Professional Documents
Culture Documents
B C16MB5260019
GITAM
UNIVERSITY
(Estd. u/s 3 of the UGC Act, 1956)
Name SHYLAJA.B
Specialization FINANCE
1. PROBLEM STATEMENT:-
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
prices. By their very nature, the financial markets are marked by a very high
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minimize the impact of fluctuations in asset prices on the profitability and cash
such products for almost three hundred years. The financial derivatives came into
However, since their emergence, these products have become very popular and by
products. In recent years, the market for financial derivatives has grown
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
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
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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
prices. By their very nature, the financial markets are marked by a very high
minimize the impact of fluctuations in asset prices on the profitability and cash
sole form of such products for almost three hundred years. The financial
the financial markets. However, since their emergence, these products have
become very popular and by 1990s, they accounted for about two-thirds of total
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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
The following factors have been driving the growth of financial derivatives:
markets,
costs,
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and returns over a large number of financial assets, leading to higher returns,
financial assets.
Different investment avenues are available for investors. Stock market also offers
good investment opportunities to the investor alike all investments, they also carry
certain risks. The investor should compare the risk and expected yields after
adjustment off tax on various instruments while talking investment decision the
investor may seek advice from consultancy include stock brokers and analysts
while making investment decisions. The objective here is to make the investor
Derivatives act as a risk hedging tool for the investors. The objective is to help the
and to construct the portfolio in such a manner to meet the investor should decide
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To develop and improve strategies in the investment policy formulated. This will
help the selection of asset classes and securities in each class depending up on their
1.3. Objectives:-
2. To examine the different strategy which are used by the investors for the
options, swaps and forwards in the Indian context; the study is not based on the
The study is limited to the analysis made for types of instruments of derivates each
strategy is analyzed according to its risk and return characteristics and derivatives
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2. RESEARCH METHODOLOGY:-
Concept of Derivatives
The term ‘derivatives, refers to a broad class of financial instruments which mainly
include options and futures. These instruments derive their value from the price
and other related variables of the underlying asset. They do not have worth of their
own and derive their value from the claim they give to their owners to own some
derivative of milk. The price of butter depends upon price of milk, which in turn
depends upon the demand and supply of milk. The general definition of derivatives
means to derive something from something else. Some other meanings of word
derivatives are:
Derivatives are those financial instruments that derive their value from the other
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assets. For example, the price of gold to be delivered after two months will depend,
among so many things, on the present and expected price of this commodity.
Derivative as:
unsecured, risk instrument or contract for differences or any other form of security;
b) “a contract which derives its value from the prices, or index of prices, of
underlying securities”.
iv. Bonds of different types, including medium to long term negotiable debt
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vii. Over- the Counter (OTC) 2 money market products such as loans or deposits.
1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated
this category.
2. Speculators: They transact futures and options contracts to get extra leverage in
betting on future movements in the price of an asset. They can increase both the
discrepancy between prices of more or less the same assets or competing assets in
different markets. If, for example, they see the futures price of an asset getting out
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of line with the cash price, they will take offsetting positions in the two markets to
lock in a profit.
management is not about the elimination of risk rather it is about the management
of risk. Financial derivatives provide a powerful tool for limiting risks that
requires a thorough understanding of the basic principles that regulate the pricing
of financial derivatives. Effective use of derivatives can save cost, and it can
components and that leads to improving market efficiency. Traders can use a
more attractive instrument than the underlying security. This is mainly because of
the greater amount of liquidity in the market offered by derivatives as well a the
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3. Speculation: This is not the only use, and probably not the most important use,
discovery which means revealing information about future cash market prices
diverse and scattered opinions of future are collected into one readily discernible
derivative reduces both peak and depths and leads to price stabilization effect in
Classification of Derivatives
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underlying asset can be commodities like wheat, gold, silver etc., whereas in case
of financial derivatives underlying assets are stocks, currencies, bonds and other
interest rates bearing securities etc. Since, the scope of this case study is limited to
only.
buy or sell an asset at a specified point of time in the future. In case of a forward
contract the price which is paid/ received by the parties is decided at the time of
entering into contract. It is the simplest form of derivative contract mostly entered
deferred until the contract has been made. Although the delivery is made in the
future, the price is determined on the initial trade date. One of the parties to a
forward contract assumes a long position (buyer) and agrees to buy the underlying
asset at a certain future date for a certain price. The other party to the contract
known as seller assumes a short position and agrees to sell the asset on the same
date for the same price. The specified price is referred to as the delivery price. The
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contract terms like delivery price and quantity are mutually agreed upon by the
parties to the contract. No margins are generally payable by any of the parties to
the other. Forwards contracts are traded over-the- counter and are not dealt with on
an exchange unlike futures contract. Lack of liquidity and counter party default
risks are the main drawbacks of a forward contract. For instance, consider a US
based company buying textile from an exporter from England worth £ 1 million
payment due in 90 days. The Importer is short of Pounds- it owes pounds for future
delivery. Suppose the spot (cash market) price of pound is US $ 1.71 and importer
fears that in next 90 days, pounds might rise against the dollar, thereby raising the
dollar cost of the textiles. The importer can guard against this risk by immediately
negotiating a 90 days forward contract with City Bank at a forward rate of say, £
1= $1.72. According to the forward contract, in 90 days the City Bank will give the
US Importer £ I million (which it will use to pay for textile order), and importer
will give the bank $ 1.72 million (1million ×$1.72) which is the dollar cost of £ I
(short) the underlying asset at a specified price at a specified future date through a
specified exchange. Futures contracts are traded on exchanges that work as a buyer
or seller for the counterparty. Exchange sets the standardized terms in term of
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Quality, quantity, Price quotation, Date and Delivery place (in case of
i These are traded on an organized exchange like IMM, LIFFE, NSE, BSE, CBOT
etc.
ii These involve standardized contract terms viz. the underlying asset, the time of
iii These are associated with a clearing house to ensure smooth functioning of the
market.
iv There are margin requirements and daily settlement to act as further safeguard.
authority.
vi Almost ninety percent future contracts are settled via cash settlement instead of
transaction, provides a mechanism that guarantees the honoring of the contract and
ensuring very low level of default (Hirani, 2007). Following are the important
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holds 1000 shares of ABC Ltd. Current (spot) price of ABC Ltd shares is Rs 115 at
National Stock Exchange (NSE). Ramesh entertains the fear that the share price of
ABC Ltd may fall in next two months resulting in a substantial loss to him.
Ramesh decides to enter into futures market to protect his position at Rs 115 per
share for delivery in January 2008. Each contract in futures market is of 100
Shares. This is an example of equity future in which Ramesh takes short position
on ABC Ltd. Shares by selling 1000 shares at Rs 115 and locks into future price.
Options Contract:- In case of futures contact, both parties are under obligation to
the name suggests, is in some sense, an optional contract. An option is the right,
but not the obligation, to buy or sell something at a stated date at a stated price. A
“call option” gives one the right to buy; a “put option” gives one the right to sell.
Options are the standardized financial contract that allows the buyer (holder) of the
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option, i.e. the right at the cost of option premium, not the obligation, to buy (call
options) or sell (put options) a specified asset at a set price on or before a specified
date through exchanges. Options contracts are of two types: call options and put
options. Apart from this, options can also be classified as OTC (Over the Counter)
options and exchange traded options. In case of exchange traded options contract,
options are customized contracts traded privately between the parties. A call
options gives the holder (buyer/one who is long call), the right to buy specified
quantity of the underlying asset at the strike price on or before expiration date. The
seller (one who is short call) however, has the obligation to sell the underlying
asset if the buyer of the call option decides to exercise his option to buy. Suppose
an investor buys One European call options on Infosys at the strike price of Rs.
3500 at a premium of Rs. 100. Apparently, if the market price of Infosys on the
day of expiry is more than Rs. 3500, the options will be exercised. In contrast, a
put options gives the holder (buyer/ one who is long put), the right to sell specified
quantity of the underlying asset at the strike price on or before an expiry date. The
seller of the put options (one who is short put) however, has the obligation to buy
the underlying asset at the strike price if the buyer decides to exercise his option to
sell. Right to sell is called a Put Options. Suppose X has 100 shares of Bajaj Auto
Limited. Current price (March) of Bajaj auto shares is Rs 700 per share. X needs
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money to finance its requirements after two months which he will realize after
selling 100 shares after two months. But he is of the fear that by next two months
price of share will decline. He decides to enter into option market by buying Put
Option (Right to Sell) with an expiration date in May at a strike price of Rs 685 per
whereby parties agree to exchange obligations that each of them have under their
or more parties to exchange stream of cash flows over a period of time in the
future. The parties that agree to the swap are known as counter parties.
i) Interest rate swaps which entail swapping only the interest related cash flows
ii) 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 the
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primary sources.
Interviews.
Questionnaires.
2.3. Sampling:-
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Universe
Sampling
Population
Technique
Sampling
plan
Sample Sampling
Size unit
Sampling
frame
Universe- All the people who are dealing in derivatives and were interested
to deal in derivatives.
Population-
Dehradun.
nearby places.
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sampling.
Bar diagrams.
Pie charts.
2.5. Review of literature:- Before derivatives markets were truly developed, the
means for dealing with financial risks were few and financial risks were largely
outside managerial control. Few exchange- traded derivatives did exist, but they
allowed corporate users to hedge only against certain financial risks, in limited
ways and over short time horizons. Companies were often forced to resort to
structures of their assets and liabilities (Santomero, 1995). Allen and Santomero
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(1998) wrote that, during the 1980s and 1990s, commercial and investment banks
in handling financial risks. At the same time, the derivatives exchanges, which
successfully introduced interest rate and currency derivatives in the 1970s, have
existing ones, and finding new ways to increase their liquidity. Since than, markets
for derivative instruments such as forwards and futures, swaps and options, and
developing and growing at a breathtaking pace. The range and quality of both
exchangetraded and OTC derivatives, together with the depth of the market for
widespread and growing. It could be said that the derivatives revolution has begun.
1995; 1996). Therefore, under these new conditions, shareholders and stakeholders
exposures to financial risks. It was long believed that corporate risk management
was irrelevant to the value of the firm and the arguments in favour of the
irrelevance were based on the Capital Asset Pricing Model (Sharpe, 1964; Lintner,
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1965; Mossin, 1966) and the Modigliani-Miller theorem (Modigliani and Miller,
shareholders should care only about the systematic component of total risk. On the
surface this may imply that managers of firms who are acting in the best interests
of shareholders should be indifferent about the hedging of risks that are non-
systematic.
Miller and Modigliani’s proposition supports the CAPM findings. The conditions
exposures to interest rate, exchange rate and commodity price risks are completely
constantly engaged in hedging activities that are directed towards reduction of non-
systematic risk. As an explanation for this clash between theory and practice,
imperfections in the capital market are used to argue for the relevance of corporate
risk management function. Studies that test the relevance of derivatives as risk
risks and firm’s characteristics. Stulz (1984), Smith and Stulz (1985) and Froot,
Scharfstein and Stein (1993) constructed the models of financial risk management.
These models predicted that firms attempted to reduce the risks arising from large
costs of potential bankruptcy, or had funding needs for future investment projects
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Kracaw (1987), Bessembinder (1991), Nance, Smith and Smithson (1993), Dolde
(1995), Mian (1996), as well as Getzy, Minton and Schrand (1997) and Haushalter
(2000) found empirical evidence that firms with highly leveraged capital structures
encounter financial distress is directly related to the size of the firm’s fixed claims
relative to the value of its assets. Hence, hedging will be more valuable the more
indebted the firm, because financial distress can lead to bankruptcy and
profits, hedging decreases the likelihood, and thus the expected costs, of financial
distress (see: Mayers and Smith, 1982; Myers, 1984; Stulz, 1984; Smith and Stulz,
1985; Shapiro and Titman, 1998). The argument of reducing theexpected costs of
financial distress implies that the benefits of risk management should be greater the
larger the fraction of fixed claims in the firm’s capital structure. The results of the
empirical studies suggest that the use of derivatives and risk management practices
are broadly consistent with the predictions from the theoretical literature, which is
currency, interest rate and commodity risk, firms can decrease cash flow volatility.
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By reducing the cash flow volatility, firms can decrease the expected financial
distress and agency costs, thereby enhancing the present value of expected future
cash flows. In addition, reducing cash flow volatility can improve the probability
of having sufficient internal funds for planned investments, (e.g. see: Stulz, 1984;
Smith and Stulz, 1985; Froot, Scharfstein and Stein, 1993; 1994) eliminating the
need to either cut profitable projects or bear the transaction costs of external
funding. The main hypothesis is that, if access to external financing (debt and/or
equity) is costly, firms with investment projects requiring funding will hedge their
cash flows to avoid a shortfall in own funds, which could precipitate a costly visit
that firms with substantial investment opportunities that are faced with high costs
of raising funds under financial distress will be more motivated to hedge against
risk exposure than average firms. This rationale has been explored by numerous
(1991), Dobson and Soenen (1993), Froot, Scharfstein and Stein (1993), Getzy,
Minton and Schrand (1997), Gay and Nam (1998), Minton and Schrand (1999),
Haushalter (2000), Mello and Parsons (2000), Allayannis and Ofek (2001) and
Haushalter, Randall and Lie (2002). The results of the studies mentioned above
confirm that companies using derivative instruments to manage financial risks are
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The results of empirical studies have also proven that the benefits of risk
management programs depend on the company size. Nance, Smith and Smithson
(1993), Dolde (1995), Mian (1996), Getzy, Minton and Schrand (1997) and
Hushalter (2000) argue that larger firms are more likely to hedge and use
derivatives. One of the key factors in the corporate risk management rationale
include the direct transaction costs and the agency costs of ensuring that managers
transact appropriately.3 the assumption underlying this rationale is that there are
derivatives use. Indeed, for many firms (particularly smaller ones), the marginal
suggests that there may be sizable set-up costs related to operating a corporate risk-
management program. Thus, numerous firms may not hedge at all, even though
worthwhile activity. On the basis of empirical results, it can be argued that only
large firms with sufficiently large risk exposures are likely to benefit from formal
hedging programs.
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Derivatives carry high risk factor and amongst that commodity derivatives
Profit is the main reason for motivating the people to invest in derivatives.
2.7. Limitations:-
Limitations are the limiting lines that restrict the work in some way or other. In this
research study also there will be some limiting factors, some of them are as under:
1. Data Collection: The most important constraint in this study will going to be
data collection as both Primary and Secondary data was selected for study.
Secondary data means data that are already available i.e. they refer to the data
2. Time Period: Time period will one of the main factor as only one month is
allotted and the topic covered in research has a wide scope. So, it was not possible
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3. Reliability: The data collected in research work will be secondary data, so, this
4. Accuracy: The facts and findings of the data cannot be accepted as accurate to
some extent as firstly, secondary data will be collected. Secondly, for doing
descriptive research time needed to be more, because in short period you cannot
2.8. References:-
(3), 261-297.
http://www.nseindia.com.
http://www.valuenotes.com/njain/nj_derivatives_15sep03.asp?ArtCd=33178
&Cat=T&Id=10.
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Delhi, India.
Websites
www.derivativesindia.com
www.nse-india.com
www.sebi.gov.in
www.rediff/money/derivatives.htm
www.iinvestor.com
www.appliederivatives.com
www.economictimes.com
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