[DERIVATIVES AND HEDGING] August 6, 2011

Q.1 FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract specifications/details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.

SALIENT FEATURES OF FROWARD CONTRACT

They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged. However, forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market.

FORWARD CONTRACT AND HEDGING

Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. 1

[DERIVATIVES AND HEDGING] August 6, 2011

FORWARD CONTRACT AND SPECULATION

If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.

LIMITATIONS OF FORWARD MARKETS

Forward markets world-wide are afflicted by several problems: Lack of centralization of trading, Illiquidity, and Counterparty risk In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradable. Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.

[DERIVATIVES AND HEDGING] August 6, 2011

Q.2 Analysis
Since, the holder of the underlying (LP ltd) is long in the spot market the position required to hedge or to mitigate risk is the opposite to that of spot market. Thus the holder of underlying (LP ltd) has to go short in the future market that is to sell Sensex future. Number of Futures contract = Hedge Ratio * Units of Spot Position requiring Hedge Need to Acquire Units of Underlying in 1 Future Contract

Therefore, Number of Future Contract Need to Acquire = 1.1 * 1000 50 = 22 contracts If the price of underlying (LP ltd) falls by 12% in the spot market, then, The underlying (LP ltd) price in the spot market = 100 12% of 100 = 100 12 = 88/- INR Also, consequently the index (Sensex) will fall/drop by, = 12 1.1 = 10.909/- INR Therefore the index (Sensex) will fall/drop by, = 4500 10.91 = 4489.091/- INR

Loss in the Spot Market 3

[DERIVATIVES AND HEDGING] August 6, 2011

Since, the price of the underlying (LP ltd) drops by 12% (i.e. INR 12/-), the overall loss to the holder is, = 1000 * 12 = 12000/- INR

Gain in the Future Market Since, the holder has taken short position on the underlying (Sensex) in the future market, the gain from the future market is, = 22 * 50 * 10.909 = 12000/- INR Therefore, the loss in the spot market is mitigated from the equal amount of gain in the future market which can be seen from the above calculation. Thus, the holder can be protected from the drop in the spot market by taking opposite position to that of the spot market, that is the holder has to take short in the future market. If the price of underlying (LP ltd) goes up by 5% in the spot market, then, The underlying (LP ltd) price in the spot market = 100 + 5% of 100 = 100 + 5 = 105/- INR Also, consequently the index (Sensex) will increase/jumps by, = 5 1.1 = 4.545/- INR Therefore the index (Sensex) will increase/jumps by, = 4500 + 4.55 = 4504.545/- INR

Gain in the Spot Market 4

[DERIVATIVES AND HEDGING] August 6, 2011

Since, the price of the underlying (LP ltd) increase/jumps by 5% (i.e. INR 5/-), the overall gain to the holder is, = 1000 * 5 = 5000/- INR

Loss in the Future Market Since, the holder has taken short position on the underlying (Sensex) in the future market, the loss from the future market is, = 22 * 50 * 4.545 = 5000/- INR Therefore, the gain in the spot market because of price increase is mitigated from the equal amount of loss in the future market which can be seen from the above calculation. Thus, the holders profit from the price increase in the spot market is set off from the equal amount of loss in the future market.

Q.3 Market participants

The three categories of participants in the derivatives market are as follows, HEDGERS SPECULATORS ARBITRAGEURS

HEDGERS
Hedgers are individuals and firms that make purchases and sales in the futures market solely for the purpose of establishing a known price level weeks or months in advance for something they later intend to buy or sell in the cash market. In this way they attempt to protect themselves against the risk of an unfavorable price 5

[DERIVATIVES AND HEDGING] August 6, 2011

change in the interim or hedgers may use futures to lock in an acceptable margin between their purchase cost and their selling price. Hedgers provide the principal motivation and justification for the establishment of the futures market.

SPECULATOR
Speculator wants to maximize their gain by making profits in a fluctuating market. They take high risk to get higher return in a short time span. They have a close watch on the price movement. They anticipate price movements with the objective of achieving profits. For example, if a speculator wants to earn profit he keeps close watch on the scrip where he wants to put money. After observing the price movements he put in money and takes risk with the price movements. Speculators provide the useful function of adding liquidity to a market.

Long Hedger Speculator Secure a price now to protect against future rising prices Secure a price now in anticipation of rising prices

Short Secure a price now to protect against future declining prices Secure a price now in anticipation of declining prices

ARBITRAGEUR
Arbitrageur is a class of investor tries to earn risk less profit by taking the advantage of price differentials. Arbitrageurs profit from the price differential which are there in two or more different markets by simultaneously operating in those markets.

[DERIVATIVES AND HEDGING] August 6, 2011

For example, an arbitrageur hunt for price inconsistency between the stocks or underlying which are listed in different exchanges and buying the one which has lower value in the one exchange and by selling the underlying or stock in another exchange whose value is higher. FUNCTIONS OF HEDGER, SPECULATOR AND ARBITRAGEUR Hedgers and investors provide the economic substance to any financial market. Speculators provide the useful function of adding liquidity and depth to a market. Arbitrageurs bring price uniformity and help price discovery.