Kavita Bhansali-05-Hedging Performance

“Hedging performance and basis risk in stock index
futures”
Submitted in partial fulfillment of the requirements of

the M.B.A Degree Course of Bangalore University
By
KAVITA BHANSALI
(REGD.NO:05 XQCM 6036)
Under the Guidance

Of
DR. T.V.NARASIMHA RAO
Faculty
MPBIM
M.P.BIRLA INSTITUTE OF MANAGEMENT

Associate Bharatiya Vidya Bhavan
43, Race Course Road, Bangalore-560001
2005-2007
M P Birla Institute of Management 1

DECLARATION
I hereby declare that the dissertation entitled “Hedging

performance and basis risk in stock index futures” is the result of
work undertaken by me, under the guidance of Dr.T.V.N.Rao,
Associate Professor, M.P.Birla Institute of Management,
Bangalore.
I also declare that this dissertation has not been submitted to any
other University/Institution for the award of any Degree or
Diploma.
Place: Bangalore
Date : 13th May 2007 Kavita Bhansali

ACKNOWLEDGEMENT
It’s my special privilege to extend words of the thanks to all of

them who have helped me and encouraged me in completing the
project successfully.
I would thank Dr.T.V.N.Rao for giving me valuable inputs

required for completing this project report successfully. I owe my
sincere gratitude to him for spending his valuable time with me
and for his guidance.
It would be improper if I do not acknowledge the help and

encouragement by my friends and well wishers who always helped
me directly or indirectly.
My gratitude will not be complete without thanking the almighty

god and my loving parents who have been supportive through out
the project.
Kavita Bhansali

TABLE OF CONTENTS
CHAPTERS PARTICULARS PAGE NO.
ABSTRACT 02
1 INTRODUCTION AND THEORETICAL 03

BACKGROUND
2 REVIEW OF LITERATURE 46
3 RESEARCH METHODOLOGY 49
4 PROBLEM STATEMENT 50
5 OBJECTIVE OF THE STUDY 50
6 SAMPLE SIZE AND DATA SOURCES 51

7 TEST OF STATIONARITY 5
9 LIMITATIONS OF THE RESEARCH 55
10 DATA ANALYSIS 56
11 CONCLUSION 66
12 ANNEXTURE 67
13 BIBLIOGRAPHY 68

ABSTRACT
Corporation in which individual investor place their money have exposure to

fluctuation of all kinds of financial price, as a natural by product of their operation.
Financial prices include foreign exchange rate, interest rates, commodity prices
and equity prices. The effect of changes in prices reported on earnings is
overwhelming.
Hedging is a way of reducing some of the risk involved in holding an investment.

There are many financial instruments which are used in hedging. In considering
potential application of index futures, it is clear that in nearly every case a cross
hedge is involved. That is the stock position that is being hedge is different from
the underlying portfolio of index contract. This means that the return and risk for
an index futures hedge will depend upon the behavior of “Basis” i.e., the
difference between the futures prices and cash prices. Hedging a position in
stock will necessarily expose it to some measure of Basis risk – risk that the
change in future price over time will not track exactly the value of cash position.
This paper will examine the basis and different sources of basis risk in NSE’s
NIFTY index contract. It will also simplify the theory of hedging in a presence of
basis risk and displays the risk return combination that could have been achieved
in practice by hedging some broadly diversified portfolio with NIFTY index
futures.
We studied the basis risk between S&P CNX NIFTY, S&P CNX 500 and NIFTY
Futures and find out the theoretical price which can be compare with the actual
futures price which gives us the basis data on which we applied the “t” test and
find out that basis risk is exist or not.

CHAPTER 1
INTRODUCTION AND
THEORETICAL BACKGROUND

Introduction to Derivatives
The evolution occurred in stages. The Chicago Board of Trade (CBOT), which
opened in 1848, is, to this day, the largest futures market in the world. The
general rules framed by CBOT in 1865 became a pacesetter for many other
markets. In 1870, the New York cotton exchange was founded.
The London metal exchange was established in 1877 and is now the leading
market in metal trading (both spot and forward). Thereafter many new futures
market were started. The first financial futures market was the international
monetary, founded in 1972 by the Chicago mercantile exchange. The London
international financial futures exchange followed this in 1982.
As already mentioned, some form of forward trading probably existed in India

also. The first organized forward markets came into existence in India in the late
19th and early 20th century in Calcutta (for jute and jute goods) and Mumbai (for
cotton).
Chronologically, India’s experience in organized forward trading is almost as long

as that of the United Kingdom, and certainly longer than many developed
nations. However, the tidal wave of price control, nationalization and state
intervention in markets, which swept through all economic policy making after
independence, led to a rapid decline in number of futures markets. Frequently
markets were closed due to the feeling that they were responsible for sudden
movements of price in the commodities.

Definition of Derivatives
Derivatives are the financial instruments, which derive their value from some
other financial instruments, called the underlying. The foundation of all
derivatives market is the underlying market, which could be spot market for gold,
or it could be a pure number such as the level of the wholesale price index of a
market price.
A derivative is a financial instrument whose value depends on the value of

other basic underlying variables.
John c hull
According to the Securities Contract (Regulation) Act, 1956, derivatives

include:
A security derived from a debt instrument, share, and loan whether

secured or Unsecured, risk instrument or contract for differences or any
other form of Security.
A contract, which derives its value from the prices or index of prices of
underlying securities.
Therefore, derivatives are specialized contracts to facilitate temporarily for

hedging which is protection against losses resulting from unforeseen price or

volatility changes. Thus, derivatives are a very important tool of risk
management. Derivatives perform a number of economic functions like price
discovery, risk transfer and market completion.
The simplest kind of derivative market is the forward market. Here a buyer and
seller write a contract for delivery at a specific future date and a specified future
price. In India, a forward market exists in the form of the dollar-rupee market. But
forward market suffers from two serious problems; counter party risk resulting in
comparatively high rate of contract noncompliance and poor liquidity.
Futures markets were invented to cope with these two difficulties of forward
markets. Futures are standardized forward contracts traded on an organized
stock exchange. In essence, a future contract is a derivative instrument whose
value is derived from the expected price of the underlying security or asset or
index at a pre-determined future date.
Types of Derivatives
• FORWARDS
• FUTURE
• OPTIONS
• SWAPS
One form of classification of derivatives is between commodity derivatives and

financial derivatives. Thus futures, option or swaps on gold, sugar, jute, pepper
etc are commodity derivatives.

While futures, options or swaps on currencies, gilt-edged securities, stock and
share stock market indices etc are financial derivatives.
PREREQUISITES FOR DERIVATIVES MARKET
There are five essential prerequisites for derivatives market to flourish in a

country.
a) Large market capitalization
At a market capitalization of near $1.5 trillion, India is well ahead of many other
countries where derivatives markets have succeeded.
b) Liquidity in the underlying
A few years ago, the total trading volume in India used to be around Rs-300
crores a day. Today, daily trading volume in India is around Rs-15000 crores a
day. This implies a degree of liquidity, which is around six times superior to the
earlier conditions. There is empirical evidence to suggest that there are many
financial instruments in the country today, which have adequate to support
derivative market.
c) Clearing house that guarantees trades

Counter party risk is one of the major factor recognized as essential for starting a
strong and healthy derivatives market. Trade guarantee therefore becomes
imperative before a derivatives market could start. The first clearinghouse
corporation guarantees trades have become fully functional from July 1996 in the
form of National Securities Clearing Corporation (NSCC). NSCC is responsible
for guaranteeing all open positions on the National Stock Exchange (NSE) for
which it does the clearing. Other exchanges are also moving towards setting up
separate and well-funded clearing corporations for providing trade guarantees
d) Physical infrastructure
India.s equity markets are all moving towards satellite connectivity, which allows
investors and traders anywhere in the country to buy liquidity services from
anywhere else. This telecommunications infrastructure, India.s capabilities in
computer hardware and software, will enable the establishment of computer
system for creation of derivatives markets. Setting up of automated trading
system as an experience with various prospective exchanges will also be
beneficial while setting up the derivative market.
e) Risk-taking capability and Analytical skills
India’s investors are very strong in their risk-bearing capacity and can cope with
the risk that derivatives pose. Evidence of the volumes traded on the capital
markets, which are akin to a futures market, is indicative of this capacity. In
contrast, in some other countries, investors simply lack the risk-bearing capacity
to sustain the growth of even the equity market. It is expected that such a barrier
will not appear in India.

On the subject of analytical skills, derivatives require a high degree of analytical
capability for many subtle trading strategies to pricing. India has an enormous
pool of mathematically literate finance professionals, who would excel in this
field. Lastly, an obvious advantage for the Indian market is that we have
enormous experience with futures markets through the settlement cycle oriented
equity which is not truly a spot market but a futures market (including concepts
like market-to-market margin, low delivery ratios, and last-day-of settlement
abnormalities in prices). We also have active futures markets on six
commodities. With this state of development of the capital markets it is felt that
there is no major hurdle left for the creation of development of the capital
markets. Hence on July 2, 1996 the SEBI board gave an in principal approval for
the launch of derivatives markets in India.
A) OPTIONS:
The concept of options is not new one. In Fact, options have been in use for
centuries. The idea of an option existed in ancient Greece and Rome. The
Romans wrote options on the cargo that were transported by their ship. In the
17th century, there was an active option markets in Holland. In fact, options were
used in a large measure in the .tulip bulb mania . of that century. However, in the
absence of mechanism to guarantee the performance of the contract, the refusal
of many put option writers to take delivery of the tulip bulb and pay the high
prices of the bulb they had originally agreed to, led to bursting of the bulb bubble
during the winter of 1637.A number of speculators were wiped out in the process.
In India, options on stocks of companies were illegal until 25th January 1995
according to sec. 20 of Securities Contracts (Regulation) Act, 1956. When

Securities Laws (Amendment) Act, 1956 deleted sec. 20, thus making the
introduction of options as legal act.
An options contract is an agreement between a buyer and a seller. Such a

contract confers on the buyer a right but not an obligation to buy or sell a
specified quantity of the underlying asset at a fixed price on or up to a fixed day
in the future on a payment of a premium to the seller. The premium paid by the
buyer to the seller is the price of an
option contract
Options on a futures contract have added a new dimension to future trading like
futures options provide price protection against adverse price move. Present day
options trading on the floor of an exchange began in April 1973. When the
Chicago Board of trade created the Chicago Board Options Exchange (CBOE)
for the sole purpose of trading Options on a limited number of NEW YORK
STOCK EXCHAGE listed equities
B) FORWARDS:
A forward is an agreement between two parties to exchange an agreed quantity

of asset at a specified future date at a predetermined price specified in the
agreements. The parties concerned agree the settlement date and price in
advance. The promised asset may be currency, commodity, instrument etc. It is
the oldest type of all the derivatives. The party who promises to buy but he
specified asset at an agreed price at a fixed future date is said to be in the .Long
position . and the party who promises to sell at an agreed price at a future date is
said to be in . short position..

C) FUTURES:
It is similar to the forward contract in all the respect. In fact, a future is a

standardized form of forward contract. A future is a contract or an agreement
between two parties to exchange assets / currency or commodity at a certain
future date at an agreed price. The trader who promises to buy is said to be in .
long position . and the party who promises to sell said be in .short position..
Futures contracts are contracts specifying a standard volume of a particular

currency to be exchanged on a specific settlement date. A future contract is an
agreement between a buyer and a seller. Such a contract confers on the buyer
an obligation to buy from the seller, and the seller an obligation to sell to the
buyer a specified quantity of an underlying asset at a fixed price on or before a
fixed day in future. Such a contract can be for delivery of an underlying asset.
To eliminate counter party risk and guarantee traders, futures markets use a
clearing house which employs initial margin, daily market to market margin,
exposures limits etc. to ensure contract compliance and guarantee settlement
standardized futures contracts generate liquidity. In addition, due to these
instruments being traded on recognized exchange.s results in grater
transparency, fairness and efficiency. Due to these inherent advantages, futures
markets have been enormously successful in comparison with forward markets
all over the world The difference between forward contract and future is that
future is a standardized contract in terms of quantity, date and delivery. It is
traded on organized exchanges. So it has secondary markets. Future contract is

always settled daily, irrespective of the maturity date, which is called marking to
the market.
D) SWAP:
Swap is an agreement between two parties to exchange one set of financial

obligations with other. It is widely used throughout the world but is recent in India.
Swap may be interest swap or currency swaps.
Swaps give companies extra flexibility to exploit their comparative advantage in

their respective borrowing markets.
Swaps allow companies to focus on their comparative advantage in borrowing in

a single currency in the short end of the maturity spectrum vs. the long-end of the
maturity spectrum.
Swaps allow companies to exploit advantages across a matrix of currencies and

maturities

THEORETICAL BACKGROUND
Corporation in which individual investor place their money have exposure to

fluctuation of all kinds of financial price, as a natural by product of their operation.
Financial prices include foreign exchange rate, interest rates, commodity prices
and equity prices. The effect of changes in prices reported on earnings is
overwhelming.
Hedging is a way of reducing some of the risk involved in holding an investment.

There are many financial instruments which are used in hedging. In considering
potential application of index futures, it is clear that in nearly every case a cross
hedge is involved. That is the stock position that is being hedge is different from
the underlying portfolio of index contract. This means that the return and risk for
an index futures hedge will depend upon the behavior of “Basis” i.e., the
difference between the futures prices and cash prices. Hedging a position in
stock will necessarily expose it to some measure of Basis risk – risk that the
change in future price over time will not track exactly the value of cash position.
Future prices and the factors that determine these prices will ultimately influence
every user of the market. Futures market prices reflect economically important
relationship to other prices as well. For example, the futures prices for delivery of
gold in 3 months must be related to the spot price for immediate delivery. The
spot price is also known as cash price or current price. The difference between
the cash price and the futures price is called the Basis. Basis is an important
concept in futures contract. Similarly, the future prices are for delivery of gold in
six months. This price difference of the futures on the same commodity is an
intra-commodity spread. The time spread can also be an economically important
variable in futures contracts. The relation between futures prices and expected

future spot prices is so strong, that some market observers believe that they
must be, or at least should be equal. The price for storing the goods underlying
the futures contract helps determine the relationship among future prices and the
relationship between the future price and the spot prices. Thus the future pricing
issues like the bases,the spreads, the expected future spot price and the cost of
storage are interconnected
Basis and Spreads
What is Basis?
The basis is the current cash prices of a particular commodity at a particular

location minus the prices of particular future contract for the same commodity.
Basis: Current Cash Price – Future Price
If the same commodity had two prices in two different markets, a trader could buy
the commodity in cheaper market and sell it in the market with higher price,
thereby making an arbitrage profit. So the basis is calculated in considering
futures prices may differ, depending upon the geographic location of the spot
price that is used to calculate the basis.
Future markets can exhibit a pattern of either normal or inverted prices. Prices for
more distant futures are higher than for nearby futures in a normal market.
Distant futures prices are lower than the prices for contracts near to expiration in
an inverted market. This is so particularly in agricultural products in view of
seasonal production and drastic reduction in price due to heavy supply of

products in that season. This situation may also happen in case of other
commodities including securities also in view of political and other environmental
factors. Traders believe that understanding these seasonal and environmental
factors can be very beneficial for speculation and hedging. The futures prices
and the spot price of gold must be the same. The basis must be zero, again
subject to the disperancy due to transaction cost.
Spreads
Spreads refers to difference in prices of two futures contracts. There are two
types of spreads viz., intra-commodity spreads and inter- commodity spreads.
The difference in price between two future contracts of different maturity dates on
the same commodity is known as intra-commodity spread. An intra –commodity
spread is the difference for two different commodities with the same maturity. An
understanding of spread relationship is essential to earn speculative profits.
Though certain general principles may help to earn profits, considerable
knowledge in a particular commodity itself, will enable the trader to make use of
spread relationship.
What is a stock index futures contract?
Stock index futures are traded in terms of number of contracts. Each contract is
to buy or sell a fixed value of the index. The value of the index is defined as the
value of the index multiplied by the specified monetary amount. In the S&P 500
futures contract traded at the Chicago Mercantile Exchange (CME), the contract
specification states:
1 Contract = $250 * Value of the S&P 500

If we assume that the S&P 500 is quoting at 1,000, the value of one contract will
be equal to $250,000 (250*1,000). The monetary value -- $250 in this case -- is
fixed by the exchange where the contract is traded.
Mechanics of futures trading
Like most other financial instruments, futures contracts are traded on recognised
exchanges. In India, both the NSE and the BSE plan to introduce index futures in
the S&P CNX Nifty and the BSE Sensex. The operations are similar to that of the
stock market, the exception being that, in index futures, the marking-to-market
principle is followed, that is, the portfolios are adjusted to the market values on a
daily basis.
Depending on the position of the portfolio, margins are forced upon investors.
The other important aspect of index futures is that the contracts are settled on a
cash basis. This means it is impossible to make actual delivery of the index. The
difference between the cash and the futures index on the date of settlement is
the profit/loss for the players.
Why buy index futures?
What is the rationale behind using index futures? Academic literature on the
subject shows that, in some cases, the introduction of the index futures has
actually reduced the volatility in the underlying index. The theory behind this is
interesting.
Technical analysts thrive on their ability to predict the movement of the broad
market indices. However, as they cannot trade the index, the normal practice is

to try to capture a relation between the index and individual stocks. The
introduction of the futures contract on stock indices gives them the opportunity to
actually buy into the components of the index.
The other important use of stock index futures is for hedging. Mutual funds and
other institutional investors are the main beneficiaries. Hedging is a technique by
which such institutions can protect their portfolios from market risks. There are
three different views in the literature on the nature and purpose of hedging:
* Risk minimization.
* Profit maximization.
* Reaching a satisfactory risk-return trade-off using a portfolio.
Historically, stock index futures have supplemented, and often replaced, the
secondary stock market as a stock price discovery mechanism. The futures
market has heralded institutional participation in the market with increased
velocity and concentration on stock-trading.
Programme-trading and index arbitrage are necessary for an efficient and

thriving futures market. However, on the flip side, these strategies have
increased the risks associated with stock specialists. The increased
concentration, the velocity of futures trading, and the resultant increase in
volatility in the stock market, may have a long-term impact on the participation of
individual investors in the market.

However, index futures provide investors an efficient and cost-effective means of
hedging and significant improvements in market timing. The introduction of index
futures need not necessarily be bad for the capital market, so long as proper
checks are in place to prevent unwarranted speculation.
Meaning and definitions of hedging
The first rule of hedging is ‘do no harm.’ Like no-fat cream cheese, there are
some things that remove more good stuff than bad. A good hedge diminishes
volatility proportionally more than the return, so that if the hedge reduces
annualized volatility by X%, it should reduce annualized return by no more than
X%.
The best way to understand hedging is to think of it as insurance. When people

decide to hedge, they are insuring themselves against a negative event. This
doesn't prevent a negative event from happening, but if it does happen and
you're properly hedged, the impact of the event is reduced. So, hedging occurs
almost everywhere, and we see it everyday. For example, if you buy house
insurance, you are hedging yourself against fires, break-ins or other unforeseen
disasters.
Portfolio managers, individual investors and corporations use hedging techniques

to reduce their exposure to various risks. In financial markets, however, hedging
becomes more complicated than simply paying an insurance company a fee
every year. Hedging against investment risk means strategically using
instruments in the market to offset the risk of any adverse price movements. In
other words, investors hedge one investment by making another.

Technically, to hedge you would invest in two securities with negative
correlations. Of course, nothing in this world is free, so you still have to pay for
this type of insurance in one form or another.
Although some of us may fantasize about a world where profit potentials are
limitless but also risk free, hedging can't help us escape that hard reality of the
risk-return tradeoff. A reduction in risk will always mean a reduction in potential
profits. So, hedging, for the most part, is a technique not by which you will make
money but by which you can reduce potential loss. If the investment you are
hedging against makes money, you will have typically reduced the profit that you
could have made, and if the investment loses money, your hedge, if successful,
will reduce that loss.
How Do Investors Hedge?
For the most part, hedging techniques involve using complicated financial
instruments known as derivatives, the two most common of which are options
and futures. We're not going to get into the nitty-gritty of describing how these
instruments work, but for now just keep in mind that with these instruments you
can develop trading strategies where a loss in one investment is offset by a gain
in a derivative.
.
Keep in mind that because there are so many different types of options and
futures contracts an investor can hedge against nearly anything, whether a
stock, commodity price, interest rate, or currency.

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.
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. This level of
sophistication depends on the firm's experience, personnel 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.
The hedging problem
The core problem when deciding upon a hedging policy is to strike a balance
between uncertainty and the risk of opportunity loss. It is in the establishment of
balance that we must consider the risk aversion, the preferences, of the
shareholders. Make no mistake about it. Setting hedging policy is a strategic
decision, the success or failure of which can make or break a firm.

Consider the example of the Canadian pulp-and-paper company from before,
75% of whose product is sold in US dollars to customers located all over the
world. The US dollar here is called the price of determination because all sales of
pulp-and-paper are denominated in US dollars.
They close a deal for US$10 million worth of product and they know that in one
month's time they will receive payment into their US dollar accounts. However,
they understand that from the inception of the contract which binds them to have
receivables in US dollars in one month's time they are exposed to changes in the
rate of exchange for the Canadian dollar against the US dollar.
Immediately, they are faced with a problem. As a Canadian company, they will
have to repatriate those US dollars at some point because they have decided
that foreign exchange risk is not something that they are prepared to carry as it is
deemed it to be peripheral to their core business.
The problem has two dimensions: uncertainty and opportunity.
If they do not hedge the transaction in any way, they do not know with any
certainty at what rate of exchange they can exchange the US$10 million when it
is delivered. It could be at a better rate or at a worse rate than the rate prevailing
currently for exchange of that amount in one month's time.

Let's call the prevailing spot rate, for argument's sake, 1.5300 and the prevailing
one month forward outright rate at which they could hedge themselves 1.5310.
If they do enter into a forward contract in which they obligate themselves to buy
Canadian dollars and sell US dollars for delivery on the same date as the
delivery date on their pulp-and-paper contract, they have removed this
uncertainty. They know without any question at what rate this exchange will be. It
will be 1.5310.
But, they have now taken on infinite risk of opportunity loss. If the Canadian
dollar weakens because of some unforeseen event and in one month's time the
prevailing spot rate turns out to be 1.5600, then they have foregone 290,000
Canadian dollars. This is their opportunity loss.
Are there instruments that address both certainty and opportunity loss?
Fortunately, there are. They are called derivatives or derivative products. Most
financial institutions make markets in a panoply of risk management solutions
involving derivative products. Some of them come as stand-alone solutions and
others are presented as packages or combinations.
A derivative product is a financial instrument whose price depends indirectly on

the behaviour of a financial price.

For example, the price of a foreign exchange option on the Canadian dollar in
which our company had the right but not the obligation to buy Canadian dollars
and sell US dollars at a pre-set strike price will vary on a day-to-day basis with
the movement in the Canadian dollar/US dollar exchange rate. If the Canadian
dollar gets stronger, the Canadian dollar call becomes more valuable. If the
Canadian dollar gets weaker, the Canadian dollar becomes less valuable.
Instead of entering into a forward contract to buy Canadian dollars, the pulp-and-
paper company could purchase a Canadian dollar call struck at 1.5310 for a
premium from one of its financial institution counterparties. Doing so reduces
their certainty about the rate at which they will repatriate the US dollars but it
limits their worst case in exchange for allowing them to enjoy potential
opportunity gains, again conditioned by the premium they have paid.
Derivatives just like any other economic mechanism are best thought of in terms
of tradeoffs. The tradeoffs here are between uncertainty and opportunity loss.
However, a Canadian dollar call is only one of the possible risk management
solutions to this problem. There are dozens of possible instruments, each of
which has a differing tradeoff between uncertainty and opportunity loss, that the
pulp-and-paper company could use to manage this exposure to changes in the
exchange rate.
The key to hedging is to decide which of these solutions to choose. Hedging is

not just about putting on a forward contract. Hedging is about making the best

possible decision, integrating the firm's level of sophistication, systems and the
preferences of their shareholders.
Future articles will discuss in depth the nature of some of these alternative
solutions and the ways in which firms approach these other instruments.
Hedging objectives
Earlier, we noted that a hedge is a financial instrument whose sensitivity to a

particular financial price offsets the sensitivity of the firm's core business to that
price. Straightaway, we can see that there are a number of issues that present
themselves.
First, what is the hedging objective of the firm?
Some of the best-articulated hedging programs in the corporate world will choose
the reduction in the variability of corporate income as an appropriate target. This
is consistent with the notion that an investor purchases the stock of the company
in order to take advantage of their core business expertise.
Other companies just believe that engaging in a forward outright transaction to

hedge each of their cross-border cash flows in foreign exchange is sufficient to
deem themselves hedged. Yet, they are exposing their companies to untold
potential opportunity losses. And this could impact their relative performance
pejoratively.
Second, what is the firm's exposure to financial price risk?
It is important to measure and to have on a daily basis some notion of the firm's
potential liability from financial price risk. Financial institutions whose core

business is the management and acceptance of financial price risk have whole
departments devoted to the independent measurement and quantification of their
exposures. It is no less critical for a company with billions of dollars of
internationally driven revenue to do so.
There are three types of risk for every particular financial price to which the firm
is exposed.
Transactional risks reflect the pejorative impact of fluctuations in financial prices

on the cash flows that come from purchases or sales. This is the kind of risk we
described in our example of the pulp-and-paper company concerned about their
US$10 million contract. Or, we could describe the funding problem of the
company as a transactional risk. How do they borrow money? How do they
hedge the value of a loan they have taken once it is on the books?
Translation risks describe the changes in the value of a foreign asset due to
changes in financial prices, such as the foreign exchange rate.
Economic exposure refers to the impact of fluctuations in financial prices on the

core business of the firm. If developing markets economies devalue sharply while
retaining their high technology manufacturing infrastructure, what effect will this
have on an Ottawa-based chip manufacturer that only has sales in Canada? If it
means that these countries will flood the market with cheap chips in a desperate
effort to obtain hard currency, it could mean that the domestic manufacturer is in
serious jeopardy.
Third, what are the various hedging instruments available to the corporate
Treasurer and how do they behave in different pricing environments?
When is it best to use which instrument is the question the corporate Treasurer
must answer. The difference between a mediocre corporate Treasury and an
excellent one is their ability to operate within the context of their shareholder-
delineated limits and choose the optimal hedging structure for a particular

exposure and economic environment. Not every structure will work well in every
environment. The corporate Treasury should be able to tailor the exposure using
derivatives so that it fits the preferences and the view of the senior management
and the board of directors.
A stock trader believes that the stock price of FOO, Inc., will rise over the next
month, due to this company's new and efficient method of producing widgets. He
wants to buy FOO shares to profit from their expected price increase. But FOO is
part of the highly volatile widget industry. If the trader simply bought the shares
based on his belief that the FOO shares were underpriced, the trade would be a
speculation.
Since the trader is interested in the company, rather than the industry, he wants
to hedge out the industry risk by short selling an equal value (number of shares ×
price) of the shares of FOO's direct competitor, BAR. If the trader were able to
short sell an asset whose price had a mathematically defined relation with FOO's
stock price (for example a call option on FOO shares) the trade might be
essentially riskless and be called an arbitrage. But since some risk remains in the
trade, it is said to be "hedged."
The first day the trader's portfolio is:
• Long 1000 shares of FOO at $1 each

• Short 500 shares of BAR at $2 each
(Notice that the trader has sold short the same value of shares.)

On the second day, a favorable news story about the widgets industry is
published and the value of all widgets stock goes up. FOO, however, because it
is a stronger company, goes up by 10%, while BAR goes up by just 5%:
• Long 1000 shares of FOO at $1.10 each — $100 profit

• Short 500 shares of BAR at $2.10 each — $50 loss
(In a short position, the investor loses money when the price goes up.)
The trader might regret the hedge on day two, since it reduced the profits on the
FOO position. But on the third day, an unfavorable news story is published about
the health effects of widgets, and all widgets stocks crash -- 50% is wiped off the
value of the widgets industry in the course of a few hours. Nevertheless, since
FOO is the better company, it suffers less than BAR:
Value of long position (FOO):
• Day 1 — $1000
• Day 2 — $1100
• Day 3 — $550 => $450 loss
Value of short position (BAR):
• Day 1 — $1000
• Day 2 — $1050

• Day 3 — $525 => $475 profit
Without the hedge, the trader would have lost $450. But the hedge - the short
sale of BAR - gives a profit of $475, for a net profit of $25 during a dramatic
market collapse
Natural hedges
Many hedges do not involve exotic financial instruments or derivatives. A natural

hedge is an investment that reduces the undesired risk by matching cash flows,
i.e. revenues and expenses. For example, an exporter to the United States faces
a risk of changes in the value of the U.S. dollar, and could choose to open a
production facility in that market to match its expected sales revenue to its cost
structure. Another example is a company that opens a subsidiary in another
country and borrows in the local currency to finance its operations, even though
the local interest rate may be more expensive than in its home country: by
matching the debt payments to expected revenues in the local currency, the
parent company has reduced its foreign currency exposure.
Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but
face costs in a different currency; it would be applying a natural hedge if it agreed
to, for example, pay bonuses to employees in U.S. dollars.

One of the oldest means of hedging against risk is the purchase of protection
against accidental property damage or loss, personal injury, or loss of life. See
Insurance.
Contract for differences
A Contract for Differences (CfD) is a two way hedge or swap contract that allows
the seller and purchaser to fix the price of a volatile commodity. For instance,
consider a deal between an electricity producer and an electricity retailer who
both trade through an electricity market pool. If the producer and the retailer
agree to a strike price of $50 per MWh, for 1 MWh in a trading period, and if the
actual pool price is $70, then the producer gets $70 from the pool but has to
rebate $20 (the "difference" between the strike price and the pool price) to the
retailer. Conversely, the retailer pays the difference to the producer if the pool
price is lower than the agreed upon contractual strike price.
In effect, the pool volatility is nullified and the parties pay and receive $50 per
MWh. However, the party who pays the difference is "out of the money" because
without the hedge they would have received the benefit of the pool price
Currency hedging is used both by financial investors to parse out the risks they
encounter when investing overseas, as well as by non-financial actors in the
global economy for whom multi-currency activities is a necessary evil rather than
a desired state of exposure. For example, cost of labor variables dictate that
much of the simple commoditized manufacturing in the global economy today
goes on in China and south-east Asia (Taiwan, Philippines, Vietnam, Indonesia,
etc.). The cost benefit of moving manufacturing to outsource providers outweighs
the uncertainties of never having done business in foreign countries, so many
businesses are jumping into the fray and becoming part of the globalization trend

of moving manufacturing operations overseas. The benefits of doing this
however, come with numerous risks that were never a problem when
manufacturing was done at home--among them currency risk.
If your cost of manufacturing goods in another country is denominated in a

currency other than the one that you sell the finished goods in, there is the risk
that the currency "volatility" alone may destroy the margin between what you pay
to produce your product, and what you collect when you sell it (note you may be
selling your product in a foreign country too, so you can hedge against the
currency risk on this side as well!). So when you convert all costs on the
production side, and all sales receipts from the retail side, back into your home
currency, you may be alarmed to find that your profits have diminished
significantly, or disappeared altogether. That's currency risk-- it is germane to
doing business globally, but entirely independent of your specific business or
products. Currency hedging then, is the insurance you can purchase to limit the
impact this unpredictable risk has on your business, the same way Fire or
Hurricane insurance protects your physical premises from unexpected events
beyond your control.
Currency hedging is not always available, but is readily found at least in the
major currencies of the world economy, the growing list of which qualify as major
liquid markets beginning with the "Major Eight" (USD, GBP, EUR, JPY, CHF,
HKD, AUD, CAD), which are also called the "Benchmark Currencies", and
expands to include several others by virtue of liquidity. The currencies beyond
the Major 8 can most reliably be identified by checking to see which are included
within the "Continuous-Linked Settlement Bank" "(CLS Bank)", which handles a
growing percentage of the globe's daily settlement volume between currencies.
Currency hedging, like many other forms of financial hedging, can be done in two
primary ways, with standardized contracts, or with customized contracts (also
known as over-the-counter or OTC).

The financial investor may be a hedge fund that decides to invest in a company
in, for example, Brazil, but does not want to necessarily invest in the Brazilian
currency. The hedge fund can separate out the credit risk (i.e. the risk of the
Company defaulting), from the currency risk of the Brazilian Real by "hedging"
out the currency risk. In effect, this means that the investment is effectively a
USD investment, in Brazil. Hedging allows the investor to transfer the currency
risk to someone else who does want a position in the currency. The hedge fund
has to pay this other investor to take on the currency exposure, similar to insuring
against other types of events.
As with other types of financial products, hedging may allow economic activity to
take place that would otherwise not have been possible (as a loan, for example,
may allow an individual to purchase a home that would be "too expensive". The
increased investment is assumed in this way to raise economic efficiency.
Constructing the hedge portfolio
The dealer will then take this analysis of the behavioural characteristics of the
swap portfolio and he will construct a hedging portfolio using one or more
financial instruments in order to offset those aspects of the risk that he is
unhappy carrying. Note that the dealer will not close out all of the aspects of the
risk.
Why will the dealer only partially hedge the swaps portfolio?
Hedging costs money. The main benefit of hedging activity is to reduce the risk of
the portfolio. This benefit must be compared to the hedging cost. If the marginal
benefit of reducing the risk with an individual transaction is less than its marginal
cost, it is not worthwhile to hedge that risk.

Another reason for not completely hedging the swaps portfolio is the fact that the
dealer may carry a proprietary position in one or more aspects of the risk. If, for
example, he thinks that interest rates are going to fall in the 2-year to 3-year
bucket, he may be happy to continue received fixed interest payments for that
period. If he is correct, he will make money on a mark-to-market basis that he
can realize by hedging the position at a preferable level.
Floating rate cash flow management
One of the more difficult aspects of managing a swap portfolio is managing the
short-term cash flows or the floating rate cash flows. There are two problems that
confront the dealer.
First, there may be mismatches in the timing of short-term cash flows.
Consider a hedge that was entered into two years ago to hedge a two year fixed-
floating plain vanilla interest rate swap where the hedge transaction took place a
week after the initial customer transaction. Unless the dealer matched the dates
precisely at the time he conducted the hedge transaction, there will be a one-
week mismatch of flows. Matching the dates may have cost extra money in terms
of the market prices at the time of transaction making it too expensive to match
the timing of the cash flows. Some people might argue that one week is not very
much of a difference. That is no way to run a business. To paraphrase an old
saying, ten grand here and one hundred grand there and pretty soon you're
talking about some real money.
Second, there may be mismatches in the type of index used to hedge.

Consider a swap in which the floating rate index is the 3-month US Bankers'
Acceptance rate. If the best swap available at the time is the 3-month US LIBOR
(London Interbank Offered Rate for US dollars), then there is an index mismatch
risk. If the correlation between these two indices changes (and correlation
between financial indices is rarely stable), then the swap portfolio is exposed to
refunding risk.
One way for the commercial bank to hedge its floating rate cash flows is to
establish a separate book dedicated to hedging such risks, one which
participates actively in the futures markets such as the IMM Eurodollar market
and one which takes aggressive positions in short-term interest rates.
An alternative might be to pay the hedging costs necessary for closing out the
mismatches. This can get expensive. With the increased commoditization of
global derivatives markets, dealers are losing much of their pricing edge, a
phenomenon that makes paying for outside hedging more difficult.
By giving an appreciation for the way swaps dealers manage their combined
portfolio risk, this article has identified some of the key types of risk in interest
rate swaps and interest rate products, generally.
EXAMPLE
Portfolio managers prefer futures to options to hedge their market risk. Why? If
you buy futures, you have to pay a margin, which is adjusted daily for the
gains/losses that you make on your futures position. You, therefore, do not incur
any cost for buying futures. This is quite unlike options, where you have to pay a
premium to buy calls and puts. This premium is a cost to the call/put buyer.

Now, consider a fund that has portfolio worth Rs 100 crore. Suppose the fund
manager sells Nifty futures contract at 1070. If the Nifty futures falls to 1044, the
fund will generate profits from the futures contract.
The profit will be 1070 minus 1044 times the number of futures contracts. This
profit will help reduce the losses that the fund will incur because of the fall in
price of stocks in its portfolio.
The most important step in portfolio hedging is the hedge ratio. This ratio tells the
fund manager how many contracts to buy to minimise the portfolio risk.
The fund manager may sometimes choose to hedge only part of the portfolio
because of the associated costs.
Average annual volatility comparison
Sensex or Nifty-35-45%
Govt Sec Index-5-10%
Gold -12-18%
Silver-15-25%
Cotton-10-12%
Oil seeds -15-20%
What is Risk Management?

In general no risk can be eliminated but still one can try to avoid it by transferring
someone.
Risk Management
Transferring the risk to some one who can handle it better or Transfer the risk to
some one who has the appetite for risk Financial derivatives are used to hedge
the exposure to market risk Hedgers transfer their risk to speculators who are
willing to assume the risk
Commodities are less volatile compared to stock market The determinants of

volatility are different for capital market and commodity markets
EXAMPLE
For example an investor has 1000 RELIANCE in cash market & he wants to
hedge the risk of adverse price movement ,he can sell the reliance futures or the
index futures so that if the price are going down he can lose in cash market but at
the same time he can gain in the futures markets .……..
A cotton hedge –an example
Two varieties of cotton are available for trading on NCDEX –J-34 (short
staple) and S-6 (long staple)

Suppose, a farmer in Andhra Pradesh producing Buny/ Brahma variety
(extra long staple) wishes to hedge on NCDEX
Net gain = Rs 1870 – Rs 1620 = Rs 250
Thus, we see that the farmer gains Rs. 250/-(per contract) by hedging at
NCDEX.
The loss in the spot market is notional.
For hedging to be effective, two things are necessary.
The futures and spot price for S-6 should move together Also, the spot price for
S-6 and Brahma / Buny should also move together.

Basis
Basis is usually quoted as a premium or discount i.e, the cash price as a

premium or discount to the futures price.
For example cash price of the XYZ share on 31-7-98 at Madras Stock Exchange
is Rs.400 and the 31.12.98 futures price would be Rs.440, at the Madras Stock
Exchange XYZ share basis is Rs.40.This is commonly quoted as 40 under as the
cash price is Rs.40 under the December’98 futures price. The basis will be
constant, if the futures and cash prices change by the same amount. Such a
hedge is called a ‘Perfect Hedge’ as it eliminates all price risk.
The basis is said to be narrowing when it moves towards zero line. It does
mean that the absolute difference between cash price and futures prices become
smaller. A widening of the basis occurs the basis moves away from the zero line
and the difference of prices increases. A narrowing or widening of the basis
results in profit or loss for hedgers depending on the type of hedge (long or short)
and on market conditions. A short hedger is said to be the long basis and the
long hedger is said to be the short basis. A narrowing of the basis, regardless of
the general price trend, benefits the short hedger( he is long the basis) and a
widening of the basis benefits the long hedger( he is short the basis) in a carry
market is also known as Contango market.
In a backwardation market (or an inverted market) a narrowing of the basis

benefits the long hedger, and a widening of the basis benefits the short hedger,
just the reverse of the contango market. Variation in basis often follows a
seasonal pattern which reflects the changing relationships between demand for
and supply of a commodity. Hedgers should recognize this seasonality. They

may be able to benefit when the market switches from backwardation into
contango and vice versa.
A loss in one market means a profit in the other, as long as opposite

positions are maintained, one in each market. Prices in both markets run parallel
because both respond to the same stimuli of supply and demand. The rule of
thumb is rooted in the relationship of cash-to-futures prices called the “basis”.
The basis widens or narrows as the cash and futures prices fluctuate
independently. It is this change that provides the foundation for hedging.
To a certain extent, selling hedges are matched one-for-one by buying

hedges. However, in actual practice, seldom are two parties ready at precisely
the same moment to initiate a futures contract. And to further complicate the
trading, the quantities of the two parties may differ. Or both may want to sell or to
buy at the same time. Some hedgers therefore may not find others whose
interests are in hedging. This is where the speculator comes in.
For the most part, the speculator carries the hedging load by assuming
the risk and taking the opposite side of the contract. The speculator bridges the
gap between the buying and selling hedgers. Further, a hedger uses many
speculators in the market as underwriters and the contract as insurance policy.
The risk is shifted from one person’s shoulders and distributed in smaller parts
among the many speculators.
Most business persons are not in business to speculate on the rise or

fall of commodity prices. To protect their profit margin , therefore, against a
decline in the price of the actual commodity while it is in their possession ,they

hedge by selling the number of futures contracts approximately equivalent to the
amount of actual held. Selling hedges are used for basically 3 purposes.
To protect inventories of commodities not covered by actual sales or by sales of
its products.
To protect, to earn, an expected carrying charge on commodities

stored to protect, or to ensure, a given price for prospective or estimated
production of commodities.
Short Hedge with Zero Basis Risk
A fertilizer company of Andhra Pradesh which has large inventory on 1,may’98,

enters into an agreement to supply fertilizers to the farmers on 3rd Aug’98 at a
price equal to the cash price that exists in Andhra Pradesh on this date. Thus the
company’s selling price in August is unknown in May. For example, the cost of
fertilizer per quintal is Rs.300 on 1 May’98 and the cost of inventory is Rs.20 per
quintal to carry until 3rd Aug’96. The company would earn a profit of Rs.30, if the
fertilizer price would be Rs.350 on 3rd Aug’98. The company would incur loss of
Rs.20, if the fertilizer price would be Rs.300 per quintal on 3rd Aug ’98. The
company can protect its profit margin by the short hedge (by entering into futures
contracts) in view of the variability of the net revenue is zero.
Long Hedge in Wheat Futures

Short Hedge with Basis Risk
When futures prices increase more than that of cash prices due to widening in
the basis, the hedger incurs a larger loss on his short futures positions. When the
basis is assumed to narrow, futures prices fall by more than cash prices. The
loss incurred on the distributor’s cash position is more than offset by the profit on
the futures position. Therefore, the net profits are considerably higher. As such,
changes in the basis can dramatically alter hedging results from what they would
be in the absence of basis risk. Hence, the strategy in constructing a hedge
would be to minimize basis risk in order to make the outcome of the hedge more
predictable.

Buying hedge
A buying hedge is intended to protect against an advance in the price of the cash
commodity (or its products) that had already been sold at a specific price; but not
yet purchased. Exporter and manufacturers commonly sell commodities or their
products at an agreed –upon price for forward delivery. The forward delivery is

said to be uncovered if the commodity is not on hand. The secret of success in a
buying hedge is that initiating a futures position should coincide as closely as
possible with the signing of a contract for actual forward sales. Timing is very
important.
Buying hedges are used, basically for three purposes; each of these is discussed
below:
To protect uncovered forward sales of a commodity or its products.

To replace inventory at a lower cost.
To maintain prices on stable –price products.
Long Hedge with Zero Basis Risk
The wholesaler of rice has a long term supply contract on 1 March’98 that
requires him to deliver 50,000 tonnes of rice on 15th October’98 to retailers at Rs.
11000 per tonne to the retailers. The wholesaler discovers on 15th Oct’98 that he
does not have enough stock to cover this agreement in view of unseasonal
factors. He will, therefore, have to acquire additional stock, to meet his supply
obligations. The 1 March’98 price cash price was Rs.9000 per tonne. The 15th
Oct’98 cash price is Rs.12000per tonne.
There are two alternatives. The first one is purchase price on 1 March’98
at Rs.9000 and incurs carry cost @ Rs.500 per tonne and delivers it at Rs.11000
on 15th Oct’98. In this case his net profit is Rs.11000- Rs.9500 (Rs.9000+500)
Rs.1500 per tonne. The second strategy is promised on the belief that the rice
prices will fall between 1 March and 15th Oct when cash prices are assured to be

lower. This will result for even greater profits, if the prices on 15th Oct’98 are
lower than Rs.9000. The risk, of course, is that prices will rise instead of fall, in
which case he may incur a loss. The wholesaler does not want to be exposed to
this risk nor does he want to purchase rice now and carry it. Therefore he settles
on a third strategy i.e, a long hedge in rice. The following two examples describe
the result of such a hedging strategy under the assumption that the basis does
not change. The basis is Rs.11000-9000=2000. In case 1 cash prices fall to
Rs.8500, whereas in case 2, they rise to Rs.12000 and the hedge succeed in
locking profit in both the cases.
Long Hedge with Basis Risk
If the constant basis is not taken as an assumption, unanticipated changes in the

basis can cause substantial variation in hedging results for either long or short
hedgers.
• The future contract standardized size units do not match the cash
position quantity
• Use a combination of regular size futures and mini contracts to reach
a futures position as close as possible to the cash position
• An over hedged occurs when futures quantity exceeds the cash
quantity
• An under hedged occurs when the cash position exceeds the future
quantity

COST OF HEDGING
• Lack of liquidity in the market resulting in impact cost

• Low liquidity results in higher volatility
• Margin finance
• Margins are based on volatility
• The real cost of hedging is the finance cost of margins
• Margins could range from 5% to 50%

CHAPTER 2
REVIEW OF LITERATURE

Basis Risk: Measurement and Analysis of Basis Fluctuations for Selected
Livestock Markets
Philip Garcia; Raymond M. Leuthold; Mohamed E. Sarhan

American Journal of Agricultural Economics, Vol. 66, No. 4. (Nov., 1984), pp.
499-504.
This study examines the unsystematic, or random, fluctuations of the hog and
cattle basis over time in several Midwest markets. They found that unanticipated
basis changes can reduce the ability of futures markets to transfer risk and can
affect income levels of producers and market participants.
Taxes and the Pricing of Stock Index Futures

Bradford Cornell; Kenneth R. French
The Journal of Finance, Vol. 38, No. 3. (Jun., 1983), pp. 675-694.
This paper examines the pricing of stock index futures contracts. Under the
standard assumption that taxes are levied on both realized and unrealized capital
gains, we find that the futures price will differ from the stock price for two
reasons. First, payment for the stock is required today while the futures payment
is deferred until the contract matures. Second, the futures trader does not receive
the dividends that are paid to the stockholder.
Cross Hedging
Ronald W. Anderson; Jean-Pierre Danthine
The Journal of Political Economy, Vol. 89, No. 6. (Dec., 1981), pp. 1182-1196.
We have ignored the fact that futures contracts are standardized as to quantity
and must be traded in integer multiples. For a small user this discreteness is a

serious concern and nearly eliminate the possibility of multiple cross hedges.
Even for the large hedger the discreteness of futures markets implicitly may limit
the number of markets that should be considered in the portfolio.

CHAPTER 3
RESEARCH METHODOLOGY

Statement of problem
When the portfolio is hedged with the help of index futures, the future prices will
not track exactly the value of cash position. There are some sources of basis risk
prevalent in the market which causes the poor performance of hedge.
RESEARCH OBJECTIVES
• To understand the use and analyze the performance of index futures in

hedging.
• To know the basis risk and sources of basis risk.
• To analyze effect of different sources of basis risk.

Study Design
a) Study Type:
The study type is analytical, quantitative and historical. Analytical because

facts and existing information is used for the analysis, Quantitative as
relationship is examined by expressing variables in measurable terms and also
Historical as the historical information is used for analysis and interpretation.
b) Study population:
Population is the entire stock market and daily closing of NIFTY Index,
S&P CNX 500 and NIFTY Futures.
c) Sampling frame:
Sampling Frame would be Indian stock market and index futures markets.
d) Sample:
Sample chosen is daily closing values of NIFTY Index, S&P CNX 500 and
NIFTY Futures from 01-07-2000 to 31-3-2007.
e) Sampling technique:
Deliberate sampling is used because only particular units are selected

from the sampling frame. Such a selection is undertaken as these units represent
the population in a better way and reflect better relationship with the other
variable.

SAMPLE SIZE AND DATA SOURCES
The data will be the daily closing price of NIFTY, S&P CNX 500 & closing prices
of NIFTY index futures from.
SAMPLE PERIDOD
1st of July, 2000 to 31st March 2007

Analysis and Interpretation
Steps followed in the analysis-

• The data is collected for-
i) NIFTY Index
ii) NIFTY Futures
iii) S&P CNX 500.
• Period of data collection is 1st July,2000 to 31st march,2007
• The data is converted into log naturals format to way out any spurious
correlations within the data sets.
• Then the data is tested for its stationarity using Augmented Dickey fuller
test

TEST OF STATIONARITY
Dickey-fuller Test for unit root:
Dickey fuller statistic test for the unit root in the time series data rt is regressed
against rt-1 to test for unit root in a time series random walk model.
This is given as:
rt = ρ rt-1 + ut
if ρ is significant equal to 1, then the stochastic variable rt is said to be having unit

root. A series with unit root is said to be un-stationary and does not follow
random walk. There are three most popular dickey-fuller tests for testing unit root
in a series.
The above equation can be rewritten as:
∆ rt = δ rt-1 + ut
Here δ = (ρ-1) and here it is tested if δ is equal to zero. rt is random walk if δ is

equal to zero. It is possible that time series could behave as a random walk with
a drift. This means that the value of rt may not center to zero and thus a constant
should be added to the random walk equation. A linear trend value could also be
added align with the constant it the equation, which results in a null hypothesis
reflecting stationary deviations from trend.
The Augmented Dickey-fuller Test:

In conducting the DF test as above, it is assumed that the error term ut was
uncorrelated. But in case the ut are correlated, Dickey and Fuller have developed
a test, known as the augmented Dickey- Fuller ( ADF) test. The ADF test
consists of estimating the following regression:
ΔYt= β1 + β2t + δYt-1 + αi ΔYt-i + εt
Where, εt is a pure white noise term and ΔYt-1 = (Yt-1-Yt-2), ΔYt-2 = (Yt-2-Yt-3),etc.
The number of lagged difference terms to include is often determined empirically,
the idea being to include enough terms so the error term in above equation is
serially correlated. In ADF we still test whether δ=0 and the ADF test follow the
same asymptotic distribution as the DF statistic, so the same critical value can be
used.
Limitation of Research
• The study conducted on the sample of six years starting from 2000 to
2006.
• The volatility in the market during two years was very high.
• S&P CNX 500 index used as a portfolio.

CHAPTER 4
DATA ANALYSIS

Analysis and Interpretation
Steps followed in the analysis-

• The data is collected for-
iv) NIFTY Index
v) NIFTY Futures
vi) S&P CNX 500.
• Period of data collection is 1st July,2000 to 31st march,2007
• The data is converted into log naturals to normalized the data to find out
any spurious correlations within the data sets.
• Then the data is tested for its stationarity using Augmented Dickey fuller
test
3.3 SAMPLE SIZE AND DATA SOURCES
In this study S&P CNX 500 has been considered as a proxy for the portfolio and
accordingly the closing index values were collected from July 1, 2000 till March 31,
2007. The daily observations were converted into continuous compounded returns in the
standard method as the log differences:
Rt = ln (It / It-1)
Where, It stands for the closing index value on day‘t’; The data is converted into log
naturals format to normalized the data to way out any spurious correlations within
the data sets.

ADF RESULT
NIFTY FUTURES
ADF Test
Statistic -17.2837 1% Critical Value* -3.4371
5% Critical Value -2.8637
NIFTY INDEX
ADF Test
S&P CNX 500
ADF Test

Interpretation
As it can be easily seen from the ADF test, the null hypothesis of unit root can be
rejected as the estimated τ value is 17.2837 for NIFTY Futures, 16.9875 for
NIFTY Index and 16.6139 for S&P CNX 500 Index , which in absolute value is
greater than all the critical value at 1%, 5% and 10% level of significance.
The absence of unit root means the series is stationary, combined with the
phenomenon of volatility clustering implies that volatility can be predicted and the
forecasting ability of the different models can be generalized to other time
periods also.

Residual stationary test
stationery test of rsiduals of fut n nifty
1% Critical
ADF Test Statistic -25.1793 Value* -3.4371
*MacKinnon critical values for rejection of hypothesis of a unit root.
Augmented Dickey-Fuller Test Equation

Dependent Variable: D(SER12)
Method: Least Squares
Date: 05/05/07 Time: 12:37
Sample(adjusted): 8 1731
Included observations: 1724 after adjusting endpoints
Std.
Variable Coefficient Error t-Statistic Prob.
SER12(-1) -1.93776 0.076958 -25.1793 0

D(SER12(-1)) 0.583542 0.066863 8.727393 0
D(SER12(-2)) 0.368815 0.054351 6.785774 0
D(SER12(-3)) 0.217908 0.040113 5.43238 0

D(SER12(-4)) 0.099741 0.023948 4.164858 0
C 7.59E-06 8.23E-05 0.092229 0.9265
Mean dependent
R-squared 0.657488 var 1.15E-06
Adjusted R- S.D. dependent
squared 0.656491 var 0.005829
Akaike info
S.E. of regression 0.003417 criterion -8.51691
Sum squared
resid 0.020054 Schwarz criterion -8.49793
Log likelihood 7347.573 F-statistic 659.5771
Durbin-Watson
stat 2.009048 Prob(F-statistic) 0

Nifty & S&P Residual test
stat test of res of nifty n snp

ADF Test 1% Critical
Statistic -20.1187 Value* -3.4371

Date: 05/13/07 Time: 11:54
Std.
SER32(-1) -1.12818 0.056076 -20.1187 0

D(SER32(-1)) 0.2548 0.049484 5.149143 0
D(SER32(-2)) 0.129413 0.039857 3.246955 0.0012
D(SER32(-3)) -0.11591 0.031916 -3.63169 0.0003
D(SER32(-4)) 0.026371 0.024148 1.092064 0.275
C -2.39E-05 0.000305 -0.07848 0.9375
Mean dependent
R-squared 0.498802 var 2.58E-06
squared 0.49734 var 0.017833
S.E. of Akaike info
regression 0.012644 criterion -5.89984
Sum squared
Durbin-Watson

Nifty futures & S&P CNX 500
ADF Test 1% Critical

Statistic -16.6139 Value* -3.4371

Date: 05/10/07 Time: 12:38
Std.
SER30(-1) -8.17E-01 0.049153 -16.6139 0

D(SER30(-1)) -0.04601 0.044993 -1.02269 0.3066
D(SER30(-2)) -0.13952 0.039027 -3.57498 4.00E-04
D(SER30(-3)) -0.11571 0.031713 -3.64846 0.0003
D(SER30(-4)) -0.02498 0.024121 -1.03539 0.3006
C 0.000537 0.000359 1.496878 0.1346
Mean dependent -7.29E-

R-squared 0.447809 var 07
squared 0.446199 var 0.019921
S.E. of Akaike info
regression 0.014825 criterion -5.58158
Sum squared
Durbin-Watson

Interpretation
As it can be easily seen from the ADF test, the null hypothesis of unit root can be
rejected as the estimated τ value is 25.1793 for NIFTY Futures Vs Nifty , 20.1187
for NIFTY Index Vs S&P CNX 500 and 16.6139 for Nifty Futures Vs S&P CNX
500 Index , which in absolute value is greater than all the critical value at 1%, 5%
and 10% level of significance.
It also proves that there is correlation between Nifty Futures and Nifty, Nifty
Futures and S&P CNX 500 and Nifty Futures and S&P CNX 500

After finding Correlation Hedge Ration of Portfolio is found which is shown in the
table below:
Coefficients(a)
Mode Unstandardized Standardized
l Coefficients Coefficients T Sig.
B Std. Error Beta
43.7813 3.3E-
1 (Constant) 216.077 4.935369 3 282
379.773
Snp 1.092546 0.002877 0.994073 3 0
a Dependent Variable: futures
Here the ratio is 1.092546. Since the ratio is greater than 1 perfect hedge is
possible.

CHAPTER 5
CONCLUSION

CONCLUSION
After that theoretical future price was calculated using S(1+Rn) Where s is the
spot price, r is the risk free rate(t-bills rate), n is no of days Then the theoretical
price is compared with actual and the difference is known as basis.
We took the T Bills annulized rate and coverted into monthly risk free return and
use in finding out the theoretical price of NIFTY futures. Then we calculated the
difference between the actual futures price & theoretical futures price, Which is
known as basis.
We took the monthly average of basis (actual price – theoretical price) and apply
“t” test which shows that the basis risk is exist or not.
After applying “t” test for the above mentioned data we found that basis risk
exist in the market.

BIBLIOGRAPHY
BOOKS
1. Basic Econometrics: By Damodar N. Gujrati

2. Introductory Econometrics: By Ramu Ramanathan
WEBSITES
1. www.nseindia.com
2. www.yahoofinance.com
ECONOMETRICS SOFTWARE PACKAGES
1. Eviews
2. SPSS
References
1. Ronald W. Anderson; Jean-Pierre Danthine “Cross Hedging”,

The Journal of Political Economy, Vol. 89, No. 6. (Dec., 1981), pp. 1182-1196.
2. Philip Garcia; Raymond M. Leuthold; Mohamed E. Sarhan

“Basis Risk: Measurement and Analysis of Basis Fluctuations for Selected
LivestockMarkets”,American Journal of Agricultural Economics, Vol. 66, No. 4.
(Nov., 1984), pp. 499-504.
3. Warren Bailey; K. C. Chan“ Macroeconomic Influences and the Variability

of the Commodity Futures Basis”,The Journal of Finance, Vol. 48, No. 2.
(Jun., 1993), pp. 555-573.
4. Bradford Cornell; Kenneth R. French“Taxes and the Pricing of Stock Index

Futures”,The Journal of Finance, Vol. 38, No. 3. (Jun., 1983), pp. 675-694.
5. James D. Sartwelle, III , Edward Smith, Terry Kastens and Daniel

O’Brien,“Selling Hedge with Futures”, The Texas A&M University system
6. James D. Sartwelle, III , Edward Smith, Terry Kastens and Daniel

O’Brien,“Buying Hedge with Futures”, The Texas A&M University
system

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“Hedging performance and basis risk in stock index

Submitted in partial fulfillment of the requirements of

Under the Guidance

M.P.BIRLA INSTITUTE OF MANAGEMENT

M P Birla Institute of Management 1

I hereby declare that the dissertation entitled “Hedging

M P Birla Institute of Management 2

It’s my special privilege to extend words of the thanks to all of

I would thank Dr.T.V.N.Rao for giving me valuable inputs

It would be improper if I do not acknowledge the help and

My gratitude will not be complete without thanking the almighty

M P Birla Institute of Management 3

CHAPTERS PARTICULARS PAGE NO.

1 INTRODUCTION AND THEORETICAL 03

5 OBJECTIVE OF THE STUDY 50

6 SAMPLE SIZE AND DATA SOURCES 51

M P Birla Institute of Management 4

Corporation in which individual investor place their money have exposure to

Hedging is a way of reducing some of the risk involved in holding an investment.

M P Birla Institute of Management 5

M P Birla Institute of Management 6

As already mentioned, some form of forward trading probably existed in India

Chronologically, India’s experience in organized forward trading is almost as long

M P Birla Institute of Management 7

A derivative is a financial instrument whose value depends on the value of

According to the Securities Contract (Regulation) Act, 1956, derivatives

A security derived from a debt instrument, share, and loan whether

Therefore, derivatives are specialized contracts to facilitate temporarily for

M P Birla Institute of Management 8

One form of classification of derivatives is between commodity derivatives and

M P Birla Institute of Management 9

PREREQUISITES FOR DERIVATIVES MARKET

There are five essential prerequisites for derivatives market to flourish in a

a) Large market capitalization

b) Liquidity in the underlying

c) Clearing house that guarantees trades

M P Birla Institute of Management 10

e) Risk-taking capability and Analytical skills

M P Birla Institute of Management 11

M P Birla Institute of Management 12

An options contract is an agreement between a buyer and a seller. Such a

A forward is an agreement between two parties to exchange an agreed quantity

M P Birla Institute of Management 13

It is similar to the forward contract in all the respect. In fact, a future is a

Futures contracts are contracts specifying a standard volume of a particular

M P Birla Institute of Management 14

Swap is an agreement between two parties to exchange one set of financial

Swaps give companies extra flexibility to exploit their comparative advantage in

Swaps allow companies to focus on their comparative advantage in borrowing in

Swaps allow companies to exploit advantages across a matrix of currencies and

M P Birla Institute of Management 15

Corporation in which individual investor place their money have exposure to

Hedging is a way of reducing some of the risk involved in holding an investment.

M P Birla Institute of Management 16

Basis and Spreads

The basis is the current cash prices of a particular commodity at a particular

Basis: Current Cash Price – Future Price

M P Birla Institute of Management 17

What is a stock index futures contract?

1 Contract = $250 * Value of the S&P 500

M P Birla Institute of Management 18

Mechanics of futures trading