INTERCONTINENTAL JOURNAL OF FINANCE RESEARCH REVIEW ISSN: ONLINE ISSN: PRINT - IMPACT FACTOR:1.552 VOLUME 4, ISSUE 5, MAY 2016

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1 AN ANALYSIS OF DERIVATIVE AS AN FINANCIAL STRATEGY FOR RISK MANAGEMENT BY THE INVESTORS IN INDIA ABSTRACT Dr ASHOK KUMAR RATH Professor in Accounting and Finance, Regional college of Management, Bhubaneswar Derivative Market is a high risk high return segment of an equity market. The past decade has witnessed a massive growth in the use of financial derivatives by a wide range of corporate and financial institutions. This growth has run in parallel with the increasing direct reliance of companies on the capital market as the major source of long term funding. In this respect, derivatives have a vital role to play in enhancing shareholder value by ensuring access to the cheapest source of funds. OBJECTIVE OF THE STUDY i. (i)to give an insight into derivatives and their application in Indian context. ii. (ii)to gain an insight into derivative trading at a broking firm iii. (iii)to identify, understand and analyze the strategies which help to minimize the Risk in the Indian Equity Derivative Market in different market conditions. iv. (iv)to implement strategies on investor s portfolio and measures the profit or loss as a result of implementing the strategies. Review of Literature The trading of financial derivatives has received extensive attention, while at the same time it has led to a debate over its impact on the underlying stock market from various facets by the academicians. The researchers all over the world have done research on derivative trading and were able to find out various facts about derivative and its trading. In this literature review efforts have been made to bring into the picture the research done about various issues throughout the world by the researchers. 1-. Bajpai (2006) concludes that the capital market in India has gone through various stages of liberalization, bringing about fundamental and structural changes in the market design and operation, resulting in broader investment choices, drastic reduction in transaction costs, and efficiency, transparency and safety as also increased integration with the global markets. The opening up of the economy for investment and trade, the dismantling of administered interest and exchange rates regimes and setting up of sound regulatory institutions have enabled time. 2-Mohan (2007) reviews India s approach to financial sector reforms that set in process since early 1990s. Allen, Chakrabarti, and De (2007) concludes that with recent growth rates among large countries second only to China s, India has experienced nothing short of an economic transformation since the liberalisation process began in the early 1990s. 3-Chhaochharia (2008) arrives at the conclusion that India has a more modern financial and banking system than China that allocates capital in a more efficient manner. However, the study is skeptical about who would emerge with the stronger capital market, as both the country is facing challenges regarding their capital markets. 16 icmrrjournal@gmail.com

2 4-Bose, Suchismita conducted research on (2009) found that Derivatives products provide certain important economic benefits such as risk management or redistribution of risk away from risk-averse investors towards those more willing and able to bear risk. Derivatives also help price discovery, i.e. the process of determining the price level for any asset based on supply and demand. These functions of derivatives help in efficient capital allocation in the economy. At the same time their misuse also poses threat to the stability of the financial sector and the overall economy. 5-Sen Shankar Som and Ghosh Santanu Kumar (2010) studied the relationship between stock market liquidity and volatility and risk. The paper also deals with time series data by applying Cochrane Orchutt two step procedures. An effort has been made to establish a relation between liquidity and volatility in their paper. It has been found that there is a statistically significant negative relationship between risk and stock market liquidity. Finally it is concluded that there is no significant relationship between liquidity and trading activity in terms of turnover. 6-Shenbagraman (2011) reviewed the role of some non-price variables such as open interests, trading volume and other factors, in the stock option market for determining the price of underlying shares in cash market. The study covered stock option contracts for four months from Nov to Feb consisting 77 trading 49 days. The study concluded that net open interest of stock option is one of the significant variables in determining future spot price of underlying share. The results clearly indicated that open interest based predictors are statistically more significant than volume based predictors in Indian context. All the existing studies found that the Equity return has a significant and positive impact on the FII (Agarwal, 1997; Chakrabarti, 2001; and Trivedi & Nair, 2003). 7-Masih AM, Masih R, (2012), had studied Global Stock Futures: A Diagstinoc Analysis of a Selected Emerging and Developed Markets with Special Reference to India, by using tools correlation coefficients, granger s causality test, augmented Dicky Fuller test (ADF), Elliott, Rothenberg and Stock point optimal test. The Authors, through this paper, have tried to find out what kind of relationship exists between emerging and developed futures markets of selected countries. 8-Kumar, R. and Chandra, A. (2013), had studied that Individuals often invest in securities based on approximate rule of thumb, not strictly in tune with market conditions. Their emotions drive their trading behavior, which in turn drives asset (stock) prices. Investors fall prey to their own mistakes and sometimes other s mistakes, referred to as herd behavior. Markets are efficient, increasingly proving a theoretical concept as in practice they hardly move efficiently. The purely rational approach is being subsumed by a broader approach based upon the trading sentiments of investors. The present paper documents the role of emotional biases towards investment (or disinvestment) decisions of individuals, which in turn force stock prices to move. 9-Srivastava, S., Yadav, S. S., Jain, P. K. (2014), had conducted a survey of brokers in the recently introduced derivatives markets in India to examine the brokers assessment of market activity and their perception of benefits and costs of derivative 50 trading. The need for such a study was felt as previous studies relating to the impact of derivatives securities on Indian Stock market do not cover the perception of market participants who form an integral part of the functioning of derivatives markets. The issues covered in the survey included: perception of brokers about the attractiveness of different derivative securities for clients; profile of clients dealing in derivative securities; popularity of a particular derivative security out of the total set; different purposes for which the clients are using these securities in order of preference; issues concerning derivatives trading; reasons for non usage of derivatives by some investors. The investors are using derivative securities for different purposes after its penetration into the Indian Capital market. 17 icmrrjournal@gmail.com

3 10-Naresh, G., (2015), studied the dynamic growth of the Derivatives market, particularly Futures & Options and the perceived risks to the financial sector continue to stimulate debate on the proper regulation of these instruments. METHODOLOGY USED The Methodology collecting information in order to verify a phenomenon. Both the research methods were followed: Sources of Data Collection Primary Data: This was done through discussion with guide and other officials of credit department. Secondary Data: INTERCONTINENTAL JOURNAL OF FINANCE RESEARCH REVIEW For the success of the present study data was collected mainly from secondary sources like annual reports, news letter,magazines and journals of the company, Analysis of DERIVATES A STRATEGY FOR RISK MANAGEMENT The term derivatives is used to refer to financial instruments which derive their value from some underlying assets. The underlying assets could be equities (shares), debt (bonds, T-bills, and notes), currencies, and even indices of these various assets, such as the Nifty 50 Index. Derivatives can be traded either on a regulated exchange, such as the NSE or off the exchanges, i.e., directly between the different parties, which is called over-the-counter (OTC) trading. (In India only exchange traded equity derivatives are permitted under the law.) Average Daily Turnover in derivative segment(rs. cr.) Average Daily Turnover (Rs. cr.) The basic purpose of derivatives is to transfer the price risk (inherent in fluctuations of the asset prices) from one party to another; they facilitate the allocation of risk to those who are willing to take it. In so doing, derivatives help mitigate the risk arising from the future uncertainty of prices. For example, on November 1, 2009 a rice farmer may wish to sell his harvest at a future date (say January 1, 2010) for a pre-determined fixed price to eliminate the risk of change in prices by that date. Such a 18 icmrrjournal@gmail.com

4 transaction is an example of a derivatives contract. The price of this derivative is driven by the spot price of rice which is the "underlying asset". Types of derivatives The main use of derivatives is to either remove risk or take on risk depending if one were a hedger or a speculator. The main types of derivatives are 1. Future Contracts 2. Forward Contracts 3. Option Contracts and 4. Swaps 1-FORWARD CONTRACT It is an agreement between two parties to buy or sell an asset (which can be of any kind) at a preagreed future point in time. Therefore, the trade date and delivery date are separated. It is used to control and hedge risk, for example currency exposure risk (e.g. forward contracts on USD or EUR) or commodity prices (e.g. forward contrcts on oial). 2-FUTURE CONTRACT In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. (a) FUTURES PAYOFFS Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. (b) Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a twomonth Nifty index futures contract when the Nifty stands at The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. APPLICATION OF FUTURES Hedging: Long security, sell futures Futures can be used as an effective risk-management tool. Take the case of an investor who holds the shares of a company and gets uncomfortable with market movements in the short run. He sees the value of his security falling from Rs.450 to Rs.390. In the absence of stock futures, he would either suffer the discomfort of a price fall or sell the security in anticipation of a market upheaval. With security futures he can minimize his price risk. All he need do is enter into an offsetting stock futures position, in this case, take on a short futures position. Assume that the spot price of the security he holds is Rs.390. Two-month futures cost him Rs.402. For this he pays an initial margin. Now if the 19 icmrrjournal@gmail.com

5 price of the security falls any further, he will suffer losses on the security he holds. However, the losses he suffers on the security, will be offset by the profits he makes on his short futures position. Take for instance that the price of his security falls to Rs.350. The fall in the price of the security will result in a fall in the price of futures. Futures will now trade at a price lower than the price at which he entered into a short futures position. Hence his short futures position will start making profits. The loss of Rs.40 incurred on the security he holds, will be made up by the profits made on his short futures position. Index futures in particular can be very effectively used to get rid of the market risk of a portfolio. Every portfolio contains a hidden index exposure or a market exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 30-60% of the securities risk is accounted for by index fluctuations). Hence a position LONG PORTFOLIO + SHORT NIFTY can often become one-tenth as risky as the LONG PORTFOLIO position! 3-OPTION CONTRACTS Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security. For example, buying a call option provides the right to buy a specified amount of a security at a set strike price at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party that sold, or wrote, the option must fulfill the terms of the contract. For example, Jewelry manufacturer Goldbuyer agrees to buy gold at Rs. 600 (the forward or delivery date) from gold mining concern Goldseller. Suppose that Goldbuyer belives that there is some chance for the spot price to fall below Rs.600, so that he losses on his forward position. To limit his loss, Goldbuyer could purchase a call option for Rs. 5 (the option price or premium) at a strike or exercise price of Rs. 600 with an expiration date three months from now. The call option gives Goldbuyer the right (but not the obligation) to buy gold at the strike price on the expiration date. Then, if the spot price indeed declines, he could choose not to exercise the option, and his loss would be limited to the purchase price of Rs. 5. Alternatively, Goldbuyer may anticipate that the spot price is very likely to decline, and attempt to profit from such an eventuality by buying a put option, giving him the right to sell gold at the strike price on the expiration date. Options turnover over years with growth percentage % % % % % % National turnover(rs cr.) Growth 0.00% % % 7.69% 78.39% 90.02% 74.62% % % 0.00% National turnover(rs cr.) Growth 20 icmrrjournal@gmail.com

6 OPTION STRATEGIES BUY CALL Strategy View Investor thinks that the market will rise significantly in the short-term. Strategy Implementation Call options are bought with a strike price of a. The more bullish the investor is, the higher the strike price should be. By this strategy, the downside risk is avoided BUY CALL (RELIANCE CAPITAL) Price of Rel Cap on 1 st June 2010 Rs The stock is expected to increase up to Rs 765 in Short term. So buy a call option of Rel cap with a strike price Of Rs 720 of the maturity 24 June. Premium paid for the option Rs Exercise the option on 21 June 2010 as on 21 june, the price of the scrip touched Rs Payoff = ( ) Rs 8.55(profit) BUY PUT Strategy View - Investor thinks that the market will fall significantly in the short-term.. Strategy Implementation - Put option is bought with a strike price of E. The more bearish the investor is, the lower the strike price should be. SELL CALL Strategy View Investor is certain that the market will not rise and is unsure/ unconcerned whether it will fall. Strategy Implementation Call option is sold with a strike price of E. If the investor is very certain of his view then at-the-money options should be sold, if less certain, then out-of-the-money ones should be sold. EXAMPLE Exercise Price 150 Size of the contract 100 shares Price of the share on the date of contract 144 Price of option on the date of contract 10 Option premium to be received Rs10.00*100 = Rs1000 Amount to be received for selling shares = Rs150*100 = Rs15000 If market value of the underlyned share will be Rs140, then the buyer will not exercise the contract. Hence / will be the premium received = 100*10 = 1000(profit) 21 icmrrjournal@gmail.com

7 Sell Call E Stock price SELL PUT Strategy View Investor is certain that the market will not go down, but unsure/unconcerned about whether it will rise. Strategy Implementation Put options are sold with a strike price E. If an investor is very bullish, then in-the-money puts would be sold. EXAMPLE Exercise price Size of the contract Price of the put option on the date of the contract Rs shares Rs7.5 Option premium to be received Rs7.50*100 = Rs750. Amount to be paid for buying shares = Rs110*100 = Rs11000 If market value of the underlying share will be Rs100, then the buyer will exercise the contract. Hence / will be the premium received = (100*100) = 250(loss) Possible prices of the share Investor Position icmrrjournal@gmail.com

8 Stock pricce VOLUME 4, ISSUE Payoff 5, MAY from short 2016put Total pay off Net profit= Payoff + premium S1>110 0(Not exercised) 0 Rs7.50 S1= =0 S1< X< Sell Put BULL SPREAD (CALL) Strategy View Investor thinks that the market will not fall. It is a Conservative strategy for one who thinks that the market is more likely to rise than fall. Strategy Implementation It involves having two calls on the same stock with same expiry date but with different exercise prices. Call option is bought with a strike price below the stock price and another call option sold with a strike price above the stock price. E Stock price Ex-1- BULL SPREAD (SIEMENS) WITH CALL Price of Siemens on 1 st June 2010 Rs 684. The stock is expected to increase up to Rs 735 in Short term. So buy a call option of 24 June with a strike price of Rs 680 premium paid Rs & sell a call option with same maturity date with a strike price of 700 premium received Rs Initial outlay = = Exercise the option on 23 June 2010 as on 23 June, the price of the scrip touched Rs 738. Payoff from bought call = = 58 Payoff from sold call = = -38 Total payoff = 58 - ( ) = Rs 56.10(loss) 23 icmrrjournal@gmail.com

9 Bull Spread (Call) a b Stock price /loss BULL SPREAD (PUT) Strategy View Investor thinks that the market will not fall, but wants to minimize the risk. It is a conservative strategy for one who thinks that the market is more likely to rise than fall. Strategy Implementation It involves writing put b at a higher strike price and buying a put a with a lower strike price. EX-2- BULL SPREAD (AXIS BANK) WITH PUT Price of Axis Bank stock on 1 st June 2010 Rs The stock is expected to increase up to Rs 1100 in Short term. So buy a put option with maturity 29 July with a strike price of Rs 1100 premium paid Rs & sell a put option with same maturity date with a strike price of 1250 premium received Rs Initial payoff = = Exercise the option on 29 July 2010 as on 23 June, the price of the scrip touched Rs 738. Payoff from bought call = 0 Payoff from sold call = 0 Total payoff = 22.95(loss) Bull Spread (Put) /loss a b Stock price 24 icmrrjournal@gmail.com

10 BEAR SPREAD (CALL) Strategy View Investor thinks that the market will not rise, but wants to minimize the risk. It is a conservative strategy for one who thinks that the market is more likely to fall than rise. Strategy Implementation Call option is sold with a lower strike price of a and another call option is bought with a higher strike of b BEAR SPREAD (PUT) Strategy View Investor thinks that the market will not rise, but wants to minimize the risk. Conservative strategy for one who thinks that the market is more likely to fall than rise. Strategy Implementation Put option is sold with a lower strike price of a and another put option is bought with a strike of b Ex-3-BEAR SPREAD (BPCL) WITH PUT Price of BPCL stock on 1 st June 2010 = Rs 583. The stock is expected to be bearish in Short term. 1. Option 1 - Sell a put option with maturity of 24 th June with an exercise price of Rs 580 premium received Rs Option 2 - Buy a put option with same maturity date with an exercise price price of Rs 600 premium paid Rs Initial payoff = = (-16.10) Exercise the option on 24 th June Stock price on 24 th june = Rs Payoff from put-1 = = (-29.95) Payoff from Put-2 = = Net payoff = ( ) Rs 03.90(profit).BUY STRADDLE (LONG STRADDLE) Strategy view Where the Investor expects a sharp movement in the share price, but unsure of direction, it is an appropriate strategy. Strategy implementation long straddle involves buying a Call & a Put at the same exercise price and for the same tenure. A buyer of the Straddle buys both call & the put. EXAMPLE-4 ASSUMPTION -- STRIKE = Rs 100 CALL PREMIUM = Rs 5 Put premium = Rs 4 Initial investment = Rs 9 25 icmrrjournal@gmail.com

11 IF END STOCK IS CALL PAYOFF PUT PAYOFF NET PAYOFF SHORT STRADDLE Buy Straddle a /loss Stock price Strategy view: Investor thinks that the market will be not be very volatile in the short-term. It is a strategy for relatively stable stock. A short straddle works whenever the price remains within the band. Strategy implementation: A short straddle involves selling both the call and the put. Ex-5-SHORT STRADDLE (JP ASSOCIATE) Price of BPCL stock on 1 st June 2010 = Rs The stock is a relatively less volatile one. 1. Option 1 - Sell a call option with maturity of 29 th July with an exercise price of Rs 130 premium received Rs Option 2 - Sell a put option with same maturity date and exercise price premium paid Rs Initial payoff = = Rs Exercise the option on 22 nd July Stock price on 22 nd July Rs Payoff from option-1 = = (-01.50) Payoff from option-2 = 0 option will not be exercised. 26 icmrrjournal@gmail.com

12 Net payoff = Rs 10.05(profit) Sell Straddle /loss a Stock price BUY STRANGLE Strategy view: Investor thinks that the market will be very volatile in the short-term. Strategy implementation: This is identical to the straddle except that the call has an exercise price above the stock price and the put has an exercise price below the stock price and the premium paid is less. Ex-6- BUY STRANGLE (TATA STEEL) Price of Tata Steel stock on 1 st June 2010 = Rs The stock shows a high volatility in the short term. 1. Option 1 - Buy a call option with maturity of 24 th June with an exercise price of Rs premium paid Rs Option 2 Buy a put option with same maturity date and exercise price of Rs premium paid Rs Initial outlay = -( ) = Exercise the option on 24 th June Stock price on 24 th June Rs Payoff from option-1 = = Payoff from option-2 = 0 option will not be exercised. Net payoff = Rs 05.82(profit) 27 icmrrjournal@gmail.com

13 Buy Strangle /loss /loss a b Stock price SELL STRANGLE Strategy view: The investor thinks that the market will not be volatile within a broadish band. Strategy implementation: This is identical to the straddle except that the call has an exercise price above the stock price and the put has an exercise price below the stock price and the premium paid is less. Ex-7-SELL STRANGLE (SUZLON) Price of Suzlon stock in June 2010 = Rs The stock shows a relative stability in the short term. 1. Option 1 - Sell a call option with maturity of 24 th June with an exercise price of Rs premium received Rs Option 2- Sell a put option with same maturity date and exercise price of Rs premium received Rs Initial payoff = = Exercise the option on 24 th June Stock price on 24 th June Rs Payoff from option-1 = 0 (option will not be exercised). Payoff from option-2 = 0 (option will not be exercised). Net payoff = 00.65() Sell Strangle /loss a b /loss 28 icmrrjournal@gmail.com

14 BUTTERFLY SPREAD Strategy view: This strategy hopes that the price will remain want exposure to an unexpected rise or fall. within a steady range, but does not Strategy implementation: This involves the following;- 1. Buying a call at low exercise price 2. Buying a call at higher exercise price 3. Selling two calls at an intermediate price. Ex-8- BUTTERFLY SPREAD (UNITECH) Price of Suzlon stock in June 2010 = Rs Option 1 - Buy a call option with maturity of 24 th June with an exercise price of Rs premium paid Rs Option 2- Buy another call option with same maturity date and exercise price of Rs premium paid Rs Option 3&4- Sell two calls with the same maturity of intermediate strike price of Rs premium received 2*4.35 = Rs Initial payoff = ( ) = Exercise the option on 23 rd June Stock price = Rs Payoff from option-1 = = Rs Payoff from option-2 = = Rs Payoff from option-3&4 = 2*( ) = Net payoff = 01.35() Conclusion From the above discussion it may be concluded that Research studies have proved that the equities have outperformed most other forms of investments in the long term. Further it may be concluded that concludes that the capital market in India has gone through various stages of liberalization, bringing about fundamental and structural changes in the market design and operation, resulting in broader investment choices, drastic reduction in transaction costs, and efficiency, transparency and safety as also increased integration with the global markets. The opening up of the economy for investment and trade, the dismantling of administered interest and exchange rates regimes and setting up of sound regulatory institutions have enabled time. 29 icmrrjournal@gmail.com

15 REFERENCES INTERCONTINENTAL JOURNAL OF FINANCE RESEARCH REVIEW 1. Websites steel.com 2. Books & Journals The custom Act, 1962 (Universal law publisher) Import documentation International marketing Financial management, I M Pandey. Booklets of Orissa project Research methodology, C.R. Kothari. 30 icmrrjournal@gmail.com