DERIVATIVES

What is a derivative?
A derivative is an instrument (security or contract) that derives its value from the value of an underlying asset (security or a commodity). For example, in the case of an oil derivative (say oil futures), the underlying asset is a commodity i.e. oil. Derivatives are used primarily as an instrument to hedge the exposure to a certain asset, be it a security or a commodity.

Different types of derivatives:

Why Derivatives?
We should perhaps explore why should someone take a position in a security which does not exist on its own. If there are no "dividends" or "interest" payments to accrue from a security, and the time horizon is limited to a maximum of one year.

To understand this, let us clear one aspect. Nobody invests in a futures market. One either speculates, hedges or exploits arbitrage opportunities. When a particular person or entity buys or sells a derivative on the expectation that the market will rise or fall without a portfolio to protect, it is a case of speculative trade. However, when a trade has been entered to protect the value of a portfolio in uncertain or bearish market conditions, the particular position so created would be classified as a hedge. As a hedger, you enter into a transaction either - to protect the value of your portfolio in case you are expecting the market to fall, or, to square off an existing open position.

What is an Index future?
Index future is a derivative. Hence, its value is dependent on the value of the underlying asset, in this case the stock market index (BSE or NSE). When you buy an index based mutual fund you are buying the index, any movement in the index will reflect on the value of your investment. Similarly the index future in itself is an instrument whose value is dependent on the index. If your portfolio replicates the index and you hedge using index futures then it guarantees you a risk free rate of return. Therefore, it is of maximum use when markets are volatile.

Index derivatives are of use primarily to the fund managers controlling large portfolios, who wish to hedge their portfolio against any adverse market movements. The popularity of this hedging instrument can also be attributed in part to the very low transaction costs associated with it.

How does a person go about hedging the value of his portfolio?
The first step for any person towards hedging a portfolio would be to evaluate the riskiness of the portfolio. If the portfolio is twice as sensitive as the market, the person would take a suitable exposure in derivatives to protect the portfolio in bearish market conditions.

Example 1
Let us assume a particular fund, XYZ, has a sensitivity of 1.1 times vis-à-vis the market or a suitable representative, say, S&P CNX Nifty. The sensitivity is denoted by Beta, which is the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1.1. As a logical extension of the above example, when the index increases by 10%, the value of the portfolio increases 11%.

Let us assume that the corpus of the fund is Rs 100 m. The person, on 14th February, 2000 feels that the market is highly overvalued and due for a correction. So he sells Nifty futures worth

Rs 100 m * 1.1 (Value of the Beta) = Rs 110 m. (61,265 Nifty Futures) (Rs 110 m / 1795.45)

The value of the Nifty then was 1795.45, and on 25th May it closed at 1247.65. That is, the market had crashed by 30.51%. The NAV of XYZ would have fallen by 30.51* 1.1 = 33.56% had the fund manager not hedged her portfolio. On the other hand, the manager would stand to profit in the futures market (as he would be able to buyback the futures he had earlier shorted at a lower price). Now let us compute the losses / gains for the fund after the hedge:

Therefore, with some good use of the futures, the person has protected the value of the portfolio.

Example 2
Mr. Y is expecting the price of Reliance to increase on his projections of sharp growth in profits. He is however, neutral on market expectations, i.e. he is expecting the market to move horizontally. The stock markets are however risky, and within the short span of a fortnight, the expectations could change dramatically. In a bear market, even the best of stocks would lose value.

Therefore, while Mr. Y would be buying shares of Reliance, he will be short selling the futures in proportion to the sensitivity of Reliance to the market. Thus in the normal course of events and expectations, the investor will see appreciation of his portfolio. In case on some adverse news that causes the market to crash, the investors' losses in the cash market would be limited by gains on the futures market. Thus, we see the investor can manage the downside risk of his portfolio reasonably well with the deft use of index futures.

Calculation:
Assume the beta for Reliance as 1.5 times
Number of shares purchased: 1000 @ Rs 325 per share.
Value of portfolio: Rs 325,000.
To create a hedge, Y would look to sell futures worth 325,000 * 1.5 = 487,500. Assuming a value of 1,300 for a Nifty Future, Y would sell 375 Nifty Futures to cover his position completely. Alternatively, he could choose to cover only a part of his portfolio and bear partial market risk.

Example 3
Mr. Z is expecting the price of ITC (Assumed Beta: 1.35 times) to fall in the immediate future. He will therefore short sell the shares or the stock futures. But, if the market takes an upturn, he could be severely affected as the price of ITC prices would also rise in line with the market. Therefore, when he sells 1,000 shares of ITC at Rs 750, he will also go long on the Nifty to the extent of 1.35 * 750,000 = Rs. 1,012,500. Again assuming Nifty Futures price at 1,300, Z would be required to buy 779 Nifty Futures to cover his position completely.

How are margins calculated on Index Futures?
The Clearing Corporation retains some margin for every open position in the exchange. These comprise an initial margin and a daily mark to market margin. The initial margin is the amount deposited with the exchange at the time of entering the contract. The second component, the mark to market margin, is maintained on a day to day basis depending on the movement of the index future.

Currently, NSE has not specified the margin that the clearing corporation would be retaining. However, as per the J. R. Verma Committee Report, it might be at 6%. Assuming the margin rate at 6%, the margins are computed as follows:

Initial margin:
Consider Mr. X having bought into 100 Nifty Futures at a value of 1,500. Therefore, his open position is 1,500 * 100 = Rs 150,000. This makes the initial margin requirement as Rs. 150,000 * 6% = Rs 9000/-.

Mark to market margin:
Let us assume that the market goes down by 5% the following day. Then, the Nifty would quote at 1,425. Therefore, the margin requirement would be - 1,425 * 100 * 6% = Rs 8,550.

The transactions in his margin account would be as follows:
Losses on investment: 75 * 100 = Rs 7,500

Margin Refund (as the 6% margin has to maintained on a lower value of investment):
7,500 * 6% = Rs 450.

Therefore, net payment to be made: Rs 7,500 - Rs 450 = Rs 7,050.

Conclusion
The complicated nature of this instrument is probably evident by now. It would be wise for retail investors to steer clear of this instrument, unless of course, they have taken professional advice. For the funds, however, the introduction of these instruments will come as a boon, especially in view of the increasing volatility in the markets.

Understanding Derivatives

The capital market is a complex world. One is flooded with so many diverse opinions and vague theories that at times people throw up their hands in despair. Now we have one more phantom to grapple with - the phantom of derivatives. Often one wonders as what exactly is hedging. How does a product that seems like a pure gambling tool help an investor? Below here, we narrate a small story how Savitri uses a pure betting tool to eliminate her risk.

An example in use of hedging mechanism

Savitri is a forty-year-old lady who sells homemade papads for a living. Though not highly educated she was a shrewd lady who knew her business and the ways of the world.

She faced a problem that was not unique to her alone. As one would understand, papads need to dry after rolling them. Savitri had no other source of income apart from the papads she made and sold. But come rains, there was no way she could make the papads since they would get spoilt if it rained in the few hours she had left the papads out to dry.

It was the 16th of May. Savitri had prepared the dough for the papads and rolled them out. She only had to put them out to dry. Then in the news, she heard that there was some chance of pre-monsoon showers the following day. Caught in a bind, she thought up a ruse, which she felt, if properly implemented, could assure her that she could safely make papads throughout the monsoons.

No, she did not dream up some new technology. She just did some financial jugglery. To understand the same, read on…

Savitri first made a cost estimate how much the dough has cost her. She estimated that she had spent seventy-five rupees on the ingredients and another twenty-five as her personal labour. If it did not rain, she would be selling the papads for four hundred rupees. After having done this estimate, she goes for a casual chat with Jayesh.

Mr. Jayesh, one of Savitri's neighbors, was an inveterate gambler. Savitri knew of his weakness to lay a wager to resolve any argument. In due conversation with Jayesh, they "happen" to enter into an argument regarding the weather forecasts by the Indian Meteorological Department as being rather unreliable. They eventually decided to lay a bet. Savitri had "predicted" that it will rain the next day and Jayesh remained insistent that it wouldn't rain the next day. The stakes were decided by Savitri as one hundred rupees.

Now, let us see what has Savitri gained out of this entire arrangement. Let us assume that Savitri "wins" the bet and it does rain. As the first effect, she will lose out her entire investment she had made in papads, i.e., Rs100/-. But she wins the bet she had laid with Jayesh. So she gets back her basic investment plus the labour she had put in. Therefore, this arrangement made her position more secure than before.

Let us now see what had happened, had she lost the bet. In this case, she has to pay her dues to Jayesh. She thus loses hundred rupees in the bargain. But she can merrily sell her papads and earn four hundred rupees and maintain a profit of two hundred rupees.

Therefore, with the help of some clever financial jugglery, she has transferred her risk to Jayesh. This transfer of risk has cost her some money, but it makes her income more certain and considerably eliminates the chances of losses due to rains.

Now, with this kind of arrangement, Savitri can make papads for almost throughout the year and is earning a more regular income than ever before.

Here we have seen how Savitri has covered her risk. The use of index futures is very similar to the example mentioned above. But one must be careful to note that betting on rains is by no means a derivative. The difference between betting on rain and using a real derivative will be clearer in the story that follows...

Forwards and Futures - An introduction: (Understanding Derivatives)

Let us consider the case of Mr. Chandar. He is a farmer who grows two crops a year. He has planned to get his daughter married after he harvests the winter crop. He is certain that he can harvest 20 tons of rice. Currently, rice is trading at Rs 5/- per kg. At current price levels, he will earn Rs 100,000 that will cover the expenses for his daughter's wedding. But he knows that if there were a bumper crop of rice all over the state, he would be forced to sell his rice at as little as Rs 2 per kg. In that case, he would fall short to meet the expenses.

So Chandar goes to the local rice merchant, Thakur, and enters into an agreement that three months hence, he will sell his twenty tons of rice to him at the rate of Rs 5 per kg. Now, our Thakur is not a simpleton and knows that three months hence, all the farmers would be selling their produce, and the rates that would be then would be about 15% - 20% lower than what it is now. So Thakur offers to buy the rice at the price of Rs 4.2 per kg.

At this, Chandar argues that it is equally likely that in event of a poor crop, the price of Rice may be higher than what it is now. Thakur and Chandar finally agree to a price of Rs 5 per kg of rice for 20,000 kgs to be delivered at Thakur's shop after three months.

This is what we know as the most primitive kind of a derivative contract. Such contracts are called "Forwards" or a Forward Contract. Let us now suppose, Chandar has the freedom to transfer the contract. If the price of rice begins to increase, the value of this contract will also increase for Thakur and decrease for Chandar and vice versa.

Now let us contrast the differences between rains and the rice forward.

Now, Chandar has entered into the contract with Thakur. Let us see what problems he may now face.

·  Thakur may refuse to honour the contract, either by fraud or because of genuine circumstances.

·  Chandar, if he wishes to exit out of this arrangement, either Thakur or he decide to mutually cancel the deal. If the expected price of rice is higher than the agreed price, then Thakur may command a premium for canceling the contract. Alternatively, Chandar may choose to sell the contract to somebody else. In case Chandar decides to sell his contract to somebody else, he will have to find a person who can meet the exact conditions, which could be very difficult, and thus lead to a loss of value.

In financial terms, a forward contract is exposed to default risk and can be very illiquid.

To counter the above problems, the Chicago Board of Trade invented the first futures type contract. They standardized the contract terms like the quantity, quality and the date and location of delivery. In the above example of Chandar, the terms would be of the type "To Deliver One ton of Grade XYZ rice on DDMMYYYY at the Shop of Mr. Thakur." Such standardized forward contracts that are guaranteed by the exchange are called "Futures" or a Future Contract.

Chandar would sell twenty such contracts to secure his cash flows. Since the terms are standardized into small units, squaring off your contract is not an issue, because they can be done even one ton at a time. So if Chandar feels that he will have 18 tons, he can buy back two futures.

Index futures, like these rice futures will have similar properties - The terms of the futures contract would be specified in advance. In context to the expected launch of derivatives, the specifications of the first series are:

Having seen how Chandar has created a hedge for his situation, let us see how an investor will create a hedge using index futures.

Index Futures - (Understanding Derivatives)

Mr. Nimish Desai has one a considerable amount of research on some companies and he has selected 12 scrips which he feels will do exceedingly well, even if the market has a whole does not show substantial gain. After having built his portfolio of Rs 1 million he adopts a wait and watch approach. Being an experienced player, he knows that if some adverse news hits the economy, all stocks will decline in value. So he would like to be in a position, that if the market remains steady, he makes profits, and in case the market falls, he should minimize his losses.

Nimish therefore does some further exploration and finds that the average volatility of the scrips in his portfolio vis-à-vis the Nifty is 1.2. That is, if the Nifty increased by 1%, the improvement of the overall sentiment would cause an increase of 1.2% in the value of Nimish's portfolio. Like wise, if the value of the index decreased by 1%, the value of his portfolio decreased by 1.2% purely because of poorer sentiment.

Nimish does not want to bear this uncertainty. All he had to do was to get into a kind of arrangement, that a loss in index would mean an increase in his portfolio value, or the gain in Index mean a loss for him in his portfolio value. This can be achieved by short selling the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings. Therefore, Nimish would be selling

1.2 * I million = 1.2 million worth Nifty.

Now let us study the gain / loss that accrues to Nimish because of the arrangement

As we see, that Nimish is completely insulated from any losses arising out of poor sentiment. But as a cost, he has to forego any gains that arise out of improvement in the overall sentiment. One would be justified in asking then why should Nimish invest in equities at all if the gains in cash market will be offset by losses in futures market. The idea is, Nimish is expecting his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase.

To summarize the chapter on hedging with index futures, we could say,

·  In hedging, you are not looking to make a profit.

·  You have invested in stocks that will outperform the market.

·  The index you have used is a good representative of the entire stock market.

·  You do not want to bear losses that would arise out of adverse events that affect the entire economy.

·  You will not stand to gain from any such news either.

·  Hedging may not always lead to a better outcome. However, it may lead to a more certain outcome.