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)