Project Complete Document

A STUDY ON THE EFFECTIVENESS OF FINANCIAL DERIVATIVES AS A RISK DIVERSIFICATION AND PROFIT MAXIMIZATION TOOL

“A STUDY ON THE EFFECTIVENESS OF FINANCIAL DERIVATIVES AS A RISK DIVERSIFICATION AND PROFIT

MAXIMIZATION TOOL”

AT

HEDGE EQUITIES, COCHIN

A project report submitted to the University of Kerala

For the partial fulfillment of the award of the degree of

Master of Business Administration

Submitted By

GOKUL VT

Reg. No: 11811020

Under the guidance of

Prof Dr. K Govindankutty

Professor, MSNIMT, Chavara

MEMBER SREE NARAYANA PILLAI INSTITUTE OF MANAGEMENT AND TECHNOLOGY

(Approved by AICTE and Affiliated to the University of Kerala)

Mukundapuram P.O,Chavara,Kollam-691585,Kerala

2011 – 2013

1MSN Institute of Management and Technology, Chavara,. Kollam


CHAPTER 1

INTRODUCTION TO THE STUDY



INTRODUCTION

Derivative contract is a contract whose value is determined by the changes in the

value of underlying asset. Underlying assets include stocks, bonds, commodities,

currencies, interest rates and market indices. Hedgers are the investors who use

derivatives as a hedging tool to reduce their future risk. Hedge is an investment

made in order to reduce the risk of adverse price movements in a security by

taking an offsetting position in a related security.

In this study, we use derivative futures and options to diversify the risk and

maximize the profit from the investment. A future is defined as a standardized

contract to buy or sell a specified commodity of standardized quality at a certain

date in future and at a determined future price. The party agreeing to buy the

underlying asset in future is said to have taken a long position and the party who

agrees to sell the underlying in future is said to have taken a short position.

In finance, an option is a contract which gives the owner the right, but not the

obligation, to buy or sell an underlying asset or instrument at a specified strike

price on or before a specified date. The seller incurs a corresponding obligation to

fulfill the transaction, which is to sell or buy, if the long holder elects to "exercise"

the option prior to expiration. The buyer pays a premium to the seller for this

right. An option which conveys the right to buy something at a specific price is

called a call; an option which conveys the right to sell something at a specific

price is called a put. Both are commonly traded, though in basic finance for clarity

the call option is more frequently discussed, as it moves in the same direction as

the underlying asset, rather than opposite, as does the put.



1.1. BACKGROUND OF THE PROBLEM

The project aims to analyse the effectiveness of using financial derivatives as a

risk diverisification and profit maximization tool. Derivatives such as futures and

options are used to diversify risk and maximize profit of a portfolio. Here we

consider Nifty Index futures and options for the study.

Investing in securities such as shares, debentures and bonds is profitable as well as

existing. It is indeed rewarding, but involves a great deal of risk and calls for

scientific as well as artistic skill. In such investment both rational as well as

emotional responses are involved. Investing in financial securities is now

considered to be one of the most risky avenues of investments.

It is rare to investors investing their savings in a single security. Instead they tend

to invest in a group of securities. Such a group of securities is called as Portfolio.

Creation of a portfolio helps to reduce risk without sacrificing returns.

Portfolio management deals with the analysis of individual securities as well as

with the theory and practice of optimally combining securities into portfolios. An

investor who understands the fundamental principles and analytical aspects of

portfolio management has a better chance of success. An investor considering

investments in securities is faced with the problem of choosing from among a

large number of securities. His choice depends upon the risk returns

characteristics of individual securities. He would attempt to choose the most

desirable securities and like to allocate his funds over this group of securities.

Again he is faced with the problem of deciding which securities to hold and how

much to invest in each. The investor faces an infinite number of possible

portfolios differ from those of individual securities combining to form a portfolio.

The investor tries to choose the optimal portfolio taking into consideration the risk

return characteristics of all possible portfolios.

An investor invests his funds in a portfolio expecting to get a good return

consistent with the risk that has to be bear. The return realized from the portfolio

has to be measured and the performance of the portfolio has to be evaluated. It is



evident that rational investment activity involves creation of an investment

portfolio.

Portfolio management comprises all the process involved in the creation and

maintenance of an investment portfolio. It deals specially with security analysis,

portfolio analysis, portfolio selection, portfolio revision and portfolio evaluation it

also make use of analytical techniques of analysis and conceptual theories

regarding rational allocation of funds. Portfolio management is a complex process

which tries to make investment activity more rewarding less risky.

A portfolio is a group of securities held together as investment. Investors invest

their funds in a portfolio of securities rather than in a single security because they

are risk averse. By constructing a portfolio, investor attempts to spread risk by not

putting all their eggs in to one basket. Thus diversification of one’s holdings is

intended to reduce risk in investment.



1.2 INTRODUCTION TO THE INDUSTRY

Financial services

Financial services are the economic services provided by the finance industry,

which encompasses a broad range of organizations that manage money, including

credit unions, banks, credit card companies, insurance companies, consumer

finance companies, stock brokerages, investment funds and some government

sponsored enterprises.

The Indian financial services industry is characterized by increasingly vibrant

public- and private-sector institutions. As the common Indian acronym BFSI,

which stands for “banking and financial services industry,” indicates, the banking

sector has historically dominated the industry. But other sectors have made

significant gains as well. Though the industry continues to be dominated by

public-sector institutions, particularly in insurance and asset management, there is

a growing list of private enterprises, competing fiercely both among themselves

and with the public entities.

Recent economic growth has given rise to a growing consumer middle class

—”Middle India”—with a strong credit culture and increasing financial

sophistication. Many of the goods and services these newly affluent consumers

seek—such as autos, housing, and retirement planning—indicate a significant role

for financial services. On the institutional side, as Indian companies continue to

grow and globalize they will likely require increasingly sophisticated services

from the industry.

Strong demand from consumers and businesses drove India’s growth over the last

two decades and are expected to continue to set the pace in the future.

Asset management - the term usually given to describe companies which

run collective investment funds. Also refers to services provided by others,

generally registered with the Securities and Exchange Commission as

Registered Investment Advisors.

Hedge fund management - Hedge funds often employ the services of

"prime brokerage" divisions at major investment banks to execute their

trades.



Custody services - the safe-keeping and processing of the world's

securities trades and servicing the associated portfolios. Assets under

custody in the world are approximately US$100 trillion.

Intermediation or advisory services - These services involve stock

brokers (private client services) and discount brokers. Stock brokers assist

investors in buying or selling shares. Primarily internet-based companies

are often referred to as discount brokerages, although many now have

branch offices to assist clients. These brokerages primarily target

individual investors. Full service and private client firms primarily assist

and execute trades for clients with large amounts of capital to invest, such

as large companies, wealthy individuals, and investment management

funds.

Private equity - Private equity funds are typically closed-end funds,

which usually take controlling equity stakes in businesses that are either

private, or taken private once acquired. Private equity funds often use

leveraged buyouts (LBOs) to acquire the firms in which they invest. The

most successful private equity funds can generate returns significantly

higher than provided by the equity markets

Venture capital is a type of private equity capital typically provided by

professional, outside investors to new, high-potential-growth companies in

the interest of taking the company to an IPO or trade sale of the business.

Angel investment - An angel investor or angel (known as a business angel

or informal investor in Europe), is an affluent individual who provides

capital for a business start-up, usually in exchange for convertible debt or

ownership equity. A small but increasing number of angel investors

organize themselves into angel groups or angel networks to share research

and pool their investment capital.

Conglomerates - A financial services conglomerate is a financial services

firm that is active in more than one sector of the financial services market

e.g. life insurance, general insurance, health insurance, asset management,

retail banking, wholesale banking, investment banking, etc. A key

rationale for the existence of such businesses is the existence of

diversification benefits that are present when different types of businesses

are aggregated i.e. bad things don't always happen at the same time. As a



consequence, economic capital for a conglomerate is usually substantially

less than economic capital is for the sum of its parts.

Debt resolution is a consumer service that assists individuals that have too

much debt to pay off as requested, but do not want to file bankruptcy and

wish to pay off their debts owed. This debt can be accrued in various ways

including but not limited to personal loans, credit cards or in some cases

merchant accounts. There are many services/companies that can assist with

this.

Money market

As money became a commodity, the money market became a component of the

financial markets for assets involved in short-term borrowing, lending, buying and

selling with original maturities of one year or less. Trading in the money markets

is done over the counter, is wholesale. Various instruments exist, such as Treasury

bills, commercial paper, bankers' acceptances, deposits, certificates of deposit,

bills of exchange, repurchase agreements, federal funds, and short-lived

mortgage-, and asset-backed securities. It provides liquidity funding for the global

financial system. Money markets and capital markets are parts of financial

markets. The instruments bear differing maturities, currencies, credit risks, and

structure. Therefore they may be used to distribute the exposure.

Participants

The money market consists of financial institutions and dealers in money or credit

who wish to either borrow or lend. Participants borrow and lend for short periods

of time, typically up to thirteen months. Money market trades in short-term

financial instruments commonly called "paper." This contrasts with the capital

market for longer-term funding, which is supplied by bonds and equity.

The core of the money market consists of interbank lending--banks borrowing and

lending to each other using commercial paper, repurchase agreements and similar

instruments. These instruments are often benchmarked to (i.e. priced by reference

to) the London Interbank Offered Rate (LIBOR) for the appropriate term and

currency.

Finance companies typically fund themselves by issuing large amounts of asset-

backed commercial paper (ABCP) which is secured by the pledge of eligible

assets into an ABCP conduit. Examples of eligible assets include auto loans, credit



card receivables, residential/commercial mortgage loans, mortgage-backed

securities and similar financial assets. Certain large corporations with strong credit

ratings, such as General Electric, issue commercial paper on their own credit.

Other large corporations arrange for banks to issue commercial paper on their

behalf via commercial paper lines.

Functions of the money market

The money market functions are

transfer of large sums of money

transfer from parties with surplus funds to parties with a deficit

allow governments to raise funds

help to implement monetary policy

determine short-term interest rates

Common money market instruments

Certificate of deposit - Time deposit, commonly offered to consumers by

banks, thrift institutions, and credit unions.

Repurchase agreements - Short-term loans—normally for less than two

weeks and frequently for one day—arranged by selling securities to an

investor with an agreement to repurchase them at a fixed price on a fixed

date.

Commercial paper - short term usanse promissory notes issued by

company at discount to face value and redeemed at face value

Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank

branch located outside the United States.

Federal agency short-term securities - (in the U.S.). Short-term securities

issued by government sponsored enterprises such as the Farm Credit

System, the Federal Home Loan Banks and the Federal National Mortgage

Association.

Federal funds - (in the U.S.). Interest-bearing deposits held by banks and

other depository institutions at the Federal Reserve; these are immediately

available funds that institutions borrow or lend, usually on an overnight

basis. They are lent for the federal funds rate.

Municipal notes - (in the U.S.). Short-term notes issued by municipalities

in anticipation of tax receipts or other revenues.



Treasury bills - Short-term debt obligations of a national government that

are issued to mature in three to twelve months.

Money funds - Pooled short maturity, high quality investments which buy

money market securities on behalf of retail or institutional investors.

Foreign Exchange Swaps - Exchanging a set of currencies in spot date and

the reversal of the exchange of currencies at a predetermined time in the

future.

Short-lived mortgage- and asset-backed securities

Discount and accrual instruments

There are two types of instruments in the fixed income market that pay the interest

at maturity, instead of paying it as coupons. Discount instruments, like

repurchase agreements, are issued at a discount of the face value, and their

maturity value is the face value. Accrual instruments are issued at the face value

and mature at the face value plus interest.

Stock Markets:

Stock Market is a market where the trading of company stock, both listed

securities and unlisted takes place. It is different from stock exchange because it

includes all the national stock exchanges of the country. For example, we use the

term, "the stock market was up today" or "the stock market bubble."

Stock Exchanges:

Stock Exchanges are an organized marketplace, either corporation or mutual

organization, where members of the organization gather to trade company stocks

or other securities. The members may act either as agents for their customers, or

as principals for their own accounts. Stock exchanges also facilitates for the issue

and redemption of securities and other financial instruments including the

payment of income and dividends. The record keeping is central but trade is

linked to such physical place because modern markets are computerized. The

trade on an exchange is only by members and stock broker do have a seat on the

exchange.



History of the Indian Stock Market - The Origin

One of the oldest stock markets in Asia, the Indian Stock Markets has a 200 years

old history.

It dates back to the close of 18th century when the East India Company used to

transact loan securities. In the 1830s, trading on corporate stocks and shares in

Bank and Cotton presses took place in Bombay. Though the trading was broad but

the brokers were hardly half dozen during 1840 and 1850.

An informal group of 22 stockbrokers began trading under a banyan tree opposite

the Town Hall of Bombay from the mid-1850s, each investing a (then) princely

amount of Rupee 1. This banyan tree still stands in the Horniman Circle Park,

Mumbai. In 1860, the exchange flourished with 60 brokers. In fact the 'Share

Mania' in India began with the American Civil War broke and the cotton supply

from the US to Europe stopped. Further the brokers increased to 250. The

informal group of stockbrokers organized themselves as the The Native Share and

Stockbrokers Association which, in 1875, was formally organized as the Bombay

Stock Exchange (BSE).

BSE was shifted to an old building near the Town Hall. In 1928, the plot of land

on which the BSE building now stands (at the intersection of Dalal Street,

Bombay Samachar Marg and Hammam Street in downtown Mumbai) was

acquired, and a building was constructed and occupied in 1930.

Premchand Roychand was a leading stockbroker of that time, and he assisted in

setting out traditions, conventions, and procedures for the trading of stocks at

Bombay Stock Exchange and they are still being followed.

Several stock broking firms in Mumbai were family run enterprises, and were

named after the heads of the family.

The following is the list of some of the initial members of the exchange, and who

are still running their respective business:

D.S. Prabhudas & Company (now known as DSP, and a joint venture

partner with Merrill Lynch)

Jamnadas Morarjee (now known as JM)

Champaklal Devidas (now called Cifco Finance)

Brijmohan Laxminarayan



In 1956, the Government of India recognized the Bombay Stock Exchange as the

first stock exchange in the country under the Securities Contracts (Regulation)

Act.

The most decisive period in the history of the BSE took place after 1992. In the

aftermath of a major scandal with market manipulation involving a BSE member

named Harshad Mehta, BSE responded to calls for reform with intransigence. The

foot-dragging by the BSE helped radicalise the position of the government, which

encouraged the creation of the National Stock Exchange (NSE), which created an

electronic marketplace. NSE started trading on 4 November 1994. Within less

than a year, NSE turnover exceeded the BSE. BSE rapidly automated, but it never

caught up with NSE spot market turnover. The second strategic failure at BSE

came in the following two years. NSE embarked on the launch of equity

derivatives trading. BSE responded by political effort, with a friendly SEBI

chairman (D. R. Mehta) aimed at blocking equity derivatives trading. The BSE

and D. R. Mehta succeeded in delaying the onset of equity derivatives trading by

roughly five years. But this trading, and the accompanying shift of the spot market

to rolling settlement, did come along in 2000 and 2001 - helped by another major

scandal at BSE involving the then President Mr. Anand Rathi. NSE scored nearly

100% market share in the runaway success of equity derivatives trading, thus

consigning BSE into clearly second place. Today, NSE has roughly 66% of equity

spot turnover and roughly 100% of equity derivatives turnover.

CAPITAL MARKET:

The capital market is the market for securities, where companies and the

government can raise long-term funds. The capital market includes the stock

market and the bond market. The capital markets consist of the primary

market, where new issues are distributed to investors, and the secondary market,

where existing securities are traded.

Primary market

The primary market is that part of the capital markets that deals with the

issuance of new securities. Companies, governments or public sector institutions


http://en.wikipedia.org/wiki/Secondary_market

http://en.wikipedia.org/wiki/Primary_market

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http://en.wikipedia.org/wiki/Bond_market

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http://en.wikipedia.org/wiki/Corporation

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can obtain bonds through the sale of a new stock or bond issue. This is typically

done through a syndicate of securities dealers. The process of selling new issues to

investors is called underwriting. In the case of a new stock issue this sale is an

Initial Public Offering (IPO). Dealers earn a commission that is built into the price

of the security offering, though it can be found in the prospectus. Primary markets

create long term instruments through which corporate entities borrow from capital

market.

Features of primary markets are:

This is the market for new long term equity capital. The primary market is

the market where the securities are sold for the first time. Therefore it is

also called the new issue market (NIM).

In a primary issue, the securities are issued by the company directly to

investors.

The company receives the money and issues new security certificates to

the investors.

Primary issues are used by companies for the purpose of setting up new

business or for expanding or modernizing the existing business.

The primary market performs the crucial function of facilitating capital

formation in the economy.

The new issue market does not include certain other sources of new long

term external finance, such as loans from financial institutions. Borrowers

in the new issue market may be raising capital for converting private

capital into public capital; this is known as "going public."

The financial assets sold can only be redeemed by the original holder.

Methods of issuing securities in the primary market are:

Public issuance, including initial public offering;

Rights issue(for existing companies);

Preferential issue.



Secondary Market

The secondary market, also called aftermarket, is the financial market in which

previously issued financial instruments such as stock, bonds, options, and futures

are bought and sold. Another frequent usage of "secondary market" is to refer to

loans which are sold by a mortgage bank to investors such as Fannie Mae and

Freddie Mac. The term "secondary market" is also used to refer to the market for

any used goods or assets, or an alternative use for an existing product or asset

where the customer base is the second market (for example, corn has been

traditionally used primarily for food production and feedstock, but a "second" or

"third" market has developed for use in ethanol production).

With primary issuances of securities or financial instruments, or the primary

market, investors purchase these securities directly from issuers such as

corporations issuing shares in an IPO or private placement, or directly from the

federal government in the case of treasuries. After the initial issuance, investors

can purchase from other investors in the secondary market.

The secondary market for a variety of assets can vary from loans to stocks, from

fragmented to centralized, and from illiquid to very liquid. The major stock

exchanges are the most visible example of liquid secondary markets - in this case,

for stocks of publicly traded companies. Most bonds and structured products trade

“over the counter,” or by phoning the bond desk of one’s broker-dealer. Loans

sometimes trade online using a Loan Exchange.

Function

In the secondary market, securities are sold by and transferred from one investor

or speculator to another. It is therefore important that the secondary market be

highly liquid (originally, the only way to create this liquidity was for investors and

speculators to meet at a fixed place regularly; this is how stock exchanges

originated. As a general rule, the greater the number of investors that participate in

a given marketplace, and the greater the centralization of that marketplace, the

more liquid the market.

Fundamentally, secondary markets mesh the investor's preference for liquidity

(i.e., the investor's desire not to tie up his or her money for a long period of time,

in case the investor needs it to deal with unforeseen circumstances) with the



capital user's preference to be able to use the capital for an extended period of

time.

Accurate share price allocates scarce capital more efficiently when new projects

are financed through a new primary market offering, but accuracy may also matter

in the secondary market because:

1) price accuracy can reduce the agency costs of management, and make hostile

takeover a less risky proposition and thus move capital into the hands of better

managers, and

2) accurate share price aids the efficient allocation of debt finance whether debt

offerings or institutional borrowing.

SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI):

Securities and Exchange Board of India (SEBI) is an autonomous body created by

the Government of India in 1988 and given statutory form in 1992 with the

SEBI Act 1992. Its head office is in Mumbai, and has regional offices in

Chennai, Kolkata and Delhi. SEBI is the regulator of Securities markets in India.

FUNCTIONS OF SEBI:

Regulating the business in stock exchanges and any other securities market.

Registering and regulating the working of collective investment schemes

including mutual funds.

Promoting and regulating self-regulatory organisations.

Prohibiting fraudulent and unfair trade practices in the securities market.

Promoting investors education and training of intermediaries in securities market.

Prohibiting insiders trading in securities.

Regulating substantial acquisition of shares and take-over of companies.

OBJECTIVES OF SEBI:

The promulgation of the SEBI ordinance in the parliament gave statutory status to

SEBI in 1992. According to the preamble of the SEBI, the three main objectives

are: -


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To protect the interests of the investors in securities.

To promote the development of securities market.

To regulate the securities market.

SALIENT FEATURES OF SEBI:

The SEBI shall be a body corporate by the name having perpetual succession and

a common seal with power to acquire, hold and dispose of property, both movable

and immovable, and to contract, and shall, by the said name, sue or by sued.

The Head Office of the Board shall be at Bombay. The Board may

establish offices at other places in India. In Bombay, the Board is situated

at Mittal Court, B-Wing, 224, Nariman Point, Bombay-400 021.

The Chairman and the Members of the Board are appointed by the Central

Government.

The general superintendence, direction and management of the affairs of

the Board are in a Board of Members, which may exercise all powers and

do all acts and things which may be exercised or done by that Board.

The Government can prescribe terms of office and other conditions of

service of the Chairman and Members of the Board. The members can be

removed under section 6 of the SEBI Act under specified circumstances.

It is primary duty of the Board to protect the interest of the investor in

securities and to promote the development of and to regulate the securities

market by such measures, as it thinks fit.

BOMBAY STOCK EXCHANGE:

The Stock Exchange, Mumbai, Popularly known as "Bombay Stock Exchange"

(BSE) was established in 1875 as "The Native Share and Stock Brokers

Association", as a voluntary non-profit making association. It has evolved over the

years into its present status as the premier Stock Exchange in the country. It may

be noted that the Bombay Stock Exchange is the oldest one in Asia, even older

than the Tokyo Stock Exchange, which was founded in 1878.



The Bombay Stock Exchange, while providing an efficient and transparent market

for trading in securities, upholds the interests of the investors and ensures

redressed of their grievances, whether against the companies or its own member-

brokers. It also strives to educate and enlighten the investors by making available

necessary informative inputs and conducting investor education program.

A Governing Board having 20 directors is the apex body, which decides the

policies and regulates the affairs of the Exchange. The Governing Board consists

of 9 elected directors, who are from the broking community (one third of them

retire every year by rotation), three SEBI nominees, six public representatives and

an Executive Director & Chief Executive Officer and a Chief Operating Officer.

The Executive Director as the Chief Executive Officer is responsible for the day-

to-day administration of the Exchange and he is assisted by the Chief Operating

Officer and other Heads of Department. The Exchange has inserted new Rule in

its Rules, Bye-laws & Regulations pertaining to constitution of the Executive

Committee of the Exchange. Accordingly, an Executive Committee, consisting of

three elected directors, three SEBI nominees or public representatives, Executive

Director & CEO and Chief Operating Officer has been constituted. The

Committee considers judicial & quasi matters in which the Governing Board has

powers as an Appellate Authority, matters regarding annulment of transactions,

admission, continuance and suspension of member-brokers, declaration of a

member-broker as defaulter, norms, procedures and other matters relating to

arbitration, fees, deposits, margins and other monies payable by the member-

brokers to the Exchange, etc.

SENSEX:

The sensitive index has long been known as the barometer of the daily

temperature of Indian bourses. In 1978-79 stock market contained only private

sector companies and they were mostly geared to commodity production.

SENSEX is a "Market Capitalization-Weighted" index of 30 stocks representing a

sample of large, well-established and financially sound companies. SENSEX is



considered to be the pulse of the Indian stock markets. SENSEX is widely used to

describe the mood in the Indian Stock markets.

Source: Sensex fact sheet Dec 2012, http://www.bseindia.com

NATIONAL STOCK EXCHANGE:

The National Stock Exchange (NSE) is India's leading stock exchange covering

364 cities and towns across the country. NSE was set up by leading institutions to

provide a modern, fully automated screen-based trading system with national

reach. The Exchange has brought about unparalleled transparency, speed &

efficiency, safety and market integrity. It has set up facilities that serve as a model

for the securities industry in terms of systems, practices and procedures.

NSE has played a catalytic role in reforming the Indian securities market in terms

of microstructure, market practices and trading volumes. The market today uses

state-of-art information technology to provide an efficient and transparent trading,

clearing and settlement mechanism, and has witnessed several innovations in

products & services viz. demutualisation of stock exchange governance, screen

based trading, compression of settlement cycles, dematerialisation and electronic

transfer of securities, securities lending and borrowing, professionalisation of

trading members, fine-tuned risk management systems, emergence of clearing

corporations to assume counterparty risks, market of debt and derivative

instruments and intensive use of information technology. The National Stock

Exchange of India Limited has genesis in the report of the High Powered Study

Group on Establishment of New Stock Exchanges, which recommended



promotion of a National Stock Exchange by financial institutions (FIs) to provide

access to investors from all across the country on an equal footing. Based on the

recommendations, NSE was promoted by leading Financial Institutions at the

behest of the Government of India and was incorporated in November 1992 as a

tax-paying company unlike other stock exchanges in the country. On its

recognition as a stock exchange under the Securities Contracts (Regulation) Act,

1956 in April 1993, NSE commenced operations in the Wholesale Debt Market

(WDM) segment in June 1994. The Capital Market (Equities) segment

commenced operations in November 1994 and operations in Derivatives segment

commenced in June 2000. NSE's mission is setting the agenda for change in the

securities markets in India. The NSE was set-up with the following objectives:

establishing a nation-wide trading facility for equities, debt instruments

and hybrids,

ensuring equal access to investors all over the country through an

appropriate communication network,

providing a fair, efficient and transparent securities market to investors

using electronic trading systems,

enabling shorter settlement cycles and book entry settlements systems, and

Meeting the current international standards of securities markets.

The standards set by NSE in terms of market practices and technologies have

become industry benchmarks and are being emulated by other market participants.

NSE is more than a mere market facilitator. It's that force which is guiding the

industry towards new horizons and greater opportunities. Till the advent of NSE,

an investor wanting to transact in a security not traded on the nearest exchange

had to route orders through a series of correspondent brokers to the appropriate

exchange. This resulted in a great deal of uncertainty and high transaction costs.

One of the objectives of NSE was to provide a nationwide trading facility and to

enable investors spread all over the country to have an equal access to NSE. NSE

has made it possible for an investor to access the same market and order book,

irrespective of location, at the same price and at the same cost. NSE uses

sophisticated telecommunication technology through which members can trade



remotely from their offices located in any part of the country. NSE trading

terminals are present in 363 cities and towns all over India. NSE has been

promoted by leading financial institutions, banks, insurance companies and other

financial intermediaries NSE is one of the first demutualised stock exchanges in

the country, where the ownership and management of the Exchange is completely

divorced from the right to trade on it. Though the impetus for its establishment

came from policy makers in the country, it has been set up as a public limited

company, owned by the leading institutional investors in the country.

From day one, NSE has adopted the form of a demutualised exchange - the

ownership, management and trading is in the hands of three different sets of

people. NSE is owned by a set of leading financial institutions, banks, insurance

companies and other financial intermediaries and is managed by professionals,

who do not directly or indirectly trade on the Exchange. This has completely

eliminated any conflict of interest and helped NSE in aggressively pursuing

policies and practices within a public interest framework. The NSE model

however, does not preclude, but in fact accommodates involvement, support and

contribution of trading members in a variety of ways. Its Board comprises of

senior executives from promoter institutions, eminent professionals in the fields of

law, economics, accountancy, finance, taxation, etc, public representatives,

nominees of SEBI and one full time executive of the Exchange. While the Board

deals with broad policy issues, decisions relating to market operations are

delegated by the Board to various committees constituted by it. Such committees

include representatives from trading members, professionals, the public and the

management. The day-to-day management of the Exchange is delegated to the

Managing Director who is supported by a team of professional staff.

NIFTY:

The Nifty is relatively a new comer in the Indian market. S&P CNX Nifty is a 50

stock index accounting for 23 sectors of the economy. S&P CNX Nifty is owned

and managed by India Index Services and Products Ltd. (IISL), which is a joint

venture between NSE and CRISIL. IISL is a specialized company focused upon

the index as a core product. IISL have a consulting and licensing agreement with

Standard & Poor's (S&P), who are world leaders in index services.



MCX-SX

MCX Stock Exchange Limited (MCX-SX), India’s new stock exchange, is

recognized by Securities and Exchange Board of India under Section 4 of

Securities Contracts (Regulation) Act, 1956. The Exchange was notified as a

“recognized stock exchange” under Section 2(39) of the Companies Act, 1956 by

the Govt. of India on December 21, 2012. In line with global best practices and

regulatory requirements, clearing and settlement of trades done on the Exchange is

conducted through a separate clearing corporation − MCX-SX Clearing

Corporation Ltd. (MCX-SX CCL).

MCX-SX commenced operations in Currency Futures in the Currency Derivatives

(CD) segment on October 7, 2008 under the regulatory framework of SEBI and

Reserve Bank of India (RBI). The Exchange commenced trading in Currency

Options on August 10, 2012. MCX-SX commenced trading in Capital Market

(Equity Cash) and Futures & Options (Equity Derivatives) Segments with effect

from February 11, 2013.

SX40-Index of India

SX40 is the flagship Index of MCX-SX. A free float based index of 40 large cap -

liquid stocks representing diversified sectors of the economy. SX40 is designed to

measure the economic performance with better representation of various

industries and sectors based on ICB®, leading global Industry Classification

system from FTSE. The Index is devised to offer cost-effective support for

investment and structured products such as index futures and option, index

portfolio, exchange traded funds, Index funds, etc.

BROKING FIRMS

STOCK BROKERS

A broker is an intermediary who arranges to buy and sell securities on behalf of

clients (the buyer and the seller).

According to Rule 2 (e) of SEBI (Stock Brokers and Sub-Brokers) Rules, 1992, a

stockbroker means a member of a recognized stock exchange. No stockbroker is

allowed to buy, sell or deal in securities, unless he or she holds a certificate of



registration granted by SEBI.

A stockbroker applies for registration to SEBI through a stock exchange or stock

exchanges of which he or she is admitted as a member. SEBI may grant a

certificate to a stock-broker [as per SEBI (Stock Brokers and Sub-Brokers) Rules,

1992] subject to the conditions that:

a) he holds the membership of any stock exchange;

b) he shall abide by the rules, regulations and bye-laws of the stock exchange or

stock exchanges of which he is a member;

c) in case of any change in the status and constitution, he shall obtain prior

permission of SEBI to continue to buy, sell or deal in securities in any stock

exchange;

d) he shall pay the amount of fees for registration in the prescribed manner; and

e) he shall take adequate steps for redressal of grievances of the investors within

one month of the date of the receipt of the complaint and keep SEBI informed

about the number, nature and other particulars of the complaints.

While considering the application of an entity for grant of registration as a stock

broker, SEBI shall take into account the following namely, whether the stock

broker applicant –

a) is eligible to be admitted as a member of a stock exchange;

b) has the necessary infrastructure like adequate office space, equipment and man

power to effectively discharge his activities;

c) has any past experience in the business of buying, selling or dealing in

securities;



d) is being subjected to any disciplinary proceedings under the rules, regulations

and bye-laws of a stock

exchange with respect to his business as a stockbroker involving either himself or

any of his partners, directors or employees

MAJOR STOCK BROKERS IN INDIA

HEDGE EQUITIES LTD

Hedge Equities is one of the leading Financial Services Company in India,

specialized in offering a wide range of financial products, tailor made to suit

individual needs. As a first step to make their presence Global, Hedge Equities

have initiated operations in Middle East to cater to the vast Non Resident Indian

(NRI) population in that region. Ever since their inception, they have spanned

their presence all over India through their Meticulous Research, High Brand

Awareness, and Intellectual Management and Extensive Industry knowledge. At

Hedge they believe in creating a new breed of Investors who take judicious

decisions through them. Hedge equities ltd. is one of the leading retail stock

broking house which is running successfully in the country.

GEOJIT BNP PARIBAS

Geojit BNP Paribas today is a leading retail financial services company in India

with a growing presence in the Middle East. The company rides on its rich

experience in the capital market to offer its clients a wide portfolio of savings and

investment solutions. The gamut of value added products and services offered

ranges from equities and derivatives to mutual funds., Life & General insurance

and third party fixed deposits. The need of over 5, 76,000 clients are met via

multichannel services – a country wide network of over 540 offices, phone

service, dedicated customer care centre and internet.

Geojit BNP Paribas has membership in National Stock Exchange (NSE) and the

Bombay Stock Exchange (BSE). In 2007, global ranking major BNP Paribas

joined the company’s other major shareholders- Mr .C .J. George, KSIDC (Kerala

State Industriai Development Corporation) and Mr. RakeshJunjunwala- when it

took a stake to become the single largest share holder.



At the forefront of the many fruitful associations between Geojit BNP Pariba and

BNP Paribas in their joint venture namely, BNP Paribas Securities India Private

Limited. This joint venture was created exclusively for domestic and foreign

institutional clients. An industry first was achieved when Geojit BNP Paribas

became the first broker in India to offer full Direct Market Access (DMA) on NSE

to JV’s institutional clients.

JRG SECURITIES

JRG Securities Ltd. Is one of India’s leading finance services providers with

strong presence in south India. It was incorporated in 1994 and over the years, it

acquired a name of trust through equity and commodity broking business. In 2007,

Baring India Private Equity fund II Ltd, a leading private equity firm of

international repute acquired a majority stake in the company. With the

investment of BIPEF came fresh inflow of talent and a focused team committed to

taking this company to greater heights. Since then JRG has undergone several

transformations- expanding into new geographies, adopting new state of art

technology, strengthening credit, and risk management systems, creating new

products and strengthening client relationships through service focus. The

company is committed to fully compliant with all regulatory compliances with the

exchanges, SEBI, IRDA, FMC, and RBI. JRG is listed on the BSE and has a

divers set of public shareholders.

RELIGARE

Religare is an emerging market financial services group with a presence across

Asia, Africa, Middle East, Europe and the Americas. In India Religare’s largest

market, the group offers a wide array of products and services including broking,

insurance, and asset management, lending solutions, investment banking and

wealth management. With more than 10000 employees across multiple

geographies, Religare serves over a million clients, including corporate and

institutions, high net worth families and individuals, and retail investors.

MUTHOOT SECURITIES

The Muthoot group has emerged as one of the India’s largest financial group of its

kind with business interest in 17 diverse fields, a network of over 2000 branches



nationwide and serving 750 million customers across the country. The muthoot

group with more than 16000 employers representing almost every culter and state

in the country, shall continue to provide supreme quality of service and earn the

trust of millions of people with its constant innovation and dynamism in the times

to come.

SHARE WEALTH

Sharewealth Securities Ltd is the first corporate member of National Stock

Exchange of India Ltd, Bombay Stock Exchange IndiaLtd and MCX Stock

Exchange from Thrissur, the cultural capital of Kerala. It is also depository

participant with CDSL ( Central Depository Services India Ltd). This securities

have two group companies:

Share wealth commodities Pvt Ltd

Share wealth Financial Services Ltd,

MOTILAL OSWAL

MotilalOswal Securities Ltd (MOSL) was founded in 1987 as a small sub-broking

unit, with just two people running the show. Focus on customer first attitude,

ethical and transparent business practises, respect for professionalism. Research

based value investing and implementation of innovative technology has enabled

us to blossom into an over 1600 member team. Today they are a well diversified

financial services firm offering a arrange of financial products and services such

as Wealth Management, broking & distribution. Commodity broking, portfolio

management services, institutional equities. Private equity, investment banking

services and principal strategies.

ANANDRATHI

AnandRathi is a leading full service investment bank founded in 1994 offering a

wide range of financial services and wealth management solutions to institutions,

corporations, high net worth individuals and families. The firm has rapidly

expanded its footprint to over 350 locations across India with international

presence in Hong Kong, Dubai & London.



ANGEL BROKING

Angel broking’s tryst with excellence in customer relation began in 1987. Today,

angel has emerged as one of the most respected Stock broking and wealth

management companies in India. With the unique retail focused stock trading

business model, angel is committed to providing Real value for money to all its

clients.

RECENT CORPORATE ACTIONS

Reliance Industrial Infrastructure Limited announces a dividend - final

Rs.3.50 + special Re.0.25 per share on Annual General Meeting held on

20-5-2013.

IRB Infrastructure Developers Limited announces fourth interim

dividend @ Re.1/- per equity share on 20-5-2013

MT Educare Limited announces second interim dividend @ Re.1/- per

equity share.

Bharati Airtel announces annual general meeting / dividend Re 1 per

share on 23-5-2013.

Yes Bank Limited announces annual general meeting / final dividend

Rs.6/- per equity share on 23-5-2013.

Forbes & Company Ltd has informed BSE that a meeting of the Board of

Directors of the Company will be held on May 28, 2013, to consider the

following;

1. Audited Accounts of the Company for the year ended March 31, 2013.

2. Dividend for the year ended March 31, 2013, if any.

Redington (India) Ltd has informed BSE that :

"During February 2012, Redington International Mauritius Limited

(RIML), a Wholly Owned Subsidiary (WOS) of Redington (India) Ltd

had taken a five year term loan of USD 78 Million at all-inclusive interest

rate of LIBOR plus 5.50 % P.A.

We wish to inform you that RIML has negotiated a refinance loan from a

bank for the same amount and similar terms, but at a lesser all-inclusive



interest rate of LIBOR plus 3.50% P.A. and prepaid the existing loan. This

refinance will reduce significantly our interest cost by approximately USD

2.5 Million over the next 4 year period."



1.3 INTRODUCTION TO THE COMPANY

HEDGE EQUITIES LTD

Hedge equities ltd. is one of the leading retail stock broking house which is

running successfully in the country. Hedge offers its customers a wide range of

equity related services including trade execution on BSE , NSE , Derivatives ,

Depository services , online trading , investment advice etc.. The firm has an

online trading and investment site –www.hedgeequities.com. The site gives access

to superior content and transaction facility to retail customers across the country.

As a first step to make our presence Global, Hedge Equities have initiated

operations in Middle East to cater to the vast Non Resident Indian (NRI)

population in that region. Known for its jargon- free, investor friendly language

and high quality research, the site has a registered base of over thousands of

customers. The content rich and research oriented portal has stood out among its

contemporaries because of its steadfast dedication to offering customers best-of-

breed technology and superior market information. Hedge Equities endeavor to

become a well reputed financial services super-mart catering to the evolving needs

and unique requirements of our clientele, and partnering with them to build,

manage, and grow their Wealth. The objective has been to let customers make

informed decision and to simplify the process of investing in stocks. Hedge

equities have always believed in investing in technology to build its business.

BACKGROUND AND INCEPTION OF THE COMPANY

Hedge Equities is one of the leading Financial Services Company in India,

specialized in offering a wide range of financial products, tailor made to suit

individual needs. As a first step to make our presence Global, Hedge Equities

have initiated operations in Middle East to cater to the vast Non Resident Indian

(NRI) population in that region. Ever since their inception, they have spanned

their presence all over India through their Meticulous Research, High Brand

Awareness, and Intellectual Management and Extensive Industry knowledge.

Hedge believes in creating a new breed of Investors who take judicious decisions

through them.



Team Hedge Equities is a balanced mix of more than 25 years of cutting edge

experience cutting across various industries with a strong background in the

financial market. The Board comprises of veterans from six power houses in their

respective fields: Fedex Securities, Baby Marine Exports, Thakker Developers,

Smart Financial, S.M.Hegde (CFO, Videocon Industries), and Padmashree Mohan

Lal.

Fedex securities: Managed by a team of ex-bankers, Fedex is a SEBI

registered category 1 merchant banker. The company concentrates on non-fund

based activities like structuring, tie up of project financing, financial restructuring

investment banking, corporate and advisory services. The core management team

consists of bankers with rich experience of decades and exposure to volatile

situations in commercial and investment banking. With offices at Nariman point

and Vile Parle east, Mumbai, state of the art infrastructure and qualified

manpower to conduct the business, Fedex securities envisages a phenomenal

growth in this sector for its clients.

Baby Marine Exports: Baby Marine Group, started its operation in 1977

from Kozhikode and through innovations and hard work has grown into three

unit and related industries spanning both the west and east coast of Indian. Baby

Marine Exports, B.M Products and Baby Marine (Eastern) Exports are

efficiently aided by pre-processing units, ice factories and a fleet of insulated

and refrigerated trucks for sea food transportation. Due to constant upgrading of

machinery, state-of-the-art infrastructural facilities, better links with raw

materials suppliers, and an established network of purchasers have obviously

made Baby Marine Group a leading exporter of processed marine products to

various international markets.

Smart financial: Smart financial entered the financial market only in 1992

but over this brief span has covered a niche for itself by becoming the leading

financial provider. The company offer guidance to investors as equities,

commodities, mutual fund’s portfolio management services and insurance. It

offers complete range of financial solutions that encompasses every sphere of life

Thakker group: Starting off as a land developer and builder in 1962,

Thakkers groups diversified into commercial production of agricultural and

horticultural products, housing real estate marketing plantation etc. They have

provided shelter to more than 40000 families by offering residential plots and



premises .Thakker developers is the flagship company of the group. It was

established as private limited in 1987 and later went on to become the only

public limited company in North Maharashtra engaged in housing ,commercial

construction and land development. The company is also a Class1 contractor

registered with the Public Work Department, Govt. of Maharashtra.

SM Hedge: Mr. S.M Hedge, a chartered accountant by profession is the

Chief Finance Officer of the Indian Multinational Videocon International and has

been at the helm of affairs for the last 20 year.

Padmashree Bharat Mohanlal: Mohanlal, the south Indian movie

superstar has become a legend, a brand and cultural ambassador owing to

various factors. Versatility and natural flair for donning complex characters have

won him numerous accolades not to speak of some unforgettable films

contributed by him. A multifaceted personality, he has some business ventures

also which include Vismaya Max Film Post Production Studio, College for

Dubbing Artists at the Kinfra film and Video Park Thiruvananthapuram. He is

the also the director of Uni Royal Marine Exports; a Seafood Export Company.

Intellectual and knowledge arbitrage is the mantra of modern day business. The

same holds true for the financial markets. With the breadth and depth of

knowledge of modern day business that the Board of Hedge brings to the table,

you can be rest assured that some of the best minds in the business are taking care

of your investments.

Mission

“To create an ethical and sustainable financial services platform for

our customers and partner them to build business, to provide

employees with meaningful work, self-development and progression,

and to achieve a consistent and competitive growth in profit and

earnings for our shareholders and staff”.

Vision

“Ever since its inception, Hedge Equities has been a household name

among the masses owing our success to timely Professional financial

assistance to our clients. This aptly articulates our vision of 'Evolving



into a financial supermarket which will be a one stop shop for all

financial solutions”.

Corporate Social Responsibility

Being a Responsible Corporate Citizen, Hedge Equities has initiated a Non Profit

movement, ‘Hedge Yuva’, which focuses on educating the masses about Stock

Market. The movement has also formulated various scholarship programs for

young and dynamic youth.

Hedge School of Applied Economics

In its efforts to promote financial education in the country, Hedge Equities has

launched the Hedge School of Applied Economics in the year 2010 with the

objective of creating professionals for the financial markets. The focus is to groom

students in share trading, banking, insurance or wealth management, by

implementing innovative solutions. The tailor-made syllabus is interspersed with

live class rooms, where live share trading is shown and explained. The packed

academic schedules are conducted in sessions led by experienced faculty, market

players from the trading and financial industry, and experts from BSE, NSE and

SEBI. The Hedge School will complement the motivating cause of attracting the

largely untapped segment.

Hedge Yuva

Hedge Equities has also initiated a non-profit movement called Hedge Yuva, an

ambitious programme aimed at propagating the virtues of stock market. The

movement seeks to trickle down to the micro level and educate the masses,

especially the youth, with the intention of converting liquid money to an

investment in shares. It is as part of this programme that the Hedge School of

Applied Economics was started. This movement believes in creating a financially

strong young India and this initiative is to enlighten the youth into making

educated investment decisions. To accelerate its objectives, it started to become

member of many social networking sites like Face book, Orkut, etc. and as a

result, they are getting faster response. They say that they looking forward for

“smart investors.” If any personal advice is needed, just drop in the details and

the rest will be assured.



Hedge Equities Wealth Management Services

As a part of national wise service development, Hedge Equities launched its

wealth management service (WMS) during December 2010. The services include

portfolio management services, portfolio advisory services and Mutual Fund

Advisory services. This service offering will have tailor-made investment

solutions for each client-based on their risk appetite.

The main objective of this WMS is to make a customer into a successful investor.

In order to understand the customer’s behavior and their risk bearing capacity,

hedge equities appointed certain wealth management service teams. They will

collect details regarding customers through questionnaires. After studying

consumer’s expectations and goals they will prepare special investment policies

and teach them its merits and demerits. It’s the one of the main duties of WMS

teams. Team will choose investment policies from the different kind of assets like

Equity, Commodity, etc. The launch of Wealth Management Services has helped

the company in expanding its services in the State.

Hedge Dhruva

The company rolled out a mobile service outlet called Hedge Dhruva– a new

concept aimed at imparting investment awareness programs throughout Kerala.

The vehicle has investment advisors and conduct investment awareness programs

throughout the state. The idea is being carried out through a mobile van which

will have investment advisors for providing proper financial education thereby,

improving the market participation. The focus will be more on the rural side of the

State where the company feels that there is lot of potential.

Product & Services of Hedge Equities

Equity Trading: Equity gives you the opportunity to have a partnership with

all the leading Business tycoons around the globe. Total capital contribution

for a company comprises of investments through equity share holdings by

small and big investors. The investors who have a stake in a company are

referred to as shareholders. Power of Equity shareholders lies in the optimum

selection of the Industry, have a strong belief in the Company's fundamentals

and also having a confidence in the profit making capability of the company.



Equity Market, at present, is a rewarding field for the investors and investing

in Indian stocks are profitable for not only the long and medium-term

investors, but also the position traders, short-term swing traders and also very

short term intra-day traders. Fundamentally, stock market is an avenue for

business people to meet shareholders. Other than bank loans, they now have

another option to finance their business. They did it by offering their

company's equities in exchange of shareholders cash. The company is never

required to repay the capital, but the new shareholders have a right to future

profits distributed by the company. For shareholders, they have alternatives to

where they should put their money into. In the same time, they get the

opportunity to participate in capital intensive businesses at an affordable price.

Equity is an investment area which you can capitalize on with proper

assistance regardless of the market circumstances. Hedge Equities opens the

door to this highly lucrative investment opportunity that could provide a

feasible solution to all your financial queries.

Commodities Trading: Commodity "futures" are contracts to buy or sell

certain goods at set prices at a predetermined time in the future. Futures

trading plays a key role in the marketing of a number of important agricultural

and nonagricultural commodities as it provides the industrial and farming

communities with a transparent price discovery platform, which also enables

them to hedge their price risk and price volatility. The growth of Indian

commodities futures trading towards an efficient, transparent and well-

organized market has thrown open a window of benefits and opportunities to

Indian producers and traders. Besides the primary benefits of its twin

economic functions of price discovery and price risk management, commodity

futures trading has also played an instrumental role in integrating various

fragmented components of the commodity ecosystem, thus developing the

overall infrastructure of agricultural commodities marketing in the country.

At present, 24 commodity futures exchanges are operational in India,

which include 21 regional bourses and the three national-level players, with

another three proposed exchanges on the cards. With the state-of the-art

technology-powered secure and efficient operational infrastructure, these

national exchanges are creating a near-perfect market situation with a much



wider participation from the ecosystem stakeholders in a large number of

domestic and global commodities during local and international timings.

While the trade in non-agricultural commodities, especially bullion and crude,

has increased in the past two financial years, the same in agricultural

commodities has declined. The share of agricultural commodities almost

halved during 2008-09, due to the continued ban on several commodities. The

clients can trade in commodity futures like gold, silver, crude oil, rubber etc.

And take advantage of the extended trading hours (10 am to 11pm) in

commodities trading.

Currency Trading: Investments in Currency Derivatives can help you to

diversify your portfolio from traditional asset classes. Currency derivatives

can be described as contracts between the sellers and buyers, whose values are

to be derived from the underlying assets, the currency amounts. These are

basically risk management tools in force and money markets used for hedging

risks and act as insurance against unforeseen and unpredictable currency and

interest rate movements. Any individual or corporate expecting to receive or

pay certain amounts in foreign currencies at future date can use these products

to opt for a fixed rate - at which the currencies can be exchanged now itself.

Mutual Funds: A Mutual Fund is a trust that pools the savings of a number of

investors who share a common financial goal. The money thus collected is

invested by the fund manager in different types of securities depending upon

the objective of the scheme. These could range from shares to debentures to

money market instruments. The income earned through these investments and

the capital appreciations realized by the scheme are shared by its unit holder.

Thus a Mutual Fund is the most suitable investment for the common man as it

offers an opportunity to invest in a diversified, professionally managed

portfolio at a relatively low cost.

Online trading: Hedge Equities has a large network of branches with online

terminals of NSE and BSE in the Capital market and derivative segments. The

clients are assured of prompt order execution through dedicated phones and expert

dealers at our offices.



Internet trading: Hedge Equities offers Internet trading through this site. You

can trade through the Internet from the comforts of your office or home, anywhere

in the world. The dedicated IT systems ensure service up time and speed, making

Internet broking through Hedge Equities hassle-free. Using the ‘easiest’ facility

provided by NSDL, the clients can transfer the shares sold by them online without

delivery instruction slips. Additionally, digitally signed contract notes can be sent

to clients through E-mail.

Depository services: Hedge Equities is a member of the National Securities

Depository Limited (NSDL), offer depository services with minimum Annual

Maintenance Charges and transaction charges. Account holders can view their

holding position through the Internet. They also offer the ‘easiest’ facility

provided by NSDL (electronic access to securities information and execution of

secured transaction) through which clients can give delivery instructions via the

Internet.

Derivative trading: Hedge offer trading in the futures and options segment of the

National Stock Exchange (NSE).Through the present derivative trading an

investor can take a short-term view on the market for up to a three months’

perspective by paying a small margin on the futures segment and a small premium

in the options segment. In the case of options, if the trade goes in the opposite

direction the maximum loss will be limited to the premium paid.

Knowledge Centre: Knowledge Centre activities are intended to provide

systematic and structured services mainly to new investors and also to young

aspirant aiming for a career in financial markets. The centre has three functional

areas: the Publication Division, the Training Centre, and Wealth Management

Advisory Service. And the Hedge Equities initiates Hedge School of Applied

Economics with the sole objective of moulding highly qualified investment

professionals in the state.

Equity Research: Hedge Equities constantly strive to deliver insightful research

to enable pro-active investment decisions. The research department is broadly

divided into two divisions-Fundamental Analysis Group (FAG) and Technical

Analysis Group (TAG).The fundamental analysts are continuously scanning the

entire economy for discovering what they call the “hidden gems” in stock market

terminology and present it to the clients for profitable investments. Timing the

market has always been the most difficult task for all analysts and their Technical



Analysis Group has emerged to predict the market movements well in advance

using complex Analytical methods including Eliot Wave Theory. They are

equipped with cutting –edge technologies for technical charting which assist the

technical analysts to predict both upside and downside movements efficiently for

the benefit of clients.

Portfolio Management Service: Hedge Equities is a SEBI-approved portfolio

manager offering discretionary and non-discretionary schemes to its clients.

Hedge Equities ‘portfolio management team keeps track of the markets on a daily

basis and is exposed to a lot of information and analytic tools which an investor

would not normally have access to. Other technicalities pertaining to shares like

dividends, rights, bonus, buy-back, mergers and acquisitions are also taken care of

by them.

AREA OF OPERATION:

Hedge Equities has 130 branches in India and one branch in Dubai, UAE.

106 branches in Kerala

06 branches in Karnataka

07 branches in Maharashtra

01 branch in Tamilnadu.

Hedge Equities registered office is at Nariman Point, Mumbai and Corporate

office is in Kaloor, Kochi and their regional offices are in Bnagalore, Shimoga,

and Hyderabad. There are 117 employees in their Head office, 8-10 employees in

their Regional office and 4-5 employees in each branch.

Main Competitors:

Geojit BNP Parbas

JRG Securities

Religare

Muthoot Securities

Share wealth

MotilalOswal



Anandrathi

Angel Brocking

Functional departments

Client Relation Department: The client relation department assists the client or

customer top open an account in HEDGE EQUITIES (p) Ltd securities. This

department is also known as the front office. A client has to open two types of

accounts to trade and own securities in the NSE & BSE.

Finance Department: Thus a department, to organize financial activities may be

created under the direct control of the board of directors. Finance manager will

decide the major financial policy methods. Lower levels can delegate the other

routine activities.

Marketing Department: The major functions of marketing department are:

(i) Business associate development: The company takes up the marketing

activities of the various branches. It ensures an efficient marketing arena at its

various branches. The company encourages better relations in its branches and

promotes for the development of various marketing strategies.

(ii) Brand promotion: An important function of marketing department is to

promote the name of the company.

(iii) Investment promotion: The main clients of the company were its investors.

Hence the marketing department tries to capture as many investors as possible to

encourage them to invest.

(iv) Delivery promotion: Intraday trading is not always profitable and might

involve a lot of risk hence the company promotes for delivery were the shares are

kept to be sold for a later date analysing the profitability factors.

Systems Department: The systems department is playing a vital role in the day

operations of the company. It is through the systems department that the clients

can avail the facilities of Internet trading. Optic fibre cables and high bandwidth

connections from the Hedge Equities (P) Ltd office to the ISP, a dedicated server

and back-up ISDN connections were maintained directly by the systems

department. For the purpose of trading they have made use of two software

namely ODIN (Open Dealers Integrated Network)

Human Resources Department: Human resource is often considered as the back

bone of an organization even in this age of advanced automation and



mechanization. Since virtual organizations are not very much popular in our part

of the world, it is very important to any organization to have a HR department.

The presence of an excellent HR department increases the efficiency of an

organization considerably. Human resource management is defined as asset of

practices, policies and programmes designed to maximize both personal and

organizational goals.

a. Training and induction: The selected employees will undergo three days

continuous induction. During this period, he will undergo training with all the

department of Hedge Equities (P) Ltd Securities (India) Pt. Ltd. There will also

be classroom induction also within 3 months.

b. Wages and Salary Administration: The wages and salaries of the employees

were fixed and granted by the HR department with consent of the finance

department.

c. Performance Appraisal: It was human resources department which gives the

promotion to all employees, making transfers and taking disciplinary actions if

needed.

d. Grievance Handling: The grievance of employees were received only

through proper channels i.e., through the particular department heads. The HR

department will make solutions to the complaints as per the rules and regulations

of the company.

Trading Department: The department deals with the trading related activities of

the company. The trading refers to the buying and selling of shares. This

department is the most important part of the organization. There are two types of

trading. They are

a. Online Trading: These are the trading terminal of the organization. The

each computer of the department is termed as the trading terminal. The each

terminal is assigned with NCFM certified dealers, who is in charge of each portal

will do the trade according to the client request. The terminal is managed by

either NEAT (National Exchange for Automated Trading) software or ODIN

(Open Dealers Integrated Network) software. The client can also place his

through written request or through the telephone, in this the order will be place d

by the dealer.

b. Internet Trading: It is a facility provides by the company in order to trade

the securities from his convenient place like his office, home etc. the order will



be placed by the client itself, and he can make changes before the trade is done

for changing the price, cancellation of the order.

Delivery and Depository Department: Delivery refers to the share that bought

on particular day are not sold on that day itself and holding of the share for an

appreciation in the value of the security and to trade it on a future date. Deliver

Instruction Slip: it is a slip the client should fill and gave to the dealer regarding

the purchase of the share.

Equity Research Department: The function of the department is to study the

details regarding the share or securities and to make prediction regarding the

future performance of the company. The following types of approaches done

through this department:

i) Fundamental analysis

ii) Technical analysis

Management of the Company

Alex K Babu Managing Director

Bhuvanendran CEO

Bobby J Arakunnel COO

Mr. Mohanlal Director

Mr. Joy Arrackal Director

Dr.Samuel George Director

Pradeep Kumar C Director



Organisation Structure



Under the GM

Regional Organization Structure



1.4. RESEARCH METHODOLOGY

A) OBJECTIVE OF THE STUDY

For the effectiveness of the study the objectives are:

PRIMARY OBJECTIVE:

1. To analyse and determine the effectiveness of Financial Derivatives as a

risk diversification and profit maximization tool.

SECONDARY OBJECTIVES:

2. To study about the impact of hedging in the derivative market.

3. To construct an optimal portfolio to test the diversification strategy.

4. To study how to use derivatives, especially futures and options in volatile

markets to make profits maximization and risk reduction.

B) METHODOLOGY AND SAMPLE DESIGN

Research Problem

Stock market is an investment avenue where the returns can be maximum and

within no time. However, the market is volatile and the investment involves high

risk. Investors always expect the market to be bullish and give them maximum

possible returns. For that the risk diversification must be done. Hedging is a

popular method used by investors to reduce the risk and maximize the profit from

such investments. This research analyses whether hedging with financial

derivatives such as futures and options is effective in risk management.

Methodology of Data Collection

The data are collected in the form of secondary data. It is taken from published

reports, annual company reports, and library books and from the websites of NSE

and various other websites. The data used for the study and historical or secondary



nature. The companies are selected according to their beta value and market

capitalization.

Area of Study – Index Futures and Options

Fluctuations in the market indices affect the investors’ investments in the stock

market. Stocks with high beta value have a positive change in response to the

market indices. Derivatives help to reduce to the risk of losing value due to the

volatility of the market. Index futures and index options were the first derivatives

to be introduced in India. These are basically derivative tools based on stock

index. They are considered to be the real risk management tools. Since the

derivatives are permitted legally, one can use them to insulate its portfolio against

the vagaries of the market.

Sample design / Portfolio Build up

For the purpose of the study a portfolio has been built with 10 companies from 5

different industries based on high beta value and market capitalization.

The companies and the industries are:

Industry Name Company Name Beta Value Market Cap in million

Steel TATA STEEL LTD. 2.04 290,150.59

JINDAL STEEL &

POWER LTD

1.5 266,240.69

Banking ICICI Bank Ltd 1.67 1,313,518.00

HDFC Bank Ltd 1.02 1,627,000.00

Telecom Idea Cellular LTD 1.08 449,054.41

Reliance Communications

Ltd

1.85 227,662.20

Power Adani Power Ltd 1.2 161,258.41

Reliance Power Ltd 1.61 194,535.50

Engineering Larsen & Toubro Ltd 1.55 868,572.69

Bharath Heavy Electricals

Ltd

1.34 478,138.69



C) SAMPLING PLAN

The data used is secondary data from the Indian stock market. Data is

collected from March 1st 2013 to May 30th 2013. The historical data

regarding the stock market index S&P Nifty, the futures index FUTIDX

NIFTY and OPTIDX Nifty are considered.

D) RESEARCH DESIGN

The research is conducted at Hedge Equities, Cochin. The type of research

used is descriptive research.

E) PERIOD OF STUDY

The period of study is from May 2nd 2013 to June 15th 2013, with duration

of 45 days.

F) SOURCES OF DATA COLLECTION

The nature of data used is historical data. The information is collected

from various textbooks, websites and company data.

G) STATISTICAL TOOLS USED FOR ANALYSIS

1) Beta value analysis

Beta is the slope of the characteristic regression line. The beta value

describes the relationship between the stock’s return and the index returns.

Beta = +1

One percent change in market index return causes exactly one percent

change in the stock return indicates that the stock moves in tandem with

market.

Beta = +0.5

One percent changes in market index return causes 0.5 percent change in

the stock return. The stock is less volatile compared to the market.

Beta = +2

One percent change in market index return causes 2 percent change in the

stock return. The stock return is more volatile. When there is a decline in

the market return, the stock with beta of 2 would give a negative return of



20 percent. The stocks with more than 1 beta value are considered to be

risky.

Negative Beta value indicates that the stock return moves in the opposite

direction to the market return. A stock with a negative beta of -1 would

provide a return of 10 percent, if the market return declines by 10 percent

and vice versa. Stocks with negative returns are very rare.

Recipe for calculation of beta value:

β = n ∑ X Y - (∑ x) ∑ y)

N ∑ x2 - (∑ x) 2

Where

X Index Return

Y Stock Return

X Sum of Index return

Y Sum of stock return

N No. of days

The beta is calculated in excel sheet by using data on month of April of the

particular stock & Index market.

2) Weightage of Share

Weightage of share = No of s h ares × share price

Totalamount of t h e portfolio

3) Hedge Ratio



Hedge Ratio= Value of t h e portfolio X Beta of t h e portfolio

Nifty Index value

1.5 SCOPE OF THE STUDY

1. The study is attempted to assess the power of hedging technique using

index futures and options

2. This study aims at providing an insight into the operations of hedging

strategies. Hedging provides security to the investment and also reduces

the level of risk borne by the investors.

3. The study describes the strategies to select the right hedging techniques

based on the requirements of the investors.

1.6 LIMITATIONS OF THE STUDY

1) The study is focused on the risk diversification using Nifty Index futures

and options only.

2) This study covers the Indian scenario of hedging in derivatives only.

3) The market is always volatile, so the prediction or anticipation that can be

used depends upon each individual investor.

4) The study is based on the past performance of the stock market, which

cannot guarantee future performance

1.7 CHAPTERISATION

Chapter 1 – Introduction to the study

Deals with background of the problem, Industry Analysis, Introduction to the

company, research methodology, Scope of the study, Limitations of the study and

Chapterisation.

Chapter 2- Literature review



Includes the quotes about various topics related to the area of study. It also

includes the theoretical framework explaining the theories related to the subject.

Chapter 3 – Data analysis and Discussion

Basic analysis of the economy, industry and the companies included in the

portfolio.

Profit or loss analysis of the portfolio without the use of derivatives.

Profit or loss analysis of the portfolio with the use of derivatives.

Effectiveness of hedging in the reduction of risk and profit maximization.

Chapter 4 –Empirical result

Contains a detailed discussion on the basis of results of analysis

Chapter 5 – Summary and Conclusion



CHAPTER 2

LITERATURE REVIEW



Comments about the effectiveness of Hedging by various Scholars

Butterworth and Holmes (2000) studied hedging effectiveness of FTSE -100

and FTSE Mid 250 index futures contracts. They found that FTSE-100

provided effective hedge for portfolio dominated by large firms and FTSE

Mid 250 was equally effective for portfolios dominated by small

capitalizations stocks.

Brails ford et al. (2000) estimated hedge ratio by several techniques for the

Australian All Ordinary Share Price index futures contract. Yang (2009)

showed that M-GARCH dynamic hedge ratio provides largest degree of

reduction in variance of returns. Nonetheless, some recent studies for example

Lien et al (2011) and Moosa (2003) have reported that basic OLS approach

outperforms other advanced models of hedge ratio estimation. In India very

few studies were conducted on the hedging effectiveness of the Futures

contract.

Roy and Kumar (2007) studied hedging effectiveness of wheat futures in

India. They used conventional OLS method for hedge ratio estimation and

found wheat futures contracts do not provide effective hedge in avoiding risk.

Bhaduri and Durai (2008) examined hedging effectiveness of Nifty Futures.

They found OLS based strategy provided better hedge in shorter time

horizons. However, at higher time horizons bivariate GARCH clearly

dominates. Further, Kumar et al (2008) examined hedging effectiveness of

constant and time varying hedge ratio of Nifty Futures, Gold Futures and

Soybean futures. Their results showed that the time varying hedge ratio

provided greatest variance reduction as compared to other hedges based on

constant hedge ratio. Investors studying the market often come across a

security, which they believe is intrinsically undervalued. It may be the case

that the profits and the profits the quality of the company make it seem worth



a lot more than the market think. A stock picker carefully purchases securities

based on a sense that they worth more than the market price. When doing so,

he faces two kinds of risks:

1. His understanding can be wrong, and the company is really not worth

more than the market price, or

2. The entire market moves against him and generates losses even

though the underlying idea was correct.

2.1 Quotes about derivatives

The world seems to be divided into two camps: those who embrace financial derivatives as the holy grail of the new investment area, and those who denigrate derivatives as the financial Antichrist

David Edington.

Quoted in Risk, June 1994, p.67

Derivative products have undoubtedly allowed management to achieve significant gains in the efficiency of their businesses, so much so that the successful use of derivatives has become an essential component of product management.

“Risk Management: Laying Firmer Foundations”

Controlling Risk:

Risk Magazine Special Supplement June 1995, p.21

People are not apologizing anymore for using derivatives. They’ve realized that they are not the evil instruments they have been made out to be.

Sarah Orsay

Derivatives Strategy

April, 1997, p.15



The beauty of derivatives is that they self-destruct every month and you get another commission

Don Stone, NYSE specialist

Stealing the Market by Martin Mayer, 1992, p.84

Futures markets are designed to permit trading among strangers, as against other markets which permit only trading among friends.

Terence Martell, former Research Director, COMEX

The Wall Street Journal, March 2, 1995, p.A14

The Key to understanding derivatives is a deeper understanding of all that’s underlying.

Morgan Stanley Dean Witter

Advertisement in Derivatives Strategy, October, 1997, p.15

You can think of a derivative as a mixture of its constituent underlies much as a cake is a mixture of eggs, flour, and milk in carefully specified proportions. The derivative’s model provides a recipe for the mixture, one whose ingredient’s quantities vary with time.

Emmanuel Derman

Risk, July 2001, p.48

Futures markers re an accurate representation of consensus opinion, but if we pool all our ignorance, we do not get wisdom from it.

Jim Bianco

The Wall Street Journal, March 11, 2006

Page B3

A senior derivatives trader, interviewed recently by Risk, was asked how he thought the derivatives market would develop over the next five years. His response was a spin on an old joke- each desk will comprise a sophisticated trading model, a trader, and a dog. The model will make all the trading decisions; the trader acts as a back-up in case the model crashes; the dog is trained to bite the trader if he or she tries to touch the model in any other circumstance.

Nick Sawyer



Risk, September 2006 p.6

Hedging is a popular strategy for reducing risk and keeping a business alive, among other things.

Gene Rotberg

Fortune, March 7, 1994, p.53

The markets will follow the path to hurt the highest number of hedgers. The best hedges are those you alone put on.

Nassim Taleb

Derivatives Strategy. April 1997, p.25

It is often said in the derivatives business that “you cannot hedge history.”

Dan Goldman

Risk Management for the Investment Community(Risk Magazine Financial Products Guide) 1999, p.16

Dealers make money by convincing people that they need derivatives. You can no longer just hang out the shingle and hope to gain a competitive advantage.

Craig Schiffer, Partner, Price Waterhouse

Risk, January, 1995

Derivatives are much more of a high volume, low margin production business now. Once they were a labour of love, something that was crafted. Now it’s about high volumes and high efficiency. Each year, you have to run to stand still.

Rob Standing

Chase Manhattan

Risk, October, 1997, p.28

Most derivatives are sold rather than bought.

Robert Brooks

CFA Magazine, March/April 2004 p.42

Derivatives are like NFL quarterbacks. They get too much of the credit and too much of the blame.



Gerald Corrigan, Goldman Sachs

Speech before the State of Wisconsin Investment Board

May 5, 1994

Derivatives are nothing more than a set of tools. And just as a saw can build your house, it can cut off your arm if it isn’t used properly.

Walter D Hops, Treasurer, Ciba-Geigy

Business Week, October 31, 1994, p.98

Well, it helps to look at derivatives like atoms. Split them one way and you have heat and energy – useful stuff. Split them another way and you have a bomb. You have to understand the subtleties.

Moral Hazard

Kate Jennings

Fourth Estate, 2002, p.8

Derivatives are like prescription drugs. They can be beneficial when used appropriately but they may be habit-forming and carry the risk of unpleasant side effects.

David Litvack

Fitch

Risk, April 2006, p.20

A common misperception about risk management in some quarters is that the use of derivative securities constitutes speculation- that is, the addition of financial risk to the business risk of a firm’s operation. Some folks think that condom use increases risk..!

Walter Dolde

“The Trajectory of Corporate Risk Management”

Journal of Applied Corporate Finance 1993, Vol.6, No.3, 33-41

We have seen situations where a company purged itself of derivatives and the result was even greater risk than it had before.

Tanya S Beder, Principal

Capital Market Risk Advisors



Business Week, October 31, 1994, p.100

The Futures market is probably to our way of thinking the safest market in the U.S

Patricia C Dunn, Managing Director

Wells Fargo Nikko Investment Advisors

“Portfolio Manages Talk Futures and Risk Management”

Chicago Mercantile Exchange Video Tape, 1995

The inappropriate use of derivatives can threaten a company’s rating. However, the absence of derivative activities also can increase the volatility of corporate cash flows as significantly as their speculative use.

Fitch Investors Services

“The Art Not Science of Risk Management”

Risk Magazine Special Supplement, June 1995, p.2

Efficient risk sharing is what much of the futures and options revolution has been all about.

Merton Miller

“Financial Innovation and Economic Performance”

Journal of Applied Corporate Finance, Vol.4 No.4, 1992

Derivatives are innovations in risk sharing, not in risk itself.

Big Bets Gone Bad, 1995, p.141

A bird in the hand approach is an apt way to describe the strategy of today’s options investor. Taking the immediate income of writing a covered call, the battle-tested investor is strategically managing market risk.

Lawrence Serven, President

Buttonwood Capital Management

Futures and Options World, October, 1995. Pp.73-74

With derivatives products and options you can pick any point of the payoff distribution and sell off the others.



Stan Jonas

Derivatives Strategies, November, 1995, p.66

Fund managers who aren’t using futures and options are dealing with an incomplete set of resources.

Paul Daley, Vice President and manager

ANB Investment Management and Trust Company

“Portfolio Managers Talk Futures and Risk Management”

Chicago Mercantile Exchange Video tape, 1995.



2.2THEORETICAL FRAMEWORK

INTRODUCTION

Avoiding risk is difficult no matter how you choose to invest. Most investors are

aware that you must take greater risks to achieve higher returns. However, no one

wants to take more risk than necessary to achieve one's financial goals.

There are some risks investors take for which they expect to be rewarded. Other

risks are so haphazard that they cannot be rewarded, nor should investors take

them. It is the latter kind of risk that investors eliminate through diversification.

Savvy investors don't take risks for which they don't get paid.

Risk is defined as the chance that an investment's actual return will be different

than expected. This includes the possibility of losing some or all of the original

investment.

All investments are subject to risk. It is generally believed that investors are

rewarded for taking risk. However, some risk is not rewarded. Investors need to

control or eliminate risks for which they are not rewarded from their investment

portfolio. Every investment is characterized by return and risk. In general, it refers

to the possibility of incurring a loss in a financial transaction. In finance, a person

making an investment expects to get some return from the investment in the

future. But, as future is uncertain, so is the future expected return. It is the

uncertainty associated with the returns from an investment that introduces risk

into an investment. So the essence of risk in an investment is the variation in its

returns. This variation in returns is caused by a number of factors constituting the

elements of risk the total variability in returns of a security represent the total risk

of that security. Systematic risk and unsystematic risk are the two components of

total risk. Thus,

Total risk = Systematic risk + Unsystematic risk



Systematic Risk - Systematic risk influences a large number of assets. A

significant political event, for example, could affect several of the assets in your

portfolio. It is virtually impossible to protect yourself against this type of risk.

Some events can affect all firms at the same time. Events such as inflation, war,

and fluctuating interest rates influence the entire economy, not just a specific firm

or industry. It is called systematic risk or market risk.

As the society is dynamic, changes occur in the economic, political and social

system constantly. These changes have an influence on the performance of

companies and thereby on their stock prices in varying degrees. The impact of

these changes is system-wide and that portion of total variability in security

returns caused by such system-wide factors is referred to as systematic risk.

Systematic risk is further subdivided into interest rate risk, market risk, and

purchasing power risk .Interest rate risk is a type of systematic risk that

particularly affects debt securities like bonds and debentures. The market price of

debt securities fluctuates in response to variations in the market interest rates. The

interest rate variations have an indirect impact on stock prices also. As interest

rate increase, margin trading becomes less attractive. The lower demand by

speculators may push down stock prices and vice versa. Interest rate risk is a

systematic risk affects bonds directly and shares indirectly. Market prices of

shares move up or down consistently. A general rise in share prices is referred to

as a bullish trend, whereas a general fall in share prices is referred to as a bearish

trend. Business cycles are considered to be a major determinant of the timing and

extent of the bull and bear phases. This volatile market leads to variations in the

returns of investors in shares. The variation in returns caused by the volatility of

the stock market is referred to as the market risk. Another type of systematic risk

is the purchasing power risk. It refers to the variation in investor returns caused by

inflation. The two important sources of inflation are raising costs of production

and excess demand for goods and services in relation to their supply. They are

known as cost-push and demand-pull respectively. In an inflationary economy,

rational investors would include an allowance for the purchasing power risk in

their estimate of the expected rate of return from an investment.

Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk".

This kind of risk affects a very small number of assets. An example is news that



affects a specific stock such as a sudden strike by employees. Unsystematic risk

(also called diversifiable risk) is risk that is specific to a company. This type of

risk could include dramatic events such as a strike, a natural disaster such as a fire,

or something as simple as slumping sales. Two common sources of unsystematic

risk are business risk and financial risk.

The returns from a security may sometimes vary because of certain factors

affecting only the company issuing such security like raw material scarcity, labour

strike etc. When availability of returns occurs because of such factors, it is known

as unsystematic risk. The unsystematic or unique risk affecting specific securities

arises from two sources: (a) the operating environment of the company and (b) the

financial pattern adopted by the company. These two types of unsystematic risk

are referred to as business risk and financial risk respectively. Every company

operates within a particular operating environment. This operating environment

comprises both internal environment within the firm and external environment

outside the firm. The impact of these conditions is reflected in the operating costs

of the company which are segregated into fixed costs and variable costs. Business

risk is thus a function of the operating conditions and is the variability in operating

income caused by the operating conditions. Financial risk is a function of financial

leverage which is the use of debt in the capital structure. The presence of debt in

the capital structure creates fixed payments in the form of interest which is a

compulsory to be made which creates more variability in the EPS. This is specific

to each company and forms part of its unsystematic risk. Financial risk is an

avoidable risk in so far as a company is free to finance its activities without

resorting to debt.

THE RISK-RETURN TRADEOFF

The risk-return tradeoff could easily be called the iron stomach test. Deciding

what amount of risk you can take on is one of the most important investment

decisions you will make.

The risk-return tradeoff is the balance an investor must decide on between the

desires for the lowest possible risk for the highest possible returns. Remember to

keep in mind that low levels of uncertainty (low risk) are associated with low



potential returns and high levels of uncertainty (high risk) are associated with high

potential returns.

The following chart shows an example of the risk/return tradeoff for investing. A

higher standard deviation means a higher risk:

MEASUREMENT OF RISK

An intelligent investor would attempt to anticipate the kind of risk that he

is likely to face. He would attempt to estimate the extent of risk associated with

different investment proposals. He tries to quantify the risk of each investment

that he considers before making the final selection. Risk in investment is

associated with return. The risk of an investment cannot be measured without

reference to return. The return, in turn, depends on the cash inflows to be received

from the investment. The expected return of the investment is the probability

weighted average of all the possible returns. If the possible returns are denoted by

X i and the related probabilities are p ( X i ) the expected return may be represented

as X and can be calculated as:

X = ∑i=1

n

X i p( X i)

It is the sum of the products of possible returns with their respective

probabilities. Expected returns are insufficient for decision making. The risk

aspect should also be considered. The most popular measure of risk is the variance

or standard deviation of the probability distribution of possible returns. Variance

is usually denoted by σ 2 and is calculated by the following formula:



σ 2=∑i=1

n

[ ( X i−X )2p ( X i ) ]

The variance and standard deviation measure the extent of variability of

possible returns from the expected return. For an investor, the unsystematic risk is

not so important as it can be reduced through diversification. It is an irrelevant

risk. The risk that is relevant in investment decision-making is the systematic risk

because it is undiversifiable. Hence, the investor seeks to measure the systematic

risk of a security.

The systematic risk of a security is measured by a statistical measure

called Beta. Two statistical methods may be used for the calculation of Beta,

namely the correlation method or the regression method. Using the correlation

method, beta can be calculated from the historical data of returns by the following

formula:

β i=rℑ σ i σm

σm2 , where

rℑ = Correlation coefficient,

σ i = Standard deviation of returns of stock i.

σ m = Standard deviation of returns of the market index.

σ m2 = variance of market returns.

The second method of calculating beta is by using the regression method. The

form of regression equation is as follows:

Y=α+βX , where

Y = Dependent variable, X = Independent variable, α and β are constants.

The formula used for the calculation of αand β are given below.

α=Y −β X

β = n ∑ XY−(∑ X )(∑Y )

n ∑ X 2−(∑ X)2 , where



n = Number of items Y = Mean value of dependent variable

scores.

X = Mean value of independent variable scores,

Y = Dependent variable scores X = Independent variable scores.

A security can have betas that are positive, negative or zero. A beta of 1.0

indicates a security of average risk. A stock with beta greater than 1.0 has above

average risk and vice versa.

PORTFOLIO

Portfolio is a financial term denoting a collection of investments held by an

investment company, hedge fund, financial institution or individual. The term

portfolio refers to any collection of financial assets such as stocks, bonds and

cash. Portfolios may be held by individual investors and/or managed by financial

professionals, hedge funds, banks and other financial institutions. It is a generally

accepted principle that a portfolio is designed according to the investor's risk

tolerance, time frame and investment objectives. The euro amount of each asset

may influence the risk/reward ratio of the portfolio and is referred to as the asset

allocation of the portfolio. When determining a proper asset allocation one aims at

maximizing the expected return and minimizing the risk.

A combination of securities with different risk and return characteristics will

constitute the portfolio of the investor. Thus, a portfolio is the combination of

various assets and/ or instruments of investments. The combination may have

different features of risk and return, separate from those of the components. The

portfolio is also built up out of the wealth or income of the investor over a period

of time, with a view to suit his risk and return preference to that of the portfolio

that he holds. The portfolio analysis of the risk and return characteristics of

individual securities in the portfolio and changes that may take place in

combination with other securities due to interaction among themselves and impact

of each one of them on others.



An investor considering investments in securities is faced with the problem of

choosing from among a large number of securities. His choice depends upon the

risk and return characteristics of individual securities. He would attempt to choose

the most desirable securities and like to allocate is funds over this group of

securities. Again he is faced with the problem of deciding which securities to hold

and how much to invest in each. The risk and return characteristics of portfolio

differ from those of individual securities combining to form a portfolio. The

investor tries to choose the optimal portfolio taking in to consideration the risk –

return characteristics of all possible portfolios.

As the economy and the financial environment keep changing the risk return

characteristics of individual securities as well as portfolio also change. This calls

for periodical review and revision of investment portfolios of investors. An

investor invests his funds in a portfolio expecting to get a good return consistent

with the risk that he has to bear. The return realised from the portfolio has to be

measured and the performance of the portfolio has to be evaluated. Portfolio

management comprises all the processes involved in the creation and the

maintenance of an investment portfolio. It deals specifically with the security

analysis, portfolio analysis, portfolio selection, portfolio revision, and portfolio

evaluation. Portfolio management makes use of analytical techniques of analysis

and conceptual theories regarding rational allocation of funds. Portfolio

management is a complex process which tries to make investment activity more

rewarding and less risky.

OPTIMAL PORTFOLIO

The optimal portfolio concept falls under the modern portfolio theory. The theory

assumes (among other things) that investors fanatically try to minimize risk while

striving for the highest return possible. The theory states that investors will act

rationally, always making decisions aimed at maximizing their return for their

acceptable level of risk.

Harry Markowitz used the optimal portfolio in 1952, and it shows us that it is

possible for different portfolios to have varying levels of risk and return. Each

investor must decide how much risk they can handle and then allocate (or

diversify) their portfolio according to this decision.



The chart below illustrates how the optimal portfolio works. The optimal-risk

portfolio is usually determined to be somewhere in the middle of the curve

because as you go higher up the curve, you take on proportionately more risk for a

lower incremental return. On the other end, low risk/low return portfolios are

pointless because you can achieve a similar return by investing in risk-free assets,

like government securities.

You can choose how much volatility you are willing to bear in your portfolio by

picking any other point that falls on the efficient frontier. This will give you the

maximum return for the amount of risk you wish to accept. Optimizing your

portfolio is not something you can calculate in your head. There are computer

programs that are dedicated to determining optimal portfolios by estimating

hundreds (and sometimes thousands) of different expected returns for each given

amount of risk.

OPTIMAL PORTFOLIO OF SHARPE

This optimal portfolio of Sharpe is called the single Index Model. The optimal

portfolio is directly related to the Beta. If is expected return on stock i and is

Risk free Rate, then the excess return = Ri - R f . This has to be adjusted toBi ,

namely R i−R f

β i which is the equation for ranking stocks in the order of their

return adjusted for risk. The method involves selecting a cut off rate for inclusion



of securities in a portfolio. For this purpose, excess return to Beta ratio given

above has to be calculated for each stock and rank them from highest to lowest.

Then only those securities which have greater cut off point fixed in advance can

be selected. For a portfolio of i stocks is given by cut off rate.

CAPM

William F. Sharpe and John Linter developed the Capital Asset Pricing Model

(CAPM). The model is based on the portfolio theory developed by Harry

Markowitz. The model emphasises the risk factor in portfolio theory is a

combination of two risks, systematic risk and unsystematic risk. The model

suggests that a security’s return is directly related to its systematic risk, which

cannot be neutralised through diversification. The combination of both types of

risks stated above provides the total risk. The total variance of returns is equal to

market related variance plus company’s specific variance. CAPM explains the

behaviour of security prices and provides a mechanism whereby investors could

assess the impact of a proposed security investment on the overall portfolio risk

and return. CAPM suggests that the prices of securities are determined in such a

way that the risk premium or excess returns are proportional to systematic risk,

which is indicated by the beta coefficient. The model is used for analysing the

risk-return implications of holding securities. CAPM refers to the manner in

which securities are valued in line with their anticipated risks and returns. A risk-

averse investor prefers to invest in risk-free securities. For a small investor having

few securities in his portfolio, the risk is greater. To reduce the unsystematic risk,

he must build up well-diversified securities in his portfolio.

The asset return depends on the amount for the asset today. The price paid must

ensure that the market portfolio’s risk/return characteristics improve when the

asset is added to it. The CAPM is a model, which derives the theoretical required

return (i.e. discount rate) for an asset in a market, given the risk-free rate available

to investors and the risk of the market as a whole.

The CAPM is usually expressed:



β(Beta), is the measure of asset sensitivity to a movement in the overall market;

Beta is usually found via regression on historical data. Betas exceeding one

signify more than average “riskiness”; betas below one indicate lower than

average.

(Rf) is the market premium, the historically observed excess return of the market

over the risk- free rate. Once the expected return, E(ri), is calculated using CAPM,

the future cash flows of the asset can be discounted to their present value using

this rate to establish the correct price for the asset.

A more risky stock will have a higher beta and will be discounted at a higher rate;

less sensitive stocks will have lower betas and be discounted at a lower rate. In

theory, an asset is correctly priced when its observed price is the same as its value

calculated using the CAPM derived discount rate. If the observed price is higher

than the valuation, then the asset is overvalued; it is undervalued for a too low

price.

ASSUMPTIONS TO CAPITAL ASSET PRICING MODEL

Because the CAPM is a theory, we must assume for argument that

1. All assets in the world are traded.

2. All assets are infinitely divisible.

3. All investors in the world collectively hold all assets.

4. For every borrower, there is a lender.

5. There is a riskless security in the world.

6. All investors borrow and lend at the riskless rate.

7. Everyone agrees on the inputs to the Mean-STD picture.

8. Preferences are well described by simple utility functions.

9. Security distributions are normal, or at least well described by two

parameters.



10. There are only two periods of time in our world.

This is a long list of requirements, and together they describe the capitalist’s ideal

world. 'Everything may be bought and sold in perfectly liquid fractional amounts

even human capital! There is a perfect, safe haven for risk-averse investors i.e. the

riskless asset. This means that everyone is an equally good credit risk! No one has

any informational advantage in the CAPM world. Everyone has already

generously shared all of their knowledge about the future risk and return of the

securities, so no one disagrees about expected returns. All customer preferences

are an open book risk attitudes are well described by a simple utility function.

There is no mystery about the shape of the future return distributions. Last but not

least, decisions are not complicated by the ability to change your mind through

time. You invest irrevocably at one point, and reap the rewards of your investment

in the next period at which time you and the investment problem cease to exist.

Terminal wealth is measured at that time i.e. he who dies with the most toys wins!

The technical name for this setting is “A frictionless one-period, multi-asset

economy with no asymmetric information.”

MARKOWITZ MEAN-VARIANCE MODEL

Harry Markowitz is regarded as the father of modern portfolio theory. According

to him, investors are mainly concerned with two properties of an asset: risk and

return, but by diversification of portfolio it is possible to trade-off between them.

The essence of his theory is that risk of an individual asset hardly matters to an

investor. What really counts is the contribution it makes to the investor’s total

risk. By turning his principle into a useful technique for selecting the right

portfolio from a range of different assets, he developed ‘Mean Variance Analysis’

in 1952. The thrust has been on balancing safety, liquidity and return depending

on the taste of different investors. The portfolio selection problem can be divided

into two stages, first finding the mean-variance efficient portfolios and secondly

selecting one such portfolio. Investors do not like risk and the greater the riskiness

of returns on an investment, the greater will be the returns expected by investors.

There is a trade-off between risk and return, which must be reflected in the

required rates of return on investment opportunities. The standard deviation (or

variance) of return measures the total risk of an investment. It is not necessary for



an investor to accept the total risk of an individual security. Investors can and do

diversify to reduce risk. As number of holdings approach larger, a good deal of

total risk is removed by diversification.

ASSUMPTIONS

This model has taken into account of risks associated with investments — using

variance or standard deviation of the return. This model is based on the following

assumptions:

The return on an investment adequately summarises the outcome of the

investment.

All investors are risk-averse. For a given expected return he prefers to take

minimum risk, obviously for a given level of risk the investor prefers to

get maximum expected return.

Investors are assumed to be rational in so far as they would prefer greater

returns to lesser ones given equal or smaller risk and risk averse. Risk

aversion in this context means merely that, as between two investments

with equal expected returns, the investment with the smaller risk would be

preferred.

‘Return’ could be any suitable measure of monetary inflows such as NPV,

but yield has been the most commonly used measure of return, in this

context, so that where the standard deviation of returns is referred to we

shall mean the standard deviation of yield about its expected value.

The investors can visualise a probability distribution of rates of return.

The investors’ risk estimates are proportional to the variance of return they

perceive for a security or portfolio.

Investors base their investment decisions on two criteria i.e., expected

return and variance of return.

Harry M. Markowitz is credited with introducing new concepts of risk

measurement and their application to the selection of portfolios. He started with

the idea of risk aversion of average investors and their desire to maximize the

expected return with the least risk. Markowitz model is thus a theoretical



framework for analysis of risk and return and their inter-relationships. He used the

statistical analysis for measurement of risk and mathematical programming for

selection of assets in a portfolio in an efficient manner. His framework led to

the .concept of efficient portfolios. An efficient portfolio is expected to yield the

highest return for a given level of risk or lowest risk for a given level of return.

Markowitz postulated that diversification should not only aim at reducing the risk

of a security by reducing its variability or standard deviation, but by reducing the

covariance or interactive risk of two or more securities in a portfolio. As by

combination of different securities, it is theoretically possible to have a range of

risk varying from zero to infinity. Markowitz theory of portfolio diversification

attaches importance to standard deviation, to reduce it to zero, if possible,

covariance to have as much as possible negative interactive effect among the

securities within the portfolio and coefficient of correlation to have – 1(-ive) so

that the overall risk of the portfolio as a whole is nil or negligible. Then the

securities have to be combined in a m3nner that standard deviation is zero.

EFFICIENT FRONTIER

Markowitz has formulised the risk return relationship and developed the concept

of efficient frontier. For selection of a portfolio, comparison between

combinations of portfolios is essential. As a rule, a portfolio is not efficient if

there is another portfolio with:

a higher expected value of return and a lower standard deviation (risk)

a higher expected value of return and the same standard deviations (risk).

the same expected value but a lower standard deviation (risk).

Markowitz has defined the diversification as the process of combining assets that

are less than perfectly positively correlated in order to reduce portfolio risk

without sacrificing any portfolio returns. If an investor’s portfolio is not efficient

he may:

increase the expected value of return without increasing the risk.

decrease the risk without decreasing the expected value of return, or



obtain some combination of increase of expected return and decreased

risk.

This is possible by switching to a portfolio on the efficient frontier. If all the

investments are plotted on the risk-return sphere, individual securities would be

dominated by portfolios, and the efficient frontier would take shape, indicating

investments which yield maximum return given the level of risk bearable, or

which minimises risk given the expected level of return. The figure depicts

the boundary of possible investments in securities A, B, C, D, E and F; and B, C,

D are lying on the efficient frontier.

The best combination of expected value of return and risk (standard deviation)

depends upon the investors’ utility function. The individual investor will want to

hold that portfolio of securities that places him on the highest indifference curves,

choosing from the set of available portfolios. The dark line at the top of the set is

the line of efficient combinations, or the efficient frontier. It depicts the trade-off

between risk and expected value of return.

The optimal investment achieved at a point where the indifference curve is at a

tangent to the efficient frontier. This point reflects the risk level acceptable to the

investor in order to achieve a desired return and provide maximum return for the



bearable level of risk. The concept of efficient frontier, and the optimal point

location is explained with help of next figure. A, B, C, D, E and F define the

boundary of all possible investments out of which investments in B, C and D are

the efficient proposals lying on the efficient frontier. The attractiveness of the

investment proposals lying on the efficient frontier depends on the investors’

attitude to risk. At point B, the level of risk and return is at optimum level. The

returns are the highest at point D, but simultaneously it carries higher risk than

any other investment.

The shaded area represents all attainable portfolios that are all the combinations of

risk and expected return that may be achieved with the available securities. The

efficient frontier denotes all possible efficient portfolios and any point on the

frontier dominates any point to the right of it.

EFFICIENT MARKET HYPOTHESIS

In finance, the efficient-market hypothesis (EMH) asserts that financial markets

are "informationally efficient". That is, one cannot consistently achieve returns in

excess of average market returns on a risk-adjusted basis, given the information

available at the time the investment is made. The efficient-market hypothesis was

developed by Professor Eugene Fama as an academic concept of study through his

published Ph.D. thesis in the early 1960s at the same school. Any one person can

be wrong about the market, indeed, everyone can be, but the market as a whole is



always right. There are three common forms in which the efficient-market

hypothesis is commonly stated- weak-form efficiency, semi-strong-form

efficiency and strong-form efficiency, which has different implications for how

markets work.

In weak-form efficiency, future prices cannot be predicted by analyzing prices

from the past. Excess returns cannot be earned in the long run by using investment

strategies based on historical share prices or other historical data. Share prices

exhibit no serial dependencies. This implies that future price movements are

determined entirely by information not contained in the price series. Hence, prices

must follow a random walk. This does not require that prices remain at or near

equilibrium, but only that market participants not be able to systematically profit

from market 'inefficiencies'.

In semi-strong-form efficiency, it is implied that share prices adjust to publicly

available new information very rapidly and in an unbiased fashion, such that no

excess returns can be earned by trading on that information. It implies that neither

fundamental analysis nor technical analysis techniques will reliably produce

excess returns. To test for semi-strong-form efficiency, the adjustments to

previously unknown news must be of a reasonable size and must be instantaneous.

In strong-form efficiency, share prices reflect all information, and no one can earn

excess returns. If there are legal barriers to private information becoming public,

strong-form efficiency is impossible. To test for strong-form efficiency, a market

needs to exist where investors cannot consistently earn excess returns over a long

period of time. Even if some money managers are consistently observed to beat

the market, no refutation even of strong-form efficiency follows: with thousands

of fund managers worldwide, even a normal distribution of returns should be

expected to produce a few dozen "star" performers.

PORTFOLIO DESIGN

Before designing a portfolio one will have to know the intention of the investor or

the returns that the investor is expecting from his investment. This will help in

adjusting the amount of risk. This becomes an important point of view of the

portfolio designer because if the investor will be ready to take more risk at the



same time he will also get more returns. This can be more appropriately

understood from the figure drawn below.

From the above figure we can see that when the investor is ready to take the risk

of M1, he is likely to get expected return of R1, and if the investor is taking the

risk of M2, he will be getting more returns i.e. R2. So we can conclude that risk

and return is directly related with each other. As one increases the other will also

increase in same of different proportion and same if one decreases the other will

also decreases.

From the above discussion we can conclude that the investors can be of the

following:

1. Investors willing to take minimum risk and at the same time are also

expecting minimum returns.

2. Investors willing to take moderate risk and the same time are also

expecting moderate returns.

3. Investors willing to take maximum risk and at the same time are also

expecting maximum returns.

RISK REDUCTION BY DIVERSIFICATION OF THE PORTFOLIO

Diversification means dividing your investments among a variety of assets.

Diversification helps to reduce risk because different investments rise and fall

independent of each other. The combinations of these assets more often than not



will cancel out each other's fluctuations, therefore reducing risk. Diversification

helps to reduce risk because different investments rise and fall independent of

each other. There are many ways to diversify your investment portfolio. You can

diversify across one type of asset classification—such as stocks. For example, you

might purchase shares in the leading companies across many different (and

unrelated) industries. Alternatively, you can diversify your portfolio across

different types of assets such as stocks, bonds, and real estate, for example. You

can also diversify on the basis of regional decisions such as state, region, or

country. Simply stated, diversification means "don't put all your eggs into one

basket."

The ultimate goal of diversification is to improve performance while reducing

investment risks. A well-diversified portfolio spreads risks over a range of

investments whose performances are not tied to the performance of the other

assets in the portfolio.

Diversification is a risk-management technique that mixes a wide variety of

investments within a portfolio in order to minimize the impact that any one

security will have on the overall performance of the portfolio Diversification

lowers the risk of your portfolio. Academics have complex formulas to

demonstrate how this works, but we can explain it clearly with an example:

Suppose that you live on an island where the entire economy consists of only two

companies: one sells umbrellas, while the other sells sunscreen. If you invest your

entire portfolio in the company that sells umbrellas, you’ll have strong

performance during the rainy season, but poor performance when it’s sunny

outside. The reverse occurs with the sunscreen company, the alternative

investment; your portfolio will be high performance when the sun is out, but it

will tank when the clouds roll in. Chances are you’d rather have constant, steady

returns. The solution is to invest 50% in one company and 50% in the other.

Because you have diversified your portfolio, you will get decent performance year

round, instead of having either excellent or terrible performance depending on the

season

There are three main things that should ensure that the portfolio is adequately

diversified:



1. The portfolio should be spread among many different investment vehicles

such as cash, stocks, bonds, mutual funds, and perhaps even some real

estate.

2. The securities should vary in risk. You're not restricted to picking only

blue chip stocks. In fact, the opposite is true. Picking different investments

with different rates of return will ensure that large gains offset losses in

other areas.

3. The securities should vary by industry, minimizing unsystematic risk to

small groups of companies.

Diversification can greatly reduce unsystematic risk from a portfolio. It is unlikely

that events such as the ones listed above would happen in every firm at the same

time. Therefore, by diversifying, one can reduce their risk. There is no reward for

taking on unneeded unsystematic risk.

Investors are induced to take risks for potentially higher returns. However, not all

risks offer such potential rewards. The wise investor identifies these risks and

eliminates them from his or her portfolio through diversification.

Diversification helps reduce risk from an investment portfolio by eliminating

unsystematic risk from the portfolio. By choosing securities of different

companies in different industries, you can minimize the risks associated with a

particular company's "bad luck." By diversifying among asset classes that are

negatively or weakly correlated (i.e., whose up or down price movements don't

mirror each other), you further reduce the volatility of your portfolio.

However, diversification can reduce the return of your portfolio as well. By

selecting several assets, the overall return on your portfolio will be the weighted

average of the returns of those assets. For example, let us look at a portfolio made

up 50/50 of a single stock and a single bond. In one year, the stock has a total

return of 30 percent, the bond 6 percent. The portfolio return will be only 18

percent (36 divided by 2). However, if the entire portfolio were invested in the

stock, the return would have been 30 percent.

Many investors feel that settling for a lower average return is a small price to pay

for eliminating risks for which they cannot be rewarded (unsystematic risk) from



their portfolio. They might argue that if the stock in the example above tanked,

then 3% would look pretty good. Of course, in practice these extremes, while

possible, are rare.

Diversification reduces portfolio risk by eliminating unsystematic risk for which

investors are not rewarded. Investors are rewarded for taking market risk. Because

diversification averages the returns of the assets within the portfolio, it attenuates

the potential highs and lows. Diversification among companies, industries, and

asset classes affords the investor the greatest protection against business risk,

financial risk, and volatility.

Diversification is the most important component in helping you reach your long-

range financial goals while minimizing your risk. At the same time, diversification

is not an ironclad guarantee against loss. No matter how much diversification you

employ, investing does involve taking on some risk.

Another question that frequently baffles investors is how many stocks should be

bought in order to reach optimal diversification. According to portfolio theorists,

adding about 20 securities to your portfolio reduces almost all of the individual

security risk involved. This assumes that you buy stocks of different sizes from

various industries.

FINANCIAL DERIVATIVES

A derivative is a financial instrument which derives its value from the value of

underlying entities such as an asset, index, or interest rate--it has no intrinsic value

in itself. Derivative transactions include a variety of financial contracts, including

structured debt obligations and deposits, swaps, futures, options, caps, floors,

collars, forwards, and various combinations of these.

The term “Derivative” indicates that it has no independent value, i.e., its value is

entirely derived from the value of the underlying asset. The underlying asset can

be securities, commodities, bullion, currency, livestock or anything else. In other

words, derivative means forward, futures, option or any other hybrid contract of

predetermined fixed duration, linked for the purpose of contract fulfillment to the

value of a specified real or financial asset or to an index of securities.



The Securities Contracts (Regulation) Act 1956 defines “derivative” as under:

“Derivative” includes

1. Security derived from a debt instrument, share, loan whether secured or

unsecured, risk instru¬ment or contract for differences or any other form

of security.

2. A contract which derives its value from the prices, or index of prices of

underlying securities.

The above definition conveys that

The derivatives are financial products.

Derivative is derived from another financial instrument/contract called the

underlying. In the case of Nifty futures, Nifty index is the underlying. A

derivative derives its value from the underlying assets. Accounting

Standard SFAS133 defines a derivative as, ‘a derivative instrument is a

financial derivative or other contract with all three of the following

characteristics:

i. It has (1) one or more underlyings, and (2) one or more notional amount or

payments provisions or both. Those terms determine the amount of the

settlement or settlements.

ii. It requires no initial net investment or an initial net investment that is

smaller than would be required for other types of contract that would be

expected to have a similar response to changes in market factors.

iii. Its terms require or permit net settlement. It can be readily settled net by a

means outside the contract or it provides for delivery of an asset that puts

the recipients in a position not substantially different from net settlement.

In general, from the aforementioned, derivatives refer to securities or to contracts

that derive from another—whose value depends on another contract or assets. As

such the financial derivatives are financial instruments whose prices or values are

derived from the prices of other underlying financial instruments or financial

assets. The underlying instruments may be a equity share, stock, bond, debenture

treasury bill, foreign currency or even another derivative asset. For example, a



stock option’s value depends upon the value of a stock on which the option is

written. Similarly, the value of a treasury bill of futures contracts or foreign

currency forward contract will depend upon the price or value of the underlying

assets, such as Treasury bill or foreign currency. In other words, the price of the

derivative is not arbitrary rather it is linked or affected to the price of the

underlying asset that will automatically affect the price of the financial derivative.

Due to this reason, transactions in derivative markets are used to offset the risk of

price changes in the underlying assets. In fact, the derivatives can be formed on

almost any variable. for example, from the price of hogs to the among of snow

falling at a certain ski resort.

The term financial derivative relates with a variety of financial instruments which

include stocks, treasury bills, interest rate, foreign currencies and other hybrid

securities. Financial derivatives include futures, forwards, options, swaps, etc.

Futures contracts are the most important form of derivatives which are in

existence long before the term ‘derivative’ was coined. Financial derivatives can

also be derived from a combination of cash market instruments or other financial

derivative instruments. In fact most of the financial derivatives are not

revolutionary new instruments rather they are merely combinations of older

generation derivatives and/or standard cash market instruments.

In the 1980s, the financial derivatives were also known as off-balance sheet

instruments because no asset or liability underlying the contract was put on the

balance sheet as such. Since the value of such derivatives depend upon the

movement of market prices of the underlying assets, hence, they were treated as

contingent asset or liabilities and such transactions and positions in derivatives

were not recorded on the balance sheet. However, it is a matter of considerable

debate whether off-balance sheet instruments should be included in the definition

of derivatives. Which item or product given in the balance sheet should be

considered for derivative is a debatable issue.

In brief, the term financial market derivative can be defined as a treasury or

capital market instrument which is derived from, or bears a close relation to a

cash instrument or another derivative instrument. Hence, financial derivatives are

financial instruments whose prices are derived from the prices of other financial

instruments.



In practice, derivatives are a contract between two parties that specify conditions

(especially the dates, resulting values and definitions of the underlying variables,

the parties' contractual obligations, and the notional amount) under which

payments are to be made between the parties. The most common underlying assets

include commodities, stocks, bonds, interest rates and currencies.

There are two groups of derivative contracts: the privately traded Over-the-

counter (OTC) derivatives such as swaps that do not go through an exchange or

other intermediary, and exchange-traded derivatives (ETD) that are traded through

specialized derivatives exchanges or other exchanges.

Derivatives are more common in the modern era, but their origins trace back

several centuries. One of the oldest derivatives is rice futures, which have been

traded on the Dojima Rice Exchange since the eighteenth century. Derivatives are

broadly categorized by the relationship between the underlying asset and the

derivative (such as forward, option, swap); the type of underlying asset (such as

equity derivatives, foreign exchange derivatives, interest rate derivatives,

commodity derivatives, or credit derivatives); the market in which they trade

(such as exchange-traded or over-the-counter); and their pay-off profile.

Derivatives may broadly be categorized as "lock" or "option" products. Lock

products (such as swaps, futures, or forwards) obligate the contractual parties to

the terms over the life of the contract. Option products (such as interest rate caps)

provide the buyer the right, but not the obligation to enter the contract under the

terms specified.

Derivatives can be used either for risk management (i.e. to "hedge" by providing

offsetting compensation in case of an undesired event, a kind of "insurance") or

for speculation (i.e. making a financial "bet"). This distinction is important

because the former is a legitimate, often prudent aspect of operations and financial

management for many firms across many industries; the latter offers managers

and investors a seductive opportunity to increase profit, but not without incurring

additional risk that is often undisclosed to stakeholders.

FEATURES OF A FINANCIAL DERIVATIVE



The basic features of the derivative instrument can be drawn from the general

definition of a derivative irrespective of its type. Derivatives or derivative

securities are future contracts which are written between two parties (counter

parties) and whose value are derived from the value of underlying widely held and

easily marketable assets such as agricultural and other physical (tangible)

commodities, or short term and long term financial instruments, or intangible

things like weather, commodities price index (inflation rate), equity price index,

bond price index, stock market index, etc. Usually, the counter parties to such

contracts are those other than the original issuer (holder) of the underlying asset.

From this definition, the basic features of a derivative may be stated as follows:

1. A derivative instrument relates to the future contract between two parties.

It means there must be a contract-binding on the underlying parties and the same

to be fulfilled in future. The future period may be short or long depending upon

the nature of contract, for example, short term interest rate futures and long term

interest rate futures contract.

2. Normally, the derivative instruments have the value which derived from

the values of other underlying assets, such as agricultural commodities, metals,

financial assets, intangible assets, etc. Value of derivatives depends upon the value

of underlying instrument and which changes as per the changes in the underlying

assets, and sometimes, it may be nil or zero. Hence, they are closely related.

3. In general, the counter parties have specified obligation under the

derivative contract. Obviously, the nature of the obligation would be different as

per the type of the instrument of a derivative. For example, the obligation of the

counter parties, under the different derivatives, such as forward contract, future

contract, option contract and swap contract would be different.

4. The derivatives contracts can be undertaken directly between the two

parties or through the particular exchange like financial futures contracts. The

exchange-traded derivatives are quite liquid and have low transaction costs in

comparison to tailor-made contracts. Example of exchange traded derivatives are

Dow Jons, S&P 500, Nikki 225, NIFTY option, S&P Junior that are traded on

New York Stock Exchange, Tokyo Stock Exchange, National Stock Exchange,

Bombay Stock Exchange and so on.



5. In general, the financial derivatives are carried off-balance sheet. The size

of the derivative contract depends upon its notional amount. The notional amount

is the amount used to calculate the pay off. For instance, in the option contract, the

potential loss and potential payoff, both may be different from the value of

underlying shares, because the payoff of derivative products differs from the

payoff that their notional amount might suggest.

6. Usually, in derivatives trading, the taking or making of delivery of

underlying assets is not involved; rather underlying transactions are mostly settled

by taking offsetting positions in the derivatives themselves. There is, therefore, no

effective limit on the quantity of claims, which can be traded in respect of

underlying assets.

7. Derivatives are also known as deferred delivery or deferred payment

instrument. It means that it is easier to take short or long position in derivatives in

comparison to other assets or securities. Further, it is possible to combine them to

match specific, i.e., they are more easily amenable to financial engineering.

8. Derivatives are mostly secondary market instruments and have little

usefulness in mobilizing fresh capital by the corporate world, however, warrants

and convertibles are exception in this respect.

9. Although in the market, the standardized, general and exchange-traded

derivatives are being increasingly evolved, however, still there are so many

privately negotiated customized, over-the- counter (OTC) traded derivatives are in

existence. They expose the trading parties to operational risk, counter-party risk

and legal risk. Further, there may also be uncertainty about the regulatory status of

such derivatives.

10. Finally, the derivative instruments, sometimes, because of their off-

balance sheet nature, can be used to clear up the balance sheet. For example, a

fund manager who is restricted from taking particular currency can buy a

structured note whose coupon is tied to the performance of a particular currency

pair.

USAGE OF DERIVATIVES



Derivatives are used by investors for the following:

hedge or mitigate risk in the underlying, by entering into a derivative

contract whose value moves in the opposite direction to their underlying

position and cancels part or all of it out;

create option ability where the value of the derivative is linked to a

specific condition or event (e.g. the underlying reaching a specific price

level);

obtain exposure to the underlying where it is not possible to trade in the

underlying (e.g., weather derivatives);

provide leverage (or gearing), such that a small movement in the

underlying value can cause a large difference in the value of the derivative;

Speculate and make a profit if the value of the underlying asset moves the

way they expect (e.g., moves in a given direction, stays in or out of a

specified range, reaches a certain level).

Switch asset allocations between different asset classes without disturbing

the underlining assets, as part of transition management.

SERVICES PROVIDED BY DERIVATIVES

Derivatives are supposed to provide the following services:

1. One of the most important services provided by the derivatives is to control,

avoid, shift and manage efficiently different types of risks through various

strategies like hedging, arbitraging, spreading, etc. Derivatives assist the

holders to shift or modify suitably the risk characteristics of their portfolios.

These are specifically useful in highly volatile financial market conditions like

erratic trading, highly flexible interest rates, volatile exchange rates and

monetary chaos.

2. Derivatives serve as barometers of the future trends in prices which result in

the discovery of new prices both on the spot and futures markets. Further, they

help in disseminating different information regarding the futures markets

trading of various commodities and securities to the society which enable to

discover or form suitable or correct or true equilibrium prices in the markets.



As a result, they assist in appropriate and superior allocation of resources in

the society.

3. As we see that in derivatives trading no immediate full amount of the

transaction is required since most of them are based on margin trading. As a

result, large number of traders, speculators arbitrageurs operates in such

markets. So, derivatives trading enhance liquidity and reduce transaction costs

in the markets for underlying-assets.

4. The derivatives assist the investors, traders and managers of large pools of

funds to devise such strategies so that they may make proper asset allocation

increase their yields and achieve other investment goals.

5. It has been observed from the derivatives trading in the market that the

derivatives have smoothen out price fluctuations, squeeze the price spread,

integrate price structure at different points of time and remove gluts and

shortages in the markets.

6. The derivatives trading encourage the competitive trading in the markets,

different risk taking preference of the market operators like speculators,

hedgers, traders, arbitrageurs, etc. resulting in increase in trading volume in

the country. They also attract young investors, professionals and other experts

who will act as catalysts to the growth of financial markets.

7. Lastly, it is observed that derivatives trading develop the market towards

‘complete markets’. Complete market concept refers to that situation where no

particular investors be better of than others, or patterns of returns of all

additional securities are spanned by the already existing securities in it, or

there is no further scope of additional security.

TYPES OF DERIVATIVES

OTC AND EXCHANGE-TRADED

In broad terms, there are two groups of derivative contracts, which are

distinguished by the way they are traded in the market:



Over-the-counter (OTC) derivatives are contracts that are traded (and

privately negotiated) directly between two parties, without going through

an exchange or other intermediary. Products such as swaps, forward rate

agreements, exotic options — and other exotic derivatives — are almost

always traded in this way. The OTC derivative market is the largest market

for derivatives, and is largely unregulated with respect to disclosure of

information between the parties, since the OTC market is made up of

banks and other highly sophisticated parties, such as hedge funds.

Reporting of OTC amounts are difficult because trades can occur in

private, without activity being visible on any exchange.

Exchange-traded derivatives (ETD) are those derivatives instruments that

are traded via specialized derivatives exchanges or other exchanges. A

derivatives exchange is a market where individuals’ trade standardized

contracts that have been defined by the exchange. A derivatives exchange

acts as an intermediary to all related transactions, and takes initial margin

from both sides of the trade to act as a guarantee. The world's largest

derivatives exchanges (by number of transactions) are the Korea Exchange

(which lists KOSPI Index Futures & Options), Eurex (which lists a wide

range of European products such as interest rate & index products), and

CME Group (made up of the 2007 merger of the Chicago Mercantile

Exchange and the Chicago Board of Trade and the 2008 acquisition of the

New York Mercantile Exchange). According to BIS, the combined

turnover in the world's derivatives exchanges totaled USD 344 trillion

during Q4 2005. By December 2007 the Bank for International

Settlements reported that "derivatives traded on exchanges surged 27% to

a record $681 trillion."

COMMON DERIVATIVE CONTRACT TYPES

Some of the common variants of derivative contracts are as follows:

1. Forwards: A tailored contract between two parties, where payment takes

place at a specific time in the future at today's pre-determined price.

2. Futures: are contracts to buy or sell an asset on or before a future date at a

price specified today. A futures contract differs from a forward contract in



that the futures contract is a standardized contract written by a clearing

house that operates an exchange where the contract can be bought and

sold; the forward contract is a non-standardized contract written by the

parties themselves.

3. Options are contracts that give the owner the right, but not the obligation,

to buy (in the case of a call option) or sell (in the case of a put option) an

asset. The price at which the sale takes place is known as the strike price,

and is specified at the time the parties enter into the option. The option

contract also specifies a maturity date. In the case of a European option,

the owner has the right to require the sale to take place on (but not before)

the maturity date; in the case of an American option, the owner can require

the sale to take place at any time up to the maturity date. If the owner of

the contract exercises this right, the counter-party has the obligation to

carry out the transaction. Options are of two types: call option and put

option. The buyer of a Call option has a right to buy a certain quantity of

the underlying asset, at a specified price on or before a given date in the

future, he however has no obligation whatsoever to carry out this right.

Similarly, the buyer of a Put option has the right to sell a certain quantity

of an underlying asset, at a specified price on or before a given date in the

future, he however has no obligation whatsoever to carry out this right.

4. Binary options are contracts that provide the owner with an all-or-nothing

profit profile.

5. Warrants: Apart from the commonly used short-dated options which have

a maximum maturity period of 1 year, there exists certain long-dated

options as well, known as Warrant (finance). These are generally traded

over-the-counter.

6. Swaps are contracts to exchange cash (flows) on or before a specified

future date based on the underlying value of currencies exchange rates,

bonds/interest rates, commodities exchange, stocks or other assets.

Another term which is commonly associated to Swap is Swaption which is

basically an option on the forward Swap. Similar to a Call and Put option,

a Swaption is of two kinds: a receiver Swaption and a payer Swaption.

While on one hand, in case of a receiver Swaption there is an option



wherein you can receive fixed and pay floating, a payer swaption on the

other hand is an option to pay fixed and receive floating.

Swaps can basically be categorized into two types:

Interest rate swap: These basically necessitate swapping only interest

associated cash flows in the same currency, between two parties.

Currency swap: In this kind of swapping, the cash flow between the two

parties includes both principal and interest. Also, the money which is

being swapped is in different currency for both parties.

OPTIONS

An option is a contract which gives the owner the right, but not the obligation,

to buy or sell an underlying asset or instrument at a specified strike price on or

before a specified date. The seller incurs a corresponding obligation to fulfill

the transaction that is to sell or buy, if the long holder elects to "exercise" the

option prior to expiration. The buyer pays a premium to the seller for this

right. An option which conveys the right to buy something at a specific price

is called a call; an option which conveys the right to sell something at a

specific price is called a put. Options come in two varieties, calls and puts, and

you can buy or sell either type. You make those choices - whether to buy or

sell and whether to choose a call or a put - based on what you want to achieve

as an options investor.

EQUITY OPTIONS

An equity option is a contract which conveys to its holder the right, but not the

obligation, to buy (in the case of a call) or sell (in the case of a put) shares of

the underlying security at a specified price (the strike price) on or before a

given date (expiration day). After this given date, the option ceases to exist.

The seller of an option is, in turn, obligated to sell (in the case of a call) or buy

(in the case of a put) the shares to (or from) the buyer of the option at the

specified price upon the buyer's request.

STRIKE PRICE



Strike prices (or exercise prices) are the stated price per share for which the

underlying security may be purchased (in the case of a call) or sold (in the

case of a put) by the option holder upon exercise of the option contract. The

strike price, a fixed specification of an option contract, should not be confused

with the premium, the price at which the contract trades, which fluctuates

daily.

The strike price (or exercise price) of an option is the fixed price at which the

owner of the option can purchase (in the case of a call), or sell (in the case of a

put), the underlying security or commodity.

The strike price is a key variable in a derivatives contract between two parties.

Where the contract requires delivery of the underlying instrument, the trade

will be at the strike price, regardless of the spot price (market price) of the

underlying instrument at that time.

TYPES

The Options can be classified into following types:

EXCHANGE-TRADED OPTIONS

Exchange-traded options (also called "listed options") are a class of

exchange-traded derivatives. Exchange traded options have standardized

contracts, and are settled through a clearing house with fulfillment

guaranteed by the Options Clearing Corporation (OCC). Since the

contracts are standardized, accurate pricing models are often available.

Exchange-traded options include:

stock options,

bond options and other interest rate options

stock market index options or, simply, index options and

options on futures contracts

callable bull/bear contract

OVER-THE-COUNTER



Over-the-counter options (OTC options, also called "dealer options") are

traded between two private parties, and are not listed on an exchange. The

terms of an OTC option are unrestricted and may be individually tailored to

meet any business need. In general, at least one of the counterparties to an

OTC option is a well-capitalized institution. Option types commonly traded

over the counter include:

1. interest rate options

2. currency cross rate options, and

3. options on swaps or swaptions.

OTHER OPTION TYPES

Another important class of options, particularly in the U.S., is employee stock

options, which are awarded by a company to their employees as a form of

incentive compensation. Other types of options exist in many financial

contracts, for example real estate options are often used to assemble large

parcels of land, and prepayment options are usually included in mortgage

loans. However, many of the valuation and risk management principles apply

across all financial options.

TRADES

LONG CALL

A trader who believes that a stock’s price will increase might buy the right to

purchase the stock (a call option) at a fixed price, rather than just purchase the

stock itself. He would have no obligation to buy the stock, only the right to do

so until the expiration date. If the stock price (spot Price, S) at expiration is

above the exercise price(X) by more than the premium (price) paid, he will

profit i.e. if S>X, the deal is profitable. If the stock price at expiration is lower

than the exercise price, he will let the call contract expire worthless, and only

lose the amount of the premium. A trader might buy the option instead of

shares, because for the same amount of money, he can control (leverage) a

much larger number of shares.



LONG PUT

A trader who believes that a stock’s price will decrease can buy the right to

sell the stock at a fixed price (a put option). He will be under no obligation to

sell the stock, but has the right to do so until the expiration date. If the stock

price at expiration is below the exercise price by more than the premium paid,

he will profit. If the stock price at expiration is above the exercise price, he

will let the put contract expire worthless and only lose the premium paid.In the

whole story, the premium also plays a major role as it enhances the break-even

point. For example, if exercise price is 100 premium paid is 10 then a spot

price of 100 to 90 is not profitable, he would earn profit if the spot price is

below 90.

SHORT CALL

A trader who believes that a stock price will decrease can sell the stock short

or instead sell, or "write," a call. The trader selling a call has an obligation to

sell the stock to the call buyer at the buyer's option. If the stock price

decreases, the short call position will make a profit in the amount of the

premium. If the stock price increases over the exercise price by more than the

amount of the premium, the short will lose money, with the potential loss

unlimited.

SHORT PUT

A trader who believes that a stock price will increase can buy the stock or

instead sell, or "write", a put. The trader selling a put has an obligation to buy

the stock from the put buyer at the put buyer's option. If the stock price at

expiration is above the exercise price, the short put position will make a profit

in the amount of the premium. If the stock price at expiration is below the

exercise price by more than the amount of the premium, the trader will lose

money, with the potential loss being up to the full value of the stock.

OPTION STRATEGIES

Combining any of the four basic kinds of option trades (possibly with different

exercise prices and maturities) and the two basic kinds of stock trades (long



and short) allows a variety of options strategies. Simple strategies usually

combine only a few trades, while more complicated strategies can combine

several.

Strategies are often used to engineer a particular risk profile to movements in

the underlying security. For example, buying a butterfly spread (long one X1

call, short two X2 calls, and long one X3 call) allows a trader to profit if the

stock price on the expiration date is near the middle exercise price, X2, and

does not expose the trader to a large loss.

An Iron condor is a strategy that is similar to a butterfly spread, but with

different strikes for the short options offering a larger likelihood of profit but

with a lower net credit compared to the butterfly spread.

Selling a straddle (selling both a put and a call at the same exercise price)

would give a trader a greater profit than a butterfly if the final stock price is

near the exercise price, but might result in a large loss.

Similar to the straddle is the strangle which is also constructed by a call and a

put, but whose strikes are different, reducing the net debit of the trade, but also

reducing the risk of loss in the trade.

One well-known strategy is the covered call, in which a trader buys a stock

(or holds a previously-purchased long stock position), and sells a call. If the

stock price rises above the exercise price, the call will be exercised and the

trader will get a fixed profit. If the stock price falls, the call will not be

exercised, and any loss incurred to the trader will be partially offset by the

premium received from selling the call. Overall, the payoffs match the payoffs

from selling a put. This relationship is known as put-call parity and offers

insights for financial theory.

THE LONG STRADDLE

The long straddle, also known as buy straddle or simply "straddle", is a neutral

strategy in options trading that involve the simultaneously buying of a put and

a call of the same underlying stock, striking price and expiration date.



By having long positions in both call and put options, straddles can achieve

large profits no matter which way the underlying stock price heads, provided

the move is strong enough.

The formula for calculating profit is given below:

Maximum Profit = Unlimited

Profit Achieved When Price of Underlying > Strike Price of Long Call +

Net Premium Paid OR Price of Underlying < Strike Price of Long Put -

Net Premium Paid

Profit = Price of Underlying - Strike Price of Long Call - Net Premium

Paid OR Strike Price of Long Put - Price of Underlying - Net Premium

Paid

BREAKEVEN POINT(S)

There are 2 break-even points for the long straddle position. The breakeven

points can be calculated using the following formulae.

•Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid



•Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

THE LONG STRANGLE

The long strangle, also known as buy strangle or simply "strangle", is a neutral

strategy in options trading that involve the simultaneous buying of a slightly

out-of-the-money put and a slightly out-of-the-money call of the same

underlying stock and expiration date.

The long options strangle is an unlimited profit, limited risk strategy that is

taken when the options trader thinks that the underlying stock will experience

significant volatility in the near term. Long-strangles are debit spreads as a net

debit is taken to enter the trade.

Large gains for the long strangle option strategy is attainable when the

underlying stock price makes a very strong move either upwards or

downwards at expiration.

The formula for calculating profit is given below:

•Maximum Profit = Unlimited

•Profit Achieved When Price of Underlying > Strike Price of Long Call + Net

Premium Paid OR Price of Underlying < Strike Price of Long Put - Net

Premium Paid

•Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid

OR Strike Price of Long Put - Price of Underlying - Net Premium Paid



BREAKEVEN POINT(S)

There are 2 break-even points for the long strangle position. The breakeven

points can be calculated using the following formulae.

•Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid

•Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

INTRINSIC VALUE AND TIME VALUE OF OPTIONS

Intrinsic value and time value are two of the primary determinants of an

option's price.

Intrinsic value can be defined as the amount by which the strike price of an

option is in-the-money. It is actually the portion of an option's price that is not

lost due to the passage of time. The following equations will allow you to

calculate the intrinsic value of call and put options:

•Call Options: Intrinsic value = Underlying Stock's Current Price - Call Strike

Price

Time Value = Call Premium - Intrinsic Value

•Put Options: Intrinsic value = Put Strike Price - Underlying Stock's Current

Price



Time Value = Put Premium - Intrinsic Value

The Intrinsic Value is derived at using a fairly straightforward calculation. The

strike price is subtracted from the stock’s current market value as long as

market value is higher than the striking price for a call or lower than the

striking price for a put. When a call’s strike price is greater than the stock’s

market value or when a put’s strike price is less than the stock’s market value,

there is no Intrinsic Value.

Time Value is the difference between total option premium and intrinsic value.

For example, when the LEAPS (Long Term Equity Anticipation Securities)

contract is out-of-the-money, the entire premium is time value. For buyers,

time value is a continual problem because as time passes, it declines. Thus

even when a stock is moving upward, it may only offset what the buyer paid

for the option.

OPTION STYLE

An option style refers to whether the option contract can be exercised before

the expiration date or not. European options cannot be exercised before the

expiration date of the option contract. American options can be exercised by

the option holder (the option buyer) any time during the life of the contract.

HEDGING

Hedging is any strategy designed to offset or reduce the risk of price

fluctuations for an asset or investment. Hedging should not be confused with

hedge funds, which are private investment funds that often, but not always,

employ hedging strategies.

When an investor buys or sells a security, the investor bets that the price of the

investment will move in a certain direction. As with any bet, there's always the

risk of losing money if the price moves in the opposite direction. An investor

hedges against this risk if he employs any tool or strategy that minimizes this

risk.



In general, creating a hedge requires the purchase of a second asset with a

negative correlation to the first. If the hedged security does not move as

predicted, the hedge minimizes loss to the investor. Hedging is profitable

when used sparingly and effectively.

Hedging is used to reduce risk. But with reduced risk comes reduced returns.

Hedging is usually expensive, and extensive hedging will not be cost-

effective. Should an investor hedge extensively, he may find himself spending

all of his investment profits and possibly more towards hedging. Thus, most

retail investors do not hedge. A few investors hedge if they know that their

investment values depend on a certain event, such as an earnings report.

Should the earnings report be negative, the hedge minimizes losses. Other than

that, hedging and counter-risk measures are primarily used by corporations

and institutional investors.

One reason why companies attempt to hedge these price changes is because

they are risks that are peripheral to the central business in which they operate

(Giddy, and Dufey, 1992)1. For example, an investor buys the stock of a pulp-

and-paper company in order to gain from its management of a pulp-and-paper

business. She does not buy the stock in order to take advantage of a falling

Canadian dollar, knowing that the company exports over 75% of its product to

overseas markets. This is the insurance argument in favour of hedging.

Similarly, companies are expected to take out insurance against their exposure

to the effects of theft or fire.

By hedging, in the general sense, we can imagine the company entering into a

transaction whose sensitivity to movements in financial prices offsets the

sensitivity of their core business to such changes. As we shall see in this

article and the ones that follow, hedging is not a simple exercise nor is it a

concept that is easy to pin down. Hedging objectives vary widely from firm to

firm, even though it appears to be a fairly standard problem, on the face of it.

And the spectrum of hedging instruments available to the corporate Treasurer

is becoming more complex every day.



Another reason for hedging the exposure of the firm to its financial price risk

is to improve or maintain the competitiveness of the firm. Companies do not

exist in isolation. They compete with other domestic companies in their sector

and with companies located in other countries that produce similar goods for

sale in the global marketplace. Again, a pulp-and-paper company based in

Canada has competitors located across the country and in any other country

with significant pulp-and-paper industries, such as the Scandinavian countries.

Companies that are the most sophisticated in this field recognize that the

financial risks that are produced by their businesses present a powerful

opportunity to add to their bottom line while prudently positioning the firm so

that it is not pejoratively affected by movements in these prices (Broll Udo,

1993). This level of sophistication depends on the firm's experience, personnel

and management approach. It will also depend on their competitors. If there

are five companies in a particular sector and three of them engage in a

comprehensive financial risk management program, then that places

substantial pressure on the more passive companies to become more advanced

in risk management or face the possibility of being priced out of some

important markets. Firms that have good risk management programs can use

this stability to reduce their cost of funding or to lower their prices in markets

that are deemed to be strategic and essential to the future progress of their

companies. Most importantly, hedging is contingent on the preferences of the

firm's shareholders. There are companies whose shareholders refuse to take

anything that appears to be financial price risk while there are other companies

whose shareholders have a more worldly view of such things. It is easy to

imagine two companies operating in the same sector with the same exposure

to fluctuations in financial prices that conduct completely different policy,

purely by virtue of the differences in their shareholders' attitude towards risk.

ALPHA

Alpha is a risk-adjusted measure of the so-called "excess return" on an

investment. It is a common measure of assessing an active manager's

performance as it is the return in excess of a benchmark index or "risk-free"

investment.



The difference between the fair and actually expected rates of return on a

stock is called the stock's alpha.

The concept and focus on Alpha comes from an observation increasingly

made during the middle of the twentieth century, that around 75% of stock

investment managers did not make as much money picking investments as

someone who had simply invested in every stock in proportion to the weight it

occupied in the overall market in terms of market capitalization, or indexing.

Many academics felt that this was due to the stock market being "efficient"

which means that since so many people were paying attention to the stock

market all the time, the prices of stocks rapidly moved to the correct price at

any one moment, and that only luck made it possible for one manager to

achieve better results than another, before fees or taxes were considered. A

belief in efficient markets spawned the creation of market capitalization

weighted index funds that seek to replicate the performance of investing in an

entire market in the weights that each of the equity securities comprises in the

overall market. The best examples are the S&P 500 and the Wilshire 5000

which approximately represent the 500 largest equities and the largest 5,000

securities respectively, accounting for approximately 80%+ and 99%+ of the

total market capitalization of the US market as a whole.

In fact, to many investors, this phenomenon created a new standard of

performance that must be matched: an investment manager should not only

avoid losing money for the client and should make a certain amount of money,

but in fact should make more money than the passive strategy of investing in

everything equally (since this strategy appeared to be statistically more likely to

be successful than the strategy of any one investment manager). The name for

the additional return above the expected return of the beta adjusted return of the

market is called "Alpha".

EXAMPLES, TYPES, OR VARIATIONS

Jensen's Alpha or Jensen's Measure



In finance, Jensen's alpha (or Jensen's Performance Index) is used to determine

the excess return of a stock, other security, or portfolio over the security's

required rate of return as determined by the Capital Asset Pricing Model. This

model is used to adjust for the level of beta risk, so that riskier securities are

expected to have higher returns. The measure was first used in the evaluation of

mutual fund managers by Michael Jensen in the 1970's.

Portable Alpha

Portable alpha is an investment management term which refers to the return of

an investment manager who has intentionally and completely eliminated his

market risk, or beta. The return of such a portfolio will only represent the

manager's skill in selecting investments within the market, and will be

independent of the direction or magnitude of the market's movement. The

elimination of market risk can be accomplished through use of futures, swaps,

options, or short selling.

Weighted Alpha

A weighted measure of how much a stock has risen or fallen over a certain

period, usually a year.

Formula

Alpha= [ (sum of y) - ((b)(sum of x)) ] / n

Where:

n = number of observations (36 mos.)

b = beta of the fund

x = rate of return for the market

y = rate of return for the fund

BETA



The Beta coefficient, in terms of finance and investing, is a measure of a

stock's (or portfolio's) volatility in relation to the rest of the market. Beta is

calculated for individual companies using regression analysis.

The beta coefficient is a key parameter in the capital asset pricing model

(or CAPM). It measures the part of the asset's statistical variance that

cannot be mitigated by the diversification provided by the portfolio of

many risky assets, because it is correlated with the return of the other

assets that are in the portfolio.

EXAMPLES, TYPES, OR VARIATIONS

Beta < 0: Negative Beta - not likely.

Beta = 0: Cash in the bank.

Beta Between 0 and 1: Low-volatility

Beta = 1: Matching the market.

Beta > 1: More volatile than the market.

EXAMPLE OF USE:

A fund with a beta of 1 is deemed to have the same volatility as the S&P

500; therefore a fund with a beta of 4 is four times more volatile than the

S&P 500, and a fund with a beta of .25 is 25% as volatile as the S&P 500.

This means that a fund with a beta of 4 would rise 40% if the S&P 500

rose 10% (the same is true of a drop).

The three basic interpretations of Beta are as follows:

1. Econometric Beta: The primary risk factor for the CAPM. Relevant to

pricing and not valuation.

2. Graphical Beta: The slope coefficient of the characteristic line.

3. Statistical Beta: The measure of systematic risk in the CAPM.

Beta is also referred to as financial elasticity or correlated relative

volatility, and can be referred to as a measure of the asset's sensitivity of



the asset's returns to market returns, its non-diversifiable risk, its

systematic risk or market risk. On an individual asset level, measuring beta

can give clues to volatility and liquidity in the marketplace. On a portfolio

level, measuring beta is thought to separate a manager's skill from his or

her willingness to take risk.

FORMULA

The Formula for Beta of an asset within a portfolio is

β a=Cov (ra , rp)

Var (rp)

Where ra measures the rate of return of the asset, rp measures the rate of

return of the portfolio, and cov(ra, rp) is the covariance between the rates of

return. The portfolio of interest in the CAPM formulation is the market

portfolio that contains all risky assets, and so the rp terms in the formula

are replaced by rm, the rate of return of the market.



Chapter 3

DATA ANALYSIS AND DISCUSSION



CURRENT INDIAN ECONOMIC SCENARIO

Introduction

After a promising start to the decade in 2010-11 with achievement like GDP

growth of 8.4 per cent, bringing down fiscal deficit to 4.7 per cent from 6.4 of

GDP in 2009-10, as well as containing current account deficit to 2.6 per cent from

2.8 per cent in 2009-10. GDP growth decelerated sharply to a nine year low of 6.5

per cent during 2011-12.

The slowdown was reflected in all sectors of the economy but the industrial sector

suffered the sharpest deceleration which decelerated to 2.9 per cent during 2011-

12 from 8.2 per cent in 2010-11. The centre’s finances for 2011-12 experienced

considerable slippages as key deficit indicators turned out to be much higher than

budgeted due to shortfall in tax revenues and overshooting of expenditure. The

gross fiscal deficit (GFD)-GDP ratio moved up to 5.8 per cent in 2011-12

compared to the budgeted ratio of 4.6 per cent. The substantial increase in

subsidies during 2011-12 on account of high crude oil prices further impacted the

deficit of the Government.

The year 2011 -12, especially the second half, was characterised by a burgeoning

current account deficit (CAD), subdued equity inflows, depletion of foreign

exchange reserves, rising external debt and deteriorating international investment

position. Inflation remained elevated at over 9 per cent in the first eight months of

2011-12, before softening moderately in December and remained sticky in the

range of 6.9-7.7 percent.



SECTORAL ANALYSIS

1) STEEL INDUSTRY

The Indian steel industry has entered into a new development stage from 2007-08,

riding high on the resurgent economy and rising demand for steel. Rapid rise in

production has resulted in India becoming the 4 th largest producer of crude steel

and the largest producer of sponge iron or DRI in the world. As per the report of

the Working Group on Steel for the 12 th Plan, there exist many factors which

carry the potential of raising the per capita steel consumption in the country,

currently estimated at 55 kg (provisional). These include among others, an

estimated infrastructure investment of nearly a trillion dollars, a projected growth

of manufacturing from current 8% to 11-12%, increase in urban population to 600

million by 2030 from the current level of 400 million, emergence of the rural

market for steel currently consuming around 10 kg per annum buoyed by projects

like Bharat Nirman, Pradhan Mantri Gram Sadak Yojana, Rajiv Gandhi Awaas

Yojana among others.

At the time of its release, the National Steel Policy 2005 had envisaged steel

production to reach 110 million tonnes by 2019-20. However, based on the

assessment of the current ongoing projects, both in greenfield and brownfield, the

Working Group on Steel for the 12 th Plan has projected that the crude steel steel

capacity in the county is likely to be 140 mt by 2016-17 and has the potential to

reach 149 mt if all requirements are adequately met.

The National Steel Policy 2005 is currently being reviewed keeping in mind the

rapid developments in the domestic steel industry (both on the supply and demand

sides) as well as the stable growth of the Indian economy since the release of the

Policy in 2005.

a) TATA STEEL LTD

Tata Steel Ltd., a Tata Group company, is India’s largest integrated steel player in

the private sector and the world’s seventh largest steel producer with an annual

crude steel capacity of around 30 million tonnes per annum (mtpa). It



manufactures hot and cold rolled coils and sheets, galvanized sheets, tubes, wire

rods, construction rebars, rings and bearings. After the acquisition of Corus in

2007, it is now the 7th largest steel producer in the world. Apart from India, the

company operates through its major subsidiaries on a consolidated basis – Europe

(Corus) and South-East Asia (NatSteel & Thailand). In India the company has

manufacturing facilities at Jharkhand, Chhattisgarh, Orissa, West Bengal and

Tamil Nadu. It has operations in 26 countries and commercial presence in over 50

countries with over 81,000 employees.

Beta: 2.04

Market Cap (Mil.): Rs290,150.59

Shares Outstanding (Mil.): 971.22

Dividend: 8.00

P/E (TTM): --

EPS (TTM): -74.06

ROI: -7.70

ROE: -18.38



Source:http://finance.yahoo.in

QUARTERLY RESULTS




b) JINDAL STEEL AND POWER LTD

Jindal Steel & Power Limited (JSPL) is a Jindal Group company with an annual

turnover of over Rs. 11,000 Cr. JSPL operates in a promising mix of two business

segments- Power & Steel. It is a leading player in the Steel Industry. The company

produces economical and efficient steel and power through backward integration

from its own captive coal and iron-ore mines. JSPL is the one of the lowest cost

producer of sponge iron in India. Backward integration has given JSPL the

distinction of being the only sponge iron producer with its own captive raw

material sources and power. JSPL sells power on merchant basis, which

commands higher realizations than other power generation companies that are

subject to regulated tariffs. The company serves both domestic as well as

international markets. It is also entering into niche value-added segment such as

rounds, billets, blooms and slabs.

Beta: 1.5



Dividend: 1.60

P/E (TTM): 9.15

EPS (TTM): 31.13

ROI: 8.41

ROE: 14.79




QUARTERLY RESULTS




2) BANKING INDUSTRY

The growth in the Indian Banking Industry has been more qualitative than

quantitative and it is expected to remain the same in the coming years. Based on

the projections made in the "India Vision 2020" prepared by the Planning

Commission and the Draft 10th Plan, the report forecasts that the pace of

expansion in the balance-sheets of banks is likely to decelerate. The total assets of

all scheduled commercial banks by end-March 2010 are estimated at Rs 40,

90,000 crores. That will comprise about 65 per cent of GDP at current market

prices as compared to 67 per cent in 2002-03. Bank assets are expected to grow at

an annual composite rate of 13.4 per cent during the rest of the decade as against

the growth rate of 16.7 per cent that existed between 1994-95 and 2002-03. It is

expected that there will be large additions to the capital base and reserves on the

liability side.

As far as the present scenario is concerned the Banking Industry in India is going

through a transitional phase. The first phase of financial reforms resulted in the

nationalization of 14 major banks in 1969 and resulted in a shift from Class

banking to Mass banking. This in turn resulted in a significant growth in the



geographical coverage of banks. Every bank had to earmark a minimum

percentage of their loan portfolio to sectors identified as “priority sectors”. The

manufacturing sector also grew during the 1970s in protected environs and the

banking sector was a critical source. The next wave of reforms saw the

nationalization of 6 more commercial banks in 1980. Since then the number of

scheduled commercial banks increased four-fold and the number of bank branches

increased eight-fold.

a) ICICI BANK LIMITED

ICICI Bank is India’s second largest bank and largest private sector bank, with

total assets of Rs. 5367.95 billion as on March 31, 2013. It mainly operates in

Retail Banking, Wholesale Banking and Treasury. It has a large customer base of

around 24 million. The bank has a presence in 19 countries, including India. It has

subsidiaries in UK, Russia and Canada, branches in US, Singapore, Bahrain, Hong

Kong, Sri Lanka, Qatar and Dubai International Finance Centre and representative

offices in United Arab Emirates, China, South Africa, Bangladesh, Thailand,

Malaysia and Indonesia. Its UK subsidiary has established branches in Belgium

and Germany.

ICICI Bank also offers wide range of financial services to corporate and retail

customers through its specialized subsidiaries in the areas of investment banking,

life and non-life insurance, venture capital and asset management.

ICICI Bank, in the last 10 years, increased its net interest income by 29.17% on a

stand-alone basis, from Rs. 2185 Cr. in FY04 to Rs. 13866 Cr. in FY13. On a

consolidated basis, its net interest income was Rs. 16599.18 Cr. in FY13. Its

CASA ratio was below 30% till FY09; but in the last two financial years, it

boosted its CASA ratio was 43.5% at March 31, 2012, which is quite remarkable.

The bank earned net interest margins of 3.11% in FY13. Its book value per share

grew only by 10.71% in FY12. The book value of the bank increased from Rs.

125.28 in FY04 to Rs. 578 in FY13. ICICI Bank acquired Bank of Rajasthan in

2010.

ICICI Bank managed to attain ROE (Return on Equity) of 13.62% in FY12. The

net non-performing assets to net advances ratio of the bank have been



continuously above 1% in the last five years, which shows its asset quality is not

up to the mark. If we look at its trend, it is showing decreasing net non-performing

assets to net advances ratio in the last two years, from 1.11% in FY11 to 0.73% in

FY12. This shows it is continuously improving its asset quality with a large focus

on it.

At the end of FY13, its capital adequacy ratio was at 18.74%; much higher than

the RBI guideline of 9%, which will help the bank grow its operation comfortably.

Beta: 1.67

Market Cap (Mil.): Rs1,313,518.00

Shares Outstanding (Mil.): 1,154.03

Dividend: 20.00

P/E (TTM): 37.81

EPS (TTM): 30.1

ROI: --

ROE: --




QUARTERLY RESULTS


b) HDFC BANK LIMITED

HDFC Bank, the second largest private sector bank in India, deals with three key

business segments - Retail Banking, Wholesale Banking and Treasury. HDFC

Bank is the market leader in retail banking. Retail banking accounts 52% of the

total income. It also provides sophisticated product structures, sound advice and

fine pricing mainly in areas of foreign exchange and derivatives, money markets

and debt trading and equity research through its state-of-the-art dealing room. The

business philosophy of HDFC Bank is based on four core values - Customer

Focus, Operational Excellence, Product Leadership and People. The HDFC Group

holds 23.15% stake in the Bank. HDFC Bank has world-class technology. HDFC

Bank is a market leader in auto loan provider and credit card business. The Bank

has been named “Organization of the year” at the Skoch Financial Inclusion

Awards 2013.



It has two subsidiaries:

1. HDFC Securities Ltd. – It is mainly in the business of providing brokerage

services

2. HDB Financial Services Ltd. – non-deposit taking NBFC

HDFC Bank increased its net interest income by 17.72% in FY12 on the stand-

alone basis. NII (Net Interest Income) rose from Rs.1817.9 Cr. in FY04 to Rs.

22,663.7 Cr. in FY13. Its CASA (Current Account Savings Account), the source

of low cost funds, was 47.4% as on March 31, 2013; which is the highest in the

Indian banking Industry. The high interest income and the low cost because of

high CASA helped the Bank maintain an average net interest margin at a very

high level of 4.5% for FY13. This higher NIM(Net Interest Margin) is due to the

reclassification of retail cost of acquisition which was earlier set off against the

interest income. Now they are shown as an operating expense. Had the

reclassification not taken place, NIM would have been 4.3%. The Bank has

increased its book value per share by 17.06% in FY12. In the last 10 years, it rose

from Rs. 18.9 in FY04 to Rs. 127.52 in FY12, on a stand-alone basis.

HDFC Bank managed to maintain a ten-year-average ROA (Return on assets) at

1.77% in FY12, which is significantly higher than the benchmark of 1.25%. The

non-performing assets to net advances ratio of the bank have been continuously

below 0.5%, which shows its asset quality is very good. The ratio was 0.18%

FY13. Currently, its capital adequacy ratio is at 16.8%; well above the RBI

guideline of 9%, which will help the Bank grow its operation comfortably. Asset

quality was healthy with gross non-performing assets (NPAs) at 0.97% of gross

advances as on March 31, 2013. Net non-performing assets remained at 0.2% of

net advances as on March 31, 2013.

Beta: 1.02

Market Cap (Mil.): Rs1,627,000.00




Dividend: 5.50

P/E (TTM): 87.88

EPS (TTM): 7.77

ROI: --

ROE: 18.05


QUARTERLY RESULTS




3) TELECOM INDUSTRY

The Indian telecommunications industry is one of the fastest growing in the world.

Government policies and regulatory framework implemented by Telecom

Regulatory Authority of India (TRAI) have provided conducive environment for

service providers. This has made the sector more competitive, while enhancing the

accessibility of telecommunication services at affordable tariffs to the consumers.

In the last two decades, the Indian Telecom Sector and mobile telephony in

particular has caught the imagination of India by revolutionizing the way we

communicate, share information; and through its staggering growth helped

millions stay connected. This growth, however, has and continues to be at the cost

of the Climate, powered by an unsustainable and inefficient model of energy

generation and usage. Simultaneously, tins growth has also come at significant

and growing loss to the state exchequer, raising fundamental questions on the

future business and operation model of the Telecom sector.

The telecom industry has witnessed significant growth in subscriber base over the

last decade, with increasing network coverage and a competition-induced decline

in tariffs acting as catalysts for the growth in subscriber base. The growth story



and the potential have also served to attract newer players in the industry, with the

result that the intensity of competition has kept increasing. The sector expected to

witness up to USS 56.3 billion investments and the market will cross the US$ 101

billion mark in five years.

The Indian telecom sector has witnessed tremendous growth over the past decade.

Today, the Indian telecom network is the second largest in the world after China.

A liberal policy regime and involvement of the private sector have played an

important role in transforming this sector. The total number of telephones has

increased from 429.73 million on 31 March 2009 to 926.55 million on 31

December 2011.

The telecom industry has witnessed significant growth in subscriber base over the

last decade, with increasing network coverage and a competition-induced decline

in tariffs acting as catalysts for the growth in subscriber base. The growth story

and the potential have also served to attract newer players in the industry, with the

result that the intensity of competition has kept increasing. Also, broadband

segment has seen significant growth with total internet subscribers reaching 20.99

million in September 2011, which includes 13.30 broadband subscribers.

a) IDEA CELLULAR LIMITED

Idea Cellular Limited is a part of the Aditya Birla Group (45.98% holding) and

one of India’s leading GSM telecom Services provider. The company has licenses

to operate in 22 telecom circles. It has over 105 million subscribers with a market

share of around 14%. The company reports 1.15 billion minutes per day and is

among top 10 national operators across the globe in terms of voice minutes of

usage. The company offers basic voice and short message service (SMS), high-

end value added services and general packet radio service (GPRS), such as

Blackberry, Datacard, Mobile TV and Games. Idea has deep penetration in the

non-urban and rural market. Idea Cellular boasts of the highest share of rural

subscribers as a percentage of total subscribers among GSM players.

Idea Cellular has managed to clock very good sales growth but the profits of the

company have been on a declining trend. The company’s Net Sales has increased



from Rs. 4366.4 Cr. in FY2007 to Rs. 19488.69 Cr. in FY12 with 5 years CAGR

of 34% showing a consistent demand for its products. However, the EPS has taken

a hit post FY09.

The company clocked exponential growth in EPS in the FY05-FY08 period.

During this period the competition was limited in the telecom market and as a

result company could register such huge growth in profits. The last four financial

years have not been good for the company. Its EPS performance has deteriorated

owing to the entry of new players making the telecom market a highly competitive

one. This competition led to tariff wars and since then tariffs have been constantly

reduced until recently in July 2011 where they were raised by 20%. This along

with the increased operating cost as the company ventured in to new mobile

circles led to bad EPS performance in the FY09-FY12 period.

Similar trend is observed in the company’s profit margins. After FY08, the

operating profit margins (OPM) and net profit margins (NPM) have gone down

owning to the rise in competition and rise in operating cost because the company

entered in to new mobile circles. However, the decrease in profit margin has been

marginally mitigated by higher earnings from its tower business, as the tenancy

rates have gone up in recent past.

Idea has around Rs. 12070.50 Cr. as debt on its book due to very high 3G costs

and the capex it carried out in FY11. Idea has won 3G spectrum in 11 out of 22

service areas in the recent auction and was amongst the highest spender in 3G and

BWA (broadband wireless access) auction. This high debt has resulted in high

debt–net profit ratio and a very high interest cost, resulting in lower profit

margins.

As there was de-growth in earnings, company could not maintain it ROE and

ROIC numbers. The company has experienced substantial reduction in both these

numbers FY09 onwards.

Beta: 1.08





Dividend: 0.30

P/E (TTM): 44.41

EPS (TTM): 3.05

ROI: 3.81

ROE: 7.39


QUARTERLY RESULTS




b) RELIANCE COMMUNICATIONS LTD

Reliance Communications Limited, an Anil Dhirubhai Ambani Group (ADAG)

company is an integrated telecommunications service provider. It provides CDMA

and GSM based wireless services on a nationwide basis and has a customer base

of 148 million (however, subscriber quality is not good as active / VLR subscriber

base stands at 92.5 million). The Company's business encompasses a complete

range of telecom services covering mobile and fixed line telephony. It includes

broadband, national and international long distance services and data services

along with a range of value-added services. If all the businesses are taken in to

consideration, then the total customer base of Reliance Communications stands at

156 million including over 2.5 million individual overseas retail customers.

Beta: 1.85





Dividend: 0.25

P/E (TTM): 33.75

EPS (TTM): 3.27

ROI: 1.10

ROE: 1.92




QUARTERLY RESULTS


4) POWER SECTOR

The Indian Power Industry is one of the largest and most important industries in

India as it fulfills the energy requirements of various other industries. It is one of

the most critical components of infrastructure that affects economic growth and

the well-being of our nation.

India has the world’s 5th largest electricity generation capacity and it is the 6th

largest energy consumer accounting for 3.4% of global energy consumption. Due

to the fast-paced growth of the Indian economy, the country’s energy demand has

grown at an average of 3.6% p.a. over the past 30 years. In India, power is

generated by State utilities, Central utilities and Private players.

As per the latest Report of CEA (Central Electricity Authority) i.e. as on 31-03-

2011, the Total Installed Capacity of Power in India is 173626.40 MW. Of this,

more than 75% of the installed capacity is with the public sector (state and

central), the state sector having the largest share of 48%.



a) ADANI POWER LTD

Adani Power Limited is part of the Adani group which has business interest in

sectors like infrastructure, power, logistics, mining, oil and gas, agri business,

realestate, etc. Adani Power is engaged in the business of generation and

transmission of power. Currently it is the largest private thermal power producer

in India with thermal power generation capacity of 2640 MW. On the whole, it is

implementing 16,500 MW of power generation projects across six locations in

India and has plans of generating 20,000 MW of power by 2020.

The company started generating sales in FY10 when it commissioned two of its

330 MW plants at Mundra. The consolidated sales increased by 391% from Rs.

434.86 Cr. in FY10 to Rs. 2135.19 Cr. in FY11 as the company had

commissioned additional 1320 MW of generating capacity in FY11. EPS saw a

jump of 209.21% from FY10 to FY11. EPS growth has not been commensurate

with the sales growth because of high interest payments in FY11. Company’s debt

to net profit ratio has been exorbitantly high at 62.27 in FY10 and 47.75 in FY11.

This is because the company has taken debt and made investments in many power

projects of which only a few have started generating revenue. This high debt has

led to promoters pledging their shares to the tune of 53.56%. Operating profit

margin in FY11 was similar to that in FY10 but there was a reduction in net profit

margin because of the increase in debt which led to high interest expenses.

Beta: 1.2



Dividend: --

P/E (TTM): --

EPS (TTM): -9.58

ROI: -5.99



ROE: -44.41


QUARTERLY RESULTS




b) RELIANCE POWER LTD

Reliance Power is primarily in the development, construction and operation of

power generation projects whereas Reliance Infrastructure takes care of

transmission and distribution of power business, along with its other business

areas. Reliance Power on its own and through subsidiaries has a portfolio of over

35,000 MW of power generation capacity, both operational as well as under

development. Currently the Company has 600 MW of operational power

generation assets. The projects under development include seven coal-fired

projects (18,880 MW) to be fuelled by reserves from captive mines and supplies

from India and abroad, two gas-fired projects (10,280MW) to be fuelled primarily

by reserves from the Krishna-Godavari Basin and seven hydroelectric projects

(4620 MW), six of them in Arunachal Pradesh and one in Uttarakhand.

Beta: 1.61



Dividend: --

P/E (TTM): 19.19

EPS (TTM): 3.61

ROI: 2.48

ROE: 5.60




QUARTERLY RESULTS




5) ENGINEERING INDUSTRY

The engineering sector is the largest segment of the overall Indian industrial

sector. India has a strong engineering and capital goods base. The important

groups within the engineering industry include machinery & instruments, primary

and semi finished iron & steel, steel bars & rods, non-ferrous metals, electronic

goods and project exports. The engineering sector employs over 4 million skilled

and semi-skilled workers (direct and indirect).

The sector can be categorized into heavy engineering and light engineering

segments. Heavy engineering segment forms the majority of the engineering

sector in India. In the year 2003-04, out of the total engineering production of US$

22 billion, the heavy engineering market contributed over 80 per cent with the

light engineering segment accounting for the remaining. India has a well-

developed and diversified industrial machinery/capital base capable of

manufacturing the entire range of industrial machinery. The industry has also

managed to successfully develop advanced manufacturing technology over the

years. Among the developing countries, India is a major exporter of heavy and

light engineering goods, producing a wide range of items. The bulk of capital

goods required for power projects, fertilizer, cement, steel and petrochemical

plants and mining equipment are made in India. The country also makes

construction machinery, equipment for irrigation projects, diesel engines, tractors,

transport vehicles, cotton textile and sugar mill machinery.

The engineering industry has shown capacity to manufacture large-size plants and

equipment for various sectors like power, fertilizer and cement. Lately, air

pollution control equipment is also being made in the country. The heavy

electrical industry in India meets the entire domestic demand.

a) LARSEN AND TOUBRO LTD



Larsen & Toubro Ltd, an L & T Group company, is India’s largest engineering

and construction company. Its business is categorized into three segments, viz.

Engineering and construction (E&C), Electrical and Electronics (E&E) and other

diversified businesses. Its clientele consists of a mix of public and private sector

companies. Some of its clients are ONGC, Reliance (RIL), Indian Oil, GSPC,

NHAI, Tata Steel, NTPC, ExxonMobil etc. It was incorporated in 1938 and went

public in 1952.

It is largely a domestic player, with 85% of its revenue contribution from

domestic region and rest 15% from rest of the globe.

The company is slowly increasing its geographical presence in US, Middle East

and China. It has manufacturing facilities in India, China, Oman and Saudi Arabia

to cater to demands of customers spread across 30 countries. Major international

projects executed recently include wellhead platform project of Maersk Oil Qatar,

Gas handling facilities for GASCO (Abu Dhabi Gas Industries Ltd.), Gas pipeline

for Qatar petroleum and construction of Jet fuel depot project for Kuwait aviation

fuelling company. The major domestic projects in recent times include Delhi

international airport terminal 3, refurbishing Wankhede stadium project, part of

Delhi metro, etc.

Beta: 1.55



Dividend: 18.50

P/E (TTM): 102.95

EPS (TTM): 13.69

ROI: --

ROE: --




QUARTERLY RESULTS




b) BHARAT HEAVY ELECTRICALS LTD

Bharat Heavy Electricals Ltd., a Navratna company, is the largest engineering and

manufacturing enterprise in India for power & infrastructure-related products,

with 54% market share. The company has a 25 years' history of consistent

profitability and manufactures over 180 products for power sector and other

industries like transportation, fertilizer, water, steel and renewable energy. The

company's operations are organised around two major business segments - power

(79% of FY11 revenues) and industry (21%).

The company has 15 manufacturing divisions, 4 power sector regional centers,

over 100 project sites, 8 service centres and 15 regional offices. It is also one of

the largest exporters of engineering products and services from India. It supplies

its product to over 60 countries in the world. The company gets 96.80% revenues

from domestic markets and 3.20% from exports. The Company was incorporated

in 1964.

BHEL has performed extremely well in the past ten years, except in FY03. The

company has increased its Net Sales by 22% CAGR in the last ten years; however

the EPS increased by 28% during the same period. This was due to the margin

expansion that the company witnessed from FY04 to FY08. India’s increased

focus on infrastructure and the monopoly situation enjoyed by the company made

this possible. FY09 and FY10 again saw a decrease in margins on the back of

increasing raw material prices. The company’s margins have increased

substantially to 18% in FY11 as raw material prices dipped. The company has

grown its BVPS by 19% 10 yr. CAGR. Given the huge revenues and profitability

enjoyed by the company, it has managed to increase its operating cash flow by

14.3% over the last 10 years. Hence, the Company has expanded its business

successfully in the past. Currently, the Company has Debt to Net Profit ratio of

0.03, which shows the company is a relatively debt free company & can repay all

its debt easily within a year at current level of profit.



BHEL has maintained a high ROE & ROIC, above 25%, over the last 5 years.

This shows that the management of the Company is very efficient in utilizing the

funds. Being a capital intensive industry, the company has huge working capital

requirements. The company has managed to maintain its working capital days at

an average of 514 days. However, this is 1.5 times higher than the industry

average of 360 days. The company has managed to reduce its net working capital

from 180 levels to 107 in FY11, which is lower than the industry average of 180

days but very high when compared to its competitors like ABB and Siemens.

Beta: 1.34



Dividend: 3.29

P/E (TTM): 15.35

EPS (TTM): 12.73

ROI: --

ROE: --




QUARTERLY RESULTS




From the analysis we have given the weightage to the shares as follows:

WEIGHTAGE OF THE SHARES IN THE PORTFOLIO

TABLE 3.1 weightage of the shares in the portfolio

Industry Name Company Name Weightage

Steel TATA STEEL LTD. 0.1014552

JINDAL STEEL & POWER LTD 0.09868375

Banking ICICI Bank Ltd 0.10035325

HDFC Bank Ltd 0.099448

Telecom Idea Cellular LTD 0.1000482

Reliance Communications Ltd 0.09993465

Power Adani Power Ltd 0.1000524

Reliance Power Ltd 0.0999664

Engineering Larsen & Toubro Ltd 0.0994071

Bharath Heavy Electricals Ltd 0.1006509

The beta values of the shares are calculated and the beta of the portfolio is found.

TABLE 3.2 beta values of shares

Company Name Beta Value Weightage Beta*weightage

TATA STEEL LTD. 2.04 0.1014552 0.206968608

JINDAL STEEL &

POWER LTD

1.5 0.09868375 0.148025625

ICICI Bank Ltd 1.67 0.10035325 0.167589928



HDFC Bank Ltd 1.02 0.099448 0.10143696

Idea Cellular LTD 1.08 0.1000482 0.108052056

Reliance

Communications Ltd

1.85 0.09993465 0.184879103

Adani Power Ltd 1.2 0.1000524 0.12006288

Reliance Power Ltd 1.61 0.0999664 0.160945904

Larsen & Toubro

Ltd

1.55 0.0994071 0.154081005

BHEL 1.34 0.1006509 0.134872206

Beta of the portfolio 1.486914274

Beta of the portfolio = 1.486914274

The companies selected having higher beta value denotes that the portfolio is an

aggressive portfolio that indicates that the value of the portfolio changes with the

changes in the index value.

DISTRIBUTION OF SELECTED COMPANIES AND SHARES

TABLE 3.3 distribution of shares of the companies in the portfolio

Company Name Share Price on

1-3-2013

No of shares Amount

TATA STEEL LTD. 341.6 297 101455.2

JINDAL STEEL &

POWER LTD

358.85 275 98683.75

ICICI Bank Ltd 1056.35 95 100353.25

HDFC Bank Ltd 621.55 160 99448

Idea Cellular LTD 116.2 861 100048.2



Reliance

Communications Ltd

61.65 1621 99934.65

Adani Power Ltd 45.15 2216 100052.4

Reliance Power Ltd 72.65 1376 99966.4

Larsen & Toubro Ltd 1400.1 71 99407.1

Bharath Heavy

Electricals Ltd

200.9 501 100650.9

Total 10,00000

As per the weightage given to each company in the portfolio, number of shares

has been determined and a sum of ten lakhs rupees has been divided accordingly.

Table 3.4 Portfolio of the month March 2013

Companies No of

shares

Share

Price as on

1-3-2013

Total

Amount

Share

Price as on

28-3-2013

Total

Amount

TATA STEEL

LTD.

297 341.6 101455.2 312.3 92753.1

JINDAL STEEL

& POWER LTD

275 358.85 98683.75 348.15 95741.25

ICICI Bank Ltd 95 1056.35 100353.25 1045.35 99308.25

HDFC Bank Ltd 160 621.55 99448 624.1 99856

Idea Cellular

LTD

861 116.2 100048.2 113.2 97465.2

Reliance

Communications

Ltd

1621 61.65 99934.65 55.2 89479.2

Adani Power Ltd 2216 45.15 100052.4 40.65 90080.4

Reliance Power

Ltd

1376 72.65 99966.4 61.55 84692.8

Larsen & Toubro

Ltd

71 1400.1 99407.1 1364.9 96907.9



Bharat Heavy

Electricals Ltd

501 200.9 100650.9 176.95 88651.95

Total 1000000 934936.05

Calculation of the Hedging Position of the Portfolio for March 2013

Nifty Index Value as on 01 March 2013 = 5719.7

Value of the portfolio on 01 March 2013 = 1000000


Nifty Lot Size = 50

Hedge ratio

The required number of future contracts can be calculated using Hedge Ratio

Hedge Ratio= Value of the portfolio X Beta of the portfolio

Nifty Index value

=1000000× 1.4869

5719.7

=259.961

Number of lots to be hedged=Hedge ratioNifty lot ¿¿¿

=259.961

50

=5.199

That is approximately 5 future contracts.

It was anticipated that the index will fall down due to the high inflation rate, rise

in the crude oil price, European Union recession, India’s high Current Account

Deficit and low GDP rate.

So we consider hedging the portfolio by shorting index futures. That’s we need to

sell the index futures on 01 March 2013 and buy back on 28th March 2013.



Portfolio profit/loss analysis

Value of the portfolio on 01 March 2013 = Rs 1000000

Value of the portfolio on 28th March 2013 = Rs 934936.05

Loss in the value = Rs 65063.8

Effectiveness of Hedging using Index futures

Price of a future on 01 March 2013 = Rs 5729.95

Price of 5 future contracts = 5729.95 X 5 X 50

=Rs 1432487.5

Price of a future on 28th March 2013 = Rs 5676.5


=Rs 1419125

On 01 March 2013 the investor shorts index futures for Rs 1432487.5 fearing a

fall in the market that means he sells 5 future contracts.

On 28th March as the investor feared, the markets fell due to the reasons

anticipated. So he bought back the futures on the expiry date 28th March at a price

of Rs 5676.5 per future contract.

Profit from the future trading

Since the index futures are shorted and the price has been decreased the investor

got a profit.

The profit from future trading = 1432487.5-1419125

=13362.5

Hence with hedging the investor could reduce the loss up to Rs 13362.5



The Net Loss

The loss of the portfolio after hedging = Loss of portfolio- profit from future

trading

= 65063.8-13362.5

= 51701.3

The loss without hedging = 65063.8

The loss with hedging = 51701.3

Interpretation

In the month March 2013, portfolio made a high loss due to the economic

conditions such as the high inflation rate, rise in the crude oil price, European

Union recession, India’s high Current Account Deficit and low GDP rate. These

conditions badly affected the Indian stock market. In the analysis we applied Nifty

index futures to reduce the risk. However due to the high risk of the portfolio, the

tool could only reduce a certain percentage of the loss.

TABLE 3.5 Portfolio from 1st April 2013 to 25th April 2013

Companies No of

Share

s

Share Price

as on 1-4-

2013

Total

Amount

Share Price

as on 25-4-

2013

Total

Amount

TATA STEEL

LTD.

297 314.5 93406.5 312.55 92827.35

JINDAL STEEL

& POWER LTD

275 342.4 94160 328.8 90420

ICICI Bank Ltd 95 1051.8 99921 1177.45 111857.7

5

HDFC Bank Ltd 160 623.9 99824 689.35 110296

Idea Cellular

LTD

861 114.75 98799.75 116.25 100091.2

5

Reliance Comm. 1621 57.1 92559.1 95.55 154886.5



Ltd 5

Adani Power Ltd 2216 42.2 93515.2 49.65 110024.4

Reliance Power

Ltd

1376 63.15 86894.4 73.95 101755.2

Larsen & Toubro

Ltd

71 1394.7 99023.7 1518.75 107831.2

5

Bharath Heavy

Electricals Ltd

501 181.95 91156.95 192.45 96417.45

Total 949260.6 1076407.

2

Calculation of the Hedging Position of the Portfolio for April 2013

Nifty Index Value as on 01 April 2013 = 5704.4

Value of the portfolio on 01 April 2013 = 949260.6


Nifty Lot Size = 50

Hedge ratio



Nifty Index value

=949260.6 ×1.4869

5704.4

=247.432


=247.432

50

= 4.948




It is anticipated that the market will be bullish in April due the cutting of Repo

Rates in India by 25 bpts to 7.5 % by the RBI and Government of India hiked the

Debt Limits for overseas Financial Institutions to US $ 25 billion for Indian

Sovereign Debt and to US $ 50 billion for Indian Commercial Paper to attract

foreign capital and to improve forex inflows.

So we consider taking a long position by buying index futures on April 1st and

selling it on the maturity date 25th April 2013.


Value of the portfolio on 01 April 2013 = Rs 949260.6

Value of the portfolio on 25th April 2013 = Rs 1076407.2

Profit of the portfolio = Rs. 127146.6


Price of a future on 01 April 2013 = Rs 5726.55


=Rs 1431637.5

Price of a future on 25th April 2013 = Rs 5910.05


=Rs 1477512.5

On April 1st 2013 the investor bought 5 future contracts expecting a bullish

market.

On 25th April 2013 when the market rose as he expected, the investor sold the

contracts and made a profit.

Profit from Future trading



Since the investor took a long position on the futures and sold them when the

market is high, he made a profit.

Profit from future trading = 1477512.5 -1431637.5

= 45875

Hence with hedging the investor can maximize the profit.

The Net Profit

The Total profit of the portfolio with hedging= Profit of the portfolio + profit from

future trading

= 127146.6 + 45875

= 173021.6

The profit without hedging = 127146.6

The profit with hedging = 173021.6

Interpretation

In the month of April 2013 the RBI’s action of cutting the interest rates and the

Government of India’s actions have helped the market to be bullish.

Therefore on the month of April the portfolio made a huge profit. Trading using

the futures also helped to increase the profit.

TABLE 3.6 Portfolio from 26th April 2013 to 30th May 2013

Companies No of

Shares

Share

Price as

on 26-4-

2013

Total

Amount

Share Price

as on 30-5-

2013

Total

Amount

TATA STEEL

LTD.

297 304.85 90540.4

5

301.8 89634.6

JINDAL

STEEL &

275 314.7 86542.5 296.25 81468.75



POWER LTD

ICICI Bank Ltd 95 1144.3 108708.

5

1182.75 112361.25

HDFC Bank Ltd 160 689.15 110264 723.8 115808

Idea Cellular

LTD

861 122.3 105300.

3

133.7 115115.7

Reliance

Communication

s Ltd

1621 93.05 150834.

05

109.85 178066.85

Adani Power

Ltd

2216 48.85 108251.

6

58.55 129746.8

Reliance Power

Ltd

1376 71.05 97764.8 72 99072

Larsen &

Toubro Ltd

71 1541.8 109467.

8

1426.65 101292.15

Bharat Heavy

Electricals Ltd

501 188.9 94638.9 205.35 102880.35

Total 1062312

.9

1125446.45

Calculation of the Hedging Position of the Portfolio for 26th April 2013 to 30th

May 2013

Nifty Index Value as on 26 April 2013 = 5871.45

Value of the portfolio on 26 April 2013 = 1062312.9


Nifty Lot Size = 50

Hedge ratio



Nifty Index value



=1062312.9× 1.4869

5871.45

=269.022


=260.022

50

= 5.38


The investor takes a long position by buying index futures on 26th April 2013,

expecting a rise in the market.


Value of the portfolio on 26th April 2013 = Rs 1062312.9

Value of the portfolio on 30th May 2013 = Rs 1125446.45

Profit of the portfolio = Rs. 63133.55


Price of a future on 26th April 2013 = Rs 5887.75

Price of 5 future contracts =5887.75 X 5 X 50

=Rs 1471937.5

Price of a future on 30th May 2013 = Rs 6124.2


=Rs 1531050

On April 26th 2013 the investor bought 5 future contracts expecting a bullish

market.



On 30th May 2013 when the market rose as he expected, the investor sold the

contracts and made a profit.

Profit from Future trading

Since the investor took a long position on the futures and sold them when the

market is high, he made a profit.

Profit from future trading = 1531050-1471937.5

= 59112.5

Hence with hedging the investor can maximize the profit.

The Net Profit

The Total profit of the portfolio with hedging= Profit of the portfolio + profit from

future trading

= 63133.55+ 59112.5

= 122246.05

The profit without hedging = 63133.55

The profit with hedging = 122246.05

Interpretation

The bullish market was also persistent in the month of May 2013 too. The RBI

slashed benchmark Repo rate by 25 bpts to 7.25 % but left CRR unchanged.

These altogether helped the portfolio to make a good profit in the month of May

2013. By hedging using futures the profit is maximized.

Effectiveness of using Index futures on the portfolio from March to May 2013

The loss of the portfolio in the month March 2013 after hedging = 51701.3

The profit of the portfolio in the month April 2013 after hedging = 173021.6

The profit of the portfolio in the month May 2013 after hedging = 122246.05



Total Profit from the portfolio from March to May = (122246.05 + 173021.6)-

51701.3

= 243566.35

If we didn’t use hedging using futures, then

Loss of the portfolio in March = 65063.8

Profit of the portfolio in April = 127146.6

Profit of the portfolio in May = 63133.55

The total profit will be = (127146.6+63133.55)-

65063.8

= 125216.35

We can show these details in a table

TABLE 3.7 comparison of hedging using index futures

Month Without hedging With hedging

March -65063.8 -51701.3

April 127146.6 173021.6

May 63133.55 122246.05

March to May 125216.35 243566.35

Interpretation

We have calculated the portfolio returns with hedging and without hedging using

Nifty index futures. The portfolio made a profit by using Nifty index future or

reduced the loss to minimum. It is found that if we didn’t use hedging there would

be less profit. So it is effective to use future contracts for hedging.

EFFECTIVENESS OF USING INDEX OPTION

In the month of March



By analyzing the market condition in March 2013, the market is expected to be

bearish as explained above in the usage of Nifty Future Index. We use put option

of strike price 5800 to hedge the portfolio.

Nifty Index value on 1-3-2013 = 5719.7

No of contracts used for hedging = 5

Put option price in 1-3-2013 = 120

Lot size = 50

Total amount needed for 5 contracts = 120 X 5 X 50

= 30000

If we exit the 5 contracts in 26th March 2013 then,

Put option price in March 26 = 158

Put option price for 5 contracts = 158 X 5 X 50

= 39500

Profit from option trading = 39500-30000

= 9500

Loss of the portfolio in March 2013 = 65063.8

Loss of the portfolio after hedging = 65063.8-9500

= 55563.8

Interpretation

By using option trading we can minimize the loss. For the option trading we need

to give a small amount of premium.

In the month April 2013

In the month April the investor expects a rise in the market. So he needs to buy

call option for the strike price 5800.



Nifty Index Value on April 1st 2013 = 5704.40

No of contracts needed for hedging = 5

Call option price in April 1st 2013 = 45.9

Total amount for buying 5 call options = 45.9 X 5 X 50

= 11475

Call option price in 25th April 2013 = 103.75

Call option price for 5 contracts =103.75 X 5 X 50

= 25937.5

Profit from option trading = 25937.5-11475

=14462.5


Total profit after hedging = 127146.6 + 14462.5

= 141609.1

Interpretation

In the month April 2013, the market was bullish. Therefore the portfolio was in

profit. Hedging by option helped to increase the profit.

Hedging from April 26 to May 30, 2013

The market is expected to be bullish in May 2013, so the investor buys call

options with strike price 5800 expiring on 30th May.

Nifty index value on April 26, 2013 = 5871.45

No of contracts for hedging = 5

Call option price on April 26 = 142.90



Lot size = 50

Total amount needed for 5 contracts = 142.90 X 5 X 50

= 35725

Call option price on 30th May 2013 = 321.20

Call option price for 5 contracts = 321.20 X 5 X 50

= 80300

Profit for option trading = 80300-35725

= 44575

Profit of the portfolio = 63133.55

Total Profit after hedging = 63133.55 + 44575

= 107708.55

Interpretation

In the month May, there was a bullish market. So portfolio was in profit. Hedging

using the options maximized the profit.

Now we may analyse the whole effect of index option in the portfolio from the

month March to May 2013.

Loss of the portfolio in the month March 2013 after hedging = 55563.8

Profit of the portfolio in April 2013 after hedging = 141609.1

Profit of the portfolio in May 2013 after hedging = 107708.55

Total profit from the portfolio from March to May = (107708.55+141609.1)-

55563.8

=193753.85

If we didn’t use hedging for the portfolio, then



Loss of the portfolio in March = 65063.8


Profit of the portfolio in May = 63133.55

The total profit will be = (127146.6+63133.55)-

65063.8

= 125216.35

We can show this in a table

Table 3.8 comparison of hedging using options

Month Without Hedging With Hedging

March -65063.8 -55563.8

April 127146.6 141609.1

May 63133.55 107708.55

Total 125216.35 193753.85

March April May

-100000

-50000

0

50000

100000

150000

200000

Without HedgingWith Hedging

Chart No: 3.1 comparison of hedging using index options

COMPARISON BETWEEN INDEX FUTURE AND INDEX OPTION

Table 3.9 Calculation of the amount of margin given for the future contract



Month No of

contracts

Price for one

contract

Total Margin (8%)

March 5 5729.95 1432487.5 114599

April 5 5726.55 1431637.5 114531

May 5 5887.75 1471937.5 117755

Along with the initial margin sometimes a maintenance margin in needed. Margin

Maintenance is the amount of money where a loss on your futures position

requires you to allocate more funds to bring the margin back to the initial margin

level.

Table 3.10 COMPARISON BETWEEN FUTURE AND OPTION

Month Future

Margin

Profit for

trading

Profit in

%

Option

premium

Profit

from

trading

Profit in

%

March 114599 13362.5 11.66 30000 9500 31.66

April 114531 45875 40.05 11475 14462.5 126.03

May 117755 59112.5 50.19 35725 44575 124.77

March April May0

20

40

60

80

100

120

140

Profit future tradingProfit in option trading

Chart no : 3.2 effectiveness of using derivatives from March to May.

INTERPRETATION



From the above table and chart we can found that option trading is more effective

than future trading for risk reduction and also for profit making. Future trading

needs a high amount of margin, however option trading only needs premium. If

our anticipation about the market condition was wrong, then there is a chance for

loss from future trading, however in the case of option trading, we may loss the

premium and make unlimited profit. Also future trading needs a maintenance

margin if we have debt in our trading account or decreasing our 8% margin in the

trading account. Option trading has no obligation, but future is a contract and it

has an obligation to exercise it. From this analysis we can say that option index is

more effective and less-risky tools than future index.

We can also calculate the total effect of hedging from March 1st to May 30th

Value of the portfolio in 1st March, 2013 = 1000000

Value of the portfolio in 30th May, 2013 = 1125446.45

Profit of the portfolio = 125446.45

Profit from future trading = 13362.5 + 45875 + 59112.5

= 118350

Profit of the portfolio for 3 months after Hedging with futures

=125446.45 + 118350

= 243796.45

Profit from option trading = 9500 + 14462.5 + 44575

= 68537.5

Profit of the portfolio for 3 months after hedging with options

= 125446.45 + 68537.5

= 193983.95

These details can be shown in a table

Table 3.11 effect of hedging strategy on the portfolio



Strategy Effect on the portfolio

Without Hedging Profit of Rs 125446.45

Hedging with Index futures Profit of Rs 243796.45

Hedging with Index Options Profit of Rs 193983.95

INTERPRETATION

From the above calculation, it is found that without hedging the portfolio makes a

less profit than with hedging with futures and options. After hedging with index

futures, the portfolio makes a profit of Rs 243796.45 and with option trading

portfolio makes a profit of Rs 193983.95. From these analyses we can say that

hedging with financial derivatives is an effective technique for risk diversification

and profit maximization.



CHAPTER 4

EMPIRICAL RESULTS



FINDINGS FROM THE STUDY

a) Effectiveness of Financial Derivatives as a risk

diversification tool

Financial Derivatives such as futures and options can be used as an

effective tool to diversify the risks associated in investing in a

volatile stock market.

To diversify the risk a proper portfolio must be prepared by

analysing the market condition.

The risk can be reduced to an extent only, it cannot be avoided.

Risk is associated in any type of investment; financial derivatives

can be used to hedge the risk.

The effectiveness of risk diversification depends upon the type of

tool used that is futures or options.

The selection of the tool entirely depends upon the anticipation of

the investor, so that an experienced investor can make huge profits

in comparison to a newcomer.

Strategies can be varying according to the time period. The

selection of the tool and the strategy that should be adopted varies

with time to time.

100% protection from risk is not possible; however the risk can be

reduced.

b) Effectiveness of Financial Derivatives as a profit

maximisation tool

By using futures and options the profit from the portfolio can be

maximised.



If the portfolio incurs a loss, by using index futures or options the

loss can be minimised. Thereby the net effect of the loss is reduced.

If the portfolio makes a profit, the trading of futures and options

add extra profit to the investment.

An investor might need the advice of a portfolio manager to

prepare a portfolio which delivers maximum profit.

An aggressive portfolio delivers maximum profit as it changes with

the market index.

SUGGESTIONS

On the basis of analysis done and findings reached, the following suggestions are

given to existing and prospective customers.

The losses that arise from the market risk can be reduced effectively using

hedging. The minimization of the risk is its primary objective.

Awareness programmes must be introduced by the brokers or financial

institutions about the importance of using financial derivatives as hedging

tools.

If an investor wants to minimize the risk of the portfolio, it must consists

of shares from various sectors and here Nifty index futures are used as a

tool for hedging, since they are convenient and represent the security

market as a whole. The advantage is that the risk within the portfolio can

be minimised completely and the portfolio will only be affected by the

market risk.

Strategic thinking and positive thinking are the two qualities that are

needed for a Hedger. These qualities will enable him to comprehend

market trends and fluctuations. If he lacks these qualities the strategies

adopted by him will earn only losses.

The selection of the hedging tool depends on the time frame and the nature

of the investor. An investor who prefers short term investments can go for

hedging, and the tools must be specifically adopted by him, depending on



the risk he is willing to suffer and the amount of liquid cash he has. Since

the market is always volatile long term investor should always be careful.

The level to which the risk is to be reduced must be determined by the

investor before he selects a risk reduction strategy. The cost and the

benefit of each strategy must be considered with the existing market

situations.

The strategies must be changed according to the market situations rather

than sticking to a particular strategy.



CHAPTER 5

SUMMARY AND CONCLUSION



5. SUMMARY AND CONCLUSION

The project titled “A Study on the effectiveness of Financial Derivatives as a Risk

Diversification and Profit Maximization Tool”– The case of Hedge equities Ltd,

for a period of 45 days from May 2nd 2013 to June 15th 2013.

Investments in the stock market involve high risk due to the volatile market

conditions. We use derivatives such as futures and options to hedge the risk

associated with such investments.

It is realized that derivative instrument have been in the market right from the 13th

century onwards. But derivative has come to the notice of modern security market

only in recent years. Therefore not much people are aware of its usage as hedging

tool.

This project is focused on the effectiveness of hedging in portfolio management.

The project is prepared using real market data and arrives at a conclusion based on

the results that are calculated minimizing any discrepancies.

A portfolio construction is an important step for every investor. It should be made

sure that the portfolio is a diversified one with different set of sectors included in

it. It can greatly reduce the risk of heavy loss due to the problems in any one

sector. Futures and options are two of the major hedging tools that can make

unlimited profits and limited loss within a short time frame. Options provide us

with a set of different strategies on the basis of the investor’s risk profile which

can be applied accordingly. The greatest benefit on using futures is that the

investor has to pay a particular amount of premium to buy option contracts. On

the other hand, we have futures as another hedging tool which is commonly used.

But in order to apply futures, the investor has to keep a particular percentage as



margin. If the hedging tool acts in the inverse direction, making losses, amount

from our margin will be deteriorating slowly. But the percentage of profits future

contracts makes is very much high.

Thus, here by we can conclude that, a systematic investment with proper hedging

along with in can earn us extra profits than the normal portfolio return. Also a

diversified portfolio is a kind of hedging technique that reduces heavy loss in the

portfolio. Thus we can reduce the risk and maximize the profit of a portfolio.

CHAPTER 6

BIBILIOGRAPHY



BOOKS

PRASANNA CHANDRA – Investment Analysis and Portfolio Management, TATA McGraw Hill Publishing Company LTD New Delhi 2005

PUNITHAVATHY PANDIAN – Security Analysis and Portfolio Management, Vikas Publishing House PVT LTD New Delhi 2001

SUDHINDRA BHAT – Security Analysis and Portfolio Management, EXCEL Publications, New Delhi 2008

P. VIJAYA BHASKAR, B. MAHAPATRA- Derivatives Simplified, Response Books New Delhi, 2001

WEBSITES

www.bseindia.org

www.nseindia.org

www.hedgeequities.com

www.yahoofinance.com

www.rediffmoney.com

www.investopedia.com

Finance.reuters.in

stockshastra.moneyworks4me.com

www.wikipedia.com


http://www.wikipedia.com/

http://www.investopedia.com/

http://www.rediffmoney.com/

http://www.yahoofinance.com/

http://www.hedgeequities.com/

http://www.nseindia.org/

http://www.bseindia.org/


CHAPTER 7

APPENDIX



APPENDIX

Historical Data for CNX NIFTY

For the period 01-03-2013 to 31-05-2013

Date Open High Low Close Shares TradedTurnover

( Cr)

01-Mar-2013 5702.45 5739.45 5679.90 5719.70 174517984 6877.59

04-Mar-2013 5704.70 5712.00 5663.60 5698.50 144887325 5778.72

05-Mar-2013 5722.45 5790.10 5722.40 5784.25 154406134 6321.31

06-Mar-2013 5816.40 5828.70 5795.05 5818.60 156901392 6244.47

07-Mar-2013 5801.30 5878.00 5801.30 5863.30 134679762 5676.89

08-Mar-2013 5883.65 5952.85 5883.00 5945.70 150781148 6214.19

11-Mar-2013 5946.10 5971.20 5930.35 5942.35 125384918 5688.38

12-Mar-2013 5944.60 5952.00 5893.65 5914.10 115944389 5098.38

13-Mar-2013 5884.80 5893.85 5842.25 5851.20 116710808 4950.09

14-Mar-2013 5845.95 5920.15 5791.75 5908.95 149008437 7204.09

15-Mar-2013 5914.90 5945.65 5861.00 5872.60 152156666 6984.19

18-Mar-2013 5816.75 5850.20 5814.35 5835.25 102663402 4690.01

19-Mar-2013 5859.50 5863.60 5724.30 5745.95 182311867 8255.03

20-Mar-2013 5740.55 5745.30 5682.30 5694.40 187624850 7103.68

21-Mar-2013 5705.90 5757.75 5647.95 5658.75 179177573 7053.93

22-Mar-2013 5659.80 5691.45 5631.80 5651.35 165293291 5909.38

25-Mar-2013 5707.30 5718.40 5624.40 5633.85 150388821 5683.44

26-Mar-2013 5613.75 5655.30 5612.05 5641.60 126500524 4939.19

28-Mar-2013 5647.75 5692.95 5604.85 5682.55 209658945 8372.35

01-Apr-2013 5697.35 5720.95 5675.90 5704.40 97779717 3683.38

02-Apr-2013 5701.70 5754.60 5687.15 5748.10 106423845 4262.15

03-Apr-2013 5740.20 5744.95 5650.10 5672.90 140713330 5313.95



04-Apr-2013 5640.65 5644.45 5565.65 5574.75 134586976 5000.44

05-Apr-2013 5568.10 5577.30 5534.70 5553.25 137461477 5281.57

08-Apr-2013 5550.50 5569.20 5537.05 5542.95 97021471 3673.21

09-Apr-2013 5568.75 5603.05 5487.00 5495.10 138184712 5485.91

10-Apr-2013 5536.25 5569.25 5477.20 5558.70 128558760 5387.08

11-Apr-2013 5601.65 5610.65 5542.85 5594.00 146828501 6469.38

12-Apr-2013 5520.70 5544.50 5494.90 5528.55 127323273 7447.27

15-Apr-2013 5508.50 5592.85 5500.30 5568.40 142918219 7133.92

16-Apr-2013 5562.45 5699.25 5555.85 5688.95 142679244 5943.06

17-Apr-2013 5708.65 5732.15 5669.00 5688.70 154575403 7304.10

18-Apr-2013 5682.70 5794.35 5681.85 5783.10 149883469 6588.70

22-Apr-2013 5789.85 5844.85 5789.80 5834.40 135095797 6073.25

23-Apr-2013 5843.10 5844.30 5791.55 5836.90 132218357 5366.87

25-Apr-2013 5856.10 5924.60 5853.30 5916.30 199597725 9211.66

26-Apr-2013 5899.75 5907.05 5860.50 5871.45 141311877 6840.01

29-Apr-2013 5877.60 5918.65 5868.80 5904.10 118882089 5364.86

30-Apr-2013 5932.60 5962.30 5867.80 5930.20 153186197 6699.02

02-May-2013 5911.40 6019.45 5910.95 5999.35 162376438 7277.43

03-May-2013 5993.50 6000.30 5930.15 5944.00 145754275 6590.91

06-May-2013 5944.90 5976.50 5928.45 5971.05 110166713 4612.49

07-May-2013 5983.45 6050.50 5982.95 6043.55 136372981 5572.16

08-May-2013 6064.15 6083.55 6024.95 6069.30 122278698 5159.97

09-May-2013 6078.35 6084.70 6040.45 6050.15 109997276 5164.76

10-May-2013 6046.25 6105.30 6045.60 6094.75 111351573 5162.22

11-May-2013 6088.20 6114.55 6084.15 6107.25 7991165 355.74

13-May-2013 6098.20 6104.95 5972.90 5980.45 107948706 4633.05

14-May-2013 5989.70 6026.20 5970.05 5995.40 119265483 4921.65

15-May-2013 6018.85 6157.10 6018.85 6146.75 153892843 7240.73

16-May-2013 6128.25 6187.30 6128.25 6169.90 158635506 6733.31

17-May-2013 6172.95 6199.95 6146.15 6187.30 147280254 5870.44

20-May-2013 6198.00 6229.45 6146.05 6156.90 122252978 5589.97

21-May-2013 6152.35 6180.25 6102.35 6114.10 130589228 5122.71

22-May-2013 6127.05 6147.60 6074.45 6094.50 133763685 5837.19

23-May-2013 6050.40 6081.45 5955.70 5967.05 198930489 8230.10

24-May-2013 6010.70 6015.30 5936.80 5983.55 161622562 6193.00

27-May-2013 5989.40 6099.90 5975.55 6083.15 115115365 4961.15

28-May-2013 6086.35 6127.65 6055.40 6111.25 139668916 5481.14

29-May-2013 6120.45 6125.05 6069.80 6104.30 120205054 5135.80



30-May-2013 6072.15 6133.75 6072.15 6124.05 194092801 7794.82

31-May-2013 6098.70 6106.25 5975.55 5985.95 175311989 7223.11


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