A study on hedging effectiveness in index future


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A study on hedging effectiveness in index future

  1. 1. 1. INTRODUCTION In India, National Stock Exchange (NSE) and Bombay Stock Exchange (BSE)introduced financial derivatives in the year 2000. Derivatives allow managing risks moreeffectively by reducing the burden of risk and allowing either hedging or taking only onerisk at a time. It is indeed rewarding but involves a great deal of risk. Investing infinancial securities is considered to be one of the best avenues for investing one’s savingswhile it is acknowledged to be one of the most risky for investment. Investment is theemployment of funds with the aim of earning additional income or capital appreciation. Ithas two attributes i.e., time and risk. The sacrifice that has to be made by the investor iscertain but return in the future is uncertain. Every investor is exposed to risk of marketprice of fluctuations. Derivatives were evolved to curtail the risk of market pricefluctuations in the commodity market. Derivatives have been in use way back in 13thcentury onwards and later it was developed for the securities market. Risk is a characteristic future of all commodity and capital market. Prices of allcommodities like wheat, cotton, rice, coffee, tea, silver, gold etc are subject tofluctuations in demand and supply over time. Producers of commodities cannot be sure ofthe price that they produce may fetch when they are ready for sale. Similarly prices ofshares and debentures or bond etc are subject to fluctuations. In the same way the foreignexchange are also subject to fluctuations. In the current economic scenario, investmentsin financial markets have become more complicated. Investing in securities such asshares, debentures, bond etc are profitable as well as interesting and attracts people fromall walks of life irrespective of their occupation, economic status, education or familybackground. Risk reduction is one of the main issues for an investor as it is directlyrelated to the return on the investments. 1
  2. 2. Some of the risk management techniques used in the capital market now a day is: • Risk avoidance • Combination • Diversification • Risk transfer • Portfolio investment • Hedging The project entries “A STUDY ON HEDGING EFFECTIVENESS IN INDEXFUTURE” deals with the construction of a profitable portfolio on the basis of risk-returnevaluation and loss minimization using hedging. The companies are selected on the basisof their industrial performance. Investing in individual securities involves lot of risks. Itis better to invest in-group of securities to reduce risk. Selecting the group of securities isan important task. Investors are interested in maximizing the return with minimum risk,here ten securities have been selected for constructing the portfolio these securities arerepresentatives of different sector. The securities selected are SBI BANK, HDFC BANK,WIPRO, INFOSYS, MAHINDRA, MARUTI SUZUKI, HUL, ITC, CIPLA andRANBAXY. There exist a considerable degree of different in return and risk of variousportfolios.PORTFOLIO MANAGEMENT Investing in securities such as shares, debentures and bonds is profitable as wellas existing. It is indeed rewarding, but involves a great deal of risk and calls for scientificas well as artistic skill. In such investment both rational as well as emotional responsesare involved. Investing in financial securities is now considered to be one of the mostrisky avenues of investments. It is rare to investors investing their savings in a single security. Instead they tendto invest in a group of securities. Such as group of securities is called as Portfolio.Creation of a portfolio helps to reduce risk without sacrificing returns. 2
  3. 3. Portfolio management deals with the analysis of individual securities as well aswith the theory and practice of optimally combining securities into portfolios. Aninvestor who understands the fundamental principles and analytical aspects of portfoliomanagement has a better chance of success. An investor considering investments in securities is faced with the problem ofchoosing from among a large number of securities. His choice depends upon the riskreturns characteristics of individual securities. He would attempt to choose the mostdesirable securities and like to allocate his funds over this group of securities. Again he isfaced with the problem of deciding which securities to hold and how much to invest ineach. The investor faces an infinite number of possible portfolios differ from those ofindividual securities combining to form a portfolio. The investor tries to choose theoptimal portfolio taking into consideration the risk return characteristics of all possibleportfolios.TECHNICAL ANALYSIS Technical analysis is a method of evaluating securities by analyzing the statisticsgenerated by market activity, such as past prices and volume. Technical analysis do notattempt to measure a security’s intrinsic value, but instead use charts and other tools toidentify patterns that can suggest future activity. Just as there are many investment styles on the fundamental side, there are alsomany different types of technical traders. Some rely on chart patterns, others usetechnical indicators and oscillators and most use some combination of the two. In anycase, technical analyst’s exclusive use of historical price and volume data is whatseparates them from their fundamental counterparts. Unlike fundamental analysts,Technical analysts don’t care whether a stock is undervalued- the only thing that mattersis a security’s past trading data and what information this data can provide about wherethe security might move in the future. 1. The market discounts everything. 2. Price moves in trends. 3. History trends to repeat itself. 3
  4. 4. INVESTMENT ANALYSIS Investment is the employment of funds on assets with the aim of earning incomeor capital appreciation. Investment has two attributes namely time and risk. Presentconsumption is sacrificed to get a return in the future. The sacrifice that has to be borne iscertain, but the return in the future may be uncertain. This attribute of investmentindicates the risk factor. The risk is undertaken with a view to reap some return from theinvestment. Investment means some monetary commitment.RISK Every investment is characterized by return and risk. Risk can be defined in termsof variability I returns. “Risk is the potential for variability in returns”. An investmentwhose returns are fairly stable is considered to be low risk investment, where as aninvestment whose returns fluctuate significantly is considered to be a high-riskinvestment. Equity shares whose returns fluctuate significantly are considered to be ahigh-risk investment and those are considered as risky investment.ELEMENTS OF RISK The total variability in return of a security represents the total risk of that security.Systematic risk and unsystematic risk are the two components of total risk. Thus Systematic risk / Total risk Unsystematic riskSYSTEMATIC RISK The impact of economic, political and social changes is system wide and thatportion of total variability in security returns caused by such system wide factors isreferred to as systematic risk. Systematic risk is further sub divided into interest rate risk,market risk and purchasing power risk. 4
  5. 5. UNSYSTEMATIC RISK The risk of price changes due to the unique circumstances of a specific security,as opposed to the overall market. The risk can be virtually eliminated from a portfoliothrough diversification. This risk is unique of peculiar to a company or industry andaffects it in addition to the systematic risk affecting all securities. The unsystematic orunique risk affecting specific securities arises from two sources: • The operating environment of the company, and • The financing pattern adopted by the company. These two types of unsystematic are referred to as business risk and financial risk respectively.INDUSTRY PROFILE The capital market is the market for securities, where companies and governmentcan raise long term funds. The capital market includes the stock market and the bondmarket. The capital market is basically divided into: • Primary market • Secondary marketThe primary market is the part of capital market that deals with the issuing of newsecurities.The secondary market is the financial market for trading of securities that have alreadybeen issued in an initial private or public offering.OTC EXCHANGE OF INDIA (OTCEI) The OTC Exchange of India (OTCEI) has been setup to provide cost effective andconvenient platforms for raising finance from the capital market. OTCEI was promotedby a consortium of financial institutions sated its operations in 1992. It is a ring less,electronic, nation wider stock exchange committed to providing entrepreneurs with asmooth economical vehicle for going public and investors with a fair, sable and efficientmarket. Thus the OTCEI brings investors and promoters closer together. 5
  6. 6. NATIONAL STOCK EXCHANGE (NSE) National Stock Exchange (NSE) of India commenced its operations in the capitalmarket on 3rd November 1994 in Mumbai. The recommendations of Pherwani committeeled to the beginning of NSE. The main objective of NSE is to establish a nationwide trading facility forequities, debt and hybrids:  To ensure equal access to investors all over the country through appropriate communication network.  To provide a fair, efficient and transparent security market to investors by using an electronic communication network.  To enable shorter settlement cycle and book entry system.  To meet current international standards of securities market.NSE 50-INDEX The NSE 50 Index, commonly known as Nifty. It is a market capitalizationweighted index. It was introduced in April 1996, replacing the earlier NSE-100. Theobjective of the NSE 50- Index is • To reflect the market movement more accurate. • To provide fund manager with a bench mark for measuring portfolio performance. • To establish a basis for introducing index based derivative product.BOMBAY STOCK EXCHANGE (BSE) The stock exchange, Mumbai, popularly known as “BSE” was established in 1875as “the native share and stock brokers association. It is the oldest one in Asia, even olderthan the Tokyo Stock Exchange, which was established in 1878. It is a voluntary non-profit making association of persons (AOP) and is currently engaged in the process ofconverting itself into demutualised and corporate entity. It has evolved over the years intoits present status as the premier stock exchange in the country. It is the first stockexchange in the country to have obtained permanent recognition in 1956 from thegovernment of India under the Securities Contract (Regulation) Act, 1956. 6
  7. 7. The exchange, while providing an efficient and transparent market for trading insecurities, debt and derivatives upholds the interests of the investors and ensuresredressed of their grievances whether against the companies or its own member-brokers.It also strives to educate enlighten the investors by conducting investor educationprograms and making available to them necessary informative inputs. A governing board having 20 directors is the APEX body, which decides thepolicies and regulates the affairs of the exchange. The governing board consists of 9elected directors, who are from the broking community (one third of them retire everyyear by rotation), three SEBI nominees, six public representatives and an executivedirector and chief operating officer. The executive director as the chief executive officer is responsible for the day-to-day administration of the exchange and the chief operating officer and other heads ofdepartments assist him. The exchange has inserted new rule No. 126 A in its Rules, byelaws andRegulations pertaining to constitution of the executive committee of the exchange.Accordingly, an executive committee, consisting of 3 elected directors, 3 SEBI nomineesor public representatives, executive director, CEO and Chief Operating Officer has beenconstituted. The committee considers judicial and quasi matters, in which the governingboard has powers as an Appellate Authority, matters regarding annulment of transactions,Admission, continuance and suspension of member brokers, declaration of a memberbroker as defaulter, norms, procedures and other matters relating to arbitration, fees,deposits, margins and other moneys payable by the member brokers to the exchange etc.SEBI’s POWER IN RELATION TO STOCK EXCHANGEThe SEBI ordinance has given it the following powers:- 1. It may call periodical returns from Stock Exchange. 2. It has the power to prescribe maintenance of certain documents by the stock exchanges. 3. SEBI may call upon the exchange or any mate to furnish explanation or information relating to the affairs of the stock exchange or any member. 7
  8. 8. 4. It has the power to approve byelaws of the stock exchange for regulation and control of contracts. 5. It can amend byelaws of stock exchange. 6. In certain areas it can license the dealers in securities.1.1 COMPANY PROFILEUNICON SECURITIES PRIVATE LIMITED UNICON is a financial services company which has emerged as a one-stopinvestment solutions provider. It was founded in 2004 by two visionary and flamboyantentrepreneurs, Mr. Gajendra Nagpal and Mr. Ram M. Gupta, who possess expertise inthe field of Finance. The company is headquartered in New Delhi, and has its corporateoffice in Mumbai with regional offices in Kolkata, Chennai, Hyderabad and Noida. UNICON is a professionally managed company led by a team with outstandingmanagerial acumen and cumulative experience of more than 400 man years in thefinancial markets The Company is supported by more than 4500 Uniconians and has ateam of over 900 business offices in 235 cities across India. With a customer base of over 200,000 the Unicon Group has an eye for theintricate financial needs of its clients and caters to both their short – term and long – termfinancial needs through a comprehensive bouquet of investment services. It has beenfounded with the aim of providing world class investing experience to the investingcommunity. These services range from offline & online trading in equity, commoditiesand currency derivatives to debt markets to corporate finance and portfolio managementservices. The company has a sizable presence in the distribution of 3rd party financialproducts like mutual funds, insurance products and property broking. It also providesexpert Advisory on Life Insurance, General Insurance, Mutual Funds and IPO’s. Thedistribution network is backed by in-house back office support to provide prompt andefficient customer service The Equity broking arm – UNICON Securities Pvt. Ltd offers personalizedpremium services on the NSE, BSE & Derivatives market. The Commodity broking armUnicon Commodities Pvt. Ltd offers services in Commodity trading on NCDEX and 8
  9. 9. MCX. The UNICON group also has a PCG division providing investments solutions forHigh Net worth Individuals. The Corporate Advisory Services arm – Unicon CapitalServices (P) Ltd offers entire gamut of Investment Banking services to corporate. UNICON can boast of some of the most respected names in the private equityspace like Sequoia Capitals, Nexus India Capital and Subhkam Ventures as itsshareholders.MISSION :“To create long term value by empowering individual investors through superiorfinancial services supported by culture based on highest level of teamwork, efficiencyand integrity”.VISION :“To provide the most useful and ethical Investment Solutions - guided by values drivenapproach to growth, client service and employee development”. 9
  11. 11. PRODUCT AND SERVICES Unicon customers have the advantage of trading in all the market segmentstogether in the same window, as we understand the need of transactions to be executedwith high speed and reduced time. At the same time, they have the advantage of havingall Advisory Services for Life Insurance, General Insurance, Mutual Funds and IPO’salso. Unicon is a customer focused financial services organization providing a range ofinvestment solutions to our customers. We work with clients to meet their overallinvestment objectives and achieve their financial goals. Our clients have the opportunityto get personalized services depending on their investment profiles. Our personalizedapproach enables clients to achieve their Total Investment Objectives.Our key product offerings are as follows: 11
  12. 12. EquityCommodityDepositoryDistribution 12
  13. 13. 1. EQUITY:UniconEasyBrowser based trading terminal that can be accessed by a unique ID and password. Thisfacility is available to all our online customers the moment they get registered with usUniconSwiftApplication based terminal for active traders. It provides better speed, greater analyticalfeatures & priority access to Relationship Managers. Greater exposure for trading on themargin available. 2. COMMODITY:Unicon offers a unique feature of a single screen trading platform in MCX andNCDEX.Unicon offers both Offline & Online trading platforms. Live Market Watch for commodity market (NCDEX, MCX) in one screen. Add any number of scrips in the Market Watch. Tick by tick live updation of Intraday chart. Greater exposure for trading on the margin available Common window for market watch and order execution. Key board driven short cuts for punching orders quickly. Real time updation of exposure and portfolio. Facility to customize any number of portfolios & watchlists. Market depth, i.e. Best 5 bids and offers, updated live for all scripts. Facility to cancel all pending orders with a single click. Instant trade confirmations Stop-loss feature. 13
  14. 14. 3. DEPOSITORY:Unicon Depository Services offers dematerialization services as a participant in CentralDepository Services Limited (CDSL), through its Depository operations. The companybelieves in efficient and cost-effective and integrated service support to its brokeragebusiness. Unicon Securities Private Limited, as a depository participant, will offerdepository accounts for individual investors as well as corporates which will enable themto transact in the dematerialized segment, without any hassles. Depository offer a safe, convenient way to hold securities as compared to holdingsecurities in paper form. Our service provides an integrated single platform for all ourclients ensuring a risk free, efficient and prompt depository process. 4. DISTRIBUTION:Unicon is fast emerging as a leader in the Insurance and Mutual Funds distributionspace. Unicon has over 100 branches and a huge number of “Business DevelopmentExecutives” who help to source and service the customers throughout the country.Unicon is fast becoming the preferred “Vendor Independent” distribution housesbecause of providing efficient service like free pick-up of collection of cheques/DD’s,Keeping track of the premiums etc to its customers. 14
  15. 15. Unicon offers the following distribution products:-  IPOs  Mutual Funds  Insurance  Properties NRI SERVICES: 15
  16. 16. With India becoming the epicentre of growth the Global Indian feels the need to be connected to the domestic growth story. Unicon now offers a convenient and hassle-free way of I vesting in the Indian Securities Market to the people who are living outside India and wish to participate in the Indian Growth story. Procedure for NRI operations in Indian Capital Markets:- The NRI can deal with only one bank at any point of time. He is allowed to invest only 5% of the paid up capital of a company. The aggregate paid up value of equity of any company purchased by all NRIs and OCBs cannot exceed 10 percent of the paid up capital of the company and in the case of convertible debentures, the aggregate paid up value of each series of debentures purchased by all NRIs and OCBs cannot exceed 10 % of the paid up value of each series of convertible debentures. He can enter only into delivery based trades, all deliveries must only be routed through beneficiary accounts and not directly through the broker. Shares bought by him cannot be sold unless the payout of the same is received from exchange. All purchase and sale transactions have to be reported to the RBI by the designated bank. Original broker’s contract notes have to be submitted to the designated Bank branch, within 24 hours of the transaction. He will be required to make bill to bill payments/ settlements. No adjustments 16
  17. 17. 5. BACK OFFICE: Unicon through its online back-office aims to increase the transparency and provides you the link to view the details of your account online anytime and anywhere. Here you have the advantage of viewing the following reports online: Sauda Details Financial Ledger Net position for the day Net position Detail (for the complete financial year) E-Contract Note6. FIXED INCOME: The Fixed income vertical of UNICON Group deals in Sovereign Paper and Money Market/Fixed Income Instruments Broadly, it undertakes following: 17
  18. 18.  Dealing in all types of money market instruments viz. Commercial paper (Origination & Placement), Certificate of Deposit and Treasury Bills both in Primary and Secondary market.  Dealing in Government securities (including securities of Oil, Fertilizer & Food Bonds) and other PSU/ Corporate bonds with counterparties like Banks, Primary Dealers, Mutual Funds, Insurance Companies, Regional Rural Banks, Cooperative Banks, Central & State PSUs, Housing Finance Companies, NBFCs & Corporates.  Retailing of Central, State Government Securities and Bonds to PF Trusts, Universities  Advisory Services to PF Trusts.  Arrangers for Private placement of Bonds & placing it with Banks, Mutual funds, Insurance Companies & Corporates.  Securitization of receivable portfolio of Housing Finance Companies& Bank. 7. INVESTMENT BANKING:The Investment Banking arm of Unicon Capital Services (P) Ltd. caters to the fundingrequirements of corporates. Our wide experience and market knowledge as a leadingsecurities firm ensures that clients’ requirements are met at optimum cost. By constantlyimproving our knowledge capital and remaining focused on client needs, we aim tocreate significant value for our clients by helping them execute the right capitalizationstrategy. We also intend to initiate merchant banking services (Capital MarketsFundraising) in the short term (Merchant Banking License pending) 18
  19. 19. CURRENCY DERIVATIVES:Currency FuturesCurrently in India, US Dollar Indian Rupee (USD INR) currency futures are tradedon the NSE and MCX. Since its introduction in Aug 2008, USD INR futures haveseen a 1500% burst in volume growth. Unicon offers clients the opportunity to tradethis product, either in online or offline mode as per their needs. The product providesample liquidity to function both as a speculative tool and as a hedging instrument forexporters and importers. The attractive features of the product are as follows 19
  20. 20. arequotedindollarsForexportersandimporters,nocreditlinerequiredfromthe 20
  21. 21. Unicon Advantage :Securitiescanbeusedforeithersegment–EquityOther awaited products 21
  22. 22. EuroINRisexpectedtobeintroducedanytimenowSEBIhasalsorecommended 22
  23. 23. 8. PORTFOLIO MANAGEMENT:Portfolio Management ServicesGone are the days when an investor could directly participate in the capital markets,for they have not only become far more complex in terms of compliances,methodologies, effects and analysis but also need a constant tracking mechanism. Asis the case globally, the Indian investor has also realized the advantages of seekingprofessional advice in order to not only manage but also augment his portfolio.The Portfolio Management Schemes of the Company offer Discretionary Schemes(Unicon Optimizer & Unicon Growth) for Individuals, Corporate Bodies, Partnershipfirms, Proprietors, Non Resident Indians etc. The Company is registered with SEBIenabling it to undertake Portfolio Management activities under a specific license.The Schemes, duly approved by SEBI, are managed by a highly competent teamcomprising of portfolio managers and equity strategists, backed by a team offundamental, technical and derivatives analysts. The principle objectives are toidentify investment opportunities through globally recognized analyticalmethodologies, given pre-defined risk parameters construct portfolios to incorporateclient objectives periodically review of portfolios in order to consistently deliverreturns surpassing the benchmarked index and tailor-make portfolios to incorporate ajudicious mix of equity, quazi-equity, money market instruments and derivateproducts. 23
  24. 24. PMS is a very personalized service wherein each portfolio has to be specificallyconstructed in order to reflect the objective and risk appetite of a particular client. Ourqualified managers are constantly evolving methodologies and financial models thatprovide them with a composite mix of:1.Mediumtermcomprisingofvalueinvesting 24
  25. 25. 25
  26. 26. UNICON PMS provides following benefits:   S   P   P   S   T  26
  27. 27. 1.3 OBJECTIVE OF THE STUDYFor the effectiveness of the study the objectives are:PRIMARY OBJECTIVE: 1. To find out the effectiveness of index futures as a Hedging instrument.SECONDARY OBJECTIVE: 2. To study about the impact of hedging in the derivative market. 3. To know about the emphasis of hedging in the future trading. 4. To analyze the effectiveness of hedging to reduce the risk. 5. To visualize about the Derivative market. 1.4 NEED FOR THE STUDY The study on hedging strategies has been done to help the stock holders to controltheir losses. With the help of this project the stock holders can focus on areas werehedging strategies is required. Capital market in India is always uncertain. Anything can happen in the market. Astock picker carefully purchases securities based on a sense that they are worth more thanthe market price. While doing so he faces a risk that the entire market moves against himand generates losses even though the underlying idea was correct. To exit from this wehave to make securities independent from index through hedging with index futures.Hedging with index futures removes the unwanted exposure of index movements. Thisproject can serve as a guide to bring new ideas to the stock holders. 27
  28. 28. 1.5 SCOPE OF THE STUDY 1. The study is attempted to assess the power of hedging technique using index future. 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 conclusion cannot be conclusive as market fluctuations are unpredictable. 2. Index futures are only considered for Hedging. 3. The beta value for risk assessment is not precisely correct as it changes from time to time. 4. The duration of the study was limited to period of three month so that the extensive and deep study could not be possible. 5. The study is depending mostly on the web information. 6. Brokerages are not taken into consideration. 7. The study was limited only to UNICON SECURITIES PVT LTD, Chennai. 28
  29. 29. 1.6.1. Three Types of Exclusions from Effectiveness Testing:In defining how hedge effectiveness will be assessed, an entity must specify whether itwill include in that assessment all of the gain or loss on a hedging instrument. a. If the effectiveness of a hedge with an option contract is assessed based onchanges in the options intrinsic value, the change in the time value of the contract wouldbe excluded from the assessment of hedge effectiveness. b. If the effectiveness of a hedge with an option contract is assessed based onchanges in the options minimum value, that is, its intrinsic value plus the effect ofdiscounting, the change in the volatility value of the contract would be excluded from theassessment of hedge effectiveness. c. If the effectiveness of a hedge with a forward or futures contract is assessedbased on changes in fair value attributable to changes in spot prices, the change in the fairvalue of the contract related to the changes in the difference between the spot price andthe forward or futures price would be excluded from the assessment of hedgeeffectiveness. 2. REVIEW OF LITERATURE 2.1. NEWSPAPER ARTICLE:SENSEX SEEMS TO HIT MAX IN 2011: SAYS MADHUMITHA GHOSH"The first quarter of 2011 would start with third quarter results and would face events likeBudget in the latter part. We expect better allocations towards India from foreigninstitutions based on India growth story," Unicon Securities Vice-President ResearchMadhumita Ghosh said.However, experts cautioned that pressure in the form of higher inflation and interest ratesmay act as spoilsport. Also currency appreciation is expected with increased inflow andrecovery. 29
  30. 30. The past year saw the Sensex hitting its record closing level of 21004.96 points on Diwaliday, November 5. However, the index could not surpass its highest intra-day level of21,206.77 points, scaled on February 10, 2008.While the performance of the countrys most valued firm Reliance Industries was not upto the mark, a number of other blue-chips, mostly from auto, banking, pharmacy and ITspace, performed well.Some of the key stocks that gave impressive returns to investors included BajajAuto, Tata Motors, TCS, Hidalgo, M&M, ICICI Bank, HDFC Bank and SBI.2.2. MAGAZINE ARTICLE: NMDC Ltd - Q3 FY11 Result Update - Unicon Investment Solutions At CMP the stock is trading at PE multiple of FY12E 12x and EV/EBITDA of 8x which is quite attractive compared to its peers. Considering the strong demand for iron ore and robust expansion plan of the company. • NMDC registered a strong top-line growth of 65% to INR 26.2 bn in Q3FY11 (22% above our estimate of INR 23,890 mn) supported by increased mining coupled with better realization of iron ore prices. On QoQ basis, top line increased marginally by 6.6%. • EBITDA increased 87% YoY to INR 20,159 mn. EBITDA margin expanded 899 bps in Q3FY11 to 76.9%. • The Net profit of the company stood at INR 15,180.3 mn in Q3FY11 (13% above our estimate of INR 13,350 mn). At CMP the stock is trading at PE multiple of FY12E 12x and EV/EBITDA of 8x which is quite attractive compared to its peers. Considering the strong demand for iron ore and robust expansion plan of the company, we maintain our buy rating on the stock with a target price of INR 350. 30
  31. 31. 2.3. HEDGING’S EFFECTIVENESS TESTED BY DIFFERENT SCHOLARS:Butterworth and Holmes (2000) studied hedging effectiveness of FTSE -100 andFTSE Mid 250 index futures contracts. They found that FTSE-100 provided effectivehedge for portfolio dominated by large firms and FTSE Mid 250 was equally effective forportfolios dominated by small capitalizations stocks.Brails ford et al. (2000) estimated hedge ratio by several techniques for the AustralianAll Ordinary Share Price index futures contract. Yang (2009) showed that M-GARCHdynamic hedge ratio provides largest degree of reduction in variance of returns.Nonetheless, some recent studies for example Lien et al (2011) and Moosa (2003) havereported that basic OLS approach outperforms other advanced models of hedge ratioestimation. In India very few studies were conducted on the hedging effectiveness of theFutures 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 futurescontracts do not provide effective hedge in avoiding risk. Bhaduri and Durai (2008)examined hedging effectiveness of Nifty Futures. They found OLS based strategyprovided better hedge in shorter time horizons. However, at higher time horizonsbivariate GARCH clearly dominates. Further, Kumar et al (2008) examined hedgingeffectiveness of constant and time varying hedge ratio of Nifty Futures, Gold Futures andSoybean futures. Their results showed that the time varying hedge ratio provided greatestvariance reduction as compared to other hedges based on constant hedge ratio. Investors studying the market often come across a security, which they believe isintrinsically undervalued. It may be the case that the profits and the profits the quality ofthe company make it seem worth a lot more than the market think. A stock pickercarefully purchases securities based on a sense that they worth more than the marketprice. When doing so, he faces two kinds of risks: 31
  32. 32. 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.Choice of hedging instruments: The literature on the choice of hedging instruments is very scant. Among theavailable studies, Géczy et al. (1997) argues that currency swaps are more cost-effectivefor hedging foreign debt risk, while forward contracts are more cost-effective for hedgingforeign operations risk. This is because foreign currency debt payments are long-term andpredictable, which fits the long-term nature of currency swap contracts. Foreign currencyrevenues, on the other hand, are short-term and unpredictable, in line with the short-termnature of forward contracts. A survey done by Marshall (2000) also points out thatcurrency swaps are better for hedging against translation risk, while forwards are betterfor hedging against transaction risk. This study also provides anecdotal evidence thatpricing policy is the most popular means of hedging economic exposures.These results however can differ for different currencies depending in the sensitivity ofthat currency to various market factors. Regulation in the foreign exchange markets ofvarious countries may also skew such results.Production and Trade vs. Hedging DecisionsAn important issue for multinational firms is the allocation of capital among differentcountries production and sales and at the same time hedging their exposure to the varyingexchange rates. Research in this area suggests that the elements of exchange rateuncertainty and the attitude toward risk are irrelevant to the multinational firms sales andproduction decisions (Broll, 1993). Only the revenue function and cost of production areto be assessed, and, the production and trade decisions in multipleCountries are independent of the hedging decision.The implication of this independence is that the presence of markets for hedginginstruments greatly reduces the complexity involved in a firm’s decision making as it can 32
  33. 33. separate production and sales functions from the finance function. The firm avoids theneed to form expectations about future exchange rates and formulation of risk preferenceswhich entails high information costs.FACTORS AFFECTING HEDGING DECISIONS:The following section describes the factors that affect the decision to hedge and then thefactors affecting the degree of hedging are considered.  Firm size: Firm size acts as a proxy for the cost of hedging or economies of scale. Risk management involves fixed costs of setting up of computer systems and training/hiring of personnel in foreign exchange management. Moreover, large firms might be considered as more creditworthy counterparties for forward or swap transactions, thus further reducing their cost of hedging. The book value of assets is used as a measure of firm size.  Leverage: According to the risk management literature, firms with high leverage have greater incentive to engage in hedging because doing so reduces the probability, and thus the expected cost of financial distress. Highly levered firms avoid foreign debt as a means to hedge and use derivatives.  Liquidity and profitability: Firms with highly liquid assets or high profitability have less incentive to engage in hedging because they are exposed to a lower probability of financial distress. Liquidity is measured by the quick ratio, i.e. quick assets divided by current liabilities). Profitability is measured as EBIT divided by book assets.  Sales growth: Sales growth is a factor determining decision to hedge as opportunities are more likely to be affected by the underinvestment problem. For these firms, hedging will reduce the probability of having to rely on external financing, which is costly for information asymmetry reasons, and thus enable them to enjoy uninterrupted high growth. 33
  34. 34. HEDGING USING INDEX FUTURES Stock index futures can be used to hedge the risk in a well-diversified portfolio ofstocks. Here the strategy employed is “HAS PORTFOLIO SHORT NIFTY”. It isexplained as follows: When one owns a portfolio of shares and there are chances that market will fall inthe near future, it could be a very uncomfortable feeling. Or it could be that the marketis in a few days of volatility and the investor is not the kind who can handle suchanxiousness. The union budget being a common and reliable source of such volatilitymarket volatility is always enhanced for one week before or two weeks after a budget.This is particularly a problem if it is required to sell shares in the near future, forexample, for buying a car or financing children’s education. This planning can gowrong if, by the time the shares are sold, Nifty has dropped sharply. There are traditionally two things that one can try in such situations. 1. Sell shares immediately. The sentiment generates panic selling which is rarely optimal for the investor. 2. Do nothing; i.e. suffer the pain of the volatility. This leads to political pressures for government to do so something when stock prices fall. Now with index futures there is a third and remarkable alternative for those who arenot satisfied with the above two alternatives: Remove the exposure to index fluctuations temporarily using index futures. Thisallows rapid response to market condition, without panic selling of shares. It allows aninvestor to be in total control of his risk, instead of doing nothing and suffering the risk.The idea here is quite is simple. Each portfolio contains a hidden index exposure. Thisstatement is true for all portfolios; most of the portfolio risk is accounted for by indexfluctuations (unlike individual stocks, where only 30-60% of the stock risk is accounted 34
  35. 35. for by index fluctuations). Hence, a position LONG PORTFOLIO + SHORT NIFTYcan often become one-tenth as risky as the LONG PORTFOLIO position.LONG HEDGE In a long hedge one buys futures contract. The hedger is either currently shortthe cash good or has a future commitment to buy the good at the spot price that willexist at a later date. In either case, any subsequent price rise would lead to profit in thefutures market and losses in the cash good market. The hedger must also be aware thatprices might fall leading to a profit in the cash good market and loss in the futuremarket. The hedger must thus be reasonably sure that price changes of the cash positionand changes in the futures price will be correlated.SHORT HEDGE In a short hedge, one sells futures contracts. Here the hedger fears that priceswill fall and if they do loss will be sustained in the spot market. The shot hedger eithercurrently long the cash good or has a commitment to sell it on a future date at anunknown price. With the hedge in place if prices do indeed decline, loss will beincurred on the cash position but there will be a profit in the futures position. As a resultany loss that arising from cash position can be minimized with a hedge in that place.HEDGE RATIO Hedge ratio is referred to the number of futures contracts required to be sold orbought provide maximum offset of risk of a given value of investment in shares or othergoods. This depends on the following: • Value of a future contract • Value of the portfolio or stock to be hedged and • Sensitivity of the movement of the portfolio price to that of the index (beta) 35
  36. 36. It is calculated using the following formula. Hedge ratio = value of shares or portfolio * beta value / value of futures percontract. The hedge ratio is closely related to the correlation between the asset (portfolio ofshares) to be hedged and underlying (index) from which the future is derived.Accidental offsetting: Using the same example above, assume that the forward contract was not anexchange traded instrument but a bilateral, uncollateralized contract. If the counterpartyto the forward contract had a sudden, severe deterioration in its credit standing then theoffset between the change in the value of the future commodity purchase and the changein fair value of the hedging instrument would be accidental. This is because the effect ofthe change in the credit standing of the counterparty is unrelated to and dominates theeffect of changes in the commodity price. The optimal hedge ratio of 1.11 to one (iehedging 100t of purchases with a forward contract volume of 90t) would still be drivenby the commodity price changes but because of the credit risk related change of the valueof the forward contract the hedging relationship would no longer have the systematicoffset of fair value changes regarding the commodity risk that would otherwise resultfrom a hedge ratio of 1.11 to one.Qualitative assessment: An entity acquired a 100,000 CU debt instrument that pays 6-month Liborsemi-annually. The maturity of the instrument is 2 years. Entity A is exposed to interestrate decreases and would like to eliminate the risk of changes in the variability in the cashflows by entering into an interest rate swap whereby it would pay 6-month Libor semi-annually (aligned with the cash flows received on the bond) and would receive a fixedrate. For simplification the effect of credit risk is being ignored in this example. 36
  37. 37. Entity A wants to hedge the exposure to the variability of the cash flows using an existinginterest rate swap with the same remaining maturity and variable payments but a differentfixed rate (reflecting the interest level when the swap was originally entered into). EntityA considered the fair value of the swap at the inception of the swap to be immaterial.Hence, if there are no differences in the other critical terms, hedge ineffectiveness wouldresult from the swap’s fair value at the time of designating it as the hedging instrument.This hedge ineffectiveness arises because of the effect of interest rate changes on that fairvalue as well as the unwinding of the discount on that amount.HEDGING STRATEGIES A number of strategies are available for hedging with derivatives. But inhedging with futures contracts, that too, with index features, four strategies areidentified. They are listed below: • Have portfolio / short index futures • Have funds / long index futures • Long stock / short index futures • Short stock / long index futures.3. RESEARCH METHODOLOGYINTRODUCTION Research methodology is a way to systematically solve the research problem. Itmay be understood as a science of studying how research is done scientifically. In it westudy the various steps that are generally adopted by researcher in studying his researchproblem along with the logic behind them. The methodology used for carrying out the present study covers title of the studyand significance of the study. Aims and objectives of the study, research hypothesis, 37
  38. 38. Research design, sampling design, pilot study, method for data collection, operationdefinition statistical Analysis, limitation of the study and chapterisation.3.1. NATURE OF DATA:  Primary data  Secondary dataPrimary data: - The primary data are those, which are collected for the first time and thushappen to be original character.  Observation : The stock market is closely observed for volatility. The trend is changing every second and the readings are mostly taken from intra-day calculation. The index changes reflect in the investment decision and the market is very vicious by its own way. The data collected may become obsolete on the same day itself.  Interview : By interviewing the analyst the data can be collected. The data collected by means of analyst is reliable to some days. Technical analysis and fundamental analysis are done.  Questionnaires: The questionnaires are given to the stock brokers and got the answers. The answer may be biased and incorrect. It depends on the person answering the questions. Questionnaires won’t work every time.Secondary data: 38
  39. 39. Secondary data are those which have already been collected by someone else andwhich already had been passed through the statistical process. The secondary data for thestudy was collected through books, web.3.2. SOURCES OF DATA The study has used secondary data from various financial journals, websites andthe fact sheets of those concerned mutual fund companies.3.3. TOOLS USED:  Beta value analysis  Index future analysis1) BETA VALUE ANALYSIS Beta value is a measure of systematic risk or non divisible risk of a security. Betashow how the price of a security responds to market forces. Beta measures the degree towhich any portfolio of stocks is affected as compared to the effect on the market as awhole. Beta = N∑ x y - ∑ x ∑ y N ∑ x2 - ∑ x2 Where, ‘N’ is the number of data points or Number of observations ‘X’ is the bench mark returns, and ‘Y’ is the investment returns. Note: beta values are taken from NSE siteCALCULATION  Amount of investment made = no of shares * share price of the company as on the particular date. 39
  40. 40.  No of shares = investment in each company / share price (closing)  Portfolio beta amount = beta value of each company * portfolio amount  Beta of the portfolio = value of the beta amount / value of the portfolio.INDEX FUTURE ANALYSIS  Amount of nifty sold = portfolio amount * beta of the portfolio  No of nifty sold = amount of nifty to be sold / closing price of nifty future  Nifty lot = 50  No of nifty to be verified = no of nifty to be sold / nifty sold  Hedged value = nifty * no of nifty to be hedged * lot Note: Closing price of nifty’s are taken from NSE site The following diagram represents the movement of nifty index according to the investments.MEASURING HEDGING EFFECTIVENESS:Selecting an appropriate hedge effectiveness methodology is vitally important, since thewrong choice can produce spurious and misleading results. There are accountingstandards (IAS39, FAS133) in place for hedge accounting, but these are based on verygeneral principles and allow a significant amount of flexibility.The four main methods to measure hedge effectiveness are: • Critical Term Match Method • Dollar-Offset Method • Regression Analysis • Risk Reduction Method 40
  41. 41. The Critical Term Match Method:Allows the assumption that a hedge can be considered “perfect” without an on-goingassessment of effectiveness. For instance, an interest rate swap is likely to be a perfecthedge if the following parameters in both loan (hedged instrument) and swap (hedge) areidentical: • notional amounts • terms • payment and fixing dates • amortization schedules • reference rates • day conventionsOften, however, these parameters do not (fully) match, so other methods should beapplied. Before introducing these, let us turn our attention to the term “referenceexposure”. It is possible to review an underlying with an existing hedging instrument orto compare it to an Ideal Designated-Risk Hedge (IDRH). We use the IDRH as thereference exposure, on the basis of which we define an ideal hedge for an underlyinginstrument. Intuitively for a floating rate loan, the IDRH is an interest rate swap in whichwe receive floating rate and pay fixed rate. Note: The ideal swap’s floating leg hasidentical terms to those of the loan.Dollar Offset Method and Regression Analysis:In both cases - Dollar Offset Method and Regression Analysis – the cumulative change ofthe hypothetical swap cash flows (net payments) is compared to the cumulative change ofthe actual swap cash flows (net payments). The next step is to use this data to implementeither the Dollar Offset Method or Regression Analysis for both retrospective andprospective analysis. Note: It is important to perform analyses for both historical andfuture periods. 41
  42. 42. Now consider a loan and a swap in relation to which an analysis of hedge accounting is tobe performed. The instruments have the parameters outlined in table 1. As you can see,the actual swap is not an ideal hedge for this loan. The receive leg pays semi-annuallyaccording to 6-month Euribor. For an ideal swap, there should be monthly payments (1-month Euribor). Common sense tells one that the actual swap has fairly reasonablehedging properties, as 1-month and 6-month Euribor rates behave similarly. This wouldnot be the case, however, for 1-month Euribor versus 10-year swap rate. The belowexample explains the hedging mechanism:TABLE-1: Details of the hedged item (loan) and hedging instrument (swap) Hedged item Hedging IDRH instrument Type of contract Loan Actual swap Ideal swapnotional (EUR) 1 000 000 1 000 000 1 000 000settlement date 8.09.2009 8.09.2009 8.09.2009maturity date 8.09.2022 8.09.2022 8.09.2022 Receive legpayment frequency NA semi- Monthly annuallycoupon accrual day NA act/360 act/360conventionreference rate NA 6M Euribor 1M Euribor Pay legpayment frequency Monthly annually Monthlycoupon accrual day act/360 30/360 act/360conventionreference rate 1M Euribor fixed fixed @4.189% @4.189% The results of any effectiveness test need to be interpreted in the context of hedgingobjectives. This interpretation is usually facilitated by defining effectiveness ’thresholds’for the test (referred to as ’lower’ and ’upper’ in our explanation). For example, the actualswap is an effective hedge according to the Regression Analysis if the correlation is 42
  43. 43. between 0.8 and 1.0, the slope of the regression line is between 0.8 and 1.25 and thedetermination coefficient (R-squared) is above 0.64.The results show that the hedge surpasses both Dollar Offset and Regression Analysis forprospective periods. But there is a different outcome in the retrospective analysis:According to the regression test, it is an effective hedge but fails the Dollar Offset test.TABLE-2: Dollar-Offset Analysis (retrospective): Effective hedge test lower upper result test DOR threshold 80% 125% NA NAcompliance level 80% 100% 59,72 FAIL! % Compliance level number of 43 compliments sample size 72compliance level 59,72%TABLE-3: Dollar-Offset Analysis (prospective) Effective hedge test lower upper result test DOR threshold 80% 125% NA NAcompliance level 80% 100% 88.57 PASS! % Compliance level number of 62 compliments sample size 70compliance level 88.57% 43
  44. 44. TABLE-4: Regression Analysis (retrospective) Effective hedge test Lower upper result test correlation 0.800 1.000 0.979 PASS! R2 0.640 1.000 0.958 PASS! slope 0.800 1.250 0.989 PASS!CHART-1: REGRESSION ANALYSIS: 44
  45. 45. TABLE-5: Regression Analysis (prospective) Effective hedge test Lower upper result Test correlation 0.800 1.000 0.984 PASS! R2 0.640 1.000 0.968 PASS! slope 0.800 1.250 0.981 PASS!CHART-2: PROSPECTIVE REGRESSIONN ANALYSIS: 4. DATA ANALYSIS: 4.1. DESCRIPTIVE STATISTICS: 45
  46. 46. This study uses daily price changes of dollar spot, dollar futures data on thenearby contract and Non-Deliverable Forwards (NDF) from January 2, 2009 to December28, 2010. The data are from data-stream and Bloomberg. The closing data of the dollarspot futures data are from 4:00 p.m. on the basis of New York Standard time. The pricechanges of all time series are calculated as follows: RSTτ = STt − STt −1 (1) RFTτ = FTt − FTt −1 (2) The terms, RSTτ means the price change of dollar cash price. RFTτ Represent thedaily price changes of Dollar futures and NDFs. Where STt and STt −1 are the Dollar spotprice at time t and at time t-1 respectively. FTt And FTt −1 is the closing price of the Dollarfutures and NDFs at time t and at time t-1 respectively. The summary statistics for the daily dollar spot and futures, 1 month NDF and 3month NDF data. Furthermore, all the Dollar exchange spot, futures and NDFs series are tested toensure whether they are stationary. As we expected the level variables are all non-stationary which means that each has a unit root in its autoregressive representation. Thisindicates that each series is non-stationary, necessitating the calculation of firstdifferences and the difference series are then checked for the presence of a unit root. Wesee that the ADF and the PP tests clearly reject the null hypothesis of the presence of aunit root for each series, implying that the difference series are indeed stationary, that is,I(0). Since it is established that each series is I (1), the next step is to test the co-integration relationship between dollar spot and futures as well as between dollar spotand NDFs. We employ the Johansen co-integration test. According to the test results,there is a co-integration relationship between the level variables of dollar cash and futuresdata. However there is no co-integration relationship between the level variables of dollarspot and NDFs data. Therefore, when we estimated the optimal hedge ratio and hedgeperformance of Dollar futures markets we incorporate the error-correction term in our 46
  47. 47. hedging model suggested by Engle and Granger (1987). The error correction termimposes the long-run restrictions into this short-run model. Measures for skewness and excess kurtosis indicate that all foreign currencyseries are significantly skewed and leptokurtic with respect to the normal distribution.The Bera-Jacque statistics for the return series of the Dollar exchange spot, futures andNDFs are statistically significant, indicating the presence of serial correlation (lineardependencies). This suggests the presence of autoregressive conditionalheteroskedasticity, i.e. volatility clustering, which can be properly modeled by the ARCHframework of Engle (1982) and Bollerslev (1986). Data summary statistics for daily dollar spot exchange rate and dollar futuresexchange rate from January 2, 2009 to December 28, 2010. Return of spot exchange rateand futures exchange rate is defined as the value: RSTτ = STt − STt −1 , RFTτ = FTt − FTt −1 ,where STt and FTt is the spot and futures exchange value at time t .B-J is the Bera-Jarque test for normality. The statistic is  skewness 2 (kurtosis − 3) 2 B-J = T  +    6 24   2PB-J is distributed X 2 under the null of normality. ***. ** indicate the significance atthe 0.1 and 0.5 percent level, respectively.The relation between spot and future exchange rates and their variance is shon below. İtdenoted the rate of return depends on the exchange rates.TABLE-6: Dollar spot and futures exchange rates: Spot Futures Rate Return Rate Return 47
  48. 48. Mean 1270.98 -0.14 1273.27 -0.15Median 1284.00 -0.10 1286.50 -0.20Maximum 1365.20 21.50 1367.00 23.50Minimum 1165.60 -23.10 1167.70 -21.00Standard 44.52 5.72 44.46 5.78deviationSkewness -0.54 0.19 -0.52 0.21Kurtosis 2.09 4.37 2.07 4.13J-B 40.53*** 40.89*** 39.79*** 29.49*** TABLE-7: NDF Forwards exchange rates: 1 Month NDF 3Month NDF Rate Return Rate ReturnMean 1273.37 -0.17820 1278.18 -0.1684Median 1286.70 -0.2000 1290.80 -0.1000Maximum 1366.00 23.5000 1370.00 25.0000Minimum 1168.40 -22.0000 1173.60 -21.5000Standard 44.5554 5.7638 44.3099 5.8661deviationSkewness -0.5204 0.21031 -0.4821 0.2169Kurtosis 2.0676 4.3436 2.0442 4.3427J-B 39.9444*** 40.5556*** 37.7108*** 40.7382*** A. Ederington (1979) Risk Minimization Hedge: Ederington (1979) suggests that the minimum variance hedge model in whichthe spot position is considered fixed and the optimal hedge ratio (number of futurescontract per spot contract) is determined from the Ordinary Least Squares (OLS)regression of spot price changes on futures price changes. The optimal hedge ratiorepresents the minimum risk level for the spot/futures portfolio and consists of thecovariance between the spot and futures divided by the variance of the futures. Theobjective of the hedger is to minimize the variance of the price changes for the Dollar 48
  49. 49. exchange spot rate/futures rate portfolio. The expected price change and variance of thehedged position are established as follows; RSTt − RSTt −1 = α + β ( RFTt − RFTt −1 ) + ε t (3) Where RSTt − RSTt −1 represents the price change of the Dollar spot exchange ratefrom t-1 to t, RFTt − RFTt −1 represents the price change of the Dollar futures, 1 month and3 month NDFs exchange rate from t-1 to t. β is the optimal hedge ratio estimated by theOrdinary Least Squares (OLS) regression. The slope coefficient of equation (3) is used asthe measure of optimal hedge ratio under the conventional hedge model system. We alsodefine the optimal hedge ratio as the covariance between Dollar cash and futures andbetween Dollar cash and NDF. The hedge ratios of 0.97636 for Dollar futures, 0.98794 and 0.96597 for 1 monthNDFs and 3 month NDFS imply that 0.97636 daily contract, 0.98794 1 month NDFs and0.96597 3 month NDFs of the Dollar futures and forwards markets needs to be shortedfor a long position of 1 spot exchange to minimize the variance of the hedged positionvalue change. This hedge ratio is considerably less than one, which implies that theDollar futures and forwards exchange are more volatile than the Dollar spot exchangerate. Hedging effectiveness (HE) of Dollar futures and NDFs markets can be measuredas the percent reduction in the variance of the unhedged Dollar spot position by the riskminimization hedge as follows; Var (∆C t ,t +1 ) − Var (∆Portfolio t ,t +1 ) HE = Var (∆C t ,t +1 ) (4)For example, the minimum variance of the Dollar spot exchange and futures portfoliovalue change is as follows: [Cov( ∆C t ,t +1 , ∆Ft ,t +1 )] 2Var (∆Portfolio t ,t +1 ) = Var (∆C t ,t +1 ) − (5) Var ( ∆Ft ,t +1 ) 49
  50. 50. The same equation is applied for the minimum variance between Dollar spot andNDFs portfolio value changes. Consequently, from the above equations 4 and 5, weemploy the following equation (6) to figure out the hedge performance between Dollarfutures market and NDFs market. [Cov(∆C t ,t +1 , ∆ t ,t +1 )] 2 HE = =ρ2 (6) Var (∆C t ,t +1 )Var (∆Ft ,t +1 Where ρ 2 is the population coefficient of determination between Dollar spotand futures exchange changes as well as Dollar spot and forwards rate change, and it canbe estimated as RP2P, the sample coefficient of determination of regression 3. Table 2reports RP2P, of 0.9736, 0.9914, and 0.9817 so that a 97.36%, 99.14%, and 98.17%reduction of the daily variance of the Dollar spot position has been achieved by the riskminimum hedging strategy. In details, If we have a long position of one (1) Dollarportfolio at foreign exchange spot market theoretically we have to take a short position of0.97636 contract at the Dollar futures market to hedge the downside risk of Dollar spotposition during the period from January 2, 2009 to December 28, 2010. As a result, thevariance reduction for the hedged portfolio is 97.36% compared with the unhedged spotposition. In case of Dollar forward markets, the risk adverse hedger has to sell 0.9914 and0.9817 NDFs to cover the downside risk in Dollar spot position.The estimation results of optimal hedge ratio using conventional minimum variancehedge model with constant hedge ratio to Dollar futures and NDFs marketTo determine the optimal hedge ratio of One-dollar futures, 1 month NDFs and 3 monthNDFs to cover the downside risk of Dollar spot position, the following regression isestimated using time-matched daily data for the period from January 2, 2009 toDecember 28, 2010. ( RSTτ − RSTt −1 ) = α + β ( RFTt + RFTt −1 ) + ε t 50
  51. 51. where ε t = ∑i =1α i ε t −i + η t , the dependent variable is the price change of Dollar spot pexchange rate and the independent variable is the price changes of Dollar futures andNDFs from day t and t+1, β coefficient represents the minimum risk hedge ratio(number of futures and NDFs contracts per one(1) Dollar spot position), and thecoefficient of determination, R 2 , measures the hedging effectiveness in terms of thepercent reduction of the variance of the unheeded spot position. *** indicates thesignificance at the 1% percent level. Asymptotic t-statistics are given in parentheses.TABLE-8: 1 Month 3 Month Futures Markets NDF Market NDF Market +0.00531 -0.00764 -0.02100 α (0.04198P)P (-0.3189) (-0.6009) Hedging 0.97636*** +0.98794*** +0.96597*** Ratio ( β ) (134.28) (+237.45) (162.01) HedgingEffectivene 0.9736 0.9914 0.9817 ss ( R 2 ) F 18032.26*** 56371.00** 26250.29*** B. Vicariate GARCH and ECT-ARCH Hedge: The results of optimal hedge ratio using the Dollar NDF markets usingbivariate ECT-ARCH (1) and GARCH (1, 1) modelsEstimates of the following bivariate GARCH (1, 1) model are established as follows; RSTτ = α 0 s + e st , RFTτ = α 0 f + e ft  es , t   h ss ,t h sf ,t  e  ψ t −1 ∼ N (0,HBtB), H t = h h ff ,t   f ,t   sf ,t  51
  52. 52.  hss , t   a1  b11 b12 b13   hss ,t −1   c11 c 12 c13   ε s2,t −1  a  + b     b23   hsf ,t −1  + c 21 c 23  ε s ,t −1 , ε f ,t −1   HBtB=  hsf ,t  =  2   21 b22   c 22  h ff , t     a3  b31    b32 b33  h ff ,t −1  c31    c32 c33   ε 2 ,t −1   f where RSTτ and RFTτ are the Dollar spot rate and NDF forwards price changes,respectively, eτ is a (2x1) vector of residuals, ψ τ −1 is the information set at time t-1, HBtB is a (2x2) conditional variance-covariance matrix of residuals, and the a , b and cmatrices are assumed to be diagonal. The model is estimated using time-matched dailyfrom January 2, 2009 to December 28, 2010. ***, **, * indicate the significance at the 1,5, and 10 percent level, respectively.TABLE-9:Standard deviation is given in parentheses. 1 Month NDF market 3Month NDF markets a 0s +0.011649 +0.08571 (+0.20868) (+0.18024) a0 f +0.02309 +0.10459 (+0.21050) (+0.17804) a11 +22.49248*** +23.21146*** (+0.78934) (+1.71877) a 22 +22.64801*** +28.29347*** (+0.71437) (+2.96977) a33 +22.53457*** +29.45349*** 52
  53. 53. (+0.72771) (+4.90508) b11 +0.32758*** +0.42171*** (+0.03306) (+0.04051) b22 +0.32385*** +0.30601*** (+0.03158) (0.07292) b33 +0.32822*** +0.28779*** (+0.03143) (+0.11809) c11 +0.23891*** +0.11394*** (0.02730) (+0.02928) c 22 +0.23833*** +0.11144*** (+0.02609) (+0.02955) c 33 +0.23778*** +0.11859*** (0.02524) (0.03073) Log-L -894.23 -1181.00 HR +0.99537*** +0.98082*** (+0.01060) (+0.01985)The following chart indicates the changes in the firstquarter of the financial year in s&p cnx nifty index values.It shows an increasing phase in the starting of march andthen decrease in the month of may. 53
  54. 54. The stock market shows a gradual increase till 1970, and then it started to decline. Thederivatives are still in implement phase in India so it will take time and programs formaking it popular. The economic changes always keeps the market volatile and the futureadvancements will lead to better growth in the market.The extension of trend line on the changes in the future market: 54
  55. 55. 55
  56. 56. 5.1. INTREPRETATION AND FINDINGS An overall comparison of the Hedged portfolio and Portfolio without Hedgingand Descriptive hedging was made. It was found that in case of portfolio without hedgingthe investor incurred a loss of Rs. 760.7 where as in case of all time hedging he incurred aprofit of Rs.12, 675, after trading the investor would have earn profit to Rs.11, 914.3 andin case of descriptive hedging he incurred a profit of Rs.4, 58,424.3 So this study revealsthe following facts about hedging: - Hedging helps to minimize the risk:  In case of hedged position the investor was able to make a profit in Descriptive hedging and reduce loss in All Time Hedging.  Though hedging minimizes risk, it is not possible always. If the index moves up from the day of hedging, then it can be loss.  Higher the beta value higher will be the risk.  The time of applying these strategies has an important role in determining the effectiveness of hedging.6.1. SUGGESTIONS On the basis of analysis made and findings reached at, following suggestions areforwarded to existing investors and prospective investors.  If one wants to hedge with portfolio, the portfolio must consist of scrip’s from different sectors and here index futures are better for hedging, since they are convenient and represent the true nature of the security market as a whole. The advantage is that risk within the portfolio can be minimized completely and the portfolio will only be affected by the market risk.  Investor should read Newspapers, Business Journals, and Websites etc to get the awareness about the stock market situations and factors, which will affect the stock market. He should give keen attention on the activities of the major players in the market. 56
  57. 57.  Hedging is actually a tool to reduce the losses that may arise from the market risk. Its primary objective is loss minimization, not profit maximization.  If the trend of the market is to move up, instead of hedging in index futures, option is more advisable.  The investor should not stick on one strategy in the whole time; he should change his strategies according to their market situations.  With the expectation of making huge profit from derivatives one should not trade and speculate in the market. It is very risky and may incur huge losses.  The hedger will have to be a strategic thinker and also one who thinks positively. He should be able to comprehend market trend and fluctuations. Otherwise the strategies adopted by him will earn him only losses.6.2. CONCLUSION Hedging with index futures proved to be an effective instrument. Through theindex futures hedging we reduce the unnecessary risk of the index movement. Thushedging reduces the loss from the portfolio. Our study also finds out that India’sderivative market is not much established because it introduced in India at 2000. Stillmany investors don’t know about derivatives and its use correctly. Index in comingfuture, the derivative market will show a remarkable growth. Hedging does not remove losses. The best that can be achieved using hedging isthe removal of unwanted exposure (i.e. Unnecessary Risk). The hedged position willmake less profit than the un-hedged position. In some cases it makes an additional profitalso. One should not enter into a hedging strategy hoping to make excess profits. All thatcome out of hedging is to reduce risk. 57
  58. 58. BIBLIOGRAPHY:  Economic times(PTI, Jan 2, 2010, 02.34pm IST)  economy watch(Feb 18, 2010 – NMDC Ltd - Q3 FY11 Result Update)  www.unicon.com  www.sebi.india.com  www.stockchart.com  www.journals.com 58