1. INTRODUCTION

In India, National Stock Exchange (NSE) and Bombay Stock Exchange (BSE)

introduced financial derivatives in the year 2000. Derivatives allow managing risks more

effectively by reducing the burden of risk and allowing either hedging or taking only one

risk at a time. It is indeed rewarding but involves a great deal of risk. Investing in

financial securities is considered to be one of the best avenues for investing one’s savings

while it is acknowledged to be one of the most risky for investment. Investment is the

employment of funds with the aim of earning additional income or capital appreciation. It

has two attributes i.e., time and risk. The sacrifice that has to be made by the investor is

certain but return in the future is uncertain. Every investor is exposed to risk of market

price of fluctuations. Derivatives were evolved to curtail the risk of market price

fluctuations in the commodity market. Derivatives have been in use way back in 13 th

century onwards and later it was developed for the securities market.

Risk is a characteristic future of all commodity and capital market. Prices of all

commodities like wheat, cotton, rice, coffee, tea, silver, gold etc are subject to

fluctuations in demand and supply over time. Producers of commodities cannot be sure of

the price that they produce may fetch when they are ready for sale. Similarly prices of

shares and debentures or bond etc are subject to fluctuations. In the same way the foreign

exchange are also subject to fluctuations. In the current economic scenario, investments

in financial markets have become more complicated. Investing in securities such as

shares, debentures, bond etc are profitable as well as interesting and attracts people from

all walks of life irrespective of their occupation, economic status, education or family

background. Risk reduction is one of the main issues for an investor as it is directly

related to the return on the investments.

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Some of the risk management techniques used in the capital market now a day is:

Risk avoidance

Combination

Diversification

Risk transfer

Portfolio investment

Hedging

The project entries “A STUDY ON HEDGING EFFECTIVENESS IN INDEX

FUTURE” deals with the construction of a profitable portfolio on the basis of risk-return

evaluation and loss minimization using hedging. The companies are selected on the basis

of their industrial performance. Investing in individual securities involves lot of risks. It

is better to invest in-group of securities to reduce risk. Selecting the group of securities is

an important task. Investors are interested in maximizing the return with minimum risk,

here ten securities have been selected for constructing the portfolio these securities are

representatives of different sector. The securities selected are SBI BANK, HDFC BANK,

WIPRO, INFOSYS, MAHINDRA, MARUTI SUZUKI, HUL, ITC, CIPLA and

RANBAXY. There exist a considerable degree of different in return and risk of various

portfolios.

PORTFOLIO MANAGEMENT

Investing in securities such as shares, debentures and bonds is profitable as well

as existing. It is indeed rewarding, but involves a great deal of risk and calls for scientific

as well as artistic skill. In such investment both rational as well as emotional responses

are involved. Investing in financial securities is now considered to be one of the most

risky avenues of investments.

It is rare to investors investing their savings in a single security. Instead they tend

to invest in a group of securities. Such as group of securities is called as Portfolio.

Creation of a portfolio helps to reduce risk without sacrificing returns.

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Portfolio management deals with the analysis of individual securities as well as

with the theory and practice of optimally combining securities into portfolios. An

investor who understands the fundamental principles and analytical aspects of portfolio

management has a better chance of success.

An investor considering investments in securities is faced with the problem of

choosing from among a large number of securities. His choice depends upon the risk

returns characteristics of individual securities. He would attempt to choose the most

desirable securities and like to allocate his funds over this group of securities. Again he is

faced with the problem of deciding which securities to hold and how much to invest in

each. The investor faces an infinite number of possible portfolios differ from those of

individual securities combining to form a portfolio. The investor tries to choose the

optimal portfolio taking into consideration the risk return characteristics of all possible

portfolios.

TECHNICAL ANALYSIS

Technical analysis is a method of evaluating securities by analyzing the statistics

generated by market activity, such as past prices and volume. Technical analysis do not

attempt to measure a security’s intrinsic value, but instead use charts and other tools to

identify patterns that can suggest future activity.

Just as there are many investment styles on the fundamental side, there are also

many different types of technical traders. Some rely on chart patterns, others use

technical indicators and oscillators and most use some combination of the two. In any

case, technical analyst’s exclusive use of historical price and volume data is what

separates them from their fundamental counterparts. Unlike fundamental analysts,

Technical analysts don’t care whether a stock is undervalued- the only thing that matters

is a security’s past trading data and what information this data can provide about where

the security might move in the future.

1. The market discounts everything.

2. Price moves in trends.

3. History trends to repeat itself.

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INVESTMENT ANALYSIS

Investment is the employment of funds on assets with the aim of earning income

or capital appreciation. Investment has two attributes namely time and risk. Present

consumption is sacrificed to get a return in the future. The sacrifice that has to be borne is

certain, but the return in the future may be uncertain. This attribute of investment

indicates the risk factor. The risk is undertaken with a view to reap some return from the

investment. Investment means some monetary commitment.

RISK

Every investment is characterized by return and risk. Risk can be defined in terms

of variability I returns. “Risk is the potential for variability in returns”. An investment

whose returns are fairly stable is considered to be low risk investment, where as an

investment whose returns fluctuate significantly is considered to be a high-risk

investment. Equity shares whose returns fluctuate significantly are considered to be a

high-risk investment and those are considered as risky investment.

ELEMENTS OF RISK

The total variability in return of a security represents the total risk of that security.

Systematic risk and unsystematic risk are the two components of total risk. Thus

Total riskSystematic risk /

Unsystematic risk

SYSTEMATIC RISK

The impact of economic, political and social changes is system wide and that

portion of total variability in security returns caused by such system wide factors is

referred to as systematic risk. Systematic risk is further sub divided into interest rate risk,

market risk and purchasing power risk.

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UNSYSTEMATIC RISK

The risk of price changes due to the unique circumstances of a specific security,

as opposed to the overall market. The risk can be virtually eliminated from a portfolio

through diversification. This risk is unique of peculiar to a company or industry and

affects it in addition to the systematic risk affecting all securities. The unsystematic or

unique risk affecting specific securities arises from two sources:

The operating environment of the company, and

The financing pattern adopted by the company. These two types of

unsystematic are referred to as business risk and financial risk

respectively.

INDUSTRY PROFILE

The capital market is the market for securities, where companies and government

can raise long term funds. The capital market includes the stock market and the bond

market. The capital market is basically divided into:

Primary market

Secondary market

The primary market is the part of capital market that deals with the issuing of new

securities.

The secondary market is the financial market for trading of securities that have already

been issued in an initial private or public offering.

OTC EXCHANGE OF INDIA (OTCEI)

The OTC Exchange of India (OTCEI) has been setup to provide cost effective and

convenient platforms for raising finance from the capital market. OTCEI was promoted

by a consortium of financial institutions sated its operations in 1992. It is a ring less,

electronic, nation wider stock exchange committed to providing entrepreneurs with a

smooth economical vehicle for going public and investors with a fair, sable and efficient

market. Thus the OTCEI brings investors and promoters closer together.

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NATIONAL STOCK EXCHANGE (NSE)

National Stock Exchange (NSE) of India commenced its operations in the capital

market on 3rd November 1994 in Mumbai. The recommendations of Pherwani committee

led to the beginning of NSE.

The main objective of NSE is to establish a nationwide trading facility for

equities, debt and hybrids:

To ensure equal access to investors all over the country through appropriate

communication network.

To provide a fair, efficient and transparent security market to investors by using

an electronic communication network.

To enable shorter settlement cycle and book entry system.

To meet current international standards of securities market.

NSE 50-INDEX

The NSE 50 Index, commonly known as Nifty. It is a market capitalization

weighted index. It was introduced in April 1996, replacing the earlier NSE-100. The

objective of the NSE 50- Index is

To reflect the market movement more accurate.

To provide fund manager with a bench mark for measuring portfolio performance.

To establish a basis for introducing index based derivative product.

BOMBAY STOCK EXCHANGE (BSE)

The stock exchange, Mumbai, popularly known as “BSE” was established in 1875

as “the native share and stock brokers association. It is the oldest one in Asia, even older

than the Tokyo Stock Exchange, which was established in 1878. It is a voluntary non-

profit making association of persons (AOP) and is currently engaged in the process of

converting itself into demutualised and corporate entity. It has evolved over the years into

its present status as the premier stock exchange in the country. It is the first stock

exchange in the country to have obtained permanent recognition in 1956 from the

government of India under the Securities Contract (Regulation) Act, 1956.

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The exchange, while providing an efficient and transparent market for trading in

securities, debt and derivatives upholds the interests of the investors and ensures

redressed of their grievances whether against the companies or its own member-brokers.

It also strives to educate enlighten the investors by conducting investor education

programs and making available to them necessary informative inputs.

A governing board having 20 directors is the APEX body, which decides the

policies and regulates the affairs of the exchange. The governing board consists of 9

elected directors, who are from the broking community (one third of them retire every

year by rotation), three SEBI nominees, six public representatives and an executive

director and chief operating officer.

The executive director as the chief executive officer is responsible for the day-to-

day administration of the exchange and the chief operating officer and other heads of

departments assist him.

The exchange has inserted new rule No. 126 A in its Rules, byelaws and

Regulations pertaining to constitution of the executive committee of the exchange.

Accordingly, an executive committee, consisting of 3 elected directors, 3 SEBI nominees

or public representatives, executive director, CEO and Chief Operating Officer has been

constituted. The committee considers judicial and quasi matters, in which the governing

board has powers as an Appellate Authority, matters regarding annulment of transactions,

Admission, continuance and suspension of member brokers, declaration of a member

broker as defaulter, norms, procedures and other matters relating to arbitration, fees,

deposits, margins and other moneys payable by the member brokers to the exchange etc.

SEBI’s POWER IN RELATION TO STOCK EXCHANGE

The SEBI ordinance has given it the following powers:-

1. It may call periodical returns from Stock Exchange.

2. It has the power to prescribe maintenance of certain documents by the stock

exchanges.

3. SEBI may call upon the exchange or any mate to furnish explanation or

information relating to the affairs of the stock exchange or any member.

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4. It has the power to approve byelaws of the stock exchange for regulation and

control of contracts.

5. It can amend byelaws of stock exchange.

6. In certain areas it can license the dealers in securities.

1.1 COMPANY PROFILE

UNICON SECURITIES PRIVATE LIMITED

UNICON is a financial services company which has emerged as a one-stop

investment solutions provider. It was founded in 2004 by two visionary and flamboyant

entrepreneurs, Mr. Gajendra Nagpal and Mr. Ram M. Gupta, who possess expertise in

the field of Finance. The company is headquartered in New Delhi, and has its corporate

office in Mumbai with regional offices in Kolkata, Chennai, Hyderabad and Noida.

UNICON is a professionally managed company led by a team with outstanding

managerial acumen and cumulative experience of more than 400 man years in the

financial markets The Company is supported by more than 4500 Uniconians and has a

team of over 900 business offices in 235 cities across India.

With a customer base of over 200,000 the Unicon Group has an eye for the

intricate financial needs of its clients and caters to both their short – term and long – term

financial needs through a comprehensive bouquet of investment services. It has been

founded with the aim of providing world class investing experience to the investing

community. These services range from offline & online trading in equity, commodities

and currency derivatives to debt markets to corporate finance and portfolio management

services. The company has a sizable presence in the distribution of 3rd party financial

products like mutual funds, insurance products and property broking. It also provides

expert Advisory on Life Insurance, General Insurance, Mutual Funds and IPO’s. The

distribution network is backed by in-house back office support to provide prompt and

efficient customer service

The Equity broking arm – UNICON Securities Pvt. Ltd offers personalized

premium services on the NSE, BSE & Derivatives market. The Commodity broking arm

Unicon Commodities Pvt. Ltd offers services in Commodity trading on NCDEX and

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MCX. The UNICON group also has a PCG division providing investments solutions for

High Net worth Individuals. The Corporate Advisory Services arm – Unicon Capital

Services (P) Ltd offers entire gamut of Investment Banking services to corporate.

UNICON can boast of some of the most respected names in the private equity

space like Sequoia Capitals, Nexus India Capital and Subhkam Ventures as its

shareholders.

MISSION :

“To create long term value by empowering individual investors through superior

financial services supported by culture based on highest level of teamwork, efficiency

and integrity”.

VISION :

“To provide the most useful and ethical Investment Solutions - guided by values driven

approach to growth, client service and employee development”.

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GROUP COMPANIES

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UNICON FINANCIAL

INTERMEDIARIES Pvt. Ltd.

FIXED INCOME & INVESTMENT

BANKING

UNICON CAPTIAL

SERVICES Pvt. Ltd.

DISTRIBUTION

UNICON INSURANCE

ADVISORS Pvt. Ltd.

COMMODITIES TRADING

UNICON COMMODITIE

S Pvt. Ltd.

REAL ESTATES

UNICON REAL

ESTATES Pvt. Ltd.

TRADING IN EQUITIES &

DERIVATIVES

UNICON SECURITIES

Pvt. Ltd.

FINANCE (SHARES & IPO)

UNICON FINCAP Pvt.

Ltd.

PRODUCT AND SERVICES

Unicon customers have the advantage of trading in all the market segments

together in the same window, as we understand the need of transactions to be executed

with high speed and reduced time. At the same time, they have the advantage of having

all Advisory Services for Life Insurance, General Insurance, Mutual Funds and IPO’s

also.

Unicon is a customer focused financial services organization providing a range of

investment solutions to our customers. We work with clients to meet their overall

investment objectives and achieve their financial goals. Our clients have the opportunity

to get personalized services depending on their investment profiles. Our personalized

approach enables clients to achieve their Total Investment Objectives.

Our key product offerings are as follows:

Equity  

Commodity  

Depository  

Distribution  

NRI Services  

Back Office  

Fixed Income  

Investment Banking  

Currency Derivatives  

Portfolio Management

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1. EQUITY:

UniconEasy

Browser based trading terminal that can be accessed by a unique ID and password. This

facility is available to all our online customers the moment they get registered with us

UniconSwift

Application based terminal for active traders. It provides better speed, greater analytical

features & priority access to Relationship Managers. Greater exposure for trading on the

margin available.

2. COMMODITY:

Unicon offers a unique feature of a single screen trading platform in MCX and

NCDEX.Unicon offers both Offline & Online trading platforms.

Live Market Watch for commodity market (NCDEX, MCX) in one screen.

Add any number of scrips in the Market Watch.

Tick by tick live updation of Intraday chart.

Greater exposure for trading on the margin available

Common window for market watch and order execution.

Key board driven short cuts for punching orders quickly.

Real time updation of exposure and portfolio.

Facility to customize any number of portfolios & watchlists.

Market depth, i.e. Best 5 bids and offers, updated live for all scripts.

Facility to cancel all pending orders with a single click.

Instant trade confirmations

Stop-loss feature.

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3. DEPOSITORY:

Unicon Depository Services offers dematerialization services as a participant in Central

Depository Services Limited (CDSL), through its Depository operations. The company

believes in efficient and cost-effective and integrated service support to its brokerage

business. Unicon Securities Private Limited, as a depository participant, will offer

depository accounts for individual investors as well as corporates which will enable them

to transact in the dematerialized segment, without any hassles.

Depository offer a safe, convenient way to hold securities as compared to holding

securities in paper form. Our service provides an integrated single platform for all our

clients ensuring a risk free, efficient and prompt depository process.

4. DISTRIBUTION:

Unicon is fast emerging as a leader in the Insurance and Mutual Funds distribution space. Unicon has over 100 branches and a huge number of “Business Development Executives” who help to source and service the customers throughout the country. Unicon is fast becoming the preferred “Vendor Independent” distribution houses because of providing efficient service like free pick-up of collection of cheques/DD’s, Keeping track of the premiums etc to its customers.

Unicon offers the following distribution products:-

IPO's

Mutual Funds

Insurance

Properties

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NRI SERVICES:

With India becoming the epicentre of growth the Global Indian feels the need

to be connected to the domestic growth story.

Unicon now offers a convenient and hassle-free way of

Ivesting in the Indian Securities Market to the people who are living outside India

and wish to participate in the Indian Growth story.

Procedure for NRI operations in Indian Capital Markets:-

  The NRI can deal with only one bank at any point of time.

  He is allowed to invest only 5% of the paid up capital of a company. The

aggregate paid up value of equity of any company purchased by all NRI's and

OCBs cannot exceed 10 percent of the paid up capital of the company and in

the case of convertible debentures, the aggregate paid up value of each series

of debentures purchased by all NRI's and OCBs cannot exceed 10 % of the

paid up value of each series of convertible debentures.

  He can enter only into delivery based trades, all deliveries must only be

routed through beneficiary accounts and not directly through the broker.

  Shares bought by him cannot be sold unless the payout of the same is

received from exchange.

  All purchase and sale transactions have to be reported to the RBI by the

designated bank.

  Original broker’s contract notes have to be submitted to the designated Bank

branch, within 24 hours of the transaction.

  He will be required to make bill to bill payments/ settlements. No adjustments

of purchase against sale consideration should be done.

  Shares cannot be bought against the shares sold in the same settlement.

  All Purchase and Sales will be dealt separately for payments / receipts.

  A Sale proceeds of any transaction not reported/approved by the RBI is

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allowed to be credited to the NRE/NRO savings/demat account. The

transaction will have to be reversed in the account and losses if any will be

borne by the client.

 All tax liabilities arising out of buying and selling of securities will be handled

by the designated bank.

5. BACK OFFICE:

Unicon through its online back-office aims to increase the transparency and

provides you the link to view the details of your account online anytime and

anywhere.

Here you have the advantage of viewing the following reports online:

  Sauda Details

  Financial Ledger

  Net position for the day

  Net position Detail (for the complete financial year)

  E-Contract Note

6. FIXED INCOME:

The Fixed income vertical of UNICON Group deals in Sovereign Paper and

Money Market/Fixed Income Instruments Broadly, it undertakes following:

Dealing in all types of money market instruments viz. Commercial paper

(Origination & Placement), Certificate of Deposit and Treasury Bills both in

Primary and Secondary market.

Dealing in Government securities (including securities of Oil, Fertilizer &

Food Bonds) and other PSU/ Corporate bonds with counterparties like Banks,

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Primary Dealers, Mutual Funds, Insurance Companies, Regional Rural Banks,

Cooperative Banks, Central & State PSUs, Housing Finance Companies,

NBFCs & Corporates.

Retailing of Central, State Government Securities and Bonds to PF Trusts,

Universities

Advisory Services to PF Trusts.

Arrangers for Private placement of Bonds & placing it with Banks, Mutual

funds, Insurance Companies & Corporates.

Securitization of receivable portfolio of Housing Finance Companies& Bank.

7. INVESTMENT BANKING:

The Investment Banking arm of Unicon Capital Services (P) Ltd. caters to the

funding requirements of corporates. Our wide experience and market knowledge as a

leading securities firm ensures that clients’ requirements are met at optimum cost. By

constantly improving our knowledge capital and remaining focused on client needs,

we aim to create significant value for our clients by helping them execute the right

capitalization strategy. We also intend to initiate merchant banking services (Capital

Markets Fundraising) in the short term (Merchant Banking License pending)

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CURRENCY DERIVATIVES:

Currency Futures

Currently in India, US Dollar Indian Rupee (USD INR) currency futures are traded

on the NSE and MCX. Since its introduction in Aug 2008, USD INR futures have

seen a 1500% burst in volume growth. Unicon offers clients the opportunity to trade

this product, either in online or offline mode as per their needs. The product provides

ample liquidity to function both as a speculative tool and as a hedging instrument for

exporters and importers. The attractive features of the product are as follows

Unlike currency forwards offered by banks, currency futures trading does not

have to be backed by an underlying merchant transaction exposure

Tight bid ask spreads; usually 0.25 paisa wide

Margin requirements less than 5% to take exposure on a lot size of $1000

New asset class for diversification for all resident individuals

Commodity traders can hedge against unfavourable movements since gold,

crude etc. are quoted in dollars

For exporters and importers, no credit line required from their Banker as is the

case with forwards

Ideal tool for those with smaller exposures, as in the case of travel needs,

educational payments etc.

Unicon Advantage :

Online & Offline trading facility on all the bourses

Exclusive daily commentary and research reports by our Currency analyst team

Regular updates on Dollar INR movement with calls to buy and sell

Special consultancy to Exporters, Importers & Corporate for their Forex

transactions

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Receive education on the product through seminars/con-calls organized by

Unicon

Your Cash Margin with Unicon Securities can be used for either segment –

Equity

Other awaited products

Euro INR is expected to be introduced anytime now

SEBI has also recommended introduction of Pound Sterling (GBP) and Japanese

Yen (JPY) futures in the near future

Currency options are also expected to be added to the basket of products soon.

8. PORTFOLIO MANAGEMENT:

Portfolio Management Services

Gone are the days when an investor could directly participate in the capital markets,

for they have not only become far more complex in terms of compliances,

methodologies, effects and analysis but also need a constant tracking mechanism. As

is the case globally, the Indian investor has also realized the advantages of seeking

professional advice in order to not only manage but also augment his portfolio.

The Portfolio Management Schemes of the Company offer Discretionary Schemes

(Unicon Optimizer & Unicon Growth) for Individuals, Corporate Bodies, Partnership

firms, Proprietors, Non Resident Indians etc. The Company is registered with SEBI

enabling it to undertake Portfolio Management activities under a specific license.

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The Schemes, duly approved by SEBI, are managed by a highly competent team

comprising of portfolio managers and equity strategists, backed by a team of

fundamental, technical and derivatives analysts. The principle objectives are to

identify investment opportunities through globally recognized analytical

methodologies, given pre-defined risk parameters construct portfolios to incorporate

client objectives periodically review of portfolios in order to consistently deliver

returns surpassing the benchmarked index and tailor-make portfolios to incorporate a

judicious mix of equity, quazi-equity, money market instruments and derivate

products.

PMS is a very personalized service wherein each portfolio has to be specifically

constructed in order to reflect the objective and risk appetite of a particular client. Our

qualified managers are constantly evolving methodologies and financial models that

provide them with a composite mix of:

1. Medium term comprising of value investing and other fundament tools

2. Short term comprising primarily of technical analysis and tools.

3. Hedging strategies comprising of derivative products.

Along with this water tight investment evaluation strategy we have up in place an

equally foolproof client servicing and feedback methodology. All Investment advisors

are handpicked and trained on a gamut of Wealth product, this ensures that he is in a

very good position to deliver a wholesome wealth experience to the client.

UNICON PMS provides following benefits:

Strong Research Team

Profile based investment solution

Professional Fund Management

Strict Risk Management

Timely performance reporting

Periodic reviews & rebalancing

Dedicated relationship manager

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1.2.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 is 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 determined 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 that binds them

to have receivables in US dollars in one month’s time they are exposed to

changes in the rate of exchanges 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.

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The problem has two dimensions: uncertainty and opportunity.

If they don’t hedge the transaction in any way, they don’t 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

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 290000

Canadian dollars. This is their opportunity loss.

Are there instruments that address both certainty losses? Fortunately, there

are. They are called derivatives or derivative products. Most financial institution

makes markets in 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 behavior 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

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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 form one of its financial institution counter parties. 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 uncertain 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, system and the

preferences of their shareholders.

The effectiveness assessment in the current hedge accounting model is based

on a rule-based approach that is onerous and has arbitrary results. This assessment

has to be performed prospectively and retrospectively. This means that companies

are required to perform two tests: a prospective test to ensure that the hedging

relationship is expected to be highly effective and a quantitative retrospective test

to ensure that the hedging relationship has been highly effective throughout the

reporting period. The quantitative test uses a range of 80 to 125 per cent for the

‘highly effective’ criterion.

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1.3 OBJECTIVE OF THE STUDY

For the effectiveness of the study the objectives are:

PRIMARY OBJECTIVE:

1. To find out the effectiveness of index futures as a Hedging instrument.

SECONDARY OBJECTIVE:

2. To study about the impact of hedging in the derivative market.

3. To know about the emphasis of hedging in the future trading.

4. To analyze the effectiveness of hedging to reduce the risk.

5. To visualize about the Derivative market.

1.4 NEED FOR THE STUDY

The study on hedging strategies has been done to help the stock holders to control

their losses. With the help of this project the stock holders can focus on areas were

hedging strategies is required.

Capital market in India is always uncertain. Anything can happen in the market. A

stock picker carefully purchases securities based on a sense that they are worth more than

the market price. While doing so he faces a risk that the entire market moves against him

and generates losses even though the underlying idea was correct. To exit from this we

have to make securities independent from index through hedging with index futures.

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Hedging with index futures removes the unwanted exposure of index movements. This

project can serve as a guide to bring new ideas to the stock holders.

1.5 SCOPE OF THE STUDY

1. The study is attempted to assess the power of hedging technique using index

future.

2. This study aims at providing an insight into the operations of hedging strategies.

Hedging provides security to the investment and also reduces the level of risk

borne by the investors.

3. The study describes the strategies to select the right hedging techniques based on

the requirements of the investors.

1.6. LIMITATIONS OF THE STUDY

1. The conclusion cannot be conclusive as market fluctuations are unpredictable.

2. Index futures are only considered for Hedging.

3. The beta value for risk assessment is not precisely correct as it changes from time

to time.

4. The duration of the study was limited to period of three month so that the

extensive and deep study could not be possible.

5. The study is depending mostly on the web information.

6. Brokerages are not taken into consideration.

7. The study was limited only to UNICON SECURITIES PVT LTD, Chennai.

24

1.6.1. Three Types of Exclusions from Effectiveness Testing:

In defining how hedge effectiveness will be assessed, an entity must specify whether it

will include in that assessment all of the gain or loss on a hedging instrument.

a. If the effectiveness of a hedge with an option contract is assessed based on

changes in the option's intrinsic value, the change in the time value of the contract would

be excluded from the assessment of hedge effectiveness.

b. If the effectiveness of a hedge with an option contract is assessed based on

changes in the option's minimum value, that is, its intrinsic value plus the effect of

discounting, the change in the volatility value of the contract would be excluded from the

assessment of hedge effectiveness.

c. If the effectiveness of a hedge with a forward or futures contract is assessed

based on changes in fair value attributable to changes in spot prices, the change in the fair

value of the contract related to the changes in the difference between the spot price and

the forward or futures price would be excluded from the assessment of hedge

effectiveness.

2. REVIEW OF LITERATURE

2.1. NEWSPAPER ARTICLE:

SENSEX SEEMS TO HIT MAX IN 2011: SAYS MADHUMITHA GHOSH

"The first quarter of 2011 would start with third quarter results and would face events like

Budget in the latter part. We expect better allocations towards India from foreign

institutions based on India growth story," Unicon Securities Vice-President Research

Madhumita Ghosh said. 

25

However, experts cautioned that pressure in the form of higher inflation and interest rates

may act as spoilsport. Also currency appreciation is expected with increased inflow and

recovery. 

The past year saw the Sensex hitting its record closing level of 21004.96 points on Diwali

day, November 5. However, the index could not surpass its highest intra-day level of

21,206.77 points, scaled on February 10, 2008. 

While the performance of the country's most valued firm Reliance Industries was not up

to the mark, a number of other blue-chips, mostly from auto, banking, pharmacy and IT

space, performed well. 

Some of the key stocks that gave impressive returns to investors included Bajaj

Auto, Tata Motors, TCS, Hidalgo, M&M, ICICI Bank, HDFC Bank and SBI. 

2.2. MAGAZINE ARTICLE:

NMDC Ltd - Q3 FY11 Result Update - Unicon Investment

Solutions

At CMP the stock is trading at PE multiple of FY12E 12x and EV/EBITDA of

8x which is quite attractive compared to its peers. Considering the strong

demand for iron ore and robust expansion plan of the company.

•   NMDC registered a strong top-line growth of 65% to INR 26.2 bn in Q3FY11

(22% above our estimate of INR 23,890 mn) supported by increased mining

coupled with better realization of iron ore prices. On QoQ basis, top line

increased marginally by 6.6%. 

•   EBITDA increased 87% YoY to INR 20,159 mn. EBITDA margin expanded

899 bps in Q3FY11 to 76.9%. 

•   The Net profit of the company stood at INR 15,180.3 mn in Q3FY11 (13%

above our estimate of INR 13,350 mn). 

26

At CMP the stock is trading at PE multiple of FY12E 12x and EV/EBITDA of

8x which is quite attractive compared to its peers. Considering the strong 

demand for iron ore and robust expansion plan of the company, we maintain our

buy rating on the stock with a target price of INR 350.

2.3. HEDGING’S EFFECTIVENESS TESTED BY DIFFERENT SCHOLARS:

Butterworth and Holmes (2000) studied hedging effectiveness of FTSE -100 and

FTSE Mid 250 index futures contracts. They found that FTSE-100 provided effective

hedge for portfolio dominated by large firms and FTSE Mid 250 was equally effective for

portfolios dominated by small capitalizations stocks.

Brails ford et al. (2000) estimated hedge ratio by several techniques for the Australian

All Ordinary Share Price index futures contract. Yang (2009) showed that M-GARCH

dynamic hedge ratio provides largest degree of reduction in variance of returns.

Nonetheless, some recent studies for example Lien et al (2011) and Moosa (2003) have

reported that basic OLS approach outperforms other advanced models of hedge ratio

estimation. In India very few studies were conducted on the hedging effectiveness of the

Futures contract.

Roy and Kumar (2007) studied hedging effectiveness of wheat futures in India.

They used conventional OLS method for hedge ratio estimation and found wheat futures

contracts do not provide effective hedge in avoiding risk. Bhaduri and Durai (2008)

examined hedging effectiveness of Nifty Futures. They found OLS based strategy

provided better hedge in shorter time horizons. However, at higher time horizons

bivariate GARCH clearly dominates. Further, Kumar et al (2008) examined hedging

effectiveness of constant and time varying hedge ratio of Nifty Futures, Gold Futures and

Soybean futures. Their results showed that the time varying hedge ratio provided greatest

variance reduction as compared to other hedges based on constant hedge ratio.

Investors studying the market often come across a security, which they believe is

intrinsically undervalued. It may be the case that the profits and the profits the quality of

27

the company make it seem worth a lot more than the market think. A stock picker

carefully purchases securities based on a sense that they worth more than the market

price. When doing so, he faces two kinds of risks:

1. His understanding can be wrong, and the company is really not worth more

than the market price, or

2. The entire market moves against him and generates losses even though the

underlying idea was correct.

Choice of hedging instruments:

The literature on the choice of hedging instruments is very scant. Among the

available studies, Géczy et al. (1997) argues that currency swaps are more cost-effective

for hedging foreign debt risk, while forward contracts are more cost-effective for hedging

foreign operations risk. This is because foreign currency debt payments are long-term and

predictable, which fits the long-term nature of currency swap contracts. Foreign currency

revenues, on the other hand, are short-term and unpredictable, in line with the short-term

nature of forward contracts. A survey done by Marshall (2000) also points out that

currency swaps are better for hedging against translation risk, while forwards are better

for hedging against transaction risk. This study also provides anecdotal evidence that

pricing policy is the most popular means of hedging economic exposures.

These results however can differ for different currencies depending in the sensitivity of

that currency to various market factors. Regulation in the foreign exchange markets of

various countries may also skew such results.

Production and Trade vs. Hedging Decisions

An important issue for multinational firms is the allocation of capital among different

countries production and sales and at the same time hedging their exposure to the varying

exchange rates. Research in this area suggests that the elements of exchange rate

uncertainty and the attitude toward risk are irrelevant to the multinational firm's sales and

28

production decisions (Broll, 1993). Only the revenue function and cost of production are

to be assessed, and, the production and trade decisions in multiple

Countries are independent of the hedging decision.

The implication of this independence is that the presence of markets for hedging

instruments greatly reduces the complexity involved in a firm’s decision making as it can

separate production and sales functions from the finance function. The firm avoids the

need to form expectations about future exchange rates and formulation of risk preferences

which entails high information costs.

FACTORS AFFECTING HEDGING DECISIONS:

The following section describes the factors that affect the decision to hedge and then the

factors affecting the degree of hedging are considered.

Firm size: Firm size acts as a proxy for the cost of hedging or economies of

scale. Risk management involves fixed costs of setting up of computer systems

and training/hiring of personnel in foreign exchange management. Moreover,

large firms might be considered as more creditworthy counterparties for forward

or swap transactions, thus further reducing their cost of hedging. The book value

of assets is used as a measure of firm size.

Leverage: According to the risk management literature, firms with high

leverage have greater incentive to engage in hedging because doing so reduces

the probability, and thus the expected cost of financial distress. Highly levered

firms avoid foreign debt as a means to hedge and use derivatives.

Liquidity and profitability: Firms with highly liquid assets or high

profitability have less incentive to engage in hedging because they are exposed to

a lower probability of financial distress. Liquidity is measured by the quick ratio,

i.e. quick assets divided by current liabilities). Profitability is measured as EBIT

divided by book assets.

Sales growth: Sales growth is a factor determining decision to hedge as

opportunities are more likely to be affected by the underinvestment problem. For

these firms, hedging will reduce the probability of having to rely on external

29

financing, which is costly for information asymmetry reasons, and thus enable

them to enjoy uninterrupted high growth.

HEDGING USING INDEX FUTURES

Stock index futures can be used to hedge the risk in a well-diversified portfolio of

stocks. Here the strategy employed is “HAS PORTFOLIO SHORT NIFTY”. It is

explained as follows:

When one owns a portfolio of shares and there are chances that market will fall in

the near future, it could be a very uncomfortable feeling. Or it could be that the market

is in a few days of volatility and the investor is not the kind who can handle such

anxiousness. The union budget being a common and reliable source of such volatility

market volatility is always enhanced for one week before or two weeks after a budget.

This is particularly a problem if it is required to sell shares in the near future, for

example, for buying a car or financing children’s education. This planning can go

wrong if, by the time the shares are sold, Nifty has dropped sharply.

There are traditionally two things that one can try in such situations.

1. Sell shares immediately. The sentiment generates panic selling which is

rarely optimal for the investor.

2. Do nothing; i.e. suffer the pain of the volatility. This leads to political

pressures for government to do so something when stock prices fall.

Now with index futures there is a third and remarkable alternative for those who are

not satisfied with the above two alternatives:

30

Remove the exposure to index fluctuations temporarily using index futures. This

allows rapid response to market condition, without panic selling of shares. It allows an

investor to be in total control of his risk, instead of doing nothing and suffering the risk.

The idea here is quite is simple. Each portfolio contains a hidden index exposure. This

statement is true for all portfolios; most of the portfolio risk is accounted for by index

fluctuations (unlike individual stocks, where only 30-60% of the stock 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.

LONG HEDGE

In a long hedge one buys futures contract. The hedger is either currently short

the cash good or has a future commitment to buy the good at the spot price that will

exist at a later date. In either case, any subsequent price rise would lead to profit in the

futures market and losses in the cash good market. The hedger must also be aware that

prices might fall leading to a profit in the cash good market and loss in the future

market. The hedger must thus be reasonably sure that price changes of the cash position

and changes in the futures price will be correlated.

SHORT HEDGE

In a short hedge, one sells futures contracts. Here the hedger fears that prices

will fall and if they do loss will be sustained in the spot market. The shot hedger either

currently long the cash good or has a commitment to sell it on a future date at an

unknown price. With the hedge in place if prices do indeed decline, loss will be

incurred on the cash position but there will be a profit in the futures position. As a result

any loss that arising from cash position can be minimized with a hedge in that place.

HEDGE RATIO

31

Hedge ratio is referred to the number of futures contracts required to be sold or

bought provide maximum offset of risk of a given value of investment in shares or other

goods. This depends on the following:

Value of a future contract

Value of the portfolio or stock to be hedged and

Sensitivity of the movement of the portfolio price to that of the index (beta)

It is calculated using the following formula.

Hedge ratio = value of shares or portfolio * beta value / value of futures per

contract.

The hedge ratio is closely related to the correlation between the asset (portfolio of

shares) to be hedged and underlying (index) from which the future is derived.

Accidental offsetting:

Using the same example above, assume that the forward contract was not an

exchange traded instrument but a bilateral, uncollateralized contract. If the counterparty

to the forward contract had a sudden, severe deterioration in its credit standing then the

offset between the change in the value of the future commodity purchase and the change

in fair value of the hedging instrument would be accidental. This is because the effect of

the change in the credit standing of the counterparty is unrelated to and dominates the

effect of changes in the commodity price. The optimal hedge ratio of 1.11 to one (ie

hedging 100t of purchases with a forward contract volume of 90t) would still be driven

by the commodity price changes but because of the credit risk related change of the value

of the forward contract the hedging relationship would no longer have the systematic

offset of fair value changes regarding the commodity risk that would otherwise result

from a hedge ratio of 1.11 to one.

Qualitative assessment:

32

An entity acquired a 100,000 CU debt instrument that pays 6-month Libor

semi-annually. The maturity of the instrument is 2 years. Entity A is exposed to interest

rate decreases and would like to eliminate the risk of changes in the variability in the cash

flows by entering into an interest rate swap whereby it would pay 6-month Libor semi-

annually (aligned with the cash flows received on the bond) and would receive a fixed

rate. For simplification the effect of credit risk is being ignored in this example.

Entity A wants to hedge the exposure to the variability of the cash flows using an existing

interest rate swap with the same remaining maturity and variable payments but a different

fixed rate (reflecting the interest level when the swap was originally entered into). Entity

A considered the fair value of the swap at the inception of the swap to be immaterial.

Hence, if there are no differences in the other critical terms, hedge ineffectiveness would

result from the swap’s fair value at the time of designating it as the hedging instrument.

This hedge ineffectiveness arises because of the effect of interest rate changes on that fair

value as well as the unwinding of the discount on that amount.

HEDGING STRATEGIES

A number of strategies are available for hedging with derivatives. But in

hedging with futures contracts, that too, with index features, four strategies are

identified. They are listed below:

Have portfolio / short index futures

Have funds / long index futures

Long stock / short index futures

Short stock / long index futures.

3. RESEARCH METHODOLOGY

INTRODUCTION

33

Research methodology is a way to systematically solve the research problem.  It

may be understood as a science of studying how research is done scientifically.  In it we

study the various steps that are generally adopted by researcher in studying his research

problem along with the logic behind them. 

       The methodology used for carrying out the present study covers title of the study

and significance of the study.  Aims and objectives of the study, research hypothesis,

Research design, sampling design, pilot study, method for data collection, operation

definition statistical Analysis, limitation of the study and chapterisation. 

3.1. NATURE OF DATA:

Primary data

Secondary data

Primary data: - 

The primary data are those, which are collected for the first time and thus

happen to be original character.

Observation :

The stock market is closely observed for volatility. The trend is changing

every second and the readings are mostly taken from intra-day calculation. The

index changes reflect in the investment decision and the market is very vicious

by its own way. The data collected may become obsolete on the same day itself.

Interview :

By interviewing the analyst the data can be collected. The data collected by

means of analyst is reliable to some days. Technical analysis and fundamental

analysis are done.

Questionnaires:

34

The questionnaires are given to the stock brokers and got the answers. The

answer may be biased and incorrect. It depends on the person answering the

questions. Questionnaires won’t work every time.

Secondary data:

Secondary data are those which have already been collected by someone else and

which already had been passed through the statistical process. The secondary data for the

study was collected through books, web. 

3.2. SOURCES OF DATA

The study has used secondary data from various financial journals, websites and

the fact sheets of those concerned mutual fund companies. 

3.3. TOOLS USED:

Beta value analysis

Index future analysis

1) BETA VALUE ANALYSIS

Beta value is a measure of systematic risk or non divisible risk of a security. Beta

show how the price of a security responds to market forces. Beta measures the degree to

which any portfolio of stocks is affected as compared to the effect on the market as a

whole.

Beta = N∑ x y - ∑ x ∑ y

N ∑ x2 - ∑ x2

Where,

‘N’ is the number of data points or Number of observations

‘X’ is the bench mark returns, and

‘Y’ is the investment returns.

35

Note: beta values are taken from NSE site

CALCULATION

Amount of investment made = no of shares * share price of the company as on the

particular date.

No of shares = investment in each company / share price (closing)

Portfolio beta amount = beta value of each company * portfolio amount

Beta of the portfolio = value of the beta amount / value of the portfolio.

INDEX FUTURE ANALYSIS

Amount of nifty sold = portfolio amount * beta of the portfolio

No of nifty sold = amount of nifty to be sold / closing price of nifty future

Nifty lot = 50

No of nifty to be verified = no of nifty to be sold / nifty sold

Hedged value = nifty * no of nifty to be hedged * lot

Note: Closing price of nifty’s are taken from NSE site

The following diagram represents the movement of nifty index according to the

investments.

MEASURING HEDGING EFFECTIVENESS:

Selecting an appropriate hedge effectiveness methodology is vitally important, since the

wrong choice can produce spurious and misleading results. There are accounting

standards (IAS39, FAS133) in place for hedge accounting, but these are based on very

general principles and allow a significant amount of flexibility.

The four main methods to measure hedge effectiveness are:

Critical Term Match Method

36

Dollar-Offset Method

Regression Analysis

Risk Reduction Method

The Critical Term Match Method:

Allows the assumption that a hedge can be considered “perfect” without an on-going

assessment of effectiveness. For instance, an interest rate swap is likely to be a perfect

hedge if the following parameters in both loan (hedged instrument) and swap (hedge) are

identical:

notional amounts

terms

payment and fixing dates

amortization schedules

reference rates

day conventions

Often, however, these parameters do not (fully) match, so other methods should be

applied. Before introducing these, let us turn our attention to the term “reference

exposure”. It is possible to review an underlying with an existing hedging instrument or

to compare it to an Ideal Designated-Risk Hedge (IDRH). We use the IDRH as the

reference exposure, on the basis of which we define an ideal hedge for an underlying

instrument. Intuitively for a floating rate loan, the IDRH is an interest rate swap in which

we receive floating rate and pay fixed rate. Note: The ideal swap’s floating leg has

identical terms to those of the loan.

Dollar Offset Method and Regression Analysis:

In both cases - Dollar Offset Method and Regression Analysis – the cumulative change of

the hypothetical swap cash flows (net payments) is compared to the cumulative change of

the actual swap cash flows (net payments). The next step is to use this data to implement

either the Dollar Offset Method or Regression Analysis for both retrospective and

37

prospective analysis. Note: It is important to perform analyses for both historical and

future periods.

Now consider a loan and a swap in relation to which an analysis of hedge accounting is to

be performed. The instruments have the parameters outlined in table 1. As you can see,

the actual swap is not an ideal hedge for this loan. The receive leg pays semi-annually

according to 6-month Euribor. For an ideal swap, there should be monthly payments (1-

month Euribor). Common sense tells one that the actual swap has fairly reasonable

hedging properties, as 1-month and 6-month Euribor rates behave similarly. This would

not be the case, however, for 1-month Euribor versus 10-year swap rate. The below

example explains the hedging mechanism:

TABLE-1: Details of the hedged item (loan) and hedging instrument (swap)

  Hedged item Hedging

instrument

IDRH

Type of contract Loan Actual swap Ideal swap

notional (EUR) 1 000 000 1 000 000 1 000 000

settlement date 8.09.2009 8.09.2009 8.09.2009

maturity date 8.09.2022 8.09.2022 8.09.2022

Receive leg      

payment frequency NA semi-

annually

Monthly

coupon accrual day

convention

NA act/360 act/360

reference rate NA 6M Euribor 1M Euribor

Pay leg      

payment frequency Monthly annually Monthly

coupon accrual day

convention

act/360 30/360 act/360

reference rate 1M Euribor fixed fixed

38

@4.189% @4.189%

The results of any effectiveness test need to be interpreted in the context of hedging

objectives. This interpretation is usually facilitated by defining effectiveness ’thresholds’

for the test (referred to as ’lower’ and ’upper’ in our explanation). For example, the actual

swap is an effective hedge according to the Regression Analysis if the correlation is

between 0.8 and 1.0, the slope of the regression line is between 0.8 and 1.25 and the

determination coefficient (R-squared) is above 0.64.

The results show that the hedge surpasses both Dollar Offset and Regression Analysis for

prospective periods. But there is a different outcome in the retrospective analysis:

According to the regression test, it is an effective hedge but fails the Dollar Offset test.

TABLE-2: Dollar-Offset Analysis (retrospective):

Effective hedge test

  lower upper result test

DOR threshold 80% 125% NA NA

compliance level 80% 100% 59,72% FAIL!

Compliance level

number of

compliments

43

sample size 72

compliance level 59,72%

TABLE-3: Dollar-Offset Analysis (prospective)

Effective hedge test

  lower upper result test

DOR threshold 80% 125% NA NA

39

compliance level 80% 100% 88.57% PASS!

Compliance level

number of

compliments

62

sample size 70

compliance level 88.57%

TABLE-4: Regression Analysis (retrospective)

Effective hedge test 

  Lower upper result test

correlation 0.800 1.000 0.979 PASS!

R2 0.640 1.000 0.958 PASS!

slope 0.800 1.250 0.989 PASS!

CHART-1: REGRESSION ANALYSIS:

40

TABLE-5: Regression Analysis (prospective)

Effective hedge test 

  Lower upper result Test

correlation 0.800 1.000 0.984 PASS!

R2 0.640 1.000 0.968 PASS!

slope 0.800 1.250 0.981 PASS!

CHART-2: PROSPECTIVE REGRESSIONN ANALYSIS:

41

4. DATA ANALYSIS:

4.1. DESCRIPTIVE STATISTICS:

This study uses daily price changes of dollar spot, dollar futures data on the

nearby contract and Non-Deliverable Forwards (NDF) from January 2, 2009 to December

28, 2010. The data are from data-stream and Bloomberg. The closing data of the dollar

spot futures data are from 4:00 p.m. on the basis of New York Standard time. The price

changes of all time series are calculated as follows:

(1)

(2)

42

The terms, means the price change of dollar cash price. Represent

the daily price changes of Dollar futures and NDFs. Where and are the Dollar

spot price at time t and at time t-1 respectively. And is the closing price of the

Dollar futures and NDFs at time t and at time t-1 respectively.

The summary statistics for the daily dollar spot and futures, 1 month NDF and 3

month NDF data.

Furthermore, all the Dollar exchange spot, futures and NDFs series are tested to

ensure whether they are stationary. As we expected the level variables are all non-

stationary which means that each has a unit root in its autoregressive representation. This

indicates that each series is non-stationary, necessitating the calculation of first

differences and the difference series are then checked for the presence of a unit root. We

see that the ADF and the PP tests clearly reject the null hypothesis of the presence of a

unit root for each series, implying that the difference series are indeed stationary, that is,

I(0).

Since it is established that each series is I (1), the next step is to test the co-

integration relationship between dollar spot and futures as well as between dollar spot

and NDFs. We employ the Johansen co-integration test. According to the test results,

there is a co-integration relationship between the level variables of dollar cash and futures

data. However there is no co-integration relationship between the level variables of dollar

spot and NDFs data. Therefore, when we estimated the optimal hedge ratio and hedge

performance of Dollar futures markets we incorporate the error-correction term in our

hedging model suggested by Engle and Granger (1987). The error correction term

imposes the long-run restrictions into this short-run model.

Measures for skewness and excess kurtosis indicate that all foreign currency

series are significantly skewed and leptokurtic with respect to the normal distribution.

The Bera-Jacque statistics for the return series of the Dollar exchange spot, futures and

NDFs are statistically significant, indicating the presence of serial correlation (linear

dependencies). This suggests the presence of autoregressive conditional

heteroskedasticity, i.e. volatility clustering, which can be properly modeled by the ARCH

framework of Engle (1982) and Bollerslev (1986).

43

Data summary statistics for daily dollar spot exchange rate and dollar futures

exchange rate from January 2, 2009 to December 28, 2010. Return of spot exchange rate

and futures exchange rate is defined as the value: , ,

where and is the spot and futures exchange value at time .

B-J is the Bera-Jarque test for normality. The statistic is

B-J =

PB-J is distributed under the null of normality. ***. ** indicate the significance at the

0.1 and 0.5 percent level, respectively.

The relation between spot and future exchange rates and their variance is shon below. İt

denoted the rate of return depends on the exchange rates.

TABLE-6: Dollar spot and futures exchange rates:

Spot Futures

Rate Return Rate Return

Mean 1270.98 -0.14 1273.27 -0.15

Median 1284.00 -0.10 1286.50 -0.20

Maximum 1365.20 21.50 1367.00 23.50

Minimum 1165.60 -23.10 1167.70 -21.00

Standard

deviation

44.52 5.72 44.46 5.78

Skewness -0.54 0.19 -0.52 0.21

Kurtosis 2.09 4.37 2.07 4.13

J-B 40.53*** 40.89*** 39.79*** 29.49***

44

TABLE-7: NDF Forwards exchange rates:

1 Month NDF 3Month NDF

Rate Return Rate Return

Mean 1273.37 -0.17820 1278.18 -0.1684

Median 1286.70 -0.2000 1290.80 -0.1000

Maximum 1366.00 23.5000 1370.00 25.0000

Minimum 1168.40 -22.0000 1173.60 -21.5000

Standard

deviation

44.5554 5.7638 44.3099 5.8661

Skewness -0.5204 0.21031 -0.4821 0.2169

Kurtosis 2.0676 4.3436 2.0442 4.3427

J-B 39.9444*** 40.5556*** 37.7108*** 40.7382***

A. Ederington (1979) Risk Minimization Hedge:

Ederington (1979) suggests that the minimum variance hedge model in which

the spot position is considered fixed and the optimal hedge ratio (number of futures

contract per spot contract) is determined from the Ordinary Least Squares (OLS)

regression of spot price changes on futures price changes. The optimal hedge ratio

represents the minimum risk level for the spot/futures portfolio and consists of the

covariance between the spot and futures divided by the variance of the futures. The

objective of the hedger is to minimize the variance of the price changes for the Dollar

exchange spot rate/futures rate portfolio. The expected price change and variance of the

hedged position are established as follows;

45

(3)

Where represents the price change of the Dollar spot exchange

rate from t-1 to t, represents the price change of the Dollar futures, 1

month and 3 month NDFs exchange rate from t-1 to t. is the optimal hedge ratio

estimated by the Ordinary Least Squares (OLS) regression. The slope coefficient of

equation (3) is used as the measure of optimal hedge ratio under the conventional hedge

model system. We also define the optimal hedge ratio as the covariance between Dollar

cash and futures and between Dollar cash and NDF.

The hedge ratios of 0.97636 for Dollar futures, 0.98794 and 0.96597 for 1 month

NDFs and 3 month NDFS imply that 0.97636 daily contract, 0.98794 1 month NDFs and

0.96597 3 month NDFs of the Dollar futures and forwards markets needs to be shorted

for a long position of 1 spot exchange to minimize the variance of the hedged position

value change. This hedge ratio is considerably less than one, which implies that the

Dollar futures and forwards exchange are more volatile than the Dollar spot exchange

rate.

Hedging effectiveness (HE) of Dollar futures and NDFs markets can be measured

as the percent reduction in the variance of the unhedged Dollar spot position by the risk

minimization hedge as follows;

HE = (4)

For example, the minimum variance of the Dollar spot exchange and futures portfolio

value change is as follows:

(5)

46

The same equation is applied for the minimum variance between Dollar spot and

NDFs portfolio value changes. Consequently, from the above equations 4 and 5, we

employ the following equation (6) to figure out the hedge performance between Dollar

futures market and NDFs market.

HE = = (6)

Where is the population coefficient of determination between Dollar spot and

futures exchange changes as well as Dollar spot and forwards rate change, and it can be

estimated as RP2P, the sample coefficient of determination of regression 3. Table 2 reports

RP2P, of 0.9736, 0.9914, and 0.9817 so that a 97.36%, 99.14%, and 98.17% reduction of

the daily variance of the Dollar spot position has been achieved by the risk minimum

hedging strategy. In details, If we have a long position of one (1) Dollar portfolio at

foreign exchange spot market theoretically we have to take a short position of 0.97636

contract at the Dollar futures market to hedge the downside risk of Dollar spot position

during the period from January 2, 2009 to December 28, 2010. As a result, the variance

reduction for the hedged portfolio is 97.36% compared with the unhedged spot position.

In case of Dollar forward markets, the risk adverse hedger has to sell 0.9914 and 0.9817

NDFs to cover the downside risk in Dollar spot position.

The estimation results of optimal hedge ratio using conventional minimum variance

hedge model with constant hedge ratio to Dollar futures and NDFs market

To determine the optimal hedge ratio of One-dollar futures, 1 month NDFs and 3 month

NDFs to cover the downside risk of Dollar spot position, the following regression is

estimated using time-matched daily data for the period from January 2, 2009 to

December 28, 2010.

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where , the dependent variable is the price change of Dollar spot

exchange rate and the independent variable is the price changes of Dollar futures and

NDFs from day t and t+1, coefficient represents the minimum risk hedge ratio (number

of futures and NDFs contracts per one(1) Dollar spot position), and the coefficient of

determination, , measures the hedging effectiveness in terms of the percent reduction

of the variance of the unheeded spot position. *** indicates the significance at the 1%

percent level. Asymptotic t-statistics are given in parentheses.

TABLE-8:

Futures Markets

1 Month

NDF Market

3 Month

NDF Market

+0.00531

(0.04198P)P

-0.00764

(-0.3189)

-0.02100

(-0.6009)

Hedging

Ratio ( )

0.97636***

(134.28)

+0.98794***

(+237.45)

+0.96597***

(162.01)

Hedging

Effectivene

ss ( )

0.9736 0.9914 0.9817

F 18032.26*** 56371.00** 26250.29***

B. Vicariate GARCH and ECT-ARCH Hedge:

The results of optimal hedge ratio using the Dollar NDF markets using

bivariate ECT-ARCH (1) and GARCH (1, 1) models

Estimates of the following bivariate GARCH (1, 1) model are established as follows;

,

N (0,HBtB),

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HBtB= =

where and are the Dollar spot rate and NDF forwards price changes,

respectively, is a (2x1) vector of residuals, is the information set at time t-1, HBt

Bis a (2x2) conditional variance-covariance matrix of residuals, and the , and

matrices are assumed to be diagonal. The model is estimated using time-matched daily

from January 2, 2009 to December 28, 2010. ***, **, * indicate the significance at the 1,

5, and 10 percent level, respectively.

TABLE-9:

Standard deviation is given in parentheses.

1 Month NDF market 3Month NDF markets

+0.011649

(+0.20868)

+0.08571

(+0.18024)

+0.02309

(+0.21050)

+0.10459

(+0.17804)

+22.49248***

(+0.78934)

+23.21146***

(+1.71877)

+22.64801*** +28.29347***

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(+0.71437) (+2.96977)

+22.53457***

(+0.72771)

+29.45349***

(+4.90508)

+0.32758***

(+0.03306)

+0.42171***

(+0.04051)

+0.32385***

(+0.03158)

+0.30601***

(0.07292)

+0.32822***

(+0.03143)

+0.28779***

(+0.11809)

+0.23891***

(0.02730)

+0.11394***

(+0.02928)

+0.23833***

(+0.02609)

+0.11144***

(+0.02955)

+0.23778***

(0.02524)

+0.11859***

(0.03073)

Log-L -894.23 -1181.00

+0.99537***

(+0.01060)

+0.98082***

(+0.01985)

The following chart indicates the changes in the first

quarter of the financial year in s&p cnx nifty index values.

It shows an increasing phase in the starting of march and

then decrease in the month of may.

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The stock market shows a gradual increase till 1970, and then it started to decline. The

derivatives are still in implement phase in India so it will take time and programs for

making it popular. The economic changes always keeps the market volatile and the future

advancements will lead to better growth in the market.

The extension of trend line on the changes in the future market:

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5.1. INTREPRETATION AND FINDINGS

An overall comparison of the Hedged portfolio and Portfolio without Hedging

and Descriptive hedging was made. It was found that in case of portfolio without hedging

the investor incurred a loss of Rs. 760.7 where as in case of all time hedging he incurred a

profit of Rs.12, 675, after trading the investor would have earn profit to Rs.11, 914.3 and

in case of descriptive hedging he incurred a profit of Rs.4, 58,424.3 So this study reveals

the following facts about hedging: -

Hedging helps to minimize the risk:

In case of hedged position the investor was able to make a profit in Descriptive

hedging and reduce loss in All Time Hedging.

Though hedging minimizes risk, it is not possible always. If the index moves up

from the day of hedging, then it can be loss.

Higher the beta value higher will be the risk.

The time of applying these strategies has an important role in determining the

effectiveness of hedging.

6.1. SUGGESTIONS

On the basis of analysis made and findings reached at, following suggestions are

forwarded to existing investors and prospective investors.

If one wants to hedge with portfolio, the portfolio must consist of scrip’s from

different sectors and here index futures are better for hedging, since they are

convenient and represent the true nature of the security market as a whole. The

advantage is that risk within the portfolio can be minimized completely and the

portfolio will only be affected by the market risk.

Investor should read Newspapers, Business Journals, and Websites etc to get the

awareness about the stock market situations and factors, which will affect the

stock market. He should give keen attention on the activities of the major players

in the market.

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Hedging is actually a tool to reduce the losses that may arise from the market risk.

Its primary objective is loss minimization, not profit maximization.

If the trend of the market is to move up, instead of hedging in index futures,

option is more advisable.

The investor should not stick on one strategy in the whole time; he should change

his strategies according to their market situations.

With the expectation of making huge profit from derivatives one should not trade

and speculate in the market. It is very risky and may incur huge losses.

The hedger will have to be a strategic thinker and also one who thinks positively.

He should be able to comprehend market trend and fluctuations. Otherwise the

strategies adopted by him will earn him only losses.

6.2. CONCLUSION

Hedging with index futures proved to be an effective instrument. Through the

index futures hedging we reduce the unnecessary risk of the index movement. Thus

hedging reduces the loss from the portfolio. Our study also finds out that India’s

derivative market is not much established because it introduced in India at 2000. Still

many investors don’t know about derivatives and its use correctly. Index in coming

future, the derivative market will show a remarkable growth.

Hedging does not remove losses. The best that can be achieved using hedging is

the removal of unwanted exposure (i.e. Unnecessary Risk). The hedged position will

make less profit than the un-hedged position. In some cases it makes an additional profit

also. One should not enter into a hedging strategy hoping to make excess profits. All that

come out of hedging is to reduce risk.

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BIBLIOGRAPHY:

Economic times(PTI, Jan 2, 2010, 02.34pm IST)

economy watch(Feb 18, 2010 – NMDC Ltd - Q3 FY11 Result Update)

www .unicon.com

www .sebi.india.com

www. stockchart.com

www.journals.com

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