Complete Thesis

THE INDIAN INSTITUTE OF PLANNING AND MANAGEMENT NEW DELHI
THESIS ON EFFECTIVENESS OF HEDGING IN FUTURE AND OPTION WITH A SPECIAL CASE OF NSE
SUBMITTED TO: PROF. SUMANTA SHARMA MR. VIJAY KUMAR BODDU
UNDER THE GUIDANCE OF: ALOK SHYAMSUKHA
SUBMITTED BY: SAURABH SHYAMSUKHA ALUMNI ID NUMBER: DF68-F079 BATCH: SS/06-08
EXECUTIVE SUMMARY
Both the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) have decided to introduce trading in stock index futures, the likely candidates being the BSE Sensitive Index (Sensex) and the S&P CNX Nifty. But are these two indices the right ones for index futures? Not really. On the contrary, a derivatives instrument based on the S&P CNX Mid-Cap Index appears better suited, based on an empirical analysis of a representative sample of mutual fund portfolios and some randomly chosen ones. Should investor portfolios largely mimic mutual fund portfolios, the Sensex may turn out to be the worst choice for index futures. But clearly, index futures is the way to go, as the market needs a tool for hedging that can be used by institutional and individual investors, as also, of course, speculators. While the futures market is likely to cater to the needs of mutual funds, institutional investors and high net worth investors, the impact will also be felt by the retail investors in a change in the volatility of the underlying index and its constituents As of today, most international big names in the securities business have set up shop in the country, with most of them having a controlling interest in domestic mutual funds. However, unlike other developed markets, the Indian market has so far not offered any tools to hedge risks. The badla system, an indigenous form of forward-trading, is prone to misuse and is not a hedging tool. Hence, the logical step is to introduce stock index futures. Investors would look to ìndex futures' contract as a device for hedging their portfolios against losses. Alternatively, they would want to lock into a reasonable and acceptable rate of return. This is where index futures come in. The investors would have to enter into a contract for sale of ìndex futures' at the going value of the index. The idea being that even if the value of the index falls -- indicating a decline in the value of the portfolio -- that could be offset by a gain in the `futures' market.
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Alumni ID: DF68-F079
After all, when you sell something for delivery at a future date, where the price agreed on is the current market price, any fall in the price of the asset on the delivery date actually represents a profit. So, the loss on current holdings of investment is offset by the gains in sale contract (futures) in a declining market. But the effectiveness of this strategy -- that is, selling index futures -- lies in the investor portfolio reflecting the composition of the index itself. If not in terms of the actual identity, at least in terms of the relative value movements between the net asset values of the portfolios and the index being considered. introducing futures trading. Every index should have certain attributes to be used for futures trading. The most important issue in selecting an index is its liquidity. Illiquid indices have certain inherent problems that reduce the effectiveness of the products derived from them. The important issue is that a highly liquid index is less prone to market manipulation than an illiquid one. Market manipulation refers to a few players moving the market to their convenience. Such markets fail to enthuse genuine investors, and this may result in the failure of the contracts. The main problem with price manipulation is that it may lead to basis risk, which is the risk associated with the difference between the futures and the spot market. Consider this: If, on the arrival of significant information, the futures prices move in a way that reflects the available information, but the spot price does not move in tandem, some form of market manipulation may ensue. This tends to hamper the price discovery mechanism in an efficient market.
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SIGNATORY PAGE
---------- Forwarded message ---------From: alokshyamsukha@motilaloswal.com <alokshyamsukha@motilaloswal.com> Date: Sep 10, 2008 6:36 PM Subject: Re: completion of thesis confirmation To: saurabh shamsukha <saurabhshyamsukha@gmail.com>
To whomsoever it may concern, This is to certify that I have the thesis done by saurabh shyamsukha is his hard work and dedication towards stock market and that to derivative. I am completely satisfied with his work and approve his final thesis report. For the following topic. EFFECTIVENESS OF HEDGING IN INDEX FUTURES AND OPTIONS "A STUDY WITH SPECIAL REFERENCE TO NATIONAL STOCK EXCHANGE
I wish him all the best for his endeavours Warm regards Alok Shyamsukha Institutional Derivatives | Motilal Oswal Securities Ltd Board: +91 22 3982 5500 | DID: +91 22 3982 5570 | Mobile: +91 98601 78728 Address: Hoechst House, 3rd Floor, Nariman Point, Mumbai 400 021, INDIA. E Mail: alokshyamsukha@motilaloswal.com
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TOPIC APPROVAL LETTER

From: Thesis <thesis@iipm.edu> Date: Sep 4, 2008 4:00 PM Subject: Thesis Topic Approval (Fin) SS/ 2006-08 To: saurabhshyamsukha@gmail.com
Dear Saurabh, This is to inform that the thesis topic "Effectiveness of Hedging in Index Futures and Options: A case of NSE", as proposed by you, has been approved. This email is an official confirmation that you would be doing your thesis work under the guidance of Mr. Alok Shyamsukha. Make it a comprehensive thesis; the objective of a thesis should be value addition to the existing knowledge base. Please ensure that the objectives as stated by you in your synopsis are met using the appropriate research design. You must always use the thesis title as approved and registered with us. Your Alumni ID Number is DF68-F079
Regards,
Sumanta Sharma
Dean (Projects) The Indian Institute of Planning and Management New Delhi Sumanta.sharma@iipm.edu Phone: 011-42789876
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APPROVED THESIS SYNOPSIS
Student detail: Name: Saurabh shyamsukha Batch: ss/06-08 Section: FN - 7 Specialization: Finance Mobile: 9833257382/9320857382 E-mail: saurabhshyamsukha@gmail.com
Title of the Thesis: A detailed study of the effectiveness of hedging in future and option with a special case of NSE
Desired Area of Research: Finance
PROBLEM DEFINITION: Both the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) have decided to introduce trading in stock index futures, the likely candidates being the BSE Sensitive Index (Sensex) and the S&P CNX Nifty. But are these two indices the right ones for index futures? Not really. On the contrary, a derivatives instrument based on the S&P CNX Mid-Cap Index appears better suited, based on an empirical analysis of a representative sample of mutual fund portfolios and some randomly chosen ones. Should investor portfolios largely mimic mutual fund portfolios, the Sensex may turn out to be the worst choice for index futures. But clearly, index futures is the way to go, as the market needs a tool for hedging that can be used by institutional and individual investors, as also, of course, speculators. While the futures market is likely to cater to the needs of mutual funds, institutional investors and high net worth investors, the impact will also be felt by the retail investors in a change in the volatility of the underlying index and its constituents
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As of today, most international big names in the securities business have set up shop in the country, with most of them having a controlling interest in domestic mutual funds. However, unlike other developed markets, the Indian market has so far not offered any tools to hedge risks. The badla system, an indigenous form of forward-trading, is prone to misuse and is not a hedging tool. Hence, the logical step is to introduce stock index futures. Investors would look to ìndex futures' contract as a device for hedging their portfolios against losses. Alternatively, they would want to lock into a reasonable and acceptable rate of return. This is where index futures come in. The investors would have to enter into a contract for sale of ìndex futures' at the going value of the index. The idea being that even if the value of the index falls -- indicating a decline in the value of the portfolio -- that could be offset by a gain in the `futures' market. After all, when you sell something for delivery at a future date, where the price agreed on is the current market price, any fall in the price of the asset on the delivery date actually represents a profit. So, the loss on current holdings of investment is offset by the gains in sale contract (futures) in a declining market. But the effectiveness of this strategy -- that is, selling index futures -- lies in the investor portfolio reflecting the composition of the index itself. If not in terms of the actual identity, at least in terms of the relative value movements between the net asset values of the portfolios and the index being considered. introducing futures trading. Every index should have certain attributes to be used for futures trading. The most important issue in selecting an index is its liquidity. Illiquid indices have certain inherent problems that reduce the effectiveness of the products derived from them. The important issue is that a highly liquid index is less prone to market manipulation than an illiquid one. Market manipulation refers to a few players moving the market to their convenience. Such markets fail to enthuse genuine investors, and this may result in the failure of the contracts. The main problem with price manipulation is that it may lead to basis risk, which is the risk associated with the difference between the futures and the spot market. Consider this: If, on the arrival of significant information, the futures prices move in a way that reflects the available information, but the spot price does not move in tandem, some form of market manipulation may ensue. This tends to hamper the price discovery mechanism in an efficient market.
INTRODUCTION: The term Hedge Funds first came into use in the 1950s to describe any investment fund that use incentive fees, short selling and leverage. Hedge Funds usually refer to private investment vehicle that seeks above average returns through active portfolio management. Investors are attracted to Hedge Funds for a variety of reasons. This includes the potential to deliver positive returns under all market conditions, absolute returns, which are not correlated to the returns of the traditional asset classes which include stock
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and bond and access to highly specialized strategies not typically available through traditional money management. Hedge Funds have attracted significant capital over the last decade, triggered by successful track record. The Global Hedge Fund volume has increased from US $ 50 billion in 1988 to US $ 875 billion in 2004 yielding an astonishing average cumulative growth rate in excess of 24%. According to Hennessee Group LLC, an advisor to Hedge Fund investors, the Hedge Fund industry assets increased by $ 139 billion to $ 934 billion in 2004. Hedge Funds also outperformed the mutual funds in the falling equity market. During the past fourteen years starting 1990-2004 the S$P 500 index has had 16 negative quarters totaling a negative return of 110.4%. During those negative quarters the average US equity mutual fund had a total negative return of 113% while the average Hedge Fund had a total negative return of only 10.4%, displaying the ability of Hedge Funds to preserve capital in falling equity market. In the last three years, hedge funds have boomed because of extremely volatile and punitive market conditions. Investors, frustrated by the lowest interest rates in modern financial history, have been aggressively searching for returns. While mutual funds have lost over a trillion dollars in assets since the tech meltdown of 2000, and are now barely clawing back to their earlier asset level, hedge funds have doubled in the last three years alone to over a trillion dollars. Now, not only do hedge funds get monies from wealthy billionaires and Swiss private banks, but also from pension funds, college endowments, et al. The brightest fund managers are also rushing to set up their own hedge funds, thanks to the lure of high fees. With institutional interest in market-neutral investments growing, the next trillion dollars will go into the funds much faster. Hedge Funds are sometimes perceived to be speculative and volatile but they can provide benefit to the financial market by contributing to market efficiency by enhancing liquidity. They often assume risk by serving ready counter parties to entities that wish to hedge risks. Hedge Funds can also serve as an important risk management tool for investors by providing valuable portfolio diversification. Some jurisdictions are gradually moving towards allowing the marketing of hedge fund and fund of funds products to retail investors. Those jurisdictions have simultaneously imposed disclosure requirements to ensure that investors understand the complexity and associated risk of investing in hedge funds. Realizing the growing importance of hedge funds, several emerging market regulators have opened their markets to offshore hedge funds by providing authorization as registered foreign investors. The role played by some of the large hedge funds has often been associated with major financial crisis that took place in the 90s. However, subsequent research could not produce robust evidence implicating the hedge funds for precipitating the crisis. Researchers have, however, attributed the negative public perception of the role of hedge fund managers in crisis partly to the limited information available about what they actually do
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SCOPE: 1. 2. 3. 4. 5. 6. 7. 8. 9. This is a detailed study taken to explore: Meaning of Hedge Funds. Types of Hedge Funds. What is future and option Benefits of Hedge Funds. Performance of the Global Hedge Funds markets. How future and option relate to NSE fund. How volatility effect the hedging. Prospects for Hedge Funds in India.
RESEARCH METHODOLOGY: My research will include: 1. Primary Data: Analyst of KPOs (Knowledge Process Outsourcing) and Share Trading firms were approach & NSE 2. Secondary Data: News Papers, books, internet, Reports. JUSTIFICATION FOR CHOOSING THIS TOPIC: As I am doing MBA, finance being my area of interest, I liked to do thesis on hedging which is the most effective tools now a days used by the company which is presently boom in India and it will be great learning experience at the beginning of my career, this research on A detailed study of the hedging in future and option in NSE will help me a lot in future career
DETAILS OF THE EXTERNAL GUIDE: Name: Alok Shyamsukha Institutional Derivatives Motilal Oswal Securities Ltd
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ACKNOWLEDGMENTS
It is well-established fact that behind every achievement lies an unfathomable sea of gratitude to those who have extended their support and without whom the project would never have come into existence. I express my gratitude to IIPM, New Delhi for providing me an opportunity to work on this thesis as a part of the curriculum. Also, I express my gratitude to Prof. Sumanta Sharma & Prof. Vijay Boddu for their kind cooperation.
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CONTENTS
Executive Summary ...................................................................................... ii Signatory page ............................................................................................. iv Topic Approval Letter .................................................................................. v Approved Thesis Synopsis ........................................................................ vi Acknowledgments ........................................................................................ x Introduction .................................................................................................. 1 Literature Review .......................................................................................... 8 Strategies of Hedge Fund ........................................................................... 10 Hedging with Future & Options ................................................................ 39 Comparison of Hedging.............................................................................. 59 Research Methodology ............................................................................... 71 Findings & Analysis .................................................................................... 72 Conclusions................................................................................................. 78 Recommendation ........................................................................................ 81 Bibliography ............................................................................................... 83
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INTRODUCTION
Indian Hedging Industry

All these countries have spent 40 years trying to build up their economies and a moron like Soros comes along with a lot of money to speculate and ruin things. Mahathir Mohamad, Prime Minister of Malaysia, 1998 (from The Color of Hot Money)
To hedge means to minimize risk or insulate oneself. Conventionally the term 'hedge fund' is used to refer to a type of private investment vehicle that invests all or most of its assets in publicly traded securities and hedges the investors risk from market exposure. These investment vehicles are commonly structured as limited partnerships in which the investment manager, or the investment manager's capital management company, acts as the general partner while the investors act as the limited partners. These funds are alternative investment vehicles and are generally available to high net worth individuals and institutional investors. For the investors who make up the fund, there is usually little or no market liquidity. In fact they usually have a minimum lock in period ranging from one to three years. Albert Willson Jones formed the first hedge fund in 1949. The unique feature of the fund was that it offered operational flexibility and use of unconventional strategies to the managers. It took both long and short positions (see strategies below) in securities to increase returns while reducing net market exposure and used leverage to further enhance the performance. This fund earned substantially higher and more regular than the normal mutual funds. Today the term hedge funds takes on a much broader connotation, as many of the hedge funds control risk by hedging one or more methods. Moreover hedge funds are broadly defined by their structural characteristics, rather than their hedged nature. They are considered to be an asset class that aims in producing absolute (not relative) returns, irrespective of how the markets perform. The best of these funds offer greater diversification, less risk and more stable returns than conventional equity investments moreover some
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offshore hedge funds can offer plan sponsors a third advantage: tax-free hedge fund investing. The conventional equity and bond managers performance is largely related to the performance of the underlying markets. On the other hand, performance of hedge funds depends on the skills of the fund manager, who risk his own as well as his clients capital. The manager receives a fee for managing the fund, only if it is productive. This is called an incentive based fee or a performance based fee. Some funds also add a watermark or hurdle (a benchmark), which the fund must outperform in order for the General Manager to earn his fee. The General Manager's fee is typically 1-2% of the total assets of the fund and 20-30% of the profits. The general manager may use any investment strategy or style he chooses, no matter how risky or "volatile", to manage the fund's assets for greater return.
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An excellent overview of the industry by Business Week characterized the pattern more pointedly. "Bankers, security industry professionals, mutual fund managers all are beating the drumIts no secret that Wall Street hates hedge funds." But why? "Its not just jealousy or scapegoat that makes the hedge funds anathema to the powers on Wall Street. Fear is another possibilityfear that the public may demand incentive-based compensation for their funds as well." The concept of performance-based compensation may well be unsettling to an industry that charges according to the volume of transactions made or the total assets under engagement, regardless of whether the customers earn profits or not.
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Looking at these curves, it appears that the rapid growth of mutual funds began some ten years prior to that of hedge funds; approximately 1980 for mutual funds and 1990 for hedge funds. The rapid growth stage for mutual funds has lasted more than 15 years (1980-1997). Granted, that some of the underlying drivers of growth may be different for mutual funds than for hedge funds. However, if one assumes that the growth cycles will parallel each other to some extent, then one can conclude that hedge funds are at the beginning of their journey and the growth cycle for hedge funds could last another ten years taking us well into the next century. History In this section we will try to follow the steps of the hedge funds history as they were developed from the creation of the first Hedge Fund by Alfred Winslow Jones to nowadays. We go through the days of Genesis of the first Hedge Fund, followed by the Dark Ages of the industry, then the Renaissance and up to the form and the role Hedge Funds appear to have today and the one that they will probably have in the days to come. I. GENESIS Alfred Winslow Jones was the father of the first hedge funds in 1949. A truly remarkable individual, Jones graduated from Harvard in 1923 and then he toured the world first as a purser on tramp steamers, then as a U.S. diplomat in Germany during the rise of Nazism in the 1930s and after as a journalist
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covering the Spanish Civil War. In 1941, he received his Doctorate in Sociology from Columbia University and became a reporter for the Fortune Magazine. Joness occupation with finance started in 1949, when he decided to make a research on the practices of the asset management industry and wrote a remarkable article on the technical methods of market analysis, trends in investing and market forecasting. In his article he seemed convinced that he had found a better system for managing money. Following his research he managed to raise $100 000 ($ 40 000 of his own capital) and started to put his theories in practice by forming a general investment partnership. The choice of the general partnership structure had as an aim to avoid the restrictive Securities and Exchange Commission regulation and to allow the maximum latitude and flexibility in portfolio construction. Thus, the first hedge fund was found. Joness investment model relied on two assumptions. Jones was convinced that he had first, superior stock selection ability and second, no market timing skills. In other words, he believed that he was able to identify stocks that would rise more than the market, as well as stocks that would rise less than the market, but that he was unable to predict market directions. Therefore, his strategy consisted in combining long positions in undervalued stocks and short positions in overvalued stocks. That was the foundation of Joness novel investment approach: hedging his long stock positions by selling other stocks to protect against market risk. To magnify his portfolios returns, Jones added leverage. That is, he used the proceeds from his short sales to finance the purchase of additional long positions. Jones was actually the first to use short sales, leverage and incentives fees in combination. Joness model performed remarkably well and managed to beat the market for several years. He operated in almost complete secrecy with very few changes to the original approach. Surprisingly, he rapidly became uncomfortable with his own ability to pick stocks. He, therefore in 1952, converted his general partnership fund into a limited partnership investing with several independent portfolio managers and created the first multi- manager hedge fund. In the mid 1950s other funds started using the short- selling of shares, although for the majority of these funds the hedging of market risk was not central in their investment strategy. And quite a package it turned out to be. Operating in almost absolute for seventeen years, Joness success was
IIPM Alumni ID: DF68-F079
finally brought to the public eye in 1966 in an article in Fortune magazine titled The Jones That Nobody Can Keep Up With. It was an article about a hedge fund run by a certain A. W. Jones, which shocked the investment community. Apparently, the fund had outperformed all the mutual funds of its time, even after accounting for a hefty 20% incentive fee. The first rush into hedge funds followed and the number of hedge funds increased from a handful to over a hundred within a few years. II. THE DARK AGES Unfortunately, many of the new hedge fund managers werent really hedging at all. Shorting restrained performance in the go-go markets of the mid-late 1960s. So most hedge fund managers simply stopped doing it. They were leveraged long-particularly risky business in less accommodating markets. This produced some big hedge fund losses in 1969-70 and major bloodletting in the savage 1973-74 bear market. The more prudent hedge fund operators survived, but many more closed the doors. In 1984, only 68 funds were identified in the US market III. THE RENAISSANCE By 1980 and throughout the 1990s, with the arrival of derivatives, new styles of management were developed and hedge funds became a more heterogeneous group. The hedge fund industry started to offer a greater array of products, using more sophisticated strategies. This was the start of a growth industry. Hedge funds became the magic word. Everybody wanted to be part of the actionboth managers and investors. It was only then, when the financial press once again began trumpeting the returns achieved by hedge fund superstars George Soros (Quantum Fund) and Julian Robertson (Tiger Fund and its offshore sister Jaguar Fund). Many hedge funds no longer resembled the classic long/short equities model developed by Jones. For example, Soros made his big killing in the currency markets and Robertson employed modern financial derivatives such as futures and options, which did not exist when Jones started his fund. With lots of new hedging tools and a tide of favorable publicity hedge fund universe exploded. At the end of 1999,
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VAN hedge fund advisors estimated as many as 6,200 hedge funds of all shapes, sizes and investment disciplines existed. After 1990 reality stuck when the Tech Bubble burst in 2000. The subsequent market meltdown and separated the true hedge fund managers from the improvised managers. The industry had too many players and it was time for a cleansing. The nature of a good hedge fund is to perform well in ALL market conditions. Many funds were too directional and that was their downfall. The high performance years from 1987 to 1993 helped boost the formation of new hedge funds. More recently, hedge funds have begun to receive many negative headlines in newspapers. The 1992-drop of the British Pound out of the European Currency System was believed to have been caused largely by hedge funds although a study published by the International Monetary Fund showed no evidence of market manipulation or higher market volatility caused by hedge funds. In 1994, many hedge funds had problems coping with the strong increase of U.S. interest rates. The following bond market crash in the U.S. led to substantial losses and a few bankruptcies. The hedge fund industry recovered in 1995 and 1996 and entered a more mature stage. IV. TODAY & TOMORROW Today, investors have access to a healthier hedge fund industry. Good hedge funds are a bit easier to pick. Generating absolute returns through shifting market conditions is the business of todays hedge funds. With continued market volatility, the spread between good quality hedge funds and poor performers is still widening, making it easier for investors to recognize true hedge funds from directional. Over the last 10 years, the investment industry has changed tremendously. New financial tools are brought forward to better navigate the new complexities of the market. Investors are more sophisticated and demand the same from their managers. In this new financial climate, fund managers are evolving and becoming more knowledgeable, using more complex tools, and improving their strategies to outperform the competition. Capturing the extra returns, lowering volatility and being able to swiftly change direction on good, precise information are the hallmarks of the expert money manager and no one is more equipped to do this than the hedge fund manager.
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LITERATURE REVIEW
In the last decade hedge funds have received a great deal of media attention, but still the term hedge fund has no precise legal definition. On the contrary, there are several contradictory definitions, as we will just see below, based on the various applied legal structures, investment strategies, superior returns, risk taking or hedging tactics. In an attempt to show the contradiction that characterizes the term hedge fund, given below are some of the available definitions, as given from official organizations and other researchers. I. SEC (Securities and Exchange Commission) Hedge Fund is a general, non-legal term that was originally used to describe a type of private and unregistered investment pool that employs sophisticated hedging and arbitrage techniques to trade in the corporate equity markets. Today, the term hedge fund refers not so much to hedging techniques, which hedge funds may apply not employ, as it does to their status as private and unregistered investment pools. II. VAN A hedge fund can be classified as an alternative investment. Alternative investments are investments other than stocks and bonds. A U.S. "hedge fund" usually is a U.S. private investment partnership invested primarily in publicly traded securities or financial derivatives. Offshore hedge funds usually are mutual fund companies that are domiciled in tax heavens, such as Bermuda, and that can utilize hedging techniques to reduce risk. They have no legal limits on numbers of non-U.S. investors. III. HENNESSEE A "hedge fund" refers broadly to any private pool of capital whose investment manager is compensated primarily on the fund's performance. Hedge funds seek superior returns relative to risk by utilizing a broad spectrum of investment styles, hedging strategies and financial instruments. The manager
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generally has a significant commitment of personal net worth invested in the fund. IV. INVESTINGINOPTIONS.COM An investment pool which in contradiction to its description often uses a wide range of derivative contracts to leverage the amount of capital available for investment into far larger positions V. INVESTOPEDIA An aggressively managed portfolio taking positions on speculative
opportunities. Clearly, as the number of products in existence increase, so does the level of difficulty of forming a uniform definition of hedge funds. Additionally, the term hedge fund has no longer any connection with a systematic hedging attitude; admittedly a misleading situation.
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STRATEGIES OF HEDGE FUNDS

Hedgers use the futures market to protect themselves from risk. Similarly the portfolio managers hedge stock fund risk. Commonly, prices in the cash markets have a fundamental relationship to the futures prices. When the forces of demand and supply change the prices in the cash market, the future prices are supposed to move in a parallel fashion. But in reality they do not move in exact amounts. Hedgers take advantage of this relationship between cash and futures prices. Analysts attempt to classify them into a number of different strategies and sectors, but each set of managers is essentially looking to exploit pricing anomalies through trading, rather than through simply buying and holding assets. In each case, hedge fund managers aim to exploit price differentials, remaining market-neutral but buying one asset and selling another. Price convergence will lead to profit irrespective of the overall price movements in the sector. The successful funds with good track records make money and prosper, although limits to the size of trades and the need to stay nimble do limit a manager's size. There are approximately 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return.
Very high risk strategies Emerging Markets: Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation, volatile growth and the potential for significant future growth. Examples include Brazil, China, India, and Russia. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available. This strategy is defined purely by geography; the manager may invest in any asset class (e.g., equities, bonds, currencies) and may construct his portfolio on any basis (e.g. value, growth, arbitrage) Short Selling: In order to short sell, the manager borrows securities from a prime broker and immediately sells them on the market. The
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manager later repurchases these securities, ideally at a lower price than he sold them for, and returns them to the broker. In this way, the manager is able to profit from a fall in a security's value. Short selling managers typically target overvalued stocks; characterized by prices they believe are too high given the fundamentals of the underlying companies. It is often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. Macro: Aims to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates, in turn affecting currency, stock, and bond markets. Rather than considering how individual corporate securities may fare, the manager constructs his portfolio based on a top-down view of global economic trends, considering factors such as interest rates, economic policies, inflation, etc and seeks to profit from changes in the value of entire asset classes. For example, the manager may hold long positions in the U.S. dollar and Japanese equity indices while shorting the euro and U.S. treasury bills. Uses leverage and derivatives to accentuate the impact of market moves. The leveraged directional investments tend to make the largest impact on performance
High risk strategies Aggressive Growth: A primarily equity-based strategy whereby the manager invests in companies, with smaller or micro capitalization stocks, characterized by low or no dividends, but experiencing or expected to experience strong growth in earnings per share. The manager may consider a company's business fundamentals when investing and/or may invest in stocks on the basis of technical factors, such as stock price momentum. Managers employing this strategy generally utilize short selling to some degree, although a substantial long bias is common. This includes sector specialist funds such as technology, banking, or biotechnology.
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Market Timing: The manager attempts to predict the short-term movements of various markets (or market segments) and based on those predictions, moves capital from one asset class to another in order to capture market gains and avoid market losses. While a variety of asset classes may be used, the most typical ones are mutual funds and money market funds. Market timing managers focusing on these asset classes are sometimes referred to as mutual fund switchers. Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy.
Moderate risk strategies Special Situations: The manager invests, both long and short, in stocks and/or bonds which are expected to change in price over a short period of time due to an unusual event. Examples of event-driven situations are mergers, hostile takeovers, Reorganizations or
leveraged buyouts. It may involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit From the spread between the current market price and the ultimate purchase price of the company. Value: A primarily equity-based strategy whereby the manager invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. The manager takes long positions in stocks that he believes are undervalued, i.e. the stock price is low given company fundamentals such as high earnings per share, good cash flow, strong management, etc. Possible reasons that a stock may sell at a perceived discount could be that the company is out of favour with investors or that its future prospects are not correctly judged by Wall Street analysts. Securities may be out of favour or under-followed by analysts. Long-term holding, patience, and strong discipline are often required, until the ultimate value is recognized by the market. The manager can take short positions in stocks he believes are overvalued.
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Funds of Hedge Funds: The manager invests in other hedge funds (or managed accounts programs) rather than directly investing in securities such as stocks, bonds, etc. These underlying hedge funds may follow a variety of investment strategies or may all employ similar approaches. Because investor capital is diversified among a number of different hedge fund managers, funds of funds generally exhibit lower risk than do single-manager hedge funds. Funds of funds are also referred to as multi-manager funds. Its a diversified portfolio of generally uncorrelated hedge funds and its a preferred investment of choice for many pension funds, endowments, insurance companies, private banks and high-net-worth families and individuals.
Characteristics of Hedge Funds Hedge funds, fortunately, share a series of common characteristics that helps distinguish them easily from the more conventional investment funds. Following we review some of them, while it is important to keep in mind that these are just positive indicators of hedge fund activities rather than absolute signal. I. Active management Active management and skill-based strategies are the weapons with which managers of hedge funds fight to add value. They reject traditional investment paradigms, such as the efficient market hypothesis or modern portfolio theory, and believe that markets do not price all assets correctly. Based on that belief, they aim to build a competitive advantage by relying on faster information
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collection, cheaper access to markets, better analysis of investment opportunities, and superior trade or portfolio structuring. II. Flexible investment policies One of the main differences of the hedge funds with the traditional investment funds and a characteristic that let us consider them as an alternative way of investment is their flexible investment policies. Hedge fund managers are given extremely freedom over the investment styles, asset classes and investment techniques they can use and they do that with the aim of outstanding performance and returns. This can clearly be a double-edged sword: it subjects the fund to greater manager risk but also gives the fund greater discretion to outperform. III. Special regulation rules Actually, it is more accurate to say that there is no official legal structure for what we call hedge funds. They can be organized in a variety of legal forms. With the aim of avoiding the numerous restrictive regulations applied to financial intermediaries and/or of minimizing their tax bills, hedge funds use legal structures that are unusual in the traditional asset management world. There are often limited partnerships or limited liability companies when targeting US investors, and offshore investment companies established in taxfavorable jurisdictions when operating outside the United States. Moreover, Hedge funds are not subject to the numerous regulations that apply to mutual funds; such as regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares are redeemable at any time, regulations protecting against conflicts of interest, regulations to assure fairness in the pricing of fund shares, disclosure regulations, regulations limiting the use of leverage etc. This freedom from regulation permits hedge funds to engage in leverage and other sophisticated investment techniques to a much greater extent than mutual funds. On the other hand, hedge funds are not required to register under the federal securities laws. They are not required to register because they generally accept financially accredited investors, do not publicly offer their securities and are not allowed to advertise to the public because of the nature of private partnership. This limited regulation allows hedge fund managers to have wider flexibility in making their investment decisions.
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Moreover, in June 1997, in order to encourage investment in hedge funds, the SEC allowed hedge funds to exceed their previous limit of 100 investors while still avoiding the kind of registrations and disclosure required of mutual funds. This change in the SEC regulations will allow hedge funds to grow more quickly in the future. Although hedge funds are not subject to registration requirements and all of the regulations that apply to mutual funds, they are subject to the antifraud provisions of the federal securities laws. IV. Liquidity Limitations Traditional investment funds offer daily subscription and redemption, a favorable feature for investors as they can enter or exit a fund whenever they wish. However, this increased liquidity hides costs, which hedge funds try to avoid by limiting the subscription and redemption possibilities and by insisting upon a minimum investment period. For this reason in hedge funds language the following terms are often used: - Terms subscription: they specify the dates when investors can enter into a hedge fund. - Lockup period: meaning, the minimum time an investor is required to keep his money invested in a hedge fund before being allowed to redeem his shares according to the terms of redemption. - Terms of redemption: terms specifying the dates and the conditions under which investors can redeem their shares. - Advance notice: it is often required for the investors to inform in advance of their wish to redeem. Despite the limitations imposed to the investors, these restrictions have a positive impact on a hedge funds performance. All the partners have benefits as they can control cash flow transactions and the managers can focus on investing instead of redeeming assets of investors who try to time the market themselves. With these guidelines, managers can also focus on relatively long-term horizons, hold illiquid positions and reduce cash holdings.
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V. Charging performance fees and targeting absolute returns One of the main characteristics as well as of the main points that the hedge funds differentiate from the mutual funds is the use of performance fees. While mutual fund managers change only a management fee, hedge fund managers are paid both a management fee and an incentive fee. Management fees are usually expressed as a percentage of assets under management and are charged annually or quarterly. They range from 1% to 3% per year and are essentially intended to meet operating expenses. Hedge funds are characterized by strong managerial incentives designed to motivate managers. One of the tools in use is the Incentive fees. They aim at encouraging managers to achieve maximum returns and they range from 15% to 25% of the annual realized performance. Incentive fees can explain part of the higher performance of hedge funds comparing to mutual funds, but not the increased total risk. Many hedge funds include also a high water mark clause in their offering memorandum. This clause states that a minimum rate of return must be achieved and any previous losses must be recouped by new profits before the incentive fee is to be paid. That is the reason why several hedge funds pursue an absolute return target, meaning that their goal is to be profitable regardless of the stock or bond market environment. This attitude differs significantly from traditional investment vehicles, which do compare their performance relative to standard market benchmarks. Something else that we can see in the hedge funds is the application of a proportional adjustment clause in their bylaws. This clause states that if the fund manager loses money and some investors consequently withdraw their assets, the fund manager is allowed to reduce proportionally the amount of loss he has to recover by the percentage of the assets that were removed. VI. Managers- partners, not managers- employees A hedge fund manager generally invests a significant personal amount of money in his fund and so he shares both upside and downside risks with the investors. His stake combined with the incentive fees are supposed to closely align the hedge fund managers interests with those of his or her investors, and to encourage him to seek to achieve substantial total returns while prudently controlling risks. However, contrary to common
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Belief, personal wealth commitment is not necessarily a good indicator of motivation and can even produce undesirable side effects. VII. Limited Transparency Detailed published information on hedge funds is hard to find. This characteristic is the result of two factors. First, the particular legal structure and/or offshore registration of hedge funds preclude them from publicly disclosing performance information, detailed asset allocations or earnings. Second, revealing specific positions about individual holdings or strategies could be precarious, both for the fund and for its investors. VIII. No benefits from economies of scales In contrast with the traditional funds, size is not a factor of success in the hedge fund industry. Hedge fund strategies crucially depend on manager skills and available investment opportunities, two factors that are not scalable. Therefore, several hedge funds can be reported to deny access to new investors once they have reached a target size. IX. Restrictive Target Group of Investors While mutual funds typically target retail investors, hedge funds focus rather on high net worth private individuals (accredited investors) and institutional investors. An accredited investor is any natural person whose individual net worth exceeds $1,000,000, or whose individual income was in excess of $ 200,000 or whose joint income was in excess of $300,000 in each of the two last years and expects to reach the same level of income in the current year. They are considered ideal investors for Hedge Funds because they are ready to commit themselves for the long run, willing to bear high risks in exchange for high return prospects and they have a sufficient level of net worth to invest sizable amounts directly in a fund as partners. X. Tax Implication At the end of each year a Hedge Fund as a limited partnership reports in a K1 form gains or losses for the trades the fund made that year. These gains or loses are treated as are any other capital gain. It is important to note that the return of a fund is separate from the taxable gains and losses the fund has made over the course of the year. For example, it is possible that a fund may
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have "realized" a loss for tax purposes but have reported positive performance (capital appreciation) through unrealized gains. The opposite is also possible. XI. Fees Charged The majority of U.S. hedge funds charge the standard "one-and-twenty": 1% of assets and 20% of profits, annually (more precisely, the 1% fee is usually charged in .25% increments quarterly, in advance while the 20% is usually calculated annually). These are known as the "management fee" and "performance fee" respectively. There are many variations and
embellishments, some fairly common. For instance, most funds observe a "high-water mark". This simply means that if, in a given performance fee period, a fund loses part of its investor's money; the investors will not be charged in later periods until the losses have been recovered. Another common variation is the "preferred return." This means that a fund will not collect a performance fee until a certain return is achieved. This is often fixed, say at 10%, or floats along with some risk-free interest rate indicator. XII. Investment in IRA or ERISA assets Usually qualified clients may invest IRA or ERISA assets in hedge funds; however, funds are limited in the amount of these assets they may accept. IRA investments in hedge funds makes a great deal of sense because of the deferral of taxes on capital gains. The details of this deferral should be discussed with an accountant before making an investment. Distinction between Hedge Fund and Other Pooled Investment Vehicles: Hedge funds are sometimes called as rich mans mutual fund. In addition, other unregistered investment pools, such as venture capital funds, private equity funds and commodity pools, are sometimes referred to as hedge funds. Although all of these investment vehicles are similar in the fact that they accept investors money and generally invest it on a collective basis, they also have characteristics that distinguish them from hedge funds.
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1. Mutual Fund or Registered Investment Companies Hedge funds are different from mutual funds and investment trusts in several ways: While mutual funds are investment vehicles meant for the retail investor who is not sophisticated enough to manage the risks of investing directly in stock markets, hedge funds are investment vehicles for high net worth individuals and institutions who have the necessary skills and expertise to manage their investments and do not require the regulatory safeguards put in place for smaller retail investors. Conventional mutual funds look for long-term capital appreciation and their returns are generally tied to market performance over the long term. Hedge funds seek to give a positive return under all market conditions by exploiting market distortions such as undervalued or over-valued securities. Mutual funds are operated by investment companies, which are registered with respective regulators. Hedge funds are not registered as investment management companies. As registered investment companies, mutual funds are regulated in terms of investment limits, disclosure requirements such as daily NAV, restrictions on short selling and speculative trading, restrictions on leverage and trading in derivatives, real estate, commodities etc. No such restrictions are applicable to hedge funds. Hedge funds are not required to give daily NAV. In many cases, where hedge funds invest in illiquid securities, valuation of such investments is not easily available. Mutual funds provide high liquidity and redemption is possible at any time. Hedge funds generally require a notice of two to three months and may even specify a lock-in period of one year. This gives them the flexibility to deploy capital or liquidate assets in an optimal manner. Mutual funds raise money from the public. Very little of the investment companys own money is invested in the mutual fund. In hedge funds, own capital of the hedge fund manager is invested in the hedge fund to share the risk of the fund.
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Mutual funds generally remunerate fund mangers as a per cent of the assets under management. A hedge fund managers remuneration is always performance related, normally 20% incentive fee of net fund profits, along with a fixed fee of 1-2% of assets under management. A mutual fund manager would be paid, irrespective of fund performance, whereas a hedge fund manager gets paid only when the hedge fund provides a return. Table: 1
2. Private Equity Fund A private equity fund, like a hedge fund, is an unregistered investment vehicle in which investors pool money to invest. Private equity funds concentrate their investments in unregistered (and typically illiquid) securities. Both private equity funds and US based hedge funds are typically organized as limited partnerships (LLP). Like hedge funds, private equity funds also rely on the exemption from registration of the offer and sale of their securities. Both private equity and hedge funds. The investors in private equity funds and hedge funds typically include high net worth individuals and families, pension funds, endowments, banks and insurance companies. Private equity funds, however, differ from hedge funds in terms of the manner in which contribution to the investment pool is made by the investors. Private equity investors typically commit to invest a certain amount of money with the fund over the life of the fund, and make their contributions in response to capital calls from the funds general partner. Private equity funds are long term investments, provide for liquidation at the end of the term specified in the funds governing documents and offer little, if any, opportunities for investors to redeem their
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investments. A private equity fund may distribute cash to its investors when it sells its portfolio investment, or it may distribute the securities of a portfolio company. 3. Venture Capital Fund Venture capital pools are similar to hedge funds or private equity; they attract the same class of investors. Venture capital funds, however, invest in the start-up or early stages of a company. Unlike hedge fund advisors, general partners of venture capital funds often play an active role in the companies in which the funds invest. In contrast to a hedge fund, which may hold an investment in a portfolio security for an indefinite period based on market events and conditions, a venture capital fund typically seeks to liquidate its investment once the value of the company increases above the value of the investments. 4. Commodity Pool Commodity pools are investment trusts, syndicates or similar enterprises that are operated for the purpose of trading commodity futures. The investment concentration in commodity futures distinguishes commodity pools from hedge funds.
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Hedge Funds by Strategy Types: The hedge fund sector industry can be broken down into 7 main strategies:
Table 2: Hedge Funds by strategy types 1. RELATIVE VALUE i. Convertible Arbitrage: In general, the strategy entails purchasing a convertible bond while simultaneously hedging a portion of the equity risk by selling short the underlying common stock. Certain managers may also seek to hedge interest rate exposure by selling Treasuries. The strategy generally benefits from three different sources: interest earned on the cash resulting from the short sales of equities, coupon offered by the bond component of the convertible and the so-called gamma effect. The last component results from the change in volatility of the underlying equity and involves frequent trading. This strategy is often leveraged in order to enhance returns. ii. Fixed Income Arbitrage: This strategy seeks profits by exploiting the pricing inefficiencies between related fixed-income securities while often neutralizing exposure to interest rate risk. This strategy is often leveraged in order to enhance returns.
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iii. Statistical Arbitrage: Managers using this strategy attempt to benefit from pricing inefficiencies that are identified using mathematical models. Statistical arbitrage strategies are based on the premise that prices will return to their historical norms. These strategies are often leveraged in order to enhance returns. 2. EVENT-DRIVEN i. Merger Arbitrage Also known as risk arbitrage, this strategy invests in merger situations. The classic merger arbitrage strategy consists of being long on the stock of the target company while simultaneously selling short the stock of the acquiring company. ii. Distressed Securities This investment strategy generally consists of buying securities of companies in bankruptcy proceedings and/or in the process of restructuring the debt portion of their balance sheets. The complexity of such operations often creates mis-pricing opportunities, hence high potential returns. iii. Special Situations Also known as corporate life cycle, this strategy focuses on opportunities created by significant transactional events, such as division spin-offs, mergers, acquisitions, bankruptcies, reorganizations, share buybacks, and management changes. 3. LONG / SHORT EQUITY i. Long / Short Equity This style accounts for the majority of the strategies used by hedge fund managers today. This directional strategy combines both long and short positions in stocks. The net market exposure is adjusted opportunistically. The manager can diversify holdings across different industries, countries, market capitalizations, etc. ii. Short Sellers The short selling approach seeks to profit from declines in the value of stocks. The strategy consists of borrowing a stock and selling it on the market with
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the intention of buying it back later at a lower price. By selling the stock short, the seller receives interest on the cash proceeds resulting from the sale. If the stock advances, the short seller takes a loss when buying it back to return to the lender. iii. Market Neutral This strategy is designed to exploit inefficiencies in the equity market by trying to remove the element of systematic risk while extracting the stock-specific returns. These portfolios minimise market risk by being simultaneously long and short on stocks having different characteristics. 4. OPPORTUNISTIC i. Macro Macro managers make in-depth analyses of macro-economic trends and formulate their investment strategy based on these, taking out positions on the fixed income, currency and equity markets through either direct investments or futures and other derivative products. ii. CTA CTA is the acronym for Commodity Trading Advisor and is also known as Managed Futures. This strategy essentially invests in futures contracts on financial, commodity, and currency markets around the world. Trading decisions are often based on proprietary quantitative models and technical analysis. These portfolios have embedded leverage through the derivative contracts employed.
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Figure 1 : Breakdown of Hedge Fund investment strategies
Types of Hedge Funds: 1. Domestic Hedge Fund Domestic hedge funds are usually organized (in USA) as limited partnerships to accommodate investors that are subject to U.S. income taxation. The funds sponsor typically is the general partner and investment adviser. Hedge funds may also take the form of limited liability companies (LLC) or business trusts. LLPs, LLCs and business trusts are generally not separately taxed and, as a result, income is taxed only at the level of the individual investors. Each of three firms also limits investors liability; LLCs offer the additional benefit of limited liability for fund advisors (general partners). 2. Offshore Hedge Fund Offshore hedge funds are typically organized as corporations in countries such as the Cayman Islands, British Virgin Islands, the Bahamas, Panama, The Netherlands Antilles or Bermuda. Offshore funds generally attract investments of US. tax exempt entities, such as pension funds, charitable trusts, foundations and endowments, as well as non-U.S. residents. U.S. taxexempt investors favor investments in offshore hedge funds because they
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may be subject to taxation if they invest in domestic limited partnership hedge funds. 3. Fund of Funds Rather than investing in individual securities, a Fund of Funds invests in other hedge funds. Technically any fund that pools capital together, while utilizing two or more sub managers to invest money in equity, commodities, or currencies, is considered a Fund of Funds. Investors are allocating assets to Fund of Funds products mainly for diversification amongst the different managers' styles, while keeping an eye on risk exposure. Fund of Funds are structured as limited partnerships, which afford advantages to the investor. One of the advantages is due diligence. Due diligence is a primary advantage because the fund of funds manager may spend his whole day evaluating strategies and speaking with individual fund managers. This would be an extremely hard task for an individual. The fund of fund also may combat risk by achieving manager diversity, because of the different strategies employed by the underlying managers. For example, some fund of funds may have exposure to a long/short fund, a distressed fund, and a private equity fund. By investing within the fund of funds, the investor is given the opportunity to have a unique asset allocation product, while trying to limit the risk on the downside. Fund of funds have some drawbacks however. The first to come to mind is the double layer of fees. When dealing with fund of funds, an investor must understand that the underlying funds charge a fee, as well as the fund of funds manager. This translates to "layers" of fees before the investor receives his first rupee return. Transparency issues are also important. Research such as the individual manager's background and reputation, not to mention the nature of the investments that they are utilizing, are all issues a fund of fund manager must investigate. Therefore, investors have to rely on the fund of funds manager's talent and expertise in choosing managers, when investing in a fund of funds. Investors look for Fund of funds because hopefully, they provide more stable returns while reducing risk.
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Size of the Hedge Fund Market: Since hedge funds do not register with SEC their actual data cannot be independently followed; therefore hedge fund data is self reported. Despite the ambivalent image, hedge funds have attracted significant capital over the last decade, triggered by successful track records. The global hedge funds volume has increased from US $ 50 billion in 1988 to US $ 750 billion in 2003 yielding an astonishing cumulative average growth rate (CAGR) of 24 %. The global hedge fund volume accounts for about 1% of the combined global equity and bond market. The number of hedge funds increased from 5000 to about 8000 between 1998 and 2003.
Figure 3: Number of Hedge Funds Estimates of new assets flowing into hedge funds exceed US $25 billion on average for the last few years. In the next five to ten years, hedge fund assets have been predicted to exceed US $ 1 trillion. In Europe the overall hedge fund volume is still small with about US $ 80 billion in 2003 which accounts for about 11% of the global hedge fund volume. The number of hedge funds in Europe is about 600. Within Europe, hedge funds become particularly popular in France and Switzerland where already 35% and 30% of all institutional
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investors have allocated funds into hedge funds. In 2003, Italys hedge fund industry nearly tripled in size as assets grew from Euro 2.2 billion to Euro 6.2 billion. Germany is at the lower end with only 7% of the institutional investors using hedge funds. But the Investment Modernization Act, may well trigger rising interest from German investors. Overall, hedge fund assets are estimated to increase ten fold in Europe over the next 10 years. The acceptance of hedge funds seems to be growing through out Europe, as investors have sought alternatives that are perceived as less risky during the last three years equity bear market. This trend is also evident in Asia, where hedge funds are starting to take off. According to Asia Hedge magazine, some 150 hedge funds operate in Asia, till year 2002 which together managed assets estimated at around US $ 15 billion. In Japan, too hedge funds are becoming the focus of more attention. Recently, Japans Government Pension Fund one of the worlds largest pension fund with US $ 300 billion has announced plans to start allocating money to hedge funds. Industry participants believe that Asia could be the next region of growth for the hedge fund industry. The potential of Asian hedge funds is well supported by fundamentals. From an investment perspective, the volatility in the Asian markets in recent years has allowed long-short and other strategic players to out perform regional indices. The relative inefficiency of the regional markets also presents arbitrage opportunities from a demand stand point US and European investors are expected to turn to alternatives in Asia as capacity in their home markets diminish. Further, the improving economic climate in South East Asia should help foreign fund managers and investors to refocus their attention on the region. Overall, hedge funds look set to play a larger role in Asia.
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Figure 4: Assets under management (in billion USD) Reasons for Rapid Growth of Hedge Fund Industry While high net worth individuals remain the main source of capital, hedge funds are becoming more popular among institutional and retail investors. Funds of funds (hedge funds) and other hedge fund-linked products are increasingly being marketed to the retail investors in some jurisdictions. There are a number of factors behind the rising demand for hedge funds. The unprecedented bull run in the US equity markets during the 1990s swelled investment portfolios this lead both fund managers and investors to become more keenly aware of the need for diversification. Hedge funds are seen as a natural hedge for controlling downside risk because they employ exotic investments strategies believed to generate returns that are uncorrelated to asset classes. Until recently, the bursting of the technology and
telecommunications bubbles, the wave of scandals that hit corporate America and the uncertainties in the US economy have lead to a general decline in the stock markets worldwide. This in turn provided fresh impetus for hedge funds as investors searched for absolute returns. The growing demand for hedge fund products has brought changes on the supply side of the market. The prospect of untold riches has spurred on many former fund managers and proprietary trades to strike out on their own and set up new hedge funds. With
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hedge funds entering the main stream and becoming respectable, an increasing number of banks, insurance companies, pension funds, are investing in them. Market Benefits of Hedge Funds: Hedge funds seek to achieve positive investment returns, often with less volatility than traditional asset classes such as stocks and bonds. Hedge funds engage in a wide variety of investment strategies, such as investing in distressed securities, illiquid securities, securities of companies in emerging markets and derivatives, as well as pursue arbitrage opportunities, such as those arising from possible mergers or acquisitions. They typically are managed by entrepreneurs who employ more complicated, flexible investment strategies than advisers at mutual funds, brokerage firms and bank trust departments. Hedge funds can provide benefits to financial markets by contributing to market efficiency and enhancing liquidity. Many hedge fund advisers take speculative trading positions on behalf of their managed hedge funds based on extensive research about the true value or future value of a security. They may also use short-term trading strategies to exploit perceived mispricings of securities. Because securities markets are dynamic, the result of such trading is that market prices of securities will move toward their true value. Trading on behalf of hedge funds can thus bring price information to the securities markets, which can translate into market price efficiencies. Hedge funds also provide liquidity to the capital markets by participating in the market. Hedge funds play an important role in a financial system where various risks are distributed across a variety of innovative financial instruments. They often assume risks by serving as ready counterparties to entities that wish to hedge risk. For example, hedge funds are buyers and sellers of certain derivatives, such as securitized financial instruments, that provide a mechanism for banks and other creditors to un- bundle the risks involved in real economic activity. By actively participating in the secondary
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market for these instruments, hedge funds can help such entities to reduce or manage their own risks because a portion of the financial risks are shifted to investors in the form of these tradable financial instruments. By reallocating financial risk, this market activity provides the added benefit of lowering the financing costs shouldered by other sectors of the economy. The absence of hedge funds from these markets could lead to fewer risk management choices and a higher cost of capital. Hedge funds also can serve as an important risk management tool for investors by providing valuable portfolio diversification. Hedge fund investment strategies are typically designed to protect investment principal. Hedge funds frequently use financial instruments (e.g., derivatives) and techniques (e.g., short selling) to hedge against market risk and construct a conservative investment portfolio -- one designed to preserve wealth. In addition, hedge fund investment performance can exhibit low correlation to that of traditional investments in the equity and fixed-income markets. Institutional investors have used hedge funds to diversify their investments based on this historic low correlation with overall market activity. Advantage of Hedge Fund over Mutual Fund Hedge funds are extremely flexible in their investment options because they use financial instruments generally beyond the reach of mutual funds, which have SEC regulations and disclosure requirements that largely prevent them from using short selling, leverage, concentrated investments, and derivatives. This flexibility, which includes use of hedging strategies to protect downside risk, gives hedge funds the ability to best manage investment risks. The strong results can be linked to performance incentives in addition to investment flexibility. Unlike many mutual fund managers, hedge fund managers are usually heavily invested in a significant portion of the funds they run and shares the rewards as well as risks with the investors. "Incentive fees" remunerate hedge fund managers only when returns are positive, whereas mutual funds pay their financial managers according to the volume of assets managed, regardless of performance. This incentive fee structure tends to attract many of Wall Streets best practitioners and other financial
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experts to the hedge fund industry. In the last nine years, the number of hedge funds has risen by about 20 percent per year and the rate of growth in hedge fund assets has been even more rapid. Currently, there are estimated to be approximately 7000 hedge funds managing $400-$500 billion. While the number and size of hedge funds are small relative to mutual funds, their growth reflects the importance of this alternative investment category for institutional investors and wealthy individual investors. HEDGE FUND REGULATION IN INDIA INDIA The new destination India will grow faster than China and most other countries over the next fifteen years, said the Global Research arm of Deutsche Bank. Top five Growth Centers until 2020 (GDP growth 2006-2020) In Emerging Markets India Malaysia China Thailand Turkey 5.5 5.4 5.2 4.5 4.1 Source: Economic Times
India will be among the top five emerging markets between 2006-2020 and clock a GDP growth of 5.5%. Malaysia at 5.4%, China at 5.2%, Thailand at 4.5% and Turkey at 4.1% will be trailing behind. Strong population growth, a rapid improvement in human capital and increasing trade with other countries will allow average real GDP growth of more than 5% per year in India. In terms of purchasing power parity India will replace Japan as the worlds largest economy after the US and China.
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Indias fundamentals are robust. As a result India has become the most sought after destination for the parking of funds. The biggest investors are the FIIs followed by retail participants. The total market value of FII market
investment in India is now about 18% of the BSE 200 market capitalization, up from 8-13% in the period between 1999-2003. According to a Smith Barney (a Citigroup division) study, the estimated market value of FII investment in the top 200 companies (including ADRs and GDRs) at current market price is a whopping $ 43 Billion. India presently has received the second highest FII inflows in the Asian market at $ 7.8 Billion in 2004. Korea leads with $10.5 Billion. In addition to the Singapore government, Capital International, Janus Fund and Vanguard Fund, funds from Australia and New Zealand have also started investing in India. Hedge Funds operating in India SEBI has recognized the fact that hedge funds are operating in India. Significant among them are : Kingdom Standard Pacific Tiger Management Faqrralone Capital Bayer Alden
Most of them invest in India through the offshore derivative instrument issued by FIIs (Participatory Notes). As at the end of March 2004 total investment by Hedge Funds in the offshore derivative instruments against Indian equity was Rs 80.5 billion which represents about 8% of the total net equity investment by all FIIs.On basis of market values the Hedge account for about 5% of the market value of the total assets held by FIIs in India. Till this report is filed FIIs have already invested US $ 10 bn. during this year alone which is a record. Robust economic fundamentals, strong corporate earnings and improvement in market micro structure are driving the FII interest in India. Investors all over the world are keen to come to Indian market. From informal discussions with institutional investors including some reputed and well established hedge
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funds, one could gauge the extent of interest they have about Indian markets. During the discussions they have requested whether India, like other Asian emerging markets, can provide a regulatory framework that will allow them to directly invest in Indian market in a transparent manner. Hedging for Future and Option Rising price volatility has led to a number of specialized financial instruments that allowparticipants to hedge against unexpected price movement. Like any other derivative, futures contracts can be used as an insurance against unfavorable price fluctuations. In Indian context, S&P CNX Nifty index futures and commodity futures are comparatively new and were introduced in the year 2000 and 2003 respectively. In last 4-5 years, the Indian stocks as well as commodity markets have grown considerably4. Bose (2007) found that Indian stock markets are more volatile as compared to developed markets. Indian commodity futures markets are going through many ups and downs and many atimes allegations of speculative activity have been made in the popular press. Despite controversies, there is a need for systematic investigation of stock and commodity derivatives markets to asses their effectiveness in transferring the risk. This research investigates the hedging effectiveness provided by the futures market. Hedging effectiveness of futures markets is one of the important determinants of success of futures contracts (Silber, 1985; Pennings & Meulenberg, 1997). Price risk management, using hedging tools like futures and options and their effectiveness, is an active area of research. Hedging decisions based on futures contracts have to deal with finding optimal hedge ratio and hedging effectiveness. Role of hedging using multiple risky assets and using futures market for minimizing the risk of spot market fluctuation has been extensively researched. Several distinct approaches have been developed to estimate the optimal hedge ratio. Techniques like OLS, VAR, and VECM estimate constant hedge ratio and bivariate GARCH models estimates dynamic hedge ratios which factor in conditional distribution of spot and futures returns. However, there has been extensive debate on which model generates the best hedging performance (Baillie & Myers, 1991; Ghosh, 1993; Park & Switzer, 1995; Kavussanos &
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Nomikos, 2000; Lien et al., 2002; Moosa; 2003, Floros & Vougas, 2006). Superior performance of bivariate GARCH models was supported by Baillie and Myers (1991), Park and Switzer, (1995), Kavussanos and Nomikos, (2000), Floros and Vougas (2006) etc. Ghosh (1993), however, found better performance of VECM among constant hedge models and Lien et al. (2002) and Moosa (2003) found that the basic OLS approach clearly dominates other alternatives Traditionally, hedging is envisaged using a hedge ratio of -1, i.e., taking a position in futures contract which is equal in magnitude and opposite in sign to the position in spot market. If the movement of changes in spot prices and futures prices is exactly the same, then such a strategy eliminates the price risk. Such a perfect correlation between spot and futures prices is rarely observed in markets and hence a need was felt for a better strategy. Johnson (1960) proposed minimum variance hedge ratio (MVHR), which factored in less than perfect relationship between spot and futures prices.. Risk was defined as the variance of returns on a two-asset hedged position. The Minimum-Variance Hedge Ratio (Benninga, et al., 1983, 1984) has been suggested as slope coefficient of the OLS regression in which changes in spot prices is regressed on changes in futures price. The optimal hedge ratio for any unbiased futures market can be given by ratio of covariance of (cash Prices, futures Prices) and variance of (futures Prices). In other words, MVHR is the regression coefficient of the regression model (changes in spot prices over changes in futures prices) which gives maximum possible variance reduction or hedging effectiveness. Many researchers have defined hedging effectiveness as the extent of reduction in variances as a risk minimization problem (Johnson, 1960; Ederington, 1979). However, Rolfo (1980) and Anderson and Danthine (1981) calculated optimal hedge ratio by maximizing traders expected utility, which is determined by both expected return and variance of portfolio. Because of the relationship (trade-off) between risk and return, they argued that optimal ratio must be estimated in mean-variance framework rather than for minimizing only risk. Using OLS regression for estimating the hedge ratio and assessing hedging effectiveness based on its R-square, has been criticized mainly on two grounds (Baillie & Myers, 1991;Park & Switzer, 1995). First, the hedge ration estimated using OLS
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regression is based on assumption of unconditional distribution of spot and futures prices; whereas, the use of conditional distributions is more appropriate because hedging decision made by any hedger is based on all the information available at that time. Second, OLS model is based on assumption that the relationship between spot and future prices is time invariant but empirically it has been found that the joint distribution of spot and futures prices are time variant (Mandelbrot, 1963; Fama, 1965). Recent advancements in the time series modeling techniques have tried to remove the deficiencies of the OLS estimation. Multivariate GARCH (Bollerslev et al, 1988) has been used to calculate time varying hedge ratio. Many recent works on the hedging effectiveness estimate time varying hedge ratios (Baillie & Myers, 1991; Park & Switzer, 1995; Holmes, 1995; Lypny & Powella, 1998; Kavussanos & Nomikos, 2000; Choudhry, 2004; Floros & Vougas, 2006; Bhaduri & Durai, 2008). Park and Switzer applied MGARCH approach to calculate hedge effectiveness of three types of stock index futures: S&P 500, MMI futures and Toronto 35 index futures and found that Bivariate GARCH estimation improves the hedging performance. Lypny and Powella (1998) used VEC-MGARCH (1,1) model to examine the hedging effectiveness of German stock Index DAX futures and found that dynamic model was superior than constant hedge model. However, some recent studies such as those of Lien et al. (2002) and Moosa (2003) have found that the basic OLS approach clearly dominates. Thus, empirical findings across markets seem to suggest that the best model for hedging may be country and market specific. There are very few empirical investigations of the stock futures markets and hedge ratios in emerging market context (Choudhry, 2004; Floros & Vougas, 2006; Bhaduri & Durai, 2008) and especially in context of Indian commodity futures. Choudhary (2004) investigated the hedging effectiveness of Australian, Hong Kong, and Japanese stock futures markets. Both constant hedge models and time varying models were used to estimate and compare the hedge ratio and hedging effectiveness. He found that time-varying GARCH hedge ratio outperformed the constant hedge ratios in most of the cases, inside-thesample as well as outside-the-sample. Floros and Vougas (2006) studied the hedging effectiveness in Greek Stock index futures market for the period of
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1999-2001 and found that time varying hedge ratio estimated by GARCH model provides highestvariance reduction as compared to the other methods. Bhaduri and Durai (2008) found similar results while analyzing the effectiveness of hedge ratio through mean return and variance reduction between hedge and unhedged position for various horizon periods of NSE Stock Index Futures. However, the simple OLS-based strategy also performed well at shorter time horizons. Roy and Kumar (2007) studied hedging effectiveness of wheat futures in India using least square method and found that hedging effectiveness provided by futures markets was low (15%).Since the hedging effectiveness has been found to be contingent on model used to estimate hedge ratio and whether it is kept constant or allowed to vary over the hedging horizon, it is interesting to investigate the same in Indian context. While there has beensome work in this direction for the Stock Index Futures, Indian Commodity Futures have not been extensively researched empirically on the choice of model for estimating hedgeratio and resultant hedge effectiveness. Presumably, this research would help in understanding effectiveness of commodity futures contracts once the relationship between spot and futures prices is modeled and factored in estimating hedge ratio. It may also help concerned exchanges and the government to devise better risk management tools or supports towards commodity-specific public policy objectives. At the time of writing this paper, reports suggest that the Indian government is planning on aggregation model to encourage participation of farmers on the commodity exchanges. Finally, this study may help hedgers in devising better hedging strategies. This study investigates optimal hedge ratio and hedge effectiveness of select futures contracts from Indian markets. Three different futures contracts have been empirically investigated in this study. One of these is a Stock index futures on S&P CNX Nifty, which is a value-weighted index consisting of 50 large capitalization stocks maintained by National Stock Exchange. The other two futures contracts are- Gold futures and Soybean futures. All futures contracts traded in the market at any point in time have been considered. Daily closing price data on S&P CNX Nifty index and its futures contracts5(all three) available at any given time, and similarly three Gold futures6and three Soybean futures7contracts trading contemporaneously are included. Since
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hedge effectiveness of NIFTY futures was investigated by Bhaduri and Durai (2008) for the period 4 September 2000 to 4 August 2005, we have used data for the period of 1stJan 2004 to 8thMay 2008 of NIFTY futures to supplement their work HEDGE RATIO AND HEDGING EFFECTIVENESS In this study, four models, conventional OLS, VAR, VEC and VAR-MGARCH areemployed to estimate optimal hedge ratio. The OLS, VAR and VECM models estimate constant hedge ratio whereas time varying optimal hedge ratios are calculated usingbivariate GARCH model (Bollerslev et al., 1988). In this section, first we discuss the hedge ratio and hedging effectiveness and then all four models are presented. In portfolio theory, hedging with futures can be considered as a portfolio selection problem in which futures can be used as one of the assets in the portfolio to minimize the overall risk or to maximize utility function. Hedging with futures contracts involves purchase/sale of futures in combination with another commitment, usually with theexpectation of favorable change in relative prices of spot and futures market (Castelino, 1992). The basic idea of hedging through futures market is to compensate loss/ profit in futures market by profit/loss in spot markets
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HEDGING WITH FUTURE & OPTION

The NSE were the one's who spear headed the introductions of derivatives in the Indian markets based on the recommendations of the Gupta committee. Although the BSE started two days earlier (on 9th 2000), they simply did this without proper preparations just to take credit as being the first exchenge in India to start derivatives. As such it was the NSE who laid all the groundwork and followed the recommendations of the Gupta committee. Its primarily because of the NSE (and of course the change in foreign policy by the govt.) that FII's have entered the Indian markets with confidence, they have given credibility to the Indian markets. NSE gurantees that every single trader who trades through them will receive his money even if they opposite party defaults, they even have a gurantee fund which has now accumulated to the tune of over 2000 crores to pay any creditors in case of default of the opposite party (even though this has nothing to do with NSE). They've fullfilled their promise all though there have been a few cases of default (you can count them on your fingers they are so few) despite this every credible or desrving trader has got his dues. Even when the markets fell by a recored 18% a few years ago not a single case of default took place. The CME (Chicago mercantile exchange, chicago wale ither attay hai!) was so impressed by this they actually came to the NSE to study their working as to how the NSE managed this. In short what I'm trying to say you can believe the NSE instead of Mr. McMillan, take my word for it. Although I do not have the precise figures with me, the NSE derivatives dept actually calculates statistics for all its trades on a regular basis. If you would be so kind as to pm me, I'll give you the number for Mr. Paul who was responsible for the introduction, research, and implementation at the ground level of the derivatives market in India, he left NSE a few months ago and has now joined Bank of America as head of derivatives. He was the person
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looking after the derivatives section of the NSE and the person under whom most statistics and recommendations were done. You may also cntact Mr. Mukherjee (can't give you his number coz I don't know him) who is vice president of the NSE and he will confirm this as well. These are very credible people and I'm sure they will try to furnish any proof you require, I on the other hand know Mr. Paul well and take his word for it. Now coming to the reason lets try to analyse; There are four MAIN market conditions. 1) Rising market (bullish) 2) Falling market (bearish) 3) Volatile market (moving up and then down) 4) Stagnant market Lets take the example of a trader who has sold a call option. 1)The market rises and he loses 2)The market falls and he has no loss he actually pockets the premium 3)The market is volatile it moves up and down, he has no loss, he pockets the premium, why? because he will only lose once the the spot price rises beyond the value of the premium, so he has room for an up move , and besides even if it does go a little higher than the premium cover it would go down a bit, which is the nature of volatile markets. 4)The market is stagnant and once again he pockets the premium. So out of the above four basic market conditions the option writer wins in three out of the four cases, which is a 75% win porobability while the options buyer wins only in one case which is a 25% probability, all other conditions remaining the same as a general case to illustrate the example is often considered an advanced investing strategy, but the principles of hedging are fairly simple. With the popularity - and accompanying criticism - of hedge
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funds, the practice of hedging is becoming more widespread. Despite this, it is still not widely understood. Read on for a basic grasp of how this strategy works and how it is used. (To learn more, read A Beginner's Guide To Hedging.) Everyday Hedges Most people have, whether they know it or not, engaged in hedging. For example, when you take out insurance to minimize the risk that an injury will erase your income, or you buy life insurance to support your family in the case of your death, this is a hedge. You pay money in monthly sums for the coverage provided by an insurance company. Although the textbook definition of hedging is an investment taken out to limit the risk of another investment, insurance is an example of a realworld hedge. Hedging by the Book Hedging, in the Wall Street sense of the word, is best illustrated by example. Imagine that you want to invest in the budding industry of bungee cord manufacturing. You know of a company called Plummet that is revolutionizing the materials and designs to make cords that are twice as good as its nearest competitor, Drop, so you think that Plummet's share value will rise over the next month. Unfortunately, the bungee cord manufacturing industry is always susceptible to sudden changes in regulations and safety standards, meaning it is quite volatile. This is called industry risk. Despite this, you believe in this company and you just want to find a way to reduce the industry risk. In this case, you are going to hedge by going long on Plummet while shorting its competitor, Drop. The value of the shares involved will be $1,000 for each company. If the industry as a whole goes up, you make a profit on Plummet, but lose on Drop - hopefully for a modest overall gain. If the industry takes a hit, for example if someone dies bungee jumping, you lose money on Plummet but make money on Drop.
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Basically, your overall profit, the profit from going long on Plummet, is minimized in favor of less industry risk. This is sometimes called a pairs trade and it helps investors gain a foothold in volatile industries or find companies in sectors that have some kind of systematic risk. (To learn more, read the Short Selling tutorial and When To Short A Stock.) Expansion Hedging has grown to encompass all areas of finance and business. For example, a corporation may choose to build a factory in another country that it exports its product to in order to hedge against currency risk. An investor can hedge his or her long position with put options or a short seller can hedge a position though call options. Futures contracts and other derivatives can be hedged with synthetic instruments. Basically, every investment has some form of a hedge. Besides protecting an investor from various types of risk, it is believed that hedging makes the market run more efficiently. One clear example of this is when an investor purchases put options on a stock to minimize downside risk. Suppose that an investor has 100 shares in a company and that the company's stock has made a strong move from $25 to $50 over the last year. The investor still likes the stock and its prospects looking forward but is concerned about the correction that could accompany such a strong move. Instead of selling the shares, the investor can buy a single put option, which gives him or her the right to sell 100 shares of the company at the exercise price before the expiry date. If the investor buys the put option with an exercise price of $50 and an expiry day three months in the future, he or she will be able to guarantee a sale price of $50 no matter what happens to the stock over the next three months. The investor simply pays the option premium, which essentially provides some insurance from downside risk. (To learn more, read Prices Plunging? Buy A Put!) Hedging is often unfairly confused with hedge funds. Hedging, whether in your portfolio, your business, or anywhere else, is about decreasing or transferring
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risk. Hedging is a valid strategy that can help protect your portfolio, home and business from uncertainty. As with any risk/reward tradeoff, hedging results in lower returns than if you "bet the farm" on a volatile investment, but it lowers the risk of losing your shirt. Many hedge funds, by contrast, take on the risk that people want to transfer away. By taking on this additional risk, they hope to benefit from the accompanying rewards. Futures contracts provide farmers (as well as processors, merchandisers, and others) with a method for reducing their risks. Futures contracts were almost exclusively traded on commodity prices in the past, although innovations in recent decades also have introduced contracts on interest rates, foreign exchange rates, price indexes, and crop yields. A primary use of futures involves shifting risk from a firm that desires less risk (the hedger) to a party who is willing to accept the risk in exchange for an expected profit (the speculator). Also, hedgers with opposite positions in the market trade with each other, and speculators with opposing views of the market may also trade. A futures contract is an agreement priced and entered on an exchange to trade at a specified future time a commodity or other asset with specified attributes (or in the case of cash settlement, an equivalent amount of money). The U.S. exchanges that trade agricultural futures contracts are the Chicago Board of Trade; the Chicago Mercantile Exchange; the Kansas City Board of Trade; the Minneapolis Grain Exchange; the New York Coffee, Sugar, and Cocoa Exchange; and the New York Cotton Exchange. Trading is conducted either through open outcry on the floor of the exchange or electronically. The December corn contract traded on the Chicago Board of Trade, for example, specifies lots of 5,000 bushels for No. 2 yellow corn and a December delivery period. Contracts for major field crops (including corn, wheat, soybeans, cotton), four types of livestock and animal products (live cattle, feeder cattle, live hogs, and pork bellies), and sugar and frozen concentrated orange juice have been traded for years. More recently, futures contracts for rice, boneless beef, and dairy products have been introduced. Because contracts are standardized, the only issue to be negotiated at trading time is price.
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Enforcing contract terms is a key function of the exchanges where trading occurs, and guaranteeing contracts is a key function of the exchange clearinghouse. Most futures contracts are offset by opposite trades before delivery time, with each party to the transaction selling (or buying) a futures contract that was initially bought (or sold). For example, if a farmer (through his or her brokerage house and its trader on the Chicago Board of Trade) sells a corn contract in May for December delivery, his or her position may be offset by buying a December corn contract at any time before the end of the delivery period, which is about December 20. Such an offset usually occurs because the major motive in trading futures is to hold a temporary position, and then trade for money, and not to physically deliver or acquire a commodity (Hieronymus). Most hedgers offset because making or taking delivery on futures would be more costly than delivering through normal channels, while speculators generally do not want to own the actual commodity. Because futures contracts are commitments to trade in the future, actual delivery and payment are not required until the contract matures. However, both buyers and sellers are required to make margin deposits with their brokers to guarantee their respective commitments. Because the margin deposit is small (typically 5-10 percent of the underlying value of the contract), speculators (who provide liquidity) are attracted to the market. The exchanges set minimum margins by contract, which can be raised by brokers to provide the protection they deem necessary. Using the December corn contract as an example, and assuming a $2.00 per bushel price quote, a cattle feeder who buys one contract (5,000 bushels) makes a $10,000 commitment. With a 10-percent margin, the feeder must post $1,000 with his or her broker. A margin call occurs when the price of the contract moves against the trader, say to $1.90 in this example. When a margin call occurs, the producer must post additional margin with his or her broker to cover the loss and restore the deposit. Similarly, when the price moves favorably for the trader by a specified amount, money can be withdrawn from the margin deposit. Because futures prices reflect values of commodities at futures delivery points, the local cash
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prices confronted by farmers usually vary from futures contract quotes at a given point in time. The differences between futures and cash prices are termed basis, and reflect differences in price across space (due to transportation costs), time (which are associated with storage costs), or quality (such as differences in protein premiums for wheat). The basis is calculated as the difference between the cash price (at a given location and at a given point in time) and the futures price (associated with a specified exchange and contract month).11 The basis varies over time, and reflects only transportation costs and quality differences as the contract reaches maturity. As seen below, hedging largely eliminates price level uncertainty, but not basis uncertainty, which generally has a smaller variance. Two categories of hedging exist: long hedging (where a futures contract is purchased) and short hedging (where a futures contract is sold). Either type of hedge involves holding a futures position in anticipation of a later transaction in the cash market, and in both cases, the futures position is opposite to the cash position. Because futures and cash prices tend to move up and down together, losses and gains in the two markets tend to offset each other, leaving the hedger with a return near what was expected (the initial futures price plus the end- operands basissee later discussion). Thus, hedging helps protect the business from changes in price levels. Farmers may choose to hedge in many different situations, including the following: Storage hedgingFarmers or merchants who own a commodity can protect themselves from declines in the commoditys price by short hedging. This involves selling futures contracts as the commodity is harvested or acquired, holding the resulting short futures position during the storage period, and buying it out when the cash commodity is sold. Losses (gains) in the value of the cash commodity due to unexpected price changes will be largely offset by gains (losses) in the value of the futures position leaving the owner of the commodity with approximately the expected return from storage. Production hedgingCrop and livestock producers can protect themselves from declines in prices of expected outputs by short hedging. This generally
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involves selling futures contracts at the beginning of or during the growing or feeding period, holding the resulting short futures position until the product is ready to sell, and buying the futures as the output is sold. Losses (gains) in the value of the output due to unexpected price changes tend to be offset by gains (losses) in the value of the futures position. However, yield variability reduces the risk-reducing effectiveness of hedging for crop growers and generally makes it inadvisable to sell futures equal to more than one-half to two-thirds of the expected crop. Hedging expected purchases Livestock feeders anticipating the purchase of corn or feeder cattle can protect themselves from price increases by long hedging. This involves buying corn or feeder cattle futures contracts to match anticipated requirements and selling the resulting long futures positions as these inputs are purchased on the cash market. Increases (declines) in the cost of feeders or feed due to unexpected price changes will be partly offset by gains (losses) in the value of the futures position leaving the feeder with approximately the expected costs of inputs. Feeders overall price risks may be further reduced by selling futures on prospective outputs, as discussed above. To better understand the importance of basis risk in hedging, consider the example of a corn producer with irrigated acreage who is considering the pricing of his growing crop. Because the producer irrigates and faces few other natural perils, he knows the size of his crop with a great deal of certainty and is concerned only with price risk. If the farmer does not hedge, his risk is solely associated with the harvest cash price (P2), which can also be calculated as the harvest futures price (F2) plus the harvest basis (B2). Thus, the farmers net return in a cash-saleat- harvest situation (Ru) can be calculated as the cash price (F2 + B2) at harvest multiplied by actual production (Y2 ), minus production costs (C): Ru = [(F2 + B2) * Y2 ] - C. Suppose now that the producer places a short hedge (for example, sells a futures contract) to reduce the risk of a price decline and a lower sales price for his growing crop. The expected final net return at harvest (Rh) is based on the cash price at harvest (F2 + B2), and the profit or loss associated with the
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farmers futures market position (F1 - F2). The farmers actual level of production is designated as Y2 in the following equation, and the quantity hedged is h * Y1, where h is the hedge ratio and Y1 is expected production: Rh = [(F2 + B2) * Y2 ] + [(F1 - F2) * (h * Y1)] - C. Assuming that output is known with certainty at the time the hedge is placed, and that actual production equals the quantity hedged (for example, Y2 = h * Y1), gives the following: Rh = [(F2 + B2) * Y2] + [(F1 - F2) * Y2] - C, or: Rh = [Y2 * (F1 + B2 )] - C. This last equation indicates that the price component of the farmers net return depends on the futures price at the time the hedge is placed plus the harvest basis. Because the futures price is known with certainty at planting, and output is known with certainty in this example, the only risk faced by the farmer is the risk associated with the harvest basis. Thus, price level risk is eliminated by this anticipatory hedge, and the only risk faced by the grower is basis risk (the uncertain nature of B2). The existence of basis risk is a key factor distinguishing the risk associated with futures hedging and the use of many types of cash forward contracts (see previous section). When a producer enters into a flat price forward contract with his or her local elevator, for example, the basis risk he or she faces is zero. In addition, forward contracts are generally less standardized than futures contracts, and specific terms may vary across elevators. Physical delivery to the local elevator at harvest is generally required, and no margin calls exist when cash forward contracts are used. Using a numerical example to illustrate hedging, suppose the corn producer discussed earlier wishes to reduce his income uncertainty by selling a futures contract at planting time. Because the farmer irrigates his corn crop, he is not concerned about yield
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risk, and the hedge quantity is assumed to equal actual output. The farmer in this example observes a $2.75 per bushel futures price at planting time. He expects a harvest basis of -$0.25, giving an expected cash price of $2.75 plus -$0.25, or $2.50 per bushel. Two outcomes are shown in the table, a $0.25price decrease between planting and harvest, and a $0.25- price rise. In both cases, the realized harvest basis is -$0.25, as expected.13 With hedging, the return per bushel is $2.50 in both cases. This return can be calculated as (1) the futures price at planting time ($2.75) plus the harvest basis (-$0.25 in both scenarios), or (2) the cash price at harvest ($2.25 or $2.75, depending on the scenario) plus the gain or loss from the futures market position (+$0.25 or $0.25). The US dollar was worth Rs40 a short while ago and is now worth almost Rs44. Given the precipitous fall in equity markets and rising commodity prices, most of us may have anticipated the appreciation of the dollar but had no way to profit from it. All that is about to changeIndia is launching currency futures. For the uninitiated, currency futures (or foreign exchange futures, or fx futures) are standardized contracts, traded on an exchange, to buy or sell an underlying asset at a certain date in the future at a specified priceor how much a currency is worth in terms of another at a certain date. Investors may soon be able to open a currency futures trading account with their broker, buy (or sell) US dollar-rupee exchange rate futures and aim to make money on the basis of their view. Currency futures are similar to equity futures and commodity futures except that the underlying asset is the exchange rate. Currency futures were initially created in the early 1970s in the US as a tool for commodity importers, exporters and traders so that they could hedge their currency risks. Even today, importers and exporters of several commodities remain significant users of this market. With the introduction of exchange-traded currency futures, the next few weeks will see a major step forward for Indian financial markets. It signifies a
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determination to put in place a very crucial piece in the globalization puzzle and marks a significant step towards full convertibility. After all, you cant have full convertibility without a transparent market to dynamically fix exchange rates. In fact, currency futures were first introduced in the US after the goldexchange standard was abandoned (the gold-standard itself flopped after the first world war) and after the fixed exchange rate mechanism was discarded in favour of market driven rates. Volatile certainty The last few weeks have seen a serious erosion in rupees value and dented the balance sheets of many importers. Exporters, software and otherwise, are better off now but they were at the receiving end for much of 2007 when the rupee gained against the dollar. At any time, both exporters and importers would have liked to hedge their currency risk but were forced to go to banks to do soand the systems of banks are, to put it mildly, opaque. Currency futures will be as transparent and hopefully as liquid as the Nifty, the benchmark index of the National Stock Exchange. And exchange-traded instruments are easier to regulate and manage. Because the underlying is a financial asset, currency futures come under the category of financial futures. This market, like other futures markets, is a price-discovery and risk-management mechanism and is not meant for physical exchange of currency. For that, there is the spot market with banks and money-changers as the main participants. Though the only contract initially listed may be the rupeeUS dollar contract and though the size of the contract may be only $1,000 (Rs43,700) to start with, this will see Indias full-fledged entry into the worlds biggest financial marketcurrency futures. In fact, the $1,000 contract size will help to get retail traders to provide liquidity. The limit per client will be small given that $25 million is the members limit, and may currently not attract large players (who will continue to use the over the counter, or OTC, markets via banks) but it is a beginning and could soon lead to higher limits.
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Moreover, this market must be grown gradually. The next contracts could be rupee-euro ones. This, too, will attract corporates and they will soon appreciate the transparency provided by the futures markets vis--vis OTC marketseven though there are no margins there. Recent losses incurred by corporates due to the non-transparency of such instruments should help settle the matter. Therefore, the spotlight will be on the new exchange from day one. Strict risk-management and disclosure criteria are expected to strengthen the system in currency markets further. Like the commodity futures in India, liquidity will be provided by retail traders and high networth individuals till such time the regulators are convinced of the infrastructure and process execution. Currency markets are traders paradise because of continuous trading opportunities due to the immediate effect of news flow on exchange rates. The Reserve Bank of India has allowed banks and brokers to start currency futures on specified exchanges. Banks will also help provide liquidity to the markets. The memberships of brokers will be stringently regulated with objective and subjective criteria, such as net worth, track record and reputation. Companies too can trade but may have to make suitable disclosures in their annual reports and to their shareholdersand they are expected to hedge, not speculate. Currently, foreign institutional investors are not allowed but will soon be when the market reaches some stability and depth. The idea is to not have large players sway the exchange rate due to order size. Nevertheless, restrictions distort markets and there should be a transparent mechanism for their removal based on volume and other parameters. The market will be regulated by stock market regulator Securities and Exchange Board of India and the contracts will be listed as a separate segment on exchanges. Worldwide, currency futures are more considered part of the commodities basket and that is probably natural because importers and exporter as well as hedgers and arbitrageurs who deal in international commodities such as agricultural products, bullion, energy and metals, are exposed to currency risk and would like to hedge that alongside their commodity position. Being a new market, there could initially be a shortage of
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trained, certified personnel but there is no reason why the currency futures markets in India will not be larger than other futures markets soon. Over a period of time, India can aim to become a centre for currency futures trading and try to be the financial hub for Asia for all financial products. This is also a step towards full convertibility of the rupee. And this is not the last stop. Another important market is soon going to get open upinterest rate futures! That the Indian derivatives market has improved in volumes is indeed commendable. But a cause for concern is the discernible shift in the market structure volumes in the options segment have fallen even as trading in the futures segment has improved. For instance, equity options as a percentage of total turnover in the derivatives segment fell from 23 per cent in April 2003 to 11 per cent in September. The problem is that futures are useful for pricebetters while options aid hedgers. If price-betters move from options to futures, there may not be enough counter parties for hedgers in the options market. If this trend persists, the options market may well become dormant after a while. Hedging: Options are typically suitable for portfolio hedging. The reason is that options cap the downside without limiting the upside potential. Suppose the Nifty spot index is 1500. A portfolio may be effectively hedged with, say, the November 1480 Nifty puts. The hedged portfolio is protected if the spot index declines below 1480. But this downside protection does not come at the expense of limited upside; of course, the portfolio will have to bear the option premium cost for enjoying a convex strategy. Note that this strategy is sub-optimal only if the spot index remains at 1480 levels when the hedge is lifted. The problem with futures is that the payoffs are symmetrical. Hedging with futures essentially means that the upside is sacrificed. Of course, a portfolio can be partially hedged with futures to allow for some upside, but that would also mean higher downside. Market shift: When volumes shift from options to futures segment, hedgers may not have enough counter parties. The consequences may be severe. When volumes decline, the bid-ask spread widens. Sometime back, the
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Reliance November 510 puts had a bid-ask spread of Rs 10. High bid-ask spreads not only distort price efficiency, but also dissuade hedgers. Agreed, our derivatives market primarily consists of price-betters and not hedgers. But this discernible shift in volumes from options to futures will permanently prevent hedgers from entering the derivatives market. And that may not be good for the market as a whole. Why? There is a two-way information flow between the derivatives and the spot market. Of course, it is moot as to which market is the price-setter. But it is safe to presume that the derivatives market is important for the spot market. And if the derivatives market primarily has price-betters, spot prices may be pushed away from the underlying fundamentals. Suggestion: The primary reason for the dwindling volumes is the high bid-ask spread. This is because of the highly negative convex payoffs for option writers. The maximum gain for the option writer is the option premium; the maximum loss is unlimited. The negative convexity increases, higher the underlying volatility. Clearly, there is incentive for option writers to switch to futures in a highly volatile market such as now. The workable solution is to have sub-segment market-wide limit. At present, the NSE provides a market-wide limit for each stock at the beginning of the month. This is the maximum number of contracts that can be traded during that month in each stock. If the open interest position crosses 80 per cent of this limit, margins double to prevent any systemic risk due to position defaults. Because price-betters favour the futures market, 70-85 per cent of the open interest position is in the futures segment. The NSE should provide sub-segment market-wide limit. This suggestion no doubt goes against the grain of free market. The point is that option sellers cannot be given incentives to trade in the market. The concept of market makers may not work because such specialists may demand high bid-ask spreads to lower their inventory risk. A sub-segment market-wide limit will shift volumes from futures to options market. The higher demand for contracts will reduce the bid-ask spread. And that may, in turn, create more volumes,
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leading to a self-generating demand for options. That is when portfolio managers can cost-effectively hedge in the market. NSE cleared 39 new stocks for trading in the futures and options (F&O) segment. This is routine. Every so often, the exchange reviews stocks to see if they meet requisite liquidity thresholds and it clears new sets of underlyings. These are seamlessly added to the thriving equity F& O segment. Tracking stocks at the time they are cleared for F&O, it is easy to see that there is usually a beneficial effect on liquidity. Volumes pick up once the stock is notified. The effect on cash trading volumes is accentuated for several reasons. Circuit filters are removed once a stock enters F&O. It is also possible to short an F&O stock. Higher volumes often lead to lower bid-ask spreads and that in turn sets up a virtuous circle for traders. There may or may not be an effect on price. This seems to be much more random than the generally noticed effect of higher trading volumes. This new basket of 39 is a very mixed bag. There are many counters that seem overdue for F&O inclusion such as Concor, Balaji Tele, Opto Circuits, PTC, RIIL, Thermax, TV18. There are also plenty of counters that are not noted for being high volume. I would assume that the liquidity difference will be more notable in counters that were less liquid prior to notification. Every time a new set is inducted, there is grumbling about unequal lot sizes. The NSE principle of trying to ensure market lots are all roughly the same initial value is logical enough. But inevitably, as prices change, the value of market lots change. The lack of uniform lots places an unnecessary burden on traders' memories. Instead of simply multiplying price by 100 (or some other uniform ratio) they have to calculate lot value with widely differing lots associated to every underlying. There are two attitudes that seem to prevail when it comes to new inductions in the stock F&O list. One is to cautiously wait and watch and track the new stocks until it becomes evident, which ones have caught the market's fancy. This is relatively low-risk insofar as any derivative trading can be low-risk. The
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other method is to plunge straight into the new counters from day one. This is much more fraught with risk until you have some idea of the sort of volatility and bid-ask spreads the new induction will develop. But if luck is with you, the chances of high returns are greater in the first few weeks of a stock being launched in F&O. The other new product that NSE is introducing is far more radical. Currency futures are long, long overdue. The RBI has always had an irrational fear of these instruments given that they can be offered as pure rupee products with no conceivable chance of "infecting" actual currency movements. The NSE is apparently going to do just that. From the September settlement onwards, it will offer a set of 12 monthly contracts with each one tied to the RBI reference rate for settlement purposes. The RBI offers rupee reference rates for USD, Euro, Yen and sterling. It's as yet unclear whether the NSE will offer all four sets of currency futures. It doesn't appear from the circulars that they are likely to offer cross-currency futures (Yen-Euro, GBP-USD) - at least not yet. The contract size is quite low - $1000, or roughly Rs 40,000. The margining system and mark-to-market mechanism will be very similar to equity and index F&Os. So it will be possible for retail traders to take positions as well as for institutions to structure products that suit hedgers with a longterm perspective. A quant trader can easily work out daily value-at-risk (VAR) on these and apply appropriate strategies. Apart from naked speculation, currency futures offer quite a few hedging opportunities. The exporters and importers will presumably continue using the more serious $34 billion OTC market where complex structures can be put together. But if somebody is taking an exposure in a forex-sensitive stock from the IT sector, or taking a CNXIT future, it could be offset with the new currency futures instruments. In the long-term, this is likely to become one of the most popular trading segments in the NSE portfolio. Hedging is about doing things that reduce your exposure to bad events. India's transition into a market economy has been accompanied by a new regime of market volatility. Individuals and firms are exposed to volatility in interest rates, currencies, the
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stock index and commodity prices which is quite unlike that seen in previous decades. Suppose a person exports garments and is hence exposed to the fluctuations of the dollar-rupee. There are exactly two strategies that he can adopt: speculation or hedging. Speculation He can take interest in currencies, learn about exchange--rate fluctuations, and try to forecast future fluctuations in order to make his own decisions. He could decide that currency forecasting is not part of his core competence, and he could hedge away this exposure by selling the dollars that will come to him in the future on the dollar--rupee forward market. The choice -- to hedge, or to speculate? -- appears again and again in the modern economy. A third option, of doing nothing, does not dodge the question; doing nothing is the same as speculating. A person who has unhedged interest--rate exposure is an interest--rate speculator. There was $100 billion of unhedged external debt in Thailand in 1996 -- these firms were betting that the central bank would produce a stable currency. When hedging instruments are unavailable, individuals and firms are forced to become speculators. Hedging is not a recipe to make money. Hedging is a recipe to reduce risk. Every hedging activity can look smart or look foolish, after the fact, depending on the direction that prices take. Suppose the exporter sells dollars forward on 31 Dec 2000 at Rs.45/$. On 31 Dec, there are exactly two cases: either the dollar will be above Rs.45 or below it. If the exchange rate is at Rs.50/$ on 30 June, the exporter will obtain reduced proceeds from his forward contract as compared with what he might have got on the spot market. In this sense, half of all hedged positions look like ``losses in derivatives trading'' on the day the derivative matures. This induces a feeling of ``post--hedge disappointment'' in the mind of the hedger. Yet, we should not forget that the advantage of the hedge was the elimination of risk -- the hedger was locked into the price of Rs.45, and did not have to pay attention to currency fluctuations thereafter.
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Many people get sucked into speculative activities without even noticing the steps leading up to it. Faced with risk, their innate sense of responsibility makes them try to learn more about the source of risk. This knowledge equips them to try to make statements about the future of the market. This emboldens them into assuming speculative positions. There are innumerable CEOs in India today, engaged in exports or imports, who will confidently hold forth on their views about the future of the dollar--rupee. These efforts are doomed to failure. The modern view of speculative markets emphasises the essentially adversarial nature of speculation. Speculation is a zero--sum game; every winner in speculation is matched by an equal and opposite loser. Most manufacturing companies simply do not know enough to profitably engage in financial market speculation; they are likely to suffer transactions costs and trading losses. It is useful to think of this as a question of core competence. A garment exporter should cultivate a special expertise in garments. He cannot afford to ``not be a speculator'' on questions concerning garments -- he makes speculative choices about what to produce, how to produce it, distribution strategies, etc. But a garment exporter would be diffusing his efforts if he tried to also be an expert on currency movements. In this sense, the garment exporter is better off hedging away his currency exposure. Adopting currency risk, i.e. speculating on currency movements, is not a core competence for a garment exporter. Speculation and Hedging on the Equity Market. The stock market offers a most elegant example of the distinction between speculation and hedging, and the appropriate role for each. Today, in India, we see numerous ``speculators'' on the equity (cash) market. Enormous speculative trading volumes are observed on NSE and BSE. We see individuals who are ``buy ITC'' or ``sell Infosys''. It is useful to go closer to these positions and link them up with the underlying rationale. There are exactly two cases. Many times, positions on stocks like ITC or Reliance are undertaken while treating the stock as an index proxy. A person is bullish about the ``broad
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market movement'' and adopts a position in a few highly liquid stocks so as to profit from it. In this case, the person is actually an index speculator. His positions of a few stocks are inefficient proxies for the index. Now that index futures are available, his speculation would be more efficiently implemented using the index futures market. The ``buy Nifty'' position is a more efficient bet on the index than a ``buy ITC'' position. Alternatively, there are people who are truly stock speculators. A person may truly be pessimistic about Infosys, because he has thought about the valuation of Infosys and thinks that the market price is presently too high. In this case, this ``sell Infosys'' position is an inefficient implementation of his view. This is because Infosys could additionally fluctuate because of broad market movements. The analysis of Infosys could be right, but the position could yield losses because Nifty rises! The position ``sell Infosys'' combines speculation on Infosys with gambling on Nifty. Until today, stockpickers in India could not escape the Nifty exposure when they worked on valuing stocks. In the absence of an index futures market, every stockpicker in India was forced to be an index gambler. There is a superior alternative that's now available -- the position ``sell Infosys'' coupled with ``buy Nifty''. The buy position on the futures market strips out the index exposure that is latent in the stock position. The position ``sell Infosys + buy Nifty'' is a case of hedging in speculation -- the speculator has a core competence in Infosys and has hedged away the extraneous Nifty exposure. The resulting position is less risky, which benefits the speculator and makes the overall marketplace safer. In this sense, every speculative position on the equity cash market can now be done more efficiently using the index futures market. Index speculators can now directly implement views on the index, without using inefficient proxies. Stock speculators can hedge away their latent index exposure, and hence
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avoid gambling on the index when they speculate on a stock. In doing so, they obtain less risky positions which are focussed on their core competences. Online trading, the clearing corporation, and the depository have had a tremendous impact upon the Indian equity market. Yet, their impact has only been upon convenience in trading. Today, trading technology is enormously advanced, but the ideas that underlie trading are as primitive as they were in 1992. Index futures transform the very paradigm of trading. Once a stockpicker gets used to a ``buy BSES + sell Nifty'' lifestyle, he will look back with amazement at the Jurassic markets that existed prior to June 2000, which forced him to buy Nifty every time he wanted to buy BSES.
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COMPARISON OF HEDGING
Currency options are derivative instruments, which give buyer of the option the right but not the obligation to execute a specified transaction in the underlying currency pair. It gives the buyer the flexibility to execute settlement of option or not. These are different from other derivatives like forwards and futures in a way that it provides downside protection against risk and also an upside benefit from favourable movements in the underlying exchange rates. Since the person has the right to buy or sell the foreign currency, but not the obligation, it can let the option expire by not exercising its right, in case the exchange rates move in its favour, thereby making the profits it would not have made had it hedged through currency forwards or currency futures. However, the above advantage does not come free because the above feature currency options generally cost more than other tools of hedging. The other advantage offered by options are flexibility in selecting the exchange rate at which a currency can be bought or sold unlike for forwards or futures in which there is only one exchange rate. There are two types of Currency options i.e CALL & PUT as elucidated below.
Profit/loss from an option The profit/loss arising from currency options under various circumstances are as under.
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Option Pricing Pay off from buying a Call option: It is maximum of ( 0, (Spot exchange rate Strike rate )) Pay off from buying a Put option: It is maximum of ( 0, ( Strike rate Spot exchange rate )) Premium Intrinsic and Extrinsic Value The price of buying a currency option, i.e. premium has two components namely intrinsic value and extrinsic value, which is paid upfront while executing an option transaction. Firstly, the premium includes any amount by which the option is In the Money for Call Premium = (Spot exchange rate Strike rate), and Put Premium = (Strike rate Spot exchange rate) and this is known as Intrinsic value. The second component of the premium is Extrinsic value which reflects all other factors that determine the price of an option, including time to expiration, the expected volatility of underlying currency, short term interest rates and inflation rates. Factors Influencing Option Prices Call premium = (Spot exchange rate Strike rate) Positive relationship between Call Premium & exchange rate, as exchange rate increases call premium also increases and Inverse relationship between call premium and strike rate as strike rate increases call premium decreases. Put premium = (Strike rate Spot exchange rate) There is Positive relationship between put premium and strike rate, as strike rate increases, put premium also increases. And there is inverse relationship between put premium and exchange rate, as exchange rate increases put premium decrease. Time to maturity: Call & Put options become more valuable as time to maturity increases, it is because of Risk as the time increases. Volatility: As
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volatility increases there is high degree of uncertainty about the rate of the currency and hence on the option. The owner of the call benefits from the rate increase and that of the put benefits from the rate decreases. Risk free Interest Rate: The Interest rate differential between the underlying currency pairs used to derive the FX Forward rate and therefore has an impact on the option price. As the Interest rate in the economy increases, value of Call option increases and value of Put option decreases. Treasury and Risk manager may undertake following steps before booking currency option contracts: l Calculation of Foreign exchange exposure value and period for which options covers to be taken. l Measurement of Hedge ratio and degree of risk acceptable to management. l Invitation of currency option quotes from various Banks. l Expectations and Keeping track of exchange rate movements. l Evaluation and cost benefit analys is of Currency option quotes with spot rate and forward rates. l Booking of option contracts with Bank. Need for Suitable Currency Option Hedging Strategy Indian rupee has witnessed considerable volatility against USD since beginning of this fiscal, and it has moved both ways since 2005, it appreciated to 43.10 against USD on 21st July 2005 on the day China revalued its currency and depreciated to 3 year high at 46.56 on 20th May 2006. To manage foreign exchange risks in present situation is a daunting task and calls for suitable selection of various currency options strategies combinations which when applied in the below mentioned varied market conditions will provide hedge against risk. l Bullish or Bearish market conditions l Volatility or stagnant market conditions However, in the absence of capital account convertibility and financial infrastructure availability, coupled under-developed banking and financial system and exchange control regulations and restrictions, various currency options strategies cannot be effectively and
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judiciously applied for managing risks. Currency options in India can only be booked or cancelled for genuine or contingent exposures. Banks in India are not allowed to offer option products with no underlying exposures and only European options are allowed. This restriction discourages applicability of various options combinations. The expiry date of option should not exceed the maturity of the underlying exposure. Corporate have to sign ISDA agreement with banks before undertaking option deals.
Currency option strategies for Import transactions in Bullish Market conditions forward contracts for evaluating the decision whether to cover imports by forward contracts or purchased call options: A fortune MNC in
telecommunications purchased a call option of 2 million USD for covering imports on 1st June 2006, with a expiry date on 31st August 2006. The premium on call for a 3-month duration is 20 paise. Forward contract quote for the same expiry date was spot 43.85 with a premium of 15 paise. The total cost of forward contracts is 44.00. In the Pay Off Table A when USD depreciates, purchased call options are profitable than forward contracts, because options provides downside protection against risk of opportunity loss, however when USD appreciates, purchased call options are less profitable than forward contracts Since the objective of hedging is to minimize and cover loss, it is advisable to cover imports through purchased call options. Purchased Call option: Corporate buys a USD call option for covering its import transactions from a ABN AMRO bank on 1st June 2006, at a strike rate of 45.50. The expiry date is 3 months i.e. 31st August 2006. The premium is 30 paise on the call. Gain or loss at various levels of exchange rate are demonstrated below vide pay off table and graph.
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Purchasing Call option & Selling Put Option A leading petrochemicals importer purchases USD call option from Citibank at a strike rate of 45.50, & sells USD Put option at a strike rate of 45.50. The premium paid on purchasing call option is 30 paise and received on selling Put option is 20 paise. When spot exchange rate rises above the strike price, there are gains, when it falls below the strike price there are losses, which are maximum to the extent of premium paid. Comparison of purchased call options with forward contracts for evaluating the decision whether to cover imports by forward contracts or purchased call options: A fortune MNC in telecommunications purchased a
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call option of 2 million USD for covering imports on 1st June 2006, with a expiry date on 31st August 2006. The premium on call for a 3-month duration is 20 paise. Forward contract quote for the same expiry date was spot 43.85 with a premium of 15 paise. The total cost of forward contracts is 44.00. In the Pay Off Table A when USD depreciates, purchased call options are profitable than forward contracts, because options provides downside protection against risk of opportunity loss, however when USD appreciates, purchased call options are less profitable than forward contracts Since the objective of hedging is to minimize and cover loss, it is advisable to cover imports through purchased call options. Purchasing Call option & Selling Put Option A leading petrochemicals importer purchases USD call option from Citibank at a strike rate of 45.50, & sells USD Put option at a strike rate of 45.50. The premium paid on purchasing call option is 30 paise and received on selling Put option is 20 paise. Gain or loss at various levels of exchange rate are shown through Pay Off Table A. This strategy is aggressive strategy, suited for situations when the Market is appreciating. The gains will be substantial. However, it is advisable to select
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Strike price of put option less than strike price of call option, when the market is expected to appreciate. Selling Put Option: A leading garment exporter sold Put option to bank in which USD shall be purchased at 45.50, Premium earned by selling put option is 30 paise. It is an aggressive strategy suited for situations when there is a very strong expectation for home currency to depreciate. Premium will be earned extra by selling put option. Gain or loss at various levels of exchange rate are shown above vide pay off table and graph. We can also book forward contract or purchase call option with this strategy. Currency Option strategies for Import transactions in Volatile Market conditions Long Straddle: Purchase of Call option & Put option at the same exercise rate & expiration date. A fortune MNC in consumer electronics purchased a Call option & Put option of USD at strike price of put option less than strike price of call option, when the market is expected to appreciate. Selling Put Option: A leading garment exporter sold Put option to bank in which USD shall be purchased at 45.50, Premium earned by selling put option
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is 30 paise. It is an aggressive strategy suited for situations when there is a very strong expectation for home currency to depreciate. Premium will be earned extra by selling put option. Gain or loss at various levels of exchange rate are shown above vide pay off table and graph. We can also book forward contract or purchase call option with this strategy. Currency Option strategies for Import transactions in Volatile Market conditions Long Straddle: Purchase of Call option & Put option at the same exercise rate & expiration date. A fortune MNC in consumer electronics purchased a Call option & Put option of USD at
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When market is volatile. In stagnant market there is a loss. The hedger gains when exchange rate moves in either direction. Since there are no underlying exposures to cover purchase of put option, this option product is not available with banks in India. Similarly Long Strangle and short butterfly call spreads are also not available with banks in India because of no underlying exposures to cover purchase of put options, which is a precondition. Currency Option Strategies for Export Transactions in Bearish Market Conditions
Purchased Put option: A fortune 100 office automation MNC buys a USD Put option for covering its export transactions from Citi bank on 1st June 2006, at a strike rate of 45.50. The expiry date is 3 months i.e. 31st August 2006. The premium is 30 paise on the Put. The above pay off table and graph demonstrates that on appreciation of home currency above the strike price, there are gains, when it deprecates below the strike price; there are losses, which are maximum to the extent of premium paid. Currency Options Greeks: Hedgers calculate and use range of ratios to predict the options price behavior on any change in one of the underlying factors. Delta Measures the change in option premiums for a change in the spot exchange rate. Gamma It calculates
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The sensitivity of delta, with respect to change in spot exchange rate. Theta It is a measure of option sensitivity with respect to expiration time. Vega It measures the sensitivity of the options premium with respect to volatility of underlying asset. Currency options are powerful and flexible forex risk management tool. They provide downside protection against risk and upside benefit from favourable movements in exchange rates. There are various option strategies and combinations which when applied in the volatile, stagnant, bullish, bearish market conditions, will provide hedge against risk. However, its applicability in India is still a long way to go due to exchange control restrictions, coupled with under-developed banking and financial system and financial
infrastructure availability
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RESEARCH METHODOLOGY
My research will include: 1. Primary Data: Analyst of KPOs (Knowledge Process Outsourcing) and Share Trading firms were approach & NSE 2. Secondary Data: News Papers, books, internet, Reports.
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FINDING & ANALYSIS

Findings of Primary Research
Though hedging are not an excluded category of foreign institutional investors under the SEBI (FII) Regulations, 1995 they are, however, by virtue of not being regulated by securities regulators in their place of incorporation or operations, cannot come as FII under the present provisions of SEBI (FII) Regulations. Regulation 6 (i) (b) of the FII Regulations requires an FII applicant to be a regulated entity in its place of incorporation or operations. The FII Regulations allow sub-accounts sponsored by registered FIIs to invest in India. Regulation 2 (k) defines sub-account which includes foreign corporates or foreign individuals and those institutions, established or incorporated outside India and those funds, or portfolios, established outside India, whether incorporated or not, on whose behalf investments are proposed to be made in India by a foreign institutional investor. Further, provisions of the regulation 13 lay down the conditions and procedure for granting registration to a sub-account of an FII. Hedge Funds of almost all variations can meet the requirements of sub-accounts if they are fit and proper persons. However, based on (an internal administrative decision) if an applicant indicates in the application that it is a hedge fund, the consideration of the application is withheld. Since granting of registration to FII/sub-accounts is based on the disclosure of details and on the undertaking given by the applicant in the application form, it could be possible that a few entities who described their activities in the application form in terms other than hedge funds could have already got registration as sub- accounts. However, this has led to wide spread rigging and scams in the capital market as is exemplified by the UBS Scam of May 17th, 2004. The UBS Scam has been dealt separately at a later stage. The analysts approached for, in the primary research have unanimously expressed the immediate need to abolish Regulation 6 (i) (b).
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Should Regulation 6 (i) (b) be abolished?

No-- 7.69%
Yes-- 92.31%
Yes
No
The Analysts also pointed out to the fact that Hedging should be recognized as a separate class of FIIs and allowed to invest directly in India.
Should Hedging be allowed to invest directly in India?
No-- 15.38%
Yes-- 84.62%
Yes
No
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Direct investment by Hedge Fund will infuse the much needed transparency and accountability into the capital market. It was further stated by the analysts that direct investment by Hedge Fund would also help to contain the volatility of the stock market, witnessed frequently in recent times.
Can the current volatility witnessed in the stock market be attributed to Hedging?
Average Contribution 7.69%
Large Contribution 92.31%
Large Contribution
Average Contribution
The sole cause of the present volatility experienced in the stock market is because a large extent of foreign Hedge Funds operates in India through wrapper instrument like Participatory Notes, since they are not legally allowed to invest directly in India. According to the analysts, this practice must be done away with, as they feel that PNs have been instrumental in the stock market collapse of May, 2004. PNs were also held responsible for the stock market crash of 2000. The Joint Parliamentary Committee (JPC) on the stock scam of 2000, in which the broker Ketan Parekh was the kingpin, had reported that Indian businesses had been trading in their own shares through the vehicle of overseas corporate bodies (OCBs) set up in Mauritius, who invested heavily in PNs. By definition, OCBs include overseas companies, partnership firms, trusts, societies and other corporate bodies owned either directly or indirectly to the extent of at least 60 per cent by NRIs. These private outfits are virtually unregulated either by Indian authorities or by authorities of the foreign lands where they are registered. Some of these
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OCBs were used to funnel anonymous funds parked abroad back into the stock market ultimately leading to the crash of 2000.
Extent to which Foreign Hedge Funds operate in India via Participatory Notes
Minimum Extent 7.69%
Average Contribution 23.08%
Large Contribution 69.23%
Maxim um Extent (70% & above)
Average ( 50% - 70%)
Minim um Extent (Below 50%)
All the respondents opined that that Participatory notes should be banned since it is having a destabilizing effect in Indias economic fundamentals.
Should Participatory Notes be banned?

No -- 0%
Yes -- 100%
Yes
No
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SEBI to keep our market safe from manipulation has included several checks and balances. The SEBI (Foreign Institutional Investors) Regulations Act, 1995 also lays down scrip-wise and fund wise maximum limits a fund can invest. Further, through circular No. SMD/DC/CIR-11/02 dated February 12, 2002 and SEBI/DNAD/CIR-21/2004/03/09 dated March 9, 2004 issued by Secondary Market Department, position limits for investment by FIIs in derivatives have been advised. These limits will help diversify the foreign hedge fund investments and will help in jettisoning concentration in any specific scrip. The provisions of Chapter III (Regulation 15 (3) (a)) disallows short selling by FIIs and stipulates that all trades by FIIs are delivery based. However the respondents feel that this provision should be done away it since it will encourage FIIs to pump in more money, Improve long run relation between the spot and derivatives market, ultimately leading to development of the derivatives market, Enable Mutual Funds to hedge against risk.
But concerns have also been expressed by some of the respondents as they feel that it may lead to increased speculation in the derivatives market.
Should Short Selling be allowed?
No-- 7.69%
Yes-- 92.31%
Yes
No
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Chapter II of the SEBI (Foreign Institutional Investors) Regulations, 1995 interalia list out the instruments in which an FII/sub-account can invest. The regulation does not include currency or commodities as eligible instruments for investment for the FIIs. Therefore, currency trading or investment in commodity related financial products will not be an option for any hedge funds under the present FII Regulations. But the respondents feel that Hedge Funds should be allowed to invest in the Currency and Commodities market since this will be instrumental in development of our Commodities market, which is lagging far behind.
Should Hedge Funds be allowed to invest in Currency and Commodities?

No-- 7.69%
Yes-- 92.31%
Yes
No
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CONCLUSION
The advent of Hedging in the Indian market can be viewed as a sign of the domestic market's realignment with the global market. During the second half of 2008, emerging markets, including India, were the favorite destination for Hedging. These funds also delivered much higher returns on emerging market portfolios compared to the returns on their average global portfolio. However, they were also charged with playing a role in the 1997-98 Asian crisis. It is believed that their forward sales of the Thai baht occurred well after Thai firms and global banks had bet that the baht would collapse. But the eventual spread of the malaise to other currencies like the Indonesian rupiah caught Hedging unawares. Having learnt their lesson, some of the developing countries drafted stringent policy guidelines. In 1998, the Malaysian government came up with a guideline that required portfolio investment funds to remain in the country for a year. Another fact that must be taken into account is the likely impact these funds will have on other institutional investors in the market. With the entry of these fast-moving funds into the market, other institutional players might be forced to realign their investment style to a shorter duration. They might be constrained to keep booking profits regularly due to the fear of a sudden selloff by Hedging. This, in turn, will boost speculative trading. Furthermore, in order to match the very high returns generated by these funds some of the institutional players may adopt a high risk-high reward strategy. The worry here is that they may not yet have adequate expertise and experience compared to Hedging. In India, a common opinion is that Hedging might bring in too much volatility in the market. Due to globalization and economic liberalization, many developing countries have experienced financial turbulence caused by the operations of such big market players. Hedging have been able to cause swings in values and prices of currencies, stocks and interest rates.
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The real worry of regulators the world over regarding Hedging has been that they tend to increase market volatility. And, occasionally, they have caused entire economies to crack under the weight of their selling. It is believed that one fifth of the huge FII investments witnessed in the Indian capital market in 2002 was 'hot money' (read Hedging). This might have contributed to the phenomenal rise in domestic indices between March 2006 and December 2008 and the unprecedented fall on Black Monday. In short, Hedging are a double-edged sword as they are momentum players who escalate the possibility of a financial crisis. However, one of the pluses of Hedging is that they provide a lot of liquidity to the market, and thus enhance the price discovery mechanism at the bourses. While their operations do result in unlocking the potential value of stocks, it is normally only in the short term. On the flip side, they also cause steep dips in prices, whenever they exit the markets, shaking sentiment badly. Also, the activities, modus operandi and even the identities of these players are kept a secret. So, is there any advantage in allowing Hedging to participate in the Indian stock market? In an open market system like ours one can't wish away Hedging. They have an appointed role in a free market. A section of analysts also points to the revenue potential these funds hold out to the illogical, lopsided and perpetually cash-strapped Indian tax system. Because Hedging managers buy and sell so frequently, investors incur high capital gains, which are normally taxed at the maximum marginal income tax rate. Hedging managers disregard benchmarks. Instead, they aim for absolute returns - in most cases a certain percentage return, year in and year out, regardless of how well the market does. Also, since Hedgings do not track the market on a pin-point basis and undertake high-speed entries and exits, they guard the investor's portfolio from the vagaries of market trends. At the same time, as several successful Hedging have demonstrated, they can also generate very high returns. A prime example is the multi-billion-dollar Quantum Fund managed by George Soros.
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While one may need to realign one's investment strategy to take cognizance of the presence of Hedging in the market, the bottom-line is that there is no escaping them.
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RECOMMENDATION
The following suggestions have been arrived at, after thorough discussions with the respondents who are analysts of well known firms and also from the research materials provided by them. 1. The investment adviser to the Hedging should be a regulated investment advisor under the relevant Investor Advisor Act or the fund is registered under Collective Investment Fund Regulations or Investment Companies Act. 2. At least 20% of the corpus of the fund should be contributed by the investors such as pension funds, university funds, charitable trusts or societies, endowments, banks and insurance companies. The presence of institutional investors in the fund is expected to ensure better governance on the part of the fund manager and fund administrators. Further, institutional investors may help fund managers to take a long term perspective of the market. 3. The fund should be a broad based fund in terms of the SEBI (Foreign Institutional Investors) Regulations, particularly in terms of the explanation to Regulation 6 (1) (d). 4. The fund manager or investment adviser must have experience of at least three years of managing funds with similar investment strategy that the applicant fund has adopted. This provision is expected to allow well managed funds to access our market and at the same time, keep our markets insulated from the possible adverse effects of trial and errors by uninitiated rookies. 5. Regulation 6 (i) (b) of the SEBI (FII) Regulation Act, 1995, which requires a FII entity to be regulated entity in its place of incorporation or operation to be recognized as a FII in India should be amended so that Hedging are recognized as a separate class of FII. 6. The provisions of Chapter III (Regulation 15 (3) (a)) disallows short selling by FIIs and stipulates that all trades by FIIs are delivery based. This provision should be amended and which will improve the long run
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relationship between the spot and derivatives market. In this respect SEBI may pull a leaf from SECs book and permit short selling based on the up tick rule.
7. Participatory notes should be done away with and Hedging should be allowed to invest directly in India. 8. Amendments needs to be done in respect of Chapter II of the SEBI (FII) Regulation, 1995 which does not allow FIIs to invest in Currency or Commodities since this will improve the price discovery mechanism of our undeveloped Commodities market.
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BIBLIOGRAPHY
1. Newspaper a. Economic Times b. Business Standard c. Business Line
2. Magazine Business World (Issue: 25th July, 2005)
3. Research Reports a. Research report by UBS Warburg b. Report by Pictet Fund c. Report of The Presidents Working Group on Financial Markets on LTCM (April 1999) d. Report of Pricewaterhouse Coopers on the regulation and distribution of Hedge Fund in Europe. (May 2003) e. Hedge Fund Performance Evaluation: Macro-factor model vs Option-based model Applied to Market Neutral and Long/Short Index Strategies by Leila ZAIRI & Nikoletta SIDERI. f. A Primer on Hedge Funds by William Fung and David A. Hsieh g. Hedge Fund Style Allocation A Risk Adjusted Fund of Hedge Funds Perspective by Patrik Adlersson and Patrik Blomdahl h. DEMOCRATIZING THE HEDGE FUND: Considering the Advent of Retail Hedge Funds by Donald E. Lacey, Jr.
4. Websites a. Invetopedia.com b. Eurekahedge.com c. Economictimes.com d. Vanguard.com e. Hedgeco.net
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THE INDIAN INSTITUTE OF PLANNING AND MANAGEMENT NEW DELHI

SUBMITTED TO: PROF. SUMANTA SHARMA MR. VIJAY KUMAR BODDU

UNDER THE GUIDANCE OF: ALOK SHYAMSUKHA

SUBMITTED BY: SAURABH SHYAMSUKHA ALUMNI ID NUMBER: DF68-F079 BATCH: SS/06-08

Alumni ID: DF68-F079

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TOPIC APPROVAL LETTER

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APPROVED THESIS SYNOPSIS

Desired Area of Research: Finance

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Indian Hedging Industry

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Alumni ID: DF68-F079

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STRATEGIES OF HEDGE FUNDS

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Figure 1 : Breakdown of Hedge Fund investment strategies

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HEDGING WITH FUTURE & OPTION

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Alumni ID: DF68-F079

Alumni ID: DF68-F079