Tag Archives: Derivatives

Jan 23

Importance of Hedging

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The financial market has numerous investment instruments and all of them come with their potential of profits and exposure to risk. One of the instruments are classified as derivatives. Derivatives are those instruments that derive their values from an underlying asset. Based upon the underlying, they could be called as equity derivatives, index derivatives, currency derivatives, commodities derivatives, etc. Derivatives not only helps in price discovery but also helps in transferring the risk. The risks could be Diversifiable or systematic and Non – Diversifiable or unsystematic and to minimize this risk fund managers, investors, businesses, banks, etc. uses hedging as a tool.

Hedging is a strategy that immunizes the risk of any potential losses against any negative price movement by transferring it to someone who is willing to accept it. People who take this risk are known as speculators. Speculators create a naked position and expect the market to move in their direction, hence, benefiting them. Their profits and losses are extreme, as they do not protect their position against diversity movement of the prices.

Hedging techniques generally involve the use of a bit of complex strategies using derivatives, commonly futures and options and in some cases hybrid instruments as well. Basically, it is done by creating either a counter position in derivatives or in equity with negative correlation. In this way, the profit of one instrument is offset by the loss of the other, limiting the profits and hence, minimizing the losses.

Hedging primarily uses Futures for security against any diversity in prices. Generally, future is a pre-defined contract whose price is determined by adjusting freight, handling, storage and quality costs, along with the impact of supply and demand factors to the spot price. There is regular change in the prices of spot and futures which is known as the basis, however, the risk arising out of the difference is defined as basis risk and the difference between spot and futures prices is defined as narrowing of the basis.

When the market is characterized by contango, narrowing of basis benefits the short hedger and a widening of the basis benefits the long hedger, whereas, in a market characterized by backwardation, a narrowing of the basis benefits the long hedger and a widening of the basis benefits the short hedger. However, if the difference between spot and futures prices increases (either on negative or positive side) it is defined as widening of the basis. The impact of this movement is opposite to that as in the case of narrowing.

We can understand Hedging by an example: An investor buys 1500 shares of XYZ company at Rs. 309 for a total of Rs. 4,63,575, with a view of rise in share prices over the next few months. But there is a fear of fall in share prices due to various circumstances. As his fears, the market falls and he would incur loss so to avoid this diversity against the price movement, he can hedge this position by selling Nifty Future.

First, he needs to consider the risk associated with the shares in respect to the Index, this is known as Beta. Beta is calculated by dividing the difference in rate of return of the share minus the risk free trade by the Index rate of return minus the risk free trade. Now supposingly, the Future of Nifty is trading at Rs. 5778 and the beta of the share is calculated to 0.81, to hedge the position he needs to sell Rs. 3,73,645 worth of Nifty Future i.e. approximately 64 units. Since, Nifty Index contains 50 units in 1 lot, he can either sell 1 lot of Nifty Future or 2 .If he over-hedges and sells 2 lots and the market falls 10%, then notionally, he is at a profit of Rs. 577.8 per lot and loss of Rs. 24.90 per share but an overall profit of Rs. 20,420. In this way the investor not only saved himself from a total loss of Rs. 37,364 instead earned Rs. 20,420 as his expectations.

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Feb 02

Synopsis of Derivatives

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A derivative instrument is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices.
Rise of Derivatives
The global economic order that emerged after World War II was a system where many under developed countries administered and controlled prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates for currencies/foreign exchange.
The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate as per demand and supply. Under developed countries like India began opening up their economies and allowing prices to vary with market conditions in early 90’s with start of economic liberalisation process and RBI started playing little role in controlling the foreign exchange prices.
Price fluctuations make it hard for businesses to estimate their future production costs and revenues. Derivative securities provided them a valuable set of tools for managing this risk.
Uses of Derivatives
Derivatives may be traded for a variety of reasons. A derivatives contract enables a trader to hedge some market risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market.
Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators.
A third type of trader, called arbitrageurs, profit from discrepancies or mispricing in the relationship of spot and derivatives prices, and thereby help to keep markets efficient.
Exchange-Traded and Over-the-Counter Derivative Instruments
India is one of the most successful developing countries in terms of a vibrant market for exchange-traded derivatives. This reiterates the strengths of the modern development of India’s securities markets, which are based on nationwide market access, anonymous electronic trading, a predominantly retail market and an active regulatory framework. There is an increasing sense that the equity derivatives market is playing a major role in shaping price discovery.
OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. OTC contracts have substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in “hawala” or forwards markets.
An exchange-traded contract, such as a futures contract, has a standardized format that specifies the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the exchanges trading derivatives as per present market structure in India. Margin requirements and daily marking-to-market of futures positions substantially mitigate the credit risk of exchange-traded contracts, relative to OTC contracts.
Derivatives Users in India
The use of derivatives varies by type of institution. Financial institutions, such as banks, have assets and liabilities of different maturities and in different currencies, and are exposed to different risks of default from their borrowers. Thus, they are likely to use derivatives on interest rates and currencies, and derivatives to manage credit risk. Non-financial institutions are regulated differently from financial institutions, and this affects their incentives to use derivatives.
In India, financial institutions have not been heavy users of exchange-traded derivatives so far. However, market insiders feel that this may be changing, as indicated by the growing share of index derivatives (which are used more by institutions than by retail investors). Transactions between banks dominate the market for interest rate derivatives, while state-owned banks remain a small presence. Corporations are active in the currency forwards and swaps markets, buying these instruments from banks.
Why do institutions not participate to a greater extent in derivatives markets? Some institutions such as banks and mutual funds are only allowed to use derivatives to hedge their existing positions in the spot market, or to rebalance their existing portfolios. Since banks have little exposure to equity markets due to banking regulations, they have little incentive to trade equity derivatives.
Foreign investors must register as foreign institutional investors (FII) to trade exchange-traded derivatives, and be subject to position limits as specified by SEBI. In practice, some foreign investors also invest in Indian markets by issuing Participatory Notes to an off-shore investor. FIIs have a significant and increasing presence in the equity derivatives markets. They have no incentive to trade interest rate derivatives since they have little investments in the domestic bond markets.
Retail investors (including small brokerages trading for themselves) are the major participants in equity derivatives. The success of single stock futures in India is unique, as this instrument has generally failed in most other countries. One reason for this success may be retail investors’ prior familiarity with “badla” trades which shared some features of derivatives trading. Another reason may be the small size of the futures contracts, compared to similar contracts in other countries. Retail investors also dominate the markets for commodity derivatives, due in part to their long-standing expertise in trading in the “hawala” or forwards markets.
Summary and Conclusions
In terms of the growth of derivatives markets, and the variety of derivatives users, the Indian market has equalled or exceeded many other regional markets. While the growth is being spearheaded by retail investors, private sector institutions and large corporations, smaller companies and state-owned institutions are gradually getting into the act. Foreign brokers are boosting their presence in India in reaction to the growth in derivatives. The variety of derivatives instruments available for trading is also expanding.
In the past, there were major areas of concern for Indian derivatives users. Large gaps exist in the range of derivatives products that are traded actively. In equity derivatives, NSE figures showed that almost 90% of activity was due to index options, index futures & stock futures, whereas trading in options is limited to a few stocks, partly because stock options were of American style & they are settled in cash and not the underlying stocks. But with the start of 2011 all stock options available for trading were changed to European style. This change has led to the liquidity in stock options not only close to ATM strikes but also across multiple strikes just as in case of index options. This change has encouraged the options writers to go ahead eliminating the assignment risk prior to expiry which will eventually benefit them.
Considering these changes derivatives market in India is poised to grow and mature further to accommodate larger participation across varied asset classes by wide range of participants.