A REPORT ON USAGE OF DERIVATIVES TO HEDGE EQUITY STOCK, COMMODITY AND CURRENCY PRICE RISK By Ramakant Thakral 11BSPHH010650 (SHAREKHAN

LIMITED)

A REPORT ON USAGE OF DERIVATIVES TO HEDGE EQUITY STOCK, COMMODITY AND CURRENCY PRICE RISK

BY RAMAKANT THAKRAL 11BSPHH010650

SHAREKHAN LIMITED
A report submitted in partial fulfilment of the requirements of MBA Program Of IBS Hyderabad
Submitted to Prof. Hariprasad R. Soni Faculty IBS Hyderabad Date of Submission 4th June, 2012

Mr. Mohammad Rafee (Branch Manager-Gurgaon) Sharekhan Limited 1

AUTHORIZATION
The report on Usage of Derivatives to hedge Equity Stock, Commodity and Currency Price Risk is prepared in partial fulfilment of the Summer Internship Program of the MBA program of Class 2013 at ICFAI Business School, Hyderabad; under the guidance of company guide Mr MOHAMMAD RAFEE, Senior Branch Manager, Sharekhan Limited and Faculty Guide Prof. HARIPRASAD R. SONI, ICFAI Business School, Hyderabad.

ACKNOWLEDGEMENTS

I would like to express my earnest gratitude to Mr. Tarun Shah, CEO Sharekhan Limited for providing me a chance to conduct my internship in Sharekhan Ltd.

I would like to express my deep sense of hearty and special gratitude to Mr. Mohammad Rafee, Senior Branch Manager, Sharekhan Limited for giving me an opportunity to work on the project, Usage of Derivatives to hedge Equity Stock, Commodity and Currency Price Risk.

I would like to further extend my heartiest gratitude towards Mr. Tarsem Verma, Relationship Manager, Sharekhan Limited for providing me valuable inputs for shaping up this project for what it is now. He always inspired me towards learning and gaining knowledge and also helped me at all the stages of the project by spending his invaluable time and efforts.

I would also like to thank and appreciate Prof. Hariprasad R. Soni, faculty guide, IBS Hyderabad for providing the regular guidance and support throughout the duration of internship. His regular directions during the internship were very much valuable for the successful completion of the project.

It has indeed been a great learning experience both professionally and personally by working in this project at Sharekhan Limited.

Ramakant Thakral 11BSPHH010650

INDEX

S.NO 1. 2. 3. 4. 5. 6.

PARTICULARS Authorisation Acknowledgement Executive Summary Company Profile Analysis of Indian Economy Analysis of Aluminum Industry Economy Industry Analysis

PAGE NO. 2 3 4 7 11 14

7. 8. 9. 10. 11. 12.

Company Analysis (Hindalco Industries Ltd.) Introduction to Derivatives Indian Derivative Market Equity Derivatives Hedging Strategies using Equity Derivatives Commodity Derivatives Aluminium

17 20 28 31 38 68 73 86 88 93

13.

Currency Derivatives USD/INR

14.

Project Analysis Findings

15. 16.

Appendix References

96 99

EXECUTIVE SUMMARY
Organisation profile: Sharekhan Ltd. is one of the leading retail brokerage firms in the country. It is the retail Broking arm of the Mumbai-based Sharekhan Group, which has over eight decades of experience in the stock broking business. Sharekhan offers its customers a wide range of equity related services including trade execution on BSE, NSE, Derivatives, depository services, online trading, investment advice, portfolio management service etc. Report: The report Usage of Derivatives to hedge Equity Sto ck, Commodity and Currency price risk aims at understanding the various strategies used for different derivatives under different market conditions and to understand the inter-linkages between the equity stock price, commodity price and the currency rate. To make this report more practical primary data is used. For equity derivatives prices of equity derivative of Hindalco Industries Ltd. is used, for commodity Aluminium May future prices is used, and for currency current spot exchange rate and future rate of USD/INR is used. Secondary data is also used from various sources to make this report more knowledge enriching.

The report also includes analysis of Hindalco Industries Ltd. and aluminium sector in India. The analysis is done to select the stock and then to establish a relation between the prices of commodity future and stock prices as well as of equity derivative.

From the report it can be concluded that an investor or a hedger can hedge his risk using derivatives, which also help in price discovery of the underlying item (stock/equity/currency). The usage of derivatives is increasing which is evident from the fact that 71% of the trade on NSE is done in derivatives. Still various investors keep themselves away from the derivatives because of their complex nature. With the increasing products on exchanges the confusion and complexity is increasing therefore, the employee of the company (Sharekhan Ltd.) should keep themselves and their clients updated.

Methodology: The main objective behind the project is to understand the functioning of derivative market and to study the various strategies used for equity derivatives, commodity derivatives and for currency derivatives to hedge the risk. The project consists of theoretical approach and practical approach. The theoretical approach tries to explain the basic

understanding of derivative market whereas the practical approach shows the theory in practice. The project contains analysis of aluminium industry and the analysis of Hindalco Industries Ltd. to explain the usage of derivative particular to this company and industry. The project also explains the interrelation of USD-INR rate with Hindalco Industries Ltd. stock prices and the usage of strategy accordingly.

COMPANY PROFILE
(Sharekhan Limited)

Sharekhan is one of the top retail brokerage houses in India with a strong online trading platform. The company offers to its clients services like portfolio management; trade execution in equities; futures and options; commodities; distribution of mutual funds, insurance and structured products; etc. It has one of the largest networks in the country with over 1529 outlets serving 950000 customers across 450 cities. It also has international presence through its branches in the UAE and Oman. It was the first company to provide end to end investment solution through its online portal www.sharkhan.com. It is a member of major stock indices in India like National Stock Exchange (NSE), Bombay Stock Exchange (BSE), National Commodity and Derivative Exchange Ltd. (NCDEX) and Multi Commodity Exchange of India Ltd. (MCX). It is also registered as a depository participant with National Securities Depository Ltd. (NSDL) and Central Depository Service Ltd. (CDSL)

Sharekhan was established by Morakhia family 8thFebruary 2000 and it continues to remain the largest shareholder, the other shareholders include General Atlantic Partners, Intel Capital and HSBC Private Equity. It is the retain brokerage arm of Mumbai based SSKI (S.S.Kantilal Ishwarlal) Group which caters to foreign and domestic institutional investors. SSKI Corporate Finance focuses on M&A, Infrastructure Advisory and Financing, Venture Capital and Private Equity.

Sharekhan is known for its jargon free and investor friendly online trading portal. Its regularly provides its clients quality investment advices based on fundamental, technical and market analysis. It is also involve in conducting seminars for non-residents through its India First Initiative to bring in the foreign investment into the system.

Sharekhan Products

1. Sharekhan First Step is a program designed for the first time investors. The programs aims at educating the investor about the basics of the stock market, understand the research products in detail and trade online with as little as Rs.5000

2. Trade Tiger is single advanced trading software which provides multiple exchange facilities like NSE and BSE (Cash and Futures & Options); MCX; NCDEX; IPO and Mutual Funds. The software provides 24 hours access to both domestic and international markets. The clients can analyze the scripts through graph studies which include Average, Band- Bollinger, Know Sure Thing, MACD, RSI, etc. The software further provides tools to gauge the markets such as Tick Query, Ticker, Market Summary, Action Watch, Option Premium Calculator, and Span Calculator . 3. PMS Protech is a portfolio management service that uses the knowledge of technical analysis and power of derivatives to identify the trading opportunities in the market. The products are designed to earn returns in both rising and falling markets by making long and short positions in 35 the Index or Stock Futures on the basis of market conditions. There are two products offered in this service:

a. Nifty Thrifty: The long and short position is taken on the nifty futures and exposure will never exceed the value of the portfolio. b. Diversified: The long and short position is taken by investing in diversified manner in Nifty, Bank Nifty, 10 Stocks, etc.

The product requires a minimum investment of five lakhs with a lock in period of 6 months. No AMC fee is being charged. 0.05 percent brokerage is charged for derivatives and 20 percent profit sharing on booked profits on quarterly basis.

4. PMS Proprime is a portfolio management service for the NRI investors who are looking for steady and superior return with a medium to low risk appetite. The product uses in depth independent fundamental research of the companies. The minimum investment is of 5 lakh. 2.5 percent AMC is being charged for the management of the portfolio on quarterly basis. The brokerage of 0.5 percent and 20 percent profit sharing after 15 percent hurdle is crossed at the end of every fiscal year.

Mission of Sharekhan To educate and empower the individual investor to make better investment decisions through Quality advice, innovative products and superior service.

Work Structure Of Sharekhan Sharekhan has always believed in investing in technology to build its business. The company had used some of the best known names in the IT industry, like Sun Microsystems, Oracle, Microsoft, Cambridge Technologies, Nexgenix, Vignette, Verisign Financial Technologies India Ltd, Spider Software Pvt. Ltd. To build its trading engine and content. The Citi Venture holds a majority stake in the company. HSBC, Intel & Carlyle are the other investors.

On April 17,2002 Sharekhan launched Speed Trade and Tiger, are net-based executable application that emulates the broker terminals along with host of other information relevant to the Day Traders. This was for the first time that a net-based trading station of this caliber was offered to the traders.

The firms online trading and investment site www.sharekhan.com - was launched on Feb 8, 2000. The site gives access to superior content and transaction facility to retail customers across the country. Known for its jargon-free, investor friendly language and high quality research, the site has a registered base of over 3 Lac customers. The number of trading members currently stands at over 7 Lacs. While online trading currently accounts for just over 5 per cent of the daily trading in stocks in India, Sharekhan alone accounts for 27 per cent of the volumes traded online.

Joint Venture with Online Trading Academy California Based Online Trading Academy is the worlds most trusted name in the investors education having partnered with the leading exchanges in the world like NASDAQ, the CME group, etc. The company provides practical application of the concepts and course is delivered during market hours with real money provided by the academy. The Academy had entered into a joint venture with Sharekhan for imparting education to the investors through the Sharekhan online trading platform Trade Tiger. The brokerage charged by Sharekhan after the end of the course will be discounted till their entire fee is reimbursed. All the profits/ loss will be borne by the academy during the seven day long training which cost Rs.87600. The training will enhance the professional skill sets of the investors.

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ANALYSIS OF INDIAN ECONOMY

The Indian Economy faced many headwinds in fiscal 2011-12 leading to growth coming off from 8.6% in fiscal year 2010-11 to 6.9%. The economy in the fiscal year faced headwind in the form of inflation, high interest rate, tight liquidity conditions and global economic uncertainty.

The current account balance is getting worse as the rate of increase in imports is greater than exports. Indian economy reported the CAD of 19.6 Billion USD in the fourth quarter of year 2011. India's current account deficit (CAD), which was 2.6% of gross domestic product in the 2010-11 fiscal year, widened to 4.3% of GDP in the October-December quarter and expected to be 4% of GDP for the fiscal year 2011-12 that ended in March.

The inflation for the fiscal year 2011-12 is 8.65% based on CPI. The average inflation in 2012 is 7.18%.

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The IIP (Index of industrial production) figures are getting worse month by month. The IIP figure for the month of 3 months of 2012 is given as

Month January February March

IIP 2012 1.10% 4.10% -3.50%

To combat with the problem of lower industrial production RBI in its revised policy reduced the repo rate by 50bps.The rate cut was welcomed by the Indian economy and creates a short term euphoria but the rupee depreciation, global uncertainty and weak macroeconomic policies prove to be a bane for the rate cut. The FIIs are withdrawing their money from Indian market due to the non-clearance on GAAR (General Anti Avoidance Rule).

Rupee is depreciating due to global uncertainty particularly Europe crisis, uncertainty in macroeconomic policies; for example the policy on FDI in aviation is still not clear, application of GAAR etc. Rupee is depreciated 12.18% in three months (from February to May 2012). The depreciation of rupee has widen the Current account deficit, results in erosion of foreign exchange reserve as RBI have to intervene into the market to save the downside of rupee.

Rupee depreciation eroded the bottom line of various multinational companies or import based companies. India is leading exporter of gems and jewellery, textiles, engineering goods, chemicals, leather manufactures and services. India is poor in oil resources and is currently heavily dependent on coal and foreign oil imports for its energy needs. Other imported products are: machinery, gems, fertilizers and chemicals

The outlook for global commodity prices, especially of crude oil, is uncertain. Global crude and petroleum product prices have increased sharply since January 2012. Although upside risks to oil prices from the demand side are limited, geo-political tensions are a concern, and any disruption in supplies may lead to further increase in crude oil prices. This will have

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implications for domestic growth, inflation and the fiscal and current account decits. Further, the large scal decit also has led to large borrowing requirements by the Government. The budgeted net market borrowings through dated securities for 2012-13 at 4.8 trillion were even higher than the expanded borrowings of 4.4 trillion last year. Such large borrowings have the potential to crowd out credit to the private sector.

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ANALYSIS OF ALUMINIUM INDUSTRY

Aluminium Industry in India is a highly concentrated industry with the top 5 companies constituting the majority of the country's production. With the growing demand of aluminium in India, the Indian aluminium industry is also growing at an enviable pace. In fact, the production of aluminium in India is currently outpacing the demand.

Though India's per capita consumption of aluminium stands too low (under 1 kg) comparing to the per capita consumptions of other countries like US & Europe (range from 25 to 30 kgs), Japan (15 kgs), Taiwan (10 kgs) and China (3 kgs), the demand is growing gradually. In India, the industries that require aluminium most include power (44%), consumer durables, transportation (10-12%), construction (17%) and packaging etc.

Aluminium production industry in India is mainly dominated by about five firms that account for the majority of the countrys metal production including Hindalco Aluminium Company (HINDALCO), National Aluminium Company (NALCO), Bharat Aluminium Company (BALCO), MALCO and INDAL. Apart from these major players in the Aluminium sector, there are many players like Hindustan Zinc, Jindal Aluminium Ltd, Maan Aluminium Ltd and Kennametal India (see Appendix 2). The contribution made by these companies is very essential and important for the economic development of India. Even though India is not a very big consumer of aluminium products compared to many other countries, but there is still a slow and steady growth in the demand.

The primary Aluminium production market in India is an oligopolistic market. The primary aluminium is a homogenous product. The reasons for the aluminium industry to be an oligopoly (Barriers to entry) is

Economies of Scale: The major input in producing primary aluminium is alumina and power which constitute about70% of the cost in producing. Although the requirement of alumina does not vary much with the size of the plant but the consumption of power varies drastically. Hence with higher production capacity the cost of production goes down. For a new player producing aluminium and low cost will be very difficult.

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Huge capital investments: The capital required to setup an aluminium production plant is huge. E.g.: BALCO spent about $1 billion to set up a 2.45 lakh ton capacity with 540MW power plant.

Time to setup: It requires around 3 years to setup a plant of the size mentioned in the above example. The new player would require about 3 years to start manufacture primary aluminium and the market demand supply equation can change by the time the firm starts manufacturing.

Control over the Bauxite mines: As the raw material for manufacturing aluminium is bauxite the existing players have control over the bauxite mines in India and it would be difficult for a new player to get new bauxite mines.

Scarcity of power: About 30-40% of the cost of producing is power. As producing primary Aluminium requires a large amount of electricity they need to have captive power plants. Setting up of captive power plants requires huge capital investment and also requires a lot of time. The basic raw material to generate power is coal. Hence the firms also would need to have coalmines. Most of the coal blocks are owned by independent power producers and hence the coal blocks are scarce.

Government Factor: The other major hurdles are getting environmental clearance from the government. The other factor would be in getting bauxite mines allotted to the firm. Hence in these two cases the government acts as a barrier.

Land: Existing players can expand as setting up a new brown field project is easy than getting land allocated for a new green field project considering the political situations in India.

Geographical factors: The bauxite ore is abundant only in the states like Orissa and hence the firms entering into the market need to setup the plant in these states.

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Economy-Industry Analysis

The greatest challenge facing the industry is the continuous increase in raw material prices which are showing no signs of going down. Most input costs such as fuel oil, coal tar pitch, and caustic soda have increased along with the freight costs.

Alumina costs for non-integrated smelters have gone up and may increase further.

Aluminium industry being a cyclical in nature depends heavily on the health of the world economy. Any slowdown in demand could have adverse effects on the profitability of the company. The European debt crisis and slowdown in world economy as well as fear of hand landing in the Chinese economy (which accounts for 40% of world aluminium demand) have already led to a decline in aluminium prices.

The expansion plans of Hindalco are also facing some delays. Some of the projects are running behind schedule. This is due to delay in getting regulatory approvals. As a result the company has to incur additional cost which will put pressure on its margins in the short term.

Increased spending on the infrastructure sector by the government would result in higher consumption of aluminium, benefiting companies

like NALCO and HINDALCO.

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COMPANY ANALYSIS
(Hindalco Industries Ltd.)

Hindalco Industries Limited, a Fortune 500 and the metals flagship company of the Aditya Birla Group, is an industry leader in aluminium and copper. A metals powerhouse with a consolidated turnover of Rs.72,078 crore (US$ 15.85 billion) in the fiscal year 2011, Hindalco is the worlds largest aluminium rolling company and one of the biggest producers of primary aluminium in Asia. Its aluminium production process encompasses the entire gamut of operations from bauxite mining, alumina refining, aluminium smelting to downstream rolling, extrusion and recycling. Its Copper smelter is the worlds largest custom smelter at a single location.

The share of Net Sales Value in the FY 2011 is given by

Over 50% of its revenue comes from overseas operations.

The shareholding pattern Hindalco Industries Ltd. is given as:

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(In %) Promoter FII DII Others Total

Mar-12 32.06 26.85 14.94 26.15 100.00

Dec-11 32.06 26.53 15.56 25.85 100.00

Sep-11 32.06 28.24 14.10 25.60 100.00

The financial ratios as on March 2011 and March 2010 are given below:

Ratios Debt Equity Ratio Current Ratio Interest Coverage Ratio Fixed Asset Turnover Ratio Inventory Turnover Ratio Debtors Turnover Ratio

March 2011 0.24 0.96 5.89 1.67 3.43 18.41

March 2010 0.23 1.02 4.3 1.42 3.63 15.48

The unaudited result of Hindalco Industries Ltd. is given below:

FY 11 Net Sales PBITDA PBT PAT EPS 23,859 3,502 2,595 2,137 11.17

FY 12 26,597 3,721 2,737 2,237 11.69

Change (%) 11.5 6.2 5.5 4.7 4.7

Hindalco Industries Ltd. has started various Greenfield projects that will significantly enhance the scale of operations and will further improve the cost competitiveness of the company. These projects are:

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Utkal Alumina International Ltd (UAIL) Mahan Aluminium Project Aditya Aluminium project Aditya Refinery Project The Jharkhand Aluminium project

In 2007, Hiindalco made an USD $6 bn acquisition of Novelis Inc. a world leader in aluminium rolling and can recycling. This move catapulted the company into the league of world's top 5 aluminium producers. It also enabled the company to have a global footprint in 12 countries outside India. Although the acquisition has made Hindalco the world's largest aluminium rolling company, resultant debt and Novelis depressed earnings with its can price ceiling contract and large exposure to the developed markets, remained one of the biggest overhang on Hindalco's performance till 2009. However, with the expiry of the can price ceiling contracts in 2009 and cost restructuring, Novelis has emerged as a successful acquisition for Hindalco with an improvement in profitability. Despite sales volume for Novelis still below 2008 levels, adjusted EBITDA has nearly doubled.

Hindalco Industries plans to start its 1.5 million tonnes per annum (mtpa) alumina refinery in Orissa by January 2013. It also expects to start mining bauxite in the state from October this year (2012).

Management of Hindalco Industries Ltd.

Name Dr. Kumar Mangalam Birla D Bhattacharya Jagdish Khattar Ram Charan Anil Malik

Designation Chairman Managing Director Independent Director Additional (Independent) Director Asst. Vice-President & Company Secretary

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INTRODUCTION TO DERIVATIVES
The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. In 1848, the Chicago Board of Trade (CBOT) was established to bring farmers and merchants together. A group of traders got together and created the `to-arrive' contract that permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. These were eventually standardised, and in 1925 the first futures clearing house came into existence. Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of indexlinked derivatives. Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index

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derivatives i.e. the derivative products based on individual securities is another reason for their growing use.

The following factors have been driving the growth of financial derivatives:

1. Increased volatility in asset prices in financial markets, 2. Increased integration of national financial markets with the international markets, 3. Marked improvement in communication facilities and sharp decline in their costs, 4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and 5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as trans-actions costs as compared to individual financial assets.

Derivatives defined

Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying.

Types of derivatives The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later. Here we take a brief look at various derivatives contracts that have come to be used.

Forwards: A forward contract is a bilateral contract that obligates one party to buy and other party to sell a specific quantity of an asset, at a set price, on a specific date in the future. Typically, neither party to the contract pays anything to get into the contract.

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Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

Options: An option contract gives its owner the right, but not the legal obligation, to conduct a transaction involving an underlying asset at a predetermined future date (the exercise date) and at a predetermined price (the exercise price or strike price). The seller of the option has the obligation to perform if the buyer exercises the option. Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

Swaptions: A swaption is an option to enter into a swap. The option to enter into an offsetting swap provides an option to terminate an existing swap. Consider that, in the case of previous 5-year pay floating swap, we purchased a 3-year call option on a 2-year pay fixed swap at 3%. Exercising this swap would give us the offsetting swap to exit our original swap. The cost for such protection is the swaption premium.

Participants and Functions Three broad categories of participants - hedgers, speculators, and arbitrageurs - trade in the derivatives market.

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Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk.

Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture.

Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

The derivative market performs a number of economic functions.

1. First, prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices.

2. Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have appetite for them.

3. Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

4. Fourth, speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.

5. Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many

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bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Sixth, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. Derivatives thus promote economic development to the extent the later depends on the rate of savings and investment. The criticism of derivatives is that they are too risky, especially to investors with limited knowledge of sometimes complex instruments. Because of the high leverage involved in derivatives payoffs, they are sometimes linked to gambling.

Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for prearranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. Although early forward contracts in the US addressed merchants concerns about ensuring that there were buyers and sellers for commodities, credit risk remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first exchange traded derivatives contract in the US; these contracts were called futures contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest financial exchanges of any kind in the world today.

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The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, etc.

Chronology of instrument 1874 1972 1973 1975 1981 1982 Commodity futures Foreign currency futures Equity options Treasury bond futures Currency swaps Interest rate swaps, T note futures, Eurodollar futures, Equity index futures, Options on T bond futures, Exchange listed currency options 1983 Options on equity index, Options on T-note futures, Options on currency futures, Options on equity index futures, interest rate caps and floors 1985 1987 1989 1990 1991 1993 1994 Eurodollar options, Swap options OTC compound options, OTC average options Futures on interest rate swaps, Quanto options Equity index swaps Differential swaps Captions, exchange listed FLEX options Credit default options

Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have

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contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange-traded derivatives:

1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. There are no formal centralized limits on individual positions, leverage, or margining, 3. There are no formal rules for risk and burden-sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchanges self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

Some of the features of OTC derivatives markets embody risks to financial market stability.

The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (i) (ii) (iii) (iv) (v) the dynamic nature of gross credit exposures; information asymmetries; the effects of OTC derivative activities on available aggregate credit; he high concentration of OTC derivative activities in major institutions; and the central role of OTC derivatives markets in the global financial system.

Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts, occur which significantly alter the perceptions of current and potential future credit exposures. When asset prices change

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rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counterparty, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic financial events, which fall outside the more formal clearing house structures. Moreover, those who provide OTC derivative products, hedge their risks through the use of exchange traded derivatives. In view of the inherent risks associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian law considers them illegal.

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INDIAN DERIVATIVE MARKET

Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of Indias (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India

Chronology of instrument 1991 14 December 1995 Liberalization Process initiated NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for index futures. 11 May 1998 7 July 1999 L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. 24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian index. 25 May 2000 9 June 2000 12 June 2000 SEBI gave permission to NSE and BSE to do index futures trading. Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE.

25 September 2000 Nifty futures trading commenced at SGX. 2 June 2001 Individual Stock Options & Derivatives

Need for derivatives in India today In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major part of the world.

Until the advent of NSE, the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the

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investors aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of Indias financial markets with the international financial markets. Introduction of risk management instruments in India has gained momentum in last few years thanks to Reserve Bank of Indias efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market.

Common Used terms: Some of the common terms used in the context of currency futures market are given below:

Spot price: The price at which the underlying asset trades in the spot market.

Futures price: The current price of the specified futures contract

Contract cycle: The period over which a contract trades. The currency futures contracts on the SEBI recognized exchanges have one-month, two-month, and three-month up to twelvemonth expiry cycles. Hence, these exchanges will have 12 contracts outstanding at any given point in time. Value Date/Final Settlement Date: The last business day of the month will be termed as the Value date / Final Settlement date of each contract. The last business day would be taken to be the same as that for Inter-bank Settlements in Mumbai. The rules for Inter-bank Settlements, including those for known holidays and subsequently declared holiday would be those as laid down by Foreign Exchange Dealers Association of India (FEDAI).

Expiry date: Also called Last Trading Day, it is the day on which trading ceases in the contract; and is two working days prior to the final settlement date. Contract size: The amount of asset that has to be delivered under one contract. Contract size is also called as lot size. In the case of USDINR it is USD 1000; EURINR it is EUR 1000; GBPINR it is GBP 1000 and in case of JPYINR it is JPY 100,000. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

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Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.

Strike Price: The price at which the buyer of an option can buy the stock (in the case of a call option) or sell the stock (in the case of a put option) on or before the expiry date of option contracts is called strike price. It is the price at which the stock will be bought or sold when the option is exercised. Strike price is used in the case of options only; it is not used for futures or forwards.

Hedge ratio: Companies generally use hedge ratio to hedge their risk. Hedge ratio can be defined as a ratio comparing the value of a position protected via a hedge with the size of the entire position itself.

Suppose an investor is holding $10,000 in foreign equity, which exposes him to currency risk. If he hedges $5,000 worth of the equity with a currency position, his hedge ratio is 0.5 (50 / 100). This means that 50% of his equity position is sheltered from exchange rate risk.

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EQUITY DERIVATIVES
The assignment that was given to me at Sharekhan limited, Gurgaon was to study and analyze the various hedging and arbitraging strategies using stock options. A good understanding of these strategies is very essential for a risk professional. Organizations which are exposed to the market risks such as volatility in foreign exchange rates, capital market, commodities markets etc. continuously monitor their positions. In order to reduce their losses they continuously hedge their positions. Also brokerage houses like Sharekhan actively arbitrage on regular basis. For the study of various strategies I had to study NCFM modules, search information on Internet. Also I had an opportunity to converse with the relationship managers at Sahrekhan, Gurgaon.

MEANING OF EQUITY DERIVATIVE

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines equity derivative to include 1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract, which derives its value from the prices, or index of prices, of underlying securities. The derivatives are securities under the SC(R) A and hence the trading of derivatives is governed by the regulatory framework under the SC(R) A.1

HEDGING AN INTRODUCTION

Hedging in financial terms is defined as entering transactions that will protect against loss through a compensatory price movement. Hedging comes from the term "to Hedge" and is any technique designed to reduce or eliminate financial risk. Hedging is the calculated installation of protection and insurance into a portfolio in order to offset any unfavorable moves.

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In fact, hedging is not restricted only to financial risks. Hedging is in all aspects of our lives; we buy insurance to hedge against the risk of unexpected medical expenses. Hence, hedging is the art of offsetting risks.

Illustration: Amp enters into a contract with Saru roopa that six months from now he will sell to Saru roopa 10 dresses for Rs 4000. The cost of manufacturing for Amp is only Rs 1000 and he will make a profit of Rs 3000 if the sale is completed.

Cost (Rs) 1000

Selling Price 4000

Profit 30000

However, Amp fears that Saru roopa may not honour his contract six months from now. So he inserts a new clause in the contract that if Saru roopa fails to honour the contract she will have to pay a penalty of Rs 1000. And if Saru roopa honours the contract Amp will offer a discount of Rs 1000 as incentive. On Saru roopas default 1000 (Initial Investment) 1000 (penalty from Saru roopa) (No gain/loss) If Saru roopa honours 3000 (Initial profit) (-1000) discount given to Saru roopa 2000 (Net gain)

As we see above if Saru roopa defaults Amp will get a penalty of Rs 1000 but he will recover his initial investment. If Saru roopa honours the contract, Amp will still make a profit of Rs 2000. Thus, Amp has hedged his risk against default and protected his initial investment.

Hedging stocks using futures Stocks carry two types of risk company specific and market risk. While company risk can be minimized by diversifying your portfolio, market risk cannot be diversified but has to be hedged. So how does one measure the market risk? Market risk can be known from Beta. Beta measures the relationship between movements of the index to the movement of the stock. The beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down

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by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your losses.

Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 million of S&P CNX Nifty futures.

Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1. 2. Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings. Therefore in the above scenario we have to short sell 1.2 * 1 million = 1.2 million worth of Nifty.

Now let us study the impact on the overall gain/loss that accrues: Index up 10% Gain/ (Loss) in Portfolio Gain/ (Loss) in Futures Net Effect Rs 120,000 (Rs 120,000) Nil Index down 10% (Rs 120,000) Rs 120,000 Nil

As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a cost, one has to forego any gains that arise out of improvement in the overall sentiment. Then why does one invest in equities if all the gains will be offset by losses in futures market. The idea is that everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase. The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a reverse position in the futures market. Thus, we have seen how one can use hedging in the futures market to offset losses in the cash market.

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HEDGING IN OPTION TRADING

Option traders hedging a portfolio of stock or hedging an option position in an option trading strategy, needs to consider 5 forms of risk. Directional risk (Delta), how directional risk will change with stock price changes (Gamma), volatility risk (Vega) and time decay risk (Theta). These risks are factors that influence the value of a stock option. Option traders do not normally perform hedging for interest rate risk (Rho) as its impact is very small. Hedging a stock option portfolio requires understanding of what the biggest risk in that portfolio is. If time decay is of concern, then theta neutral hedging should be used. If a drop in the value of the underlying stock is of greatest concern, then delta neutral hedging should be used. We restrict our study to trading strategies that help traders to hedge their position as time is a constraint. We do not indulge ourselves in study of options greek and their effect although all the strategies discussed would take care of their effects.

OPTIONS GREEK

Option Greeks Introduction The mathematical characteristics of the Black-Scholes model are named after the greek letters used to represent them in equations. These are known as the Option Greeks. The 5 Option Greeks measure the sensitivity of the price of stock options in relation to 4 different factors; Changes in the underlying stock price, interest rate, volatility, time decay. The 5 Option Greeks are:

Delta Delta is the measure of an option's sensitivity to changes in the price of the underlying asset. Therefore, it is the degree to which an option price will move given a change in the underlying stock or index price, all else being equal.

Change in option premium Delta = ---------------------------------------Change in underlying price

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For example, an option with a delta of 0.5 will move Rs 5 for every change of Rs 10 in the underlying stock or index.

Illustration: A trader is considering buying a Call option on a futures contract, which has a price of Rs 19. The premium for the Call option with a strike price of Rs 19 is 0.80. The delta for this option is +0.5. This means that if the price of the underlying futures contract rises to Rs 20 (a rise of Rs.1) then the premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.80 + 0.50 = Rs 1.30. Far out-of-the-money calls will have a delta very close to zero, as the change in underlying price is not likely to make them valuable or cheap. At-the money call would have a delta of 0.5 and a deeply in-the-money call would have a delta close to 1. While Call deltas are positive, Put deltas are negative, reflecting the fact that the put option price and the underlying stock price are inversely related. This is because if one buys a put his view is bearish and expects the stock price to go down. However, if the stock price moves up it is contrary to his view therefore, the value of the option decreases. The put delta equals the call delta minus 1. Put delta = Call delta - 1 It may be noted that if delta of ones position is positive, he desires the underlying asset to rise in price. On the contrary, if delta is negative, he wants the underlying asset's price to fall.

Gamma: This is the rate at which the delta value of an option increases or decreases as a result of a move in the price of the underlying instrument.

Change in an option delta Gamma = ------------------------------------Change in underlying price

For example, if a Call option has a delta of 0.50 and a gamma of 0.05, then a rise of +/- 1 in the underlying means the delta will move to 0.55 for a price rise and 0.45 for a price fall. Gamma is greatest for an ATM (at-the- money) option and falls to zero as an option moves deeply ITM (in-the-money) and OTM (out-of-the-money).

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If you are hedging a portfolio using the delta-hedge technique described under "Delta", then you will want to keep gamma as small as possible as the smaller it is the less often you will have to adjust the hedge to maintain a delta neutral position.

Theta: It is a measure of an option's sensitivity to time decay. Theta is the change in option price given a one-day decrease in time to expiration. It is a measure of time decay (or time shrunk). Theta is generally used to gain an idea of how time decay is affecting your portfolio.

Change in an option premium Theta = ------------------------------------------Change in time to expiry

Theta is usually negative for an option as with a decrease in time, the option value decreases. This is due to the fact that the uncertainty element in the price decreases. Assume an option has a premium of 3 and a theta of 0.06. After one day it will decline to 2.94, the second day to 2.88 and so on. Naturally other factors, such as changes in value of the underlying stock will alter the premium. Theta is only concerned with the time value. Unfortunately, one cannot predict with accuracy the change's in stock market's value, but we can measure exactly the time remaining until expiration.

Vega: This is a measure of the sensitivity of an option price to changes in market volatility. It is the change of an option premium for a given change - typically 1 % -in the underlying volatility.

Change in an option premium Vega = --------------------------------------------Change in volatility

If for example, XYZ stock has a volatility factor of 30% and the current premium is 3, a Vega of .08 would indicate that the premium would increase to 3.08 if the volatility factor increased by 1 % to 31 %. As the stock becomes more volatile the changes in premium will increase in the same proportion. Vega measures the sensitivity of the premium to these changes in volatility.

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Rho: Rho measures the change in an option's price per unit increase - typically 1 % -in the cost of funding the underlying.

Change in an option premium Rho = -----------------------------------------------Change in cost of funding underlying

Example: Assume the value of Rho is 14.10. If the risk free interest rates go up by 1 % the price of the option will move by Rs 0.1410. To put this in another way: if the risk-free interest rate changes by a small amount, then the option value should change by 14.10 times that amount. For example, if the risk-free interest rate increased by 0.01 (from 10% to 11 %), the option value would change by 14.10*0.01 = 0.14. For a put option, inverse relationship exists. If the interest rate goes up the option value decreases and therefore, Rho for a put option is negative. In general Rho tends to be small except for long-dated options.

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HEDGING STRATEGIES
BASIC BULLISH STRATEGIES:

1. LONG CALL OPTION: Buying call options, or also known as Long Call Options or simply Long Call, is the simplest bullish option strategy ever.

Buying call options / Long Call Options offers the protection of limited downside loss with the benefit of unlimited gain. An investor who is bullish on any stock opt go for this strategy.

Example: Suppose Hindalco Industries Ltd. is trading at Rs 114.35 per share at the time of this writing. Each lot of 2000 shares would cost traders Rs 228700, which is usually not an amount a beginner trader would have. One could instead control the same 2000 shares of Hindalco Industries Ltd. and benefit from the same move for 1 month if it goes up through buying call options / long call options on its call options with another 1 month to expiration for only Rs 14300 per lot, which is only 6.25% of the price of Hindalco Industries Ltd. That is the discounting effect of Buying Call Options / Long Call Optio

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Profit Potential of Long Call Options:

Buying call options / Long Call Options allow to profit with unlimited ceiling. That means that profit grows as long as the underlying stock continues to rise.

Profit Calculation Long Call Options: Profit = (Stock Price At Expiration - Strike Price Of Call Options Bought) - Premium Value Of Call Options Bought

Risk / Reward of Buying Call Options / Long Call Options:

Upside Maximum Profit: Unlimited Maximum Loss: Limited Net Debit Paid. The most one could lose is the entire amount put forward into buying call options when the underlying stock expires out of the money (OTM).

Break Even Point of Buying Call Options / Long Call Options:

Breakeven Point = Strike Price + Premium Value

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2. SHORT PUT OPTION An investor Sells Put when he is Bullish about the stock expects the stock price to rise or stay sideways at the minimum. When an investor sells a Put, he/she earn a Premium (from the buyer of the Put). The investor has sold someone the right to sell you the stock at the strike price. If the stock price increases beyond the strike price, the short put position will make a profit for the seller (investor) by the amount of the premium, since the buyer will not exercise the Put option and the Put seller can retain the Premium (which is his maximum profit). But, if the stock price decreases below the strike price, by more than the amount of the premium, the Put seller will lose money. The potential loss is being unlimited (until the stock price fall to zero).

Example: Assuming Hindalco Industries Ltd. is trading at Rs.114.3 An Investor is Bullish on the stock and therefore wants to enjoy profit by investing in it. But investing in 2000 shares requires Rs. 228600. But the investor can enjoy the profit by short on put. Suppose the investor sells the put option with the strike price of Rs.110 at a premium of Rs. 3.50 and thus his account will be credited with the amount of Rs. 7000. Break Even = 110 3.5 = Rs. 106.5 Risk: Put Strike Price Put Premium. Reward: Limited to the amount of Premium received. Breakeven: Put Strike Price - Premium

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Payoff schedule:

On expiry Hindalco Industries Ltd. closes at 80 90 100 106.5 110 120 130 140 Net payoff from the put 26.5 16.5 6.5 0 3.5 3.5 3.5 3.5

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3. LONG COMBO ( SELL A PUT , BUY A CALL)

If an investor is expecting the price of a stock to move up he can adopt a Long Combo strategy. It involves selling an OTM (lower strike) Put and buying an OTM (higher strike) Call.

This strategy simulates the action of buying a stock (or a future) but at a fraction of the stock price. It is an inexpensive trade, similar in pay-off to Long Stock, except there is a gap between the strikes (please see the payoff diagram). As the stock price rises the strategy starts making profits.

Assume the stock of Hindalco Industries Ltd. is trading at Rs. 114.30; An investor is bullish on the stock but does not want to invest Rs.114.30. He does a Long Combo. He sells a Put option with a strike price Rs. 100 at a premium of Rs 0.50 and buys a Call Option with a strike price of Rs. 130 at a premium of Rs 0.55. The lot size of put and call is 2000 shares. The net cost of the strategy (net debit) is Rs.100 (=0.05*2000)

Risk: Unlimited (Lower Strike+ net debit) Reward: Unlimited Breakeven : Higher strike + net debit

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Hindalco Industries Net Payoff from Put Net Payoff from the closes at 80 90 100 110 120 130 130.05 140 150 160 sold (Rs.) -19.5 -9.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 call purchased (Rs.) -0.55 -0.55 -0.55 -0.55 -0.55 -0.55 -0.5 9.45 19.45 29.45 Net Payoff (Rs.) -20.05 -10.05 -0.05 -0.05 -0.05 -0.05 0 9.95 19.95 29.95

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4. BULL CALL SPREAD:

A Bull Call Spread is a bullish option strategy that profits if the underlying asset rises in price. Because this option trading strategy involves simultaneously buying to open and selling to open options of the same expiration month, it is a form of Vertical Spread and because you need to pay money to put on this position, resulting in a net debit, this is also a Debit Spread.

How to use Bull Call Spread? Establishing a Bull Call Spread involves the purchase of an At The Money or In The Money call option on the underlying asset while simultaneously writing (sell to open) an Out of the Money call option on the same underlying asset with the same expiration month.

Example: Assuming trading price of Hindalco Industries Ltd. is Rs. 114.35 Bought Hindalco 31-May-2012 CE 110 with a lot size of 2000 shares at premium of Rs. 7.10 Sold Hindalco 31-May-2012 CE 130 with a lot size of 2000 shares at premium of Rs. 0.55 Net Debit in account: (7.10*2000)-(0.55*2000) = Rs.13100 Payoff schedule:

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On Expiry Hindalco Industries Ltd. Closes at 90 100 110 115 116.55 120 130 140 150

Net payoff from Call Buy (Rs.) -7.1 -7.1 -7.1 -2.1 -0.55 2.9 12.9 22.9 32.9

Net payoff from Call Sold (Rs.) 0.55 0.55 0.55 0.55 0.55 0.55 0.55 -9.45 -19.45

Net Payoff (Rs.)

-6.55 -6.55 -6.55 -1.55 0 3.45 13.45 13.45 13.45

Suppose Hindalco Industries Ltd. is trading at Rs 114.35 per share at the time of this writing. Each lot of 2000 shares would cost traders Rs 228700, which is usually not an amount a beginner trader would have. One could instead control the same 2000 shares of Hindalco Industries Ltd.

Profit Potential of Bull Call Spread: This strategy reaches its maximum profit potential when the underlying stock closes at or exceeds the strike price of the OTM call options.

Profit Calculation of Bull Call Spread: Maximum Return = (Difference in strikes - Net Debit) Net Debit

Risk / Reward of Bull Call Spread: Upside Maximum Profit: Limited Maximum Loss: Limited Net Debit Paid

Break Even Point of Bull Call Spread: Strike Price of Long Call Option + Net Debit Paid

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Advantages of Bull Call Spread: Loss is limited if the underlying financial instrument falls instead of rise. If the underlying instrument fails to rise beyond the strike price of the out of the money short call option, the profit yield will be greater than just buying call options.

Disadvantages of Bull Call Spread: There will be no more profits possible if the underlying instrument or stock rises beyond the strike price of the out of the money call option.

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5. BULL PUT SPREAD:

A Bull Put Spread is a bullish option strategy that works in the same way a Bull Call Spread does, profiting when the underlying stock rises. The Bull Put Spread is simply a naked Put write which minimizes margin requirement and limits potential loss by purchasing a lower strike price put option. Because the Bull Put Spread is a credit spread, one also makes money if the underlying asset stays stagnant through the decay and expiration of the more expensive short put options.

When to use Bull Put Spread? One should use a bull put spread when one is moderately confident of a rise in the underlying asset and wants some protection and profit should the underlying asset remains stagnant.

How to use Bull Put Spread? Establishing a Bull Put Spread involves the purchase of an At The Money or Out of The Money put option on the underlying asset while simultaneously writing (sell to open) an In the Money or At The Money put option on the same underlying asset with the same expiration month. Which strike prices to choose also depends on ones desired effect. If the Bull Put Spread is established by selling ATM Put option and buying OTM Put options, the position needs only stay stagnant or rise to result in a profit, hence a higher profit probability.

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Example: Assuming Hindalco Industries Ltd. is trading at Rs. 143 Bought Hindalco 31-May-2012 PE 110 with a lot size of 2000 shares at premium of Rs. 3.50 Sold Hindalco 31-May-2012 PE 140 with a lot size of 2000 shares at premium of Rs. 21 Net Credit in account: (21*2000)-(3.50*2000) = Rs. 35000

Payoff schedule:

On Hindalco

Expiry Net payoff Net payoff Payoff

Industries Closes at 90 100 110 120 122.5 130 140 150 160 170

Ltd. from Put Sold from Put Buy Net (Rs.) -29 -19 -9 1 3.5 11 21 21 21 21 (Rs.) 16.5 6.5 -3.5 -3.5 -3.5 -3.5 -3.5 -3.5 -3.5 -3.5 (Rs.) -12.5 -12.5 -12.5 -2.5 0 7.5 17.5 17.5 17.5 17.5

A Bull Put Spread results in maximum profit when the underlying stock closes above the strike price of the short put options. In this case, the strike price of the short put options is directly on the prevailing stock price, allowing it to reach maximum profit even if the stock remains stagnant.

Risk / Reward of Bull Put Spread: Upside Maximum Profit: Limited

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Maximum Loss: Limited

Break Even Point of Bull Put Spread: Higher Strike - Net credit

Advantages Of Bull Put Spread: Loss is limited if the underlying financial instrument falls instead of rise. If the underlying instrument fails to rise beyond the strike price of the out of the money short put option, the profit yield will be greater than just buying call options. Profits even when the underlying asset remains completely stagnant.

Disadvantages of Bull Put Spread: There will be no more profits possible if the underlying asset rises beyond the strike price of the short put option. Because it is a credit spread, there is a margin requirement in order to put on the position. As long as the short put options remain in the money, there is a possibility of it being assigned.

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6. SYNTHETIC LONG CALL

If an investor is a low risk taker and he is bullish on any stock he can hedge his risk by using alternate option. As per this strategy an investor can long a Stock and a put to hedge his risk (in case the stock turn opposite to the expectation). The put option gives the investor right to sell the stock at a certain price which is the strike price. The strike can be the price at which you bought the stock (At the money strike price) or moderately below (Out of the money strike price)

In case the price of the stock rises the investor get the full benefit of the price rise and in case the price of the stock falls, the investor can exercise the Put Option. Investor have capped his/her loss in this manner because the Put option stops further losses. It is a strategy with a limited loss and (after subtracting the Put premium) unlimited profit (from the stock price rise).

The result of this strategy looks like a Call Option Buy strategy and therefore is called a Synthetic Call.

Example: Assume Hindalco Industries ltd. is trading at Rs.114.30, an investor Mr.A buys 2000 shares of Hindalco Ltd. at this price. To cover downside risk the investor also long on put i.e 31-May-2012 PE 110 at a premium of Rs. 2.15, thus the payoff schedule will be: Risk: Losses limited to Stock price + Put Premium Put Strike price Reward: Profit potential is unlimited.

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Break-even Point: Put Strike Price + Put Premium + Stock Price Put Strike Price

Hindalco closes at 80 90 100 110 116.45 120 130 140 150

Industries Net

Payoff

from Net Payoff from the put purchased (Rs.) 27.85 17.85 7.85 -2.15 -2.15 -2.15 -2.15 -2.15 -2.15 Net Payoff (Rs.) -6.45 -6.45 -6.45 -6.45 0 3.55 13.55 23.55 33.55

Stock (Rs.) -34.3 -24.3 -14.3 -4.3 2.15 5.7 15.7 25.7 35.7

The above table shows that the investor earns in case the stock prices of Hindalco Industries Ltd. goes up and bear losses in case the stock prices move down.

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BASIC BEARISH STRATEGIES

1. SHORT CALL

When an investor is very bearish about a stock / index and expects the prices to fall, he/she can sell Call options. This position offers limited profit potential and the possibility of large losses on big advances in underlying prices. Although easy to execute it is a risky strategy since the seller of the Call is exposed to unlimited risk.

Example: Assume an investor is Bearish on Reliance Industries Ltd.The investor sells a call of Reliance Industries Ltd. (Reliance 31- May-2012 CE 680) at a premium of Rs. 14.20, when the stock is trading at Rs. 681.65. If the stock stays at 680 or below 680 the holder of call option will not exercise his/her option and thus the seller can retain premium.

Break Even Point = Strike Price + Premium = 680 + 14.20 = 694.20

1 lot of Reliance industries Ltd. is consists of 250 shares. However, payoff is shown on single share basis.

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On Expiry Reliance closes at 640 660 680 694.2 700 720 740

Net Payoff from Call Option 14.2 14.2 14.2 0 -5.8 -25.8 -45.8

The above table shows that if the stock prices of Hindalco Industries Ltd. increases investor bears losses and if the stock prices decreases, investor enjoy profits

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2. LONG PUT

When an investor is Bearish on any stock he buys a put option. A put option gives the buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price and thereby limit his risk.

Example: An investor Mr. A is bearish on Reliance Industries Ltd. which is currently trading at Rs.681.65 and thus he buys a put with a strike price of Rs.680 (Reliance 31May-2012 PE 680) at a premium of Rs. 16.55 . The lot size is of 250 shares.

Breakeven point = Strike price Premium = 680 16.55 = Rs 663.45 On Expiry Reliance closes at 620 640 The advantage of buying a put is that the investor is exposed to limited loss and the profit potential is unlimited. 660 663.45 680 700 720 740

Net Payoff from Put Option 43.45 23.45 3.45 0 -16.55 -16.55 -16.55 -16.55

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3. PROTECTIVE CALL/ SYNTHETIC LONG PUT

If an investor is a low risk taker and he is bearish on any stock he can hedge his risk by using alternate option. As per this strategy an investor can short a Stock and a call to hedge his risk (in case the stock turns opposite to the expectation). The call option gives the investor right to buy the stock at a certain price which is the strike price. The strike can be the price at which you bought the stock (At the money strike price) or moderately below (Out of the money strike price)

In case the price of the stock falls the investor get the full benefit of the price fall and in case the price of the stock rises, the investor can exercise the Call Option. Investors have capped his/her loss in this manner because the Call option stops further losses.

Breakeven: Stock Price Call Premium

Example: Assume Mr. A is bearish on Reliance Industries Ltd. which is currently trading at Rs.681.65. Mr. A short who is a low risk taker sells the shares of Reliance Industries and buys a call option to hedge the risk (in case the stock price rises). Mr. A buys a Near Call expiring at 31-May-2012 with a strike price of Rs700 at a premium of Rs7.15. The payoff schedule will be Breakeven =681.65 7.15 = 674.5

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Reliance Industries closes at 600 620 640 660 674.5 680 700 720 740 Net Payoff from Net Payoff from the Stock (Rs.) 81.65 61.65 41.65 21.65 7.15 1.65 -18.35 -38.35 -58.35 call purchased (Rs.) -7.15 -7.15 -7.15 -7.15 -7.15 -7.15 12.85 32.85 52.85 Net Payoff (Rs.) 74.5 54.5 34.5 14.5 0 -5.5 -5.5 -5.5 -5.5

The above table shows that the investor bear risk in case the stock price rises and enjoy profits in case stock prices move down.

56

4. BEAR CALL SPREAD

The Bear Call Spread is simply a naked call write which minimizes margin requirement and limits potential loss by purchasing a higher strike price call option. Because the Bear Call Spread is a credit spread, you also make money if the underlying asset stays stagnant through the decay and expiration of the more expensive short call options

When to use Bear Call Spread? One should use a Bear Call Spread when one is moderately confident of a drop in the underlying asset and wants some protection and profit should the underlying asset remains stagnant.

How to use Bear Call Spread? Establishing a Bear Call Spread involves the purchase of an At The Money or Out of The Money call option on the underlying asset while simultaneously writing (sell to open) an In the Money or At The Money call option on the same underlying asset with the same expiration month. In this strategy the investor receives a net credit because the Call he buys is of a higher strike price than the Call sold. The strategy requires the investor to buy out-of-the-money (OTM) call options while simultaneously selling in-the-money (ITM) call options on the same underlying stock index.

57

Example 2: Assuming Reliance Industries is trading at Rs. 681.65. An investor Mr. A is mildly bearish on the stock and he buys a call with a strike price of Rs. 700 and sells a call with a strike price of Rs.660; thus

Buy: Reliance 31-May-2012 CE 700 at a premium of Rs. 7.15 Sell: Reliance 31-May-2012 CE 660 at a premium of Rs. 26.05

Net Payoff from Reliance Industries closes at 600 620 640 660 678.9 680 700 720 740 Net Payoff from Call Sold (Rs.) 26.05 26.05 26.05 26.05 7.15 6.05 -13.95 -33.95 -53.95 the call purchased (Rs.) -7.15 -7.15 -7.15 -7.15 -7.15 -7.15 -7.15 12.85 32.85 Net Payoff (Rs.) 18.9 18.9 18.9 18.9 0 -13.2 -21.1 -21.1 -21.1

A Bear Call Spread results in maximum profit when the underlying stock closes below the strike price of the short call options. In this case, the strike price of the short call options is directly on the prevailing stock price, allowing it to reach maximum profit even if the stock remains stagnant.

Profit Calculation of Bear Call Spread

Maximum Return = Net Credit

Risk / Reward of Bear Call Spread Upside Maximum Profit: Limited

58

Maximum Loss: Limited

Break Even Point of Bear Call Spread BEP: Lower Strike + Net credit

Advantages of Bear Call Spread Loss is limited if the underlying financial instrument rises instead of falls. If the underlying instrument fails to drop beyond the strike price of the out of the money short call option, the profit yield will be greater than just buying put options. Able to profit even when the underlying asset remains completely stagnant.

Disadvantages of Bear Call Spread There will be no more profits possible if the underlying asset drops beyond the strike price of the short call option. Because it is a credit spread, there is a margin requirement in order to put on the position

59

BASIC VOLATILITY STRATEGIES

1. SHORT CALL BUTTERFLY

A short Butterfly is a strategy for volatile market. It can be constructed by buying two ATM call, selling one ITM and one OTM call, giving the investor net credit. There should be equal distance between each strike price. There is limited risk and limited return in this strategy. This strategy is useful when an investor is not in a position to decide the direction of the market i.e. whether the market will move up or down.

Example: Assume the share of Hindalco Industries ltd. is trading at Rs.120. An investor who is neutral purchases two ATM call at the premium of Rs.2.15 and sell one ITM call with a strike price of Rs.110 at the premium of Rs.7.10 and sell one more OTM call with a strike price of Rs.130 at a premium of Rs.0.55.

The net credit in the account of investor is 7.10 + 0.55 - 4.30 = 3.35 Upper Break-even point = Strike Price of higher strike short call net premium received

60

= 130 3.35 = 126.65

Lower Break-even Point = Strike price of lower short call + net premium received = 110 + 3.35 = 113.35

The payoff table will be: Net payoff On expiry Hindalco closes at 80 90 100 113.35 120 126.65 130 140 150 Net payoff from 2 ATM call purchased (Rs.) -4.3 -4.3 -4.3 -4.3 -4.3 9 15.7 35.7 55.7 7.1 7.1 7.1 3.75 -2.9 -9.55 -12.9 -22.9 -32.9 from ITM short call (Rs.) Net payoff from one OTM short call (Rs.) 0.55 0.55 0.55 0.55 0.55 0.55 0.55 -9.45 -19.45 Net Payoff (Rs.) 3.35 3.35 3.35 0 -6.65 0 3.35 3.35 3.35

The above table shows the potential of earning limited profit.

61

2. LONG CALL BUTTERFLY

A long Butterfly is a strategy for volatile market. It can be constructed by selling two ATM call and buying one ITM and one OTM call, giving the investor net credit. There should be equal distance between each strike price. This strategy offers good risk reward ratio, along with low investment. This strategy is useful when an investor is not in a position to decide the direction of the market but bearish on volatility.

Example: Assume the share of Hindalco Industries ltd. is trading at Rs.120. An investor who is neutral sells two ATM call at the premium of Rs.2.15 and buy one ITM call with a strike price of Rs.110 at the premium of Rs.7.10 and buy one more OTM call with a strike price of Rs.130 at a premium of Rs.0.55. The net debit in the account of investor is = 7.10 + 0.55 4.30 = 3.35

62

Upper Break-even point = Strike Price of higher strike long call net premium paid = 130 3.35 = 126.65

Lower Break-even Point = Strike price of lower long call + net premium paid = 110 + 3.35 = 113.35

The payoff table is given below:

On expiry Hindalco closes at 80 90 100 113.35 120 126.65 130 140 150

Net payoff from 2 ATM call sold (Rs.) 4.3 4.3 4.3 4.3 4.3 -9 -15.7 -35.7 -55.7

Net payoff from ITM long call (Rs.) -7.1 -7.1 -7.1 -3.75 2.9 9.55 12.9 22.9 32.9

Net payoff from one OTM long call (Rs.) -0.55 -0.55 -0.55 -0.55 -0.55 -0.55 -0.55 9.45 19.45 Net Payoff (Rs.) -3.35 -3.35 -3.35 0 6.65 0 -3.35 -3.35 -3.35

63

3. LONG STRADDLE

A straddle is a volatile strategy and is used by an investor when he is expecting that share prices will show large movements. This strategy involves buying a call and a put with the same strike price and maturity, to take the advantage of a movement in any direction, a soaring or plummeting value of a stock. If the price of the stock increases call will be exercised while put expires worthless and if price of the stock decrease, put will be exercised while call expires worthless.

The risk involved in this strategy is limited to the premium amount paid initially. The reward is unlimited.

Example: Assume the share of Hindalco Industries ltd. is trading at Rs.118. The investor is expecting higher volatility in the share price of the Hindalco Industries Ltd. and thus he purchases a call with a strike price of Rs.120 maturing on 31-May-2012 with a premium of Rs.7.10. The investor also purchases a put with a strike price of 120 maturing on 31-May2012 with a premium of Rs.2.15.

64

Upper Break even = Strike price of long call + premium paid = 120 +9.25 = 129.25 Lower break even = Strike Price of long put premium paid = 120 9.25 =110.75

The pay table is given as

On

expiry

Net

payoff Payoff

Hindalco closes Net payoff from from long put Net at 80 90 100 105 110.75 120 129.25 135 140 150 160 long call (Rs.) -7.1 -7.1 -7.1 -7.1 -7.1 -7.1 2.15 7.9 12.9 22.9 32.9 (Rs.) 37.85 27.85 17.85 12.85 7.1 -2.15 -2.15 -2.15 -2.15 -2.15 -2.15 (Rs.) 30.75 20.75 10.75 5.75 0 -9.25 0 5.75 10.75 20.75 30.75

A short straddle is opposite of long straddle. This Strategy is adopted by an investor when he feels that market will not show much movement. This strategy involves selling of Put and call with same strike price and same maturity. The investor is exposed to unlimited risk and limited profit, that is the premium received.

65

4. LONG STRANGLE

A strangle is a slight modification to the straddle to make it cheaper to execute. This strategy involves the buying of slightly OTM call and slightly OTM put with the same underlying stock and with the same expiration date. Since an investor buys OTM call and put it costs him cheaper than long straddle. However, for a Strangle to make money, it would require greater movement on the upside or downside for the stock / index than it would for a Straddle. An investor is exposed to limited risk and unlimited profit.

Example: Assume the share of Hindalco Industries Ltd. is trading at Rs.120.An investor who is expecting greater volatility buys OTM call with a strike price of Rs.130 at a premium of Rs.0.55 and a put with a strike price of Rs.110 at a premium of Rs.2.15

Net amount debited from investor account = 0.55 + 2.15 = 2.70

Upper Break-even point = Strike price of Long call + Net premium paid

66

= 130 + 2.70 = 132.70 Lower Break-even point = Strike price of long put Net premium paid = 110-2.70 = 107.30

The payoff table of this strategy is given as:

On

expiry

Net

payoff Payoff

Hindalco closes Net payoff from from long put Net at 80 90 100 107.3 110 120 130 132.7 140 150 160 long call (Rs.) -0.55 -0.55 -0.55 -0.55 -0.55 -0.55 -0.55 2.15 9.45 19.45 29.45 (Rs.) 27.85 17.85 7.85 0.55 -2.15 -2.15 -2.15 -2.15 -2.15 -2.15 -2.15 (Rs.) 27.3 17.3 7.3 0 -2.65 -2.65 -2.65 0 7.3 17.3 27.3

Short Strangle is opposite to the Long strangle. As per short strangle an investor sells one OTM call and one OTM put. The risk is unlimited and reward is limited. An investor follow short strangle when he believes that the underlying stock will show little volatility.

67

COMMODITY TRADING
Derivatives markets can broadly be classified as commodity derivatives market and financial derivatives markets. As the name suggest, commodity derivatives markets trade contracts are those for which the underlying asset is a commodity. It can be an agricultural commodity like wheat, soybeans, rapeseed, cotton, etc or precious metals like gold, silver, etc. or energy products like crude oil, natural gas, coal, electricity etc. Financial derivatives markets trade contracts have a financial asset or variable as the underlying. The more popular financial derivatives are those which have equity, interest rates and exchange rates as the underlying. In this segment we are going to discuss about Commodity Derivative Aluminium and Copper.

Difference between Commodity Derivatives and Financial Derivatives:

The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features, which are very peculiar to commodity derivative markets.

In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing.

Similarly, the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. However in the case of commodities, the quality of the asset underlying a contract can vary at times.

Indian Commodity exchanges: There are more than 20 recognized commodity futures exchanges in India under the purview of the Forward Markets Commission (FMC). The country's commodity futures exchanges are divided majorly into two categories: National exchanges Regional exchanges

68

MCX: Multi Commodity Exchange of India Ltd (MCX) is a state-of-the-art electronic commodity futures exchange. The demutualised Exchange set up by Financial Technologies (India) Ltd (FTIL) has permanent recognition from the Government of India to facilitate online trading, and clearing and settlement operations for commodity futures across the country. Having started operations in November 2003, today, MCX holds a market share of over 80% of the Indian commodity futures market, and has more than 2000 registered members operating through over 100,000 trader work stations, across India. MCX offers more than 40 commodities across various segments such as bullion, ferrous and non-ferrous metals, and a number of agri-commodities on its platform. The Exchange is the world's largest exchange in Silver, the second largest in Gold, Copper and Natural Gas and the third largest in Crude Oil futures, with respect to the number of futures contracts traded. MCX has been certified to three ISO standards including ISO 9001:2000 Quality Management System standard, ISO 14001:2004 Environmental Management System standard and ISO 27001:2005 Information Security Management System standard. The Exchanges platform enables anonymous trades, leading to efficient price discovery. Moreover, for globally-traded commodities, MCXs platform enables domestic participants to trade in Indian currency.

NCDEX: National Commodity & Derivatives Exchange Limited (NCDEX), a national level online multi commodity exchange, commenced its operations on December 15, 2003. The

69

Exchange has received a permanent recognition from the Ministry of Consumer Affairs, Food and Public Distribution, Government of India as a national level exchange. NCDEX has been formed with the following objectives: To create a world class commodity exchange platform for the market participants. To bring professionalism and transparency into commodity trading. To provide nationwide reach and consistent offering. To bring together the entities that the market can trust.

NCDEX currently offers an array of more than 50 different commodities for futures trading. The commodity segments covered include both agri and non-agri commodities [bullion, energy, metals (ferrous and non-ferrous metals) etc]. Before identifying a commodity for trading, the Exchange conducts a thorough research into the characteristics of the product, its market and potential for futures trading.

NMCE: National Multi Commodity Exchange of India Limited (NMCE) is the first demutualized, Electronic Multi-Commodity Exchange to be formed in India. On 25th July, 2001, it was granted approval by the Government of India to organize trading in the edible oil complex. It started operating in the commodity market from November 26, 2002. NMCE is the only Exchange in India to have investment and technical support from commodity relevant institutions like Central Warehousing Corporation Ltd., Gujarat State Agricultural Marketing Board, Neptune Overseas Ltd, National Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation Ltd. (GAICL), Gujarat State Agricultural Marketing Board (GSAMB) and the National Institute of Agricultural Marketing (NIAM).

ICEX: Indian Commodity Exchange Limited is a nation-wide screen based on-line derivatives exchange for commodities and has established a reliable, efficient and transparent trading platform. It has put in place assaying and warehousing facilities in order to facilitate deliveries. This exchange is ideally positioned to leverage the huge potential of commodities market and encourage participation of farmers, traders and actual users to benefit from the opportunities of hedging, risk management and supply chain management in the commodities markets

70

The Exchange is a public-private partnership with Reliance Exchangenext Ltd. as anchor investor and has MMTC Ltd., Indiabulls Financial Services Ltd., Indian Potash Ltd., KRIBHCO and IDFC among others, as its stakeholders

LIST OF TRADED COMMODITY

Metal: Aluminium, Copper, Lead, Nickel, Sponge Iron, Steel Long (Bhavnagar), Steel Long (Govindgarh), Steel Flat, Tin, Zinc

Bullion: Gold, Gold HNI, Gold M, i-gold, Silver, Silver HNI, Silver M

Fibre: Cotton L Staple, Cotton M Staple, Cotton S Staple, Cotton Yarn, Kapas

Energy: Brent Crude Oil, Crude Oil, Furnace Oil, Natural Gas, M. E. Sour Crude Oil

Spices: Cardamom, Jeera, Pepper, Red Chilli

Plantations: Areca nut, Cashew Kernel, Coffee (Robusta), Rubber

Pulses: Chana, Masur, Yellow Peas

Petrochemicals: HDPE, Polypropylene(PP), PVC

Oil and Oil seeds: Castor Oil, Castor Seeds, Coconut Cake, Coconut Oil, Cotton Seed, Crude Palm Oil, Groundnut Oil, Kapasia Khalli, Mustard Oil, Mustard Seed (Jaipur), Mustard Seed (Sirsa), RBD Palmolein, Refined Soy Oil, Refined Sunflower Oil, Rice Bran DOC, Rice Bran Refined Oil, Sesame Seed, Soymeal, Soy Bean, Soy Seeds

Cereals: Maize

Others: Gurchaku, Mentha Oil, Potato (Agra), Potato (Tarkeshwar), Sugar M-30, Sugar S-30

71

SETTLEMENT IN COMMODITY MARKET

Daily Mark to Market settlement where 'T' is the trading day Mark to Market Pay-in (Payment): T+1 working day. Mark to Market Pay-out (Receipt): T+1 working day.

Final settlement for Futures Contracts The settlement schedule for Final settlement for futures contracts is given by the Exchange in detail for each commodity.

Timings for Funds settlement: Pay-in: On Scheduled day as per settlement calendars. Pay-out: On Scheduled day as per settlement calendars.

SOME COMMON USED TERMS:

Contango refers to a situation in commodities futures contracts where the futures price is above the spot price, the price for current purchase and delivery of the physical commodity.

Backwardation refers to a situation in commodities futures contracts where the future price is below the spot price. If the dominant traders in a commodity future are producers of the commodity hedging their exposure to financial losses arising from unexpected price declines in the future, the result will be backwardation. In this situation, producers are paying for protection against price declines and that is reflected in futures prices which are lower than current market price (spot price).

Companies generally use hedge ratio to hedge their risk. Hedge ratio can be defined as a ratio comparing the value of a position protected via a hedge with the size of the entire position itself.

Suppose an investor is holding $10,000 in foreign equity, which exposes him to currency risk. If he hedges $5,000 worth of the equity with a currency position, his hedge ratio is 0.5 (50 / 100). This means that 50% of his equity position is sheltered from exchange rate risk.

72

ALUMINIUM

73

INTRODUCTION TO ALUMINIUM

Aluminium is a silvery white member of the boron group of chemical elements. It is not soluble in water under normal circumstances. Aluminium is the second most abundant element (after silicon), and the most abundant metal, in the Earth's crust. It makes up about 8% by weight of the Earth's solid surface. Aluminium metal is too reactive chemically to occur natively. Instead, it is found combined in over 270 different minerals. The chief ore of aluminium is bauxite. Aluminium is basically used in followings: Transportation Industry (automobiles, aircrafts, trucks, railways, cars, marine vessels, bicycle etc.) Packaging (cans, foil etc) Construction (windows, doors, siding, building wire etc) Cooking utensils Super purity aluminium is used in electronic and CDs.

Aluminium has the following properties:

Reflectivity: Aluminum is an excellent reflector of heat, light and electromagnetic waves.

Thermal conductivity: Aluminum's thermal conductivity is remarkable and promotes its use in diverse manufacturing sectors, such as kitchen utensils, solar collectors, refrigeration components, disks and brakes. Aluminum is also used in the electronic industry, to desalinate sea water and in all fields employing heat exchange devices.

Light Weight: Aluminum's light weight makes it particularly suitable for all means of transportation: road (30 to 50% lighter), rail, water and air (all airplanes are made of aluminum alloy). This property makes it a metal of choice for electric power transmission; with equal resistance, a wire made of aluminum alloy is twice as light as copper. Aluminum is also much appreciated in various mechanical applications, particularly for components of moving machines, such as engines and robotic devices.

74

Workability: If by workability one understands all the methods by which a material may be destructively or non-destructively shaped, joined and finished, then aluminium must rate as the most versatile of all the metal. Aluminium may be cast by all known foundry methods; it can be rolled to any thickness down to foil thinner than tissue paper, it can be stamped, drawn, spun, roll-formed, or forged; there is almost no limit to the different cross-sectional shapes in which aluminium may be extruded. All aluminium alloys can be machined, usually easily and rapidly, at maximum machine speeds.

Recyclable: Aluminum can be recycled indefinitely. Secondary aluminum manufacturing requires only 5% of the electricity necessary to produce the primary metal.

Non-toxicity: The non-toxicity of aluminium and its compounds was noted early in the development of the industry. Because of its non-contaminative characteristics, a great deal of aluminium equipment is used in the processing of food and beverages. Aluminium is not adversely affected by steam sterilizing and cleaning and it will not harbor insects or bacteria. The non-toxicity of aluminium is particularly advantageous in the handling of yeasts and other micro-biological products.

Strength: The use of aluminium for space vehicles and aircraft structures probably represents the most exacting application of the highest strength aluminium alloys where weight saving is the primary requirement. While the list of applications for aluminium broadly based on lightness benefits is enormous, it is specifically lightness combined with strength which accounts for the wide use of aluminium alloys for transportation equipment generally and for moving and movable parts.

Ductility: Aluminum is easy to process, no matter what method is used (milling, drilling, shearing, forging or spinning). It is easy to shape, making it ideal for extruding, strip rolling, bending or other plastic hot or cold fabrication methods. It can also be soldered and glued.

75

Resistance: In its pure state, aluminum is soft and flexible. Its resistance can be increased by alloys or cold treatment.

Corrosion Resistance: A compact layer of oxide forms naturally on the surface of aluminum, protecting it from atmospheric corrosion and giving aluminum products a very long life. The visual aspect of the material can be further improved by anodizing or heat treatment. Maintenance of aluminum products is minimal, even when unprotected.

Diversity of the alloys: Aluminum can be alloyed with several other metals, such as copper, magnesium, manganese, silicon, lithium and zinc, to further improve certain properties.

Electrical conductivity: Aluminum is an excellent electrical conductor. Pure aluminum and certain alloys, in the form of bars or tubes, are commonly used as conductors in many electrical applications.

Inertness: The chemical inertness and metallic stability of aluminum make it an excellent choice for product conservation

Surface treatment: Surface treatments of all kinds make it an ideal metal for aesthetic or decorative products.

Color treatment: Aluminum takes colour well and is suitable for all types of printing.

The aluminium industry is a capital and technology intensive industry. The main substitutes of aluminium are plastic, wood and glass.

76

Major Aluminium Producing Countries

Production in 000 t Countries China Russia Canada USA Australia Brazil Norway India Dubai Others Total 2008 13,695 4,191 3,124 2,658 1,978 1,661 1,383 1,348 899 9,194 40,131 % of total 34 10 8 7 5 4 3 3 2 23 100 2014 21,481 3,712 756 1,754 1,727 1,684 1,195 3,958 1026 13,042 50,335 % of total 43 7 2 3 3 3 2 8 2 26 100

25,000 20,000 15,000 10,000 5,000 0 2008 2014

77

Major Aluminium Consuming Countries

Consumption in 000 tonne Countries China USA Japan Germany Middle East India Italy South Korea Brazil Others Total 2008 12,604 5,147 2,319 1,929 1,459 1,089 951 937 933 10,051 37,419 % of total 34 14 6 5 4 3 3 3 3 24 100 2014 22,088 5,505 2,259 2,054 2,030 3,800 869 1297 1,198 9,551 50,651 % of total 44 11 4 4 4 8 2 3 2 19 100

Source: Aluminium Association of India

25,000 20,000 15,000 10,000 5,000 0 China USA Japan Germany Middle East 2008 India 2014 Italt South Korea Brazil Others

78

Global Share of Primary and Recycled Metal Production

Worldwide Evolution of recycled and Primary Aluminium

79

The primary aluminium production process consists of three stages: First is mining of bauxite (see appendix 1), Second is refining of bauxite to alumina and Finally smelting of alumina to aluminium.

India has the fifth largest bauxite reserves with deposits of about 3 bn tonnes or 5% of world deposits. India's share in world aluminium capacity rests at about 3%. Production of 1 tonne of aluminium requires 2 tonnes of alumina while production of 1 tonne of alumina requires 2 to 3 tonnes of bauxite.

The aluminium production process can be categorised into upstream and downstream activities. The upstream process involves mining and refining while the downstream process involves smelting and casting & fabricating. Downstream-fabricated products consist of rods, sheets, extrusions and foils.

Power is amongst the largest cost component in manufacturing of aluminium, as the production involves electrolysis. Consequently, manufacturers are located near cheap and abundant sources of electricity such as hydroelectric power plants. Alternatively, they could set up captive power plants, which is the pattern in India. Indian manufacturers are the lowest cost producers of the base metal due to access to captive power, cheap labour and proximity to abundant supply of raw material, i.e., bauxite.

The

Indian

aluminium

sector

is

characterized

by

large

integrated

players

like Hindalco and National Aluminium Company (Nalco). The other producers of primary aluminium include Indian Aluminium (Indal), now merged with Hindalco, and Sterlite Industries.

The per capita consumption of aluminium in India continues to remain abysmally low at1.2 kg as against nearly 15 to 18 kgs in the western world and 10 kgs in China. This offers significant upside potential. The key consumer industries in India are power, transportation, consumer durables, packaging and construction. Of this, power is the biggest consumer (about 48% of total) followed by infrastructure (20%) and transportation (about 10% to 15%). However, internationally, the pattern of consumption is in favour of transportation, primarily due to large-scale aluminium consumption by the aviation space.

80

In FY11, LME average aluminium prices remained strong at around USD $2,250 an increase of over 21% over previous year's average prices. The appreciating rupee though negated some of the LME price gains for domestic aluminium producers as the prices are dollar denominated. The prices continued to rise even as inventory levels remained at their historic highs. This was the result of tightness in the physical market, with most inventories tied up at various warehouses under financing deals. Across the globe, the cost of production of aluminium increased sharply as input costs such as alumina and power surged.

Aluminium May 2012

Date 06-032012 07-032012 08-032012 09-032012 10-032012 12-032012 13-032012 14-032012 15-032012 16-03-

Open

High

Low

Close

Vol.

Cumm Vol 1126

Turnover Open (Lakhs) 6487.11 Interest 5

Spot

114.75

116.1

114.4

114.65

1126

110.92

114.25

115.5

113.8

113.8

1822

2948

10444.89

10

109.28

113.8

114.65

112.95

112.95

1900

4848

10820.43

109.07

112.95

113.8

112.1

113

4844

9692

27340.57

108.13

113.55

113.55

112.45

113.65

898

10590

5075.08

13

108.13

113.1

114.5

112.8

113.35

4762

15352

27059.47

13

108.28

112.8

114.2

112.5

114

1314

16666

7446.66

109.18

113.45

114.85

113.15

113.2

1856

18522

10577.9

35

109.83

113.2 114.05

114.05 114.9

112.35 113.2

114.05 114.25

2346 1658

20868 22526

13279.1 9454.73

10 10

110.56 111.34

81

2012 17-032012 19-032012 20-032012 21-032012 22-032012 23-032012 24-032012 26-032012 27-032012 28-032012 29-032012 30-032012 31-032012 02-042012 03-042012 04-042012 114.25 114.8 113.7 114.4 2250 24776 12853.67 13 111.34

114.3

115.25

113.55

114.5

3430

28206

19619.19

23

111.36

114.5

115.35

113.65

114.6

3744

31950

21429.97

45

111.04

114.6

115.45

113.75

113.75

1816

33766

10404.88

15

110.94

114.25

114.6

112.9

112.9

3196

36962

18174.44

25

109.71

112.9

113.75

112.05

112.95

2782

39744

15709.09

22

109.15

112.95

113.5

112.4

112.9

2368

42112

13373.98

26

109.15

112.9

113.75

112.05

113.05

2378

44490

13424.05

15

109.03

112.55

113.9

112.2

113

7140

51630

40361.26

21

108.03

112.5

113.85

112.15

112.3

4632

56262

26165.49

24

108.56

112.85

113.15

111.45

111.45

5778

62040

32447.22

31

108.3

112

112.3

110.6

110.6

7030

69070

39193.25

37

106.77

110.6

111.15

110.05

110.05

3366

72436

18615.48

20

107.3

109.5

110.9

109.2

109.2

1500

73936

8254.05

24

105.69

108.65

110

108.4

108.8

998

74934

5448.59

21

105.84

108.8

109.6

108

108.2

1314

76248

7148.08

22

105.24

82

05-042012 07-042012 09-042012 10-042012 11-042012 12-042012 13-042012 16-042012 17-042012 18-042012 19-042012 20-042012 21-042012 23-042012 24-042012 25-042012

108.3

109

107.4

108.55

702

76950

3798.42

13

104.98

109.05

109.1

108

108.9

24

76974

130.74

104.98

108.35

109.7

108.1

108.6

966

77940

5260.98

104.96

108.5

109.4

107.8

107.9

1176

79116

6384.01

23

105.54

107.8

108.7

107.1

108.65

928

80044

5005.5

104.85

109

109.45

107.85

108.6

1992

82036

10821.93

106.03

108.5

109.4

107.8

107.8

1200

83236

6516.05

105.27

107.6

108.6

107

107.6

1162

84398

6264.02

10

104.59

107.6

108.4

106.8

107.55

1810

86208

9741.81

11

104.82

107

108.35

106.75

107.45

1160

87368

6237.25

105.03

107.55

109.3

106.65

107.9

810

88178

4349.71

105.03

107.8

108.7

107.1

108.3

1228

89406

6624.81

105.83

107.95

108.85

107.75

108.35

448

89854

2426.13

105.83

108.25

109.15

107.55

108.25

1242

91096

6728.44

11

105.36

107.7

109.05

107.45

109.05

756

91852

4091.99

106.84

108.5

109.85

108.25

108.7

1504

93356

8200.63

107

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26-042012 27-042012 28-042012 30-042012 01-052012 02-052012 03-052012 04-052012 05-052012 07-052012 08-052012 09-052012 10-052012 11-052012 12-052012 14-052012

108.7

109.5

107.9

109.1

1056

94412

5739.07

107

109.05

109.9

108.3

109.9

1438

95850

7844.51

108.95

109.35

109.9

109.35

109.9

38

95888

208.59

16

108.95

110.45

110.7

109.1

109.1

3624

99512

19917.09

16

108.7

108.55

109.9

108.3

109.9

694

100206

3784.28

17

108.47

109.9

110.7

109.1

110.7

1860

102066

10224.55

109.36

110.15

111.55

109.85

111.2

2474

104540

13694.04

16

109.19

110.9

112.05

110.35

110.35

2588

107128

14388.22

11

109.36

110.3

110.9

109.8

109.9

750

107878

4138.11

109.36

109.7

110.7

109.1

109.55

2918

110796

16032.64

17

108.33

110.1

110.35

108.75

109.5

2444

113240

13387.05

12

107.62

109.4

110.3

108.7

109.4

3016

116256

16513.15

106.8

109

110.2

108.6

108.6

2738

118994

14976.63

13

106.63

108.6

109.4

107.8

108.55

2096

121090

11380.7

106.64

108

109.1

108

108.6

804

121894

4363.33

106.64

108.6

109.4

107.8

108.15

2664

124558

14465.44

106.87

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15-052012 16-052012 17-052012 18-052012 19-052012

108.7

108.95

107.35

108

2186

126744

11820.92

106.48

107.9

108.8

107.2

108.8

2576

129320

13920.68

12

108.35

108.8

109.6

108

109.6

1866

131186

10145.2

108.03

109.6

110.4

108.8

110.4

682

131868

3737.61

109.86

110.4

110.95

109.85

110.95

724

132592

3996.43

109.86

The above showed candle stick diagram shows the trend of Aluminum May Future from 1Feb-2012 to 21-May-2012.

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CURRENCY DERIVATIVES
Foreign currency markets serve companies and individuals that purchase or sell foreign goods and services denominated in foreign currencies. An even large market, however, exists for capital flow. Foreign Currencies are needed to purchase foreign physical assets as well as foreign financial securities.

Many companies have foreign exchange risk arising from their cross-border transactions. A Japanese company that expects to receive 10 million euros when a transaction is completed in 90 days has yen/euro exchange rate risk as a result. By entering into a forward currency contract to sell 10 million euros in 90 days for a specific quantity of yen, the firm can reduce or eliminate its foreign exchange risk associated with the transaction. When a firm takes a position in the foreign exchange market to reduce an existing risk, it is said that firm is hedging its risk.

The primary dealer in currencies and originators of forward foreign exchange (FX) contracts are large multinational banks. This part of FX market is called the sell side. On the other hand, the buy side consists of the many buyers of foreign currencies and forward FX contracts. These buyers include corporations, Government and government entities, small institutional investors and retail investors.

Future and options are also available in the currency segment. Currency derivative market is expanding with greater pace and is assumed to be safe as it is regulated by SEBI and RBI. The products available in currency derivatives are:

Currency Futures (In MCX-SX and NSE) USD/INR (see Appendix 3) GBP/INR JPY/INR EUR/INR

Currency Options (NSE only) USD/INR

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The final settlement of a currency future contract is the last working day (excluding) of the expiry month. The last working day will be same as that for Interbank Settlements in Mumbai. Since future has the characteristic of mark to market settlement, therefore daily settlement of currency futures is done in T+1 day and the final settlement is done in T+2 days. The daily settlement price is based on the last half an hour weighted average price whereas the final settlement is based on the RBI reference rate.

RBI reference rate: RBI reference rate is the rate published daily by RBI for spot rate for various currency pairs. The rates are arrived at by averaging the mean of the bid / offer rates polled from a few select banks during a random five minute window between 11:45 AM and 12:15 PM and the daily press on RBI reference rate is be issued every week-day (excluding Saturdays) at around 12:30 PM. The contributing banks are selected on the basis of their standing, market-share in the domestic foreign exchange market and representative character. The Reserve Bank periodically reviews the procedure for selecting the banks and the methodology of polling so as to ensure that the reference rate is a true reflection of the market activity. There is an increasing trend of large value FX transaction being done at RBI reference rate even on OTC market. The reference rate is a transparent price which is publicly available from an authentic source.

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USD/INR

USD/INR is the most traded future on exchanges. The call and put options are only available for USD/INR. An investor can use same strategies in options which I have discussed in the equity derivative segment. Those strategies are: Long hedge Short hedge Protective call Covered call Covered put Bull call spread Bear call Spread Bull put Spread Bear put spread Long Call butterfly Short Call butterfly Long straddle Short straddle Long strangle Short strangle

A hedger, speculator and a arbitrageur uses following strategies using currency future to hedge his risk.

Hedging:

Presume Entity A is expecting a remittance for USD 1000 on 27 August 2012. He wants to lock in the foreign exchange rate today so that the value of inflow in Indian rupee terms is safeguarded. The entity can do so by selling one contract of USDINR futures since one contract is for USD 1000. Presume that the current spot rate is Rs.53 and USDINR 27 Aug 12 contract is trading at Rs.54.2500. Entity A shall do the following:

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Sell one August contract today. The value of the contract is Rs.54, 250.

Let us assume the RBI reference rate on August 27, 2012 is Rs.54.0000. The entity shall sell on August 27, 2012, USD 1000 in the spot market and get Rs. 54,000. The futures contract will settle at Rs.54.0000 (final settlement price = RBI reference rate). The return from the futures transaction would be Rs. 250, i.e. (Rs. 54,250 Rs.54, 000). As may be observed, the effective rate for the remittance received by the entity A is Rs.54. 2500 (Rs.54, 000 + Rs.250)/1000, while spot rate on that date wasRs.54.0000. The entity was able to hedge its exposure.

Speculation: Bullish, buy futures

Take the case of a speculator who has a view on the direction of the market. He would like to trade based on this view. He expects that the USD-INR rate presently at Rs.52, is to go up in the next two-three months. How can he trade based on this belief? In case he can buy dollars and hold it, by investing the necessary capital, he can profit if say the Rupee depreciates to Rs.52.50. Assuming he buys USD 10000, it would require an investment of Rs.520000. If the exchange rate moves as he expected in the next three months, then he shall make a profit of around Rs.10000.

This works out to an annual return of around 4.76%. It may please be noted that the cost of funds invested is not considered in computing this return.

A speculator can take exactly the same position on the exchange rate by using futures contracts. Let us see how this works. If the INR- USD is Rs.52 and the three month futures trade at Rs.52.40. The minimum contract size is USD 1000. Therefore the speculator may buy 10 contracts. The exposure shall be the same as above USD 10000. Presumably, the margin may be around Rs.21, 000. Three months later if the Rupee depreciates to Rs. 52.50 against USD, (on the day of expiration of the contract), the futures price shall converge to the spot price (Rs. 52.50) and he makes a profit of Rs.1000 on an investment of Rs.21, 000. This works out to an annual return of 19 percent. Because of the leverage they provide, futures form an attractive option for speculators.

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Speculation: Bearish, sell futures

Futures can be used by a speculator who believes that an underlying is over-valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasn't much he could do to profit from his opinion. Today all he needs to do is sell the futures.

Let us understand how this works. Typically futures move correspondingly with the underlying, as long as there is sufficient liquidity in the market. If the underlying price rises, so will the futures price. If the underlying price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of USD-INR. He sells one two-month contract of futures on USD say at Rs. 52.20 (each contact for USD 1000). He pays a small margin on the same. Two months later, when the futures contract expires, USD-INR rate let us say is Rs.52. On the day of expiration, the spot and the futures price converges. He has made a clean profit of 20 paisa per dollar. For the one contract that he sold, this works out to be Rs.2000.

Arbitrage:

Arbitrage is the strategy of taking advantage of difference in price of the same or similar product between two or more markets. That is, arbitrage is striking a combination of matching deals that capitalizes upon the imbalance, the profit being the difference between the market prices. If the same or similar product is traded in say two different markets, any entity which has access to both the markets will be able to identify price differentials, if any. If in one of the markets the product is trading at higher price, then the entity shall buy the product in the

Cheaper market and sell in the costlier market and thus benefit from the price differential without any additional risk.

One of the methods of arbitrage with regard to USD-INR could be a trading strategy between forwards and futures market. As we discussed earlier, the futures price and forward prices are arrived at using the principle of cost of carry. Such of those entities who can trade both forwards and futures shall be able to identify any mispricing between forwards and futures. If

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one of them is priced higher, the same shall be sold while simultaneously buying the other which is priced lower. If the tenor of both the contracts is same, since both forwards and futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less profit.

The above diagram shows the trend of USD-INR exchange rate from January 2, 2012 to May 24, 2012

FACTORS AFFECTING EXCHANGE RATE (USD/INR):

The factors those affects the exchange rates are discussed below:

Interest rate: Higher interest rate in a country attracts savings from non-residents of the country and thereby raises demand for domestic currency. Thus in turn causes appreciation in the value of the domestic currency.

Inflation: As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies.

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Current-Account Deficits: The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests

To combat with the problem of higher subsidies to the oil marketing companies, which results in higher CAD and thereby affecting exchange rate, the UPA Congress government increases petrol prices by Rs.7 on 24th May, 2012.

Political Stability and Economic Performance: Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.

Employment Outlook: Employment levels have an immediate impact on economic growth. An increase in unemployment signals a slowdown in the economy and possible devaluation of a country's currency because of declining confidence and lower demand. If demand continues to decline, the currency supply builds and further exchange rate depreciation is likely.

Central Bank Actions: Central bank of a country takes various measures to manage and control the exchange rate. For example, RBI suggest to exporters to sell their 50% dollar holding in May beginning when Rupee is about to touch its ever time low against dollar. RBI also increases the Non-resident saving rate to attract foreign capital. RBI itself is intervening into the market through banks to safe the downside risk of rupee but this step result in erosion of foreign exchange reserves.

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PROJECT ANALYSIS
Hindalco Industries Ltd. And Aluminium Future (May 2012) The covariance and correlation between the stock prices of Hindalco Industries Ltd. and the aluminium May future prices is given by covariance correlation 18.1379 0.753745

The correlation is found for the period of 1-mar-2012 to 16-May-2012. The correlation of 0.75 shows that there is good positive correlation between the stock prices of Hindalco Industries Ltd. and the Aluminium May future prices. Thus an investor of Hindalco Industries Ltd. can hedge his risk by taking opposite position in aluminium future. Although the prices of May future is available from 1st February but there were no trading volume and thats why I have taken May future prices from March.

170 160 150 140 130 120 110 100 Aluminum May 2012 Hindalco Stock

Similarly the correlation between Hindalco Stock prices and the Dollar is -0.92, which is a good negative correlation. An investor who invested in Hindalco Industries Ltd. can hedge his risk by taking the similar position in currency market. Usually companies like Hindalco who have over 50% of their asset base outside India, hedge their exchange risk by using

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Hedge ratio. For example, Hindalco got a contract from USA based company for which hindalco will get paid USD 1million one month later. By taking into consideration the fluctuation in currency spot prices and currency future prices, hindalco will calculate its hedge ratio and hedge its risk accordingly. Suppose the hedge ratio is 0.6, so Hindalco Industries Ltd. will short on Future for the amount of USD 60,000 so that it can hedge its risk in case the USD depreciates or INR appreciates.

The graph showing pattern of Hindalco Industries Ltd. and USD/INR is given below:

170 160 150 140 130 120 110 100 90 80 02-Jan-12 02-Feb-12 02-Mar-12 02-Apr-12 02-May-12 Hindalco stock prices

54 53 52 51 50 49 48 47 46 02-Jan-12 02-Feb-12

USD/INR

USD/INR

02-Mar-12

02-Apr-12

02-May-12

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The above shown graph clearly shows that there is inverse relation between the Hindalco Industries Ltd. stock prices and USD-INR rate. One can make a portfolio using various strategies to hedge his risk, even the big venture like Hindalco Industries Ltd. does same (as mentioned in its annual report that they aggressively uses derivatives to hedge their risk)

FINDINGS: Derivatives are good source of hedging. The market for derivative is increasing with a greater pace. Investors have various strategies for different marketing conditions. Derivatives also help in price discovery. Various big investors or companies use derivatives to hedge risk and to make profit. Factors generally attributed as the major driving force behind growth of financial derivatives are:

(a) Increased Volatility in asset prices in financial markets,

(b) Increased integration of national financial markets with the international markets,

(c) Marked improvement in communication facilities and sharp decline in their costs,

(d) Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and

(e) Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets.

The project is mainly focused on forming strategies so that the investors who want to invest in the derivatives market can earn profit irrespective of the market volatility and fluctuations.

The project also explains the factors affecting the demand and supply of aluminium and thereby the Hindalco prices. Since Hindalco asset base outside India account for more than 50% therefore the currency exchange rate will affects its bottom line and thereby its stock prices.

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Appendix 1 BAUXITE MINES IN INDIA

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Appendix 2 ALUMINIUM PLANTS IN INDIA

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Appendix 3 CURRENCY FUTURE

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REFERENCES

News paper Business standard Economic times

Books R.P RASTUGI, 2009. Financial Management. New Delhi: Galgotia Publishing Company KAPLAN SCHWESER, 2011. Fixed Income, Derivatives and Alternative Investments. United States Of America: Kaplan Schweser NSE, 2011. Equity Derivatives: A Beginners Module. Mumbai: National Stock Exchange of India Limited. NSE, 2010. Commodities Market Module. Mumbai: National Stock Exchange of India Limited. NSE, Currency Derivatives: A Beginners Module. Mumbai: National Stock Exchange of India Limited.

Websites www.nseindia.com www.bseindia.com www.nmce.com www.mcx.com www.sharekhan.com www.sharekhanlearning.com www.ftmarket.com www.rbi.org.in www.hindalco.com/ www.mapsofindia.com www.aluminium-india.org/ www.nseindia.com/marketinfo/fxTracker/fxTracker.jsp

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