, and Span Calculator
.
3. PMS Protech is a portfolio management service that uses the knowledge of technical
analysis and power of derivatives to identify the trading opportunities in the market.
The products are designed to earn returns in both rising and falling markets by making
long and short positions in 35 the Index or Stock Futures on the basis of market
conditions. There are two products offered in this service:
a. Nifty Thrifty: The long and short position is taken on the nifty futures and exposure will
never exceed the value of the portfolio.
b. Diversified: The long and short position is taken by investing in diversified manner in
Nifty, Bank Nifty, 10 Stocks, etc.
The product requires a minimum investment of five lakhs with a lock in period of 6 months.
No AMC fee is being charged. 0.05 percent brokerage is charged for derivatives and 20
percent profit sharing on booked profits on quarterly basis.
4. PMS Proprime is a portfolio management service for the NRI investors who are
looking for steady and superior return with a medium to low risk appetite. The
product uses in depth independent fundamental research of the companies. The
minimum investment is of 5 lakh. 2.5 percent AMC is being charged for the
management of the portfolio on quarterly basis. The brokerage of 0.5 percent and 20
percent profit sharing after 15 percent hurdle is crossed at the end of every fiscal year.
9
Mission of Sharekhan
“To educate and empower the individual investor to make better investment decisions
through Quality advice, innovative products and superior service.”
Work Structure Of Sharekhan
Sharekhan has always believed in investing in technology to build its business. The company
had used some of the best known names in the IT industry, like Sun Microsystems, Oracle,
Microsoft, Cambridge Technologies, Nexgenix, Vignette, Verisign Financial Technologies
India Ltd, Spider Software Pvt. Ltd. To build its trading engine and content. The Citi Venture
holds a majority stake in the company. HSBC, Intel & Carlyle are the other investors.
On April 17,2002 Sharekhan launched Speed Trade and Tiger, are net-based executable
application that emulates the broker terminals along with host of other information relevant to
the Day Traders. This was for the first time that a net-based trading station of this caliber was
offered to the traders.
10
The firm’s online trading and investment site www.sharekhan.com - was launched on Feb 8,
2000. The site gives access to superior content and transaction facility to retail customers
across the country. Known for its jargon-free, investor friendly language and high quality
research, the site has a registered base of over 3 Lac customers. The number of trading
members currently stands at over 7 Lacs. While online trading currently accounts for just
over 5 per cent of the daily trading in stocks in India, Sharekhan alone accounts for 27 per
cent of the volumes traded online.
Joint Venture with Online Trading Academy
California Based Online Trading Academy is the world’s most trusted name in the investor’s
education having partnered with the leading exchanges in the world like NASDAQ, the CME
group, etc. The company provides practical application of the concepts and course is
delivered during market hours with real money provided by the academy.
The Academy had entered into a joint venture with Sharekhan for imparting education to the
investors through the Sharekhan online trading platform Trade Tiger. The brokerage charged
by Sharekhan after the end of the course will be discounted till their entire fee is reimbursed.
All the profits/ loss will be borne by the academy during the seven day long training which
cost Rs.87600. The training will enhance the professional skill sets of the investors.
11
ANALYSIS OF INDIAN ECONOMY
The Indian Economy faced many headwinds in fiscal 2011-12 leading to growth coming off
from 8.6% in fiscal year 2010-11 to 6.9%. The economy in the fiscal year faced headwind in
the form of inflation, high interest rate, tight liquidity conditions and global economic
uncertainty.
The current account balance is getting worse as the rate of increase in imports is greater than
exports. Indian economy reported the CAD of 19.6 Billion USD in the fourth quarter of year
2011. India's current account deficit (CAD), which was 2.6% of gross domestic product in the
2010-11 fiscal year, widened to 4.3% of GDP in the October-December quarter and expected
to be 4% of GDP for the fiscal year 2011-12 that ended in March.
The inflation for the fiscal year 2011-12 is 8.65% based on CPI. The average inflation in
2012 is 7.18%.
12
The IIP (Index of industrial production) figures are getting worse month by month. The IIP
figure for the month of 3 months of 2012 is given as
Month IIP 2012
January 1.10%
February 4.10%
March -3.50%
To combat with the problem of lower industrial production RBI in its revised policy reduced
the repo rate by 50bps.The rate cut was welcomed by the Indian economy and creates a short
term euphoria but the rupee depreciation, global uncertainty and weak macroeconomic
policies prove to be a bane for the rate cut. The FIIs are withdrawing their money from Indian
market due to the non-clearance on GAAR (General Anti Avoidance Rule).
Rupee is depreciating due to global uncertainty particularly Europe crisis, uncertainty in
macroeconomic policies; for example the policy on FDI in aviation is still not clear,
application of GAAR etc. Rupee is depreciated 12.18% in three months (from February to
May 2012). The depreciation of rupee has widen the Current account deficit, results in
erosion of foreign exchange reserve as RBI have to intervene into the market to save the
downside of rupee.
Rupee depreciation eroded the bottom line of various multinational companies or import
based companies. India is leading exporter of gems and jewellery, textiles, engineering
goods, chemicals, leather manufactures and services. India is poor in oil resources and is
currently heavily dependent on coal and foreign oil imports for its energy needs. Other
imported products are: machinery, gems, fertilizers and chemicals
The outlook for global commodity prices, especially of crude oil, is uncertain. Global crude
and petroleum product prices have increased sharply since January 2012. Although upside
risks to oil prices from the demand side are limited, geo-political tensions are a concern, and
any disruption in supplies may lead to further increase in crude oil prices. This will have
13
implications for domestic growth, inflation and the fiscal and current account deficits.
Further, the large fiscal deficit also has led to large borrowing requirements by the
Government. The budgeted net market borrowings through dated securities for 2012-13 at 4.8
trillion were even higher than the expanded borrowings of 4.4 trillion last year. Such large
borrowings have the potential to crowd out credit to the private sector.
14
ANALYSIS OF ALUMINIUM INDUSTRY
Aluminium Industry in India is a highly concentrated industry with the top 5 companies
constituting the majority of the country's production. With the growing demand of aluminium
in India, the Indian aluminium industry is also growing at an enviable pace. In fact, the
production of aluminium in India is currently outpacing the demand.
Though India's per capita consumption of aluminium stands too low (under 1 kg) comparing
to the per capita consumptions of other countries like US & Europe (range from 25 to 30
kgs), Japan (15 kgs), Taiwan (10 kgs) and China (3 kgs), the demand is growing gradually. In
India, the industries that require aluminium most include power (44%), consumer durables,
transportation (10-12%), construction (17%) and packaging etc.
Aluminium production industry in India is mainly dominated by about five firms that account
for the majority of the country’s metal production including Hindalco Aluminium Company
(HINDALCO), National Aluminium Company (NALCO), Bharat Aluminium Company
(BALCO), MALCO and INDAL. Apart from these major players in the Aluminium sector,
there are many players like Hindustan Zinc, Jindal Aluminium Ltd, Maan Aluminium Ltd
and Kennametal India (see Appendix 2). The contribution made by these companies is very
essential and important for the economic development of India. Even though India is not a
very big consumer of aluminium products compared to many other countries, but there is still
a slow and steady growth in the demand.
The primary Aluminium production market in India is an oligopolistic market. The primary
aluminium is a homogenous product. The reasons for the aluminium industry to be an
oligopoly (Barriers to entry) is
Economies of Scale: The major input in producing primary aluminium is alumina and
power which constitute about70% of the cost in producing. Although the requirement
of alumina does not vary much with the size of the plant but the consumption of
power varies drastically. Hence with higher production capacity the cost of production
goes down. For a new player producing aluminium and low cost will be very difficult.
15
Huge capital investments: The capital required to setup an aluminium production
plant is huge. E.g.: BALCO spent about $1 billion to set up a 2.45 lakh ton capacity
with 540MW power plant.
Time to setup: It requires around 3 years to setup a plant of the size mentioned in the
above example. The new player would require about 3 years to start manufacture
primary aluminium and the market demand supply equation can change by the time
the firm starts manufacturing.
Control over the Bauxite mines: As the raw material for manufacturing aluminium
is bauxite the existing players have control over the bauxite mines in India and it
would be difficult for a new player to get new bauxite mines.
Scarcity of power: About 30-40% of the cost of producing is power. As producing
primary Aluminium requires a large amount of electricity they need to have captive
power plants. Setting up of captive power plants requires huge capital investment and
also requires a lot of time. The basic raw material to generate power is coal. Hence the
firms also would need to have coalmines. Most of the coal blocks are owned by
independent power producers and hence the coal blocks are scarce.
Government Factor: The other major hurdles are getting environmental clearance
from the government. The other factor would be in getting bauxite mines allotted to
the firm. Hence in these two cases the government acts as a barrier.
Land: Existing players can expand as setting up a new brown field project is easy
than getting land allocated for a new green field project considering the political
situations in India.
Geographical factors: The bauxite ore is abundant only in the states like Orissa and
hence the firms entering into the market need to setup the plant in these states.
16
Economy-Industry Analysis
The greatest challenge facing the industry is the continuous increase in raw material
prices which are showing no signs of going down. Most input costs such as fuel oil,
coal tar pitch, and caustic soda have increased along with the freight costs.
Alumina costs for non-integrated smelters have gone up and may increase further.
Aluminium industry being a cyclical in nature depends heavily on the health of the
world economy. Any slowdown in demand could have adverse effects on the
profitability of the company. The European debt crisis and slowdown in world
economy as well as fear of hand landing in the Chinese economy (which accounts for
40% of world aluminium demand) have already led to a decline in aluminium prices.
The expansion plans of Hindalco are also facing some delays. Some of the projects
are running behind schedule. This is due to delay in getting regulatory approvals. As a
result the company has to incur additional cost which will put pressure on its margins
in the short term.
Increased spending on the infrastructure sector by the government would result in
higher consumption of aluminium, benefiting companies
like NALCO and HINDALCO.
17
COMPANY ANALYSIS
(Hindalco Industries Ltd.)
Hindalco Industries Limited, a Fortune 500 and the metals flagship company of the Aditya
Birla Group, is an industry leader in aluminium and copper. A metals powerhouse with a
consolidated turnover of Rs.72,078 crore (US$ 15.85 billion) in the fiscal year 2011,
Hindalco is the world’s largest aluminium rolling company and one of the biggest producers
of primary aluminium in Asia. Its aluminium production process encompasses the entire
gamut of operations from bauxite mining, alumina refining, aluminium smelting to
downstream rolling, extrusion and recycling. Its Copper smelter is the world’s largest custom
smelter at a single location.
The share of Net Sales Value in the FY 2011 is given by
Over 50% of its revenue comes from overseas operations.
The shareholding pattern Hindalco Industries Ltd. is given as:
18
(In %) Mar-12 Dec-11 Sep-11
Promoter 32.06 32.06 32.06
FII 26.85 26.53 28.24
DII 14.94 15.56 14.10
Others 26.15 25.85 25.60
Total 100.00 100.00 100.00
The financial ratios as on March 2011 and March 2010 are given below:
Ratios March 2011 March 2010
Debt Equity Ratio 0.24 0.23
Current Ratio 0.96 1.02
Interest Coverage Ratio 5.89 4.3
Fixed Asset Turnover Ratio 1.67 1.42
Inventory Turnover Ratio 3.43 3.63
Debtors Turnover Ratio 18.41 15.48
The unaudited result of Hindalco Industries Ltd. is given below:
FY 11 FY 12 Change (%)
Net Sales 23,859 26,597 11.5
PBITDA 3,502 3,721 6.2
PBT 2,595 2,737 5.5
PAT 2,137 2,237 4.7
EPS 11.17 11.69 4.7
Hindalco Industries Ltd. has started various Greenfield projects that will significantly
enhance the scale of operations and will further improve the cost competitiveness of the
company. These projects are:
19
Utkal Alumina International Ltd (UAIL)
Mahan Aluminium Project
Aditya Aluminium project
Aditya Refinery Project
The Jharkhand Aluminium project
In 2007, Hiindalco made an USD $6 bn acquisition of Novelis Inc. a world leader in
aluminium rolling and can recycling. This move catapulted the company into the league of
world's top 5 aluminium producers. It also enabled the company to have a global footprint in
12 countries outside India. Although the acquisition has made Hindalco the world's largest
aluminium rolling company, resultant debt and Novelis depressed earnings with its can price
ceiling contract and large exposure to the developed markets, remained one of the biggest
overhang on Hindalco's performance till 2009. However, with the expiry of the can price
ceiling contracts in 2009 and cost restructuring, Novelis has emerged as a successful
acquisition for Hindalco with an improvement in profitability. Despite sales volume for
Novelis still below 2008 levels, adjusted EBITDA has nearly doubled.
Hindalco Industries plans to start its 1.5 million tonnes per annum (mtpa) alumina refinery in
Orissa by January 2013. It also expects to start mining bauxite in the state from October this
year (2012).
Management of Hindalco Industries Ltd.
Name Designation
Dr. Kumar Mangalam Birla Chairman
D Bhattacharya Managing Director
Jagdish Khattar Independent Director
Ram Charan Additional (Independent) Director
Anil Malik Asst. Vice-President & Company Secretary
20
INTRODUCTION TO DERIVATIVES
The emergence of the market for derivative products, most notably forwards, futures and
options, can be traced back to the willingness of risk-averse economic agents to guard
themselves against uncertainties arising out of fluctuations in asset prices. By their very
nature, the financial markets are marked by a very high degree of volatility. Through the use
of derivative products, it is possible to partially or fully transfer price risks by locking-in asset
prices. As instruments of risk management, these generally do not influence the fluctuations
in the underlying asset prices. However, by locking-in asset prices, derivative products
minimize the impact of fluctuations in asset prices on the profitability and cash flow situation
of risk-averse investors.
Derivative products initially emerged, as hedging devices against fluctuations in commodity
prices and commodity-linked derivatives remained the sole form of such products for almost
three hundred years. In 1848, the Chicago Board of Trade (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 standardised, and in 1925 the first 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.
The financial derivatives came into spotlight in post-1970 period due to growing instability
in the financial markets. However, since their emergence, these products have become very
popular and by 1990s, they accounted for about two-thirds of total transactions in derivative
products. In recent years, the market for financial derivatives has grown tremendously both in
terms of variety of instruments available, their complexity and also turnover. In the class of
equity derivatives, futures and options on stock indices have gained more popularity than on
individual stocks, especially among institutional investors, who are major users of index-
linked derivatives. Even small investors find these useful due to high correlation of the
popular indices with various portfolios and ease of use. The lower costs associated with index
21
derivatives i.e. the derivative products based on individual securities is another reason for
their growing use.
The following factors have been driving the growth of financial derivatives:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international markets,
3. Marked improvement in communication facilities and sharp decline in their costs,
4. Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and returns
over a large number of financial assets, leading to higher returns, reduced risk as well
as trans-actions costs as compared to individual financial assets.
Derivatives defined
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 a transaction is an example of a derivative. The price of this
derivative is driven by the spot price of wheat which is the “underlying”.
Types of derivatives
The most commonly used derivatives contracts are forwards, futures and options which we
shall discuss in detail later. Here we take a brief look at various derivatives contracts that
have come to be used.
Forwards: A forward contract is a bilateral contract that obligates one party to buy and other
party to sell a specific quantity of an asset, at a set price, on a specific date in the future.
Typically, neither party to the contract pays anything to get into the contract.
22
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. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts.
Options: An option contract gives its owner the right, but not the legal obligation, to conduct
a transaction involving an underlying asset at a predetermined future date (the exercise date)
and at a predetermined price (the exercise price or strike price). The seller of the option has
the obligation to perform if the buyer exercises the option. Options are of two types - calls
and puts.
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 the
underlying asset at a given price on or before a given date.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those in
the opposite direction.
Swaptions: A swaption is an option to enter into a swap. The option to enter into an
offsetting swap provides an option to terminate an existing swap. Consider that, in the case of
previous 5-year pay floating swap, we purchased a 3-year call option on a 2-year pay fixed
swap at 3%. Exercising this swap would give us the offsetting swap to exit our original swap.
The cost for such protection is the swaption premium.
Participants and Functions
Three broad categories of participants - hedgers, speculators, and arbitrageurs - trade in the
derivatives market.
23
Hedgers face risk associated with the price of an asset. They use futures or options markets
to reduce or eliminate this risk.
Speculators wish to bet on future movements in the price of an asset. Futures and options
contracts can give them an extra leverage; that is, they can increase both the potential gains
and potential losses in a speculative venture.
Arbitrageurs are in business to take advantage of a discrepancy between prices in two
different markets. If, for example, they see the futures price of an asset getting out of line
with the cash price, they will take offsetting positions in the two markets to lock in a profit.
The derivative market performs a number of economic functions.
1. First, prices in an organized derivatives market reflect the perception of market
participants about the future and lead the prices of underlying to the perceived future level.
The prices of derivatives converge with the prices of the underlying at the expiration of
derivative contract. Thus derivatives help in discovery of future as well as current prices.
2. Second, the derivatives market helps to transfer risks from those who have them but may
not like them to those who have appetite for them.
3. Third, derivatives, due to their inherent nature, are linked to the underlying cash markets.
With the introduction of derivatives, the underlying market witnesses higher trading
volumes because of participation by more players who would not otherwise participate for
lack of an arrangement to transfer risk.
4. Fourth, speculative trades shift to a more controlled environment of derivatives market. In
the absence of an organized derivatives market, speculators trade in the underlying cash
markets. Margining, monitoring and surveillance of the activities of various participants
become extremely difficult in these kind of mixed markets.
5. Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a
catalyst for new entrepreneurial activity. The derivatives have a history of attracting many
24
bright, creative, well-educated people with an entrepreneurial attitude. They often energize
others to create new businesses, new products and new employment opportunities, the
benefit of which are immense. Sixth, derivatives markets help increase savings and
investment in the long run. Transfer of risk enables market participants to expand their
volume of activity. Derivatives thus promote economic development to the extent the later
depends on the rate of savings and investment.
The criticism of derivatives is that they are “too risky”, especially to investors with limited
knowledge of sometimes complex instruments. Because of the high leverage involved in
derivatives payoffs, they are sometimes linked to gambling.
Development of exchange-traded derivatives
Derivatives have probably been around for as long as people have been trading with one
another. Forward contracting dates back at least to the 12th century, and may well have been
around before then. Merchants entered into contracts with one another for future delivery of
specified amount of commodities at specified price. A primary motivation for prearranging a
buyer or seller for a stock of commodities in early forward contracts was to lessen the
possibility that large swings would inhibit marketing the commodity after a harvest.
Although early forward contracts in the US addressed merchants’ concerns about ensuring
that there were buyers and sellers for commodities, “credit risk” remained a serious problem.
To deal with this problem, a group of Chicago businessmen formed the Chicago Board of
Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized
location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the
CBOT went one step further and listed the first “exchange traded” derivatives contract in the
US; these contracts were called “futures contracts”. In 1919, Chicago Butter and Egg Board,
a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to
Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest
organized futures exchanges, indeed the two largest “financial” exchanges of any kind in the
world today.
25
The first stock index futures contract was traded at Kansas City Board of Trade. Currently
the most popular index futures contract in the world is based on S&P 500 index, traded on
Chicago Mercantile Exchange. During the mid eighties, financial futures became the most
active derivative instruments generating volumes many times more than the commodity
futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular
futures contracts traded today. Other popular international exchanges that trade derivatives
are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in
France, etc.
Chronology of instrument
1874 Commodity futures
1972 Foreign currency futures
1973 Equity options
1975 Treasury bond futures
1981 Currency swaps
1982 Interest rate swaps, T note futures, Eurodollar futures, Equity index futures,
Options on T bond futures, Exchange listed currency options
1983 Options on equity index, Options on T-note futures, Options on currency futures,
Options on equity index futures, interest rate caps and floors
1985 Eurodollar options, Swap options
1987 OTC compound options, OTC average options
1989 Futures on interest rate swaps, Quanto options
1990 Equity index swaps
1991 Differential swaps
1993 Captions, exchange listed FLEX options
1994 Credit default options
Exchange-traded vs. OTC derivatives markets
The OTC derivatives markets have witnessed rather sharp growth over the last few years,
which has accompanied the modernization of commercial and investment banking and
globalisation of financial activities. The recent developments in information technology have
26
contributed to a great extent to these developments. While both exchange-traded and OTC
derivative contracts offer many benefits, the former have rigid structures compared to the
latter. It has been widely discussed that the highly leveraged institutions and their OTC
derivative positions were the main cause of turbulence in financial markets in 1998. These
episodes of turbulence revealed the risks posed to market stability originating in features of
OTC derivative instruments and markets.
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
1. The management of counter-party (credit) risk is decentralized and located within
individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and integrity,
and for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the
exchange’s self-regulatory organization, although they are affected indirectly by
national legal systems, banking supervision and market surveillance.
Some of the features of OTC derivatives markets embody risks to financial market stability.
The following features of OTC derivatives markets can give rise to instability in institutions,
markets, and the international financial system:
(i) the dynamic nature of gross credit exposures;
(ii) information asymmetries;
(iii) the effects of OTC derivative activities on available aggregate credit;
(iv) he high concentration of OTC derivative activities in major institutions; and
(v) the central role of OTC derivatives markets in the global financial system.
Instability arises when shocks, such as counter-party credit events and sharp movements
in asset prices that underlie derivative contracts, occur which significantly alter the
perceptions of current and potential future credit exposures. When asset prices change
27
rapidly, the size and configuration of counter-party exposures can become unsustainably
large and provoke a rapid unwinding of positions.
There has been some progress in addressing these risks and perceptions. However, the
progress has been limited in implementing reforms in risk management, including counter-
party, liquidity and operational risks, and OTC derivatives markets continue to pose a threat
to international financial stability. The problem is more acute as heavy reliance on OTC
derivatives creates the possibility of systemic financial events, which fall outside the more
formal clearing house structures. Moreover, those who provide OTC derivative products,
hedge their risks through the use of exchange traded derivatives. In view of the inherent risks
associated with OTC derivatives, and their dependence on exchange traded derivatives,
Indian law considers them illegal.
28
INDIAN DERIVATIVE MARKET
Starting from a controlled economy, India has moved towards a world where prices fluctuate
every day. The introduction of risk management instruments in India gained momentum in
the last few years due to liberalisation process and Reserve Bank of India’s (RBI) efforts in
creating currency forward market. Derivatives are an integral part of liberalisation process to
manage risk. NSE gauging the market requirements initiated the process of setting up
derivative markets in India. In July 1999, derivatives trading commenced in India
Chronology of instrument
1991
14 December 1995
Liberalization Process initiated
NSE asked SEBI for permission to trade index futures.
18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for
index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) and
interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian
index.
25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September 2000 Nifty futures trading commenced at SGX.
2 June 2001 Individual Stock Options & Derivatives
Need for derivatives in India today
In less than three decades of their coming into vogue, derivatives markets have become the
most important markets in the world. Today, derivatives have become part and parcel of the
day-to-day life for ordinary people in major part of the world.
Until the advent of NSE, the Indian capital market had no access to the latest trading methods
and was using traditional out-dated methods of trading. There was a huge gap between the
29
investors’ aspirations of the markets and the available means of trading. The opening of
Indian economy has precipitated the process of integration of India’s financial markets with
the international financial markets. Introduction of risk management instruments in India has
gained momentum in last few years thanks to Reserve Bank of India’s efforts in allowing
forward contracts, cross currency options etc. which have developed into a very large market.
Common Used terms:
Some of the common terms used in the context of currency futures market are given below:
Spot price: The price at which the underlying asset trades in the spot market.
Futures price: The current price of the specified futures contract
Contract cycle: The period over which a contract trades. The currency futures contracts on
the SEBI recognized exchanges have one-month, two-month, and three-month up to twelve-
month expiry cycles. Hence, these exchanges will have 12 contracts outstanding at any given
point in time.
Value Date/Final Settlement Date: The last business day of the month will be termed as the
Value date / Final Settlement date of each contract. The last business day would be taken to
be the same as that for Inter-bank Settlements in Mumbai. The rules for Inter-bank
Settlements, including those for ‘known holidays’ and ‘subsequently declared holiday’ would
be those as laid down by Foreign Exchange Dealers’ Association of India (FEDAI).
Expiry date: Also called Last Trading Day, it is the day on which trading ceases in the
contract; and is two working days prior to the final settlement date.
Contract size: The amount of asset that has to be delivered under one contract. Contract size
is also called as lot size. In the case of USDINR it is USD 1000; EURINR it is EUR 1000;
GBPINR it is GBP 1000 and in case of JPYINR it is JPY 100,000.
Initial margin: The amount that must be deposited in the margin account at the time a
futures contract is first entered into is known as initial margin.
30
Marking-to-market: In the futures market, at the end of each trading day, the margin
account is adjusted to reflect the investor's gain or loss depending upon the futures closing
price. This is called marking-to-market.
Strike Price: The price at which the buyer of an option can buy the stock (in the case of a
call option) or sell the stock (in the case of a put option) on or before the expiry date of option
contracts is called strike price. It is the price at which the stock will be bought or sold when
the option is exercised. Strike price is used in the case of options only; it is not used for
futures or forwards.
Hedge ratio: Companies generally use hedge ratio to hedge their risk. Hedge ratio can be
defined as a ratio comparing the value of a position protected via a hedge with the size of the
entire position itself.
Suppose an investor is holding $10,000 in foreign equity, which exposes him to currency
risk. If he hedges $5,000 worth of the equity with a currency position, his hedge ratio is 0.5
(50 / 100). This means that 50% of his equity position is sheltered from exchange rate risk.
31
EQUITY DERIVATIVES
The assignment that was given to me at Sharekhan limited, Gurgaon was to study and analyze
the various hedging and arbitraging strategies using stock options. A good understanding of
these strategies is very essential for a risk professional. Organizations which are exposed to
the market risks such as volatility in foreign exchange rates, capital market, commodities
markets etc. continuously monitor their positions. In order to reduce their losses they
continuously hedge their positions. Also brokerage houses like Sharekhan actively arbitrage
on regular basis.
For the study of various strategies I had to study NCFM modules, search information on
Internet. Also I had an opportunity to converse with the relationship managers at Sahrekhan,
Gurgaon.
MEANING OF EQUITY DERIVATIVE
In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines
“equity derivative” to include –
1. A security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.
2. A contract, which derives its value from the prices, or index of prices, of underlying
securities.
The derivatives are securities under the SC(R) A and hence the trading of derivatives is
governed by the regulatory framework under the SC(R) A.1
HEDGING – AN INTRODUCTION
Hedging in financial terms is defined as entering transactions that will protect against loss
through a compensatory price movement.
Hedging comes from the term "to Hedge" and is any technique designed to reduce or
eliminate financial risk. Hedging is the calculated installation of protection and insurance
into a portfolio in order to offset any unfavorable moves.
32
In fact, hedging is not restricted only to financial risks. Hedging is in all aspects of our lives;
we buy insurance to hedge against the risk of unexpected medical expenses. Hence, hedging
is the art of offsetting risks.
Illustration:
Amp enters into a contract with Saru roopa that six months from now he will sell to Saru
roopa 10 dresses for Rs 4000. The cost of manufacturing for Amp is only Rs 1000 and he will
make a profit of Rs 3000 if the sale is completed.
Cost (Rs) Selling Price Profit
1000 4000 30000
However, Amp fears that Saru roopa may not honour his contract six months from now. So
he inserts a new clause in the contract that if Saru roopa fails to honour the contract she will
have to pay a penalty of Rs 1000. And if Saru roopa honours the contract Amp will offer a
discount of Rs 1000 as incentive.
On Saru roopa’s default If Saru roopa honours
1000 (Initial Investment) 3000 (Initial profit)
1000 (penalty from Saru roopa) (-1000) discount given to Saru roopa
(No gain/loss) 2000 (Net gain)
As we see above if Saru roopa defaults Amp will get a penalty of Rs 1000 but he will recover
his initial investment. If Saru roopa honours the contract, Amp will still make a profit of Rs
2000. Thus, Amp has hedged his risk against default and protected his initial investment.
Hedging stocks using futures
Stocks carry two types of risk – company specific and market risk. While company risk can
be minimized by diversifying your portfolio, market risk cannot be diversified but has to be
hedged. So how does one measure the market risk? Market risk can be known from Beta.
Beta measures the relationship between movements of the index to the movement of the
stock. The beta measures the percentage impact on the stock prices for 1% change in the
index. Therefore, for a portfolio whose value goes down by 11% when the index goes down
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by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio
increases 11%. The idea is to make beta of your portfolio zero to nullify your losses.
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. 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 million of S&P
CNX Nifty futures.
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.
Now let us study the impact on the overall gain/loss that accrues:
Index up 10% Index down 10%
Gain/ (Loss) in Portfolio Rs 120,000 (Rs 120,000)
Gain/ (Loss) in Futures (Rs 120,000) Rs 120,000
Net Effect Nil Nil
As we see, that portfolio is completely insulated from any losses arising out of a fall in
market sentiment. But as a cost, one has to forego any gains that arise out of improvement in
the overall sentiment. Then why does one invest in equities if all the gains will be offset by
losses in futures market. The idea is that everyone expects his portfolio to outperform the
market. Irrespective of whether the market goes up or not, his portfolio value would increase.
The same methodology can be applied to a single stock by deriving the beta of the scrip and
taking a reverse position in the futures market.
Thus, we have seen how one can use hedging in the futures market to offset losses in the cash
market.
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HEDGING IN OPTION TRADING
Option traders hedging a portfolio of stock or hedging an option position in an option trading
strategy, needs to consider 5 forms of risk. Directional risk (Delta), how directional risk will
change with stock price changes (Gamma), volatility risk (Vega) and time decay risk (Theta).
These risks are factors that influence the value of a stock option. Option traders do not
normally perform hedging for interest rate risk (Rho) as its impact is very small. Hedging a
stock option portfolio requires understanding of what the biggest risk in that portfolio is. If
time decay is of concern, then theta neutral hedging should be used. If a drop in the value of
the underlying stock is of greatest concern, then delta neutral hedging should be used. We
restrict our study to trading strategies that help traders to hedge their position as time is a
constraint. We do not indulge ourselves in study of options greek and their effect although all
the strategies discussed would take care of their effects.
OPTIONS GREEK
Option Greeks – Introduction
The mathematical characteristics of the Black-Scholes model are named after the greek letters
used to represent them in equations. These are known as the Option Greeks. The 5 Option
Greeks measure the sensitivity of the price of stock options in relation to 4 different factors;
Changes in the underlying stock price, interest rate, volatility, time decay.
The 5 Option Greeks are:
Delta
Delta is the measure of an option's sensitivity to changes in the price of the underlying asset.
Therefore, it is the degree to which an option price will move given a change in the
underlying stock or index price, all else being equal.
Change in option premium
Delta = ----------------------------------------
Change in underlying price
35
For example, an option with a delta of 0.5 will move Rs 5 for every change of Rs 10 in the
underlying stock or index.
Illustration:
A trader is considering buying a Call option on a futures contract, which has a price of Rs 19.
The premium for the Call option with a strike price of Rs 19 is 0.80. The delta for this option
is +0.5. This means that if the price of the underlying futures contract rises to Rs 20 (a rise of
Rs.1) then the premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be
0.80 + 0.50 = Rs 1.30.
Far out-of-the-money calls will have a delta very close to zero, as the change in underlying
price is not likely to make them valuable or cheap. At-the money call would have a delta of
0.5 and a deeply in-the-money call would have a delta close to 1. While Call deltas are
positive, Put deltas are negative, reflecting the fact that the put option price and the
underlying stock price are inversely related. This is because if one buys a put his view is
bearish and expects the stock price to go down. However, if the stock price moves up it is
contrary to his view therefore, the value of the option decreases. The put delta equals the call
delta minus 1.
Put delta = Call delta - 1
It may be noted that if delta of one’s position is positive, he desires the underlying asset to
rise in price. On the contrary, if delta is negative, he wants the underlying asset's price to fall.
Gamma: This is the rate at which the delta value of an option increases or decreases as a
result of a move in the price of the underlying instrument.
Change in an option delta
Gamma = -------------------------------------
Change in underlying price
For example, if a Call option has a delta of 0.50 and a gamma of 0.05, then a rise of +/- 1 in
the underlying means the delta will move to 0.55 for a price rise and 0.45 for a price fall.
Gamma is greatest for an ATM (at-the- money) option and falls to zero as an option moves
deeply ITM (in-the-money) and OTM (out-of-the-money).
36
If you are hedging a portfolio using the delta-hedge technique described under "Delta", then
you will want to keep gamma as small as possible as the smaller it is the less often you will
have to adjust the hedge to maintain a delta neutral position.
Theta: It is a measure of an option's sensitivity to time decay. Theta is the change in option
price given a one-day decrease in time to expiration. It is a measure of time decay (or time
shrunk). Theta is generally used to gain an idea of how time decay is affecting your portfolio.
Change in an option premium
Theta = -------------------------------------------
Change in time to expiry
Theta is usually negative for an option as with a decrease in time, the option value decreases.
This is due to the fact that the uncertainty element in the price decreases.
Assume an option has a premium of 3 and a theta of 0.06. After one day it will decline to
2.94, the second day to 2.88 and so on. Naturally other factors, such as changes in value of
the underlying stock will alter the premium. Theta is only concerned with the time value.
Unfortunately, one cannot predict with accuracy the change's in stock market's value, but we
can measure exactly the time remaining until expiration.
Vega: This is a measure of the sensitivity of an option price to changes in market volatility. It
is the change of an option premium for a given change - typically 1 % -in the underlying
volatility.
Change in an option premium
Vega = ---------------------------------------------
Change in volatility
If for example, XYZ stock has a volatility factor of 30% and the current premium is 3, a Vega
of .08 would indicate that the premium would increase to 3.08 if the volatility factor
increased by 1 % to 31 %. As the stock becomes more volatile the changes in premium will
increase in the same proportion. Vega measures the sensitivity of the premium to these
changes in volatility.
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Rho: Rho measures the change in an option's price per unit increase - typically 1 % -in the
cost of funding the underlying.
Change in an option premium
Rho = ------------------------------------------------
Change in cost of funding underlying
Example:
Assume the value of Rho is 14.10. If the risk free interest rates go up by 1 % the price of the
option will move by Rs 0.1410. To put this in another way: if the risk-free interest rate
changes by a small amount, then the option value should change by 14.10 times that amount.
For example, if the risk-free interest rate increased by 0.01 (from 10% to 11 %), the option
value would change by 14.10*0.01 = 0.14. For a put option, inverse relationship exists. If the
interest rate goes up the option value decreases and therefore, Rho for a put option is
negative. In general Rho tends to be small except for long-dated options.
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HEDGING STRATEGIES
BASIC BULLISH STRATEGIES:
1. LONG CALL OPTION:
Buying call options, or also known as Long Call Options or simply Long Call, is the
simplest bullish option strategy ever.
Buying call options / Long Call Options offers the protection of limited downside loss
with the benefit of unlimited gain. An investor who is bullish on any stock opt go for
this strategy.
Example: Suppose Hindalco Industries Ltd. is trading at Rs 114.35 per share at the time of
this writing. Each lot of 2000 shares would cost traders Rs 228700, which is usually not an
amount a beginner trader would have. One could instead control the same 2000 shares of
Hindalco Industries Ltd. and benefit from the same move for 1 month if it goes up through
buying call options / long call options on its call options with another 1 month to expiration
for only Rs 14300 per lot, which is only 6.25% of the price of Hindalco Industries Ltd. That
is the discounting effect of Buying Call Options / Long Call Optio
39
Profit Potential of Long Call Options:
Buying call options / Long Call Options allow to profit with unlimited ceiling. That means
that profit grows as long as the underlying stock continues to rise.
Profit Calculation Long Call Options:
Profit = (Stock Price At Expiration - Strike Price Of Call Options Bought) - Premium Value
Of Call Options Bought
Risk / Reward of Buying Call Options / Long Call Options:
Upside Maximum Profit: Unlimited
Maximum Loss: Limited
Net Debit Paid. The most one could lose is the entire amount put forward into buying call
options when the underlying stock expires out of the money (OTM).
Break Even Point of Buying Call Options / Long Call Options:
Breakeven Point = Strike Price + Premium Value
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2. SHORT PUT OPTION
An investor Sells Put when he is Bullish about the stock – expects the stock price to rise or
stay sideways at the minimum. When an investor sells a Put, he/she earn a Premium (from the
buyer of the Put). The investor has sold someone the right to sell you the stock at the strike
price. If the stock price increases beyond the strike price, the short put position will make a
profit for the seller (investor) by the amount of the premium, since the buyer will not exercise
the Put option and the Put seller can retain the Premium (which is his maximum profit). But,
if the stock price decreases below the strike price, by more than the amount of the premium,
the Put seller will lose money. The potential loss is being unlimited (until the stock price fall
to zero).
Example: Assuming Hindalco Industries Ltd. is trading at Rs.114.3
An Investor is Bullish on the stock and therefore wants to enjoy profit by investing in it. But
investing in 2000 shares requires Rs. 228600. But the investor can enjoy the profit by short
on put. Suppose the investor sells the put option with the strike price of Rs.110 at a premium
of Rs. 3.50 and thus his account will be credited with the amount of Rs. 7000.
Break Even = 110 – 3.5 = Rs. 106.5
Risk: Put Strike Price – Put Premium.
Reward: Limited to the amount of Premium received.
Breakeven: Put Strike Price - Premium
41
Payoff schedule:
On expiry Hindalco Industries
Ltd. closes at Net payoff from the put
80 26.5
90 16.5
100 6.5
106.5 0
110 3.5
120 3.5
130 3.5
140 3.5
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3. LONG COMBO ( SELL A PUT , BUY A CALL)
If an investor is expecting the price of a stock to move up he can adopt a Long Combo
strategy. It involves
selling an OTM (lower strike) Put and
buying an OTM (higher strike) Call.
This strategy simulates the action of buying a stock (or a future) but at a fraction of the stock
price. It is an inexpensive trade, similar in pay-off to Long Stock, except there is a gap
between the strikes (please see the payoff diagram). As the stock price rises the strategy starts
making profits.
Assume the stock of Hindalco Industries Ltd. is trading at Rs. 114.30; An investor is bullish
on the stock but does not want to invest Rs.114.30. He does a Long Combo. He sells a Put
option with a strike price Rs. 100 at a premium of Rs 0.50 and buys a Call Option with a
strike price of Rs. 130 at a premium of Rs 0.55. The lot size of put and call is 2000 shares.
The net cost of the strategy (net debit) is Rs.100 (=0.05*2000)
Risk: Unlimited (Lower Strike+ net debit)
Reward: Unlimited
Breakeven : Higher strike + net debit
43
Hindalco Industries
closes at
Net Payoff from Put
sold (Rs.)
Net Payoff from the
call purchased (Rs.) Net Payoff (Rs.)
80 -19.5 -0.55 -20.05
90 -9.5 -0.55 -10.05
100 0.5 -0.55 -0.05
110 0.5 -0.55 -0.05
120 0.5 -0.55 -0.05
130 0.5 -0.55 -0.05
130.05 0.5 -0.5 0
140 0.5 9.45 9.95
150 0.5 19.45 19.95
160 0.5 29.45 29.95
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4. BULL CALL SPREAD:
A Bull Call Spread is a bullish option strategy that profits if the underlying asset rises in
price. Because this option trading strategy involves simultaneously buying to open and
selling to open options of the same expiration month, it is a form of Vertical Spread and
because you need to pay money to put on this position, resulting in a net debit, this is also a
Debit Spread.
How to use Bull Call Spread?
Establishing a Bull Call Spread involves the purchase of an At The Money or In The Money
call option on the underlying asset while simultaneously writing (sell to open) an Out of the
Money call option on the same underlying asset with the same expiration month.
Example: Assuming trading price of Hindalco Industries Ltd. is Rs. 114.35
Bought Hindalco 31-May-2012 CE 110 with a lot size of 2000 shares at premium of Rs. 7.10
Sold Hindalco 31-May-2012 CE 130 with a lot size of 2000 shares at premium of Rs. 0.55
Net Debit in account: (7.10*2000)-(0.55*2000) = Rs.13100
Payoff schedule:
45
On Expiry
Hindalco
Industries Ltd.
Closes at
Net payoff from
Call Buy (Rs.)
Net payoff from
Call Sold (Rs.) Net Payoff (Rs.)
90 -7.1 0.55 -6.55
100 -7.1 0.55 -6.55
110 -7.1 0.55 -6.55
115 -2.1 0.55 -1.55
116.55 -0.55 0.55 0
120 2.9 0.55 3.45
130 12.9 0.55 13.45
140 22.9 -9.45 13.45
150 32.9 -19.45 13.45
Suppose Hindalco Industries Ltd. is trading at Rs 114.35 per share at the time of this writing.
Each lot of 2000 shares would cost traders Rs 228700, which is usually not an amount a
beginner trader would have. One could instead control the same 2000 shares of Hindalco
Industries Ltd.
Profit Potential of Bull Call Spread:
This strategy reaches its maximum profit potential when the underlying stock closes at or
exceeds the strike price of the OTM call options.
Profit Calculation of Bull Call Spread:
Maximum Return = (Difference in strikes - Net Debit) ÷ Net Debit
Risk / Reward of Bull Call Spread:
Upside Maximum Profit: Limited
Maximum Loss: Limited
Net Debit Paid
Break Even Point of Bull Call Spread:
Strike Price of Long Call Option + Net Debit Paid
46
Advantages of Bull Call Spread:
Loss is limited if the underlying financial instrument falls instead of rise.
If the underlying instrument fails to rise beyond the strike price of the out of the
money short call option, the profit yield will be greater than just buying call options.
Disadvantages of Bull Call Spread:
There will be no more profits possible if the underlying instrument or stock rises
beyond the strike price of the out of the money call option.
47
5. BULL PUT SPREAD:
A Bull Put Spread is a bullish option strategy that works in the same way a Bull Call Spread
does, profiting when the underlying stock rises. The Bull Put Spread is simply a naked Put
write which minimizes margin requirement and limits potential loss by purchasing a lower
strike price put option. Because the Bull Put Spread is a credit spread, one also makes money
if the underlying asset stays stagnant through the decay and expiration of the more expensive
short put options.
When to use Bull Put Spread?
One should use a bull put spread when one is moderately confident of a rise in the underlying
asset and wants some protection and profit should the underlying asset remains stagnant.
How to use Bull Put Spread?
Establishing a Bull Put Spread involves the purchase of an At The Money or Out of The
Money put option on the underlying asset while simultaneously writing (sell to open) an In
the Money or At The Money put option on the same underlying asset with the same
expiration month.
Which strike prices to choose also depends on one’s desired effect. If the Bull Put Spread is
established by selling ATM Put option and buying OTM Put options, the position needs only
stay stagnant or rise to result in a profit, hence a higher profit probability.
48
Example: Assuming Hindalco Industries Ltd. is trading at Rs. 143
Bought Hindalco 31-May-2012 PE 110 with a lot size of 2000 shares at premium of Rs. 3.50
Sold Hindalco 31-May-2012 PE 140 with a lot size of 2000 shares at premium of Rs. 21
Net Credit in account: (21*2000)-(3.50*2000) = Rs. 35000
Payoff schedule:
On Expiry
Hindalco
Industries Ltd.
Closes at
Net payoff
from Put Sold
(Rs.)
Net payoff
from Put Buy
(Rs.)
Net Payoff
(Rs.)
90 -29 16.5 -12.5
100 -19 6.5 -12.5
110 -9 -3.5 -12.5
120 1 -3.5 -2.5
122.5 3.5 -3.5 0
130 11 -3.5 7.5
140 21 -3.5 17.5
150 21 -3.5 17.5
160 21 -3.5 17.5
170 21 -3.5 17.5
A Bull Put Spread results in maximum profit when the underlying stock closes above the
strike price of the short put options. In this case, the strike price of the short put options is
directly on the prevailing stock price, allowing it to reach maximum profit even if the stock
remains stagnant.
Risk / Reward of Bull Put Spread:
Upside Maximum Profit: Limited
49
Maximum Loss: Limited
Break Even Point of Bull Put Spread:
Higher Strike - Net credit
Advantages Of Bull Put Spread:
Loss is limited if the underlying financial instrument falls instead of rise.
If the underlying instrument fails to rise beyond the strike price of the out of the
money short put option, the profit yield will be greater than just buying call options.
Profits even when the underlying asset remains completely stagnant.
Disadvantages of Bull Put Spread:
There will be no more profits possible if the underlying asset rises beyond the strike
price of the short put option.
Because it is a credit spread, there is a margin requirement in order to put on the
position.
As long as the short put options remain in the money, there is a possibility of it being
assigned.
50
6. SYNTHETIC LONG CALL
If an investor is a low risk taker and he is bullish on any stock he can hedge his risk by using
alternate option. As per this strategy an investor can long a Stock and a put to hedge his risk
(in case the stock turn opposite to the expectation). The put option gives the investor right to
sell the stock at a certain price which is the strike price. The strike can be the price at which
you bought the stock (At the money strike price) or moderately below (Out of the money
strike price)
In case the price of the stock rises the investor get the full benefit of the price rise and in case
the price of the stock falls, the investor can exercise the Put Option. Investor have capped
his/her loss in this manner because the Put option stops further losses. It is a strategy with a
limited loss and (after subtracting the Put premium) unlimited profit (from the stock price
rise).
The result of this strategy looks like a Call Option Buy strategy and therefore is called a
Synthetic Call.
Example: Assume Hindalco Industries ltd. is trading at Rs.114.30, an investor Mr.A buys
2000 shares of Hindalco Ltd. at this price. To cover downside risk the investor also long on
put i.e 31-May-2012 PE 110 at a premium of Rs. 2.15, thus the payoff schedule will be:
Risk: Losses limited to Stock price + Put Premium – Put Strike price
Reward: Profit potential is unlimited.
51
Break-even Point: Put Strike Price + Put Premium + Stock Price – Put Strike Price
The above table shows that the investor earns in case the stock prices of Hindalco Industries
Ltd. goes up and bear losses in case the stock prices move down.
Hindalco Industries
closes at
Net Payoff from
Stock (Rs.)
Net Payoff from the
put purchased (Rs.) Net Payoff (Rs.)
80 -34.3 27.85 -6.45
90 -24.3 17.85 -6.45
100 -14.3 7.85 -6.45
110 -4.3 -2.15 -6.45
116.45 2.15 -2.15 0
120 5.7 -2.15 3.55
130 15.7 -2.15 13.55
140 25.7 -2.15 23.55
150 35.7 -2.15 33.55
52
BASIC BEARISH STRATEGIES
1. SHORT CALL
When an investor is very bearish about a stock / index and expects the prices to fall, he/she
can sell Call options. This position offers limited profit potential and the possibility of large
losses on big advances in underlying prices. Although easy to execute it is a risky strategy
since the seller of the Call is exposed to unlimited risk.
Example: Assume an investor is Bearish on Reliance Industries Ltd.The investor sells a call
of Reliance Industries Ltd. (Reliance 31- May-2012 CE 680) at a premium of Rs. 14.20,
when the stock is trading at Rs. 681.65. If the stock stays at 680 or below 680 the holder of
call option will not exercise his/her option and thus the seller can retain premium.
Break Even Point = Strike Price + Premium
= 680 + 14.20
= 694.20
1 lot of Reliance industries Ltd. is consists of 250 shares. However, payoff is shown on single
share basis.
53
The above table shows that if the stock prices of Hindalco Industries Ltd. increases investor
bears losses and if the stock prices decreases, investor enjoy profits
On Expiry Reliance closes at Net Payoff from Call Option
640 14.2
660 14.2
680 14.2
694.2 0
700 -5.8
720 -25.8
740 -45.8
54
2. LONG PUT
When an investor is Bearish on any stock he buys a put option. A put option gives the
buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price and
thereby limit his risk.
Example: An investor Mr. A is bearish on Reliance Industries Ltd. which is currently
trading at Rs.681.65 and thus he buys a put with a strike price of Rs.680 (Reliance 31-
May-2012 PE 680) at a premium of Rs. 16.55 . The lot size is of 250 shares.
Breakeven point = Strike price -
Premium
= 680 – 16.55
= Rs 663.45
The advantage of buying a put is that the
investor is exposed to limited loss and the
profit potential is unlimited.
On Expiry
Reliance closes at
Net Payoff
from Put
Option
620 43.45
640 23.45
660 3.45
663.45 0
680 -16.55
700 -16.55
720 -16.55
740 -16.55
55
3. PROTECTIVE CALL/ SYNTHETIC LONG PUT
If an investor is a low risk taker and he is bearish on any stock he can hedge his risk by using
alternate option. As per this strategy an investor can short a Stock and a call to hedge his risk
(in case the stock turns opposite to the expectation). The call option gives the investor right to
buy the stock at a certain price which is the strike price. The strike can be the price at which
you bought the stock (At the money strike price) or moderately below (Out of the money
strike price)
In case the price of the stock falls the investor get the full benefit of the price fall and in case
the price of the stock rises, the investor can exercise the Call Option. Investors have capped
his/her loss in this manner because the Call option stops further losses.
Breakeven: Stock Price – Call Premium
Example: Assume Mr. A is bearish on Reliance Industries Ltd. which is currently trading at
Rs.681.65. Mr. A short who is a low risk taker sells the shares of Reliance Industries and
buys a call option to hedge the risk (in case the stock price rises). Mr. A buys a Near Call
expiring at 31-May-2012 with a strike price of Rs700 at a premium of Rs7.15. The payoff
schedule will be
Breakeven =681.65 – 7.15 = 674.5
56
The above table shows that the investor bear risk in case the stock price rises and enjoy
profits in case stock prices move down.
Reliance
Industries
closes at
Net Payoff from
Stock (Rs.)
Net Payoff from the
call purchased (Rs.) Net Payoff (Rs.)
600 81.65 -7.15 74.5
620 61.65 -7.15 54.5
640 41.65 -7.15 34.5
660 21.65 -7.15 14.5
674.5 7.15 -7.15 0
680 1.65 -7.15 -5.5
700 -18.35 12.85 -5.5
720 -38.35 32.85 -5.5
740 -58.35 52.85 -5.5
57
4. BEAR CALL SPREAD
The Bear Call Spread is simply a naked call write which minimizes margin requirement and
limits potential loss by purchasing a higher strike price call option. Because the Bear Call
Spread is a credit spread, you also make money if the underlying asset stays stagnant through
the decay and expiration of the more expensive short call options
When to use Bear Call Spread?
One should use a Bear Call Spread when one is moderately confident of a drop in the
underlying asset and wants some protection and profit should the underlying asset remains
stagnant.
How to use Bear Call Spread?
Establishing a Bear Call Spread involves the purchase of an At The Money or Out of The
Money call option on the underlying asset while simultaneously writing (sell to open) an In
the Money or At The Money call option on the same underlying asset with the same
expiration month.
In this strategy the investor receives a net credit because the Call he buys is of a higher strike
price than the Call sold. The strategy requires the investor to buy out-of-the-money (OTM)
call options while simultaneously selling in-the-money (ITM) call options on the same
underlying stock index.
58
Example 2: Assuming Reliance Industries is trading at Rs. 681.65. An investor Mr. A is
mildly bearish on the stock and he buys a call with a strike price of Rs. 700 and sells a call
with a strike price of Rs.660; thus
Buy: Reliance 31-May-2012 CE 700 at a premium of Rs. 7.15
Sell: Reliance 31-May-2012 CE 660 at a premium of Rs. 26.05
Reliance Industries
closes at
Net Payoff from
Call Sold (Rs.)
Net Payoff from
the call
purchased (Rs.) Net Payoff (Rs.)
600 26.05 -7.15 18.9
620 26.05 -7.15 18.9
640 26.05 -7.15 18.9
660 26.05 -7.15 18.9
678.9 7.15 -7.15 0
680 6.05 -7.15 -13.2
700 -13.95 -7.15 -21.1
720 -33.95 12.85 -21.1
740 -53.95 32.85 -21.1
A Bear Call Spread results in maximum profit when the underlying stock closes below the
strike price of the short call options. In this case, the strike price of the short call options is
directly on the prevailing stock price, allowing it to reach maximum profit even if the stock
remains stagnant.
Profit Calculation of Bear Call Spread
Maximum Return = Net Credit
Risk / Reward of Bear Call Spread
Upside Maximum Profit: Limited
59
Maximum Loss: Limited
Break Even Point of Bear Call Spread
BEP: Lower Strike + Net credit
Advantages of Bear Call Spread
Loss is limited if the underlying financial instrument rises instead of falls.
If the underlying instrument fails to drop beyond the strike price of the out of the
money short call option, the profit yield will be greater than just buying put options.
Able to profit even when the underlying asset remains completely stagnant.
Disadvantages of Bear Call Spread
There will be no more profits possible if the underlying asset drops beyond the strike
price of the short call option.
Because it is a credit spread, there is a margin requirement in order to put on the
position
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BASIC VOLATILITY STRATEGIES
1. SHORT CALL BUTTERFLY
A short Butterfly is a strategy for volatile market. It can be constructed by buying two ATM
call, selling one ITM and one OTM call, giving the investor net credit. There should be equal
distance between each strike price. There is limited risk and limited return in this strategy.
This strategy is useful when an investor is not in a position to decide the direction of the
market i.e. whether the market will move up or down.
Example: Assume the share of Hindalco Industries ltd. is trading at Rs.120. An investor who
is neutral purchases two ATM call at the premium of Rs.2.15 and sell one ITM call with a
strike price of Rs.110 at the premium of Rs.7.10 and sell one more OTM call with a strike
price of Rs.130 at a premium of Rs.0.55.
The net credit in the account of investor is 7.10 + 0.55 - 4.30 = 3.35
Upper Break-even point = Strike Price of higher strike short call – net premium received
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= 130 – 3.35
= 126.65
Lower Break-even Point = Strike price of lower short call + net premium received
= 110 + 3.35
= 113.35
The payoff table will be:
On expiry
Hindalco closes
at
Net payoff from
2 ATM call
purchased (Rs.)
Net payoff
from ITM
short call
(Rs.)
Net payoff
from one OTM
short call (Rs.)
Net Payoff
(Rs.)
80 -4.3 7.1 0.55 3.35
90 -4.3 7.1 0.55 3.35
100 -4.3 7.1 0.55 3.35
113.35 -4.3 3.75 0.55 0
120 -4.3 -2.9 0.55 -6.65
126.65 9 -9.55 0.55 0
130 15.7 -12.9 0.55 3.35
140 35.7 -22.9 -9.45 3.35
150 55.7 -32.9 -19.45 3.35
The above table shows the potential of earning limited profit.
62
2. LONG CALL BUTTERFLY
A long Butterfly is a strategy for volatile market. It can be constructed by selling two ATM
call and buying one ITM and one OTM call, giving the investor net credit. There should be
equal distance between each strike price. This strategy offers good risk reward ratio, along
with low investment. This strategy is useful when an investor is not in a position to decide the
direction of the market but bearish on volatility.
Example: Assume the share of Hindalco Industries ltd. is trading at Rs.120. An investor who
is neutral sells two ATM call at the premium of Rs.2.15 and buy one ITM call with a strike
price of Rs.110 at the premium of Rs.7.10 and buy one more OTM call with a strike price of
Rs.130 at a premium of Rs.0.55.
The net debit in the account of investor is = 7.10 + 0.55 – 4.30 = 3.35
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Upper Break-even point = Strike Price of higher strike long call – net premium paid
= 130 – 3.35
= 126.65
Lower Break-even Point = Strike price of lower long call + net premium paid
= 110 + 3.35
= 113.35
The payoff table is given below:
On expiry
Hindalco closes
at
Net payoff from
2 ATM call sold
(Rs.)
Net payoff
from ITM
long call (Rs.)
Net payoff
from one OTM
long call (Rs.)
Net Payoff
(Rs.)
80 4.3 -7.1 -0.55 -3.35
90 4.3 -7.1 -0.55 -3.35
100 4.3 -7.1 -0.55 -3.35
113.35 4.3 -3.75 -0.55 0
120 4.3 2.9 -0.55 6.65
126.65 -9 9.55 -0.55 0
130 -15.7 12.9 -0.55 -3.35
140 -35.7 22.9 9.45 -3.35
150 -55.7 32.9 19.45 -3.35
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3. LONG STRADDLE
A straddle is a volatile strategy and is used by an investor when he is expecting that share
prices will show large movements. This strategy involves buying a call and a put with the
same strike price and maturity, to take the advantage of a movement in any direction, a
soaring or plummeting value of a stock. If the price of the stock increases call will be
exercised while put expires worthless and if price of the stock decrease, put will be exercised
while call expires worthless.
The risk involved in this strategy is limited to the premium amount paid initially. The reward
is unlimited.
Example: Assume the share of Hindalco Industries ltd. is trading at Rs.118. The investor is
expecting higher volatility in the share price of the Hindalco Industries Ltd. and thus he
purchases a call with a strike price of Rs.120 maturing on 31-May-2012 with a premium of
Rs.7.10. The investor also purchases a put with a strike price of 120 maturing on 31-May-
2012 with a premium of Rs.2.15.
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Upper Break even = Strike price of long call + premium paid
= 120 +9.25 = 129.25
Lower break even = Strike Price of long put – premium paid
= 120 – 9.25 =110.75
The pay table is given as
On expiry
Hindalco closes
at
Net payoff from
long call (Rs.)
Net payoff
from long put
(Rs.)
Net Payoff
(Rs.)
80 -7.1 37.85 30.75
90 -7.1 27.85 20.75
100 -7.1 17.85 10.75
105 -7.1 12.85 5.75
110.75 -7.1 7.1 0
120 -7.1 -2.15 -9.25
129.25 2.15 -2.15 0
135 7.9 -2.15 5.75
140 12.9 -2.15 10.75
150 22.9 -2.15 20.75
160 32.9 -2.15 30.75
A short straddle is opposite of long straddle. This Strategy is adopted by an investor when he
feels that market will not show much movement. This strategy involves selling of Put and call
with same strike price and same maturity. The investor is exposed to unlimited risk and
limited profit, that is the premium received.
66
4. LONG STRANGLE
A strangle is a slight modification to the straddle to make it cheaper to execute. This strategy
involves the buying of slightly OTM call and slightly OTM put with the same underlying
stock and with the same expiration date. Since an investor buys OTM call and put it costs him
cheaper than long straddle. However, for a Strangle to make money, it would require greater
movement on the upside or downside for the stock / index than it would for a Straddle. An
investor is exposed to limited risk and unlimited profit.
Example: Assume the share of Hindalco Industries Ltd. is trading at Rs.120.An investor who
is expecting greater volatility buys OTM call with a strike price of Rs.130 at a premium of
Rs.0.55 and a put with a strike price of Rs.110 at a premium of Rs.2.15
Net amount debited from investor account = 0.55 + 2.15
= 2.70
Upper Break-even point = Strike price of Long call + Net premium paid
67
= 130 + 2.70
= 132.70
Lower Break-even point = Strike price of long put – Net premium paid
= 110-2.70
= 107.30
The payoff table of this strategy is given as:
On expiry
Hindalco closes
at
Net payoff from
long call (Rs.)
Net payoff
from long put
(Rs.)
Net Payoff
(Rs.)
80 -0.55 27.85 27.3
90 -0.55 17.85 17.3
100 -0.55 7.85 7.3
107.3 -0.55 0.55 0
110 -0.55 -2.15 -2.65
120 -0.55 -2.15 -2.65
130 -0.55 -2.15 -2.65
132.7 2.15 -2.15 0
140 9.45 -2.15 7.3
150 19.45 -2.15 17.3
160 29.45 -2.15 27.3
Short Strangle is opposite to the Long strangle. As per short strangle an investor sells one
OTM call and one OTM put. The risk is unlimited and reward is limited. An investor follow
short strangle when he believes that the underlying stock will show little volatility.
68
COMMODITY TRADING
Derivatives markets can broadly be classified as commodity derivatives market and financial
derivatives markets. As the name suggest, commodity derivatives markets trade contracts are
those for which the underlying asset is a commodity. It can be an agricultural commodity like
wheat, soybeans, rapeseed, cotton, etc or precious metals like gold, silver, etc. or energy
products like crude oil, natural gas, coal, electricity etc. Financial derivatives markets trade
contracts have a financial asset or variable as the underlying. The more popular financial
derivatives are those which have equity, interest rates and exchange rates as the underlying.
In this segment we are going to discuss about Commodity Derivative – Aluminium and
Copper.
Difference between Commodity Derivatives and Financial Derivatives:
The basic concept of a derivative contract remains the same whether the underlying happens
to be a commodity or a financial asset. However there are some features, which are very
peculiar to commodity derivative markets.
In the case of financial derivatives, most of these contracts are cash settled. Even in
the case of physical settlement, financial assets are not bulky and do not need special
facility for storage. Due to the bulky nature of the underlying assets, physical
settlement in commodity derivatives creates the need for warehousing.
Similarly, the concept of varying quality of asset does not really exist as far as
financial underlyings are concerned. However in the case of commodities, the quality
of the asset underlying a contract can vary at times.
Indian Commodity exchanges: There are more than 20 recognized commodity futures
exchanges in India under the purview of the Forward Markets Commission (FMC). The
country's commodity futures exchanges are divided majorly into two categories:
National exchanges
Regional exchanges
69
MCX: Multi Commodity Exchange of India Ltd (MCX) is a state-of-the-art electronic
commodity futures exchange. The demutualised Exchange set up by Financial Technologies
(India) Ltd (FTIL) has permanent recognition from the Government of India to facilitate
online trading, and clearing and settlement operations for commodity futures across the
country. Having started operations in November 2003, today, MCX holds a market share of
over 80% of the Indian commodity futures market, and has more than 2000 registered
members operating through over 100,000 trader work stations, across India. MCX offers
more than 40 commodities across various segments such as bullion, ferrous and non-ferrous
metals, and a number of agri-commodities on its platform. The Exchange is the world's
largest exchange in Silver, the second largest in Gold, Copper and Natural Gas and the third
largest in Crude Oil futures, with respect to the number of futures contracts traded. MCX has
been certified to three ISO standards including ISO 9001:2000 Quality Management System
standard, ISO 14001:2004 Environmental Management System standard and ISO 27001:2005
Information Security Management System standard. The Exchange‟s platform enables
anonymous trades, leading to efficient price discovery. Moreover, for globally-traded
commodities, MCX‟s platform enables domestic participants to trade in Indian currency.
NCDEX: National Commodity & Derivatives Exchange Limited (NCDEX), a national level
online multi commodity exchange, commenced its operations on December 15, 2003. The
70
Exchange has received a permanent recognition from the Ministry of Consumer Affairs, Food
and Public Distribution, Government of India as a national level exchange. NCDEX has been
formed with the following objectives:
To create a world class commodity exchange platform for the market participants.
To bring professionalism and transparency into commodity trading.
To provide nationwide reach and consistent offering.
To bring together the entities that the market can trust.
NCDEX currently offers an array of more than 50 different commodities for futures trading.
The commodity segments covered include both agri and non-agri commodities [bullion,
energy, metals (ferrous and non-ferrous metals) etc]. Before identifying a commodity for
trading, the Exchange conducts a thorough research into the characteristics of the product, its
market and potential for futures trading.
NMCE: National Multi Commodity Exchange of India Limited (NMCE) is the first de-
mutualized, Electronic Multi-Commodity Exchange to be formed in India. On 25th July,
2001, it was granted approval by the Government of India to organize trading in the edible oil
complex. It started operating in the commodity market from November 26, 2002. NMCE is
the only Exchange in India to have investment and technical support from commodity
relevant institutions like Central Warehousing Corporation Ltd., Gujarat State Agricultural
Marketing Board, Neptune Overseas Ltd, National Agricultural Cooperative Marketing
Federation of India (NAFED), Gujarat Agro-Industries Corporation Ltd. (GAICL), Gujarat
State Agricultural Marketing Board (GSAMB) and the National Institute of Agricultural
Marketing (NIAM).
ICEX: Indian Commodity Exchange Limited is a nation-wide screen based on-line
derivatives exchange for commodities and has established a reliable, efficient and transparent
trading platform. It has put in place assaying and warehousing facilities in order to facilitate
deliveries. This exchange is ideally positioned to leverage the huge potential of commodities’
market and encourage participation of farmers, traders and actual users to benefit from the
opportunities of hedging, risk management and supply chain management in the commodities
markets
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The Exchange is a public-private partnership with Reliance Exchangenext Ltd. as anchor
investor and has MMTC Ltd., Indiabulls Financial Services Ltd., Indian Potash Ltd.,
KRIBHCO and IDFC among others, as its stakeholders
LIST OF TRADED COMMODITY
Metal: Aluminium, Copper, Lead, Nickel, Sponge Iron, Steel Long (Bhavnagar), Steel Long
(Govindgarh), Steel Flat, Tin, Zinc
Bullion: Gold, Gold HNI, Gold M, i-gold, Silver, Silver HNI, Silver M
Fibre: Cotton L Staple, Cotton M Staple, Cotton S Staple, Cotton Yarn, Kapas
Energy: Brent Crude Oil, Crude Oil, Furnace Oil, Natural Gas, M. E. Sour Crude Oil
Spices: Cardamom, Jeera, Pepper, Red Chilli
Plantations: Areca nut, Cashew Kernel, Coffee (Robusta), Rubber
Pulses: Chana, Masur, Yellow Peas
Petrochemicals: HDPE, Polypropylene(PP), PVC
Oil and Oil seeds: Castor Oil, Castor Seeds, Coconut Cake, Coconut Oil, Cotton Seed,
Crude Palm Oil, Groundnut Oil, Kapasia Khalli, Mustard Oil, Mustard Seed (Jaipur),
Mustard Seed (Sirsa), RBD Palmolein, Refined Soy Oil, Refined Sunflower Oil, Rice Bran
DOC, Rice Bran Refined Oil, Sesame Seed, Soymeal, Soy Bean, Soy Seeds
Cereals: Maize
Others: Gurchaku, Mentha Oil, Potato (Agra), Potato (Tarkeshwar), Sugar M-30, Sugar S-30
72
SETTLEMENT IN COMMODITY MARKET
Daily Mark to Market settlement where 'T' is the trading day
Mark to Market Pay-in (Payment): T+1 working day.
Mark to Market Pay-out (Receipt): T+1 working day.
Final settlement for Futures Contracts
The settlement schedule for Final settlement for futures contracts is given by the Exchange in
detail for each commodity.
Timings for Funds settlement:
Pay-in: On Scheduled day as per settlement calendars.
Pay-out: On Scheduled day as per settlement calendars.
SOME COMMON USED TERMS:
Contango refers to a situation in commodities futures contracts where the futures price is
above the spot price, the price for current purchase and delivery of the physical commodity.
Backwardation refers to a situation in commodities futures contracts where the future price
is below the spot price. If the dominant traders in a commodity future are producers of the
commodity hedging their exposure to financial losses arising from unexpected price declines
in the future, the result will be backwardation. In this situation, producers are paying for
protection against price declines and that is reflected in futures prices which are lower than
current market price (spot price).
Companies generally use hedge ratio to hedge their risk. Hedge ratio can be defined as a
ratio comparing the value of a position protected via a hedge with the size of the entire
position itself.
Suppose an investor is holding $10,000 in foreign equity, which exposes him to currency
risk. If he hedges $5,000 worth of the equity with a currency position, his hedge ratio is 0.5
(50 / 100). This means that 50% of his equity position is sheltered from exchange rate risk.
73
ALUMINIUM
74
INTRODUCTION TO ALUMINIUM
Aluminium is a silvery white member of the boron group of chemical elements. It is not
soluble in water under normal circumstances. Aluminium is the second most abundant
element (after silicon), and the most abundant metal, in the Earth's crust. It makes up about
8% by weight of the Earth's solid surface. Aluminium metal is too reactive chemically to
occur natively. Instead, it is found combined in over 270 different minerals. The chief ore of
aluminium is bauxite.
Aluminium is basically used in followings:
Transportation Industry (automobiles, aircrafts, trucks, railways, cars, marine vessels,
bicycle etc.)
Packaging (cans, foil etc)
Construction (windows, doors, siding, building wire etc)
Cooking utensils
Super purity aluminium is used in electronic and CDs.
Aluminium has the following properties:
Reflectivity: Aluminum is an excellent reflector of heat, light and electromagnetic
waves.
Thermal conductivity: Aluminum's thermal conductivity is remarkable and
promotes its use in diverse manufacturing sectors, such as kitchen utensils, solar
collectors, refrigeration components, disks and brakes. Aluminum is also used in the
electronic industry, to desalinate sea water and in all fields employing heat exchange
devices.
Light Weight: Aluminum's light weight makes it particularly suitable for all means
of transportation: road (30 to 50% lighter), rail, water and air (all airplanes are made
of aluminum alloy). This property makes it a metal of choice for electric power
transmission; with equal resistance, a wire made of aluminum alloy is twice as light as
copper. Aluminum is also much appreciated in various mechanical applications,
particularly for components of moving machines, such as engines and robotic devices.
75
Workability: If by workability one understands all the methods by which a material
may be destructively or non-destructively shaped, joined and finished, then
aluminium must rate as the most versatile of all the metal. Aluminium may be cast by
all known foundry methods; it can be rolled to any thickness down to foil thinner than
tissue paper, it can be stamped, drawn, spun, roll-formed, or forged; there is almost no
limit to the different cross-sectional shapes in which aluminium may be extruded. All
aluminium alloys can be machined, usually easily and rapidly, at maximum machine
speeds.
Recyclable: Aluminum can be recycled indefinitely. Secondary aluminum
manufacturing requires only 5% of the electricity necessary to produce the primary
metal.
Non-toxicity: The non-toxicity of aluminium and its compounds was noted early in
the development of the industry. Because of its non-contaminative characteristics, a
great deal of aluminium equipment is used in the processing of food and beverages.
Aluminium is not adversely affected by steam sterilizing and cleaning and it will not
harbor insects or bacteria. The non-toxicity of aluminium is particularly advantageous
in the handling of yeasts and other micro-biological products.
Strength: The use of aluminium for space vehicles and aircraft structures probably
represents the most exacting application of the highest strength aluminium alloys
where weight saving is the primary requirement. While the list of applications for
aluminium broadly based on lightness benefits is enormous, it is specifically lightness
combined with strength which accounts for the wide use of aluminium alloys for
transportation equipment generally and for moving and movable parts.
Ductility: Aluminum is easy to process, no matter what method is used (milling,
drilling, shearing, forging or spinning). It is easy to shape, making it ideal for
extruding, strip rolling, bending or other plastic hot or cold fabrication methods. It can
also be soldered and glued.
76
Resistance: In its pure state, aluminum is soft and flexible. Its resistance can be
increased by alloys or cold treatment.
Corrosion Resistance: A compact layer of oxide forms naturally on the surface of
aluminum, protecting it from atmospheric corrosion and giving aluminum products a
very long life. The visual aspect of the material can be further improved by anodizing
or heat treatment. Maintenance of aluminum products is minimal, even when
unprotected.
Diversity of the alloys: Aluminum can be alloyed with several other metals, such as
copper, magnesium, manganese, silicon, lithium and zinc, to further improve certain
properties.
Electrical conductivity: Aluminum is an excellent electrical conductor. Pure
aluminum and certain alloys, in the form of bars or tubes, are commonly used as
conductors in many electrical applications.
Inertness: The chemical inertness and metallic stability of aluminum make it an
excellent choice for product conservation
Surface treatment: Surface treatments of all kinds make it an ideal metal for
aesthetic or decorative products.
Color treatment: Aluminum takes colour well and is suitable for all types of
printing.
The aluminium industry is a capital and technology intensive industry. The main substitutes
of aluminium are plastic, wood and glass.
77
Major Aluminium Producing Countries
Countries
Production in ‘000 t
2008 % of total 2014 % of total
China 13,695 34 21,481 43
Russia 4,191 10 3,712 7
Canada 3,124 8 756 2
USA 2,658 7 1,754 3
Australia 1,978 5 1,727 3
Brazil 1,661 4 1,684 3
Norway 1,383 3 1,195 2
India 1,348 3 3,958 8
Dubai 899 2 1026 2
Others 9,194 23 13,042 26
Total 40,131 100 50,335 100
0
5,000
10,000
15,000
20,000
25,000
2008
2014
78
Major Aluminium Consuming Countries
Countries
Consumption in ‘000 tonne
2008 % of total 2014 % of total
China 12,604 34 22,088 44
USA 5,147 14 5,505 11
Japan 2,319 6 2,259 4
Germany 1,929 5 2,054 4
Middle East 1,459 4 2,030 4
India 1,089 3 3,800 8
Italy 951 3 869 2
South Korea 937 3 1297 3
Brazil 933 3 1,198 2
Others 10,051 24 9,551 19
Total 37,419 100 50,651 100
Source: Aluminium Association of India
0
5,000
10,000
15,000
20,000
25,000
China USA Japan Germany MiddleEast
India Italt SouthKorea
Brazil Others
2008 2014
79
Global Share of Primary and Recycled Metal Production
Worldwide Evolution of recycled and Primary Aluminium
80
The primary aluminium production process consists of three stages:
First is mining of bauxite (see appendix 1),
Second is refining of bauxite to alumina and
Finally smelting of alumina to aluminium.
India has the fifth largest bauxite reserves with deposits of about 3 bn tonnes or 5% of world
deposits. India's share in world aluminium capacity rests at about 3%.
Production of 1 tonne of aluminium requires 2 tonnes of alumina while production of 1 tonne
of alumina requires 2 to 3 tonnes of bauxite.
The aluminium production process can be categorised into upstream and downstream
activities. The upstream process involves mining and refining while the downstream process
involves smelting and casting & fabricating. Downstream-fabricated products consist of rods,
sheets, extrusions and foils.
Power is amongst the largest cost component in manufacturing of aluminium, as the
production involves electrolysis. Consequently, manufacturers are located near cheap and
abundant sources of electricity such as hydroelectric power plants. Alternatively, they could
set up captive power plants, which is the pattern in India. Indian manufacturers are the lowest
cost producers of the base metal due to access to captive power, cheap labour and proximity
to abundant supply of raw material, i.e., bauxite.
The Indian aluminium sector is characterized by large integrated players
like Hindalco and National Aluminium Company (Nalco). The other producers of primary
aluminium include Indian Aluminium (Indal), now merged with Hindalco, and Sterlite
Industries.
The per capita consumption of aluminium in India continues to remain abysmally low at1.2
kg as against nearly 15 to 18 kgs in the western world and 10 kgs in China. This offers
significant upside potential. The key consumer industries in India are power, transportation,
consumer durables, packaging and construction. Of this, power is the biggest consumer
(about 48% of total) followed by infrastructure (20%) and transportation (about 10% to 15%).
However, internationally, the pattern of consumption is in favour of transportation, primarily
due to large-scale aluminium consumption by the aviation space.
81
In FY11, LME average aluminium prices remained strong at around USD $2,250 an increase
of over 21% over previous year's average prices. The appreciating rupee though negated
some of the LME price gains for domestic aluminium producers as the prices are dollar
denominated. The prices continued to rise even as inventory levels remained at their historic
highs. This was the result of tightness in the physical market, with most inventories tied up at
various warehouses under financing deals. Across the globe, the cost of production of
aluminium increased sharply as input costs such as alumina and power surged.
Aluminium May 2012
Date Open High Low Close Vol. Cumm
Vol
Turnover
(Lakhs)
Open
Interest Spot
06-03-
2012 114.75 116.1 114.4 114.65 1126 1126 6487.11 5 110.92
07-03-
2012 114.25 115.5 113.8 113.8 1822 2948 10444.89 10 109.28
08-03-
2012 113.8 114.65 112.95 112.95 1900 4848 10820.43 2 109.07
09-03-
2012 112.95 113.8 112.1 113 4844 9692 27340.57 2 108.13
10-03-
2012 113.55 113.55 112.45 113.65 898 10590 5075.08 13 108.13
12-03-
2012 113.1 114.5 112.8 113.35 4762 15352 27059.47 13 108.28
13-03-
2012 112.8 114.2 112.5 114 1314 16666 7446.66 5 109.18
14-03-
2012 113.45 114.85 113.15 113.2 1856 18522 10577.9 35 109.83
15-03-
2012 113.2 114.05 112.35 114.05 2346 20868 13279.1 10 110.56
16-03- 114.05 114.9 113.2 114.25 1658 22526 9454.73 10 111.34
82
2012
17-03-
2012 114.25 114.8 113.7 114.4 2250 24776 12853.67 13 111.34
19-03-
2012 114.3 115.25 113.55 114.5 3430 28206 19619.19 23 111.36
20-03-
2012 114.5 115.35 113.65 114.6 3744 31950 21429.97 45 111.04
21-03-
2012 114.6 115.45 113.75 113.75 1816 33766 10404.88 15 110.94
22-03-
2012 114.25 114.6 112.9 112.9 3196 36962 18174.44 25 109.71
23-03-
2012 112.9 113.75 112.05 112.95 2782 39744 15709.09 22 109.15
24-03-
2012 112.95 113.5 112.4 112.9 2368 42112 13373.98 26 109.15
26-03-
2012 112.9 113.75 112.05 113.05 2378 44490 13424.05 15 109.03
27-03-
2012 112.55 113.9 112.2 113 7140 51630 40361.26 21 108.03
28-03-
2012 112.5 113.85 112.15 112.3 4632 56262 26165.49 24 108.56
29-03-
2012 112.85 113.15 111.45 111.45 5778 62040 32447.22 31 108.3
30-03-
2012 112 112.3 110.6 110.6 7030 69070 39193.25 37 106.77
31-03-
2012 110.6 111.15 110.05 110.05 3366 72436 18615.48 20 107.3
02-04-
2012 109.5 110.9 109.2 109.2 1500 73936 8254.05 24 105.69
03-04-
2012 108.65 110 108.4 108.8 998 74934 5448.59 21 105.84
04-04-
2012 108.8 109.6 108 108.2 1314 76248 7148.08 22 105.24
83
05-04-
2012 108.3 109 107.4 108.55 702 76950 3798.42 13 104.98
07-04-
2012 109.05 109.1 108 108.9 24 76974 130.74 3 104.98
09-04-
2012 108.35 109.7 108.1 108.6 966 77940 5260.98 5 104.96
10-04-
2012 108.5 109.4 107.8 107.9 1176 79116 6384.01 23 105.54
11-04-
2012 107.8 108.7 107.1 108.65 928 80044 5005.5 5 104.85
12-04-
2012 109 109.45 107.85 108.6 1992 82036 10821.93 4 106.03
13-04-
2012 108.5 109.4 107.8 107.8 1200 83236 6516.05 7 105.27
16-04-
2012 107.6 108.6 107 107.6 1162 84398 6264.02 10 104.59
17-04-
2012 107.6 108.4 106.8 107.55 1810 86208 9741.81 11 104.82
18-04-
2012 107 108.35 106.75 107.45 1160 87368 6237.25 3 105.03
19-04-
2012 107.55 109.3 106.65 107.9 810 88178 4349.71 2 105.03
20-04-
2012 107.8 108.7 107.1 108.3 1228 89406 6624.81 1 105.83
21-04-
2012 107.95 108.85 107.75 108.35 448 89854 2426.13 5 105.83
23-04-
2012 108.25 109.15 107.55 108.25 1242 91096 6728.44 11 105.36
24-04-
2012 107.7 109.05 107.45 109.05 756 91852 4091.99 4 106.84
25-04-
2012 108.5 109.85 108.25 108.7 1504 93356 8200.63 7 107
84
26-04-
2012 108.7 109.5 107.9 109.1 1056 94412 5739.07 7 107
27-04-
2012 109.05 109.9 108.3 109.9 1438 95850 7844.51 4 108.95
28-04-
2012 109.35 109.9 109.35 109.9 38 95888 208.59 16 108.95
30-04-
2012 110.45 110.7 109.1 109.1 3624 99512 19917.09 16 108.7
01-05-
2012 108.55 109.9 108.3 109.9 694 100206 3784.28 17 108.47
02-05-
2012 109.9 110.7 109.1 110.7 1860 102066 10224.55 7 109.36
03-05-
2012 110.15 111.55 109.85 111.2 2474 104540 13694.04 16 109.19
04-05-
2012 110.9 112.05 110.35 110.35 2588 107128 14388.22 11 109.36
05-05-
2012 110.3 110.9 109.8 109.9 750 107878 4138.11 8 109.36
07-05-
2012 109.7 110.7 109.1 109.55 2918 110796 16032.64 17 108.33
08-05-
2012 110.1 110.35 108.75 109.5 2444 113240 13387.05 12 107.62
09-05-
2012 109.4 110.3 108.7 109.4 3016 116256 16513.15 6 106.8
10-05-
2012 109 110.2 108.6 108.6 2738 118994 14976.63 13 106.63
11-05-
2012 108.6 109.4 107.8 108.55 2096 121090 11380.7 9 106.64
12-05-
2012 108 109.1 108 108.6 804 121894 4363.33 3 106.64
14-05-
2012 108.6 109.4 107.8 108.15 2664 124558 14465.44 9 106.87
85
The above showed candle stick diagram shows the trend of Aluminum May Future from 1-
Feb-2012 to 21-May-2012.
15-05-
2012 108.7 108.95 107.35 108 2186 126744 11820.92 6 106.48
16-05-
2012 107.9 108.8 107.2 108.8 2576 129320 13920.68 12 108.35
17-05-
2012 108.8 109.6 108 109.6 1866 131186 10145.2 5 108.03
18-05-
2012 109.6 110.4 108.8 110.4 682 131868 3737.61 2 109.86
19-05-
2012 110.4 110.95 109.85 110.95 724 132592 3996.43 2 109.86
86
CURRENCY DERIVATIVES
Foreign currency markets serve companies and individuals that purchase or sell foreign goods
and services denominated in foreign currencies. An even large market, however, exists for
capital flow. Foreign Currencies are needed to purchase foreign physical assets as well as
foreign financial securities.
Many companies have foreign exchange risk arising from their cross-border transactions. A
Japanese company that expects to receive 10 million euros when a transaction is completed in
90 days has yen/euro exchange rate risk as a result. By entering into a forward currency
contract to sell 10 million euros in 90 days for a specific quantity of yen, the firm can reduce
or eliminate its foreign exchange risk associated with the transaction. When a firm takes a
position in the foreign exchange market to reduce an existing risk, it is said that firm is
hedging its risk.
The primary dealer in currencies and originators of forward foreign exchange (FX) contracts
are large multinational banks. This part of FX market is called the sell side. On the other
hand, the buy side consists of the many buyers of foreign currencies and forward FX
contracts. These buyers include corporations, Government and government entities, small
institutional investors and retail investors.
Future and options are also available in the currency segment. Currency derivative market is
expanding with greater pace and is assumed to be safe as it is regulated by SEBI and RBI.
The products available in currency derivatives are:
Currency Futures (In MCX-SX and NSE)
USD/INR (see Appendix 3)
GBP/INR
JPY/INR
EUR/INR
Currency Options (NSE only)
USD/INR
87
The final settlement of a currency future contract is the last working day (excluding) of the
expiry month. The last working day will be same as that for Interbank Settlements in
Mumbai. Since future has the characteristic of mark to market settlement, therefore daily
settlement of currency futures is done in T+1 day and the final settlement is done in T+2
days. The daily settlement price is based on the last half an hour weighted average price
whereas the final settlement is based on the RBI reference rate.
RBI reference rate: RBI reference rate is the rate published daily by RBI for spot rate for
various currency pairs. The rates are arrived at by averaging the mean of the bid / offer rates
polled from a few select banks during a random five minute window between 11:45 AM and
12:15 PM and the daily press on RBI reference rate is be issued every week-day (excluding
Saturdays) at around 12:30 PM. The contributing banks are selected on the basis of their
standing, market-share in the domestic foreign exchange market and representative character.
The Reserve Bank periodically reviews the procedure for selecting the banks and the
methodology of polling so as to ensure that the reference rate is a true reflection of the market
activity. There is an increasing trend of large value FX transaction being done at RBI
reference rate even on OTC market. The reference rate is a transparent price which is publicly
available from an authentic source.
88
USD/INR
USD/INR is the most traded future on exchanges. The call and put options are only available
for USD/INR. An investor can use same strategies in options which I have discussed in the
equity derivative segment. Those strategies are:
Long hedge
Short hedge
Protective call
Covered call
Covered put
Bull call spread
Bear call Spread
Bull put Spread
Bear put spread
Long Call butterfly
Short Call butterfly
Long straddle
Short straddle
Long strangle
Short strangle
A hedger, speculator and a arbitrageur uses following strategies using currency future to
hedge his risk.
Hedging:
Presume Entity A is expecting a remittance for USD 1000 on 27 August 2012. He wants to
lock in the foreign exchange rate today so that the value of inflow in Indian rupee terms is
safeguarded. The entity can do so by selling one contract of USDINR futures since one
contract is for USD 1000.
Presume that the current spot rate is Rs.53 and ‘USDINR 27 Aug 12’ contract is trading at
Rs.54.2500. Entity A shall do the following:
89
Sell one August contract today. The value of the contract is Rs.54, 250.
Let us assume the RBI reference rate on August 27, 2012 is Rs.54.0000. The entity shall sell
on August 27, 2012, USD 1000 in the spot market and get Rs. 54,000. The futures contract
will settle at Rs.54.0000 (final settlement price = RBI reference rate).
The return from the futures transaction would be Rs. 250, i.e. (Rs. 54,250 – Rs.54, 000). As
may be observed, the effective rate for the remittance received by the entity A is Rs.54. 2500
(Rs.54, 000 + Rs.250)/1000, while spot rate on that date wasRs.54.0000. The entity was able
to hedge its exposure.
Speculation: Bullish, buy futures
Take the case of a speculator who has a view on the direction of the market. He would like to
trade based on this view. He expects that the USD-INR rate presently at Rs.52, is to go up in
the next two-three months. How can he trade based on this belief? In case he can buy dollars
and hold it, by investing the necessary capital, he can profit if say the Rupee depreciates to
Rs.52.50. Assuming he buys USD 10000, it would require an investment of Rs.520000. If the
exchange rate moves as he expected in the next three months, then he shall make a profit of
around Rs.10000.
This works out to an annual return of around 4.76%. It may please be noted that the cost of
funds invested is not considered in computing this return.
A speculator can take exactly the same position on the exchange rate by using futures
contracts. Let us see how this works. If the INR- USD is Rs.52 and the three month futures
trade at Rs.52.40. The minimum contract size is USD 1000. Therefore the speculator may
buy 10 contracts. The exposure shall be the same as above USD 10000. Presumably, the
margin may be around Rs.21, 000. Three months later if the Rupee depreciates to Rs. 52.50
against USD, (on the day of expiration of the contract), the futures price shall converge to the
spot price (Rs. 52.50) and he makes a profit of Rs.1000 on an investment of Rs.21, 000. This
works out to an annual return of 19 percent. Because of the leverage they provide, futures
form an attractive option for speculators.
90
Speculation: Bearish, sell futures
Futures can be used by a speculator who believes that an underlying is over-valued and is
likely to see a fall in price. How can he trade based on his opinion? In the absence of a
deferral product, there wasn't much he could do to profit from his opinion. Today all he needs
to do is sell the futures.
Let us understand how this works. Typically futures move correspondingly with the
underlying, as long as there is sufficient liquidity in the market. If the underlying price rises,
so will the futures price. If the underlying price falls, so will the futures price. Now take the
case of the trader who expects to see a fall in the price of USD-INR. He sells one two-month
contract of futures on USD say at Rs. 52.20 (each contact for USD 1000). He pays a small
margin on the same. Two months later, when the futures contract expires, USD-INR rate let
us say is Rs.52. On the day of expiration, the spot and the futures price converges. He has
made a clean profit of 20 paisa per dollar. For the one contract that he sold, this works out to
be Rs.2000.
Arbitrage:
Arbitrage is the strategy of taking advantage of difference in price of the same or similar
product between two or more markets. That is, arbitrage is striking a combination of
matching deals that capitalizes upon the imbalance, the profit being the difference between
the market prices. If the same or similar product is traded in say two different markets, any
entity which has access to both the markets will be able to identify price differentials, if any.
If in one of the markets the product is trading at higher price, then the entity shall buy the
product in the
Cheaper market and sell in the costlier market and thus benefit from the price differential
without any additional risk.
One of the methods of arbitrage with regard to USD-INR could be a trading strategy between
forwards and futures market. As we discussed earlier, the futures price and forward prices are
arrived at using the principle of cost of carry. Such of those entities who can trade both
forwards and futures shall be able to identify any mispricing between forwards and futures. If
91
one of them is priced higher, the same shall be sold while simultaneously buying the other
which is priced lower. If the tenor of both the contracts is same, since both forwards and
futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less
profit.
The above diagram shows the trend of USD-INR exchange rate from January 2, 2012 to May
24, 2012
FACTORS AFFECTING EXCHANGE RATE (USD/INR):
The factors those affects the exchange rates are discussed below:
Interest rate: Higher interest rate in a country attracts savings from non-residents of the
country and thereby raises demand for domestic currency. Thus in turn causes appreciation in
the value of the domestic currency.
Inflation: As a general rule, a country with a consistently lower inflation rate exhibits a
rising currency value, as its purchasing power increases relative to other currencies.
92
Current-Account Deficits: The current account is the balance of trade between a country
and its trading partners, reflecting all payments between countries for goods, services, interest
and dividends. A deficit in the current account shows the country is spending more on foreign
trade than it is earning, and that it is borrowing capital from foreign sources to make up the
deficit. In other words, the country requires more foreign currency than it receives through
sales of exports, and it supplies more of its own currency than foreigners demand for its
products. The excess demand for foreign currency lowers the country's exchange rate until
domestic goods and services are cheap enough for foreigners, and foreign assets are too
expensive to generate sales for domestic interests
To combat with the problem of higher subsidies to the oil marketing companies, which
results in higher CAD and thereby affecting exchange rate, the UPA Congress government
increases petrol prices by Rs.7 on 24th
May, 2012.
Political Stability and Economic Performance: Foreign investors inevitably seek out stable
countries with strong economic performance in which to invest their capital. A country with
such positive attributes will draw investment funds away from other countries perceived to
have more political and economic risk. Political turmoil, for example, can cause a loss of
confidence in a currency and a movement of capital to the currencies of more stable
countries.
Employment Outlook: Employment levels have an immediate impact on economic growth.
An increase in unemployment signals a slowdown in the economy and possible devaluation
of a country's currency because of declining confidence and lower demand. If demand
continues to decline, the currency supply builds and further exchange rate depreciation is
likely.
Central Bank Actions: Central bank of a country takes various measures to manage and
control the exchange rate. For example, RBI suggest to exporters to sell their 50% dollar
holding in May beginning when Rupee is about to touch its ever time low against dollar. RBI
also increases the Non-resident saving rate to attract foreign capital. RBI itself is intervening
into the market through banks to safe the downside risk of rupee but this step result in erosion
of foreign exchange reserves.
93
PROJECT ANALYSIS
Hindalco Industries Ltd. And Aluminium Future (May 2012)
The covariance and correlation between the stock prices of Hindalco Industries Ltd. and the
aluminium May future prices is given by
covariance 18.1379
correlation 0.753745
The correlation is found for the period of 1-mar-2012 to 16-May-2012. The correlation of
0.75 shows that there is good positive correlation between the stock prices of Hindalco
Industries Ltd. and the Aluminium May future prices. Thus an investor of Hindalco Industries
Ltd. can hedge his risk by taking opposite position in aluminium future. Although the prices
of May future is available from 1st February but there were no trading volume and that’s why
I have taken May future prices from March.
Similarly the correlation between Hindalco Stock prices and the Dollar is -0.92, which is a
good negative correlation. An investor who invested in Hindalco Industries Ltd. can hedge
his risk by taking the similar position in currency market. Usually companies like Hindalco
who have over 50% of their asset base outside India, hedge their exchange risk by using
100
110
120
130
140
150
160
170
Aluminum May 2012
Hindalco Stock
94
Hedge ratio. For example, Hindalco got a contract from USA based company for which
hindalco will get paid USD 1million one month later. By taking into consideration the
fluctuation in currency spot prices and currency future prices, hindalco will calculate its
hedge ratio and hedge its risk accordingly. Suppose the hedge ratio is 0.6, so Hindalco
Industries Ltd. will short on Future for the amount of USD 60,000 so that it can hedge its risk
in case the USD depreciates or INR appreciates.
The graph showing pattern of Hindalco Industries Ltd. and USD/INR is given below:
80
90
100
110
120
130
140
150
160
170
02-Jan-12 02-Feb-12 02-Mar-12 02-Apr-12 02-May-12
Hindalco stock prices
46
47
48
49
50
51
52
53
54
02-Jan-12 02-Feb-12 02-Mar-12 02-Apr-12 02-May-12
USD/INR
USD/INR
95
The above shown graph clearly shows that there is inverse relation between the Hindalco
Industries Ltd. stock prices and USD-INR rate. One can make a portfolio using various
strategies to hedge his risk, even the big venture like Hindalco Industries Ltd. does same (as
mentioned in its annual report that they aggressively uses derivatives to hedge their risk)
FINDINGS:
Derivatives are good source of hedging. The market for derivative is increasing with a
greater pace. Investors have various strategies for different marketing conditions. Derivatives
also help in price discovery. Various big investors or companies use derivatives to hedge risk
and to make profit. Factors generally attributed as the major driving force behind growth of
financial derivatives are:
(a) Increased Volatility in asset prices in financial markets,
(b) Increased integration of national financial markets with the international markets,
(c) Marked improvement in communication facilities and sharp decline in their costs,
(d) Development of more sophisticated risk management tools, providing economic agents a
wider choice of risk management strategies, and
(e) Innovations in the derivatives markets, which optimally combine the risks and returns
over a large number of financial assets, leading to higher returns, reduced risk as well as
transaction costs as compared to individual financial assets.
The project is mainly focused on forming strategies so that the investors who want to invest
in the derivatives market can earn profit irrespective of the market volatility and fluctuations.
The project also explains the factors affecting the demand and supply of aluminium and
thereby the Hindalco prices. Since Hindalco asset base outside India account for more than
50% therefore the currency exchange rate will affects its bottom line and thereby its stock
prices.
96
Appendix 1
BAUXITE MINES IN INDIA
97
Appendix 2
ALUMINIUM PLANTS IN INDIA
98
Appendix 3
CURRENCY FUTURE
99
REFERENCES
News paper
Business standard
Economic times
Books
R.P RASTUGI, 2009. Financial Management. New Delhi: Galgotia Publishing Company
KAPLAN SCHWESER, 2011. Fixed Income, Derivatives and Alternative Investments.
United States Of America: Kaplan Schweser
NSE, 2011. Equity Derivatives: A Beginner’s Module. Mumbai: National Stock Exchange of
India Limited.
NSE, 2010. Commodities Market Module. Mumbai: National Stock Exchange of India
Limited.
NSE, Currency Derivatives: A Beginner’s Module. Mumbai: National Stock Exchange of
India Limited.
Websites
www.nseindia.com
www.bseindia.com
www.nmce.com
www.mcx.com
www.sharekhan.com
www.sharekhanlearning.com
www.ftmarket.com
www.rbi.org.in
www.hindalco.com/
www.mapsofindia.com
www.aluminium-india.org/
www.nseindia.com/marketinfo/fxTracker/fxTracker.jsp
