Study On High Leverage And Hedging Strategy Finance Essay - Free Essay Example

Sample details Pages: 4 Words: 1339 Downloads: 10 Date added: 2017/06/26 Category Finance Essay Type Essay any type Did you like this example? Trading in Nifty futures is very risk as investor can face heavy loss. Trading requires lot of experience in predicting market. 75% investors in India are small investors, which mean that they concentrate more on leverage. Don’t waste time! Our writers will create an original "Study On High Leverage And Hedging Strategy Finance Essay" essay for you Create order Traders must open an account with brokerage firm and then they can start trading on margin (leverage). Traders have to invest 5% to 10% of the total size of the contract as initial margin to purchase a contract and the rest will be delivered by the brokerage firm. When the market moves leverage can work against the investors and with the investors. If the market moves, then the margin levels are increased and the broker gives an indication to the investors to add additional funds into the account in order to maintain the future position. Nifty future trading expose traders to high leverage which means that they have to invest less and borrow large amount. Leverage = Asset / Equity If Nifty 50 futures trade at Rs 20,000 Then the value of one contract = Rs 20,000 x 25 = Rs 500,000 Initial margin of Nifty futures = 10% x value of the contract = Rs 50,000 Leverage = Rs 500,000 / Rs 50,000 = 10 If the trader has Rs 500,000 in the account can trade one Nifty futu re contract. In this case the leverage will be 1. This is the case of high leverage trading. This means that there will be a 1% chance result in a loss equal to the margin. If the trader has Rs 100,000 in the account then the trader has the choice to trade the future contract with Rs 100,000 from the account and borrowing the rest of the amount from the broker. In this case leverage will be 0.5 (Ranganatham, 2004) High leverage is effective in future contracts, because future contracts are basically carried out in leverage. When leverage increases then the value of the contract also increases as it is directly related to leverage. This point is proved from the equation of leverage. This shows that when there is high leverage then traders have to put less money in the account for purchasing the futures and if the market moves down in the future then the traders has to face less loss in the margin (less loss in the money they have put to purchase the future). (Jay Seth, 2007) 3) Minimizing Risk through Hedging Strategy Index futures are the most important and useful medium for hedging in the Indian market. In commodity and currency markets this is not useful, as the commodity and currency markets are not substitutable with each other. Hedging in Nifty futures is effective only when there is a correlation between changes in prices of the underlying asset and the future contract. Hedging does not always improve the financial outcome, but it reduces the uncertainty. Hedging may be affected by basis risk, which arises because of the differences between the expiration date and the actual selling date of the future contracts. Basis risk arises due to two reasons and they are, asset that is hedged might be different from the one underlying Nifty future contract, and hedger does not know the exact time of the delivery of future contracts. In future contracts there are two types of hedge and they are: 1) Short Hedge 2) Long Hedge Short Hedge It is a process of adding short position to long position. It is a process that protects the traders against decline of price of Nifty future contracts in the underlying assets. The changes in the value of long position in the underlying asset are offset by equal and opposite change in the short position of the underlying asset. This is explained well with the help of an example. The following chart shows that an investor holds portfolio of different companies on December 12, 2003 (Deepak Gupta, 2003, p.10) The investor predicts the market movement in the future and when the investor feels that the market will go down in the future the investor will go short in order to protect against the price risk. Going short means that the investor will sell Nifty futures. Figure 2.4 (Rudhramurty, 2005) The above chart shows that Global Tele has the highest risk (as the beta is high 2.06) as the amount of holding the stock of this company is Rs 200,000. It is important for any investo rs to calculate the number of future contracts for hedging purposes. The number of NIFTY future contracts for hedging purpose is calculated as follows: Figure 2.5(Rudhramurty, 2005) Date Open High Low Close Volume Adjusted Close 9 Dec 03 1646.40 1677.90 1646.40 1675.85 345108500 1675.85 10 Dec03 1675.75 1697.30 1672.65 1686.90 359809900 1686.90 11Dec 03 1,688.35 1,701.70 1,701.70 1,695.40 304,345,700 1,695.40 12Dec 03 1,695.80 1,705.95 1,686.45 1,698.90 299,741,400 1,698.90 The above chart shows the historical prices of Nifty future contracts. Portfolio beta of all the companies mentioned in figure 2.3 is = P1 r1 + P2 r2 + P3 r3 + P 4 r4 Portfolio beta = (Rs 400,000 x 1.55) + (Rs 200,000 x 2.06) + (Rs 175,000 x 1.95) + (Rs 125,000 x 1.9) = 1.61 Nifty futures on December 12, 2003 was 1698.90 Number of Nifty futures = (Total value of portfolio x Beta / Value of Nifty futures on December 12, 2003) Number of Nifty futures = (Rs 1,000,000 x 1.61 / 1698.90) = 947.67 = 948 contracts approximately One Nifty future contract is 200 units. Number of Nifty future contracts required for hedging purpose =948 / 200 = 4.74 = 5 contracts (approximately) Long Hedge Long hedge is a process of adding long future position to short position in the underlying asset. Traders that use long hedge do not own the underlying asset, but they plan to acquire it in the future. It is beneficial to those traders who plan to purchase underlying asset and lock in the purchase price. Long hedge is used to hedge against a short position and this can be proved with the help of an example (Prasanna Chandra, 2004) Assume that in bull market, an investor expects to earn Rs 2,000,000 in 1 month time. If the investor waits for two months to invest then it means that the investor can miss the bull market altogether. The best alternative for the investor in this scenario is to use NIFTY future market. The investor could buy NIFTY futures contract that has amount equal to Rs 2,000,000. This process is called long hedge (Rudhramurty, 2005) The number of future contracts that investor should buy for long hedge is calculated as follows: Assume that on December 12, 2003, the value of NIFTY futures was 1698.90. The investor expects to receive Rs 2,000,000 by the end of January 2004. The investor has to buy June Nifty futures in May and the number of contracts he/she should buy to reduce risk is calculated as follows: Number of contracts = Amount expected by the investor / (1698.90 x 200) = Rs 2,000,000 / (1698.90 x 200) = 5.88 contracts (approximately 6 contracts). Optimal hedging ratios are used to find out the hedging effectiveness of SP CNX Nifty future contracts over a period of December 1, 2003 and January 1, 2004. In this study, Error Correction Model (ECM) is used to estimate the optimal hedging ratios. This model is a linear regression changes on spot price and future price. CRM can be expressed as: ÃÆ'Ã… ½Ãƒ ¢Ã¢â€š ¬Ã‚ St = a + ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² . ÃÆ'Ã… ½Ãƒ ¢Ã¢â€š ¬Ã‚ Ft + u (t) + ÃÆ'‘à ¢Ã¢â€š ¬Ã‚  Where St = Spot price of Nifty Ft = Future price of Nifty ut = Error term ÃÆ'‘à ¢Ã¢â€š ¬Ã‚  = Standard error a= Constant (For Nifty a =0.001388) Optimal hedging ratios are defined as the ratio of difference of variance of unhedged position and the variance of hedged position to the variance of unhedged position. The table below shows the results of ECM. Table: 2.6 (Shivraj, 2004) Putting the above value in the following equation, we have ÃÆ'Ã… ½Ãƒ ¢Ã¢â€š ¬Ã‚ St = a + ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² . ÃÆ'Ã… ½Ãƒ ¢Ã¢â€š ¬Ã‚ Ft + u (t) + ÃÆ'‘à ¢Ã¢â€š ¬Ã‚  0.40 = 0.001838 + ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² x 0.492 + (-0.000483) + 0.001 ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² = Optimal hedge ratio = 0.8103 The slope coefficient ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² is greater than 0.5 and closer to 1, which means that the hedging is highly significant. As the standard error increases the optimal ratio ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² reduces and this shows that the hedging effectiveness reduces as the standard error increases. This answers the research question that hedging has a significant effect on Nifty future trading (Shiv raj, 2004) Effects on Italian Stock Exchange The effect of introducing stock index futures on the volatility of Italian stock exchange was examined through GARCH model. Bologna and Cavallo (2002) used GARCH model to capture the variation of volatility using daily closing price of Milano Italia Borsa stock index (MIB) between December 1, 2003 and January 1, 2004. GARCH model showed there was no destabilization of Italian spot market after the introduction of futures contract in Italy. GARCH model concluded that the volatility of Italian stock market reduced after the introduction of futures contract in Italy due to impact of increased new or recent news (Bologna and Cavallo, 2002)

Personal, Cultural And Spiritual Values - 951 Words

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Book Review of From the Tropics to the Arctic - 756 Words

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Financial and Quantitative Analysis CIMIC

Question: Discuss about the Financial and Quantitative Analysis for CIMIC. Answer: Introduction Business presently face an ever increasing array of accounting issues. The financial reporting landscape needs to be regularly explored by a business to identify issues that matter most. The issues arrange from audit issues, accounting as well as regulatory alterations, and how such issues affect the business or the industry in general. To understand the effects of contemporary issues in accounting, the paper uses the case of Leighton Holding Company (CIMIC) to acknowledge and analyze the contemporary theories along with models in accounting, examining their application to the CIMIC situation. Conceptual Framework The major premise of this report is on the current issues in Australian accounting anchored on the CIMIC. The models and theories in accounting have been identified and their respective application to solve the accounting issues facing CIMIC Company has been given. Some of the key issues facing the Company have been noted as poor governance, lack of disclosure of cash flows and high executive pay packages or remuneration. Three recommendations have also been given in line with both contemporary issues and the issues identified as salient in CIMIC. Objectives of General Purpose Financial Reporting The objective of general purpose of financial reporting is to provide information to the relevant users such as potential investors, lenders, and some creditors on the entitys financial position, performance and cash flow. Leighton Holdings Kickback Scandal CIMICs success in relation to a high number of public infrastructure projects winning like WestConnex remains worrying. The high rates of winning where the market dynamics remain competitive in general correlate historically with low prices of bids, at very least characteristically implying taking more risks. Nevertheless, this might not be true of current situation of CIMIC as it is noted that industry feedback continues to indicate that the firm has been aggressively bidding, may be raising the risks that certain bids have been underpriced. Morgan Stanley has in the past queried the troubled Middle Eastern joint venture of CIMIC called Al Habtoor Leighton Group. It warned that this joint venture had increasingly failed to pay interest on the loans from the Australian construction group this suggesting the need to review the book value of the loans of CIMIC. The Morgan Stanley has target price of 12.4 dollars on CIMIC. The bank subsequently decreased its calendar 2016 forecast for the net profits after tax of CIMIC by fourteen percent to 420.90 million dollars and further dropped CIMICs 2017 and 2018 profit forecasts. CIMIC that report half annual results on July 20, has further guided investors to anticipate net profit in a range of 520-580 million dollars in complete year (Qiong and Jianjun 2011). The senate inquiry has been called to probe CIMIC engagement in 16.8 billion WestConnex project. The former executive, Stephen Sasse has given a damning evidence regarding the corruption that took place within the CIMICs offshore arm, Leighton International. The firms board failed to act on the whistleblowers concerns of 2008-2009 relating to its foreign executives. CPB Contractors, CIMIC subsidiary has won billions of dollars worth of joint contracts from the NSW administration to construct WestConnex motorway. Legitimacy Issue Issues of poor disclosure Exaggerated profits Failure to Poor corporate governance Generous executive remuneration Corruption/bribery issues in winning the construction projects Corruption Failure to generate the underlying cash flow Breach of Code of Ethics The issues raised is that CIMIC seemed to have failed to generate the underlying cash flow notwithstanding reporting net profits after tax of 130 million dollars. The analyst failed to be convinced because the contractors failed to show the same levels of seasonality despite attributing cash out flows of about 327 million dollars to seasonality. The cash flow size was never proportionately declining in line with revenue as it was increasing. Therefore, it is exceedingly hard to adjust for this, however, it might suggest that the reported profit surpassed the underlying supporting cash flow by thirty percent excluding seasonality. The information published by CIMIC contradicts the accounts of CIMICs controlling shareholder Hochtief (Sun and Shin 2014). The Stanley Morgans assessment of Hochtiefs accounts meant that operating cash for the Asia Pacific mainly consisting of activities of CIMIC deteriorated about 19% annually contrary to the CIMICs comments of 28.5% improvement in operating cash flow at first quarter. Corporate Governance failure From agency theory viewpoint, corporate governance describes the process of supervision as well as the control aimed at ensuring that the management of the company acts according to the shareholder's interest. According to ASX principle, remuneration requires that companies need to make sure that remuneration level and composition is adequate as well as reasonable and have a clear linkage to performance. Executive compensation or compensations is a mechanism through which corporate governance ensures that shareholders interest is achieved since remuneration should only be done as a stimulator to performance. Only when the compensation is understood as a stimulant to a performance by the management will the goals of corporate governance be achieved and thus an important influence in business. It can be recommended with regards to the corporate governance for a change. It is noted from the above discussion that CIMIC has poor corporate governance. Therefore, there is an increasing need for the company to adopt the new and contemporary models of corporate governance by linking compensation to performance. The Company should engage in various internal reorganization and align its governance with the current practices. Annual Report Analysis The analysis revealed that margins of CIMIC were defying the descending pattern witnessed at other construction firms, increasing 7.8% in 1st quarter, despite disturbed projects like Macaus Wynn Palace that could see CIMIC hit with liquidated damages along with Royal Adelaide Hospital that was behind schedule. It is questionable how CIMIC managed to report its best margin in a minimum of ten years when all external signs indicating that it potentially had material project issues. It is, however, a self-evident truth that more problem projects fall short of having equal record margins even when portion of the project portfolio remain performing. Financial significance As reflected in the lack of disclosure of in CIMIC of underlying cash flow, this contemporary disclosure is important. In line with the IASBs January 2016 release of the IAS 7 statement of cash flow amendments, AASB in March 2016, gave AASB 2016-2 Amendments to AAS-disclosure initiative to AASB 107. This change is relevant to solving the issues noted in CIMIC relating to the non-disclosure of underlying cash flows. This is because the amendments now makes it mandatory to disclose changes in the financial liabilities of the entity emerging from both cash flow alongside non-cash flow items. Chairmans Report The chairmans report indicates that CIMIC is doing well. The chairman has appreciated everyone in the firm for being of great significance to the firm. He has given them a motivation to continue with their efforts to contribute to the firm. Directors Duties The directors should ensure that the issues raised above are solved to avoid the negative effects they will have on the reputation of the firm. This is because they are salient issues and will thus affect negatively on the reputation of the firm. As has been witnessed in the discussion, the shares has decreased by 17% which is not good for the development of the business. Issues relating corruption, poor governance, disclosure, and executive pay remuneration identified in CIMIC are weighty and hence will give the rivals an added advantage if the directors do not take serious their duties (Fraser et al. 2013). Remuneration Report The primary aim of remuneration is to stimulate performance to ensure the shareholder's interest by attracting the right executives, retaining the right executives as well as motivate executives to maximize long-term firm value. Executive remuneration is, however, misused by some incompetent and opportunistic managers in who use remuneration systems as a motivator to fake the earnings of the firm they manage. Accordingly, remuneration is important since the effects of remuneration systems on performance as well as corporate governance is critical. ACC unit supports this issue by suggesting that remuneration systems which correlate salary of the management the salary of management with financial performance have been acknowledged as a motivator to the management thus increasing financial performance (Kumar and Rabinovitch 2013). Management will, however, be unable to forge the accounts in the long term and since there is an assumption of incompetence in management in the long-run, the positive correlation between financial performance and compensation is less probable. It is; therefore, important understand the link between executive remuneration and corporate governance to correct the deficiencies in corporate governance, decision analysis as well as judgment (Evans 2013). Performance Analysis The shares in thirteen billion construction giant CIMIC Group Ltd has declined 17% following Morgan Stanley analyst reportedly questioned its headline accounting numbers. It has been reported that the firms reported profits might surpass cash profits by thirty percent. The statutory or reported net profits for firms frequently fail to reflect the underlying cash flows of the business since they reflect the non-cash items (Kumar and Zattoni 2016). The veracity of the financial accounts of CIMIC have thus been put into question by Morgan. The stock slumped $5.99 or sixteen percent, to close at $30.25. This followed the revelation by Nicholas Robinson that he could not reconcile cash flows in the first quarter of the companys financial accounts thereby lowering earnings forecasts for 2016-2018. Performance Indicators Additional analysts have further questioned disclosure of CIMIC before along with its poor corporate governance as well as generous salary package for the executive Marcelino Fernandez Verdes, that gains from an increasing stock price. The executive has 1.2 million share appreciation rights which provide him a cash payment thereby reflecting the share price of CIMIC increase from a base price of 17.710 to the price on the trading day before executing the rights that commenced vesting in March. Sustainability Report As reflected in the case of CIMIC above, executives are paid high packages besides stock options. Nevertheless, grants of stock options and restricted stock have been discovered in current compensation models not to be free of cost to the firms and they have been failing to produce desired impact of making top management increasingly vested in long-term objectives. The contemporary practice require executives to buy and hold stock with after tax dollars and variants with similar impacts. Corporate Social Responsibility From the above case, it is now possible to identify the contemporary models and theories linked to executive remuneration, disclosure of profits and underlying cash flow as well as governance and show how they apply to the CIMICs situation as identified above. The AASB has issued amendment for Australian disclosure initiative on extra cash flow statements disclosure. The contemporary cash flow reporting models or ISA 7 will be used to compel the CIMIC to present a cash flow statement as integral component of the firms primary financial statement. This will help understand whether the profit reported by the firm was really actual or exaggerated as noted by Stanley Morgan. In this case, the CIMIC will be required to classify and present cash flow into operating undertakings based on direct or indirect method, investment undertakings and financial undertakings, with the latter 2 classification generally presented on the basis of gross. Another contemporary accounting issue facing CIMIC relates to the executive compensation. There is a need to link compensation to corporate governance. There is an increasing controversy over the executive pay packages. However, what remains clear is that executive compensation along with corporate governance remain inextricably connected and significant effort as well as cost are needed to effectively align incentives and decrease opportunism of every corporate stakeholder. Conclusion The CIMIC needs to employ the current issues of relating to disclosure by including the cash flow statements as an integral part of the primary financial report. This will make it possible for the analysts like Stanley Morgan to reconcile the cash follows. By doing this, the firm will be able to regain its reputation by clearing the negative image already created. The other recommendation relates to executive remuneration should be reviewed to be in line with the contemporary practice. Giving the executive such a huge high package alongside stock option only makes the executives to engage in short run project at the expense of the organization. This is because the executive will not be interested in the interest of the business owner but rather his own interest. Accordingly, he will engage in practices that increase the stock prices so as to get more compensation. References Evans, T. G. 2013. Accounting theory: contemporary accounting issues. Mason (Ohio), Thomson/South-Western. Fraser, I.A., Henry, W.M., House, C.A. and Yards, H., 2013. The future of corporate governance: Insights from the UK. Edinburgh: Institute of Chartered Accountants of Scotland. Kumar, P. and Rabinovitch, R. 2013. CEO entrenchment and corporate hedging: Evidence from the oil and gas industry, Journal of Financial and Quantitative Analysis, 48: 887917. Kumar, P. and Zattoni, A., 2016. Executive Compensation, Board Functioning, and Corporate Governance. Corporate Governance: An International Review, 24(1), pp.2-4. Qiong, H. and Jianjun, D., 2011. Research on Critical Issues in Contemporary Accounting. In Proceedings of the 7th International Conference on Innovation Management. Sun, Y. and Shin, T. 2014. Rewarding poor performance: Why do boards of directors increase new options in response to CEO underwater options?, Corporate Governance: An International Review, 22: 408421.