Project Complete Document

A STUDY ON THE EFFECTIVENESS OF FINANCIAL DERIVATIVES AS A RISK DIVERSIFICATION AND PROFIT
MAXIMIZATION TOOL
1
MSN Institute of Management and Technology, Chavara,. Kollam
A STUDY ON THE EFFECTIVENESS OF FINANCIAL
DERIVATIVES AS A RISK DIVERSIFICATION AND PROFIT
MAXIMIZATION TOOL
AT
HEDGE EQUITIES, COCHIN
A project report submitted to the University of Kerala
For the partial fulfillment of the award of the degree of
Master of Business Administration
Submitted By
GOKUL VT
Reg. No: 11811020
Under the guidance of
Prof Dr. K Govindankutty
Professor, MSNIMT, Chavara

MEMBER SREE NARAYANA PILLAI INSTITUTE OF MANAGEMENT
AND TECHNOLOGY
(Approved by AICTE and Affiliated to the University of Kerala)
Mukundapuram P.O,Chavara,Kollam-691585,Kerala
2011 2013

MAXIMIZATION TOOL
2

CHAPTER 1
INTRODUCTION TO THE STUDY

MAXIMIZATION TOOL
3
INTRODUCTION
Derivative contract is a contract whose value is determined by the changes in the
value of underlying asset. Underlying assets include stocks, bonds, commodities,
currencies, interest rates and market indices. Hedgers are the investors who use
derivatives as a hedging tool to reduce their future risk. Hedge is an investment
made in order to reduce the risk of adverse price movements in a security by
taking an offsetting position in a related security.
In this study, we use derivative futures and options to diversify the risk and
maximize the profit from the investment. A future is defined as a standardized
contract to buy or sell a specified commodity of standardized quality at a certain
date in future and at a determined future price. The party agreeing to buy the
underlying asset in future is said to have taken a long position and the party who
agrees to sell the underlying in future is said to have taken a short position.
In finance, an option is a contract which gives the owner the right, but not the
obligation, to buy or sell an underlying asset or instrument at a specified strike
price on or before a specified date. The seller incurs a corresponding obligation to
fulfill the transaction, which is to sell or buy, if the long holder elects to "exercise"
the option prior to expiration. The buyer pays a premium to the seller for this
right. An option which conveys the right to buy something at a specific price is
called a call; an option which conveys the right to sell something at a specific
price is called a put. Both are commonly traded, though in basic finance for clarity
the call option is more frequently discussed, as it moves in the same direction as
the underlying asset, rather than opposite, as does the put.

MAXIMIZATION TOOL
4
1.1. BACKGROUND OF THE PROBLEM
The project aims to analyse the effectiveness of using financial derivatives as a
risk diverisification and profit maximization tool. Derivatives such as futures and
options are used to diversify risk and maximize profit of a portfolio. Here we
consider Nifty Index futures and options for the study.
Investing in securities such as shares, debentures and bonds is profitable as well as
existing. It is indeed rewarding, but involves a great deal of risk and calls for
scientific as well as artistic skill. In such investment both rational as well as
emotional responses are involved. Investing in financial securities is now
considered to be one of the most risky avenues of investments.
It is rare to investors investing their savings in a single security. Instead they tend
to invest in a group of securities. Such a group of securities is called as Portfolio.
Creation of a portfolio helps to reduce risk without sacrificing returns.

Portfolio management deals with the analysis of individual securities as well as
with the theory and practice of optimally combining securities into portfolios. An
investor who understands the fundamental principles and analytical aspects of
portfolio management has a better chance of success. An investor considering
investments in securities is faced with the problem of choosing from among a
large number of securities. His choice depends upon the risk returns
characteristics of individual securities. He would attempt to choose the most
desirable securities and like to allocate his funds over this group of securities.
Again he is faced with the problem of deciding which securities to hold and how
much to invest in each. The investor faces an infinite number of possible
portfolios differ from those of individual securities combining to form a portfolio.
The investor tries to choose the optimal portfolio taking into consideration the risk
return characteristics of all possible portfolios.

An investor invests his funds in a portfolio expecting to get a good return
consistent with the risk that has to be bear. The return realized from the portfolio
has to be measured and the performance of the portfolio has to be evaluated. It is
MAXIMIZATION TOOL
5
evident that rational investment activity involves creation of an investment
portfolio.
Portfolio management comprises all the process involved in the creation and
maintenance of an investment portfolio. It deals specially with security analysis,
portfolio analysis, portfolio selection, portfolio revision and portfolio evaluation it
also make use of analytical techniques of analysis and conceptual theories
regarding rational allocation of funds. Portfolio management is a complex process
which tries to make investment activity more rewarding less risky.

A portfolio is a group of securities held together as investment. Investors invest
their funds in a portfolio of securities rather than in a single security because they
are risk averse. By constructing a portfolio, investor attempts to spread risk by not
putting all their eggs in to one basket. Thus diversification of ones holdings is
intended to reduce risk in investment.

MAXIMIZATION TOOL
6
1.2 INTRODUCTION TO THE INDUSTRY

Financial services

Financial services are the economic services provided by the finance industry,
which encompasses a broad range of organizations that manage money, including
credit unions, banks, credit card companies, insurance companies, consumer
finance companies, stock brokerages, investment funds and some government
sponsored enterprises.
The Indian financial services industry is characterized by increasingly vibrant
public- and private-sector institutions. As the common Indian acronym BFSI,
which stands for banking and financial services industry, indicates, the banking
sector has historically dominated the industry. But other sectors have made
significant gains as well. Though the industry continues to be dominated by
public-sector institutions, particularly in insurance and asset management, there is
a growing list of private enterprises, competing fiercely both among themselves
and with the public entities.
Recent economic growth has given rise to a growing consumer middle class
Middle Indiawith a strong credit culture and increasing financial
sophistication. Many of the goods and services these newly affluent consumers
seeksuch as autos, housing, and retirement planningindicate a significant role
for financial services. On the institutional side, as Indian companies continue to
grow and globalize they will likely require increasingly sophisticated services
from the industry.
Strong demand from consumers and businesses drove Indias growth over the last
two decades and are expected to continue to set the pace in the future.
Asset management - the term usually given to describe companies which
run collective investment funds. Also refers to services provided by others,
generally registered with the Securities and Exchange Commission as
Registered Investment Advisors.
Hedge fund management - Hedge funds often employ the services of
"prime brokerage" divisions at major investment banks to execute their
trades.
MAXIMIZATION TOOL
7
Custody services - the safe-keeping and processing of the world's
securities trades and servicing the associated portfolios. Assets under
custody in the world are approximately US$100 trillion.
Intermediation or advisory services - These services involve stock
brokers (private client services) and discount brokers. Stock brokers assist
investors in buying or selling shares. Primarily internet-based companies
are often referred to as discount brokerages, although many now have
branch offices to assist clients. These brokerages primarily target
individual investors. Full service and private client firms primarily assist
and execute trades for clients with large amounts of capital to invest, such
as large companies, wealthy individuals, and investment management
funds.
Private equity - Private equity funds are typically closed-end funds,
which usually take controlling equity stakes in businesses that are either
private, or taken private once acquired. Private equity funds often use
leveraged buyouts (LBOs) to acquire the firms in which they invest. The
most successful private equity funds can generate returns significantly
higher than provided by the equity markets
Venture capital is a type of private equity capital typically provided by
professional, outside investors to new, high-potential-growth companies in
the interest of taking the company to an IPO or trade sale of the business.
Angel investment - An angel investor or angel (known as a business angel
or informal investor in Europe), is an affluent individual who provides
capital for a business start-up, usually in exchange for convertible debt or
ownership equity. A small but increasing number of angel investors
organize themselves into angel groups or angel networks to share research
and pool their investment capital.
Conglomerates - A financial services conglomerate is a financial services
firm that is active in more than one sector of the financial services market
e.g. life insurance, general insurance, health insurance, asset management,
retail banking, wholesale banking, investment banking, etc. A key
rationale for the existence of such businesses is the existence of
diversification benefits that are present when different types of businesses
are aggregated i.e. bad things don't always happen at the same time. As a
MAXIMIZATION TOOL
8
consequence, economic capital for a conglomerate is usually substantially
less than economic capital is for the sum of its parts.
Debt resolution is a consumer service that assists individuals that have too
much debt to pay off as requested, but do not want to file bankruptcy and
wish to pay off their debts owed. This debt can be accrued in various ways
including but not limited to personal loans, credit cards or in some cases
merchant accounts. There are many services/companies that can assist with
this.
Money market
As money became a commodity, the money market became a component of the
financial markets for assets involved in short-term borrowing, lending, buying and
selling with original maturities of one year or less. Trading in the money markets
is done over the counter, is wholesale. Various instruments exist, such as Treasury
bills, commercial paper, bankers' acceptances, deposits, certificates of deposit,
bills of exchange, repurchase agreements, federal funds, and short-lived mortgage-
, and asset-backed securities. It provides liquidity funding for the global financial
system. Money markets and capital markets are parts of financial markets. The
instruments bear differing maturities, currencies, credit risks, and structure.
Therefore they may be used to distribute the exposure.
Participants
The money market consists of financial institutions and dealers in money or credit
who wish to either borrow or lend. Participants borrow and lend for short periods
of time, typically up to thirteen months. Money market trades in short-term
financial instruments commonly called "paper." This contrasts with the capital
market for longer-term funding, which is supplied by bonds and equity.
The core of the money market consists of interbank lending--banks borrowing and
lending to each other using commercial paper, repurchase agreements and similar
instruments. These instruments are often benchmarked to (i.e. priced by reference
to) the London Interbank Offered Rate (LIBOR) for the appropriate term and
currency.
Finance companies typically fund themselves by issuing large amounts of asset-
backed commercial paper (ABCP) which is secured by the pledge of eligible
assets into an ABCP conduit. Examples of eligible assets include auto loans, credit
MAXIMIZATION TOOL
9
card receivables, residential/commercial mortgage loans, mortgage-backed
securities and similar financial assets. Certain large corporations with strong credit
ratings, such as General Electric, issue commercial paper on their own credit.
Other large corporations arrange for banks to issue commercial paper on their
behalf via commercial paper lines.
Functions of the money market
The money market functions are
transfer of large sums of money
transfer from parties with surplus funds to parties with a deficit
allow governments to raise funds
help to implement monetary policy
determine short-term interest rates
Common money market instruments
Certificate of deposit - Time deposit, commonly offered to consumers by
banks, thrift institutions, and credit unions.
Repurchase agreements - Short-term loansnormally for less than two
weeks and frequently for one dayarranged by selling securities to an
investor with an agreement to repurchase them at a fixed price on a fixed
date.
Commercial paper - short term usanse promissory notes issued by
company at discount to face value and redeemed at face value
Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank
branch located outside the United States.
Federal agency short-term securities - (in the U.S.). Short-term securities
issued by government sponsored enterprises such as the Farm Credit
System, the Federal Home Loan Banks and the Federal National Mortgage
Association.
Federal funds - (in the U.S.). Interest-bearing deposits held by banks and
other depository institutions at the Federal Reserve; these are immediately
available funds that institutions borrow or lend, usually on an overnight
basis. They are lent for the federal funds rate.
Municipal notes - (in the U.S.). Short-term notes issued by municipalities
in anticipation of tax receipts or other revenues.
MAXIMIZATION TOOL
10
Treasury bills - Short-term debt obligations of a national government that
are issued to mature in three to twelve months.
Money funds - Pooled short maturity, high quality investments which buy
money market securities on behalf of retail or institutional investors.
Foreign Exchange Swaps - Exchanging a set of currencies in spot date and
the reversal of the exchange of currencies at a predetermined time in the
future.
Short-lived mortgage- and asset-backed securities
Discount and accrual instruments
There are two types of instruments in the fixed income market that pay the interest
at maturity, instead of paying it as coupons. Discount instruments, like
repurchase agreements, are issued at a discount of the face value, and their
maturity value is the face value. Accrual instruments are issued at the face value
and mature at the face value plus interest.

Stock Markets:
Stock Market is a market where the trading of company stock, both listed
securities and unlisted takes place. It is different from stock exchange because it
includes all the national stock exchanges of the country. For example, we use the
term, "the stock market was up today" or "the stock market bubble."
Stock Exchanges:
Stock Exchanges are an organized marketplace, either corporation or mutual
organization, where members of the organization gather to trade company stocks
or other securities. The members may act either as agents for their customers, or
as principals for their own accounts. Stock exchanges also facilitates for the issue
and redemption of securities and other financial instruments including the
payment of income and dividends. The record keeping is central but trade is
linked to such physical place because modern markets are computerized. The
trade on an exchange is only by members and stock broker do have a seat on the
exchange.
MAXIMIZATION TOOL
11
History of the Indian Stock Market - The Origin
One of the oldest stock markets in Asia, the Indian Stock Markets has a 200 years
old history.
It dates back to the close of 18th century when the East India Company used to
transact loan securities. In the 1830s, trading on corporate stocks and shares in
Bank and Cotton presses took place in Bombay. Though the trading was broad but
the brokers were hardly half dozen during 1840 and 1850.
An informal group of 22 stockbrokers began trading under a banyan tree opposite
the Town Hall of Bombay from the mid-1850s, each investing a (then) princely
amount of Rupee 1. This banyan tree still stands in the Horniman Circle Park,
Mumbai. In 1860, the exchange flourished with 60 brokers. In fact the 'Share
Mania' in India began with the American Civil War broke and the cotton supply
from the US to Europe stopped. Further the brokers increased to 250. The
informal group of stockbrokers organized themselves as the The Native Share and
Stockbrokers Association which, in 1875, was formally organized as the Bombay
Stock Exchange (BSE).
BSE was shifted to an old building near the Town Hall. In 1928, the plot of land
on which the BSE building now stands (at the intersection of Dalal Street,
Bombay Samachar Marg and Hammam Street in downtown Mumbai) was
acquired, and a building was constructed and occupied in 1930.
Premchand Roychand was a leading stockbroker of that time, and he assisted in
setting out traditions, conventions, and procedures for the trading of stocks at
Bombay Stock Exchange and they are still being followed.
Several stock broking firms in Mumbai were family run enterprises, and were
named after the heads of the family.
The following is the list of some of the initial members of the exchange, and who
are still running their respective business:
D.S. Prabhudas & Company (now known as DSP, and a joint venture
partner with Merrill Lynch)
Jamnadas Morarjee (now known as JM)
Champaklal Devidas (now called Cifco Finance)
Brijmohan Laxminarayan
MAXIMIZATION TOOL
12
In 1956, the Government of India recognized the Bombay Stock Exchange as the
first stock exchange in the country under the Securities Contracts (Regulation)
Act.
The most decisive period in the history of the BSE took place after 1992. In the
aftermath of a major scandal with market manipulation involving a BSE member
named Harshad Mehta, BSE responded to calls for reform with intransigence. The
foot-dragging by the BSE helped radicalise the position of the government, which
encouraged the creation of the National Stock Exchange (NSE), which created an
electronic marketplace. NSE started trading on 4 November 1994. Within less
than a year, NSE turnover exceeded the BSE. BSE rapidly automated, but it never
caught up with NSE spot market turnover. The second strategic failure at BSE
came in the following two years. NSE embarked on the launch of equity
derivatives trading. BSE responded by political effort, with a friendly SEBI
chairman (D. R. Mehta) aimed at blocking equity derivatives trading. The BSE
and D. R. Mehta succeeded in delaying the onset of equity derivatives trading by
roughly five years. But this trading, and the accompanying shift of the spot market
to rolling settlement, did come along in 2000 and 2001 - helped by another major
scandal at BSE involving the then President Mr. Anand Rathi. NSE scored nearly
100% market share in the runaway success of equity derivatives trading, thus
consigning BSE into clearly second place. Today, NSE has roughly 66% of equity
spot turnover and roughly 100% of equity derivatives turnover.

CAPITAL MARKET:
The capital market is the market for securities, where companies and the
government can raise long-term funds. The capital market includes the stock
market and the bond market. The capital markets consist of the primary market,
where new issues are distributed to investors, and the secondary market, where
existing securities are traded.
Primary market
The primary market is that part of the capital markets that deals with the
issuance of new securities. Companies, governments or public sector institutions
MAXIMIZATION TOOL
13
can obtain bonds through the sale of a new stock or bond issue. This is typically
done through a syndicate of securities dealers. The process of selling new issues to
investors is called underwriting. In the case of a new stock issue this sale is an
Initial Public Offering (IPO). Dealers earn a commission that is built into the price
of the security offering, though it can be found in the prospectus. Primary markets
create long term instruments through which corporate entities borrow from capital
market.
Features of primary markets are:
This is the market for new long term equity capital. The primary market is
the market where the securities are sold for the first time. Therefore it is
also called the new issue market (NIM).
In a primary issue, the securities are issued by the company directly to
investors.
The company receives the money and issues new security certificates to
the investors.
Primary issues are used by companies for the purpose of setting up new
business or for expanding or modernizing the existing business.
The primary market performs the crucial function of facilitating capital
formation in the economy.
The new issue market does not include certain other sources of new long
term external finance, such as loans from financial institutions. Borrowers
in the new issue market may be raising capital for converting private
capital into public capital; this is known as "going public."
The financial assets sold can only be redeemed by the original holder.
Methods of issuing securities in the primary market are:
Public issuance, including initial public offering;
Rights issue(for existing companies);
Preferential issue.

MAXIMIZATION TOOL
14
Secondary Market
The secondary market, also called aftermarket, is the financial market in which
previously issued financial instruments such as stock, bonds, options, and futures
are bought and sold. Another frequent usage of "secondary market" is to refer to
loans which are sold by a mortgage bank to investors such as Fannie Mae and
Freddie Mac. The term "secondary market" is also used to refer to the market for
any used goods or assets, or an alternative use for an existing product or asset
where the customer base is the second market (for example, corn has been
traditionally used primarily for food production and feedstock, but a "second" or
"third" market has developed for use in ethanol production).
With primary issuances of securities or financial instruments, or the primary
market, investors purchase these securities directly from issuers such as
corporations issuing shares in an IPO or private placement, or directly from the
federal government in the case of treasuries. After the initial issuance, investors
can purchase from other investors in the secondary market.
The secondary market for a variety of assets can vary from loans to stocks, from
fragmented to centralized, and from illiquid to very liquid. The major stock
exchanges are the most visible example of liquid secondary markets - in this case,
for stocks of publicly traded companies. Most bonds and structured products trade
over the counter, or by phoning the bond desk of ones broker-dealer. Loans
sometimes trade online using a Loan Exchange.
Function
In the secondary market, securities are sold by and transferred from one investor
or speculator to another. It is therefore important that the secondary market be
highly liquid (originally, the only way to create this liquidity was for investors and
speculators to meet at a fixed place regularly; this is how stock exchanges
originated. As a general rule, the greater the number of investors that participate in
a given marketplace, and the greater the centralization of that marketplace, the
more liquid the market.
Fundamentally, secondary markets mesh the investor's preference for liquidity
(i.e., the investor's desire not to tie up his or her money for a long period of time,
in case the investor needs it to deal with unforeseen circumstances) with the
MAXIMIZATION TOOL
15
capital user's preference to be able to use the capital for an extended period of
time.
Accurate share price allocates scarce capital more efficiently when new projects
are financed through a new primary market offering, but accuracy may also matter
in the secondary market because:
1) price accuracy can reduce the agency costs of management, and make hostile
takeover a less risky proposition and thus move capital into the hands of better
managers, and
2) accurate share price aids the efficient allocation of debt finance whether debt
offerings or institutional borrowing.

SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI):
Securities and Exchange Board of India (SEBI) is an autonomous body created by
the Government of India in 1988 and given statutory form in 1992 with the SEBI
Act 1992. Its head office is in Mumbai, and has regional offices in Chennai,
Kolkata and Delhi. SEBI is the regulator of Securities markets in India.
FUNCTIONS OF SEBI:
Regulating the business in stock exchanges and any other securities market.
Registering and regulating the working of collective investment schemes
including mutual funds.
Promoting and regulating self-regulatory organisations.
Prohibiting fraudulent and unfair trade practices in the securities market.
Promoting investors education and training of intermediaries in securities market.
Prohibiting insiders trading in securities.
Regulating substantial acquisition of shares and take-over of companies.

OBJECTIVES OF SEBI:
The promulgation of the SEBI ordinance in the parliament gave statutory status to
SEBI in 1992. According to the preamble of the SEBI, the three main objectives
are: -
MAXIMIZATION TOOL
16
To protect the interests of the investors in securities.
To promote the development of securities market.
To regulate the securities market.
SALIENT FEATURES OF SEBI:
The SEBI shall be a body corporate by the name having perpetual succession and
a common seal with power to acquire, hold and dispose of property, both movable
and immovable, and to contract, and shall, by the said name, sue or by sued.

The Head Office of the Board shall be at Bombay. The Board may
establish offices at other places in India. In Bombay, the Board is situated
at Mittal Court, B-Wing, 224, Nariman Point, Bombay-400 021.
The Chairman and the Members of the Board are appointed by the Central
Government.
The general superintendence, direction and management of the affairs of
the Board are in a Board of Members, which may exercise all powers and
do all acts and things which may be exercised or done by that Board.
The Government can prescribe terms of office and other conditions of
service of the Chairman and Members of the Board. The members can be
removed under section 6 of the SEBI Act under specified circumstances.
It is primary duty of the Board to protect the interest of the investor in
securities and to promote the development of and to regulate the securities
market by such measures, as it thinks fit.
BOMBAY STOCK EXCHANGE:
The Stock Exchange, Mumbai, Popularly known as "Bombay Stock Exchange"
(BSE) was established in 1875 as "The Native Share and Stock Brokers
Association", as a voluntary non-profit making association. It has evolved over the
years into its present status as the premier Stock Exchange in the country. It may
be noted that the Bombay Stock Exchange is the oldest one in Asia, even older
than the Tokyo Stock Exchange, which was founded in 1878.
MAXIMIZATION TOOL
17
The Bombay Stock Exchange, while providing an efficient and transparent market
for trading in securities, upholds the interests of the investors and ensures
redressed of their grievances, whether against the companies or its own member-
brokers. It also strives to educate and enlighten the investors by making available
necessary informative inputs and conducting investor education program.
A Governing Board having 20 directors is the apex body, which decides the
policies and regulates the affairs of the Exchange. The Governing Board consists
of 9 elected directors, who are from the broking community (one third of them
retire every year by rotation), three SEBI nominees, six public representatives and
an Executive Director & Chief Executive Officer and a Chief Operating Officer.

The Executive Director as the Chief Executive Officer is responsible for the day-
to-day administration of the Exchange and he is assisted by the Chief Operating
Officer and other Heads of Department. The Exchange has inserted new Rule in
its Rules, Bye-laws & Regulations pertaining to constitution of the Executive
Committee of the Exchange. Accordingly, an Executive Committee, consisting of
three elected directors, three SEBI nominees or public representatives, Executive
Director & CEO and Chief Operating Officer has been constituted. The
Committee considers judicial & quasi matters in which the Governing Board has
powers as an Appellate Authority, matters regarding annulment of transactions,
admission, continuance and suspension of member-brokers, declaration of a
member-broker as defaulter, norms, procedures and other matters relating to
arbitration, fees, deposits, margins and other monies payable by the member-
brokers to the Exchange, etc.
SENSEX:
The sensitive index has long been known as the barometer of the daily
temperature of Indian bourses. In 1978-79 stock market contained only private
sector companies and they were mostly geared to commodity production.
SENSEX is a "Market Capitalization-Weighted" index of 30 stocks representing a
sample of large, well-established and financially sound companies. SENSEX is
MAXIMIZATION TOOL
18
considered to be the pulse of the Indian stock markets. SENSEX is widely used to
describe the mood in the Indian Stock markets.

Source: Sensex fact sheet Dec 2012, http://www.bseindia.com

NATIONAL STOCK EXCHANGE:
The National Stock Exchange (NSE) is India's leading stock exchange covering
364 cities and towns across the country. NSE was set up by leading institutions to
provide a modern, fully automated screen-based trading system with national
reach. The Exchange has brought about unparalleled transparency, speed &
efficiency, safety and market integrity. It has set up facilities that serve as a model
for the securities industry in terms of systems, practices and procedures.
NSE has played a catalytic role in reforming the Indian securities market in terms
of microstructure, market practices and trading volumes. The market today uses
state-of-art information technology to provide an efficient and transparent trading,
clearing and settlement mechanism, and has witnessed several innovations in
products & services viz. demutualisation of stock exchange governance, screen
based trading, compression of settlement cycles, dematerialisation and electronic
transfer of securities, securities lending and borrowing, professionalisation of
trading members, fine-tuned risk management systems, emergence of clearing
corporations to assume counterparty risks, market of debt and derivative
instruments and intensive use of information technology. The National Stock
Exchange of India Limited has genesis in the report of the High Powered Study
Group on Establishment of New Stock Exchanges, which recommended
MAXIMIZATION TOOL
19
promotion of a National Stock Exchange by financial institutions (FIs) to provide
access to investors from all across the country on an equal footing. Based on the
recommendations, NSE was promoted by leading Financial Institutions at the
behest of the Government of India and was incorporated in November 1992 as a
tax-paying company unlike other stock exchanges in the country. On its
recognition as a stock exchange under the Securities Contracts (Regulation) Act,
1956 in April 1993, NSE commenced operations in the Wholesale Debt Market
(WDM) segment in June 1994. The Capital Market (Equities) segment
commenced operations in November 1994 and operations in Derivatives segment
commenced in June 2000. NSE's mission is setting the agenda for change in the
securities markets in India. The NSE was set-up with the following objectives:
establishing a nation-wide trading facility for equities, debt instruments
and hybrids,
ensuring equal access to investors all over the country through an
appropriate communication network,
providing a fair, efficient and transparent securities market to investors
using electronic trading systems,
enabling shorter settlement cycles and book entry settlements systems, and
Meeting the current international standards of securities markets.

The standards set by NSE in terms of market practices and technologies have
become industry benchmarks and are being emulated by other market participants.
NSE is more than a mere market facilitator. It's that force which is guiding the
industry towards new horizons and greater opportunities. Till the advent of NSE,
an investor wanting to transact in a security not traded on the nearest exchange
had to route orders through a series of correspondent brokers to the appropriate
exchange. This resulted in a great deal of uncertainty and high transaction costs.
One of the objectives of NSE was to provide a nationwide trading facility and to
enable investors spread all over the country to have an equal access to NSE. NSE
has made it possible for an investor to access the same market and order book,
irrespective of location, at the same price and at the same cost. NSE uses
sophisticated telecommunication technology through which members can trade
MAXIMIZATION TOOL
20
remotely from their offices located in any part of the country. NSE trading
terminals are present in 363 cities and towns all over India. NSE has been
promoted by leading financial institutions, banks, insurance companies and other
financial intermediaries NSE is one of the first demutualised stock exchanges in
the country, where the ownership and management of the Exchange is completely
divorced from the right to trade on it. Though the impetus for its establishment
came from policy makers in the country, it has been set up as a public limited
company, owned by the leading institutional investors in the country.
From day one, NSE has adopted the form of a demutualised exchange - the
ownership, management and trading is in the hands of three different sets of
people. NSE is owned by a set of leading financial institutions, banks, insurance
companies and other financial intermediaries and is managed by professionals,
who do not directly or indirectly trade on the Exchange. This has completely
eliminated any conflict of interest and helped NSE in aggressively pursuing
policies and practices within a public interest framework. The NSE model
however, does not preclude, but in fact accommodates involvement, support and
contribution of trading members in a variety of ways. Its Board comprises of
senior executives from promoter institutions, eminent professionals in the fields of
law, economics, accountancy, finance, taxation, etc, public representatives,
nominees of SEBI and one full time executive of the Exchange. While the Board
deals with broad policy issues, decisions relating to market operations are
delegated by the Board to various committees constituted by it. Such committees
include representatives from trading members, professionals, the public and the
management. The day-to-day management of the Exchange is delegated to the
Managing Director who is supported by a team of professional staff.
NIFTY:
The Nifty is relatively a new comer in the Indian market. S&P CNX Nifty is a 50
stock index accounting for 23 sectors of the economy. S&P CNX Nifty is owned
and managed by India Index Services and Products Ltd. (IISL), which is a joint
venture between NSE and CRISIL. IISL is a specialized company focused upon
the index as a core product. IISL have a consulting and licensing agreement with
Standard & Poor's (S&P), who are world leaders in index services.
MAXIMIZATION TOOL
21
MCX-SX
MCX Stock Exchange Limited (MCX-SX), Indias new stock exchange, is
recognized by Securities and Exchange Board of India under Section 4 of
Securities Contracts (Regulation) Act, 1956. The Exchange was notified as a
recognized stock exchange under Section 2(39) of the Companies Act, 1956 by
the Govt. of India on December 21, 2012. In line with global best practices and
regulatory requirements, clearing and settlement of trades done on the Exchange is
conducted through a separate clearing corporation MCX-SX Clearing
Corporation Ltd. (MCX-SX CCL).
MCX-SX commenced operations in Currency Futures in the Currency Derivatives
(CD) segment on October 7, 2008 under the regulatory framework of SEBI and
Reserve Bank of India (RBI). The Exchange commenced trading in Currency
Options on August 10, 2012. MCX-SX commenced trading in Capital Market
(Equity Cash) and Futures & Options (Equity Derivatives) Segments with effect
from February 11, 2013.
SX40-Index of India
SX40 is the flagship Index of MCX-SX. A free float based index of 40 large cap -
liquid stocks representing diversified sectors of the economy. SX40 is designed to
measure the economic performance with better representation of various
industries and sectors based on ICB, leading global Industry Classification
system from FTSE. The Index is devised to offer cost-effective support for
investment and structured products such as index futures and option, index
portfolio, exchange traded funds, Index funds, etc.
BROKING FIRMS
STOCK BROKERS
A broker is an intermediary who arranges to buy and sell securities on behalf of
clients (the buyer and the seller).
According to Rule 2 (e) of SEBI (Stock Brokers and Sub-Brokers) Rules, 1992, a
stockbroker means a member of a recognized stock exchange. No stockbroker is
allowed to buy, sell or deal in securities, unless he or she holds a certificate of
MAXIMIZATION TOOL
22
registration granted by SEBI.

A stockbroker applies for registration to SEBI through a stock exchange or stock
exchanges of which he or she is admitted as a member. SEBI may grant a
certificate to a stock-broker [as per SEBI (Stock Brokers and Sub-Brokers) Rules,
1992] subject to the conditions that:

a) he holds the membership of any stock exchange;

b) he shall abide by the rules, regulations and bye-laws of the stock exchange or
stock exchanges of which he is a member;

c) in case of any change in the status and constitution, he shall obtain prior
permission of SEBI to continue to buy, sell or deal in securities in any stock
exchange;

d) he shall pay the amount of fees for registration in the prescribed manner; and

e) he shall take adequate steps for redressal of grievances of the investors within
one month of the date of the receipt of the complaint and keep SEBI informed
about the number, nature and other particulars of the complaints.

While considering the application of an entity for grant of registration as a stock
broker, SEBI shall take into account the following namely, whether the stock
broker applicant

a) is eligible to be admitted as a member of a stock exchange;

b) has the necessary infrastructure like adequate office space, equipment and man
power to effectively discharge his activities;

c) has any past experience in the business of buying, selling or dealing in
securities;

MAXIMIZATION TOOL
23
d) is being subjected to any disciplinary proceedings under the rules, regulations
and bye-laws of a stock
exchange with respect to his business as a stockbroker involving either himself or
any of his partners, directors or employees

MAJOR STOCK BROKERS IN INDIA

HEDGE EQUITIES LTD
Hedge Equities is one of the leading Financial Services Company in India,
specialized in offering a wide range of financial products, tailor made to suit
individual needs. As a first step to make their presence Global, Hedge Equities
have initiated operations in Middle East to cater to the vast Non Resident Indian
(NRI) population in that region. Ever since their inception, they have spanned
their presence all over India through their Meticulous Research, High Brand
Awareness, and Intellectual Management and Extensive Industry knowledge. At
Hedge they believe in creating a new breed of Investors who take judicious
decisions through them. Hedge equities ltd. is one of the leading retail stock
broking house which is running successfully in the country.
GEOJIT BNP PARIBAS
Geojit BNP Paribas today is a leading retail financial services company in India
with a growing presence in the Middle East. The company rides on its rich
experience in the capital market to offer its clients a wide portfolio of savings and
investment solutions. The gamut of value added products and services offered
ranges from equities and derivatives to mutual funds., Life & General insurance
and third party fixed deposits. The need of over 5, 76,000 clients are met via
multichannel services a country wide network of over 540 offices, phone
service, dedicated customer care centre and internet.
Geojit BNP Paribas has membership in National Stock Exchange (NSE) and the
Bombay Stock Exchange (BSE). In 2007, global ranking major BNP Paribas
joined the companys other major shareholders- Mr .C .J. George, KSIDC (Kerala
State Industriai Development Corporation) and Mr. RakeshJunjunwala- when it
took a stake to become the single largest share holder.
MAXIMIZATION TOOL
24
At the forefront of the many fruitful associations between Geojit BNP Pariba and
BNP Paribas in their joint venture namely, BNP Paribas Securities India Private
Limited. This joint venture was created exclusively for domestic and foreign
institutional clients. An industry first was achieved when Geojit BNP Paribas
became the first broker in India to offer full Direct Market Access (DMA) on NSE
to JVs institutional clients.
JRG SECURITIES
JRG Securities Ltd. Is one of Indias leading finance services providers with
strong presence in south India. It was incorporated in 1994 and over the years, it
acquired a name of trust through equity and commodity broking business. In 2007,
Baring India Private Equity fund II Ltd, a leading private equity firm of
international repute acquired a majority stake in the company. With the
investment of BIPEF came fresh inflow of talent and a focused team committed to
taking this company to greater heights. Since then JRG has undergone several
transformations- expanding into new geographies, adopting new state of art
technology, strengthening credit, and risk management systems, creating new
products and strengthening client relationships through service focus. The
company is committed to fully compliant with all regulatory compliances with the
exchanges, SEBI, IRDA, FMC, and RBI. JRG is listed on the BSE and has a
divers set of public shareholders.
RELIGARE
Religare is an emerging market financial services group with a presence across
Asia, Africa, Middle East, Europe and the Americas. In India Religares largest
market, the group offers a wide array of products and services including broking,
insurance, and asset management, lending solutions, investment banking and
wealth management. With more than 10000 employees across multiple
geographies, Religare serves over a million clients, including corporate and
institutions, high net worth families and individuals, and retail investors.
MUTHOOT SECURITIES
The Muthoot group has emerged as one of the Indias largest financial group of its
kind with business interest in 17 diverse fields, a network of over 2000 branches
MAXIMIZATION TOOL
25
nationwide and serving 750 million customers across the country. The muthoot
group with more than 16000 employers representing almost every culter and state
in the country, shall continue to provide supreme quality of service and earn the
trust of millions of people with its constant innovation and dynamism in the times
to come.
SHARE WEALTH
Sharewealth Securities Ltd is the first corporate member of National Stock
Exchange of India Ltd, Bombay Stock Exchange IndiaLtd and MCX Stock
Exchange from Thrissur, the cultural capital of Kerala. It is also depository
participant with CDSL ( Central Depository Services India Ltd). This securities
have two group companies:
Share wealth commodities Pvt Ltd
Share wealth Financial Services Ltd,
MOTILAL OSWAL
MotilalOswal Securities Ltd (MOSL) was founded in 1987 as a small sub-broking
unit, with just two people running the show. Focus on customer first attitude,
ethical and transparent business practises, respect for professionalism. Research
based value investing and implementation of innovative technology has enabled
us to blossom into an over 1600 member team. Today they are a well diversified
financial services firm offering a arrange of financial products and services such
as Wealth Management, broking & distribution. Commodity broking, portfolio
management services, institutional equities. Private equity, investment banking
services and principal strategies.
ANANDRATHI
AnandRathi is a leading full service investment bank founded in 1994 offering a
wide range of financial services and wealth management solutions to institutions,
corporations, high net worth individuals and families. The firm has rapidly
expanded its footprint to over 350 locations across India with international
presence in Hong Kong, Dubai & London.
MAXIMIZATION TOOL
26
ANGEL BROKING
Angel brokings tryst with excellence in customer relation began in 1987. Today,
angel has emerged as one of the most respected Stock broking and wealth
management companies in India. With the unique retail focused stock trading
business model, angel is committed to providing Real value for money to all its
clients.
RECENT CORPORATE ACTIONS
Reliance Industrial Infrastructure Limited announces a dividend - final
Rs.3.50 + special Re.0.25 per share on Annual General Meeting held on
20-5-2013.
IRB Infrastructure Developers Limited announces fourth interim
dividend @ Re.1/- per equity share on 20-5-2013
MT Educare Limited announces second interim dividend @ Re.1/- per
equity share.
Bharati Airtel announces annual general meeting / dividend Re 1 per
share on 23-5-2013.
Yes Bank Limited announces annual general meeting / final dividend
Rs.6/- per equity share on 23-5-2013.
Forbes & Company Ltd has informed BSE that a meeting of the Board of
Directors of the Company will be held on May 28, 2013, to consider the
following;

1. Audited Accounts of the Company for the year ended March 31, 2013.

2. Dividend for the year ended March 31, 2013, if any.
Redington (India) Ltd has informed BSE that :
"During February 2012, Redington International Mauritius Limited
(RIML), a Wholly Owned Subsidiary (WOS) of Redington (India) Ltd
had taken a five year term loan of USD 78 Million at all-inclusive interest
rate of LIBOR plus 5.50 % P.A.
We wish to inform you that RIML has negotiated a refinance loan from a
bank for the same amount and similar terms, but at a lesser all-inclusive
MAXIMIZATION TOOL
27
interest rate of LIBOR plus 3.50% P.A. and prepaid the existing loan. This
refinance will reduce significantly our interest cost by approximately USD
2.5 Million over the next 4 year period."

MAXIMIZATION TOOL
28
1.3 INTRODUCTION TO THE COMPANY
HEDGE EQUITIES LTD
Hedge equities ltd. is one of the leading retail stock broking house which is
running successfully in the country. Hedge offers its customers a wide range of
equity related services including trade execution on BSE , NSE , Derivatives ,
Depository services , online trading , investment advice etc.. The firm has an
online trading and investment site www.hedgeequities.com. The site gives access
to superior content and transaction facility to retail customers across the country.
As a first step to make our presence Global, Hedge Equities have initiated
operations in Middle East to cater to the vast Non Resident Indian (NRI)
population in that region. Known for its jargon- free, investor friendly language
and high quality research, the site has a registered base of over thousands of
customers. The content rich and research oriented portal has stood out among its
contemporaries because of its steadfast dedication to offering customers best-of-
breed technology and superior market information. Hedge Equities endeavor to
become a well reputed financial services super-mart catering to the evolving needs
and unique requirements of our clientele, and partnering with them to build,
manage, and grow their Wealth. The objective has been to let customers make
informed decision and to simplify the process of investing in stocks. Hedge
equities have always believed in investing in technology to build its business.

BACKGROUND AND INCEPTION OF THE COMPANY
Hedge Equities is one of the leading Financial Services Company in India,
specialized in offering a wide range of financial products, tailor made to suit
individual needs. As a first step to make our presence Global, Hedge Equities
have initiated operations in Middle East to cater to the vast Non Resident Indian
(NRI) population in that region. Ever since their inception, they have spanned
their presence all over India through their Meticulous Research, High Brand
Awareness, and Intellectual Management and Extensive Industry knowledge.
Hedge believes in creating a new breed of Investors who take judicious decisions
through them.
MAXIMIZATION TOOL
29
Team Hedge Equities is a balanced mix of more than 25 years of cutting edge
experience cutting across various industries with a strong background in the
financial market. The Board comprises of veterans from six power houses in their
respective fields: Fedex Securities, Baby Marine Exports, Thakker Developers,
Smart Financial, S.M.Hegde (CFO, Videocon Industries), and Padmashree Mohan
Lal.
Fedex securities: Managed by a team of ex-bankers, Fedex is a SEBI
registered category 1 merchant banker. The company concentrates on non-fund
based activities like structuring, tie up of project financing, financial restructuring
investment banking, corporate and advisory services. The core management team
consists of bankers with rich experience of decades and exposure to volatile
situations in commercial and investment banking. With offices at Nariman point
and Vile Parle east, Mumbai, state of the art infrastructure and qualified
manpower to conduct the business, Fedex securities envisages a phenomenal
growth in this sector for its clients.
Baby Marine Exports: Baby Marine Group, started its operation in 1977
from Kozhikode and through innovations and hard work has grown into three
unit and related industries spanning both the west and east coast of Indian. Baby
Marine Exports, B.M Products and Baby Marine (Eastern) Exports are
efficiently aided by pre-processing units, ice factories and a fleet of insulated
and refrigerated trucks for sea food transportation. Due to constant upgrading of
machinery, state-of-the-art infrastructural facilities, better links with raw
materials suppliers, and an established network of purchasers have obviously
made Baby Marine Group a leading exporter of processed marine products to
various international markets.
Smart financial: Smart financial entered the financial market only in 1992
but over this brief span has covered a niche for itself by becoming the leading
financial provider. The company offer guidance to investors as equities,
commodities, mutual funds portfolio management services and insurance. It
offers complete range of financial solutions that encompasses every sphere of life
Thakker group: Starting off as a land developer and builder in 1962,
Thakkers groups diversified into commercial production of agricultural and
horticultural products, housing real estate marketing plantation etc. They have
provided shelter to more than 40000 families by offering residential plots and
MAXIMIZATION TOOL
30
premises .Thakker developers is the flagship company of the group. It was
established as private limited in 1987 and later went on to become the only
public limited company in North Maharashtra engaged in housing ,commercial
construction and land development. The company is also a Class1 contractor
registered with the Public Work Department, Govt. of Maharashtra.
SM Hedge: Mr. S.M Hedge, a chartered accountant by profession is the
Chief Finance Officer of the Indian Multinational Videocon International and has
been at the helm of affairs for the last 20 year.
Padmashree Bharat Mohanlal: Mohanlal, the south Indian movie
superstar has become a legend, a brand and cultural ambassador owing to
various factors. Versatility and natural flair for donning complex characters have
won him numerous accolades not to speak of some unforgettable films
contributed by him. A multifaceted personality, he has some business ventures
also which include Vismaya Max Film Post Production Studio, College for
Dubbing Artists at the Kinfra film and Video Park Thiruvananthapuram. He is
the also the director of Uni Royal Marine Exports; a Seafood Export Company.
Intellectual and knowledge arbitrage is the mantra of modern day business. The
same holds true for the financial markets. With the breadth and depth of
knowledge of modern day business that the Board of Hedge brings to the table,
you can be rest assured that some of the best minds in the business are taking care
of your investments.
Mission
To create an ethical and sustainable financial services platform for
our customers and partner them to build business, to provide
employees with meaningful work, self-development and progression,
and to achieve a consistent and competitive growth in profit and
earnings for our shareholders and staff.
Vision
Ever since its inception, Hedge Equities has been a household name
among the masses owing our success to timely Professional financial
assistance to our clients. This aptly articulates our vision of 'Evolving
MAXIMIZATION TOOL
31
into a financial supermarket which will be a one stop shop for all
financial solutions.
Corporate Social Responsibility
Being a Responsible Corporate Citizen, Hedge Equities has initiated a Non Profit
movement, Hedge Yuva, which focuses on educating the masses about Stock
Market. The movement has also formulated various scholarship programs for
young and dynamic youth.
Hedge School of Applied Economics
In its efforts to promote financial education in the country, Hedge Equities has
launched the Hedge School of Applied Economics in the year 2010 with the
objective of creating professionals for the financial markets. The focus is to groom
students in share trading, banking, insurance or wealth management, by
implementing innovative solutions. The tailor-made syllabus is interspersed with
live class rooms, where live share trading is shown and explained. The packed
academic schedules are conducted in sessions led by experienced faculty, market
players from the trading and financial industry, and experts from BSE, NSE and
SEBI. The Hedge School will complement the motivating cause of attracting the
largely untapped segment.
Hedge Yuva
Hedge Equities has also initiated a non-profit movement called Hedge Yuva, an
ambitious programme aimed at propagating the virtues of stock market. The
movement seeks to trickle down to the micro level and educate the masses,
especially the youth, with the intention of converting liquid money to an
investment in shares. It is as part of this programme that the Hedge School of
Applied Economics was started. This movement believes in creating a financially
strong young India and this initiative is to enlighten the youth into making
educated investment decisions. To accelerate its objectives, it started to become
member of many social networking sites like Face book, Orkut, etc. and as a
result, they are getting faster response. They say that they looking forward for
smart investors. If any personal advice is needed, just drop in the details and
the rest will be assured.
MAXIMIZATION TOOL
32
Hedge Equities Wealth Management Services
As a part of national wise service development, Hedge Equities launched its
wealth management service (WMS) during December 2010. The services include
portfolio management services, portfolio advisory services and Mutual Fund
Advisory services. This service offering will have tailor-made investment
solutions for each client-based on their risk appetite.
The main objective of this WMS is to make a customer into a successful investor.
In order to understand the customers behavior and their risk bearing capacity,
hedge equities appointed certain wealth management service teams. They will
collect details regarding customers through questionnaires. After studying
consumers expectations and goals they will prepare special investment policies
and teach them its merits and demerits. Its the one of the main duties of WMS
teams. Team will choose investment policies from the different kind of assets like
Equity, Commodity, etc. The launch of Wealth Management Services has helped
the company in expanding its services in the State.
Hedge Dhruva
The company rolled out a mobile service outlet called Hedge Dhruva a new
concept aimed at imparting investment awareness programs throughout Kerala.
The vehicle has investment advisors and conduct investment awareness programs
throughout the state. The idea is being carried out through a mobile van which
will have investment advisors for providing proper financial education thereby,
improving the market participation. The focus will be more on the rural side of the
State where the company feels that there is lot of potential.
Product & Services of Hedge Equities
Equity Trading: Equity gives you the opportunity to have a partnership with
all the leading Business tycoons around the globe. Total capital contribution
for a company comprises of investments through equity share holdings by
small and big investors. The investors who have a stake in a company are
referred to as shareholders. Power of Equity shareholders lies in the optimum
selection of the Industry, have a strong belief in the Company's fundamentals
and also having a confidence in the profit making capability of the company.
MAXIMIZATION TOOL
33
Equity Market, at present, is a rewarding field for the investors and investing
in Indian stocks are profitable for not only the long and medium-term
investors, but also the position traders, short-term swing traders and also very
short term intra-day traders. Fundamentally, stock market is an avenue for
business people to meet shareholders. Other than bank loans, they now have
another option to finance their business. They did it by offering their
company's equities in exchange of shareholders cash. The company is never
required to repay the capital, but the new shareholders have a right to future
profits distributed by the company. For shareholders, they have alternatives to
where they should put their money into. In the same time, they get the
opportunity to participate in capital intensive businesses at an affordable price.
Equity is an investment area which you can capitalize on with proper
assistance regardless of the market circumstances. Hedge Equities opens the
door to this highly lucrative investment opportunity that could provide a
feasible solution to all your financial queries.
Commodities Trading: Commodity "futures" are contracts to buy or sell
certain goods at set prices at a predetermined time in the future. Futures
trading plays a key role in the marketing of a number of important agricultural
and nonagricultural commodities as it provides the industrial and farming
communities with a transparent price discovery platform, which also enables
them to hedge their price risk and price volatility. The growth of Indian
commodities futures trading towards an efficient, transparent and well-
organized market has thrown open a window of benefits and opportunities to
Indian producers and traders. Besides the primary benefits of its twin
economic functions of price discovery and price risk management, commodity
futures trading has also played an instrumental role in integrating various
fragmented components of the commodity ecosystem, thus developing the
overall infrastructure of agricultural commodities marketing in the country.
At present, 24 commodity futures exchanges are operational in India,
which include 21 regional bourses and the three national-level players, with
another three proposed exchanges on the cards. With the state-of the-art
technology-powered secure and efficient operational infrastructure, these
national exchanges are creating a near-perfect market situation with a much
MAXIMIZATION TOOL
34
wider participation from the ecosystem stakeholders in a large number of
domestic and global commodities during local and international timings.
While the trade in non-agricultural commodities, especially bullion and crude,
has increased in the past two financial years, the same in agricultural
commodities has declined. The share of agricultural commodities almost
halved during 2008-09, due to the continued ban on several commodities. The
clients can trade in commodity futures like gold, silver, crude oil, rubber etc.
And take advantage of the extended trading hours (10 am to 11pm) in
commodities trading.
Currency Trading: Investments in Currency Derivatives can help you to
diversify your portfolio from traditional asset classes. Currency derivatives
can be described as contracts between the sellers and buyers, whose values are
to be derived from the underlying assets, the currency amounts. These are
basically risk management tools in force and money markets used for hedging
risks and act as insurance against unforeseen and unpredictable currency and
interest rate movements. Any individual or corporate expecting to receive or
pay certain amounts in foreign currencies at future date can use these products
to opt for a fixed rate - at which the currencies can be exchanged now itself.
Mutual Funds: A Mutual Fund is a trust that pools the savings of a number of
investors who share a common financial goal. The money thus collected is
invested by the fund manager in different types of securities depending upon
the objective of the scheme. These could range from shares to debentures to
money market instruments. The income earned through these investments and
the capital appreciations realized by the scheme are shared by its unit holder.
Thus a Mutual Fund is the most suitable investment for the common man as it
offers an opportunity to invest in a diversified, professionally managed
portfolio at a relatively low cost.
Online trading: Hedge Equities has a large network of branches with online
terminals of NSE and BSE in the Capital market and derivative segments. The
clients are assured of prompt order execution through dedicated phones and expert
dealers at our offices.
MAXIMIZATION TOOL
35
Internet trading: Hedge Equities offers Internet trading through this site. You
can trade through the Internet from the comforts of your office or home, anywhere
in the world. The dedicated IT systems ensure service up time and speed, making
Internet broking through Hedge Equities hassle-free. Using the easiest facility
provided by NSDL, the clients can transfer the shares sold by them online without
delivery instruction slips. Additionally, digitally signed contract notes can be sent
to clients through E-mail.
Depository services: Hedge Equities is a member of the National Securities
Depository Limited (NSDL), offer depository services with minimum Annual
Maintenance Charges and transaction charges. Account holders can view their
holding position through the Internet. They also offer the easiest facility
provided by NSDL (electronic access to securities information and execution of
secured transaction) through which clients can give delivery instructions via the
Internet.
Derivative trading: Hedge offer trading in the futures and options segment of the
National Stock Exchange (NSE).Through the present derivative trading an
investor can take a short-term view on the market for up to a three months
perspective by paying a small margin on the futures segment and a small premium
in the options segment. In the case of options, if the trade goes in the opposite
direction the maximum loss will be limited to the premium paid.
Knowledge Centre: Knowledge Centre activities are intended to provide
systematic and structured services mainly to new investors and also to young
aspirant aiming for a career in financial markets. The centre has three functional
areas: the Publication Division, the Training Centre, and Wealth Management
Advisory Service. And the Hedge Equities initiates Hedge School of Applied
Economics with the sole objective of moulding highly qualified investment
professionals in the state.
Equity Research: Hedge Equities constantly strive to deliver insightful research
to enable pro-active investment decisions. The research department is broadly
divided into two divisions-Fundamental Analysis Group (FAG) and Technical
Analysis Group (TAG).The fundamental analysts are continuously scanning the
entire economy for discovering what they call the hidden gems in stock market
terminology and present it to the clients for profitable investments. Timing the
market has always been the most difficult task for all analysts and their Technical
MAXIMIZATION TOOL
36
Analysis Group has emerged to predict the market movements well in advance
using complex Analytical methods including Eliot Wave Theory. They are
equipped with cutting edge technologies for technical charting which assist the
technical analysts to predict both upside and downside movements efficiently for
the benefit of clients.
Portfolio Management Service: Hedge Equities is a SEBI-approved portfolio
manager offering discretionary and non-discretionary schemes to its clients.
Hedge Equities portfolio management team keeps track of the markets on a daily
basis and is exposed to a lot of information and analytic tools which an investor
would not normally have access to. Other technicalities pertaining to shares like
dividends, rights, bonus, buy-back, mergers and acquisitions are also taken care of
by them.

AREA OF OPERATION:
Hedge Equities has 130 branches in India and one branch in Dubai, UAE.
106 branches in Kerala
06 branches in Karnataka
07 branches in Maharashtra
01 branch in Tamilnadu.
Hedge Equities registered office is at Nariman Point, Mumbai and Corporate
office is in Kaloor, Kochi and their regional offices are in Bnagalore, Shimoga,
and Hyderabad. There are 117 employees in their Head office, 8-10 employees in
their Regional office and 4-5 employees in each branch.
Main Competitors:
Geojit BNP Parbas
JRG Securities
Religare
Muthoot Securities
Share wealth
MotilalOswal
MAXIMIZATION TOOL
37
Anandrathi
Angel Brocking
Functional departments
Client Relation Department: The client relation department assists the client or
customer top open an account in HEDGE EQUITIES (p) Ltd securities. This
department is also known as the front office. A client has to open two types of
accounts to trade and own securities in the NSE & BSE.
Finance Department: Thus a department, to organize financial activities may be
created under the direct control of the board of directors. Finance manager will
decide the major financial policy methods. Lower levels can delegate the other
routine activities.
Marketing Department: The major functions of marketing department are:
(i) Business associate development: The company takes up the marketing
activities of the various branches. It ensures an efficient marketing arena at its
various branches. The company encourages better relations in its branches and
promotes for the development of various marketing strategies.
(ii) Brand promotion: An important function of marketing department is to
promote the name of the company.
(iii) Investment promotion: The main clients of the company were its investors.
Hence the marketing department tries to capture as many investors as possible to
encourage them to invest.
(iv) Delivery promotion: Intraday trading is not always profitable and might
involve a lot of risk hence the company promotes for delivery were the shares are
kept to be sold for a later date analysing the profitability factors.
Systems Department: The systems department is playing a vital role in the day
operations of the company. It is through the systems department that the clients
can avail the facilities of Internet trading. Optic fibre cables and high bandwidth
connections from the Hedge Equities (P) Ltd office to the ISP, a dedicated server
and back-up ISDN connections were maintained directly by the systems
department. For the purpose of trading they have made use of two software
namely ODIN (Open Dealers Integrated Network)
Human Resources Department: Human resource is often considered as the back
bone of an organization even in this age of advanced automation and
MAXIMIZATION TOOL
38
mechanization. Since virtual organizations are not very much popular in our part
of the world, it is very important to any organization to have a HR department.
The presence of an excellent HR department increases the efficiency of an
organization considerably. Human resource management is defined as asset of
practices, policies and programmes designed to maximize both personal and
organizational goals.
a. Training and induction: The selected employees will undergo three days
continuous induction. During this period, he will undergo training with all the
department of Hedge Equities (P) Ltd Securities (India) Pt. Ltd. There will also
be classroom induction also within 3 months.
b. Wages and Salary Administration: The wages and salaries of the employees
were fixed and granted by the HR department with consent of the finance
department.
c. Performance Appraisal: It was human resources department which gives the
promotion to all employees, making transfers and taking disciplinary actions if
needed.
d. Grievance Handling: The grievance of employees were received only
through proper channels i.e., through the particular department heads. The HR
department will make solutions to the complaints as per the rules and regulations
of the company.
Trading Department: The department deals with the trading related activities of
the company. The trading refers to the buying and selling of shares. This
department is the most important part of the organization. There are two types of
trading. They are
a. Online Trading: These are the trading terminal of the organization. The
each computer of the department is termed as the trading terminal. The each
terminal is assigned with NCFM certified dealers, who is in charge of each portal
will do the trade according to the client request. The terminal is managed by
either NEAT (National Exchange for Automated Trading) software or ODIN
(Open Dealers Integrated Network) software. The client can also place his
through written request or through the telephone, in this the order will be place d
by the dealer.
b. Internet Trading: It is a facility provides by the company in order to trade
the securities from his convenient place like his office, home etc. the order will
MAXIMIZATION TOOL
39
be placed by the client itself, and he can make changes before the trade is done
for changing the price, cancellation of the order.
Delivery and Depository Department: Delivery refers to the share that bought
on particular day are not sold on that day itself and holding of the share for an
appreciation in the value of the security and to trade it on a future date. Deliver
Instruction Slip: it is a slip the client should fill and gave to the dealer regarding
the purchase of the share.
Equity Research Department: The function of the department is to study the
details regarding the share or securities and to make prediction regarding the
future performance of the company. The following types of approaches done
through this department:
i) Fundamental analysis
ii) Technical analysis

Management of the Company
Alex K Babu Managing Director
Bhuvanendran CEO
Bobby J Arakunnel COO
Mr. Mohanlal Director
Mr. Joy Arrackal Director
Dr.Samuel George Director
Pradeep Kumar C Director

MAXIMIZATION TOOL
40
Organisation Structure

MAXIMIZATION TOOL
41
Under the GM

Regional Organization Structure

MAXIMIZATION TOOL
42
1.4. RESEARCH METHODOLOGY

A) OBJECTIVE OF THE STUDY
For the effectiveness of the study the objectives are:
PRIMARY OBJECTIVE:
1. To analyse and determine the effectiveness of Financial Derivatives as a
risk diversification and profit maximization tool.

SECONDARY OBJECTIVES:
2. To study about the impact of hedging in the derivative market.
3. To construct an optimal portfolio to test the diversification strategy.
4. To study how to use derivatives, especially futures and options in volatile
markets to make profits maximization and risk reduction.
B) METHODOLOGY AND SAMPLE DESIGN

Research Problem
Stock market is an investment avenue where the returns can be maximum and
within no time. However, the market is volatile and the investment involves high
risk. Investors always expect the market to be bullish and give them maximum
possible returns. For that the risk diversification must be done. Hedging is a
popular method used by investors to reduce the risk and maximize the profit from
such investments. This research analyses whether hedging with financial
derivatives such as futures and options is effective in risk management.
Methodology of Data Collection
The data are collected in the form of secondary data. It is taken from published
reports, annual company reports, and library books and from the websites of NSE
and various other websites. The data used for the study and historical or secondary
nature. The companies are selected according to their beta value and market
capitalization.
MAXIMIZATION TOOL
43
Area of Study Index Futures and Options
Fluctuations in the market indices affect the investors investments in the stock
market. Stocks with high beta value have a positive change in response to the
market indices. Derivatives help to reduce to the risk of losing value due to the
volatility of the market. Index futures and index options were the first derivatives
to be introduced in India. These are basically derivative tools based on stock
index. They are considered to be the real risk management tools. Since the
derivatives are permitted legally, one can use them to insulate its portfolio against
the vagaries of the market.
Sample design / Portfolio Build up
For the purpose of the study a portfolio has been built with 10 companies from 5
different industries based on high beta value and market capitalization.
The companies and the industries are:

Industry Name Company Name Beta Value Market Cap in million
Steel TATA STEEL LTD. 2.04 290,150.59
JINDAL STEEL &
POWER LTD
1.5 266,240.69
Banking ICICI Bank Ltd 1.67 1,313,518.00
HDFC Bank Ltd 1.02 1,627,000.00
Telecom Idea Cellular LTD 1.08 449,054.41
Reliance Communications
Ltd
1.85 227,662.20
Power Adani Power Ltd 1.2 161,258.41
Reliance Power Ltd 1.61 194,535.50
Engineering Larsen & Toubro Ltd 1.55 868,572.69
Bharath Heavy Electricals
Ltd
1.34 478,138.69

MAXIMIZATION TOOL
44
C) SAMPLING PLAN
The data used is secondary data from the Indian stock market. Data is
collected from March 1
st
2013 to May 30
th
2013. The historical data
regarding the stock market index S&P Nifty, the futures index FUTIDX
NIFTY and OPTIDX Nifty are considered.
D) RESEARCH DESIGN
The research is conducted at Hedge Equities, Cochin. The type of research
used is descriptive research.
E) PERIOD OF STUDY
The period of study is from May 2
nd
2013 to June 15
th
2013, with duration
of 45 days.
F) SOURCES OF DATA COLLECTION
The nature of data used is historical data. The information is collected
from various textbooks, websites and company data.
G) STATISTICAL TOOLS USED FOR ANALYSIS

1) Beta value analysis
Beta is the slope of the characteristic regression line. The beta value
describes the relationship between the stocks return and the index returns.
Beta = +1
One percent change in market index return causes exactly one percent
change in the stock return indicates that the stock moves in tandem with
market.
Beta = +0.5
One percent changes in market index return causes 0.5 percent change in
the stock return. The stock is less volatile compared to the market.
Beta = +2
One percent change in market index return causes 2 percent change in the
stock return. The stock return is more volatile. When there is a decline in
the market return, the stock with beta of 2 would give a negative return of
20 percent. The stocks with more than 1 beta value are considered to be
risky.
MAXIMIZATION TOOL
45

Negative Beta value indicates that the stock return moves in the opposite
direction to the market return. A stock with a negative beta of -1 would
provide a return of 10 percent, if the market return declines by 10 percent
and vice versa. Stocks with negative returns are very rare.

Recipe for calculation of beta value:

= n X Y - ( x) y)
N x
2
- ( x) 2

Where
X Index Return
Y Stock Return
X Sum of Index return
Y Sum of stock return
N No. of days
The beta is calculated in excel sheet by using data on month of April of the
particular stock & Index market.

2) Weightage of Share
Weightage of share =

3) Hedge Ratio
Hedge Ratio=

MAXIMIZATION TOOL
46
1.5 SCOPE OF THE STUDY
1. The study is attempted to assess the power of hedging technique using
index futures and options
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 study is focused on the risk diversification using Nifty Index futures
and options only.
2) This study covers the Indian scenario of hedging in derivatives only.
3) The market is always volatile, so the prediction or anticipation that can be
used depends upon each individual investor.
4) The study is based on the past performance of the stock market, which
cannot guarantee future performance

1.7 CHAPTERISATION
Chapter 1 Introduction to the study
Deals with background of the problem, Industry Analysis, Introduction to the
company, research methodology, Scope of the study, Limitations of the study and
Chapterisation.
Chapter 2- Literature review
Includes the quotes about various topics related to the area of study. It also
includes the theoretical framework explaining the theories related to the subject.
Chapter 3 Data analysis and Discussion
MAXIMIZATION TOOL
47
Basic analysis of the economy, industry and the companies included in the
portfolio.
Profit or loss analysis of the portfolio without the use of derivatives.
Profit or loss analysis of the portfolio with the use of derivatives.
Effectiveness of hedging in the reduction of risk and profit maximization.

Chapter 4 Empirical result
Contains a detailed discussion on the basis of results of analysis

Chapter 5 Summary and Conclusion

MAXIMIZATION TOOL
48

CHAPTER 2
LITERATURE REVIEW

MAXIMIZATION TOOL
49
Comments about the effectiveness of Hedging by various
Scholars
Butterworth and Holmes (2000) studied hedging effectiveness of FTSE -100
and FTSE Mid 250 index futures contracts. They found that FTSE-100
provided effective hedge for portfolio dominated by large firms and FTSE
Mid 250 was equally effective for portfolios dominated by small
capitalizations stocks.
Brails ford et al. (2000) estimated hedge ratio by several techniques for the
Australian All Ordinary Share Price index futures contract. Yang (2009)
showed that M-GARCH dynamic hedge ratio provides largest degree of
reduction in variance of returns. Nonetheless, some recent studies for example
Lien et al (2011) and Moosa (2003) have reported that basic OLS approach
outperforms other advanced models of hedge ratio estimation. In India very
few studies were conducted on the hedging effectiveness of the Futures
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 futures contracts do not provide effective hedge in avoiding risk.
Bhaduri and Durai (2008) examined hedging effectiveness of Nifty Futures.
They found OLS based strategy provided better hedge in shorter time
horizons. However, at higher time horizons bivariate GARCH clearly
dominates. Further, Kumar et al (2008) examined hedging effectiveness of
constant and time varying hedge ratio of Nifty Futures, Gold Futures and
Soybean futures. Their results showed that the time varying hedge ratio
provided greatest variance reduction as compared to other hedges based on
constant hedge ratio. Investors studying the market often come across a
security, which they believe is intrinsically undervalued. It may be the case
that the profits and the profits the quality of the company make it seem worth
a lot more than the market think. A stock picker carefully purchases securities
based on a sense that they worth more than the market price. When doing so,
he faces two kinds of risks:
MAXIMIZATION TOOL
50
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.

2.1 Quotes about derivatives

The world seems to be divided into two camps: those who embrace
financial derivatives as the holy grail of the new investment area, and
those who denigrate derivatives as the financial Antichrist
David Edington.
Quoted in Risk, June 1994, p.67
Derivative products have undoubtedly allowed management to achieve
significant gains in the efficiency of their businesses, so much so that the
successful use of derivatives has become an essential component of
product management.
Risk Management: Laying Firmer Foundations
Controlling Risk:
Risk Magazine Special Supplement June 1995, p.21
People are not apologizing anymore for using derivatives. Theyve
realized that they are not the evil instruments they have been made out to
be.
Sarah Orsay
Derivatives Strategy
April, 1997, p.15

The beauty of derivatives is that they self-destruct every month and you
get another commission
Don Stone, NYSE specialist
Stealing the Market by Martin Mayer, 1992, p.84
MAXIMIZATION TOOL
51

Futures markets are designed to permit trading among strangers, as against
other markets which permit only trading among friends.
Terence Martell, former Research Director, COMEX
The Wall Street Journal, March 2, 1995, p.A14
The Key to understanding derivatives is a deeper understanding of all
thats underlying.
Morgan Stanley Dean Witter
Advertisement in Derivatives Strategy, October, 1997, p.15
You can think of a derivative as a mixture of its constituent underlies
much as a cake is a mixture of eggs, flour, and milk in carefully specified
proportions. The derivatives model provides a recipe for the mixture, one
whose ingredients quantities vary with time.
Emmanuel Derman
Risk, July 2001, p.48
Futures markers re an accurate representation of consensus opinion, but if
we pool all our ignorance, we do not get wisdom from it.
Jim Bianco
The Wall Street Journal, March 11, 2006
Page B3
A senior derivatives trader, interviewed recently by Risk, was asked how
he thought the derivatives market would develop over the next five years.
His response was a spin on an old joke- each desk will comprise a
sophisticated trading model, a trader, and a dog. The model will make all
the trading decisions; the trader acts as a back-up in case the model
crashes; the dog is trained to bite the trader if he or she tries to touch the
model in any other circumstance.
Nick Sawyer
Risk, September 2006 p.6
Hedging is a popular strategy for reducing risk and keeping a business
alive, among other things.
Gene Rotberg
MAXIMIZATION TOOL
52
Fortune, March 7, 1994, p.53
The markets will follow the path to hurt the highest number of hedgers.
The best hedges are those you alone put on.
Nassim Taleb
Derivatives Strategy. April 1997, p.25
It is often said in the derivatives business that you cannot hedge history.
Dan Goldman
Risk Management for the Investment Community(Risk Magazine Financial
Products Guide) 1999, p.16
Dealers make money by convincing people that they need derivatives. You
can no longer just hang out the shingle and hope to gain a competitive
advantage.
Craig Schiffer, Partner, Price Waterhouse
Risk, January, 1995
Derivatives are much more of a high volume, low margin production
business now. Once they were a labour of love, something that was
crafted. Now its about high volumes and high efficiency. Each year, you
have to run to stand still.
Rob Standing
Chase Manhattan
Risk, October, 1997, p.28
Most derivatives are sold rather than bought.
Robert Brooks
CFA Magazine, March/April 2004 p.42
Derivatives are like NFL quarterbacks. They get too much of the credit
and too much of the blame.
Gerald Corrigan, Goldman Sachs
Speech before the State of Wisconsin Investment Board
May 5, 1994
MAXIMIZATION TOOL
53
Derivatives are nothing more than a set of tools. And just as a saw can
build your house, it can cut off your arm if it isnt used properly.
Walter D Hops, Treasurer, Ciba-Geigy
Business Week, October 31, 1994, p.98
Well, it helps to look at derivatives like atoms. Split them one way and you
have heat and energy useful stuff. Split them another way and you have a
bomb. You have to understand the subtleties.
Moral Hazard
Kate Jennings
Fourth Estate, 2002, p.8
Derivatives are like prescription drugs. They can be beneficial when used
appropriately but they may be habit-forming and carry the risk of
unpleasant side effects.
David Litvack
Fitch
Risk, April 2006, p.20
A common misperception about risk management in some quarters is that
the use of derivative securities constitutes speculation- that is, the addition
of financial risk to the business risk of a firms operation. Some folks
think that condom use increases risk..!
Walter Dolde
The Trajectory of Corporate Risk Management
Journal of Applied Corporate Finance 1993, Vol.6, No.3, 33-41
We have seen situations where a company purged itself of derivatives and
the result was even greater risk than it had before.
Tanya S Beder, Principal
Capital Market Risk Advisors
Business Week, October 31, 1994, p.100
The Futures market is probably to our way of thinking the safest market in
the U.S
Patricia C Dunn, Managing Director
MAXIMIZATION TOOL
54
Wells Fargo Nikko Investment Advisors
Portfolio Manages Talk Futures and Risk Management
Chicago Mercantile Exchange Video Tape, 1995

The inappropriate use of derivatives can threaten a companys rating.
However, the absence of derivative activities also can increase the
volatility of corporate cash flows as significantly as their speculative use.
Fitch Investors Services
The Art Not Science of Risk Management
Risk Magazine Special Supplement, June 1995, p.2
Efficient risk sharing is what much of the futures and options revolution
has been all about.
Merton Miller
Financial Innovation and Economic Performance
Journal of Applied Corporate Finance, Vol.4 No.4, 1992
Derivatives are innovations in risk sharing, not in risk itself.
Big Bets Gone Bad, 1995, p.141
A bird in the hand approach is an apt way to describe the strategy of
todays options investor. Taking the immediate income of writing a
covered call, the battle-tested investor is strategically managing market
risk.
Lawrence Serven, President
Buttonwood Capital Management
Futures and Options World, October, 1995. Pp.73-74
With derivatives products and options you can pick any point of the payoff
distribution and sell off the others.
Stan Jonas
Derivatives Strategies, November, 1995, p.66

MAXIMIZATION TOOL
55
Fund managers who arent using futures and options are dealing with an
incomplete set of resources.
Paul Daley, Vice President and manager
ANB Investment Management and Trust Company
Portfolio Managers Talk Futures and Risk Management
Chicago Mercantile Exchange Video tape, 1995.

MAXIMIZATION TOOL
56
2.2THEORETICAL FRAMEWORK

INTRODUCTION
Avoiding risk is difficult no matter how you choose to invest. Most investors are
aware that you must take greater risks to achieve higher returns. However, no one
wants to take more risk than necessary to achieve one's financial goals.
There are some risks investors take for which they expect to be rewarded. Other
risks are so haphazard that they cannot be rewarded, nor should investors take
them. It is the latter kind of risk that investors eliminate through diversification.
Savvy investors don't take risks for which they don't get paid.
Risk is defined as the chance that an investment's actual return will be different
than expected. This includes the possibility of losing some or all of the original
investment.
All investments are subject to risk. It is generally believed that investors are
rewarded for taking risk. However, some risk is not rewarded. Investors need to
control or eliminate risks for which they are not rewarded from their investment
portfolio. Every investment is characterized by return and risk. In general, it refers
to the possibility of incurring a loss in a financial transaction. In finance, a person
making an investment expects to get some return from the investment in the
future. But, as future is uncertain, so is the future expected return. It is the
uncertainty associated with the returns from an investment that introduces risk
into an investment. So the essence of risk in an investment is the variation in its
returns. This variation in returns is caused by a number of factors constituting the
elements of risk the total variability in returns of a security represent the total risk
of that security. Systematic risk and unsystematic risk are the two components of
total risk. Thus,
Total risk = Systematic risk + Unsystematic risk
Systematic Risk - Systematic risk influences a large number of assets. A
significant political event, for example, could affect several of the assets in your
portfolio. It is virtually impossible to protect yourself against this type of risk.
MAXIMIZATION TOOL
57
Some events can affect all firms at the same time. Events such as inflation, war,
and fluctuating interest rates influence the entire economy, not just a specific firm
or industry. It is called systematic risk or market risk.
As the society is dynamic, changes occur in the economic, political and social
system constantly. These changes have an influence on the performance of
companies and thereby on their stock prices in varying degrees. The impact of
these changes is system-wide and that portion of total variability in security
returns caused by such system-wide factors is referred to as systematic risk.
Systematic risk is further subdivided into interest rate risk, market risk, and
purchasing power risk .Interest rate risk is a type of systematic risk that
particularly affects debt securities like bonds and debentures. The market price of
debt securities fluctuates in response to variations in the market interest rates. The
interest rate variations have an indirect impact on stock prices also. As interest
rate increase, margin trading becomes less attractive. The lower demand by
speculators may push down stock prices and vice versa. Interest rate risk is a
systematic risk affects bonds directly and shares indirectly. Market prices of
shares move up or down consistently. A general rise in share prices is referred to
as a bullish trend, whereas a general fall in share prices is referred to as a bearish
trend. Business cycles are considered to be a major determinant of the timing and
extent of the bull and bear phases. This volatile market leads to variations in the
returns of investors in shares. The variation in returns caused by the volatility of
the stock market is referred to as the market risk. Another type of systematic risk
is the purchasing power risk. It refers to the variation in investor returns caused by
inflation. The two important sources of inflation are raising costs of production
and excess demand for goods and services in relation to their supply. They are
known as cost-push and demand-pull respectively. In an inflationary economy,
rational investors would include an allowance for the purchasing power risk in
their estimate of the expected rate of return from an investment.
Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk".
This kind of risk affects a very small number of assets. An example is news that
affects a specific stock such as a sudden strike by employees. Unsystematic risk
(also called diversifiable risk) is risk that is specific to a company. This type of
risk could include dramatic events such as a strike, a natural disaster such as a fire,
MAXIMIZATION TOOL
58
or something as simple as slumping sales. Two common sources of unsystematic
risk are business risk and financial risk.
The returns from a security may sometimes vary because of certain factors
affecting only the company issuing such security like raw material scarcity, labour
strike etc. When availability of returns occurs because of such factors, it is known
as unsystematic risk. The unsystematic or unique risk affecting specific securities
arises from two sources: (a) the operating environment of the company and (b) the
financial pattern adopted by the company. These two types of unsystematic risk
are referred to as business risk and financial risk respectively. Every company
operates within a particular operating environment. This operating environment
comprises both internal environment within the firm and external environment
outside the firm. The impact of these conditions is reflected in the operating costs
of the company which are segregated into fixed costs and variable costs. Business
risk is thus a function of the operating conditions and is the variability in operating
income caused by the operating conditions. Financial risk is a function of financial
leverage which is the use of debt in the capital structure. The presence of debt in
the capital structure creates fixed payments in the form of interest which is a
compulsory to be made which creates more variability in the EPS. This is specific
to each company and forms part of its unsystematic risk. Financial risk is an
avoidable risk in so far as a company is free to finance its activities without
resorting to debt.
THE RISK-RETURN TRADEOFF
The risk-return tradeoff could easily be called the iron stomach test. Deciding
what amount of risk you can take on is one of the most important investment
decisions you will make.
The risk-return tradeoff is the balance an investor must decide on between the
desires for the lowest possible risk for the highest possible returns. Remember to
keep in mind that low levels of uncertainty (low risk) are associated with low
potential returns and high levels of uncertainty (high risk) are associated with high
potential returns.
MAXIMIZATION TOOL
59
The following chart shows an example of the risk/return tradeoff for investing. A
higher standard deviation means a higher risk:

MEASUREMENT OF RISK
An intelligent investor would attempt to anticipate the kind of risk that he
is likely to face. He would attempt to estimate the extent of risk associated with
different investment proposals. He tries to quantify the risk of each investment
that he considers before making the final selection. Risk in investment is
associated with return. The risk of an investment cannot be measured without
reference to return. The return, in turn, depends on the cash inflows to be received
from the investment. The expected return of the investment is the probability
weighted average of all the possible returns. If the possible returns are denoted by
and the related probabilities are (
) the expected return may be represented

as and can be calculated as:
=

It is the sum of the products of possible returns with their respective
probabilities. Expected returns are insufficient for decision making. The risk
aspect should also be considered. The most popular measure of risk is the variance
or standard deviation of the probability distribution of possible returns. Variance
is usually denoted by

and is calculated by the following formula:

[(
)]

The variance and standard deviation measure the extent of variability of
possible returns from the expected return. For an investor, the unsystematic risk is
MAXIMIZATION TOOL
60
not so important as it can be reduced through diversification. It is an irrelevant
risk. The risk that is relevant in investment decision-making is the systematic risk
because it is undiversifiable. Hence, the investor seeks to measure the systematic
risk of a security.
The systematic risk of a security is measured by a statistical measure
called Beta. Two statistical methods may be used for the calculation of Beta,
namely the correlation method or the regression method. Using the correlation
method, beta can be calculated from the historical data of returns by the following
formula:

, where

= Correlation coefficient,

= Standard deviation of returns of stock i.

= Standard deviation of returns of the market index.
= variance of market returns.

The second method of calculating beta is by using the regression method. The
form of regression equation is as follows:
, where
Y = Dependent variable, X = Independent variable, and are constants.
The formula used for the calculation of and are given below.

=
()()
()
, where
n = Number of items = Mean value of dependent variable
scores.
= Mean value of independent variable scores,
Y = Dependent variable scores X = Independent variable scores.
MAXIMIZATION TOOL
61

A security can have betas that are positive, negative or zero. A beta of 1.0
indicates a security of average risk. A stock with beta greater than 1.0 has above
average risk and vice versa.
PORTFOLIO
Portfolio is a financial term denoting a collection of investments held by an
investment company, hedge fund, financial institution or individual. The term
portfolio refers to any collection of financial assets such as stocks, bonds and
cash. Portfolios may be held by individual investors and/or managed by financial
professionals, hedge funds, banks and other financial institutions. It is a generally
accepted principle that a portfolio is designed according to the investor's risk
tolerance, time frame and investment objectives. The euro amount of each asset
may influence the risk/reward ratio of the portfolio and is referred to as the asset
allocation of the portfolio. When determining a proper asset allocation one aims at
maximizing the expected return and minimizing the risk.
A combination of securities with different risk and return characteristics will
constitute the portfolio of the investor. Thus, a portfolio is the combination of
various assets and/ or instruments of investments. The combination may have
different features of risk and return, separate from those of the components. The
portfolio is also built up out of the wealth or income of the investor over a period
of time, with a view to suit his risk and return preference to that of the portfolio
that he holds. The portfolio analysis of the risk and return characteristics of
individual securities in the portfolio and changes that may take place in
combination with other securities due to interaction among themselves and impact
of each one of them on others.
An investor considering investments in securities is faced with the problem of
choosing from among a large number of securities. His choice depends upon the
risk and return characteristics of individual securities. He would attempt to choose
the most desirable securities and like to allocate is funds over this group of
securities. Again he is faced with the problem of deciding which securities to hold
and how much to invest in each. The risk and return characteristics of portfolio
MAXIMIZATION TOOL
62
differ from those of individual securities combining to form a portfolio. The
investor tries to choose the optimal portfolio taking in to consideration the risk
return characteristics of all possible portfolios.
As the economy and the financial environment keep changing the risk return
characteristics of individual securities as well as portfolio also change. This calls
for periodical review and revision of investment portfolios of investors. An
investor invests his funds in a portfolio expecting to get a good return consistent
with the risk that he has to bear. The return realised from the portfolio has to be
measured and the performance of the portfolio has to be evaluated. Portfolio
management comprises all the processes involved in the creation and the
maintenance of an investment portfolio. It deals specifically with the security
analysis, portfolio analysis, portfolio selection, portfolio revision, and portfolio
evaluation. Portfolio management makes use of analytical techniques of analysis
and conceptual theories regarding rational allocation of funds. Portfolio
management is a complex process which tries to make investment activity more
rewarding and less risky.
OPTIMAL PORTFOLIO
The optimal portfolio concept falls under the modern portfolio theory. The theory
assumes (among other things) that investors fanatically try to minimize risk while
striving for the highest return possible. The theory states that investors will act
rationally, always making decisions aimed at maximizing their return for their
acceptable level of risk.
Harry Markowitz used the optimal portfolio in 1952, and it shows us that it is
possible for different portfolios to have varying levels of risk and return. Each
investor must decide how much risk they can handle and then allocate (or
diversify) their portfolio according to this decision.
The chart below illustrates how the optimal portfolio works. The optimal-risk
portfolio is usually determined to be somewhere in the middle of the curve
because as you go higher up the curve, you take on proportionately more risk for a
lower incremental return. On the other end, low risk/low return portfolios are
MAXIMIZATION TOOL
63
pointless because you can achieve a similar return by investing in risk-free assets,
like government securities.
You can choose how much volatility you are willing to bear in your portfolio by
picking any other point that falls on the efficient frontier. This will give you the
maximum return for the amount of risk you wish to accept. Optimizing your
portfolio is not something you can calculate in your head. There are computer
programs that are dedicated to determining optimal portfolios by estimating
hundreds (and sometimes thousands) of different expected returns for each given
amount of risk.
OPTIMAL PORTFOLIO OF SHARPE
This optimal portfolio of Sharpe is called the single Index Model. The optimal
portfolio is directly related to the Beta. If is expected return on stock i and is
Risk free Rate, then the excess return =
. This has to be adjusted to
,
namely
which is the equation for ranking stocks in the order of their return
adjusted for risk. The method involves selecting a cut off rate for inclusion of
securities in a portfolio. For this purpose, excess return to Beta ratio given above
has to be calculated for each stock and rank them from highest to lowest. Then
only those securities which have greater cut off point fixed in advance can be
selected. For a portfolio of i stocks is given by cut off rate.

MAXIMIZATION TOOL
64
CAPM
William F. Sharpe and John Linter developed the Capital Asset Pricing Model
(CAPM). The model is based on the portfolio theory developed by Harry
Markowitz. The model emphasises the risk factor in portfolio theory is a
combination of two risks, systematic risk and unsystematic risk. The model
suggests that a securitys return is directly related to its systematic risk, which
cannot be neutralised through diversification. The combination of both types of
risks stated above provides the total risk. The total variance of returns is equal to
market related variance plus companys specific variance. CAPM explains the
behaviour of security prices and provides a mechanism whereby investors could
assess the impact of a proposed security investment on the overall portfolio risk
and return. CAPM suggests that the prices of securities are determined in such a
way that the risk premium or excess returns are proportional to systematic risk,
which is indicated by the beta coefficient. The model is used for analysing the
risk-return implications of holding securities. CAPM refers to the manner in
which securities are valued in line with their anticipated risks and returns. A risk-
averse investor prefers to invest in risk-free securities. For a small investor having
few securities in his portfolio, the risk is greater. To reduce the unsystematic risk,
he must build up well-diversified securities in his portfolio.
The asset return depends on the amount for the asset today. The price paid must
ensure that the market portfolios risk/return characteristics improve when the
asset is added to it. The CAPM is a model, which derives the theoretical required
return (i.e. discount rate) for an asset in a market, given the risk-free rate available
to investors and the risk of the market as a whole.
The CAPM is usually expressed:

(Beta), is the measure of asset sensitivity to a movement in the overall market;
Beta is usually found via regression on historical data. Betas exceeding one
signify more than average riskiness; betas below one indicate lower than
average.

MAXIMIZATION TOOL
65
(R
f
) is the market premium, the historically observed excess return of the market
over the risk- free rate. Once the expected return, E(ri), is calculated using CAPM,
the future cash flows of the asset can be discounted to their present value using
this rate to establish the correct price for the asset.
A more risky stock will have a higher beta and will be discounted at a higher rate;
less sensitive stocks will have lower betas and be discounted at a lower rate. In
theory, an asset is correctly priced when its observed price is the same as its value
calculated using the CAPM derived discount rate. If the observed price is higher
than the valuation, then the asset is overvalued; it is undervalued for a too low
price.
ASSUMPTIONS TO CAPITAL ASSET PRICING MODEL
Because the CAPM is a theory, we must assume for argument that
1. All assets in the world are traded.
2. All assets are infinitely divisible.
3. All investors in the world collectively hold all assets.
4. For every borrower, there is a lender.
5. There is a riskless security in the world.
6. All investors borrow and lend at the riskless rate.
7. Everyone agrees on the inputs to the Mean-STD picture.
8. Preferences are well described by simple utility functions.
9. Security distributions are normal, or at least well described by two
parameters.
10. There are only two periods of time in our world.
This is a long list of requirements, and together they describe the capitalists ideal
world. 'Everything may be bought and sold in perfectly liquid fractional amounts
even human capital! There is a perfect, safe haven for risk-averse investors i.e. the
riskless asset. This means that everyone is an equally good credit risk! No one has
MAXIMIZATION TOOL
66
any informational advantage in the CAPM world. Everyone has already
generously shared all of their knowledge about the future risk and return of the
securities, so no one disagrees about expected returns. All customer preferences
are an open book risk attitudes are well described by a simple utility function.
There is no mystery about the shape of the future return distributions. Last but not
least, decisions are not complicated by the ability to change your mind through
time. You invest irrevocably at one point, and reap the rewards of your investment
in the next period at which time you and the investment problem cease to exist.
Terminal wealth is measured at that time i.e. he who dies with the most toys wins!
The technical name for this setting is A frictionless one-period, multi-asset
economy with no asymmetric information.
MARKOWITZ MEAN-VARIANCE MODEL
Harry Markowitz is regarded as the father of modern portfolio theory. According
to him, investors are mainly concerned with two properties of an asset: risk and
return, but by diversification of portfolio it is possible to trade-off between them.
The essence of his theory is that risk of an individual asset hardly matters to an
investor. What really counts is the contribution it makes to the investors total
risk. By turning his principle into a useful technique for selecting the right
portfolio from a range of different assets, he developed Mean Variance Analysis
in 1952. The thrust has been on balancing safety, liquidity and return depending
on the taste of different investors. The portfolio selection problem can be divided
into two stages, first finding the mean-variance efficient portfolios and secondly
selecting one such portfolio. Investors do not like risk and the greater the riskiness
of returns on an investment, the greater will be the returns expected by investors.
There is a trade-off between risk and return, which must be reflected in the
required rates of return on investment opportunities. The standard deviation (or
variance) of return measures the total risk of an investment. It is not necessary for
an investor to accept the total risk of an individual security. Investors can and do
diversify to reduce risk. As number of holdings approach larger, a good deal of
total risk is removed by diversification.

MAXIMIZATION TOOL
67
ASSUMPTIONS
This model has taken into account of risks associated with investments using
variance or standard deviation of the return. This model is based on the following
assumptions:
The return on an investment adequately summarises the outcome of the
investment.
All investors are risk-averse. For a given expected return he prefers to take
minimum risk, obviously for a given level of risk the investor prefers to
get maximum expected return.
Investors are assumed to be rational in so far as they would prefer greater
returns to lesser ones given equal or smaller risk and risk averse. Risk
aversion in this context means merely that, as between two investments
with equal expected returns, the investment with the smaller risk would be
preferred.
Return could be any suitable measure of monetary inflows such as NPV,
but yield has been the most commonly used measure of return, in this
context, so that where the standard deviation of returns is referred to we
shall mean the standard deviation of yield about its expected value.
The investors can visualise a probability distribution of rates of return.
The investors risk estimates are proportional to the variance of return they
perceive for a security or portfolio.
Investors base their investment decisions on two criteria i.e., expected
return and variance of return.
Harry M. Markowitz is credited with introducing new concepts of risk
measurement and their application to the selection of portfolios. He started with
the idea of risk aversion of average investors and their desire to maximize the
expected return with the least risk. Markowitz model is thus a theoretical
framework for analysis of risk and return and their inter-relationships. He used the
statistical analysis for measurement of risk and mathematical programming for
selection of assets in a portfolio in an efficient manner. His framework led to the
.concept of efficient portfolios. An efficient portfolio is expected to yield the
highest return for a given level of risk or lowest risk for a given level of return.
MAXIMIZATION TOOL
68
Markowitz postulated that diversification should not only aim at reducing the risk
of a security by reducing its variability or standard deviation, but by reducing the
covariance or interactive risk of two or more securities in a portfolio. As by
combination of different securities, it is theoretically possible to have a range of
risk varying from zero to infinity. Markowitz theory of portfolio diversification
attaches importance to standard deviation, to reduce it to zero, if possible,
covariance to have as much as possible negative interactive effect among the
securities within the portfolio and coefficient of correlation to have 1(-ive) so
that the overall risk of the portfolio as a whole is nil or negligible. Then the
securities have to be combined in a m3nner that standard deviation is zero.
EFFICIENT FRONTIER
Markowitz has formulised the risk return relationship and developed the concept
of efficient frontier. For selection of a portfolio, comparison between
combinations of portfolios is essential. As a rule, a portfolio is not efficient if
there is another portfolio with:
a higher expected value of return and a lower standard deviation (risk)
a higher expected value of return and the same standard deviations (risk).
the same expected value but a lower standard deviation (risk).
Markowitz has defined the diversification as the process of combining assets that
are less than perfectly positively correlated in order to reduce portfolio risk
without sacrificing any portfolio returns. If an investors portfolio is not efficient
he may:
increase the expected value of return without increasing the risk.
decrease the risk without decreasing the expected value of return, or
obtain some combination of increase of expected return and decreased
risk.
This is possible by switching to a portfolio on the efficient frontier. If all the
investments are plotted on the risk-return sphere, individual securities would be
dominated by portfolios, and the efficient frontier would take shape, indicating
investments which yield maximum return given the level of risk bearable, or
MAXIMIZATION TOOL
69
which minimises risk given the expected level of return. The figure depicts
the boundary of possible investments in securities A, B, C, D, E and F; and B, C,
D are lying on the efficient frontier.

The best combination of expected value of return and risk (standard deviation)
depends upon the investors utility function. The individual investor will want to
hold that portfolio of securities that places him on the highest indifference curves,
choosing from the set of available portfolios. The dark line at the top of the set is
the line of efficient combinations, or the efficient frontier. It depicts the trade-off
between risk and expected value of return.
The optimal investment achieved at a point where the indifference curve is at a
tangent to the efficient frontier. This point reflects the risk level acceptable to the
investor in order to achieve a desired return and provide maximum return for the
bearable level of risk. The concept of efficient frontier, and the optimal point
location is explained with help of next figure. A, B, C, D, E and F define the
boundary of all possible investments out of which investments in B, C and D are
the efficient proposals lying on the efficient frontier. The attractiveness of the
investment proposals lying on the efficient frontier depends on the investors
attitude to risk. At point B, the level of risk and return is at optimum level. The
returns are the highest at point D, but simultaneously it carries higher risk than
any other investment.

MAXIMIZATION TOOL
70
The shaded area represents all attainable portfolios that are all the combinations of
risk and expected return that may be achieved with the available securities. The
efficient frontier denotes all possible efficient portfolios and any point on the
frontier dominates any point to the right of it.
EFFICIENT MARKET HYPOTHESIS
In finance, the efficient-market hypothesis (EMH) asserts that financial markets
are "informationally efficient". That is, one cannot consistently achieve returns in
excess of average market returns on a risk-adjusted basis, given the information
available at the time the investment is made. The efficient-market hypothesis was
developed by Professor Eugene Fama as an academic concept of study through his
published Ph.D. thesis in the early 1960s at the same school. Any one person can
be wrong about the market, indeed, everyone can be, but the market as a whole is
always right. There are three common forms in which the efficient-market
hypothesis is commonly stated- weak-form efficiency, semi-strong-form
efficiency and strong-form efficiency, which has different implications for how
markets work.
In weak-form efficiency, future prices cannot be predicted by analyzing prices
from the past. Excess returns cannot be earned in the long run by using investment
strategies based on historical share prices or other historical data. Share prices
exhibit no serial dependencies. This implies that future price movements are
determined entirely by information not contained in the price series. Hence, prices

MAXIMIZATION TOOL
71
must follow a random walk. This does not require that prices remain at or near
equilibrium, but only that market participants not be able to systematically profit
from market 'inefficiencies'.
In semi-strong-form efficiency, it is implied that share prices adjust to publicly
available new information very rapidly and in an unbiased fashion, such that no
excess returns can be earned by trading on that information. It implies that neither
fundamental analysis nor technical analysis techniques will reliably produce
excess returns. To test for semi-strong-form efficiency, the adjustments to
previously unknown news must be of a reasonable size and must be instantaneous.
In strong-form efficiency, share prices reflect all information, and no one can earn
excess returns. If there are legal barriers to private information becoming public,
strong-form efficiency is impossible. To test for strong-form efficiency, a market
needs to exist where investors cannot consistently earn excess returns over a long
period of time. Even if some money managers are consistently observed to beat
the market, no refutation even of strong-form efficiency follows: with thousands
of fund managers worldwide, even a normal distribution of returns should be
expected to produce a few dozen "star" performers.
PORTFOLIO DESIGN
Before designing a portfolio one will have to know the intention of the investor or
the returns that the investor is expecting from his investment. This will help in
adjusting the amount of risk. This becomes an important point of view of the
portfolio designer because if the investor will be ready to take more risk at the
same time he will also get more returns. This can be more appropriately
understood from the figure drawn below.
MAXIMIZATION TOOL
72

From the above figure we can see that when the investor is ready to take the risk
of M1, he is likely to get expected return of R1, and if the investor is taking the
risk of M2, he will be getting more returns i.e. R2. So we can conclude that risk
and return is directly related with each other. As one increases the other will also
increase in same of different proportion and same if one decreases the other will
also decreases.
From the above discussion we can conclude that the investors can be of the
following:
1. Investors willing to take minimum risk and at the same time are also
expecting minimum returns.
2. Investors willing to take moderate risk and the same time are also
expecting moderate returns.
3. Investors willing to take maximum risk and at the same time are also
expecting maximum returns.
RISK REDUCTION BY DIVERSIFICATION OF THE PORTFOLIO
Diversification means dividing your investments among a variety of assets.
Diversification helps to reduce risk because different investments rise and fall
independent of each other. The combinations of these assets more often than not
will cancel out each other's fluctuations, therefore reducing risk. Diversification
helps to reduce risk because different investments rise and fall independent of
each other. There are many ways to diversify your investment portfolio. You can
MAXIMIZATION TOOL
73
diversify across one type of asset classificationsuch as stocks. For example, you
might purchase shares in the leading companies across many different (and
unrelated) industries. Alternatively, you can diversify your portfolio across
different types of assets such as stocks, bonds, and real estate, for example. You
can also diversify on the basis of regional decisions such as state, region, or
country. Simply stated, diversification means "don't put all your eggs into one
basket."
The ultimate goal of diversification is to improve performance while reducing
investment risks. A well-diversified portfolio spreads risks over a range of
investments whose performances are not tied to the performance of the other
assets in the portfolio.
Diversification is a risk-management technique that mixes a wide variety of
investments within a portfolio in order to minimize the impact that any one
security will have on the overall performance of the portfolio Diversification
lowers the risk of your portfolio. Academics have complex formulas to
demonstrate how this works, but we can explain it clearly with an example:
Suppose that you live on an island where the entire economy consists of only two
companies: one sells umbrellas, while the other sells sunscreen. If you invest your
entire portfolio in the company that sells umbrellas, youll have strong
performance during the rainy season, but poor performance when its sunny
outside. The reverse occurs with the sunscreen company, the alternative
investment; your portfolio will be high performance when the sun is out, but it
will tank when the clouds roll in. Chances are youd rather have constant, steady
returns. The solution is to invest 50% in one company and 50% in the other.
Because you have diversified your portfolio, you will get decent performance year
round, instead of having either excellent or terrible performance depending on the
season
There are three main things that should ensure that the portfolio is adequately
diversified:
1. The portfolio should be spread among many different investment vehicles
such as cash, stocks, bonds, mutual funds, and perhaps even some real
estate.
MAXIMIZATION TOOL
74
2. The securities should vary in risk. You're not restricted to picking only
blue chip stocks. In fact, the opposite is true. Picking different investments
with different rates of return will ensure that large gains offset losses in
other areas.
3. The securities should vary by industry, minimizing unsystematic risk to
small groups of companies.
Diversification can greatly reduce unsystematic risk from a portfolio. It is unlikely
that events such as the ones listed above would happen in every firm at the same
time. Therefore, by diversifying, one can reduce their risk. There is no reward for
taking on unneeded unsystematic risk.
Investors are induced to take risks for potentially higher returns. However, not all
risks offer such potential rewards. The wise investor identifies these risks and
eliminates them from his or her portfolio through diversification.
Diversification helps reduce risk from an investment portfolio by eliminating
unsystematic risk from the portfolio. By choosing securities of different
companies in different industries, you can minimize the risks associated with a
particular company's "bad luck." By diversifying among asset classes that are
negatively or weakly correlated (i.e., whose up or down price movements don't
mirror each other), you further reduce the volatility of your portfolio.
However, diversification can reduce the return of your portfolio as well. By
selecting several assets, the overall return on your portfolio will be the weighted
average of the returns of those assets. For example, let us look at a portfolio made
up 50/50 of a single stock and a single bond. In one year, the stock has a total
return of 30 percent, the bond 6 percent. The portfolio return will be only 18
percent (36 divided by 2). However, if the entire portfolio were invested in the
stock, the return would have been 30 percent.
Many investors feel that settling for a lower average return is a small price to pay
for eliminating risks for which they cannot be rewarded (unsystematic risk) from
their portfolio. They might argue that if the stock in the example above tanked,
then 3% would look pretty good. Of course, in practice these extremes, while
possible, are rare.
MAXIMIZATION TOOL
75
Diversification reduces portfolio risk by eliminating unsystematic risk for which
investors are not rewarded. Investors are rewarded for taking market risk. Because
diversification averages the returns of the assets within the portfolio, it attenuates
the potential highs and lows. Diversification among companies, industries, and
asset classes affords the investor the greatest protection against business risk,
financial risk, and volatility.
Diversification is the most important component in helping you reach your long-
range financial goals while minimizing your risk. At the same time, diversification
is not an ironclad guarantee against loss. No matter how much diversification you
employ, investing does involve taking on some risk.
Another question that frequently baffles investors is how many stocks should be
bought in order to reach optimal diversification. According to portfolio theorists,
adding about 20 securities to your portfolio reduces almost all of the individual
security risk involved. This assumes that you buy stocks of different sizes from
various industries.
FINANCIAL DERIVATIVES
A derivative is a financial instrument which derives its value from the value of
underlying entities such as an asset, index, or interest rate--it has no intrinsic value
in itself. Derivative transactions include a variety of financial contracts, including
structured debt obligations and deposits, swaps, futures, options, caps, floors,
collars, forwards, and various combinations of these.
The term Derivative indicates that it has no independent value, i.e., its value is
entirely derived from the value of the underlying asset. The underlying asset can
be securities, commodities, bullion, currency, livestock or anything else. In other
words, derivative means forward, futures, option or any other hybrid contract of
predetermined fixed duration, linked for the purpose of contract fulfillment to the
value of a specified real or financial asset or to an index of securities.
The Securities Contracts (Regulation) Act 1956 defines derivative as under:
Derivative includes
MAXIMIZATION TOOL
76
1. Security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other form
of security.

2. A contract which derives its value from the prices, or index of prices of
underlying securities.
The above definition conveys that
The derivatives are financial products.
Derivative is derived from another financial instrument/contract called the
underlying. In the case of Nifty futures, Nifty index is the underlying. A
derivative derives its value from the underlying assets. Accounting
Standard SFAS133 defines a derivative as, a derivative instrument is a
financial derivative or other contract with all three of the following
characteristics:
i. It has (1) one or more underlyings, and (2) one or more notional amount or
payments provisions or both. Those terms determine the amount of the
settlement or settlements.
ii. It requires no initial net investment or an initial net investment that is
smaller than would be required for other types of contract that would be
expected to have a similar response to changes in market factors.
iii. Its terms require or permit net settlement. It can be readily settled net by a
means outside the contract or it provides for delivery of an asset that puts
the recipients in a position not substantially different from net settlement.
In general, from the aforementioned, derivatives refer to securities or to contracts
that derive from anotherwhose value depends on another contract or assets. As
such the financial derivatives are financial instruments whose prices or values are
derived from the prices of other underlying financial instruments or financial
assets. The underlying instruments may be a equity share, stock, bond, debenture
treasury bill, foreign currency or even another derivative asset. For example, a
stock options value depends upon the value of a stock on which the option is
written. Similarly, the value of a treasury bill of futures contracts or foreign
currency forward contract will depend upon the price or value of the underlying
MAXIMIZATION TOOL
77
assets, such as Treasury bill or foreign currency. In other words, the price of the
derivative is not arbitrary rather it is linked or affected to the price of the
underlying asset that will automatically affect the price of the financial derivative.
Due to this reason, transactions in derivative markets are used to offset the risk of
price changes in the underlying assets. In fact, the derivatives can be formed on
almost any variable. for example, from the price of hogs to the among of snow
falling at a certain ski resort.
The term financial derivative relates with a variety of financial instruments which
include stocks, treasury bills, interest rate, foreign currencies and other hybrid
securities. Financial derivatives include futures, forwards, options, swaps, etc.
Futures contracts are the most important form of derivatives which are in
existence long before the term derivative was coined. Financial derivatives can
also be derived from a combination of cash market instruments or other financial
derivative instruments. In fact most of the financial derivatives are not
revolutionary new instruments rather they are merely combinations of older
generation derivatives and/or standard cash market instruments.
In the 1980s, the financial derivatives were also known as off-balance sheet
instruments because no asset or liability underlying the contract was put on the
balance sheet as such. Since the value of such derivatives depend upon the
movement of market prices of the underlying assets, hence, they were treated as
contingent asset or liabilities and such transactions and positions in derivatives
were not recorded on the balance sheet. However, it is a matter of considerable
debate whether off-balance sheet instruments should be included in the definition
of derivatives. Which item or product given in the balance sheet should be
considered for derivative is a debatable issue.
In brief, the term financial market derivative can be defined as a treasury or
capital market instrument which is derived from, or bears a close relation to a
cash instrument or another derivative instrument. Hence, financial derivatives are
financial instruments whose prices are derived from the prices of other financial
instruments.
In practice, derivatives are a contract between two parties that specify conditions
(especially the dates, resulting values and definitions of the underlying variables,
the parties' contractual obligations, and the notional amount) under which
MAXIMIZATION TOOL
78
payments are to be made between the parties. The most common underlying assets
include commodities, stocks, bonds, interest rates and currencies.
There are two groups of derivative contracts: the privately traded Over-the-
counter (OTC) derivatives such as swaps that do not go through an exchange or
other intermediary, and exchange-traded derivatives (ETD) that are traded through
specialized derivatives exchanges or other exchanges.
Derivatives are more common in the modern era, but their origins trace back
several centuries. One of the oldest derivatives is rice futures, which have been
traded on the Dojima Rice Exchange since the eighteenth century. Derivatives are
broadly categorized by the relationship between the underlying asset and the
derivative (such as forward, option, swap); the type of underlying asset (such as
equity derivatives, foreign exchange derivatives, interest rate derivatives,
commodity derivatives, or credit derivatives); the market in which they trade
(such as exchange-traded or over-the-counter); and their pay-off profile.
Derivatives may broadly be categorized as "lock" or "option" products. Lock
products (such as swaps, futures, or forwards) obligate the contractual parties to
the terms over the life of the contract. Option products (such as interest rate caps)
provide the buyer the right, but not the obligation to enter the contract under the
terms specified.
Derivatives can be used either for risk management (i.e. to "hedge" by providing
offsetting compensation in case of an undesired event, a kind of "insurance") or
for speculation (i.e. making a financial "bet"). This distinction is important
because the former is a legitimate, often prudent aspect of operations and financial
management for many firms across many industries; the latter offers managers
and investors a seductive opportunity to increase profit, but not without incurring
additional risk that is often undisclosed to stakeholders.
FEATURES OF A FINANCIAL DERIVATIVE
The basic features of the derivative instrument can be drawn from the general
definition of a derivative irrespective of its type. Derivatives or derivative
securities are future contracts which are written between two parties (counter
MAXIMIZATION TOOL
79
parties) and whose value are derived from the value of underlying widely held and
easily marketable assets such as agricultural and other physical (tangible)
commodities, or short term and long term financial instruments, or intangible
things like weather, commodities price index (inflation rate), equity price index,
bond price index, stock market index, etc. Usually, the counter parties to such
contracts are those other than the original issuer (holder) of the underlying asset.
From this definition, the basic features of a derivative may be stated as follows:
1. A derivative instrument relates to the future contract between two parties.
It means there must be a contract-binding on the underlying parties and the same
to be fulfilled in future. The future period may be short or long depending upon
the nature of contract, for example, short term interest rate futures and long term
interest rate futures contract.
2. Normally, the derivative instruments have the value which derived from
the values of other underlying assets, such as agricultural commodities, metals,
financial assets, intangible assets, etc. Value of derivatives depends upon the value
of underlying instrument and which changes as per the changes in the underlying
assets, and sometimes, it may be nil or zero. Hence, they are closely related.
3. In general, the counter parties have specified obligation under the
derivative contract. Obviously, the nature of the obligation would be different as
per the type of the instrument of a derivative. For example, the obligation of the
counter parties, under the different derivatives, such as forward contract, future
contract, option contract and swap contract would be different.
4. The derivatives contracts can be undertaken directly between the two
parties or through the particular exchange like financial futures contracts. The
exchange-traded derivatives are quite liquid and have low transaction costs in
comparison to tailor-made contracts. Example of exchange traded derivatives are
Dow Jons, S&P 500, Nikki 225, NIFTY option, S&P Junior that are traded on
New York Stock Exchange, Tokyo Stock Exchange, National Stock Exchange,
Bombay Stock Exchange and so on.
5. In general, the financial derivatives are carried off-balance sheet. The size
of the derivative contract depends upon its notional amount. The notional amount
MAXIMIZATION TOOL
80
is the amount used to calculate the pay off. For instance, in the option contract, the
potential loss and potential payoff, both may be different from the value of
underlying shares, because the payoff of derivative products differs from the
payoff that their notional amount might suggest.
6. Usually, in derivatives trading, the taking or making of delivery of
underlying assets is not involved; rather underlying transactions are mostly settled
by taking offsetting positions in the derivatives themselves. There is, therefore, no
effective limit on the quantity of claims, which can be traded in respect of
underlying assets.
7. Derivatives are also known as deferred delivery or deferred payment
instrument. It means that it is easier to take short or long position in derivatives in
comparison to other assets or securities. Further, it is possible to combine them to
match specific, i.e., they are more easily amenable to financial engineering.
8. Derivatives are mostly secondary market instruments and have little
usefulness in mobilizing fresh capital by the corporate world, however, warrants
and convertibles are exception in this respect.
9. Although in the market, the standardized, general and exchange-traded
derivatives are being increasingly evolved, however, still there are so many
privately negotiated customized, over-the- counter (OTC) traded derivatives are in
existence. They expose the trading parties to operational risk, counter-party risk
and legal risk. Further, there may also be uncertainty about the regulatory status of
such derivatives.
10. Finally, the derivative instruments, sometimes, because of their off-
balance sheet nature, can be used to clear up the balance sheet. For example, a
fund manager who is restricted from taking particular currency can buy a
structured note whose coupon is tied to the performance of a particular currency
pair.
USAGE OF DERIVATIVES
Derivatives are used by investors for the following:
MAXIMIZATION TOOL
81
hedge or mitigate risk in the underlying, by entering into a derivative
contract whose value moves in the opposite direction to their underlying
position and cancels part or all of it out;
create option ability where the value of the derivative is linked to a
specific condition or event (e.g. the underlying reaching a specific price
level);
obtain exposure to the underlying where it is not possible to trade in the
underlying (e.g., weather derivatives);
provide leverage (or gearing), such that a small movement in the
underlying value can cause a large difference in the value of the derivative;
Speculate and make a profit if the value of the underlying asset moves the
way they expect (e.g., moves in a given direction, stays in or out of a
specified range, reaches a certain level).
Switch asset allocations between different asset classes without disturbing
the underlining assets, as part of transition management.
SERVICES PROVIDED BY DERIVATIVES
Derivatives are supposed to provide the following services:
1. One of the most important services provided by the derivatives is to control,
avoid, shift and manage efficiently different types of risks through various
strategies like hedging, arbitraging, spreading, etc. Derivatives assist the
holders to shift or modify suitably the risk characteristics of their portfolios.
These are specifically useful in highly volatile financial market conditions like
erratic trading, highly flexible interest rates, volatile exchange rates and
monetary chaos.
2. Derivatives serve as barometers of the future trends in prices which result in
the discovery of new prices both on the spot and futures markets. Further, they
help in disseminating different information regarding the futures markets
trading of various commodities and securities to the society which enable to
discover or form suitable or correct or true equilibrium prices in the markets.
As a result, they assist in appropriate and superior allocation of resources in
the society.
MAXIMIZATION TOOL
82
3. As we see that in derivatives trading no immediate full amount of the
transaction is required since most of them are based on margin trading. As a
result, large number of traders, speculators arbitrageurs operates in such
markets. So, derivatives trading enhance liquidity and reduce transaction costs
in the markets for underlying-assets.
4. The derivatives assist the investors, traders and managers of large pools of
funds to devise such strategies so that they may make proper asset allocation
increase their yields and achieve other investment goals.
5. It has been observed from the derivatives trading in the market that the
derivatives have smoothen out price fluctuations, squeeze the price spread,
integrate price structure at different points of time and remove gluts and
shortages in the markets.
6. The derivatives trading encourage the competitive trading in the markets,
different risk taking preference of the market operators like speculators,
hedgers, traders, arbitrageurs, etc. resulting in increase in trading volume in
the country. They also attract young investors, professionals and other experts
who will act as catalysts to the growth of financial markets.
7. Lastly, it is observed that derivatives trading develop the market towards
complete markets. Complete market concept refers to that situation where no
particular investors be better of than others, or patterns of returns of all
additional securities are spanned by the already existing securities in it, or
there is no further scope of additional security.

TYPES OF DERIVATIVES
OTC AND EXCHANGE-TRADED
In broad terms, there are two groups of derivative contracts, which are
distinguished by the way they are traded in the market:
Over-the-counter (OTC) derivatives are contracts that are traded (and
privately negotiated) directly between two parties, without going through
MAXIMIZATION TOOL
83
an exchange or other intermediary. Products such as swaps, forward rate
agreements, exotic options and other exotic derivatives are almost
always traded in this way. The OTC derivative market is the largest market
for derivatives, and is largely unregulated with respect to disclosure of
information between the parties, since the OTC market is made up of
banks and other highly sophisticated parties, such as hedge funds.
Reporting of OTC amounts are difficult because trades can occur in
private, without activity being visible on any exchange.
Exchange-traded derivatives (ETD) are those derivatives instruments that
are traded via specialized derivatives exchanges or other exchanges. A
derivatives exchange is a market where individuals trade standardized
contracts that have been defined by the exchange. A derivatives exchange
acts as an intermediary to all related transactions, and takes initial margin
from both sides of the trade to act as a guarantee. The world's largest
derivatives exchanges (by number of transactions) are the Korea Exchange
(which lists KOSPI Index Futures & Options), Eurex (which lists a wide
range of European products such as interest rate & index products), and
CME Group (made up of the 2007 merger of the Chicago Mercantile
Exchange and the Chicago Board of Trade and the 2008 acquisition of the
New York Mercantile Exchange). According to BIS, the combined
turnover in the world's derivatives exchanges totaled USD 344 trillion
during Q4 2005. By December 2007 the Bank for International
Settlements reported that "derivatives traded on exchanges surged 27% to
a record $681 trillion."
COMMON DERIVATIVE CONTRACT TYPES
Some of the common variants of derivative contracts are as follows:
1. Forwards: A tailored contract between two parties, where payment takes
place at a specific time in the future at today's pre-determined price.
2. Futures: are contracts to buy or sell an asset on or before a future date at a
price specified today. A futures contract differs from a forward contract in
that the futures contract is a standardized contract written by a clearing
house that operates an exchange where the contract can be bought and
MAXIMIZATION TOOL
84
sold; the forward contract is a non-standardized contract written by the
parties themselves.
3. Options are contracts that give the owner the right, but not the obligation,
to buy (in the case of a call option) or sell (in the case of a put option) an
asset. The price at which the sale takes place is known as the strike price,
and is specified at the time the parties enter into the option. The option
contract also specifies a maturity date. In the case of a European option,
the owner has the right to require the sale to take place on (but not before)
the maturity date; in the case of an American option, the owner can require
the sale to take place at any time up to the maturity date. If the owner of
the contract exercises this right, the counter-party has the obligation to
carry out the transaction. Options are of two types: call option and put
option. The buyer of a Call option has a right to buy a certain quantity of
the underlying asset, at a specified price on or before a given date in the
future, he however has no obligation whatsoever to carry out this right.
Similarly, the buyer of a Put option has the right to sell a certain quantity
of an underlying asset, at a specified price on or before a given date in the
future, he however has no obligation whatsoever to carry out this right.
4. Binary options are contracts that provide the owner with an all-or-nothing
profit profile.
5. Warrants: Apart from the commonly used short-dated options which have
a maximum maturity period of 1 year, there exists certain long-dated
options as well, known as Warrant (finance). These are generally traded
over-the-counter.
6. Swaps are contracts to exchange cash (flows) on or before a specified
future date based on the underlying value of currencies exchange rates,
bonds/interest rates, commodities exchange, stocks or other assets.
Another term which is commonly associated to Swap is Swaption which is
basically an option on the forward Swap. Similar to a Call and Put option,
a Swaption is of two kinds: a receiver Swaption and a payer Swaption.
While on one hand, in case of a receiver Swaption there is an option
wherein you can receive fixed and pay floating, a payer swaption on the
other hand is an option to pay fixed and receive floating.
MAXIMIZATION TOOL
85
Swaps can basically be categorized into two types:
Interest rate swap: These basically necessitate swapping only interest
associated cash flows in the same currency, between two parties.
Currency swap: In this kind of swapping, the cash flow between the two
parties includes both principal and interest. Also, the money which is
being swapped is in different currency for both parties.
OPTIONS
An option is a contract which gives the owner the right, but not the obligation,
to buy or sell an underlying asset or instrument at a specified strike price on or
before a specified date. The seller incurs a corresponding obligation to fulfill
the transaction that is to sell or buy, if the long holder elects to "exercise" the
option prior to expiration. The buyer pays a premium to the seller for this
right. An option which conveys the right to buy something at a specific price
is called a call; an option which conveys the right to sell something at a
specific price is called a put. Options come in two varieties, calls and puts, and
you can buy or sell either type. You make those choices - whether to buy or
sell and whether to choose a call or a put - based on what you want to achieve
as an options investor.
EQUITY OPTIONS
An equity option is a contract which conveys to its holder the right, but not the
obligation, to buy (in the case of a call) or sell (in the case of a put) shares of
the underlying security at a specified price (the strike price) on or before a
given date (expiration day). After this given date, the option ceases to exist.
The seller of an option is, in turn, obligated to sell (in the case of a call) or buy
(in the case of a put) the shares to (or from) the buyer of the option at the
specified price upon the buyer's request.
STRIKE PRICE
Strike prices (or exercise prices) are the stated price per share for which the
underlying security may be purchased (in the case of a call) or sold (in the
case of a put) by the option holder upon exercise of the option contract. The
strike price, a fixed specification of an option contract, should not be confused
MAXIMIZATION TOOL
86
with the premium, the price at which the contract trades, which fluctuates
daily.
The strike price (or exercise price) of an option is the fixed price at which the
owner of the option can purchase (in the case of a call), or sell (in the case of a
put), the underlying security or commodity.
The strike price is a key variable in a derivatives contract between two parties.
Where the contract requires delivery of the underlying instrument, the trade
will be at the strike price, regardless of the spot price (market price) of the
underlying instrument at that time.
TYPES
The Options can be classified into following types:
EXCHANGE-TRADED OPTIONS
Exchange-traded options (also called "listed options") are a class of
exchange-traded derivatives. Exchange traded options have standardized
contracts, and are settled through a clearing house with fulfillment
guaranteed by the Options Clearing Corporation (OCC). Since the
contracts are standardized, accurate pricing models are often available.
Exchange-traded options include:
stock options,
bond options and other interest rate options
stock market index options or, simply, index options and
options on futures contracts
callable bull/bear contract
OVER-THE-COUNTER
Over-the-counter options (OTC options, also called "dealer options") are
traded between two private parties, and are not listed on an exchange. The
terms of an OTC option are unrestricted and may be individually tailored to
MAXIMIZATION TOOL
87
meet any business need. In general, at least one of the counterparties to an
OTC option is a well-capitalized institution. Option types commonly traded
over the counter include:
1. interest rate options
2. currency cross rate options, and
3. options on swaps or swaptions.
OTHER OPTION TYPES
Another important class of options, particularly in the U.S., is employee stock
options, which are awarded by a company to their employees as a form of
incentive compensation. Other types of options exist in many financial
contracts, for example real estate options are often used to assemble large
parcels of land, and prepayment options are usually included in mortgage
loans. However, many of the valuation and risk management principles apply
across all financial options.
TRADES
LONG CALL
A trader who believes that a stocks price will increase might buy the right to
purchase the stock (a call option) at a fixed price, rather than just purchase the
stock itself. He would have no obligation to buy the stock, only the right to do
so until the expiration date. If the stock price (spot Price, S) at expiration is
above the exercise price(X) by more than the premium (price) paid, he will
profit i.e. if S>X, the deal is profitable. If the stock price at expiration is lower
than the exercise price, he will let the call contract expire worthless, and only
lose the amount of the premium. A trader might buy the option instead of
shares, because for the same amount of money, he can control (leverage) a
much larger number of shares.
LONG PUT
A trader who believes that a stocks price will decrease can buy the right to
sell the stock at a fixed price (a put option). He will be under no obligation to
MAXIMIZATION TOOL
88
sell the stock, but has the right to do so until the expiration date. If the stock
price at expiration is below the exercise price by more than the premium paid,
he will profit. If the stock price at expiration is above the exercise price, he
will let the put contract expire worthless and only lose the premium paid.In the
whole story, the premium also plays a major role as it enhances the break-even
point. For example, if exercise price is 100 premium paid is 10 then a spot
price of 100 to 90 is not profitable, he would earn profit if the spot price is
below 90.
SHORT CALL
A trader who believes that a stock price will decrease can sell the stock short
or instead sell, or "write," a call. The trader selling a call has an obligation to
sell the stock to the call buyer at the buyer's option. If the stock price
decreases, the short call position will make a profit in the amount of the
premium. If the stock price increases over the exercise price by more than the
amount of the premium, the short will lose money, with the potential loss
unlimited.
SHORT PUT
A trader who believes that a stock price will increase can buy the stock or
instead sell, or "write", a put. The trader selling a put has an obligation to buy
the stock from the put buyer at the put buyer's option. If the stock price at
expiration is above the exercise price, the short put position will make a profit
in the amount of the premium. If the stock price at expiration is below the
exercise price by more than the amount of the premium, the trader will lose
money, with the potential loss being up to the full value of the stock.
OPTION STRATEGIES
Combining any of the four basic kinds of option trades (possibly with different
exercise prices and maturities) and the two basic kinds of stock trades (long
and short) allows a variety of options strategies. Simple strategies usually
combine only a few trades, while more complicated strategies can combine
several.
MAXIMIZATION TOOL
89
Strategies are often used to engineer a particular risk profile to movements in
the underlying security. For example, buying a butterfly spread (long one X1
call, short two X2 calls, and long one X3 call) allows a trader to profit if the
stock price on the expiration date is near the middle exercise price, X2, and
does not expose the trader to a large loss.
An Iron condor is a strategy that is similar to a butterfly spread, but with
different strikes for the short options offering a larger likelihood of profit but
with a lower net credit compared to the butterfly spread.
Selling a straddle (selling both a put and a call at the same exercise price)
would give a trader a greater profit than a butterfly if the final stock price is
near the exercise price, but might result in a large loss.
Similar to the straddle is the strangle which is also constructed by a call and a
put, but whose strikes are different, reducing the net debit of the trade, but also
reducing the risk of loss in the trade.
One well-known strategy is the covered call, in which a trader buys a stock
(or holds a previously-purchased long stock position), and sells a call. If the
stock price rises above the exercise price, the call will be exercised and the
trader will get a fixed profit. If the stock price falls, the call will not be
exercised, and any loss incurred to the trader will be partially offset by the
premium received from selling the call. Overall, the payoffs match the payoffs
from selling a put. This relationship is known as put-call parity and offers
insights for financial theory.
THE LONG STRADDLE
The long straddle, also known as buy straddle or simply "straddle", is a neutral
strategy in options trading that involve the simultaneously buying of a put and
a call of the same underlying stock, striking price and expiration date.
By having long positions in both call and put options, straddles can achieve
large profits no matter which way the underlying stock price heads, provided
the move is strong enough.
The formula for calculating profit is given below:
MAXIMIZATION TOOL
90
Maximum Profit = Unlimited
Profit Achieved When Price of Underlying > Strike Price of Long Call +
Net Premium Paid OR Price of Underlying < Strike Price of Long Put -
Net Premium Paid
Profit = Price of Underlying - Strike Price of Long Call - Net Premium
Paid OR Strike Price of Long Put - Price of Underlying - Net Premium
Paid

BREAKEVEN POINT(S)
There are 2 break-even points for the long straddle position. The breakeven
points can be calculated using the following formulae.
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
THE LONG STRANGLE
The long strangle, also known as buy strangle or simply "strangle", is a neutral
strategy in options trading that involve the simultaneous buying of a slightly
MAXIMIZATION TOOL
91
out-of-the-money put and a slightly out-of-the-money call of the same
underlying stock and expiration date.
The long options strangle is an unlimited profit, limited risk strategy that is
taken when the options trader thinks that the underlying stock will experience
significant volatility in the near term. Long-strangles are debit spreads as a net
debit is taken to enter the trade.
Large gains for the long strangle option strategy is attainable when the
underlying stock price makes a very strong move either upwards or
downwards at expiration.

The formula for calculating profit is given below:
Maximum Profit = Unlimited
Profit Achieved When Price of Underlying > Strike Price of Long Call + Net
Premium Paid OR Price of Underlying < Strike Price of Long Put - Net
Premium Paid
Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid
OR Strike Price of Long Put - Price of Underlying - Net Premium Paid

BREAKEVEN POINT(S)
MAXIMIZATION TOOL
92
There are 2 break-even points for the long strangle position. The breakeven
points can be calculated using the following formulae.
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
INTRINSIC VALUE AND TIME VALUE OF OPTIONS
Intrinsic value and time value are two of the primary determinants of an
option's price.
Intrinsic value can be defined as the amount by which the strike price of an
option is in-the-money. It is actually the portion of an option's price that is not
lost due to the passage of time. The following equations will allow you to
calculate the intrinsic value of call and put options:
Call Options: Intrinsic value = Underlying Stock's Current Price - Call Strike
Price
Time Value = Call Premium - Intrinsic Value
Put Options: Intrinsic value = Put Strike Price - Underlying Stock's Current
Price
Time Value = Put Premium - Intrinsic Value
The Intrinsic Value is derived at using a fairly straightforward calculation. The
strike price is subtracted from the stocks current market value as long as
market value is higher than the striking price for a call or lower than the
striking price for a put. When a calls strike price is greater than the stocks
market value or when a puts strike price is less than the stocks market value,
there is no Intrinsic Value.
Time Value is the difference between total option premium and intrinsic value.
For example, when the LEAPS (Long Term Equity Anticipation Securities)
contract is out-of-the-money, the entire premium is time value. For buyers,
time value is a continual problem because as time passes, it declines. Thus
MAXIMIZATION TOOL
93
even when a stock is moving upward, it may only offset what the buyer paid
for the option.
OPTION STYLE
An option style refers to whether the option contract can be exercised before
the expiration date or not. European options cannot be exercised before the
expiration date of the option contract. American options can be exercised by
the option holder (the option buyer) any time during the life of the contract.
HEDGING
Hedging is any strategy designed to offset or reduce the risk of price
fluctuations for an asset or investment. Hedging should not be confused with
hedge funds, which are private investment funds that often, but not always,
employ hedging strategies.
When an investor buys or sells a security, the investor bets that the price of the
investment will move in a certain direction. As with any bet, there's always the
risk of losing money if the price moves in the opposite direction. An investor
hedges against this risk if he employs any tool or strategy that minimizes this
risk.
In general, creating a hedge requires the purchase of a second asset with a
negative correlation to the first. If the hedged security does not move as
predicted, the hedge minimizes loss to the investor. Hedging is profitable
when used sparingly and effectively.
Hedging is used to reduce risk. But with reduced risk comes reduced returns.
Hedging is usually expensive, and extensive hedging will not be cost-
effective. Should an investor hedge extensively, he may find himself spending
all of his investment profits and possibly more towards hedging. Thus, most
retail investors do not hedge. A few investors hedge if they know that their
investment values depend on a certain event, such as an earnings report.
Should the earnings report be negative, the hedge minimizes losses. Other than
MAXIMIZATION TOOL
94
that, hedging and counter-risk measures are primarily used by corporations
and institutional investors.
One reason why companies attempt to hedge these price changes is because
they are risks that are peripheral to the central business in which they operate
(Giddy, and Dufey, 1992)
1
. For example, an investor buys the stock of a pulp-
and-paper company in order to gain from its management of a pulp-and-paper
business. She does not buy the stock in order to take advantage of a falling
Canadian dollar, knowing that the company exports over 75% of its product to
overseas markets. This is the insurance argument in favour of hedging.
Similarly, companies are expected to take out insurance against their exposure
to the effects of theft or fire.
By hedging, in the general sense, we can imagine the company entering into a
transaction whose sensitivity to movements in financial prices offsets the
sensitivity of their core business to such changes. As we shall see in this
article and the ones that follow, hedging is not a simple exercise nor is it a
concept that is easy to pin down. Hedging objectives vary widely from firm to
firm, even though it appears to be a fairly standard problem, on the face of it.
And the spectrum of hedging instruments available to the corporate Treasurer
is becoming more complex every day.
Another reason for hedging the exposure of the firm to its financial price risk
is to improve or maintain the competitiveness of the firm. Companies do not
exist in isolation. They compete with other domestic companies in their sector
and with companies located in other countries that produce similar goods for
sale in the global marketplace. Again, a pulp-and-paper company based in
Canada has competitors located across the country and in any other country
with significant pulp-and-paper industries, such as the Scandinavian countries.
Companies that are the most sophisticated in this field recognize that the
financial risks that are produced by their businesses present a powerful
opportunity to add to their bottom line while prudently positioning the firm so
that it is not pejoratively affected by movements in these prices (Broll Udo,
1993). This level of sophistication depends on the firm's experience, personnel
MAXIMIZATION TOOL
95
and management approach. It will also depend on their competitors. If there
are five companies in a particular sector and three of them engage in a
comprehensive financial risk management program, then that places
substantial pressure on the more passive companies to become more advanced
in risk management or face the possibility of being priced out of some
important markets. Firms that have good risk management programs can use
this stability to reduce their cost of funding or to lower their prices in markets
that are deemed to be strategic and essential to the future progress of their
companies. Most importantly, hedging is contingent on the preferences of the
firm's shareholders. There are companies whose shareholders refuse to take
anything that appears to be financial price risk while there are other companies
whose shareholders have a more worldly view of such things. It is easy to
imagine two companies operating in the same sector with the same exposure
to fluctuations in financial prices that conduct completely different policy,
purely by virtue of the differences in their shareholders' attitude towards risk.
ALPHA
Alpha is a risk-adjusted measure of the so-called "excess return" on an
investment. It is a common measure of assessing an active manager's
performance as it is the return in excess of a benchmark index or "risk-free"
investment.
The difference between the fair and actually expected rates of return on a
stock is called the stock's alpha.
The concept and focus on Alpha comes from an observation increasingly
made during the middle of the twentieth century, that around 75% of stock
investment managers did not make as much money picking investments as
someone who had simply invested in every stock in proportion to the weight it
occupied in the overall market in terms of market capitalization, or indexing.
Many academics felt that this was due to the stock market being "efficient"
which means that since so many people were paying attention to the stock
market all the time, the prices of stocks rapidly moved to the correct price at
any one moment, and that only luck made it possible for one manager to
MAXIMIZATION TOOL
96
achieve better results than another, before fees or taxes were considered. A
belief in efficient markets spawned the creation of market capitalization
weighted index funds that seek to replicate the performance of investing in an
entire market in the weights that each of the equity securities comprises in the
overall market. The best examples are the S&P 500 and the Wilshire 5000
which approximately represent the 500 largest equities and the largest 5,000
securities respectively, accounting for approximately 80%+ and 99%+ of the
total market capitalization of the US market as a whole.

In fact, to many investors, this phenomenon created a new standard of
performance that must be matched: an investment manager should not only
avoid losing money for the client and should make a certain amount of money,
but in fact should make more money than the passive strategy of investing in
everything equally (since this strategy appeared to be statistically more likely to
be successful than the strategy of any one investment manager). The name for
the additional return above the expected return of the beta adjusted return of the
market is called "Alpha".
EXAMPLES, TYPES, OR VARIATIONS
Jensen's Alpha or Jensen's Measure
In finance, Jensen's alpha (or Jensen's Performance Index) is used to determine
the excess return of a stock, other security, or portfolio over the security's
required rate of return as determined by the Capital Asset Pricing Model. This
model is used to adjust for the level of beta risk, so that riskier securities are
expected to have higher returns. The measure was first used in the evaluation of
mutual fund managers by Michael Jensen in the 1970's.
Portable Alpha
Portable alpha is an investment management term which refers to the return of
an investment manager who has intentionally and completely eliminated his
market risk, or beta. The return of such a portfolio will only represent the
manager's skill in selecting investments within the market, and will be
MAXIMIZATION TOOL
97
independent of the direction or magnitude of the market's movement. The
elimination of market risk can be accomplished through use of futures, swaps,
options, or short selling.
Weighted Alpha
A weighted measure of how much a stock has risen or fallen over a certain
period, usually a year.
Formula
Alpha= [ (sum of y) - ((b)(sum of x)) ] / n
Where:
n = number of observations (36 mos.)
b = beta of the fund
x = rate of return for the market
y = rate of return for the fund

BETA
The Beta coefficient, in terms of finance and investing, is a measure of a
stock's (or portfolio's) volatility in relation to the rest of the market. Beta is
calculated for individual companies using regression analysis.

The beta coefficient is a key parameter in the capital asset pricing model
(or CAPM). It measures the part of the asset's statistical variance that
cannot be mitigated by the diversification provided by the portfolio of
many risky assets, because it is correlated with the return of the other
assets that are in the portfolio.
EXAMPLES, TYPES, OR VARIATIONS
Beta < 0: Negative Beta - not likely.
MAXIMIZATION TOOL
98
Beta = 0: Cash in the bank.
Beta Between 0 and 1: Low-volatility
Beta = 1: Matching the market.
Beta > 1: More volatile than the market.
EXAMPLE OF USE:
A fund with a beta of 1 is deemed to have the same volatility as the S&P
500; therefore a fund with a beta of 4 is four times more volatile than the
S&P 500, and a fund with a beta of .25 is 25% as volatile as the S&P 500.
This means that a fund with a beta of 4 would rise 40% if the S&P 500
rose 10% (the same is true of a drop).
The three basic interpretations of Beta are as follows:
1. Econometric Beta: The primary risk factor for the CAPM. Relevant to
pricing and not valuation.
2. Graphical Beta: The slope coefficient of the characteristic line.
3. Statistical Beta: The measure of systematic risk in the CAPM.
Beta is also referred to as financial elasticity or correlated relative
volatility, and can be referred to as a measure of the asset's sensitivity of
the asset's returns to market returns, its non-diversifiable risk, its
systematic risk or market risk. On an individual asset level, measuring beta
can give clues to volatility and liquidity in the marketplace. On a portfolio
level, measuring beta is thought to separate a manager's skill from his or
her willingness to take risk.
FORMULA
The Formula for Beta of an asset within a portfolio is
( )
()

MAXIMIZATION TOOL
99
Where r
a
measures the rate of return of the asset, r
p
measures the rate of
return of the portfolio, and cov(r
a
, r
p
) is the covariance between the rates of
return. The portfolio of interest in the CAPM formulation is the market
portfolio that contains all risky assets, and so the r
p
terms in the formula
are replaced by r
m
, the rate of return of the market.

MAXIMIZATION TOOL
100

Chapter 3
DATA ANALYSIS AND DISCUSSION

MAXIMIZATION TOOL
101
CURRENT INDIAN ECONOMIC SCENARIO
Introduction
After a promising start to the decade in 2010-11 with achievement like GDP
growth of 8.4 per cent, bringing down fiscal deficit to 4.7 per cent from 6.4 of
GDP in 2009-10, as well as containing current account deficit to 2.6 per cent from
2.8 per cent in 2009-10. GDP growth decelerated sharply to a nine year low of 6.5
per cent during 2011-12.
The slowdown was reflected in all sectors of the economy but the industrial sector
suffered the sharpest deceleration which decelerated to 2.9 per cent during 2011-
12 from 8.2 per cent in 2010-11. The centres finances for 2011-12 experienced
considerable slippages as key deficit indicators turned out to be much higher than
budgeted due to shortfall in tax revenues and overshooting of expenditure. The
gross fiscal deficit (GFD)-GDP ratio moved up to 5.8 per cent in 2011-12
compared to the budgeted ratio of 4.6 per cent. The substantial increase in
subsidies during 2011-12 on account of high crude oil prices further impacted the
deficit of the Government.
The year 2011 -12, especially the second half, was characterised by a burgeoning
current account deficit (CAD), subdued equity inflows, depletion of foreign
exchange reserves, rising external debt and deteriorating international investment
position. Inflation remained elevated at over 9 per cent in the first eight months of
2011-12, before softening moderately in December and remained sticky in the
range of 6.9-7.7 percent.
SECTORAL ANALYSIS
1) STEEL INDUSTRY
The Indian steel industry has entered into a new development stage from 2007-08,
riding high on the resurgent economy and rising demand for steel. Rapid rise in
production has resulted in India becoming the 4 th largest producer of crude steel
and the largest producer of sponge iron or DRI in the world. As per the report of
the Working Group on Steel for the 12 th Plan, there exist many factors which
MAXIMIZATION TOOL
102
carry the potential of raising the per capita steel consumption in the country,
currently estimated at 55 kg (provisional). These include among others, an
estimated infrastructure investment of nearly a trillion dollars, a projected growth
of manufacturing from current 8% to 11-12%, increase in urban population to 600
million by 2030 from the current level of 400 million, emergence of the rural
market for steel currently consuming around 10 kg per annum buoyed by projects
like Bharat Nirman, Pradhan Mantri Gram Sadak Yojana, Rajiv Gandhi Awaas
Yojana among others.
At the time of its release, the National Steel Policy 2005 had envisaged steel
production to reach 110 million tonnes by 2019-20. However, based on the
assessment of the current ongoing projects, both in greenfield and brownfield, the
Working Group on Steel for the 12 th Plan has projected that the crude steel steel
capacity in the county is likely to be 140 mt by 2016-17 and has the potential to
reach 149 mt if all requirements are adequately met.
The National Steel Policy 2005 is currently being reviewed keeping in mind the
rapid developments in the domestic steel industry (both on the supply and demand
sides) as well as the stable growth of the Indian economy since the release of the
Policy in 2005.
a) TATA STEEL LTD
Tata Steel Ltd., a Tata Group company, is Indias largest integrated steel player in
the private sector and the worlds seventh largest steel producer with an annual
crude steel capacity of around 30 million tonnes per annum (mtpa). It
manufactures hot and cold rolled coils and sheets, galvanized sheets, tubes, wire
rods, construction rebars, rings and bearings. After the acquisition of Corus in
2007, it is now the 7th largest steel producer in the world. Apart from India, the
company operates through its major subsidiaries on a consolidated basis Europe
(Corus) and South-East Asia (NatSteel & Thailand). In India the company has
manufacturing facilities at Jharkhand, Chhattisgarh, Orissa, West Bengal and
Tamil Nadu. It has operations in 26 countries and commercial presence in over 50
countries with over 81,000 employees.
MAXIMIZATION TOOL
103
Beta: 2.04
Market Cap (Mil.): Rs290,150.59
Shares Outstanding (Mil.): 971.22
Dividend: 8.00
P/E (TTM): --
EPS (TTM): -74.06
ROI: -7.70
ROE: -18.38

Source:http://finance.yahoo.in

MAXIMIZATION TOOL
104
QUARTERLY RESULTS


b) JINDAL STEEL AND POWER LTD
Jindal Steel & Power Limited (JSPL) is a Jindal Group company with an annual
turnover of over Rs. 11,000 Cr. JSPL operates in a promising mix of two business
segments- Power & Steel. It is a leading player in the Steel Industry. The company
produces economical and efficient steel and power through backward integration
from its own captive coal and iron-ore mines. JSPL is the one of the lowest cost
producer of sponge iron in India. Backward integration has given JSPL the
distinction of being the only sponge iron producer with its own captive raw
material sources and power. JSPL sells power on merchant basis, which
commands higher realizations than other power generation companies that are
subject to regulated tariffs. The company serves both domestic as well as
international markets. It is also entering into niche value-added segment such as
rounds, billets, blooms and slabs.

MAXIMIZATION TOOL
105
Beta: 1.5
Dividend: 1.60
P/E (TTM): 9.15
EPS (TTM): 31.13
ROI: 8.41
ROE: 14.79


MAXIMIZATION TOOL
106

QUARTERLY RESULTS

2) BANKING INDUSTRY
The growth in the Indian Banking Industry has been more qualitative than
quantitative and it is expected to remain the same in the coming years. Based on
the projections made in the "India Vision 2020" prepared by the Planning
Commission and the Draft 10th Plan, the report forecasts that the pace of
expansion in the balance-sheets of banks is likely to decelerate. The total assets of
all scheduled commercial banks by end-March 2010 are estimated at Rs 40,
90,000 crores. That will comprise about 65 per cent of GDP at current market
prices as compared to 67 per cent in 2002-03. Bank assets are expected to grow at
an annual composite rate of 13.4 per cent during the rest of the decade as against
the growth rate of 16.7 per cent that existed between 1994-95 and 2002-03. It is
expected that there will be large additions to the capital base and reserves on the
liability side.
MAXIMIZATION TOOL
107
As far as the present scenario is concerned the Banking Industry in India is going
through a transitional phase. The first phase of financial reforms resulted in the
nationalization of 14 major banks in 1969 and resulted in a shift from Class
banking to Mass banking. This in turn resulted in a significant growth in the
geographical coverage of banks. Every bank had to earmark a minimum
percentage of their loan portfolio to sectors identified as priority sectors. The
manufacturing sector also grew during the 1970s in protected environs and the
banking sector was a critical source. The next wave of reforms saw the
nationalization of 6 more commercial banks in 1980. Since then the number of
scheduled commercial banks increased four-fold and the number of bank branches
increased eight-fold.
a) ICICI BANK LIMITED
ICICI Bank is Indias second largest bank and largest private sector bank, with
total assets of Rs. 5367.95 billion as on March 31, 2013. It mainly operates in
Retail Banking, Wholesale Banking and Treasury. It has a large customer base of
around 24 million. The bank has a presence in 19 countries, including India. It has
subsidiaries in UK, Russia and Canada, branches in US, Singapore, Bahrain, Hong
Kong, Sri Lanka, Qatar and Dubai International Finance Centre and representative
offices in United Arab Emirates, China, South Africa, Bangladesh, Thailand,
Malaysia and Indonesia. Its UK subsidiary has established branches in Belgium
and Germany.
ICICI Bank also offers wide range of financial services to corporate and retail
customers through its specialized subsidiaries in the areas of investment banking,
life and non-life insurance, venture capital and asset management.
ICICI Bank, in the last 10 years, increased its net interest income by 29.17% on a
stand-alone basis, from Rs. 2185 Cr. in FY04 to Rs. 13866 Cr. in FY13. On a
consolidated basis, its net interest income was Rs. 16599.18 Cr. in FY13. Its
CASA ratio was below 30% till FY09; but in the last two financial years, it
boosted its CASA ratio was 43.5% at March 31, 2012, which is quite remarkable.
The bank earned net interest margins of 3.11% in FY13. Its book value per share
grew only by 10.71% in FY12. The book value of the bank increased from Rs.
MAXIMIZATION TOOL
108
125.28 in FY04 to Rs. 578 in FY13. ICICI Bank acquired Bank of Rajasthan in
2010.
ICICI Bank managed to attain ROE (Return on Equity) of 13.62% in FY12. The
net non-performing assets to net advances ratio of the bank have been
continuously above 1% in the last five years, which shows its asset quality is not
up to the mark. If we look at its trend, it is showing decreasing net non-performing
assets to net advances ratio in the last two years, from 1.11% in FY11 to 0.73% in
FY12. This shows it is continuously improving its asset quality with a large focus
on it.
At the end of FY13, its capital adequacy ratio was at 18.74%; much higher than
the RBI guideline of 9%, which will help the bank grow its operation comfortably.

Beta: 1.67
Market Cap (Mil.): Rs1,313,518.00
Shares Outstanding (Mil.): 1,154.03
Dividend: 20.00
P/E (TTM): 37.81

EPS (TTM): 30.1
ROI: --
ROE: --
MAXIMIZATION TOOL
109


QUARTERLY RESULTS


MAXIMIZATION TOOL
110
b) HDFC BANK LIMITED
HDFC Bank, the second largest private sector bank in India, deals with three key
business segments - Retail Banking, Wholesale Banking and Treasury. HDFC
Bank is the market leader in retail banking. Retail banking accounts 52% of the
total income. It also provides sophisticated product structures, sound advice and
fine pricing mainly in areas of foreign exchange and derivatives, money markets
and debt trading and equity research through its state-of-the-art dealing room. The
business philosophy of HDFC Bank is based on four core values - Customer
Focus, Operational Excellence, Product Leadership and People. The HDFC Group
holds 23.15% stake in the Bank. HDFC Bank has world-class technology. HDFC
Bank is a market leader in auto loan provider and credit card business. The Bank
has been named Organization of the year at the Skoch Financial Inclusion
Awards 2013.
It has two subsidiaries:
1. HDFC Securities Ltd. It is mainly in the business of providing brokerage
services
2. HDB Financial Services Ltd. non-deposit taking NBFC
HDFC Bank increased its net interest income by 17.72% in FY12 on the stand-
alone basis. NII (Net Interest Income) rose from Rs.1817.9 Cr. in FY04 to Rs.
22,663.7 Cr. in FY13. Its CASA (Current Account Savings Account), the source
of low cost funds, was 47.4% as on March 31, 2013; which is the highest in the
Indian banking Industry. The high interest income and the low cost because of
high CASA helped the Bank maintain an average net interest margin at a very
high level of 4.5% for FY13. This higher NIM(Net Interest Margin) is due to the
reclassification of retail cost of acquisition which was earlier set off against the
interest income. Now they are shown as an operating expense. Had the
reclassification not taken place, NIM would have been 4.3%. The Bank has
increased its book value per share by 17.06% in FY12. In the last 10 years, it rose
from Rs. 18.9 in FY04 to Rs. 127.52 in FY12, on a stand-alone basis.
MAXIMIZATION TOOL
111
HDFC Bank managed to maintain a ten-year-average ROA (Return on assets) at
1.77% in FY12, which is significantly higher than the benchmark of 1.25%. The
non-performing assets to net advances ratio of the bank have been continuously
below 0.5%, which shows its asset quality is very good. The ratio was 0.18%
FY13. Currently, its capital adequacy ratio is at 16.8%; well above the RBI
guideline of 9%, which will help the Bank grow its operation comfortably. Asset
quality was healthy with gross non-performing assets (NPAs) at 0.97% of gross
advances as on March 31, 2013. Net non-performing assets remained at 0.2% of
net advances as on March 31, 2013.

Beta: 1.02
Market Cap (Mil.): Rs1,627,000.00
Dividend: 5.50
P/E (TTM):
87.88
EPS (TTM): 7.77
ROI: --
ROE: 18.05

MAXIMIZATION TOOL
112


QUARTERLY RESULTS


MAXIMIZATION TOOL
113
3) TELECOM INDUSTRY
The Indian telecommunications industry is one of the fastest growing in the world.
Government policies and regulatory framework implemented by Telecom
Regulatory Authority of India (TRAI) have provided conducive environment for
service providers. This has made the sector more competitive, while enhancing the
accessibility of telecommunication services at affordable tariffs to the consumers.
In the last two decades, the Indian Telecom Sector and mobile telephony in
particular has caught the imagination of India by revolutionizing the way we
communicate, share information; and through its staggering growth helped
millions stay connected. This growth, however, has and continues to be at the cost
of the Climate, powered by an unsustainable and inefficient model of energy
generation and usage. Simultaneously, tins growth has also come at significant
and growing loss to the state exchequer, raising fundamental questions on the
future business and operation model of the Telecom sector.
The telecom industry has witnessed significant growth in subscriber base over the
last decade, with increasing network coverage and a competition-induced decline
in tariffs acting as catalysts for the growth in subscriber base. The growth story
and the potential have also served to attract newer players in the industry, with the
result that the intensity of competition has kept increasing. The sector expected to
witness up to USS 56.3 billion investments and the market will cross the US$ 101
billion mark in five years.
The Indian telecom sector has witnessed tremendous growth over the past decade.
Today, the Indian telecom network is the second largest in the world after China.
A liberal policy regime and involvement of the private sector have played an
important role in transforming this sector. The total number of telephones has
increased from 429.73 million on 31 March 2009 to 926.55 million on 31
December 2011.
The telecom industry has witnessed significant growth in subscriber base over the
last decade, with increasing network coverage and a competition-induced decline
in tariffs acting as catalysts for the growth in subscriber base. The growth story
and the potential have also served to attract newer players in the industry, with the
MAXIMIZATION TOOL
114
result that the intensity of competition has kept increasing. Also, broadband
segment has seen significant growth with total internet subscribers reaching 20.99
million in September 2011, which includes 13.30 broadband subscribers.
a) IDEA CELLULAR LIMITED
Idea Cellular Limited is a part of the Aditya Birla Group (45.98% holding) and
one of Indias leading GSM telecom Services provider. The company has licenses
to operate in 22 telecom circles. It has over 105 million subscribers with a market
share of around 14%. The company reports 1.15 billion minutes per day and is
among top 10 national operators across the globe in terms of voice minutes of
usage. The company offers basic voice and short message service (SMS), high-
end value added services and general packet radio service (GPRS), such as
Blackberry, Datacard, Mobile TV and Games. Idea has deep penetration in the
non-urban and rural market. Idea Cellular boasts of the highest share of rural
subscribers as a percentage of total subscribers among GSM players.
Idea Cellular has managed to clock very good sales growth but the profits of the
company have been on a declining trend. The companys Net Sales has increased
from Rs. 4366.4 Cr. in FY2007 to Rs. 19488.69 Cr. in FY12 with 5 years CAGR
of 34% showing a consistent demand for its products. However, the EPS has taken
a hit post FY09.
The company clocked exponential growth in EPS in the FY05-FY08 period.
During this period the competition was limited in the telecom market and as a
result company could register such huge growth in profits. The last four financial
years have not been good for the company. Its EPS performance has deteriorated
owing to the entry of new players making the telecom market a highly competitive
one. This competition led to tariff wars and since then tariffs have been constantly
reduced until recently in July 2011 where they were raised by 20%. This along
with the increased operating cost as the company ventured in to new mobile
circles led to bad EPS performance in the FY09-FY12 period.
Similar trend is observed in the companys profit margins. After FY08, the
operating profit margins (OPM) and net profit margins (NPM) have gone down
MAXIMIZATION TOOL
115
owning to the rise in competition and rise in operating cost because the company
entered in to new mobile circles. However, the decrease in profit margin has been
marginally mitigated by higher earnings from its tower business, as the tenancy
rates have gone up in recent past.
Idea has around Rs. 12070.50 Cr. as debt on its book due to very high 3G costs
and the capex it carried out in FY11. Idea has won 3G spectrum in 11 out of 22
service areas in the recent auction and was amongst the highest spender in 3G and
BWA (broadband wireless access) auction. This high debt has resulted in high
debtnet profit ratio and a very high interest cost, resulting in lower profit
margins.
As there was de-growth in earnings, company could not maintain it ROE and
ROIC numbers. The company has experienced substantial reduction in both these
numbers FY09 onwards.

Beta: 1.08
Dividend: 0.30
P/E (TTM):
44.41
EPS (TTM): 3.05
ROI: 3.81
ROE: 7.39

MAXIMIZATION TOOL
116


QUARTERLY RESULTS


MAXIMIZATION TOOL
117

b) RELIANCE COMMUNICATIONS LTD
Reliance Communications Limited, an Anil Dhirubhai Ambani Group (ADAG)
company is an integrated telecommunications service provider. It provides CDMA
and GSM based wireless services on a nationwide basis and has a customer base
of 148 million (however, subscriber quality is not good as active / VLR subscriber
base stands at 92.5 million). The Company's business encompasses a complete
range of telecom services covering mobile and fixed line telephony. It includes
broadband, national and international long distance services and data services
along with a range of value-added services. If all the businesses are taken in to
consideration, then the total customer base of Reliance Communications stands at
156 million including over 2.5 million individual overseas retail customers.

Beta: 1.85
Dividend: 0.25
P/E (TTM):
33.75
EPS (TTM): 3.27
ROI: 1.10
ROE: 1.92

MAXIMIZATION TOOL
118


QUARTERLY RESULTS


MAXIMIZATION TOOL
119
4) POWER SECTOR
The Indian Power Industry is one of the largest and most important industries in
India as it fulfills the energy requirements of various other industries. It is one of
the most critical components of infrastructure that affects economic growth and
the well-being of our nation.
India has the worlds 5th largest electricity generation capacity and it is the 6th
largest energy consumer accounting for 3.4% of global energy consumption. Due
to the fast-paced growth of the Indian economy, the countrys energy demand has
grown at an average of 3.6% p.a. over the past 30 years. In India, power is
generated by State utilities, Central utilities and Private players.
As per the latest Report of CEA (Central Electricity Authority) i.e. as on 31-03-
2011, the Total Installed Capacity of Power in India is 173626.40 MW. Of this,
more than 75% of the installed capacity is with the public sector (state and
central), the state sector having the largest share of 48%.
a) ADANI POWER LTD
Adani Power Limited is part of the Adani group which has business interest in
sectors like infrastructure, power, logistics, mining, oil and gas, agri business,
realestate, etc. Adani Power is engaged in the business of generation and
transmission of power. Currently it is the largest private thermal power producer
in India with thermal power generation capacity of 2640 MW. On the whole, it is
implementing 16,500 MW of power generation projects across six locations in
India and has plans of generating 20,000 MW of power by 2020.
The company started generating sales in FY10 when it commissioned two of its
330 MW plants at Mundra. The consolidated sales increased by 391% from Rs.
434.86 Cr. in FY10 to Rs. 2135.19 Cr. in FY11 as the company had
commissioned additional 1320 MW of generating capacity in FY11. EPS saw a
jump of 209.21% from FY10 to FY11. EPS growth has not been commensurate
with the sales growth because of high interest payments in FY11. Companys debt
to net profit ratio has been exorbitantly high at 62.27 in FY10 and 47.75 in FY11.
MAXIMIZATION TOOL
120
This is because the company has taken debt and made investments in many power
projects of which only a few have started generating revenue. This high debt has
led to promoters pledging their shares to the tune of 53.56%. Operating profit
margin in FY11 was similar to that in FY10 but there was a reduction in net profit
margin because of the increase in debt which led to high interest expenses.

Beta: 1.2
Dividend: --
P/E (TTM):
--
EPS (TTM): -9.58
ROI: -5.99
ROE: -44.41

MAXIMIZATION TOOL
121

QUARTERLY RESULTS


b) RELIANCE POWER LTD
Reliance Power is primarily in the development, construction and operation of
power generation projects whereas Reliance Infrastructure takes care of
transmission and distribution of power business, along with its other business
areas. Reliance Power on its own and through subsidiaries has a portfolio of over
35,000 MW of power generation capacity, both operational as well as under
development. Currently the Company has 600 MW of operational power
generation assets. The projects under development include seven coal-fired
projects (18,880 MW) to be fuelled by reserves from captive mines and supplies
from India and abroad, two gas-fired projects (10,280MW) to be fuelled primarily
MAXIMIZATION TOOL
122
by reserves from the Krishna-Godavari Basin and seven hydroelectric projects
(4620 MW), six of them in Arunachal Pradesh and one in Uttarakhand.

Beta: 1.61
Dividend: --
P/E (TTM):
19.19
EPS (TTM): 3.61
ROI: 2.48
ROE: 5.60

MAXIMIZATION TOOL
123

QUARTERLY RESULTS


5) ENGINEERING INDUSTRY
The engineering sector is the largest segment of the overall Indian industrial
sector. India has a strong engineering and capital goods base. The important
groups within the engineering industry include machinery & instruments, primary
and semi finished iron & steel, steel bars & rods, non-ferrous metals, electronic
goods and project exports. The engineering sector employs over 4 million skilled
and semi-skilled workers (direct and indirect).
The sector can be categorized into heavy engineering and light engineering
segments. Heavy engineering segment forms the majority of the engineering
sector in India. In the year 2003-04, out of the total engineering production of US$
22 billion, the heavy engineering market contributed over 80 per cent with the
light engineering segment accounting for the remaining. India has a well-
MAXIMIZATION TOOL
124
developed and diversified industrial machinery/capital base capable of
manufacturing the entire range of industrial machinery. The industry has also
managed to successfully develop advanced manufacturing technology over the
years. Among the developing countries, India is a major exporter of heavy and
light engineering goods, producing a wide range of items. The bulk of capital
goods required for power projects, fertilizer, cement, steel and petrochemical
plants and mining equipment are made in India. The country also makes
construction machinery, equipment for irrigation projects, diesel engines, tractors,
transport vehicles, cotton textile and sugar mill machinery.
The engineering industry has shown capacity to manufacture large-size plants and
equipment for various sectors like power, fertilizer and cement. Lately, air
pollution control equipment is also being made in the country. The heavy
electrical industry in India meets the entire domestic demand.
a) LARSEN AND TOUBRO LTD
Larsen & Toubro Ltd, an L & T Group company, is Indias largest engineering
and construction company. Its business is categorized into three segments, viz.
Engineering and construction (E&C), Electrical and Electronics (E&E) and other
diversified businesses. Its clientele consists of a mix of public and private sector
companies. Some of its clients are ONGC, Reliance (RIL), Indian Oil, GSPC,
NHAI, Tata Steel, NTPC, ExxonMobil etc. It was incorporated in 1938 and went
public in 1952.
It is largely a domestic player, with 85% of its revenue contribution from
domestic region and rest 15% from rest of the globe.
The company is slowly increasing its geographical presence in US, Middle East
and China. It has manufacturing facilities in India, China, Oman and Saudi Arabia
to cater to demands of customers spread across 30 countries. Major international
projects executed recently include wellhead platform project of Maersk Oil Qatar,
Gas handling facilities for GASCO (Abu Dhabi Gas Industries Ltd.), Gas pipeline
for Qatar petroleum and construction of Jet fuel depot project for Kuwait aviation
fuelling company. The major domestic projects in recent times include Delhi
MAXIMIZATION TOOL
125
international airport terminal 3, refurbishing Wankhede stadium project, part of
Delhi metro, etc.

Beta: 1.55
Dividend: 18.50
P/E (TTM):
102.95
EPS (TTM): 13.69
ROI: --
ROE: --

MAXIMIZATION TOOL
126

QUARTERLY RESULTS


b) BHARAT HEAVY ELECTRICALS LTD
Bharat Heavy Electricals Ltd., a Navratna company, is the largest engineering and
manufacturing enterprise in India for power & infrastructure-related products,
with 54% market share. The company has a 25 years' history of consistent
profitability and manufactures over 180 products for power sector and other
industries like transportation, fertilizer, water, steel and renewable energy. The
company's operations are organised around two major business segments - power
(79% of FY11 revenues) and industry (21%).
The company has 15 manufacturing divisions, 4 power sector regional centers,
over 100 project sites, 8 service centres and 15 regional offices. It is also one of
the largest exporters of engineering products and services from India. It supplies
its product to over 60 countries in the world. The company gets 96.80% revenues
MAXIMIZATION TOOL
127
from domestic markets and 3.20% from exports. The Company was incorporated
in 1964.
BHEL has performed extremely well in the past ten years, except in FY03. The
company has increased its Net Sales by 22% CAGR in the last ten years; however
the EPS increased by 28% during the same period. This was due to the margin
expansion that the company witnessed from FY04 to FY08. Indias increased
focus on infrastructure and the monopoly situation enjoyed by the company made
this possible. FY09 and FY10 again saw a decrease in margins on the back of
increasing raw material prices. The companys margins have increased
substantially to 18% in FY11 as raw material prices dipped. The company has
grown its BVPS by 19% 10 yr. CAGR. Given the huge revenues and profitability
enjoyed by the company, it has managed to increase its operating cash flow by
14.3% over the last 10 years. Hence, the Company has expanded its business
successfully in the past. Currently, the Company has Debt to Net Profit ratio of
0.03, which shows the company is a relatively debt free company & can repay all
its debt easily within a year at current level of profit.
BHEL has maintained a high ROE & ROIC, above 25%, over the last 5 years.
This shows that the management of the Company is very efficient in utilizing the
funds. Being a capital intensive industry, the company has huge working capital
requirements. The company has managed to maintain its working capital days at
an average of 514 days. However, this is 1.5 times higher than the industry
average of 360 days. The company has managed to reduce its net working capital
from 180 levels to 107 in FY11, which is lower than the industry average of 180
days but very high when compared to its competitors like ABB and Siemens.

Beta: 1.34
Dividend: 3.29
MAXIMIZATION TOOL
128
P/E (TTM):
15.35
EPS (TTM): 12.73
ROI: --
ROE: --


QUARTERLY RESULTS
MAXIMIZATION TOOL
129


From the analysis we have given the weightage to the shares as follows:
WEIGHTAGE OF THE SHARES IN THE PORTFOLIO
TABLE 3.1 weightage of the shares in the portfolio
Industry Name Company Name Weightage
Steel TATA STEEL LTD. 0.1014552
JINDAL STEEL & POWER LTD 0.09868375
Banking ICICI Bank Ltd 0.10035325
HDFC Bank Ltd 0.099448
Telecom Idea Cellular LTD 0.1000482
Reliance Communications Ltd 0.09993465
Power Adani Power Ltd 0.1000524
MAXIMIZATION TOOL
130
Reliance Power Ltd 0.0999664
Engineering Larsen & Toubro Ltd 0.0994071
Bharath Heavy Electricals Ltd 0.1006509

The beta values of the shares are calculated and the beta of the portfolio is found.
TABLE 3.2 beta values of shares
Company Name Beta Value Weightage Beta*weightage
TATA STEEL LTD. 2.04 0.1014552 0.206968608
JINDAL STEEL &
POWER LTD
1.5 0.09868375 0.148025625
ICICI Bank Ltd 1.67 0.10035325 0.167589928
HDFC Bank Ltd 1.02 0.099448 0.10143696
Idea Cellular LTD 1.08 0.1000482 0.108052056
Reliance
Communications Ltd
1.85 0.09993465 0.184879103
Adani Power Ltd 1.2 0.1000524 0.12006288
Reliance Power Ltd 1.61 0.0999664 0.160945904
Larsen & Toubro
Ltd
1.55 0.0994071 0.154081005
BHEL 1.34 0.1006509 0.134872206
Beta of the portfolio 1.486914274

Beta of the portfolio = 1.486914274
MAXIMIZATION TOOL
131
The companies selected having higher beta value denotes that the portfolio is an
aggressive portfolio that indicates that the value of the portfolio changes with the
changes in the index value.
DISTRIBUTION OF SELECTED COMPANIES AND SHARES
TABLE 3.3 distribution of shares of the companies in the portfolio
Company Name Share Price on
1-3-2013
No of shares Amount
TATA STEEL LTD. 341.6 297 101455.2
JINDAL STEEL &
POWER LTD
358.85 275 98683.75
ICICI Bank Ltd 1056.35 95 100353.25
HDFC Bank Ltd 621.55 160 99448
Idea Cellular LTD 116.2 861 100048.2
Reliance
Communications Ltd
61.65 1621 99934.65
Adani Power Ltd 45.15 2216 100052.4
Reliance Power Ltd 72.65 1376 99966.4
Larsen & Toubro Ltd 1400.1 71 99407.1
Bharath Heavy
Electricals Ltd
200.9 501 100650.9
Total 10,00000
As per the weightage given to each company in the portfolio, number of shares
has been determined and a sum of ten lakhs rupees has been divided accordingly.
Table 3.4 Portfolio of the month March 2013
Companies No of
shares
Share
Price as on
Total
Amount
Share
Price as on
Total
Amount
MAXIMIZATION TOOL
132
1-3-2013 28-3-2013
TATA STEEL
LTD.
297 341.6 101455.2 312.3 92753.1
JINDAL STEEL
& POWER LTD
275 358.85 98683.75 348.15 95741.25
ICICI Bank Ltd 95 1056.35 100353.25 1045.35 99308.25
HDFC Bank Ltd 160 621.55 99448 624.1 99856
Idea Cellular
LTD
861 116.2 100048.2 113.2 97465.2
Reliance
Communications
Ltd
1621 61.65 99934.65 55.2 89479.2
Adani Power Ltd 2216 45.15 100052.4 40.65 90080.4
Reliance Power
Ltd
1376 72.65 99966.4 61.55 84692.8
Larsen & Toubro
Ltd
71 1400.1 99407.1 1364.9 96907.9
Bharat Heavy
Electricals Ltd
501 200.9 100650.9 176.95 88651.95
Total 1000000 934936.05

Calculation of the Hedging Position of the Portfolio for March 2013
Nifty Index Value as on 01 March 2013 = 5719.7
Value of the portfolio on 01 March 2013 = 1000000
Nifty Lot Size = 50
Hedge ratio
The required number of future contracts can be calculated using Hedge Ratio
Hedge Ratio=

MAXIMIZATION TOOL
133
=

=259.961
Number of lots to be hedged=

=

=5.199
That is approximately 5 future contracts.
It was anticipated that the index will fall down due to the high inflation rate, rise
in the crude oil price, European Union recession, Indias high Current Account
Deficit and low GDP rate.
So we consider hedging the portfolio by shorting index futures. Thats we need to
sell the index futures on 01 March 2013 and buy back on 28
th
March 2013.

Portfolio profit/loss analysis
Value of the portfolio on 01 March 2013 = Rs 1000000
Value of the portfolio on 28
th
March 2013 = Rs 934936.05
Loss in the value = Rs 65063.8
Effectiveness of Hedging using Index futures
Price of a future on 01 March 2013 = Rs 5729.95
Price of 5 future contracts = 5729.95 X 5 X 50
=Rs 1432487.5
Price of a future on 28
th
March 2013 = Rs 5676.5
=Rs 1419125
MAXIMIZATION TOOL
134
On 01 March 2013 the investor shorts index futures for Rs 1432487.5 fearing a
fall in the market that means he sells 5 future contracts.
On 28
th
March as the investor feared, the markets fell due to the reasons
anticipated. So he bought back the futures on the expiry date 28
th
March at a price
of Rs 5676.5 per future contract.
Profit from the future trading
Since the index futures are shorted and the price has been decreased the investor
got a profit.
The profit from future trading = 1432487.5-1419125
=13362.5
Hence with hedging the investor could reduce the loss up to Rs 13362.5

The Net Loss
The loss of the portfolio after hedging = Loss of portfolio- profit from future
trading
= 65063.8-13362.5
= 51701.3
The loss without hedging = 65063.8
The loss with hedging = 51701.3
Interpretation
In the month March 2013, portfolio made a high loss due to the economic
conditions such as the high inflation rate, rise in the crude oil price, European
Union recession, Indias high Current Account Deficit and low GDP rate. These
conditions badly affected the Indian stock market. In the analysis we applied Nifty
MAXIMIZATION TOOL
135
index futures to reduce the risk. However due to the high risk of the portfolio, the
tool could only reduce a certain percentage of the loss.
TABLE 3.5 Portfolio from 1
st
April 2013 to 25
th
April 2013
Companies No of
Share
s
Share Price
as on 1-4-
2013
Total
Amount
Share Price
as on 25-4-
2013
Total
Amount
TATA STEEL
LTD.
297 314.5 93406.5 312.55 92827.35
JINDAL STEEL
& POWER LTD
275 342.4 94160 328.8 90420
ICICI Bank Ltd 95 1051.8 99921 1177.45 111857.7
5
HDFC Bank Ltd 160 623.9 99824 689.35 110296
Idea Cellular
LTD
861 114.75 98799.75 116.25 100091.2
5
Reliance Comm.
Ltd
1621 57.1 92559.1 95.55 154886.5
5
Adani Power Ltd 2216 42.2 93515.2 49.65 110024.4
Reliance Power
Ltd
1376 63.15 86894.4 73.95 101755.2
Larsen & Toubro
Ltd
71 1394.7 99023.7 1518.75 107831.2
5
Bharath Heavy
Electricals Ltd
501 181.95 91156.95 192.45 96417.45
Total 949260.6 1076407.
2

Calculation of the Hedging Position of the Portfolio for April 2013
Nifty Index Value as on 01 April 2013 = 5704.4
Value of the portfolio on 01 April 2013 = 949260.6
MAXIMIZATION TOOL
136
Nifty Lot Size = 50
Hedge ratio
Hedge Ratio=

=

=247.432

=

= 4.948
It is anticipated that the market will be bullish in April due the cutting of Repo
Rates in India by 25 bpts to 7.5 % by the RBI and Government of India hiked the
Debt Limits for overseas Financial Institutions to US $ 25 billion for Indian
Sovereign Debt and to US $ 50 billion for Indian Commercial Paper to attract
foreign capital and to improve forex inflows.
So we consider taking a long position by buying index futures on April 1
st
and
selling it on the maturity date 25
th
April 2013.
Value of the portfolio on 01 April 2013 = Rs 949260.6
th
April 2013 = Rs 1076407.2
Profit of the portfolio = Rs. 127146.6
MAXIMIZATION TOOL
137
Price of a future on 01 April 2013 = Rs 5726.55
=Rs 1431637.5
th
April 2013 = Rs 5910.05
=Rs 1477512.5
On April 1
st
2013 the investor bought 5 future contracts expecting a bullish
market.
On 25
th
April 2013 when the market rose as he expected, the investor sold the
contracts and made a profit.
Profit from Future trading
Since the investor took a long position on the futures and sold them when the
market is high, he made a profit.
Profit from future trading = 1477512.5 -1431637.5
= 45875
Hence with hedging the investor can maximize the profit.
The Net Profit
The Total profit of the portfolio with hedging= Profit of the portfolio + profit from
future trading
= 127146.6 + 45875
= 173021.6
The profit without hedging = 127146.6
The profit with hedging = 173021.6
Interpretation
MAXIMIZATION TOOL
138
In the month of April 2013 the RBIs action of cutting the interest rates and the
Government of Indias actions have helped the market to be bullish.
Therefore on the month of April the portfolio made a huge profit. Trading using
the futures also helped to increase the profit.
TABLE 3.6 Portfolio from 26
th
April 2013 to 30
th
May 2013
Companies No of
Shares
Share
Price as
on 26-4-
2013
Total
Amount
Share Price
as on 30-5-
2013
Total
Amount
TATA STEEL
LTD.
297 304.85 90540.4
5
301.8 89634.6
JINDAL
STEEL &
POWER LTD
275 314.7 86542.5 296.25 81468.75
ICICI Bank Ltd 95 1144.3 108708.
5
1182.75 112361.25
HDFC Bank Ltd 160 689.15 110264 723.8 115808
Idea Cellular
LTD
861 122.3 105300.
3
133.7 115115.7
Reliance
Communication
s Ltd
1621 93.05 150834.
05
109.85 178066.85
Adani Power
Ltd
2216 48.85 108251.
6
58.55 129746.8
Reliance Power
Ltd
1376 71.05 97764.8 72 99072
Larsen &
Toubro Ltd
71 1541.8 109467.
8
1426.65 101292.15
Bharat Heavy
Electricals Ltd
501 188.9 94638.9 205.35 102880.35
Total 1062312 1125446.45
MAXIMIZATION TOOL
139
.9

Calculation of the Hedging Position of the Portfolio for 26
th
April 2013 to 30
th

May 2013
Nifty Index Value as on 26 April 2013 = 5871.45
Value of the portfolio on 26 April 2013 = 1062312.9
Nifty Lot Size = 50
Hedge ratio
Hedge Ratio=

=

=269.022

=

= 5.38
The investor takes a long position by buying index futures on 26
th
April 2013,
expecting a rise in the market.
th
April 2013 = Rs 1062312.9
th
May 2013 = Rs 1125446.45
Profit of the portfolio = Rs. 63133.55
MAXIMIZATION TOOL
140
th
April 2013 = Rs 5887.75
Price of 5 future contracts =5887.75 X 5 X 50
=Rs 1471937.5
th
May 2013 = Rs 6124.2
=Rs 1531050
On April 26
th
2013 the investor bought 5 future contracts expecting a bullish
market.
On 30
th
May 2013 when the market rose as he expected, the investor sold the
contracts and made a profit.
Profit from Future trading
Since the investor took a long position on the futures and sold them when the
market is high, he made a profit.
Profit from future trading = 1531050-1471937.5
= 59112.5
Hence with hedging the investor can maximize the profit.
The Net Profit
The Total profit of the portfolio with hedging= Profit of the portfolio + profit from
future trading
= 63133.55+ 59112.5
= 122246.05
The profit without hedging = 63133.55
The profit with hedging = 122246.05
MAXIMIZATION TOOL
141
Interpretation
The bullish market was also persistent in the month of May 2013 too. The RBI
slashed benchmark Repo rate by 25 bpts to 7.25 % but left CRR unchanged.
These altogether helped the portfolio to make a good profit in the month of May
2013. By hedging using futures the profit is maximized.
Effectiveness of using Index futures on the portfolio from March to May 2013
The loss of the portfolio in the month March 2013 after hedging = 51701.3
The profit of the portfolio in the month April 2013 after hedging = 173021.6
The profit of the portfolio in the month May 2013 after hedging = 122246.05
Total Profit from the portfolio from March to May = (122246.05 + 173021.6)-
51701.3
= 243566.35
If we didnt use hedging using futures, then
Loss of the portfolio in March = 65063.8
Profit of the portfolio in April = 127146.6
Profit of the portfolio in May = 63133.55
The total profit will be = (127146.6+63133.55)-
65063.8
= 125216.35
We can show these details in a table
TABLE 3.7 comparison of hedging using index futures
Month Without hedging With hedging
March -65063.8 -51701.3
April 127146.6 173021.6
May 63133.55 122246.05
MAXIMIZATION TOOL
142
March to May 125216.35 243566.35

Interpretation
We have calculated the portfolio returns with hedging and without hedging using
Nifty index futures. The portfolio made a profit by using Nifty index future or
reduced the loss to minimum. It is found that if we didnt use hedging there would
be less profit. So it is effective to use future contracts for hedging.
EFFECTIVENESS OF USING INDEX OPTION
In the month of March
By analyzing the market condition in March 2013, the market is expected to be
bearish as explained above in the usage of Nifty Future Index. We use put option
of strike price 5800 to hedge the portfolio.
Nifty Index value on 1-3-2013 = 5719.7
No of contracts used for hedging = 5
Put option price in 1-3-2013 = 120
Lot size = 50
Total amount needed for 5 contracts = 120 X 5 X 50
= 30000
If we exit the 5 contracts in 26
th
March 2013 then,
Put option price in March 26 = 158
Put option price for 5 contracts = 158 X 5 X 50
= 39500
Profit from option trading = 39500-30000
= 9500
Loss of the portfolio in March 2013 = 65063.8
MAXIMIZATION TOOL
143
Loss of the portfolio after hedging = 65063.8-9500
= 55563.8
Interpretation
By using option trading we can minimize the loss. For the option trading we need
to give a small amount of premium.
In the month April 2013
In the month April the investor expects a rise in the market. So he needs to buy
call option for the strike price 5800.
Nifty Index Value on April 1
st
2013 = 5704.40
No of contracts needed for hedging = 5
Call option price in April 1
st
2013 = 45.9
Total amount for buying 5 call options = 45.9 X 5 X 50
= 11475
Call option price in 25
th
April 2013 = 103.75
Call option price for 5 contracts =103.75 X 5 X 50
= 25937.5
Profit from option trading = 25937.5-11475
=14462.5
Total profit after hedging = 127146.6 + 14462.5
= 141609.1
Interpretation
In the month April 2013, the market was bullish. Therefore the portfolio was in
profit. Hedging by option helped to increase the profit.
MAXIMIZATION TOOL
144

Hedging from April 26 to May 30, 2013
The market is expected to be bullish in May 2013, so the investor buys call
options with strike price 5800 expiring on 30
th
May.
Nifty index value on April 26, 2013 = 5871.45
No of contracts for hedging = 5
Call option price on April 26 = 142.90
Lot size = 50
Total amount needed for 5 contracts = 142.90 X 5 X 50
= 35725
Call option price on 30
th
May 2013 = 321.20
Call option price for 5 contracts = 321.20 X 5 X 50
= 80300
Profit for option trading = 80300-35725
= 44575
Profit of the portfolio = 63133.55
Total Profit after hedging = 63133.55 + 44575
= 107708.55
Interpretation
In the month May, there was a bullish market. So portfolio was in profit. Hedging
using the options maximized the profit.
Now we may analyse the whole effect of index option in the portfolio from the
month March to May 2013.
Loss of the portfolio in the month March 2013 after hedging = 55563.8
MAXIMIZATION TOOL
145
Profit of the portfolio in April 2013 after hedging = 141609.1
Profit of the portfolio in May 2013 after hedging = 107708.55
Total profit from the portfolio from March to May = (107708.55+141609.1)-
55563.8
=193753.85

If we didnt use hedging for the portfolio, then
Loss of the portfolio in March = 65063.8
Profit of the portfolio in May = 63133.55
The total profit will be = (127146.6+63133.55)-
65063.8
= 125216.35
We can show this in a table
Table 3.8 comparison of hedging using options
Month Without Hedging With Hedging
March -65063.8 -55563.8
April 127146.6 141609.1
May 63133.55 107708.55
Total 125216.35 193753.85

MAXIMIZATION TOOL
146

Chart No: 3.1 comparison of hedging using index options
COMPARISON BETWEEN INDEX FUTURE AND INDEX OPTION
Table 3.9 Calculation of the amount of margin given for the future contract
Month No of
contracts
Price for one
contract
Total Margin (8%)
March 5 5729.95 1432487.5 114599
April 5 5726.55 1431637.5 114531
May 5 5887.75 1471937.5 117755

Along with the initial margin sometimes a maintenance margin in needed. Margin
Maintenance is the amount of money where a loss on your futures position
requires you to allocate more funds to bring the margin back to the initial margin
level.
Table 3.10 COMPARISON BETWEEN FUTURE AND OPTION
Month Future
Margin
Profit for
trading
Profit in
%
Option
premium
Profit
from
trading
Profit in
%
March 114599 13362.5 11.66 30000 9500 31.66
April 114531 45875 40.05 11475 14462.5 126.03
-100000
-50000
0
50000
100000
150000
200000
March April May
Without Hedging
With Hedging
MAXIMIZATION TOOL
147
May 117755 59112.5 50.19 35725 44575 124.77

Chart no : 3.2 effectiveness of using derivatives from March to May.
INTERPRETATION
From the above table and chart we can found that option trading is more effective
than future trading for risk reduction and also for profit making. Future trading
needs a high amount of margin, however option trading only needs premium. If
our anticipation about the market condition was wrong, then there is a chance for
loss from future trading, however in the case of option trading, we may loss the
premium and make unlimited profit. Also future trading needs a maintenance
margin if we have debt in our trading account or decreasing our 8% margin in the
trading account. Option trading has no obligation, but future is a contract and it
has an obligation to exercise it. From this analysis we can say that option index is
more effective and less-risky tools than future index.
We can also calculate the total effect of hedging from March 1
st
to May 30
th

Value of the portfolio in 1
st
March, 2013 = 1000000
Value of the portfolio in 30
th
May, 2013 = 1125446.45
Profit of the portfolio = 125446.45
0
20
40
60
80
100
120
140
March April May
Profit future trading
Profit in option trading
MAXIMIZATION TOOL
148
Profit from future trading = 13362.5 + 45875 + 59112.5
= 118350
Profit of the portfolio for 3 months after Hedging with futures
=125446.45 + 118350
= 243796.45
Profit from option trading = 9500 + 14462.5 + 44575
= 68537.5
Profit of the portfolio for 3 months after hedging with options
= 125446.45 + 68537.5
= 193983.95
These details can be shown in a table
Table 3.11 effect of hedging strategy on the portfolio
Strategy Effect on the portfolio
Without Hedging Profit of Rs 125446.45
Hedging with Index futures Profit of Rs 243796.45
Hedging with Index Options Profit of Rs 193983.95

INTERPRETATION
From the above calculation, it is found that without hedging the portfolio makes a
less profit than with hedging with futures and options. After hedging with index
futures, the portfolio makes a profit of Rs 243796.45 and with option trading
portfolio makes a profit of Rs 193983.95. From these analyses we can say that
hedging with financial derivatives is an effective technique for risk diversification
and profit maximization.

MAXIMIZATION TOOL
149

MAXIMIZATION TOOL
150

CHAPTER 4
EMPIRICAL RESULTS

FINDINGS FROM THE STUDY
a) Effectiveness of Financial Derivatives as a risk
diversification tool
Financial Derivatives such as futures and options can be used as an
effective tool to diversify the risks associated in investing in a
volatile stock market.
To diversify the risk a proper portfolio must be prepared by
analysing the market condition.
MAXIMIZATION TOOL
151
The risk can be reduced to an extent only, it cannot be avoided.
Risk is associated in any type of investment; financial derivatives
can be used to hedge the risk.
The effectiveness of risk diversification depends upon the type of
tool used that is futures or options.
The selection of the tool entirely depends upon the anticipation of
the investor, so that an experienced investor can make huge profits
in comparison to a newcomer.
Strategies can be varying according to the time period. The
selection of the tool and the strategy that should be adopted varies
with time to time.
100% protection from risk is not possible; however the risk can be
reduced.
b) Effectiveness of Financial Derivatives as a profit
maximisation tool
By using futures and options the profit from the portfolio can be
maximised.
If the portfolio incurs a loss, by using index futures or options the
loss can be minimised. Thereby the net effect of the loss is reduced.
If the portfolio makes a profit, the trading of futures and options
add extra profit to the investment.
An investor might need the advice of a portfolio manager to
prepare a portfolio which delivers maximum profit.
An aggressive portfolio delivers maximum profit as it changes with
the market index.
SUGGESTIONS
On the basis of analysis done and findings reached, the following suggestions are
given to existing and prospective customers.
The losses that arise from the market risk can be reduced effectively using
hedging. The minimization of the risk is its primary objective.
MAXIMIZATION TOOL
152
Awareness programmes must be introduced by the brokers or financial
institutions about the importance of using financial derivatives as hedging
tools.
If an investor wants to minimize the risk of the portfolio, it must consists
of shares from various sectors and here Nifty index futures are used as a
tool for hedging, since they are convenient and represent the security
market as a whole. The advantage is that the risk within the portfolio can
be minimised completely and the portfolio will only be affected by the
market risk.
Strategic thinking and positive thinking are the two qualities that are
needed for a Hedger. These qualities will enable him to comprehend
market trends and fluctuations. If he lacks these qualities the strategies
adopted by him will earn only losses.
The selection of the hedging tool depends on the time frame and the nature
of the investor. An investor who prefers short term investments can go for
hedging, and the tools must be specifically adopted by him, depending on
the risk he is willing to suffer and the amount of liquid cash he has. Since
the market is always volatile long term investor should always be careful.
The level to which the risk is to be reduced must be determined by the
investor before he selects a risk reduction strategy. The cost and the
benefit of each strategy must be considered with the existing market
situations.
The strategies must be changed according to the market situations rather
than sticking to a particular strategy.

MAXIMIZATION TOOL
153

MAXIMIZATION TOOL
154

CHAPTER 5
SUMMARY AND CONCLUSION

5. SUMMARY AND CONCLUSION
The project titled A Study on the effectiveness of Financial Derivatives as a Risk
Diversification and Profit Maximization Tool The case of Hedge equities Ltd,
for a period of 45 days from May 2
nd
2013 to June 15
th
2013.
Investments in the stock market involve high risk due to the volatile market
conditions. We use derivatives such as futures and options to hedge the risk
associated with such investments.
MAXIMIZATION TOOL
155
It is realized that derivative instrument have been in the market right from the 13th
century onwards. But derivative has come to the notice of modern security market
only in recent years. Therefore not much people are aware of its usage as hedging
tool.
This project is focused on the effectiveness of hedging in portfolio management.
The project is prepared using real market data and arrives at a conclusion based on
the results that are calculated minimizing any discrepancies.
A portfolio construction is an important step for every investor. It should be made
sure that the portfolio is a diversified one with different set of sectors included in
it. It can greatly reduce the risk of heavy loss due to the problems in any one
sector. Futures and options are two of the major hedging tools that can make
unlimited profits and limited loss within a short time frame. Options provide us
with a set of different strategies on the basis of the investors risk profile which
can be applied accordingly. The greatest benefit on using futures is that the
investor has to pay a particular amount of premium to buy option contracts. On
the other hand, we have futures as another hedging tool which is commonly used.
But in order to apply futures, the investor has to keep a particular percentage as
margin. If the hedging tool acts in the inverse direction, making losses, amount
from our margin will be deteriorating slowly. But the percentage of profits future
contracts makes is very much high.
Thus, here by we can conclude that, a systematic investment with proper hedging
along with in can earn us extra profits than the normal portfolio return. Also a
diversified portfolio is a kind of hedging technique that reduces heavy loss in the
portfolio. Thus we can reduce the risk and maximize the profit of a portfolio.

MAXIMIZATION TOOL
156

CHAPTER 6
BIBILIOGRAPHY

BOOKS

PRASANNA CHANDRA Investment Analysis and Portfolio
Management, TATA McGraw Hill Publishing Company LTD New
Delhi 2005
PUNITHAVATHY PANDIAN Security Analysis and Portfolio
Management, Vikas Publishing House PVT LTD New Delhi 2001
MAXIMIZATION TOOL
157
SUDHINDRA BHAT Security Analysis and Portfolio
Management, EXCEL Publications, New Delhi 2008
P. VIJAYA BHASKAR, B. MAHAPATRA- Derivatives
Simplified, Response Books New Delhi, 2001

WEBSITES
www.bseindia.org
www.nseindia.org
www.hedgeequities.com
www.yahoofinance.com
www.rediffmoney.com
www.investopedia.com
Finance.reuters.in
stockshastra.moneyworks4me.com
www.wikipedia.com

MAXIMIZATION TOOL
158

CHAPTER 7
APPENDIX

APPENDIX
Historical Data for CNX NIFTY
For the period 01-03-2013 to 31-05-2013
Date Open High Low Close Shares Traded
Turnover
( Cr)
01-Mar-2013 5702.45 5739.45 5679.90 5719.70 174517984 6877.59
04-Mar-2013 5704.70 5712.00 5663.60 5698.50 144887325 5778.72
MAXIMIZATION TOOL
159
05-Mar-2013 5722.45 5790.10 5722.40 5784.25 154406134 6321.31
06-Mar-2013 5816.40 5828.70 5795.05 5818.60 156901392 6244.47
07-Mar-2013 5801.30 5878.00 5801.30 5863.30 134679762 5676.89
08-Mar-2013 5883.65 5952.85 5883.00 5945.70 150781148 6214.19
11-Mar-2013 5946.10 5971.20 5930.35 5942.35 125384918 5688.38
12-Mar-2013 5944.60 5952.00 5893.65 5914.10 115944389 5098.38
13-Mar-2013 5884.80 5893.85 5842.25 5851.20 116710808 4950.09
14-Mar-2013 5845.95 5920.15 5791.75 5908.95 149008437 7204.09
15-Mar-2013 5914.90 5945.65 5861.00 5872.60 152156666 6984.19
18-Mar-2013 5816.75 5850.20 5814.35 5835.25 102663402 4690.01
19-Mar-2013 5859.50 5863.60 5724.30 5745.95 182311867 8255.03
20-Mar-2013 5740.55 5745.30 5682.30 5694.40 187624850 7103.68
21-Mar-2013 5705.90 5757.75 5647.95 5658.75 179177573 7053.93
22-Mar-2013 5659.80 5691.45 5631.80 5651.35 165293291 5909.38
25-Mar-2013 5707.30 5718.40 5624.40 5633.85 150388821 5683.44
26-Mar-2013 5613.75 5655.30 5612.05 5641.60 126500524 4939.19
28-Mar-2013 5647.75 5692.95 5604.85 5682.55 209658945 8372.35
01-Apr-2013 5697.35 5720.95 5675.90 5704.40 97779717 3683.38
02-Apr-2013 5701.70 5754.60 5687.15 5748.10 106423845 4262.15
03-Apr-2013 5740.20 5744.95 5650.10 5672.90 140713330 5313.95
04-Apr-2013 5640.65 5644.45 5565.65 5574.75 134586976 5000.44
05-Apr-2013 5568.10 5577.30 5534.70 5553.25 137461477 5281.57
08-Apr-2013 5550.50 5569.20 5537.05 5542.95 97021471 3673.21
09-Apr-2013 5568.75 5603.05 5487.00 5495.10 138184712 5485.91
10-Apr-2013 5536.25 5569.25 5477.20 5558.70 128558760 5387.08
11-Apr-2013 5601.65 5610.65 5542.85 5594.00 146828501 6469.38
12-Apr-2013 5520.70 5544.50 5494.90 5528.55 127323273 7447.27
15-Apr-2013 5508.50 5592.85 5500.30 5568.40 142918219 7133.92
16-Apr-2013 5562.45 5699.25 5555.85 5688.95 142679244 5943.06
17-Apr-2013 5708.65 5732.15 5669.00 5688.70 154575403 7304.10
18-Apr-2013 5682.70 5794.35 5681.85 5783.10 149883469 6588.70
22-Apr-2013 5789.85 5844.85 5789.80 5834.40 135095797 6073.25
23-Apr-2013 5843.10 5844.30 5791.55 5836.90 132218357 5366.87
25-Apr-2013 5856.10 5924.60 5853.30 5916.30 199597725 9211.66
26-Apr-2013 5899.75 5907.05 5860.50 5871.45 141311877 6840.01
29-Apr-2013 5877.60 5918.65 5868.80 5904.10 118882089 5364.86
30-Apr-2013 5932.60 5962.30 5867.80 5930.20 153186197 6699.02
02-May-2013 5911.40 6019.45 5910.95 5999.35 162376438 7277.43
03-May-2013 5993.50 6000.30 5930.15 5944.00 145754275 6590.91
MAXIMIZATION TOOL
160
06-May-2013 5944.90 5976.50 5928.45 5971.05 110166713 4612.49
07-May-2013 5983.45 6050.50 5982.95 6043.55 136372981 5572.16
08-May-2013 6064.15 6083.55 6024.95 6069.30 122278698 5159.97
09-May-2013 6078.35 6084.70 6040.45 6050.15 109997276 5164.76
10-May-2013 6046.25 6105.30 6045.60 6094.75 111351573 5162.22
11-May-2013 6088.20 6114.55 6084.15 6107.25 7991165 355.74
13-May-2013 6098.20 6104.95 5972.90 5980.45 107948706 4633.05
14-May-2013 5989.70 6026.20 5970.05 5995.40 119265483 4921.65
15-May-2013 6018.85 6157.10 6018.85 6146.75 153892843 7240.73
16-May-2013 6128.25 6187.30 6128.25 6169.90 158635506 6733.31
17-May-2013 6172.95 6199.95 6146.15 6187.30 147280254 5870.44
20-May-2013 6198.00 6229.45 6146.05 6156.90 122252978 5589.97
21-May-2013 6152.35 6180.25 6102.35 6114.10 130589228 5122.71
22-May-2013 6127.05 6147.60 6074.45 6094.50 133763685 5837.19
23-May-2013 6050.40 6081.45 5955.70 5967.05 198930489 8230.10
24-May-2013 6010.70 6015.30 5936.80 5983.55 161622562 6193.00
27-May-2013 5989.40 6099.90 5975.55 6083.15 115115365 4961.15
28-May-2013 6086.35 6127.65 6055.40 6111.25 139668916 5481.14
29-May-2013 6120.45 6125.05 6069.80 6104.30 120205054 5135.80
30-May-2013 6072.15 6133.75 6072.15 6124.05 194092801 7794.82
31-May-2013 6098.70 6106.25 5975.55 5985.95 175311989 7223.11

Project Complete Document

Transféré par

Informations du document

Description originale:

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Project Complete Document

Transféré par

Droits d'auteur :

Formats disponibles

A STUDY ON THE EFFECTIVENESS OF FINANCIAL DERIVATIVES AS A RISK DIVERSIFICATION AND PROFIT

and the related probabilities are (

) the expected return may be represented

= Standard deviation of returns of stock i.

= Standard deviation of returns of the market index.

= variance of market returns.

. This has to be adjusted to

Vous aimerez peut-être aussi