Beruflich Dokumente
Kultur Dokumente
B C16MB5260019
GITAM
UNIVERSITY
(Estd. u/s 3 of the UGC Act, 1956)
Name SHYLAJA.B
Specialization FINANCE
1. PROBLEM STATEMENT:-
The emergence of the market for derivative products, most notably forwards, futures
and options, can be traced back to the willingness of risk-averse economic agents to
their very nature, the financial markets are marked by a very high degree of
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these generally do not influence the fluctuations in the underlying asset prices.
fluctuations in asset prices on the profitability and cash flow situation of risk-averse
investors.
commodity prices and commodity-linked derivatives remained the sole form of such
products for almost three hundred years. The financial derivatives came into
However, since their emergence, these products have become very popular and by
products. In recent years, the market for financial derivatives has grown
also turnover. In the class of equity derivatives, futures and options on stock indices
Even small investors find these useful due to high correlation of the popular indices
with various portfolios and ease of use. The lower costs associated with index
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The emergence of the market for derivative products, most notably forwards, futures
and options, can be traced back to the willingness of risk-averse economic agents to
their very nature, the financial markets are marked by a very high degree of
these generally do not influence the fluctuations in the underlying asset prices.
fluctuations in asset prices on the profitability and cash flow situation of risk-averse
investors.
such products for almost three hundred years. The financial derivatives came into
However, since their emergence, these products have become very popular and by
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products. In recent years, the market for financial derivatives has grown
also turnover. In the class of equity derivatives, futures and options on stock indices
Even small investors find these useful due to high correlation of the popular indices
with various portfolios and ease of use. The lower costs associated with index
The following factors have been driving the growth of financial derivatives:
markets,
costs,
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5. Innovations in the derivatives markets, which optimally combine the risks and
assets.
Different investment avenues are available for investors. Stock market also offers
good investment opportunities to the investor alike all investments, they also carry
certain risks. The investor should compare the risk and expected yields after
adjustment off tax on various instruments while talking investment decision the
investor may seek advice from consultancy include stock brokers and analysts while
making investment decisions. The objective here is to make the investor aware of
Derivatives act as a risk hedging tool for the investors. The objective is to help the
investor in selecting the appropriate derivates instrument to attain maximum risk and
to construct the portfolio in such a manner to meet the investor should decide how
To identity investor objective constraints and performance, which help formulate the
investment policy.
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To develop and improve strategies in the investment policy formulated. This will
help the selection of asset classes and securities in each class depending up on their
1.3. Objectives:-
2. To examine the different strategy which are used by the investors for the
options, swaps and forwards in the Indian context; the study is not based on the
The study is limited to the analysis made for types of instruments of derivates each
strategy is analyzed according to its risk and return characteristics and derivatives
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2. RESEARCH METHODOLOGY:-
Concept of Derivatives
The term ‘derivatives, refers to a broad class of financial instruments which mainly
include options and futures. These instruments derive their value from the price and
other related variables of the underlying asset. They do not have worth of their own
and derive their value from the claim they give to their owners to own some other
derivative of milk. The price of butter depends upon price of milk, which in turn
depends upon the demand and supply of milk. The general definition of derivatives
means to derive something from something else. Some other meanings of word
derivatives are:
is a derivative of ‘electric’.
are those financial instruments that derive their value from the other assets. For
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example, the price of gold to be delivered after two months will depend, among so
Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative
as:
unsecured, risk instrument or contract for differences or any other form of security;
b) “a contract which derives its value from the prices, or index of prices, of
underlying securities”.
As defined above, the value of a derivative instrument depends upon the underlying
iv. Bonds of different types, including medium to long term negotiable debt
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vii. Over- the Counter (OTC) 2 money market products such as loans or deposits.
1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated
this category.
2. Speculators: They transact futures and options contracts to get extra leverage in
betting on future movements in the price of an asset. They can increase both the
discrepancy between prices of more or less the same assets or competing assets in
different markets. If, for example, they see the futures price of an asset getting out
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of line with the cash price, they will take offsetting positions in the two markets to
lock in a profit.
management is not about the elimination of risk rather it is about the management
of risk. Financial derivatives provide a powerful tool for limiting risks that
requires a thorough understanding of the basic principles that regulate the pricing of
financial derivatives. Effective use of derivatives can save cost, and it can increase
components and that leads to improving market efficiency. Traders can use a
more attractive instrument than the underlying security. This is mainly because of
the greater amount of liquidity in the market offered by derivatives as well a the
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3. Speculation: This is not the only use, and probably not the most important use,
discovery which means revealing information about future cash market prices
diverse and scattered opinions of future are collected into one readily discernible
derivative reduces both peak and depths and leads to price stabilization effect in the
Classification of Derivatives
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underlying asset can be commodities like wheat, gold, silver etc., whereas in case of
financial derivatives underlying assets are stocks, currencies, bonds and other
interest rates bearing securities etc. Since, the scope of this case study is limited to
only.
buy or sell an asset at a specified point of time in the future. In case of a forward
contract the price which is paid/ received by the parties is decided at the time of
entering into contract. It is the simplest form of derivative contract mostly entered
deferred until the contract has been made. Although the delivery is made in the
future, the price is determined on the initial trade date. One of the parties to a forward
contract assumes a long position (buyer) and agrees to buy the underlying asset at a
certain future date for a certain price. The other party to the contract known as seller
assumes a short position and agrees to sell the asset on the same date for the same
price. The specified price is referred to as the delivery price. The contract terms like
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delivery price and quantity are mutually agreed upon by the parties to the contract.
No margins are generally payable by any of the parties to the other. Forwards
contracts are traded over-the- counter and are not dealt with on an exchange unlike
futures contract. Lack of liquidity and counter party default risks are the main
textile from an exporter from England worth £ 1 million payment due in 90 days.
The Importer is short of Pounds- it owes pounds for future delivery. Suppose the
spot (cash market) price of pound is US $ 1.71 and importer fears that in next 90
days, pounds might rise against the dollar, thereby raising the dollar cost of the
textiles. The importer can guard against this risk by immediately negotiating a 90
days forward contract with City Bank at a forward rate of say, £ 1= $1.72. According
to the forward contract, in 90 days the City Bank will give the US Importer £ I
million (which it will use to pay for textile order), and importer will give the bank $
1.72 million (1million ×$1.72) which is the dollar cost of £ I million at the forward
rate of $ 1.72.
(short) the underlying asset at a specified price at a specified future date through a
specified exchange. Futures contracts are traded on exchanges that work as a buyer
or seller for the counterparty. Exchange sets the standardized terms in term of
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Quality, quantity, Price quotation, Date and Delivery place (in case of
i These are traded on an organized exchange like IMM, LIFFE, NSE, BSE, CBOT
etc.
ii These involve standardized contract terms viz. the underlying asset, the time of
iii These are associated with a clearing house to ensure smooth functioning of the
market.
iv There are margin requirements and daily settlement to act as further safeguard.
vi Almost ninety percent future contracts are settled via cash settlement instead of
transaction. The clearinghouse, being the counter party to both sides of a transaction,
provides a mechanism that guarantees the honoring of the contract and ensuring very
low level of default (Hirani, 2007). Following are the important types of financial
futures contract:-
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1000 shares of ABC Ltd. Current (spot) price of ABC Ltd shares is Rs 115 at
National Stock Exchange (NSE). Ramesh entertains the fear that the share price of
ABC Ltd may fall in next two months resulting in a substantial loss to him. Ramesh
decides to enter into futures market to protect his position at Rs 115 per share for
delivery in January 2008. Each contract in futures market is of 100 Shares. This is
an example of equity future in which Ramesh takes short position on ABC Ltd.
Shares by selling 1000 shares at Rs 115 and locks into future price.
Options Contract:- In case of futures contact, both parties are under obligation to
perform their respective obligations out of a contract. But an options contract, as the
name suggests, is in some sense, an optional contract. An option is the right, but not
the obligation, to buy or sell something at a stated date at a stated price. A “call
option” gives one the right to buy; a “put option” gives one the right to sell. Options
are the standardized financial contract that allows the buyer (holder) of the option,
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i.e. the right at the cost of option premium, not the obligation, to buy (call options)
or sell (put options) a specified asset at a set price on or before a specified date
through exchanges. Options contracts are of two types: call options and put options.
Apart from this, options can also be classified as OTC (Over the Counter) options
and exchange traded options. In case of exchange traded options contract, contracts
are standardized and traded on recognized exchanges, whereas OTC options are
customized contracts traded privately between the parties. A call options gives the
holder (buyer/one who is long call), the right to buy specified quantity of the
underlying asset at the strike price on or before expiration date. The seller (one who
is short call) however, has the obligation to sell the underlying asset if the buyer of
the call option decides to exercise his option to buy. Suppose an investor buys One
European call options on Infosys at the strike price of Rs. 3500 at a premium of Rs.
100. Apparently, if the market price of Infosys on the day of expiry is more than Rs.
3500, the options will be exercised. In contrast, a put options gives the holder (buyer/
one who is long put), the right to sell specified quantity of the underlying asset at the
strike price on or before an expiry date. The seller of the put options (one who is
short put) however, has the obligation to buy the underlying asset at the strike price
if the buyer decides to exercise his option to sell. Right to sell is called a Put Options.
Suppose X has 100 shares of Bajaj Auto Limited. Current price (March) of Bajaj
auto shares is Rs 700 per share. X needs money to finance its requirements after two
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months which he will realize after selling 100 shares after two months. But he is of
the fear that by next two months price of share will decline. He decides to enter into
option market by buying Put Option (Right to Sell) with an expiration date in May
whereby parties agree to exchange obligations that each of them have under their
or more parties to exchange stream of cash flows over a period of time in the future.
The parties that agree to the swap are known as counter parties.
i) Interest rate swaps which entail swapping only the interest related cash flows
ii) Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than the
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Primary Sources: Data related to the Investors will collected through primary
sources.
Interviews.
Questionnaires.
2.3. Sampling:-
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Universe
Sampling
Population
Technique
Sampling
plan
Sample Sampling
Size unit
Sampling
frame
Universe- All the people who are dealing in derivatives and were interested
to deal in derivatives.
Population-
Dehradun.
nearby places.
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Bar diagrams.
Pie charts.
2.5. Review of literature:- Before derivatives markets were truly developed, the
means for dealing with financial risks were few and financial risks were largely
outside managerial control. Few exchange- traded derivatives did exist, but they
allowed corporate users to hedge only against certain financial risks, in limited ways
and over short time horizons. Companies were often forced to resort to operational
or to the natural hedging by trying to match currency structures of their assets and
liabilities (Santomero, 1995). Allen and Santomero (1998) wrote that, during the
1980s and 1990s, commercial and investment banks introduced a broad selection of
new products designed to help corporate managers in handling financial risks. At the
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same time, the derivatives exchanges, which successfully introduced interest rate
and currency derivatives in the 1970s, have become vigorous innovators, continually
adding new products, refining the existing ones, and finding new ways to increase
their liquidity. Since than, markets for derivative instruments such as forwards and
futures, swaps and options, and innovative combinations of these basic financial
instruments, have been developing and growing at a breathtaking pace. The range
and quality of both exchangetraded and OTC derivatives, together with the depth of
the market for such instruments, have expanded intensively. Consequently, the
corporate use of derivatives in hedging interest rate, currency, and commodity price
risks is widespread and growing. It could be said that the derivatives revolution has
begun. The emergence of the modern and innovative derivative markets allows
1995; 1996). Therefore, under these new conditions, shareholders and stakeholders
exposures to financial risks. It was long believed that corporate risk management
was irrelevant to the value of the firm and the arguments in favour of the irrelevance
were based on the Capital Asset Pricing Model (Sharpe, 1964; Lintner, 1965;
Mossin, 1966) and the Modigliani-Miller theorem (Modigliani and Miller, 1958).
should care only about the systematic component of total risk. On the surface this
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may imply that managers of firms who are acting in the best interests of shareholders
Miller and Modigliani’s proposition supports the CAPM findings. The conditions
to interest rate, exchange rate and commodity price risks are completely irrelevant
because stockholders already protect themselves against such risks by holding well-
an explanation for this clash between theory and practice, imperfections in the
capital market are used to argue for the relevance of corporate risk management
instruments generally support the expected relationships between the risks and
firm’s characteristics. Stulz (1984), Smith and Stulz (1985) and Froot, Scharfstein
and Stein (1993) constructed the models of financial risk management. These models
predicted that firms attempted to reduce the risks arising from large costs of potential
bankruptcy, or had funding needs for future investment projects in the face of
Bessembinder (1991), Nance, Smith and Smithson (1993), Dolde (1995), Mian
(1996), as well as Getzy, Minton and Schrand (1997) and Haushalter (2000) found
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empirical evidence that firms with highly leveraged capital structures are more
financial distress is directly related to the size of the firm’s fixed claims relative to
the value of its assets. Hence, hedging will be more valuable the more indebted the
liquidation – situations in which the firm faces direct costs of financial distress. By
reducing the variance of a firm’s cash flows or accounting profits, hedging decreases
the likelihood, and thus the expected costs, of financial distress (see: Mayers and
Smith, 1982; Myers, 1984; Stulz, 1984; Smith and Stulz, 1985; Shapiro and Titman,
1998). The argument of reducing theexpected costs of financial distress implies that
the benefits of risk management should be greater the larger the fraction of fixed
claims in the firm’s capital structure. The results of the empirical studies suggest that
the use of derivatives and risk management practices are broadly consistent with the
behaviour. By hedging financial risks such as currency, interest rate and commodity
risk, firms can decrease cash flow volatility. By reducing the cash flow volatility,
firms can decrease the expected financial distress and agency costs, thereby
enhancing the present value of expected future cash flows. In addition, reducing cash
flow volatility can improve the probability of having sufficient internal funds for
planned investments, (e.g. see: Stulz, 1984; Smith and Stulz, 1985; Froot,
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Scharfstein and Stein, 1993; 1994) eliminating the need to either cut profitable
projects or bear the transaction costs of external funding. The main hypothesis is
that, if access to external financing (debt and/or equity) is costly, firms with
investment projects requiring funding will hedge their cash flows to avoid a shortfall
in own funds, which could precipitate a costly visit to the capital markets. An
interesting empirical insight based on this rationale is that firms with substantial
investment opportunities that are faced with high costs of raising funds under
financial distress will be more motivated to hedge against risk exposure than average
firms. This rationale has been explored by numerous scholars, among others by
Hoshi, Kashyap and Scharfstein (1991), Bessembinder (1991), Dobson and Soenen
(1993), Froot, Scharfstein and Stein (1993), Getzy, Minton and Schrand (1997), Gay
and Nam (1998), Minton and Schrand (1999), Haushalter (2000), Mello and Parsons
(2000), Allayannis and Ofek (2001) and Haushalter, Randall and Lie (2002). The
results of the studies mentioned above confirm that companies using derivative
instruments to manage financial risks are more likely to have larger investment
opportunities.
The results of empirical studies have also proven that the benefits of risk
management programs depend on the company size. Nance, Smith and Smithson
(1993), Dolde (1995), Mian (1996), Getzy, Minton and Schrand (1997) and
Hushalter (2000) argue that larger firms are more likely to hedge and use derivatives.
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One of the key factors in the corporate risk management rationale pertains to the
costs of engaging in risk-management activities. The hedging costs include the direct
transaction costs and the agency costs of ensuring that managers transact
appropriately.3 the assumption underlying this rationale is that there are substantial
Indeed, for many firms (particularly smaller ones), the marginal benefits of hedging
programs may be exceeded by marginal costs. This fact suggests that there may be
numerous firms may not hedge at all, even though they are exposed to financial risks,
empirical results, it can be argued that only large firms with sufficiently large risk
Derivatives carry high risk factor and amongst that commodity derivatives are
Profit is the main reason for motivating the people to invest in derivatives.
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Do people prefer to invest their money through derivatives if they are provided
with knowledge.
2.7. Limitations:-
Limitations are the limiting lines that restrict the work in some way or other. In this
research study also there will be some limiting factors, some of them are as under:
1. Data Collection: The most important constraint in this study will going to be data
collection as both Primary and Secondary data was selected for study. Secondary
data means data that are already available i.e. they refer to the data which have
2. Time Period: Time period will one of the main factor as only one month is
allotted and the topic covered in research has a wide scope. So, it was not possible
3. Reliability: The data collected in research work will be secondary data, so, this
4. Accuracy: The facts and findings of the data cannot be accepted as accurate to
some extent as firstly, secondary data will be collected. Secondly, for doing
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descriptive research time needed to be more, because in short period you cannot
2.8. References:-
Modigliani, M. and Miler, M., 1958. “The Cost of Capital, Corporate Finance
297.
http://www.nseindia.com.
http://www.valuenotes.com/njain/nj_derivatives_15sep03.asp?ArtCd=33178
&Cat=T&Id=10.
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Delhi, India.
Websites
www.derivativesindia.com
www.nse-india.com
www.sebi.gov.in
www.rediff/money/derivatives.htm
www.iinvestor.com
www.appliederivatives.com
www.economictimes.com
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