DERIVATIVES AND

RISK
MANAGEMENT
INDEX
INVESTING
Understanding Index
Beta Concept
Hedging
Speculation
Arbitrage
 INDEX

A n i n t r o d u c ti o n

 T h e I n d e x i s a s t a ti s ti c a l m e a s u r e t h a t i s d e s i g n e d t o s u m m a r i z e t h e
price behavio r of unique set o f m arket go ods.
 I n fi n a n c i a l m a r k e t s , I n d e x i s d e fi n e d a s a p o r tf o l i o o f s e c u r i ti e s t h a t
r e p r e s e n t s a p o r ti o n o f t h e o v e r a l l m a r k e t .
 A s t o c k m a r k e t i n d e x i s c r e a t e d b y s e l e c ti n g a g r o u p o f s t o c k s t h a t
a r e r e p r e s e n t a ti v e o f t h e w h o l e m a r k e t o r a s p e c i fi e d s e c t o r o r
segment of the market.
 It is generally expressed in terms of a change from a base value.
 INDEX

S i g n i fi c a n c e o f I n d ex t o I n v e s t o r s

 It indicates the overall performance of a large variety of

d i ff e r e n t p o r tf o l i o s o r s e c u r i ti e s i n t h e m a r k e t .
 I t s e r v e s a s a b e n c h m a r k f o r p o r tf o l i o p e r f o r m a n c e . M a n y
i n v e s t o r s i n c l u d i n g H e d g e F u n d s , P o r tf o l i o M a n a g e r s a n d
Mutual Funds use Index as a measure to evaluate their
performance.
 INDEX

S i g n i fi c a n c e o f I n d e x t o I n v e s t o r s

 It is a lead indicator of the performance of the overall economy

o r a s e c t o r o f t h e e c o n o m y.
 S t o c k i n d e x e s r e fl e c t h i g h l y u p t o d a t e i n f o r m a ti o n .
 I t i s w i d e l y u s e d a s a n u n d e r l y i n g i n s t r u m e n t i n d e r i v a ti v e s
markets all over the world.
 F u t u r e s a n d o p ti o n s o n t h e m a i n I n d i c e s a r e m o r e p o p u l a r t h a n
those on the individual stocks.
 INDEX

D e s i r a b l e a tt r i b u t e s o f a n I n d e x

 It should capture the behavior of a large segment of the

m a r ke t .
 I t s h o u l d i n c l u d e s t o c k s t h a t a r e e s s e n ti a l l y v e r y l i q u i d .
 I t s h o u l d b e a t a l l ti m e s m a i n t a i n e d p r o fe s s i o n a l l y.
 NIFTY 50

 The NIFTY 50 is the flagship index on the NSE.

 The Index tracks the behavior of a portfolio of blue chip companies, the
largest and most liquid Indian securities.
 It has a base period of 3rd Nov, 1995 and a base value of 1000.
 A Nifty stock will have an impact cost of less than 0.5 on a single trade of
Rs.10 crs.
 NIFTY 50

 It captures approximately 65% of its float-adjusted market capitalization and

is a true reflection of the Indian stock market.
 The NIFTY 50 covers major sectors of the Indian economy and offers
investment managers exposure to the Indian market in one efficient portfolio.
 The Index has been trading since April 1996 and is well suited for
benchmarking, index funds and index-based derivatives.
 The NIFTY 50 is owned and managed by NSE Indices Limited (formerly known
as India Index Services & Products Limited-IISL), India’s first specialized
company focused on an index as a core product.
 GLOBAL INDICES

INDEX COUNTRY VALUE

NIFTY INDIA 18,691
DOW JONES USA 33,727
S&P 500 USA 4,348
NASDAQ COMP USA 13,492
FTSE 100 UK 7,461
DAX GERMANY 15,829
CAC 40 FRANCE 7,163
NIKEI 225 JAPAN 32,781
HANG SENG HONK KONG 18,889
 INDEX

D i ff e r e n t t y p e s o f S t o c k M a r ke t I n d i c e s

 M a r ke t C a p i t a l i z a ti o n We i g h t e d I n d e x ( M C W I )
 Free Float Methodology (FFM)
 P r i c e We i g h t e d I n d e x ( P W I )
 E q u a l We i g h t e d I n d e x ( E W I )
 INDEX

M a r ke t C a p i t a l i z a ti o n We i g h t e d I n d e x ( M C W I )

 M a r ke t C a p i t a l i z a ti o n i s t h e c u r r e n t m a r ke t p r i c e
m u l ti p l i e d b y o u t s t a n d i n g s h a r e s .
 E a c h s t o c k i s g i v e n a w e i g h t a s p e r i t s m a r ke t
c a p i t a l i z a ti o n .
 A s t o c k w i t h a h i g h e r m a r ke t c a p w i l l h a v e a h i g h e r w e i g h t
in the Index.
 MCWI Methodology

SR. SCRIPS OLD PRICE SHARES O/S NEW PRICE

NO (IN CRS)
1 Alpha 125 14 350
2 Beta 250 10 400
3 Gamma 375 15 510
4 Delta 185 17 365
5 Epsilon 225 19 435
 MCWI Methodology

Old Old Old value New New New value of

Market cap Weights of Portfolio Market cap Weights Portfolio
(Price*wts) (Price*wts)

1,750 0.1012 12.65 4,900 0.1580 55.29

2,500 0.1446 36.14 4,000 0.1289 51.58
5,625 0.3252 121.96 7,650 0.2466 125.77
3,145 0.1818 33.64 6,205 0.2000 73.01
4,275 0.2472 55.62 8,265 0.2664 115.90
17,295 1.0000 260.01 31,020 1.0000 421.55
 MCWI Methodology

M a r ke t C a p i t a l i z a ti o n We i g h t e d I n d e x ( M C W I )

 T h e o l d I n d e x v a l u e o f t h e p o r tf o l i o i s c o n v e r t e d t o a
base value 100.
 T h e r e f o r e , t h e n e w I n d e x v a l u e o f t h e p o r tf o l i o w i l l b e
421.55/260.01 * 100 = 162.13.
 Free Float Methodology (FFM)

 In FFM only those shares which are readily available for

trading are considered.
 We i g h t s a r e a s s i g n e d a c c o r d i n g t o t h e f r e e fl o a t s a n d
n o t t h e o v e r a l l m a r ke t c a p i t a l i z a ti o n .
 In India both SENSEX and NIFTY values are computed
b a s e d o n f r e e fl o a t .
 Price Weighted Index (PWI)

 In the PWI, a stock is given prominence based on its

price.
 Stocks with a higher price will command more
weightage compared to a lower priced stock.
 T h e D o w J o n e s I n d u s t r i a l A v e r a g e a n d N i k ke i 2 2 5 u s e
t h e P W I m e t h o d o l o g y.
 Price Weighted Index (PWI)

Old Old Old value New Price New New value of

Price Weights of Portfolio Weights Portfolio
(Price*wts) (Price*wts)

125 0.1077 13.47 350 0.1699 59.47

250 0.2155 53.88 400 0.1941 77.67
375 0.3232 121.23 510 0.2475 126.26
185 0.1595 29.50 365 0.1772 64.67
225 0.1940 43.64 435 0.2112 91.86
1160 1.00 261.72 2060 1.00 419.93
 Price Weighted Index (PWI)

 T h e o l d I n d e x v a l u e o f t h e p o r tf o l i o i s c o n v e r t e d t o a b a s e
value 100.
 T h e r e f o r e , t h e n e w I n d e x v a l u e o f t h e p o r tf o l i o w i l l b e
419.93/261.72 * 100 = 160.44.
 Equal Weighted Index (EWI)

 A n E W I m a ke s n o d i s ti n c ti o n b e t w e e n l a r g e a n d s m a l l
companies.
 All stocks are given equal weightage.
 The value of the index is generated by adding the prices
of each stock in the index and dividing that by the total
number of stocks.
 Equal Weighted Index (EWI)

SR. NO. SCRIP OLD PRICE SHARES OS NEW PRICE

(IN CRS)

1 Alpha 125 14 350

2 Beta 250 10 400
3 Gamma 375 15 510
4 Delta 185 17 365
5 Epsilon 225 19 435
Average 232 412
 Equal Weighted Index (EWI)

 The old value of the Index is 232.

 The old Index value is converted to a base value of 100.
 The new Index value will be 412/232*100 = 160.44
 INDEX APPLICATION

I n d e x f u t u r e s c a n b e e ff e c ti v e l y u s e d t o :

H e d g e
S p e c u l a t e
A r b i t r a g e
 INDEX APPLICATION

HEDGING
A h e d g e r i s a n i n v e s t o r w h o t a ke s s t e p s t o r e d u c e t h e r i s k
o f a n i n v e s t m e n t b y m a k i n g a n o ff s e tti n g i n v e s t m e n t .
A h e d g e r t y p i c a l l y o p e r a t e s i n a b u s i n e s s e n v i r o n m e n t
where an unacceptable price risk exists.
H e d g i n g i s t h e r a i s o n d ’ê t r e o f t h e d e r i v a ti v e s m a r ke t .
 Beta Concept

 T h e t o t a l r i s k i n a p o r tf o l i o c o n s i s t s o f t w o c o m p o n e n t s –
t h e s y s t e m a ti c r i s k a n d t h e u n s y s t e m a ti c r i s k .
 U n s y s t e m a ti c r i s k i s t h e r i s k t h a t i s u n i q u e t o a s t o c k t o a
s p e c i fi c i n d u s t r y.
 R a w m a t e r i a l s s h o r t a g e , s t r i ke s , e x o d u s o f q u a l i t y
personnel, increase in input costs etc. are examples of
u n s y s t e m a ti c r i s k .
 U n s y s t e m a ti c r i s k c a n b e r e d u c e d o r m i n i m i z e d t h r o u g h
p o r tf o l i o d i v e r s i fi c a ti o n .
 Beta Concept

 S y s t e m a ti c r i s k i s t h e r i s k o f t h e s y s t e m o r t h e r i s k o f t h e
m a r ke t i n g e n e r a l .
 I n t e r e s t r a t e c h a n g e s , i n fl a ti o n , c u r r e n c y fl u c t u a ti o n s ,
p o l i ti c a l u p h e a v a l s e t c . a r e a l l e x a m p l e s o f s y s t e m a ti c
risk.
 T h e s y s t e m a ti c r i s k c a n n o t b e d i v e r s i fi e d a w a y a n d w i l l
a l w a y s r e m a i n a s l o n g a s t h e p o r tf o l i o i s e x p o s e d t o t h e
m a r ke t s .
 B e t a i s a m e a s u r e o f t h e s y s t e m a ti c r i s k o f t h e p o r tf o l i o .
 Beta Concept

 B e t a i s a s t a ti s ti c a l t o o l t h a t m e a s u r e s t h e s e n s i ti v i t y
of the stock to that of the Index
 Beta is 1, if the Index moves 10% then the stock will
m o v e b y 1 0 % i n t h e s a m e d i r e c ti o n .
 Beta is 1.2, if the Index moves 10% then the stock will
m o v e b y 1 2 % i n t h e s a m e d i r e c ti o n .
 Beta is 0.8, if the Index moves 10% then the stock will
m o v e b y 8 % i n t h e s a m e d i r e c ti o n .
 Beta Concept

 Mathematically, Beta is expressed as the covariance between the

return on the stock and the return on the market divided by the
variance of the return on the market.
 Beta = COVARIANCE(Rj, Rm)
VARIANCE (Rm)
 Rj is the return on stock “j” and Rm is the return on the market.
 Beta Concept

 Beta is also expressed as the correlation between the return on the stock
and the return on the market multiplied by the standard deviation of the
return on the stock divided by the standard deviation of the return on
the market.
 Beta = CORRELATION (Rj, Rm) * STDEV (Rj)
STDEV (Rm)
 HEDGING

 An investor buys 3000 Infosys @ Rs. 1500.

 H i s l o n g p o s i ti o n i n I n f o s y s c a r r i e s m a r ke t r i s k .
 Assuming Beta of 1.2 for Infosys he needs to short
1500*3000*1.2 = Rs. 54,00,000 worth of index.
 NIFTY JAN FUT is trading at 18,055 and the lot size is 50.
 The investor shorts 6 lots of NIFTY i.e., 18,055*50*6 =
Rs. 54,16,500
 HEDGING

I f m a r ke t c o r r e c t s b y 1 0 % , I n f o s y s w i l l c o r r e c t b y 1 2 % s i n c e
it has a Beta of 1.2.
T h e i n v e s t o r l o s e s R s . 5 , 4 0 , 0 0 0 o n h i s l o n g p o s i ti o n i n
INFOSYS.
T h e i n v e s t o r g a i n s R s . 5 , 4 1 , 6 5 0 o n h i s s h o r t p o s i ti o n i n
NIFTY futures.
T h e i n v e s t o r h a s m i n i m i z e d h i s l o s s e s b y h e d g i n g h i s
p o s i ti o n u s i n g t h e I n d e x f u t u r e s . ( R s . 1 , 6 5 0 p r o fi t )
I f h e h a d r e m a i n e d u n h e d g e d , h e w o u l d h a v e l o s t R s .
5,40,000.
 HEDGING

A n i nv e st o r b u y s 6 0 0 0 B h a r ti A i r t e l @ R s . 7 5 0 .
H i s l o n g p o s i ti o n i n B h a r ti c a r r i e s m a r ke t r i s k .
A s s u m i n g B e ta o f 0 . 8 fo r B h a r ti h e n e e d s t o s h o r t
6 0 0 0 * 7 5 0 * 0 . 8 = R s . 3 6 , 0 0 , 0 0 0 wo r t h o f I n d ex F u t u re s .
N I F T Y JA N F U T i s t ra d i n g a t 1 8 , 0 5 5 a n d t h e l o t s i ze i s
50.
T h e i nv e st o r s h o r t s 4 l o t s o f N I F T Y i . e . 1 8 , 0 5 5 * 4 * 5 0 =
Rs. 36,11,000.
 HEDGING

I f m a r ke t c o r r e c t s b y 1 0 % , B h a r ti will correct by 8% since it

has a Beta of 0.8.
T h e i n v e s t o r l o s e s R s . 3 , 6 0 , 0 0 0 o n h i s l o n g p o s i ti o n i n B h a r ti .
T h e i n v e s t o r g a i n s R s . 3 , 6 1 , 1 0 0 o n h i s s h o r t p o s i ti o n i n N I F T Y.
T h e i n v e s t o r h a s g a i n e d a b o u t Rs. 1,100 by hedging his
p o s i ti o n u s i n g t h e I n d e x f u t u r e s .
I f h e h a d r e m a i n e d u n h e d g e d , he would have lost Rs.
3,60,000.
 HEDGING

P r a c ti c a l C o n s i d e r a ti o n s

 Beta is a historical data and there is no guarantee that the

stock will behave in a similar manner going forward.
 Hedging does not necessarily lead to an improved
o u t c o m e . I t o n l y m a ke s a n o u t c o m e c e r t a i n .
 H e d g i n g c a n n o t b e f o r e v e r. I t i s o n l y f o r a s h o r t p e r i o d a n d
f o r s p e c i fi c e v e n t s .
 SPECULATION

S p e c u l a t o r s a r e a c l a s s o f p a r ti c i p a n t s w h o a r e w i l l i n g t o
t a ke r i s k s .
T h e y e n g a g e i n r i s k y fi n a n c i a l t ra n s a c ti o n s t o p r o fi t f r o m
s h o r t t e r m o r m e d i u m - t e r m fl u c t u a ti o n s i n t h e m a r ke t s .
S p e c u l a t o r s p l a y a v e r y v i t a l e c o n o m i c r o l e b y i m p a r ti n g
liquidity into the system.
I t w i l l b e d i ffi c u l t t o i m a g i n e a m a r ke t w h i c h i s t o t a l l y
d e v o i d o f s p e c u l a ti o n .
 SPECULATION

A t r a d e r h a s a b u l l i s h v i e w o n t h e m a r k e t s .
H e i s l o n g 5 l o t s ( 2 5 0 s h a r e s o n N I F T Y J U N i n t h e F & O m a r k e t s
@ 18,716.
M a r g i n r e q u i r e m e n t w i l l b e a b o u t 1 0 % o f c o n t r a c t v a l u e .
N I F T Y e x p i r e s a r o u n d 1 9 , 2 0 0 d u r i n g J U N e x p i r y.
T h e t r a d e r m a k e s a p r o fi t o f R s . 1 , 2 1 , 0 0 0 o n t h i s t r a d e .
(484*50*5).
T h e F & O m a r k e t s o ff e r t r e m e n d o u s fl e x i b i l i t y i n t e r m s o f
leverage to trad ers w ho are willin g to take risks.
H e c a n m a k e a l o s s i f t h e N i ft y I n d e x s t a r t s c o r r e c ti n g .
 SPECULATION

A t r a d e r h a s a b e a r i s h v i e w o n t h e m a r ke t s .
H e s h o r t s 5 l o t s ( 2 5 0 s h a r e s ) o f N I F T Y J A N @ 1 8 , 7 1 6 .
T h e m a r g i n r e q u i r e m e n t w i l l b e a b o u t 8 - 1 0 % o f t h e
contract value.
N I F T Y e x p i r e s a r o u n d 1 8 , 2 0 0 d u r i n g J U N e x p i r y.
T h e t r a d e r m a ke s a p r o fi t o f R s . 1 , 2 9 , 0 0 0 o n t h i s t r a d e .
(5I6*50*5).
I t i s p o s s i b l e t o t a ke b o t h l o n g a n d s h o r t p o s i ti o n s i n t h e
F & O m a r ke t s w i t h m i n i m u m c o s t s .
H e c a n m a ke a l o s s i f N i ft y s t a r t s m o v i n g u p w a r d s .
 ARBITRAGE

A r b i t ra ge u rs a re a c l a s s o f i nve sto rs w h o t r y to
ca pt u re m i s p r i c i n g o f t h e s a m e o r s i m i l a r a s s et
a c ro s s t wo d i ff e rent m a r ket s .
U n l i ke t h e s p ec u l ato r o r t h e h e d ge r, t h e
a r b i t ra ge u r d o e s n o t h ave a ny v i ew o n t h e
m a r ket s .
A n a r b i t ra ge u r t h r i ves o n m a r ket i n effi c i en c i e s .
T h ei r ac ti o n h e l ps ke ep th e m a r ket s effi c i e nt a n d
re sto re s a n i t y w h e n eve r th ere i s a h u ge d evi ati o n
 ARBITRAGE

C o n v e n ti o n a l a r b i t r a g e i n v o l v e s t a k i n g o ff s e tti n g p o s i ti o n s
a c r o s s t w o d i ff e r e n t m a r ke t s o r t w o d i ff e r e n t l o c a ti o n s i . e . ,
BSE/NSE, BSE/CSE etc.
I n t h e f u t u r e s m a r ke t s , a r b i t r a g e i s n o t a c r o s s t w o d i ff e r e n t
p h y s i c a l l o c a ti o n s – i t i s a c r o s s ti m e .
I n f a c t , a r b i t r a g e c a n b e d o n e w i t h i n t h e s a m e p h y s i c a l
l o c a ti o n .
T h e a r b i t r a g e u r c a p i t a l i z e s o n t h e m i s p r i c i n g b e t w e e n t h e
spot prices and the future prices or simply the futures prices
a c r o s s d i ff e r e n t m a t u r i ti e s .
 ARBITRAGE

 NIFTY spot is at 18,700 at the beginning of the month.

 NIFTY one-month futures (JUL) is trading at 18,850.
 The arbitrageur will buy 250 units of NIFTY by buying all
t h e 5 0 s c r i p s i n t h e s a m e w e i g h t a s t h e y a r e i n t h e N I F T Y.
( B a s ke t Tr a d i n g ) .
 The arbitrageur pays Rs. 46,75,000 (18,700 *250) for this
trade.
 ARBITRAGE

H e s i m u l t a n e o u s l y s h o r t s 5 l o t s ( 2 5 0 s h a r e s ) o f N I F T Y J U L
Futures @ 18,850
T h e v a l u e o f t h e s o l d f u t u r e s c o n t ra c t i s R s . 4 7 , 1 2 , 5 0 0
(18,850 *250).
H e h a s l o c ke d - i n a p r o fi t o f R s . 3 7 , 5 0 0 o n t h i s p o s i ti o n
a n d w i l l h a v e t o h o l d i t ti l l e x p i r y.
O n e x p i r y b o t h f u t u r e s a n d s p o t p r i c e c o n v e r g e .
H e w i l l u n w i n d b o t h t h e p o s i ti o n s a n d m a ke a r e l a ti v e l y
r i s k l e s s p r o fi t o f R s . 3 7 , 5 0 0 a t e x p i r y.
T h i s t r a n s l a t e s i n t o a n a p p r o x i m a t e p r o fi t o f 8 0 b p s fo r a
m o n t h ( 9 . 6 0 % a n n u a l i ze d ) .
 ARBITRAGE

Consider two possible scenarios:

Scenario A

NIFTY expires at 18,400

He makes a loss of Rs. 75,000 on his spot transaction.
He makes a profit of Rs. 112,500 on his futures transaction.
Netting-off he will make a gross profit of Rs. 37,500.
 ARBITRAGE

Scenario B

N I F T Y ex p i re s at 1 9 , 0 0 0
H e m a ke s a p ro fi t of Rs. 75,000 on his spot
t ra n s a c ti o n a n d a l o s s o f R s . 3 7 , 5 0 0 o n h i s f u t u r e s
t ra n s a c ti o n .
N e tti n g - o ff h e w i l l m a ke a g ro s s p ro fi t o f R s . 3 7 , 5 0 0 .
T h i s i s p o s s i b l e b e c a u s e at t h e ti m e o f ex p i r y b o t h
s p o t a n d t h e f u t u re p r i c e s c o nv e rg e .
I r re s p e c ti v e o f t h e m a r ke t d i re c ti o n , t h e a r b i t ra g e u r
w i l l m a ke a p ro fi t o f R s . 3 7 , 5 0 0 .
 REVERSE ARBITRAGE

B a ck w a r d a ti o n
At ti m e s d u e to c e rta i n m a rket co ndi ti o ns , t he
f uture s t ra d e at a d i s co u nt to t he spo t p ric e .
T h is is k no w n a s b a c k wa rdati o n.
N I F T Y s po t i s t ra d i n g at 1 8 ,7 0 0 at t he b eg inni ng
o f t he mo nt h .
N I F T Y o ne- m o nt h f u t u res i s t ra ding at 1 8 ,5 0 0 .
T h e ar b i t ra ge u r b e n efi ts f ro m su c h pric e
a no ma li es by i n i ti ati n g a reve rs e ar bit ra ge .
 REVERSE ARBITRAGE

T h e a r b i t ra g e u r w i l l s e l l 2 5 0 u n i t s o f N I F T Y b y
s e l l i n g a l l t h e 5 0 s c r i p s i n t h e s a m e w e i g ht a s t h e y
a re i n N I F T Y.
T h e a r b i t ra ge u r re c e i v e s Rs. 46,75,000 (18,700
* 2 5 0 ) fo r t h i s t ra d e .
H e s i m u l ta n e o u s l y b u y s 5 l o t s ( 2 5 0 s h a re s ) o f N I F T Y
f u t u re s @ 1 8 , 5 0 0 .
T h e va l u e o f f u t u re s c o nt ra c t i s R s . 4 6 , 2 5 , 0 0 0
(18,500 *250).
H e h a s l o c ke d - i n a p ro fi t o f R s . 5 0 , 0 0 0 o n t h i s
re ve rs e a r b i t ra g e p o s i ti o n .
 REVERSE ARBITRAGE

Consider two possible scenarios:

Scenario A

N I F T Y s e tt l e s at 1 8 , 4 0 0 at ex p i r y
H e m a ke s a p ro fi t o f R s . 7 5 , 0 0 0 o n h i s s p o t
t ra n s a c ti o n .
H e m a ke s a l o s s o f R s . 2 5 , 0 0 0 o n h i s f u t u re s
t ra n s a c ti o n .
N e tti n g - o ff h e w i l l m a ke a g ro s s p ro fi t o f R s . 5 0 , 0 0 0 .
 REVERSE ARBITRAGE

Scenario B

NIFTY expires at 19,000

H e m a ke s a l o s s o f R s . 7 5 , 0 0 0 o n h i s s p o t t ra n s a c ti o n
a n d a p ro fi t o f R s . 1 2 5 , 0 0 0 o n h i s f u t u r e s t ra n s a c ti o n .
N e tti n g - o ff h e w i l l m a ke a g ro s s p ro fi t o f R s . 5 0 , 0 0 0 .
T h i s i s p o s s i b l e b e c a u s e a t t h e ti m e o f ex p i r y b o t h s p o t
and the future prices converge.
I r r e s p e c ti v e o f m a r ke t d i r e c ti o n s , t h e a r b i t ra g e u r w i l l
m a ke a p ro fi t o f R s . 5 0 , 0 0 0 .
THANK YOU