Executive summary: Organization of the Thesis:

Transcription

1 Executive summary: There are many types of financial instruments that are grouped under the term derivatives, but options, futures and swaps are among the most common. One of the uses of derivatives is as a tool to transfer risk (i.e. hedging). Of course, speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities. Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way that they are traded in market: Over-the-counter (OTC) derivatives products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. Worldwide the OTC derivatives market is huge. According to the Bank for International Settlements, the total outstanding notional amount is USD billion as on June 2008 quarter end. Exchange-traded derivatives products are those in which Derivatives exchange plays a role of intermediary between the parties. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), Chicago Mercantile Exchange and the Chicago Board of Trade. Organization of the Thesis: The Thesis is divided into nine chapters. The first chapter discusses the introduction and concept of financial derivatives, academic research review of financial derivatives. It also discusses the brief introduction of forwards and futures, options and swaps. Research methodology applied in the thesis has also been covered in it. The second chapter discusses the various facets of derivatives covered under literature review stage of research process. It is sub-divided into two parts. The first part covers evolution of derivatives. The second part covers the literature review related to various research questions on derivatives and contributions by other researchers in the field of financial derivatives market. The third chapter presents the research process carried out in the thesis. It also discusses the limitations of this research. The fourth chapter covers the structure, pricing and valuation of various derivatives instruments with numerical examples. It is sub-divided into six parts. The first part covers forward contracts. The second part covers swap pricing and application of interest rate iii

2 swap and currency swap. The third part covers futures contract including forward rate agreement, interest rate futures, etc. The fourth part covers various options contracts with pricing and their application. The fifth part covers packaged forward contracts. Lastly, Futures Options contracts are discussed. The fifth chapter mainly discusses various investment strategies using financial derivatives. The sixth chapter discusses the various cases of losses using derivatives. It is sub-divided into two sections; first section covers Foreign Companies cases of losses while the second section discusses the Indian Foreign Exchange Derivatives and losses to corporate companies in Indian Context. The seventh chapter covers the data analysis of statistical secondary data. The data sources are publications of Bank for International Settlement, ISDA and National Stock Exchange (NSE). The eighth chapter is the most important part of the thesis. It covers the analysis and findings of the primary survey, conducted in the context of equity derivatives and financial derivatives respectively. The ninth chapter presents the concluding part of the thesis. It starts with the comparison of the findings of this survey analysis with the findings of other researches done on derivatives by others. It covers major advantages and risks associated with financial derivatives, perceptible facts of derivatives, the global scenario as well as the Indian experience with financial derivatives. It also covers the summary of test of various hypotheses, carried out with primary data. The chapter ends with concluding remarks and future scope in financial derivatives. PROBLEM IDENTIFICATION The main research problems for the study are; 01. The scope for derivatives in India (under the regime Liberalization Policy of government) with special attention to stock market and foreign Exchange market. 02. Risk Management with derivatives for investors, treasurers of banks and corporate finance managers. (Including pricing and strategies.) RESEARCH OBJECTIVES The main objective of the study is to explore the various derivatives available to an investor in India. The broad objectives are: - (1) The scope of derivatives in Indian Financial System. (2) To study the problems and prospects of making derivative market investor friendly for individuals, corporate investors and institutional investors. (3) To study pricing of options and futures under various models (with practical data) (4) To study investment strategies with derivatives (with practical data) iv

3 (5) To study the cases of losses using derivatives in foreign countries as well as in Indian context. (6) Descriptive research: This includes, among others, the testing of main hypothesis that The Indian investors and corporate finance managers, hesitate to enter into derivative markets. RESEARCH METHODOLOGY On the basis of the research problem and research objectives, the following methodology is used. RESEARCH DESIGN Though the topic has become popular now-a-days, still there are many areas, which have remained uncovered in the Indian context. Therefore to explore a new vista in the field of derivatives, an exploratory study was done mainly in the stock market and foreign exchange market. On the basis of preliminary information, a descriptive study is done to check the attitude of investors and corporate finance managers towards dealing in derivatives. SOURCES OF DATA COLLECTION Both primary and secondary data are used for the research on derivatives. Personal interviews of investors and business managers and questionnaires/ schedules are the major research tools for primary data collection. Testing of hypothesis was done from the data collected through questionnaire. Secondary data were collected from articles from financial research journals, reference books on derivatives, business magazines, daily business/ financial news papers, internet etc. METHODS OF DATA COLLECTION Personal interviews of investors in the stock market, corporate managers having exposure in foreign exchange, authorized dealers in forex, stock brokers, etc., were conducted. Questionnaire / Schedules were used to collect the data of investors on a large scale. For this Area sampling method was applied for equity investors questionnaire (sample size: two hundred eleven), while judgment sampling was used in forex and currency derivatives (sample size: fifty five) Major Findings: Conclusions of primary survey analyses This para is divided in two parts. The first part enumerates conclusions regarding equity derivatives survey. The second part list out the conclusions regarding the foreign exchange derivatives survey. v

4 Equity Derivatives survey: Out of various risks, market risk is considered to be the most important factor by investors in equity derivatives. This conclusion is similar with the findings of Alok Dixit et al. (2011) and Sandeep Srivastava(2008) who concluded less liquidity in the market, which is a part of economy (market) risk. In our survey transaction cost was given the third rank, which shows that equity investors are not much concerned with transaction costs. Investors mainly invest in stock futures followed by index futures, stock options and index options respectively. This conclusion matches with the conclusion of Sandeep et al.(2008) who concluded that maximum trading is done in futures on individual shares. Indirectly and partly this findings also supports that futures are simpler than options which was concluded in survey analysis by P. Ganesan (2004). Investors use equity derivatives mainly for speculation followed by arbitrage and hedging the existing position respectively. These findings are similar to the research observations by P. Ganesan et al. (2004). They found that speculation is the main objective of investors in trading in equity derivatives market. But this finding is somewhat contrary to the statement of Naser I. Abumustafa. (2007) which said that speculation is an inherent part of human behaviour. Foreign Exchange Derivatives survey: The survey analysis finds that corporate managers hesitate to trade in forex derivatives. This finding is partly similar to that of P.K. Jain et al. (2009). They concluded that Private sector and Public sector firms lesser manage forex risk compared to foreign controlled firms as their exposures are not large enough. But these findings are contrary to the findings of Rafael F. Schiozer (2009) who found that foreign exchange risk is the most commonly managed with derivatives in Latin American firms. This difference might be due to the developed financial market of these countries compared to developing countries like India. This view is endorsed by conclusion of Sohnke M. Bartman et al. (2009) that middle income countries where the derivatives is less liquid, less likely to hedge using derivatives. This survey finds that for short term currency hedging forward cover is the dominating tool ( about seventy four percentages of respondents) while for long term, currency option is preferred over long term currency swap. Currency options are used for both short term as well as for long term hedging by a few respondents. This conclusion is contrary to the findings in Epharim Ciark et al.(2009) that forwards, futures and options are appropriate for short term duration for in managing export and imports while foreign currency swap is used for hedging long term exposures like, borrowings. Such clear demarcations are not observed in our findings. But the conclusion of dominance of OTC forward is similar to the survey conclusion of Chris Mallin (2001) et al. that OTC forward was the most used instrument to hedge currency risk. As per the survey the Corporate managers trade in foreign exchange derivatives mainly for hedging transaction exposure (mean rank= 5.42) followed by translation risk vi

5 (mean rank = 4.06) and economic exposure (mean rank = 3.97) respectively. These conclusions are at par with the survey findings of Manoj Anand et al. (2008) that transaction exposure is the most critical factor to the firms followed by translation exposure and economic risk respectively. In this regard El Masry (2006) has given general conclusion that the most important reason for using derivatives is hedging (managing) the volatility in cash-flows, which indirectly matches with abovementioned conclusion of our survey. There are various strategies, which can be used by investors using option and futures. Futures are mainly used for covering the open position in the underlying asset. While option combinations can be used, by anticipating bullish or bearish trend. The popular option strategies of investors are straddle, strangle, strip, strap, covered call writing, protective put, various spread strategies like vertical spread, horizontal spread, diagonal spread, ratio spread, condor, butterfly spread or simply buying/ writing call or put option. Generally investors do not go for complex exotic or combined options due to lack of knowledge. The equity derivatives investors at retail level do not go for combination of option strategies in general. The major problem for this is lack of knowledge and expertise in this. The index derivatives provide individuals with the opportunity to invest in a well-diversified portfolio to exploit the emerging potential of the market. Secondary data analysis: Worldwide interest rate derivatives like interest rate swap, forward rate agreement and interest rate options are traded in the OTC market. While under exchange-traded derivatives, equity and interest rate futures are equally popular among investors/ traders. But equity index options are the highest traded derivatives (in terms of number of contracts) followed by interest rate options and currency options respectively. At National Stock Exchange, on an average, since its inception stock futures cover 54 percent, Index futures cover 27 per cent, Index option 11 per cent and Stock option 8 per cent of the total equity derivatives market. From the study of cases of derivatives losses the following general risk categories were identified. Market Risk It covers unexpected changes in prices or rates, (1) Amaranth Advisors: They followed the trend predictions of increase of Natural gas futures prices. But the prices declined actually. (2) Barings PLC: Leeson expected bullish trend and therefore took a long position in index futures but the index fell by about 13% in five weeks due to Earthquake in Japan. Liquidity Risk It covers the risk of increased costs, or inability to adjust financial positions (e.g., hike in margin calls due to excessive volatility) Operational Risk It covers fraud, system failures, trading errors (such as deal mispricing). E.g. Enron: The company officials had not maintained the true and proper books of accounts and also entered into risky price-swap derivatives. Everything resulted into bankruptcy of the company vii

6 Credit Risk It covers changes in value associated with unexpected changes in credit quality. It is also known as default risk, which is mainly there in case of OTC contracts for derivatives. Legal risk: It pertains to change in government policy regarding trading in derivatives, e.g., forbid on certain underlying for a certain or indefinite period. In such cases disposal becomes costlier to the position holder. Primary data analysis: From the hypothesis testing it was deduced that in equity segment investors prefer to trade in derivatives. They generally use simple strategies using options as well as futures. In case of foreign exchange, the company managers do not prefer to trade in currency derivatives. They mainly deal with currency forwards and swaps with banks as counter party for hedging. The awareness level of derivatives as a hedging tool is very low among them. The survey results are comparable with the similar survey carried out in Turkey. The Turkish Capital Market Board (CMB) conducted a questionnaire survey in March 2005, covering 225 industrial and service sector companies operating in the Istanbul Stock Exchange (ISE). Their conclusion is similar to this primary research. The following are the conclusions by testing various hypotheses with the primary survey, conducted for equity derivatives and foreign exchange derivatives respectively. Equity Derivatives: 1. Investors prefer to trade in equity derivatives. 2. Out of various risks, market risk is considered to be the most important factor by investors. 3. Investors mainly invest in stock futures followed by index futures, stock option, index option, interest rate derivatives respectively. 4. Majority of people have knowledge of software application for equity derivatives pricing. 5. Investors use equity derivatives mainly for speculation followed by arbitrage and hedging the existing position. 6. Investors still have preference in trading in cash segment of equity market compare to derivatives counterpart. Foreign Exchange Derivatives: 1. Corporate managers hesitate to trade in forex derivatives. viii

7 2. Managers do not have different hedging policy for on-balance sheet and offbalance sheet transactions. 3. Time horizon and hedging strategy-using derivatives do not differ among managers. 4. The firms having documented policy for derivatives, value their portfolio either daily or weekly basis, while the firms, which do not have any documented policy, value their derivatives portfolio as needed. Concluding remarks: Derivative markets in equities, fixed income, and foreign currency were at their nascent stage of evolution in India, but looking at their present popularity among the investors, they have significant growth potential. For this potential to be realized, one or more of the following issues or impediments would have to be overcome and resolved: i. The regulatory framework applicable to the OTC derivative markets and participants would need to evolve further; ii. The technological and business process framework of several key participants in these markets needs to geared up to manage the risks relating their activity in the derivatives market; ( e.g. knowledge of software for fair pricing of derivatives should be imparted) iii. The human resources/talent of several key participants in these markets needs to be greatly upgraded and readied to manage the exposures and risks relating their activity in the derivatives market; iv. A framework which (a) relieves managements of public sector banks and FIs of the risk of being held accountable for bona fide trading losses in the derivatives book and being exposed to subsequent onerous investigative reviews; (b) but concurrently holds managements of public sector banks and FIs answerable for lost opportunity profit, needs to be escorted in; and v. The top management of several key participants needs to undergo an orientation phase to familiarize themselves with the conceptual underpinnings and microstructure of these derivatives markets (e.g. exotic options, complex forex swaps, etc.) to help them establish an appropriate governance framework for the derivatives market activity of the participant. LIMITATION OF THE RESEARCH The research is based on the present economic and financial environment relative to derivatives trading; therefore the conclusions derived will be applicable under those circumstances only. As many changes have taken place in derivatives market in the last four years, some new developments are also expected in the coming period. Some drastic changes may limit the conclusions of the research under study. The findings of the primary data pertain to Ahmedabad city and nearby areas in Gujarat. As Gujarat is one of the major states in stock-market trading and in turn, Ahmedabad, the commercial capital of Gujarat, the choice is given to Ahmedabad for primary data collection as a representative city ix