Synopsis on Financial Derivatives

7/31/2019 Synopsis on Financial Derivatives

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INVESTERS PERCEPTION TOWARDS FINANCIALDERIVATIVES

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 guard themselves againstuncertainties arising out of fluctuations in asset prices. By their very nature, the financial marketsare marked by a very high degree of volatility. Through the use of derivative products, it ispossible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices.However, by locking-in asset prices, derivative products minimize the impact of fluctuations inasset prices on the profitability and cash flow situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations in commodityprices and commodity-linked derivatives remained the sole form of such products for almostthree hundred years. The financial derivatives came into spotlight in post-1970 period due togrowing instability in the financial markets. However, since their emergence, these productshave become very popular and by 1990s, they accounted for about two-thirds of totaltransactions in derivative products. In recent years, the market for financial derivatives hasgrown tremendously both in terms of variety of instruments available, their complexity and alsoturnover. In the class of equity derivatives, futures and options on stock indices have gainedmore popularity than on individual stocks, especially among institutional investors, who aremajor users of index-linked derivatives.

Even small investors find these useful due to high correlation of the popular indices with variousportfolios and ease of use. The lower costs associated with index derivatives vis-vis derivativeproducts based on individual securities is another reason for their growing use.

1.1. Back Ground: -

The emergence of the market for derivative products, most notably forwards, futures andoptions, can be traced back to the willingness of risk-averse economic agents to guard

themselves against uncertainties arising out of fluctuations in asset prices. By their very nature,the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in assetprices. As instruments of risk management, these generally do not influence the fluctuations inthe underlying asset prices. However, by locking-in asset prices, derivative products minimizethe impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.


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Derivative products initially emerged, as hedging devices against fluctuations incommodity prices and commodity-linked derivatives remained the sole form of such products foralmost three hundred years. The financial derivatives came into spotlight in post-1970 period dueto growing instability in the financial markets. However, since their emergence, these productshave become very popular and by 1990s, they accounted for about two-thirds of totaltransactions in derivative products. In recent years, the market for financial derivatives hasgrown tremendously both in terms of variety of instruments available, their complexity and alsoturnover. In the class of equity derivatives, futures and options on stock indices have gainedmore popularity than on individual stocks, especially among institutional investors, who aremajor users of index-linked derivatives.

Even small investors find these useful due to high correlation of the popular indices with variousportfolios and ease of use. The lower costs associated with index derivatives vis-vis derivativeproducts based on individual securities is another reason for their growing use.

The following factors have been driving the growth of financial derivatives:

1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international markets,

3. Marked improvement in communication facilities and sharp decline in their costs,

4. Development of more sophisticated risk management tools, providing economic agents awider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and returnsover a large number of financial assets, leading to higher returns, reduced risk as well astrans-actions costs as compared to individual financial assets.

1.2. Motivation/Need of Study:-

Different investment avenues are available for investors. Stock market also offers goodinvestment opportunities to the investor alike all investments, they also carry certain risks. Theinvestor should compare the risk and expected yields after adjustment off tax on variousinstruments while talking investment decision the investor may seek advice from consultancyinclude stock brokers and analysts while making investment decisions. The objective here is to

make the investor aware of the functioning of the derivatives.

Derivatives act as a risk hedging tool for the investors. The objective is to help the investor inselecting the appropriate derivates instrument to attain maximum risk and to construct theportfolio in such a manner to meet the investor should decide how best to reach the goals fromthe securities available.


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To identity investor objective constraints and performance, which help formulate the investmentpolicy.

To develop and improve strategies in the investment policy formulated. This will help theselection of asset classes and securities in each class depending up on their risk return attributes.

1.3. Objectives:-

The study includes different strategies of derivatives used in present scenario.

1. To compare the risk involved in derivative instruments for customer.2. To examine the different strategy which are used by the investors for the purpose of risk

hedging in their portfolio.

1.4. Research Hypothesis:-

1. Diversification in portfolio will reduce the risk.

1.5 Scope of Study:-

The scope of study is limited to Derivatives with special reference to futures, options, swapsand forwards in the Indian context; the study is not based on the international perspective of derivative markets.

The study is limited to the analysis made for types of instruments of derivates each strategy isanalyzed according to its risk and return characteristics and derivatives performance against theprofit and policies of the company.

2. RESEARCH METHODOLOGY:-

Concept of Derivatives

The term derivatives, refers to a broad class of financial instruments which mainly includeoptions and futures. These instruments derive their value from the price and other relatedvariables of the underlying asset. They do not have worth of their own and derive their valuefrom the claim they give to their owners to own some other financial assets or security. A simpleexample of derivative is butter, which is derivative of milk. The price of butter depends uponprice of milk, which in turn depends upon the demand and supply of milk. The general definitionof derivatives means to derive something from something else. Some other meanings of wordderivatives are:


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Derived function: the result of mathematical differentiation; the instantaneous change of one quantity relative to another; df(x)/dx,

Derivative instrument: a financial instrument whose value is based on another security,(linguistics) a word that is derived from another word; "`electricity' is a derivative of

electric.

The asset underlying a derivative may be commodity or a financial asset. Derivatives are thosefinancial instruments that derive their value from the other assets. For example, the price of goldto be delivered after two months will depend, among so many things, on the present andexpected price of this commodity.

Definition of Financial Derivatives

Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative as:

a) a security derived from a debt instrument, share, loan whether secured or 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 underlyingsecurities.

Underlying Asset in a Derivatives Contract

As defined above, the value of a derivative instrument depends upon the underlying asset. Theunderlying asset may assume many forms:

i. Commodities including grain, coffee beans, orange juice;

ii. Precious metals like gold and silver;

iii. Foreign exchange rates or currencies;

iv. Bonds of different types, including medium to long term negotiable debt securities issued bygovernments, companies, etc.

v. Shares and share warrants of companies traded on recognized stock exchanges and Stock Index

vi. Short term securities such as T-bills; and

vii. Over- the Counter (OTC) 2 money market products such as loans or deposits.


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Participants in Derivatives Market

1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of an asset. Majority of the participants in derivatives market belongs to this category.

2. Speculators: They transact futures and options contracts to get extra leverage in betting onfuture movements in the price of an asset. They can increase both the potential gains andpotential losses by usage of derivatives in a speculative venture.

3. Arbitrageurs: Their behavior is guided by the desire to take advantage of a discrepancybetween prices of more or less the same assets or competing assets in different markets. If, forexample, they see the futures price of an asset getting out of line with the cash price, they willtake offsetting positions in the two markets to lock in a profit.

Applications of Financial Derivatives

Some of the applications of financial derivatives can be enumerated as follows:

1. Management of risk: This is most important function of derivatives. Risk management is notabout the elimination of risk rather it is about the management of risk. Financial derivativesprovide a powerful tool for limiting risks that individuals and organizations face in the ordinaryconduct of their businesses. It requires a thorough understanding of the basic principles thatregulate the pricing of financial derivatives. Effective use of derivatives can save cost, and it canincrease returns for the organizations.

2. Efficiency in trading: Financial derivatives allow for free trading of risk components and thatleads to improving market efficiency. Traders can use a position in one or more financialderivatives as a substitute for a position in the underlying instruments. In many instances, tradersfind financial derivatives to be a more attractive instrument than the underlying security. This ismainly because of the greater amount of liquidity in the market offered by derivatives as well athe lower transaction costs associated with trading a financial derivative as compared to the costsof trading the underlying instrument in cash market.

3. Speculation: This is not the only use, and probably not the most important use, of financialderivatives. Financial derivatives are considered to be risky. If not used properly, these can leads

to financial destruction in an organization like what happened in Barings Plc. However, these

instruments act as a powerful instrument for knowledgeable traders to expose themselves tocalculated and well understood risks in search of a reward, that is, profit.

4. Price discover: Another important application of derivatives is the price discovery whichmeans revealing information about future cash market prices through the futures market.Derivatives markets provide a mechanism by which diverse and scattered opinions of future are


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Futures Contract: - Futures is a standardized forward contact to buy (long) or sell (short) theunderlying 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 Quality, quantity, Price quotation, Date andDelivery place (in case of commodity).The features of a futures contract may be specified asfollows:

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 maturity andthe manner of maturity etc.

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.

v These provide for supervision and monitoring of contract by a regulatory authority.

vi Almost ninety percent future contracts are settled via cash settlement instead of actual deliveryof underlying asset.

Futures contracts being traded on organized exchanges impart liquidity to the transaction. Theclearinghouse, being the counter party to both sides of a transaction, provides a mechanism thatguarantees the honoring of the contract and ensuring very low level of default (Hirani, 2007).Following are the important types of financial futures contract:-

i Stock Future or equity futures,

ii Stock Index futures,

iii Currency futures, and

iv Interest Rate bearing securities like Bonds, T- Bill Futures.

To give an example of a futures contract, suppose on November 2007 Ramesh holds 1000 sharesof 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 monthsresulting 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 ABCLtd. 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 theirrespective obligations out of a contract. But an options contract, as the name suggests, is in somesense, an optional contract. An option is the right, but not the obligation, to buy or sell something


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at a stated date at a stated price. A call option gives one the right to buy; a put option givesone the right to sell. Options are the standardized financial contract that allows the buyer (holder)of the option, 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 throughexchanges. 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 recognizedexchanges, 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 shortcall) however, has the obligation to sell the underlying asset if the buyer of the call optiondecides to exercise his option to buy. Suppose an investor buys One European call options onInfosys 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 priceif the buyer decides to exercise his option to sell. Right to sell is called a Put Options. Suppose Xhas 100 shares of Bajaj Auto Limited. Current price (March) of Bajaj auto shares is Rs 700 pershare. X needs money to finance its requirements after two months which he will realize afterselling 100 shares after two months. But he is of the fear that by next two months price of sharewill decline. He decides to enter into option market by buying Put Option (Right to Sell) with anexpiration date in May at a strike price of Rs 685 per share and a premium of Rs 15 per shares.

Swaps Contract:- A swap can be defined as a barter or exchange. It is a contract wherebyparties agree to exchange obligations that each of them have under their respective underlyingcontracts or we can say, a swap is an agreement between two or more parties to exchange streamof cash flows over a period of time in the future. The parties that agree to the swap are known ascounter parties.

The two commonly used swaps are:

i) Interest rate swaps which entail swapping only the interest related cash flows between theparties in the same currency, and

ii) Currency swaps: These entail swapping both principal and interest between the parties, withthe cash flows in one direction being in a different currency than the cash flows in the oppositedirection.


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2.1. Sources of Data:

Primary Sources: Data related to the Investors will collected through primary sources. Secondary Sources: Concepts related to Derivatives and their usage will collected

through secondary sources.

2.2. Research Design:-

Descriptive research design will be used as in this research the perception investors inregard to derivatives will be studied.

Methods of Data collection:- Interviews. Questionnaires.

2.3. Sampling:-

Universe-All the people who are dealing in derivatives and were interested to deal inderivatives.

Population - All the people dealing in derivatives or interested in dealing, in Dehradun.

Sampling Unit Every single person who is dealing in derivatives in nearby places. Sampling Frame - It represents the elements of the target population. Dehradun City is

the sampling frame for this project.

Samplingplan

Universe

Population

Samplingunit

Samplingframe

SampleSize

SamplingTechnique


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Sample size- Sample size 25 (25 investors). Sampling Technique - Non Probability technique i.e. convenience sampling.

2.4. Data Analysis:-

To Study Investors Perception towards Derivatives, tools we will be using are:- Bar diagrams. Pie charts. Tables showing the responses of the investors.

2.5. Review of literature:- Before derivatives markets were truly developed, the means fordealing with financial risks were few and financial risks were largely outside managerial control.Few exchangetraded derivatives did exist, but they allowed corporate users to hedge onlyagainst certain financial risks, in limited ways and over short time horizons. Companies wereoften forced to resort to operational alternatives like establishing plants abroad, in order tominimize exchange-rate risks, 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 the1980s and 1990s, commercial and investment banks introduced a broad selection of newproducts designed to help corporate managers in handling financial risks. At the same time, thederivatives exchanges, which successfully introduced interest rate and currency derivatives in the1970s, have become vigorous innovators, continually adding new products, refining the existingones, and finding new ways to increase their liquidity. Since than, markets for derivativeinstruments 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 themarket for such instruments, have expanded intensively. Consequently, the corporate use of derivatives in hedging interest rate, currency, and commodity price risks is widespread andgrowing. It could be said that the derivatives revolution has begun. The emergence of the modernand innovative derivative markets allows corporations to insulate themselves from financialrisks, or to modify them (Hu, 1995; 1996). Therefore, under these new conditions, shareholdersand stakeholders increasingly expect companys mana gement to be able to identify and manageexposures to financial risks. It was long believed that corporate risk management was irrelevantto the value of the firm and the arguments in favour of the irrelevance were based on the CapitalAsset Pricing Model (Sharpe, 1964; Lintner, 1965; Mossin, 1966) and the Modigliani-Miller

theorem (Modigliani and Miller, 1958). One of the most important implications of CAPM is thatdiversified shareholders should care only about the systematic component of total risk. On thesurface this may imply that managers of firms who are acting in the best interests of shareholdersshould be indifferent about the hedging of risks that are non-systematic.

Miller and Modiglianis proposition supports the CAPM findings. The conditions u nderlyingMM propositions also imply that decisions to hedge corporate exposures to interest rate,


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exchange rate and commodity price risks are completely irrelevant because stockholders alreadyprotect themselves against such risks by holding well-diversified portfolios. However, it isapparent that managers are constantly engaged in hedging activities that are directed towardsreduction of non-systematic risk. As 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 function. Studies that test the relevance of derivatives as risk managementinstruments generally support the expected relationships between the risks and firmscharacteristics. Stulz (1984), Smith and Stulz (1985) and Froot, Scharfstein and Stein (1993)constructed the models of financial risk management. These models predicted that firmsattempted to reduce the risks arising from large costs of potential bankruptcy, or had fundingneeds for future investment projects in the face of strongly asymmetric information. In manyinstances, such risk reduction can be achieved by the use of derivative instruments. Campbelland Kracaw (1987), Bessembinder (1991), Nance, Smith and Smithson (1993), Dolde (1995),Mian (1996), as well as Getzy, Minton and Schrand (1997) and Haushalter (2000) found

empirical evidence that firms with highly leveraged capital structures are more inclined tohedging by using derivatives. The probability of a firm to encounter financial distress is directlyrelated to the size of the firms fixed claims relative to the value of its assets. Hence, hedgingwill be more valuable the more indebted the firm, because financial distress can lead tobankruptcy and restructuring or liquidation situations in which the firm faces direct costs of financial distress. By reducing the variance of a firms cash flows or accounting profits, hedgingdecreases the likelihood, and thus the expected costs, of financial distress (see: Mayers andSmith, 1982; Myers, 1984; Stulz, 1984; Smith and Stulz, 1985; Shapiro and Titman, 1998). Theargument of reducing theexpected costs of financial distress implies that the benefits of risk management should be greater the larger the fraction of fixed claims i n the firms capital

structure. The results of the empirical studies suggest that the use of derivatives and risk management practices are broadly consistent with the predictions from the theoretical literature,which is based upon value-maximising behaviour. By hedging financial risks such as currency,interest rate and commodity risk, firms can decrease cash flow volatility. By reducing the cashflow volatility, firms can decrease the expected financial distress and agency costs, therebyenhancing the present value of expected future cash flows. In addition, reducing cash flowvolatility can improve the probability of having sufficient internal funds for planned investments,(e.g. see: Stulz, 1984; Smith and Stulz, 1985; Froot, Scharfstein and Stein, 1993; 1994)eliminating the need to either cut profitable projects or bear the transaction costs of externalfunding. The main hypothesis is that, if access to external financing (debt and/or equity) iscostly, firms with investment projects requiring funding will hedge their cash flows to avoid ashortfall in own funds, which could precipitate a costly visit to the capital markets. Aninteresting empirical insight based on this rationale is that firms with substantial investmentopportunities that are faced with high costs of raising funds under financial distress will be moremotivated to hedge against risk exposure than average firms. This rationale has been explored bynumerous scholars, among others by Hoshi, Kashyap and Scharfstein (1991), Bessembinder


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(1991), Dobson and Soenen (1993), Froot, Scharfstein and Stein (1993), Getzy, Minton andSchrand (1997), Gay and Nam (1998), Minton and Schrand (1999), Haushalter (2000), Melloand Parsons (2000), Allayannis and Ofek (2001) and Haushalter, Randall and Lie (2002). Theresults of the studies mentioned above confirm that companies using derivative instruments tomanage financial risks are more likely to have larger investment opportunities.

The results of empirical studies have also proven that the benefits of risk management programsdepend 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 likelyto hedge and use derivatives. One of the key factors in the corporate risk management rationalepertains to the costs of engaging in risk-management activities. The hedging costs include thedirect transaction costs and the agency costs of ensuring that managers transact appropriately.3the assumption underlying this rationale is that there are substantial economies of scale oreconomically significant costs related to derivatives use. Indeed, for many firms (particularlysmaller ones), the marginal benefits of hedging programs may be exceeded by marginal costs.This fact suggests that there may be sizable set-up costs related to operating a corporate risk-management program. Thus, numerous firms may not hedge at all, even though they are exposedto financial risks, simply because it is not an economically worthwhile activity. On the basis of empirical results, it can be argued that only large firms with sufficiently large risk exposures arelikely to benefit from formal hedging programs.

2.6. Expected findings:-

What are the main factors that led to growth of derivatives?

Derivatives carry high risk factor and amongst that commodity derivatives are the mostrisky to trade.

How many people use derivative as Hedging tool.

Profit is the main reason for motivating the people to invest in derivatives.

Do people prefer to invest their money through derivatives if they are provided withknowledge.

2.7. Limitations:-

Limitations are the limiting lines that restrict the work in some way or other. In this research study alsothere 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 collectionas both Primary and Secondary data was selected for study. Secondary data means data that are


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already available i.e. they refer to the data which have already been collected and analysed bysomeone else.

2. Time Period: Time period will one of the main factor as only one month is allotted and thetopic covered in research has a wide scope. So, it was not possible to cover it in a short span of

time .

3. Reliability: The data collected in research work will be secondary data, so, this puts aquestion mark on the reliability of this data.

4. Accuracy: The facts and findings of the data cannot be accepted as accurate to some extent asfirstly, secondary data will be collected. Secondly, for doing descriptive research time needed tobe more, because in short period you cannot cover each point accurately .

2.8. References:-

The Derivatives as Financial Risk Management Instruments: The Case of Croatian andSlovenian Non-financial Companies Financial Theory and Practice 31 (4) 395-420 (2007)

Modigliani, M. and Miler, M., 1958. The Cost of Capital, Corporate Finance and Theoryof Investment. The American Econ omic Review, 48 (3), 261-297.

Indian Securities Market, A Review (ISMR) -2008 available at:http://www.nseindia.com.

Growth of Derivatives Market In India, available at:http://www.valuenotes.com/njain/nj_derivatives_15sep03.asp?ArtCd=33178&Cat=T&Id=10.

Gambhir, Neeraj and Manoj Goel, 2003, Foreign Exchange Derivatives Market in India---Status and Prospects, Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw-Hill Publishing Company Limited, New 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
http://www.valuenotes.com/njain/nj_derivatives_15sep03.asp?ArtCd=33178&Cat=T&Id=10http://www.valuenotes.com/njain/nj_derivatives_15sep03.asp?ArtCd=33178&Cat=T&Id=10http://www.valuenotes.com/njain/nj_derivatives_15sep03.asp?ArtCd=33178&Cat=T&Id=10http://www.valuenotes.com/njain/nj_derivatives_15sep03.asp?ArtCd=33178&Cat=T&Id=10

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Synopsis on Financial Derivatives