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1.1 ABOUT THE PROJECT
In this project I have studied about the possible opportunities of arbitrage
available between MCX and NCDEX in the commodity gold.
There exist price differences between the same commodity in twodifferent exchanges. This difference gives rise to arbitraging opportunities in
the commodity.
An arbitrager buys from the exchange where the price is less and sells in
the exchange where the price is more. But he should also consider the cost of
transaction. If the cost of transaction is more than the spread then arbitrage
opportunity is not available. Only if the cost of transaction is less than that of
spread arbitrage is possible.
I have calculated the NET SPREAD keeping in mind the cost of transaction
and found out whether arbitrage opportunities exist or not.
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1.2 WHY COMMODITY GOLD WAS CHOSEN
Gold is the indicator of an economy. A countrys economy is rated by the
gold reserves it has. The supply of money in the economy of India is backed
up by gold.
Moreover gold is considered as the best hedge against inflation. In an
economy where the inflation is rising and the value of money is falling, one
should invest in gold. The value of gold rises with the rise in inflation and
hence provide for hedging against inflation.
The prices of gold depend on a large number of factors and hence it is an
important commodity. The prices rise during the marriage and festivalseason due to heavy demand and they fall after the season is over.
Gold is valued in India as a savings and investment vehicle and is the second
preferred investment after bank deposits. The gold hoarding tendency is well
ingrained in Indian society
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1.3 COMPANY PROFILE
Jaypee Commodities PVT LTD.
Our Mission
At Jaypee, our mission is to provide the investors, traders with
trading opportunities in multiple markets across the globe and proprietary
research and knowledge for effective decision making.
It is our commitment to partner with each of our clients, offer
them personalized service with 24-hour execution using the latest technology
and help in achieving their financial goals using various exchange traded
financial products like stocks, options, futures, ETFs, commodities, foreign
currency on all major securities and futures exchange worldwide. We service
a global network of brokers, investors (new or experienced), and high
volume traders, financial, industrial and agricultural institutions.
Our Beliefs
KnowledgeAwareness Opportunities
We believe that by keeping our clients aware about the markets
and providing them with value added trade information and financial
knowledge we would be able to help them in identifying and takingadvantage of opportunities and achieve their financial return objectives. We
strive to realize the value of a split second for our valued clients, which
furnish exceptional trading opportunities
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Our Dedication
Market are always right.and we respect that
We are dedicated to provide our clients with the latest in
financial trading tools available and adapt ourselves and offer new trading
strategies and opportunities enabling our clients to be successful investors
and traders. We are dedicated to work with you in bull and bear markets,
market ups and downs. We are committed to our people, our clients and our
beliefs.
Unlike a huge conglomerate where a client is only a number at
Jaypee our clients receive personal attention. Our people are dedicated to
providing its clients with best financial brokerage services.
Our Services
The investment philosophy of Jaypee focuses on recommending
buy in companies/sectors that have a growth potential and are technically
strong and recommending to sell in companies/sectors that have lost the
steam or are technically weak. We advise our clients on a daily basis on how
to maximize their returns on the stocks bought/sold by suggesting exit/stop-
loss or re-entry points in the respective stocks/positions of its clients while
keeping in mind their investment objectives, personal financial situation,
time horizon and risk taking ability.
At Jaypee , teams of skilled financial professionals constantly
monitor a whole gamut of investment opportunities in companies so as to
recommend buy/sell on the basis of their analysis and research. The
companies are selected on the basis of various quantitative and qualitative
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factors. Order Execution is our main strength; our endeavor is to get the
"deals done" as soon as you place them. We want our clients to take
advantage of each and every tick movement.
Markets are Always Right! And we respect that
We also believe that the difference between a great investor and
a poor investor is not essentially that the poor investor makes more mistakes
but the difference in their ability to maximize the return from winning trades
and minimize the losses from the mistakes. Through our market research and
analysis we ensure that we are in line with the market, both on the bull and
the bear side, enabling us to maximize returns from winning trades and
minimizing from the mistakes.
Jaypee has the following service areas: -
We provide real-time quotes to our clients ensuring that they do
not miss the bus and have access to reliable data quickly.
Capital Markets Segment
Our firm's operations started in this segment. We have a rich
experience of dealing in this segment.
Derivatives Segment
Our continuous efforts to understand this segment have enabled
us to provide innovative strategies to our clients from which they can
benefit.
Equity Research
We synergize our experience in the trade with expertise of our
research analysts to provide our clients with adequate information.
Client Relations
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We believe in keeping our clients satisfied all the time. We are
known to provide prompt service to our clients. We ensure that clients get a
personalized service that enables them to meet their investment objectives.
Call us for up to date facts and figures on all the stocks before you make
your investment decision. One of our experienced executives will be pleased
to give you an advisory service when you require it.
We offer two types of Broking/Dealing Services: -
Dealing Service
It is our standard level of service where clients can telephone or
Email their orders to us. A trader will confirm the order. The clients can
check back at any time to confirm whether the trade has been executed or
not. A confirmation of the trades will be sent at the end of the trading
session. Payments / deliveries etc. should be sent or picked up by clients.
Advisory Service
A personal trader assigned to you will be responsible for all
your orders and for confirming trades executed. The trader will update you
on any significant movements in the market and your shares. You will be
given our advice on a daily basis to maximize your returns either by buying
or selling or holding the scrips, if you desire. Confirmations may be faxed,
emailed or given on the telephone. We will collect deliveries, cheques and
all other documents for our local clients.
The Jaypee Advantage
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Professional Support
Every Tick Counts !
We are there with you at every step. If you have any questions please feel
free to call or email us.
Direct Access
We provide our clients with 24/7direct access trading and order routing
platform systems and online account view.
Global Presence
We can assist Traders, Institutions and Individual Clients to trade
global equity and commodities markets and Asian exchanges in India and
Dubai.
Multiple Markets
A basket of financial instruments to choose from!
Equities, Options, Commodities, Futures, Metals & Energy etc.
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2.1 INTRODUCTION TO COMMODITY MARKET
Over the modern age of investing, commodity trading has emerged as an
important player in the way that people invest in and speculate. It was
developed as a reaction to the way that business is conducted, and it
continues today in the form of commodities trading online. Many different
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people turn their business know how into a profitable venture, and it is
commodities and futures trading that helps them get there. It might sound
like a strange term, but simply put, commodities are items like, wheat, corn,
gold and silver, and Cattle and Pork Bellies, and Crude Oil. When farmers
take their crop to "market", they are selling commodities. Trading
commodities is the world's one perfect business. The upside potential is
unlimited and you can control the downside. You can trade commodities on
a part time basis or a full-time basis. You can spend as little as an hour or
two a day yet earn a full-time income.I've met people who have started with
a small account and in a short period of time, six months to a year, built their
account up to the point that they have been able to quit their jobs and trade
commodities full-time providing themselves with a very comfortable
lifestyle. Commodities are fascinating. Most people who become traders,
even with a very small account, really never quit following the markets.
Most of the people who trade commodities are just average hard working
people, probably a lot like you who are just trying to supplement their
income and trade on a part time basis.
CommodityBasics:
Commodities are raw materials used to create the products consumers buy, from food to
furniture to gasoline. Commodities include agricultural products such as wheat and
cattle, energy products such as oil and gasoline, and metals such as gold, silver and
aluminum. There are also soft commodities, or those that cannot be stored for long
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periods of time. Soft commodities are sugar, cotton, cocoa and coffee.The commodity
market has evolved significantly from the days when farmers hauled bushels of wheat
and corn to the local market. In the 1800s, demand for standardized contracts for
trading agricultural products led to the development of commodity futures exchanges.
Today, futures and options contracts on a huge array of agricultural products, metals,
energy products and soft commodities can be traded on exchanges all over the
world.Commodities have also evolved as an asset class with the development of
commodity futures indexes and, more recently, the introduction of investment vehicles
that track commodity indexes.
Investor interest in commodities has increased dramatically in recent years as the asset
class has outperformed traditional assets such as stocks and bonds. The performance of
commodities as an asset class is usually measured by the returns on a commodity index,
such as the Dow Jones-AIG Commodity Index, which tracks the return from a passive
investment in 19 different commodity futures contracts. Over a five year period ended
March 31, 2006, the Dow Jones AIG Commodity Index has returned 10.6%, versus
2.6% for the S&P 500. Commodity prices have been driven higher by a number of
factors, including increased demand from China, India and other emerging countries
that need oil, steel and other commodities to support manufacturing and infrastructure
development. The commodity supply chain has also suffered from a lack of investment,
creating bottlenecks and adding an insurance premium and/or a convenience yield to the
returns of many commodity futures. Over the long term, these economic factors are
likely to support continued gains in commodity index returns.The potential for attractive
returns is probably the most obvious reason for increased investor interest in
commodities, but it isn't the only factor. Commodities may offer investors other
significant benefits, including enhanced portfolio diversification and a hedge against
inflation and event risk.Commodities are real assets, unlike stocks and bonds, which are
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financial assets. Commodities, therefore, tend to react to changing economic
fundamentals in different ways than traditional financial assets. For example,
commodities are one of the few asset classes that tend to benefit from rising inflation.
As demand for goods and services increases, the price of those goods and services
usually goes up as well, as do the prices of the commodities used to produce those
goods and services. Because commodity prices usually rise when inflation is
accelerating, investing in commodities may provide portfolios with a hedge against
inflation.Leverage is very important to the commodities markets. Unlike the stock
market, where you might have to invest 10,000 dollars to leverage 10,000 dollars. A
commodities trader can leverage tens of thousands of dollars worth of a commodity for
pennies on the dollar. Also unlike stocks, commodities have intrinsic value and will not
go bankrupt.The futures markets are so crucial to the well being of our nation, that the
government established the Commodity Futures Trading Commission (CFTC) to
oversee the industry. There is also a self-regulatory body, the National Futures
Association (NFA), who monitor the activities of all futures market professionals to
ensure the integrity of the futures markets.Commodities also give the investor the
ability to participate in virtually all sectors of the world economy and have the potential
to produce returns that tend to be independent of other markets. In fact portfolios that
add commodity investments can actually lower the overall portfolio risk by
diversification.
Just about every product that you consume would likely cost dramaticallymore without the commodities futures markets. Because of the intrinsic risks
associated to being in business, lacking the ability to shift risk, a
manufacturer/producer of goods or services would be forced to charge
higher prices, and the consumer would have to pay those higher prices. This
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shifting of risk to someone willing to accept it is called hedging.
Manufacturers could effectively lock in a sales price by going short an
equivalent amount of goods with futures contracts. If a mining company
knew that they were going to sell 1000 ounces of gold in several months,
they could protect themselves for a future price decline by going short 10
gold futures contracts today. If the price of gold fell by $30 in the following
months, they would receive that much less in the cash marketplace for their
gold, but earn that much back when they offset their short gold futures
position. The futures price will eventually become the cash price. A user or
buyer of goods can use the futures market in the same manner. They would
need to protect themselves from a future price increase, and therefore go
long futures contracts.The person willingly accepting a risk does so because
of the opportunity to profit from price movements, this is known as
speculating. The cotton in your shirt, the orange juice, cereal and coffee you
had for breakfast, the lumber, copper and mortgage for your home, the gas or
ethanol that you put in your car all would be priced many times higher
without the participation of speculators in the futures markets. Through
supply and demand market forces, equilibrium prices are reached in an
orderly and equitable manner within the exchanges, and world economies,
and you, benefit tremendously from futures trading.
Many new commodity traders mistakenly believe that commission rates will
have a greater impact on their trading success than the markets themselves.
Reasonable full service rates are not usually the cause for losses. Bad trades
are the cause for most losses. Many new traders begin trading commodities
with a discount account and rationalize that their trading accounts are
discount so why not do the same for their commodity account.The most
important question to ask is, Will a discount broker monitor your account to
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make sure you dont make a costly mistake? Other questions to ask are:
"Will they let you know that your sell order you are trying to place will
initiate another short future because you meant to offset a short with a buy
not a sell to exit your trade? Will they alert you to the fact that there is a
major USDA grain report coming out before you place your grain order?
Will they call you and let you know that your options have just 1 week
before they expire?" All of the examples above can be very costly to the new
trader. The answers to all of the questions above is no, because discount
brokers are not paid enough to do so.
What qualities do you want your commodity broker to have?
1. Experience- Always make sure that your commodity broker has
seen both bull and bear commodity markets. Also make sure that your
commodity broker does not have a habit of being in trouble with the
National Futures Association.
2. Honest dialogue- Does your commodity broker call you when
you are down in a trade as readily as when you are in a winner? Does
your broker only call to ask you to send in more risk capital?
3. Availability during market hours- Is your commodity broker
very often in a meeting or on the other line when you are trying to
reach them during the trading day? Are your calls returned in a prompt
and
professional manner?
There are many variables to consider when opening an account with a new
commodity broker.
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First you should fully research and understand the inherent risks involved in
commodity investments and decide how much risk capital is appropriate for
your financial situation. Second, you must decide what type of commodity
broker services you will need to achieve your trading objectives. Then you
must decide what type of account will be appropriate for you.
There are several types of services and accounts to choose from:
Full service account. A full service account is where a professional
commodity broker suggests trades for your account, monitors your account,
services your account and lets you know if its time to cut losses or lock
in profits on a particular trade. These are non discretionary which means that
the commodity broker will not buy or sell at their own discretion or without
your approval. Because of the additional time and effort involved
in these accounts commissions are usually highest for full service accounts.
Check the commission schedule before trading. This type of account is for
investors that want to participate in commodities but lack the time and
inclination to trade based on their own research and opinions.
Broker assisted account. This type of account is for an investor that knows
what they want to trade but want to call it into a commodity broker to place
the trade just so there are no order mistakes and to have brief dialogue with a
commodity broker. Order errors can be costly. This type of service also
allows for brief conversations with your commodity broker. This account is
the happy median between using a full service commodity broker or a
discount commodity broker.
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what was going on in the war, and was also affected by the likelihood that
Saddam Hussein would be able to retain control of Iraq. For other
commodities such as crops, weather plays an extremely significant
role in price changes. If the weather in a certain region is going to affect the
supply of a commodity, the price of that commodity will be affected irectly.
As with other securities, many traders use commodity futures to speculate on
future price movements. These investors analyze various events in the
market to speculate on future supply and demand. They subsequently
enter long or short futures positions depending on which direction they
believe supply and demand will move.
Most traders when asked, say that they generally use Daily Commodity price
charts. Maybe out of habit, or because most end up trading at that time level
that this has become popular. Because most traders focus on the Daily or
Intraday Commodity charts by a much larger margin than the Weekly or
higher time frames, you can see this in the more erratic pattern formations
found in these lower time frame charts as traders place their buy and sell
orders to make market. The Weekly chart is a much more concentrated look
of mass psychology as opposed to the Daily chart. For the sake of example
only, say each day brings 100,000 traders to the market and each only makes
one trading act per day. That would mean that each price Daily price bar
represents the mass psychology of 100,000 minds making 100,000 market
actions. In contrast, a single Weekly price bar then would represent 500,000
minds making 500,000 market actions. Now, if you consider that 1 inch of a
price chart may hold about 10 price bars, that 1 inch of market patterns is
representing 1,000,000 minds and market actions for the Daily price pattern,
but 5,000,000 for the same amount of space on the Weekly chart. When you
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consider the word 'Mass', which has more of it? The Weekly chart of course!
If you find yourself spending more time using the Daily charts to analyze the
commodity markets for trading, and you are not daytrading, it is advisable
that you consider seeing the bigger and more accurate picture of market
direction by using the Weekly commodity chart.
Capturing the full benefits of commodity exposure has been a challenge in
the past. Investing in physical commodities such as a barrel of oil, a herd of
cattle or a bushel of wheat is of course, quite impractical, so investors have
tended to look for commodity exposure either by purchasing commodity
related equities or through actively managed futures accounts.
The onset of investment vehicles that track commodity futures indices has
provided investors with another option for gaining exposure to commodities
that may offer better potential to capture the full benefits of the asset class.
Investment vehicles that track commodity futures indices are not the same as
actively managed futures accounts. Instead, commodity index returns
provide passive exposure to a broad range of commodities. For example, the
Dow Jones AIG Commodity Index tracks the futures price of 19 different
commodities, including energy, livestock, grains, industrial metals, precious
metals and soft commodities. Changes to the composition of the index are
determined by preset rules rather than a managers discretion.One advantage
of commodity exposure that tracks a broad index is that commodities are not
highly correlated with each other and index returns should be less volatile
than the returns on an individual commodity. Another advantage is that
commodity indexes themselves have existed for decades, providing ample
historic data for asset allocation studies and research.
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Commodities markets have gained wide popularity among investors because
of their enormous size and transparencies turn over of commodities market is
many times to that of the securities of securities essential because the
commodities traded in commoditymarket are essential and are of daily use
Also it is not false in case of Indian financial market. Commodity trading
and commodity markets are not new to India and its all hundred years old in
India. Earlier years we have used forward contract trading at regional level
in the commodity market. Introduction of innovative derivative products like
Futures and Option in this market gives newer face to commodity market.
In Indian commodity market a future trading was introduced from year 2003
by starting of national level Commodity exchanges. A future trading is
defined as 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 arestandardized exchange-traded contracts. The following three broad
categories of participants - Hedgers are interested in transferring risk
associated with transacting or carrying underlying physical asset. They use
commodity futures to reduce or limit the price risk of transacting underlying
physical asset. Speculators are interested in making money by taking view
on future price movements. Commodity futures allow speculators to create
high leveraged position to undertake calculative risk with the objective of
correctly predicting the market movement.s Arbitrager are interested in
locking in a minimum risk less profit by simultaneously entering into
transactions in two or more markets. Arbitragers lock in profit when they
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spot cash and carry arbitrage opportunity or reverse cash and carry arbitrage
opportunity.
In this project report I mainly concentrated towards the Arbitragers. Initially
by studying the commodities trading in the Indian commodity futures market
or exchanges especially agri commodity. For the arbitragers arbitrage
opportunity may exist in different way like mis-pricing in the spot and future
exchange, inter exchanges (Between the two exchanges).
Conclusion
Commodities are a distinct asset class with returns that are for the most part
independent of stock and bond returns. Therefore, investing in commodities
can help diversify a portfolio of stocks and bonds, lowering risk and possibly
boosting returns. Reaching this level of diversification has been made easier
with the development of investment products that passively track a broad
range of commodities.
2.2 INTRODUCTION TO DERIVATIVE MARKET
Introduction to Derivatives
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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 lockingin
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.
Definition of Derivatives
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.
In the Indian context of the Securities Contracts (Regulation) Act, 1956
(SC(R) A) defines derivative to include
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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.
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.
Derivatives Markets
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 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 pre-arranging 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.
Types Derivatives Market
Derivative markets can broadly be classified as commodity derivative
market and financial derivatives markets. As the name suggest, commodity
derivatives markets trade contracts 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.
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Financial derivatives markets trade contracts that have a financial asset or
variable as the underlying. The most popular financial derivatives are those,
which have equity, interest rates and exchange rates as the underlying.
Financial derivatives are used to hedge the exposure to market risk.
The commodity derivatives differ from the financial derivatives mainly in
the following two aspects
Firstly, due to the bulky nature of the underlying assets, physical
settlement in commodity derivatives creates the need for warehousing.
Secondly, in the case of commodities, the quality of the asset
underlying a contract can vary largely.
Products, Participants and Functions
Products
Derivative contracts have several variants. The most common variants are
Forwards
Futures
Options
Swaps
Forwards
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A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at todays pre-agreed
price.
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
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.
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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
Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap.
Rather than have calls and puts, the swaptions market has receiver swaptions
and payer swaptions. A receiver swaption is an option to receive fixed and
pay floating. A payer swaption is an option to pay fixed and receive floating.
Other variants of Derivative Contracts are
Warrants
Leaps
Baskets
Warrants
Options generally have lives of up to one year the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-
dated options are called warrants and are generally traded over-the-counter.
Leaps
The acronym LEAPS means Long-Term Equity Anticipation Securities.
These are options having a maturity of up to three years.
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Baskets
Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average of a basket of assets. Equity index options
are a form of basket options.
Participants
The following three broad categories of participants
Hedgers
Speculators
Arbitrageurs
Hedgers
Hedgers are interested in transferring risk associated with transacting orcarrying underlying physical asset. They use commodity futures to reduce or
limit the price risk of transacting underlying physical asset.
Speculators
Speculators are interested in making money by taking view on future price
movements. Commodity futures allow speculators to create high leveraged
position to undertake calculative risk with the objective of correctly
predicting the market movement.
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Arbitragers
Arbitragers are interested in locking in a minimum risk less profit by
simultaneously entering into transactions in two or more markets.
Arbitragers lock in profit when they spot cash and carry arbitrage
opportunity or reverse cash and carry arbitrage opportunity.
Function
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 derivatives market performs a number of economic functions.
First, prices in an organized derivatives market reflect the
perception of market participants about the future and lead the prices of
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underlying to the perceived future level. The prices of derivatives converge
with the prices of the underlying at the expiration of the derivative contract.
Thus derivatives help in discovery of future as well as current prices.
Second, the derivatives market helps to transfer risks from those
who have them but may not like them to those who have an appetite for
them.
Third, derivatives, due to their inherent nature, are linked to the
underlying cash markets. The underlying market witnesses higher trading
volumes because of participation by more players who would not otherwiseparticipate for lack of an arrangement to transfer risk.
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 kinds of mixed markets.
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 bright, creative, well-
educated people with an entrepreneurial attitude. They often energize othersto create new businesses, new products and new employment opportunities,
the benefit of which are immense. Finally, derivatives markets help increase
savings and investment in the long run. Transfer of risk enables market
participants to expand their volume of activity.
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Derivatives trading in India
The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which
withdrew the prohibition on options in securities. The market for derivatives,
however, did not take off, as there was no regulatory framework to govern
trading of derivatives.
SEBI set up a 24member committee under the Chairmanship of
Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory
framework for derivatives trading in India. The committee submitted its
report on March 17, 1998 prescribing necessary preconditions for
introduction of derivatives trading in India. The committee recommended
that derivatives should be declared as securities so that regulatory
framework applicable to trading of securities could also govern trading of
securities.
SEBI also set up a group in June 1998 under the Chairmanship of
Prof.J.R.Varma, to recommend measures for risk containment in derivatives
market in India. The report, which was submitted in October 1998, worked
out the operational details of margining system, methodology for charging
initial margins, broker net worth, deposit requirement and realtime
monitoring requirements.
The SCRA was amended in December 1999 to include derivatives within the
ambit of securities and the regulatory framework were developed for
governing derivatives trading. The act also made it clear that derivatives
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shall be legal and valid only if such contracts are traded on a recognized
stock exchange, thus precluding OTC derivatives. The government also
rescinded in March 2000, the threedecade old notification, which prohibited
forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted
the final approval to this effect in May 2000. SEBI permitted the derivative
segments of two stock exchanges, NSE and BSE, and their clearing
house/corporation to commence trading and settlement in approved
derivatives contracts. To begin with, SEBI approved trading in index futures
contracts based on S&P CNX Nifty and BSE30 (Sensex) index. This was
followed by approval for trading in options based on these two indexes and
options on individual securities.
The trading in index options commenced in June 2001 and the trading in
options on individual securities commenced in July 2001. Futures contracts
on individual stocks were launched in November 2001. Trading and
settlement in derivative contracts is done in accordance with the rules,
byelaws, and regulations of the respective exchanges and their clearing
house/corporation duly approved by SEBI and notified in the official gazette.
Commodity Future Trading
Introduction to commodity futures
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A commodity futures contract is an agreement between two parties to buy or
sell a specified quantity and quality of commodity at a certain time in future
at a certain price agreed at the time of entering into the contract on the
commodity futures exchange.
Objectives and benefits out of commodity futures are as follows
Hedging - price risk management by risk mitigation
Speculation - take advantage of favorable price movements
Leverage - pay low margin to enjoy large exposure
Liquidity - ease of entry and exit of market
Price discovery - for making farming and business decisions
Price stabilization along with balancing demand and supply position
Facilitates integrated price structure
Flexibility, certainty and transparency in purchasing commodities
facilitate bank financing.
Facilitates 'informed' lending to the banks
Need for Futures Trading in Commodities
Commodity Futures, which forms an essential component of Commodity
Exchange, can be broadly classified into precious metals, agriculture, energy
and other metals. Current futures volumes are miniscule compared to
underlying spot market volumes and thus have a tremendous potential in the
near future.
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1. Futures trading in commodities results in transparent and fair price
discovery on account of large-scale participations of entities
associated with different value chains. It reflects views and
expectations of a wider section of people related to a particular
commodity.
2. It also provides effective platform for price risk management for all
segments of players ranging from producers, traders and processors to
exporters/importers and end-users of a commodity.
3. It also helps in improving the cropping pattern for the farmers, thus
minimizing the losses to the farmers.
4. It acts as a smart investment choice by providing hedging, trading and
arbitrage opportunities to market players. Historically, pricing in
commodities futures has been less volatile compared with equity and
bonds, thus providing an efficient portfolio diversification option.
5. Raw materials form the most key element of most of the industries.
The significance of raw materials can further be strengthened by the
fact that the "increase in raw material cost means reduction in share
prices". In other words "Share prices mimic the commodity price
movements".
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6. Industry in India today runs the raw material price risk; hence going
forward the industry can hedge this risk by trading in the commodities
market.
Commodities Suitable for Future Trading
The following are some of the key factors, which decide the suitability of the
commodities for future trading: -
1. The commodity should be competitive
There should be large demand for and supply of the commodity
- no individual or group of persons acting in concert should be in a position
to influence the demand or supply, and consequently the price
substantially.
2. There should be fluctuations in price.
3. The market for the commodity should be free from substantial
government control.
4. The commodity should have long shelf life and be capable of
standardization and gradation.
Pricing of Future Trading Commodity
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Cost of carry M ethod
The relationship between cash price and futures price can be explained in
terms of cost of carry. Cost of storage, cost of insurance and cost of
financing constitute cost of carry. Cost of carry is an important element in
determining pricing relationship between spot and futures prices as well as
between prices of futures contracts of different expiry months.
When there is expected shortage of physical commodity in the future then
additional cost of holding the commodity is added to the spot price besides
cost of carry which is termed as Convenience Yield.
Basis and Spreads
Basis means difference between cash price of the asset and future price of
the underlying asset. Basis can be negative or positive depending upon
prices prevailing in cash market and future market.If cash price is less than future price than basis is negative.
If cash price is more than future price than basis is positive.
Spread means difference in prices of two futures contracts. Spread can be
classified as intra commodity spreads and inter commodity spreads. Intra
commodity spreads means difference in price between two futures contracts
of different expiry months of the same commodity. Inter commodity spread
means difference in price of two different commodities with same expiry
month.
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2.3 INTRODUCTION TO ARBITRAGE
A central idea in modern finance is the law of one price. This states that in a
competitive market, if two assets are equivalent from the point of view of
risk and return, they should sell at the same price. If the price of the same
asset is different in two markets, there will be operators who will buy in the
market where the asset sells cheap and sell in the market where it is costly.
This activity termed as arbitrage, involves the simultaneous purchase andsale of the same or essentially similar security in two different markets for
advantageously different prices (Sharpe & Alexander 1990). The buying
cheap and selling expensive continues till prices in the two markets reach
equilibrium. Hence, arbitrage helps to equalize prices and restore market
efficiency. Theoretical arbitrage requires no capital, entails no risk and
appears to be an easy way of earning profits. However, realworld arbitrage
calls for large outlay of capital, entails some risk and is a lot more complex
than the textbook definition suggests.
The science of arbitrage
Arbitrage pricing is one of the most important concepts in modern finance.
The origins of this lie in the efficient market hypothesis. In this section we
take a look at some literature on arbitrage and discuss the theory, operational
aspects and impediments to arbitrage.
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Efficient markets hypothesis
Efficient markets hypothesis states that the price of a security must be equal
to the expected present value of the future cash flows on that security. In
other words, it states that the price of a security must be equal to its
fundamental value. The two central assumptions of the efficient market
hypothesis are:
1. Investors hold rational expectations
2. Arbitrage brings prices towards fundamentals
In an efficient market there are no profitable arbitrage opportunities.
Proponents of the efficient markets hypothesis, like Fama (1965) and Ross
(2001) maintain that rational arbitrageurs will undo any mis-pricings in the
market. By buying under priced securities and selling overpriced ones,
arbitrageurs ensure that security prices converge to their fundamental values
thereby restoring market efficiency. However, the efficient market
hypothesis assumes that arbitrage strategies are risk less and do not involve
capital outlay. Hence professional arbitrageurs are willing to take unbounded
positions in the market. In reality however, arbitrage involves risk. An
arbitrage strategy is risky even if rational traders care only about the final
payoff of the arbitrage strategy. In other words, an arbitrage trade is risk less
only if a perfect substitute for the mis-priced asset exists. Arbitrageurs can
rarely fully hedge their arbitrage strategies. Recent literature on the limits to
arbitrage has identified two broad categories of risk:
1. Fundamental risk and
2. Noise trader risk.
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An arbitrage strategy can be risky because the fundamental value of a
partially hedged portfolio might change over time. Besides, the arbitrageurs
model may often not coincide with the true datagenerating process. Thus,
arbitrageurs have to bear fundamental risk even if they can sustain the
arbitrage strategy until the final payoff is realized.
In addition to this, the activity of behavioral noise traders might lead to
temporary price movements. These price changes temporarily reduce the
value of the arbitrage portfolio as prices move even further from
fundamental values. If arbitrageurs are compelled to liquidate their positions
in the intermediate term, then they are forced to take losses when the
arbitrage opportunity is greatest. This is called the noise trader risk.
In Shleifer & Vishny (1997), fund managers limit their arbitrage out of fear
of a drawdown. Fund managers are afraid that their investors will withdraw
their money if they suffer intermediate shortterm losses even though the
arbitrage provides a risk less positive payoff in the longrun. This paper
builds on the insight that distorted prices might become even more distorted
in the short run before eventually returning to their normal long run values.
Impediments to arbitrage
In its purest form, arbitrage requires no capital and is risk free (Dybvig &
Ross 1992). By simultaneously selling and purchasing identical assets at
different prices, the arbitrageur captures a profit with no upfront capital.
Unfortunately, pure arbitrage exists only in perfect capital markets. In the
real world, imperfect information and market frictions make arbitrage both
capitals intensive and risky. They impede arbitrage in two ways.
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1. When there is uncertainty over the nature of an apparent mis-
pricing, and additional learning involves a cost, arbitrageurs may be
reluctant to incur the potentially large fixed costs of entering the business of
exploiting the arbitrage opportunity (Merton 1987). Uncertainty over the
distribution of arbitrage returns, especially over the mean, will deter
arbitrage activity until wouldbe arbitrageurs learn enough about the
distribution to decide whether the expected payoff from the arbitrage is large
enough to cover the fixed costs of setting up shop. Even with active
arbitrageurs, opportunities may persist while the arbitrageurs learn to exploit
them.
2. Once the fixed costs of implementing the arbitrage strategy are
borne, imperfect information and market frictions often encourage
specialization. Specialization limits the degree of diversification in the
arbitrageurs portfolio and causes him to bear idiosyncratic risks for which
he must be rewarded. For instance, if there is a purely random chance that
prices will not converge to fundamental value, a highly specialized
arbitrageur who cannot diversify away this risk will invest less than one who
can. Even if prices eventually converge to fundamental values, the path of
convergence may be long and bumpy. While waiting for the prices of the
mis-priced securities to converge, they may temporarily diverge. If the
arbitrageur does not have access to additional capital when the security
prices diverge, he may be forced to prematurely unwind the position and
incur a loss (DeLong, Shleifer, Summers &Waldmann 1990), (Shleifer &
Summers 1990), (Shleifer & Vishny 1997). The prospect of incurring this
loss will further limit the amount that a specialized arbitrageur is willing to
invest.
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Capital intensive nature of arbitrage
Realworld arbitrage requires putting up huge capital for a short period of
time. Take the case of cash and carry arbitrage. In order to capture the mis-
pricing, the arbitrageur sells the overpriced futures, buys the underlying
stocks and holds them till the maturity of the futures contract. Buying the
underlying stock requires huge amount of capital. Very often due to lack of
capital, it is not possible for the arbitrageur to take delivery and hold stocks.
Hence small arbitrageurs are forced into intra-day arbitrage.
Arbitrage hinges on capturing profits due to mis-pricing on the market. The
underlying assumptions are that at some stage the mis-pricing will be wiped
out and prices will return to their fair value. This is when the arbitrageur
receives his profits. However it may often happen that prices do not correct
themselves immediately. There could be situations where the mis-pricing
worsens, in which case the arbitrageur would be required to bring in more
capital by way of margins. Even if eventually the prices of the two contracts
converge and the arbitrageur makes money, in the short run he loses money
and needs more capital. Arbitrageurs face difficulties in raising funds at
short notice. Very often an arbitrage strategy that is entered into is reversed
before the end of the contract. This is known as early unwind.
Operational issues in arbitrage
In situations where it is possible to exploit mispricing risklessly by
generating perfectly hedged positions and holding on to them till the final
payoff, the following operational aspects need be noted before entering into
an arbitrage.
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1. For the arbitrage to be a riskfree process, the arbitrageur must
trade simultaneously across two markets. In efficient markets, arbitrage
opportunities last for very short periods. As arbitrageurs spot these
opportunities and act upon them, the arbitrage gets wiped out. The fastest
instances of arbitrage opportunities being wiped out, are those seen in the
foreign exchange market. This market trades currency in large volumes, so
what seems like a small mispricing can often translate into huge profits.
2. Trading involves transactions costs. These transactions costs and other
market imperfections create a no arbitrage band around the fair value of an
asset. Hence the arbitrage opportunity must be sizeable enough to generate a
profit over and above the costs involved. Not all mispricings are profitable
arbitrage opportunities. However the potential returns net of transportation
costs and other overheads were clearly not attractive enough for arbitrageurs
to step in. Risks in arbitrage in India
The basic principles of an arbitrage strategy are straightforward if an asset
trades at two different prices across two markets, buy where it trades cheap
and sell where it trades expensive. This textbook arbitrage assumes a
frictionless world where arbitrage profits can be made without putting up
capital and without bearing any risk. In reality however, almost all arbitrage
requires capital and carries some risk. Shleifer & Vishny (1997) argue that
the textbook notion of arbitrage does not describe realistic arbitrage trades.
These discrepancies become particularly important when arbitrageurs
manage other people money. In India the risks become even more
pronounced due to existing market frictions.
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Arbitrage is an often-used term in share markets. The arbitrager is an
important intermediary that helps in price discovery mechanism in all
markets be it equity, money forex or derivatives. There are three important
participants that are important in a cash market, the speculator, arbitrager
and an investor. In futures market the investor is replaced by a hedger.
Arbitrager and Speculator are often confused and both are termed as
Speculators. In this article I wish to explain the difference between the two
and show how arbitrage works in the market and its influence on market
volatility. Arbitraging in India has been going on for several years. Initially
arbitrage activity was between Stock Exchange Mumbai and all other
regional exchanges. Mr. Babulal Bagri the founder of BLB Securities and
Mr. Manubhai Maneklal were legendary arbitragers of that era. They traded
between Mumbai, Delhi and Kolkatta markets. Arbitraging in those days
was done manually and not on any online system. The way the fingers of
these brokers flew on telex machines giving trade instructions was an
experience by itself. Then it shifted to cashing on price difference between
NSE and BSE limited. Today large amount of arbitrage happens between
cash and derivative markets. Arbitrage is also possible between the current
month and near or far month contracts. In case of Commodity exchanges
also there is an arbitrage opportunity between the local cash markets or
mandis and the future markets which are popularly known as National
Commodity Exchanges. Speculator is one who gives liquidity to the markets.
The buyers and sellers may not often decide at the same time to buy or sell a
security. There is a time gap as well as a difference in price and quantity at
which the buyer and seller intend to do a transaction. The speculator fills this
time gap and gives quotes to buyers as well as sellers on
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a continuous basis. This imparts liquidity to the market since each order has
a counter offer from a speculator even if there is no counter party to match
the order. The arbitrager is one who plays the role of balancing the price
differences across the markets. The markets may be two exchanges trading
in the same product or two segments such as cash and derivatives or across
international markets and local markets. The arbitrager continuously tracks
prices across the chosen segment are momentary price differences in two
markets due to difference in level of information as well as demand supply
situation in the market. These price differences are an opportunity for the
arbitrager. The arbitrager has money power at his disposal. He takes
deliveries in a particular market segment and is able to give deliveries in
another market segment. There is a time gap between giving and taking
deliveries. He holds the stock for this time and earns an interest on the funds
invested which comes by way of price differential between buy and sell
rates. The arbitrager has a particular interest return as his target. He does not
have any open positions and all his purchases or sells in a particular market
segment have a counter position in another market segment. At the net level
his position is always zero. This is how the arbitrager earns a risk free return.
The arbitrager does not always wait for the expiry of the contract or the
settlement of the transaction. They may reverse the position before the
actual settlement date even if they have to compromise on some percentage
of the price difference earned by them. Lesser return is acceptable if it is
earned with smaller or no investment. All decisions are taken with
reference to a benchmark targeted return To give example of an arbitrage
transaction, assume that the arbitrager has Rs.10 lacs available for doing
arbitrage activity. His targeted return is say 18% p.a. which works to about
1.5% p.m. We will take a simplistic transaction where he does just one trade
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to earn the return. If some share is quoting at Rs.1000 in one cash market he
will look for opportunity to buy at Rs.1000/- and sell at Rs.1015/- or more
in another cash market simultaneously. These markets must have different
settlement dates otherwise in current rolling settlement scenario it is not
possible to give and receive delivery since both happen on the same day.
Now the same example can be extended to cash and derivative segment.
Shares are purchased in cash market; and sold in futures market. Delivery of
the shares is received in the rolling settlement. Since deliveries are not
permitted in futures market a reversal pportunity is looked for before the
expiry of contract, otherwise the arbitrager will be left with the delivery of
shares. Hence if he gained say Rs.25 per share on the first leg he will reverse
the trade upto a loss of Rs.10 in order to achieve his benchmark return of
Rs.15. The returns are not often as fantastic but opportunities are many. We
also have to deduct from this the cost of brokerage, Securities transaction
tax, stock exchange charges and stamp duty. Hence it becomes unviable for
an investor unless the transaction costs are very low. The price difference is
only for a few minutes or seconds hence it must be captured instantly
through a speedy trading system. It should not so happen that one transaction
is done and the other one does not go through i.e. if the arbitrager buys and
is unable to sell and the market falls then instead of making a profit he will
end up with a loss. Automated trading programs are used in order to release
both orders so that both the prices are captured simultaneously.
Arbitrage activity thus adds to liquidity in the markets and also helps in
balancing the prices of same shares across various markets. Prices
continuously balance out once the differences are cash upon. Arbitrage helps
in reducing volatility in markets since continuous flow of orders reduces
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For example, suppose a futures contract is traded on two different
exchanges. If, Futures price = Spot price + Holding
F = S + C
However if
If F> (S + C) or F< (S + C), then arbitrage opportunity exists.
The futures price is calculated as follows:-
Example
Futures price of 100 gms of silver one-month down the line i.e. a contract
expiring 30th November is computed as follows:
What is the spot price of silver? The spot price of silver, S= Rs. 7000/kg
What is the cost of financing for a month? rT, cost of financing for a
month, 15% annualized = ln(1.15)*30/365
What are the holding costs? Assume storage cost, C = 0
The fair value of futures price, F=S*exp(rT) + C = 700 *
exp(ln(1.15)*30/365) = Rs. 708
If the contract was for a three-month period i.e. expiring on 30th January, the
cost of financing would increase the futures price. Therefore, the futures
price would be
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F = 700 * exp(ln (1.15)*90/365) = Rs. 725
In case of calculation of the price of future contracts on equities there is no
cost of storage considered in holding paper, however equity paper comes
with a dividend stream, which is a negative cost if you are long on the stock,
and a positive cost if you are short the stock.
C = financing cost - dividends
Thus, a crucial aspect of dealing with equity futures as opposed to
commodity futures is an accurate forecasting of dividends. The better the
forecast of dividend offered by a security, the better is the estimate of the
futures price.
For example
What is the fair value of a two-month S&P CNX Nifty futures contract
expiring on April 25?
What is the annual dividend yield on S&P CNX Nifty index? The dividend
yield on S&P CNX Nifty, 2% annualized = ln(1.02)*60/365
What is the spot value of S&P CNX Nifty? Current value of S&P CNX
Nifty is 910
What is the cost of financing for two months? RT, cost of financing for a
month, 15% annualized = ln(1.15)*60/365
What are the holdings costs? Assume storage cost, C=0
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The fair value of futures price, F=S*exp(ln(1+r-q))*T + C = 910 *
exp(ln(1.13)*60/365) = Rs. 928.47
Arbitrage helps investors to lend funds into the stock market, without
suffering the slightest risk. In the traditional methods of loaning money into
the stock market there is a price risk or credit risk involved. But through the
index futures market an investor can hedge both the price and credit risk.
The basic idea is simple. The lender buys all 50 stocks of S&P CNX Nifty
on the cash market, and simultaneously sells them at a future date on the
futures market. There is no price risk since the position is perfectly hedged.
There is no credit risk since the counter party on both legs is the National
Securities Clearing Corporation (NSCC) which supplies clearing services on
NSE. It is an ideal lending vehicle for entities which are shy of price risk and
credit
risk, such as traditional banks and the most conservative corporate treasuries.
Hedging the Price Risk
One buys a portfolio in which all the 50 stocks in S&P CNX Nifty are in
correct proportion, (i.e. where the money invested in each stock is
proportional to its market capitalization.) on the cash market. Simultaneously
sell S&P CNX Nifty futures of equal value. Now you are completely
hedged, so fluctuations in S&P CNX Nifty do not affect you.A few days
later, you will have to take delivery of the 50 stocks and pay for them. This
is the point at which you are "loaning money to the market".Some sell your
portfolio and reverse your future position. A few days later, you will have to
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make delivery of the 50 stocks and receive money for them. This is the point
at which "your money is repaid to you".The interest rate that you will
receive is the difference between the futures price and the cash S&P CNX
Nifty plus any dividends earned minus the transactions costs (impact cost,
brokerage) in doing these trades.
Suppose the S&P CNX Nifty spot is at 1000 and the two-month futures are
at 1040. Suppose the transactions costs involved are 0.4% per month and
dividends over the two months are nil. Then the rate of return in loaning
money to the market is 1.5% (1040/1000 over two months is near 1.9% per
month. Subtract out 0.4% as transaction costs to get 1.5% per month.
On 1 August, S&P CNX Nifty is at 1200. A futures contract is trading with
27 August expiration for 1230. Ashish wants to earn this return (30/1200 for
27 days).
He buys Rs. 3 million of S&P CNX Nifty on the spot market. In doing this,
he places 50 market orders and ends up paying slightly more. His average
cost of purchase is 0.3% higher, i.e. he has obtained the S&P CNX Nifty
spot for 1204.
He sells Rs. 3 million of the futures at 1230. The futures market is extremely
liquid so the market order for Rs. 3 million goes through at near-zero impact
cost. He takes delivery of the shares and waits.
While waiting; a few dividends come into his hands. The dividends work out
to Rs. 7,000.
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On 27 August, at 3:15, Ashish puts in market orders to sell off his S&P CNX
Nifty portfolio, putting 50 market orders to sell off all the shares. S&P CNX
Nifty happens to have closed at 1210 and his sell orders (which suffer impact
cost) goes through at 1207.
The futures position spontaneously expires on 27 August at 1210 (the value
of the futures on the last day is always equal to the S&P CNX Nifty spot).
Ashish has gained Rs. 3 (0.255) on the spot S&P CNX Nifty and Rs. 20
(1.63%) on the futures for a return of near 1.88%. In addition, he has gained
Rs. 7,000 or 0.23% owing to the dividends for a total return of 2.11% for 27days, risk free.
Arbitrage also offers an investor the opportunity to lend securities to the
market and earn revenues. The mechanism is simple -you sell off your
certificates and contract to buy them back in the future at a fixed price. The
basic idea is quite simple. You would sell all 50 stocks in S&P CNX Nifty
and buy them back at a future date using the index futures. You would soon
receive money for the shares you have sold. You can deploy this money as
you like until futures expiration. On this date, you would buy back your
shares, and pay for them.
Suppose you have Rs. 5 million of the S&P CNX Nifty portfolio (in their
correct proportion, with each share being present in the portfolio with a
weight that is proportional to its market capitalization).
Sell off all 50 shares on the cash market. This can be done using a single
keystroke (offline order entry) using the NEAT software.
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Buy index futures of an equal value.
A few days later, you will receive money and have to make delivery of the
50 shares.
Deploy this money at the riskless interest rate.
On the date that the futures expire, at 3:15 PM, put in 50 orders (using
NEAT again) to buy the entire S&P CNX Nifty portfolio.
A few days later, you will need to pay in the money and get back your
shares.
This is possible when the spot-futures basis (the difference between spot
S&P CNX Nifty and the futures S&P CNX Nifty) is smaller than the riskless
interest rate that you can find in the economy. If the spot-futures basis is
2.5% per month and you are loaning out the money at 1.5% per month, it is
not profitable. Conversely, if the spot-futures basis is 1% per month and you
are loaning out money at 1.2% per month, this stocklending could be
profitable.The stock lending rate is calculated as follows:- we assume that
transactions cost account for 0.4%. Suppose the spot-futures basis is x% and
suppose the rate at which funds can be invested is y%. Then the total return
is y - x - 0.4%, over the time that the position is held.
Example
Suppose Akash has Rs. 4 million of the S&P CNX Nifty portfolio which he
would like to lend to the market.
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Akash puts in sell orders for Rs. 4 million of S&P CNX Nifty using the
feature in NEAT to rapidly place 50 market orders, in quick succession. The
seller always suffers impact cost; suppose he contains an actual execution at
1098.
A moment later, Akash puts in a market order to buy Rs. 4 million of the
S&P CNX Nifty futures. The order executes at 1110. At this point, he is
completely hedged.
A few days later, Akash makes delivery of shares and receives Rs. 3.99
million (assuming an impact cost of 2/1100)
Suppose Akash lends this out at 1% per month for two months.
At the end of two months, the money comes back to him as Rs. 4,072,981.
Translated in terms of S&P CNX Nifty, this is1098 * 1.012 or 1120.
On the expiration date of the futures, he puts in 50 orders, using NEAT,
placing market orders to buy back his S&P CNX Nifty portfolio. Suppose
S&P CNX Nifty has moved up to 1150 by this time. This makes shares
costlier in buying back, but the difference is exactly offset by profits on the
futures contract.
When the market order is placed, suppose he ends up paying 1153 and not
1150, owing to impact cost. He has funds in hands of 1120, and the futures
contract pays 40 (1150-1110) so he ends up with a clean profit, on the entire
transaction, of 1120+40-1153 = 7. On a base of Rs. 4 million, this is Rs.
25,400
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Some of the risks associated with arbitrage
Risks in arbitrage in India
The basic principles of an arbitrage strategy are straightforward if an asset
trades at two different prices across two markets, buy where it trades cheap
and sell where it trades expensive. This textbook arbitrage assumes a
frictionless world where arbitrage profits can be made without putting up
capital and without bearing any risk. In reality however, almost all arbitrage
requires capital and carries some risk. Shleifer & Vishny (1997) argue that
the textbook notion of arbitrage does not describe realistic arbitrage trades.
These discrepancies become particularly important when arbitrageurs
manage other people money. In India the risks become even more
pronounced due to existing market frictions.
Some of the risks associated with arbitrage
Execution lags
In the ideal world, trades placed to capture an arbitrage opportunity would be
instantaneously executed. However, in the real world, execution takes time.
Very often, there can be variations in price between the time an arbitrage
opportunity is entered into and the time the trade is actually executed on the
market. There could be a slow down or halt in trading due to illiquidity or
market congestion. This slippage naturally increases when markets are
volatile.
Interest rate uncertainty
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An arbitrageur who enters into an arbitrage trade assumes that a particular
level of interest rate will remain constant. In the cashandcarry strategy, the
arbitrageur assumes that he will be able to borrow at a certain rate till the
expiration of the futures contract. Similarly, in the reversecashandcarry
strategy, he assumes that he will be able to invest the proceeds from the sale
of stocks at a particular rate of interest. However, the uncertainty about the
interest rate that will be charged on the capital that is deployed and the
returns that would be generated from the free funds deployed in the money
market, have a direct bearing on the profits generated from arbitrage
positions undertaken.
Futures spread
A futures spread position is constructed by purchasing a long position in
futures contract and selling a short position in another one simultaneously to
exploit the temporary disequilibrium between them. A spread trader
anticipates making a profit from correctly predicting the relative price
movements between two futures contracts. In general, trading spread is less
risky than trading straight positions because both contracts tend to move in
the same direction, so most of the market risk is offset by opposite positions.
Futures spreads can be divided into three varieties:
Inter - month,
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Inter - commodity
Inter month or calendar spread consists of offsetting positions in two or more
maturities of the same futures contract..
For example, a spreader buys a March and sells June Chana futures. Such
spreads represent speculation on the basis which is the difference between
the futures price and the cash price.
Inter market spread is made up of offsetting positions in different futures
markets but the same commodity, usually in the same delivery month. An
inter market spread, for instance, can be constructed between the Chana
futures in MCX and NCDEX.
As the two futures have the same delivery date, they must both have the
same value of the underlying commodity at delivery. In fact, such spread
trading results in a risk less arbitrage, called spread arbitrage (Board and
Sutcliffe, 1996).
Inter commodity spread involves different commodities, whether in the same
delivery month or not. Not all such combinations can be considered as
spreads. There must be a reasonable linkage in the prices of the two
commodities, and the linkage must be direct for a spread to be a recognized
spread. Recognized inter commodity spreads include corn versus wheat,
soybeans versus end products (oil and meal), and gold versus silver.
The common thread running through such spreads is that each set of long
and short positions are affected by the same factors of supply and demand
(Herbst, 1992, p.31). The literature on inter commodity spreading trading is
not extensive owing to the complexity of the inter commodity spread
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relationships. Inter commodity futures spreads are often constructed through
a production process. Refiners and processors use these spreads to deal with
operating risk, while arbitrageurs use them to get profits when the
commodity prices falls outside the no-arbitrage conditions implied by the
production process.
2.4 INTRODUCTION TO COMMODITY GOLD
In the last 6,000 years a little over125,000 tonnes of gold has been mined.
But this history is clearly divided into two eras - before and after the
California gold rush of 1848. Some calculations suggest that up until then
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scarcely 10,000 tonnes of gold had been excavated since the beginning of
time. Thus more than 90% of the worlds gold has been produced since
1848. Early gold mining by the Egyptians, from around 2000 BC, (in the
areas which are now Egypt, the Sudan and Saudi Arabia), is thought to have
produced no more than 1 tonne annually. Perhaps 5-10 were produced
during the time of the Roman Empire, (mainly from Spain, Portugal and
Africa), but in the Dark and Middle Ages (500-1400 AD) production, from
the mountains of central Europe, probably fell back to less than a tonne.
Throughout all this time gold was also being mined and worked in South
America, where the goldsmiths art reached very high standards. From the
middle of the 15th century the Gold Coast of West Africa (now known as
Ghana) became an important source of gold, providing perhaps 5-8 tonnes
per year. In the early 16th century the Spanish conquests of Mexico and Peru
opened up a further source of gold. By the close of the 17th century, 10-12
tonnes a year were provided by the Gold Coast and South America together.
Gold was first discovered in Brazil in the mid-16th century but significant
output did not emerge until the early 18th century. Towards the end of that
century, considerable supplies began to come from Russia as well, and
annual world production was up to 25 tonnes. By 1847, the year before the
Californian gold rush, Russian output accounted for 30-35 tonnes of the
world total of about 75 tonnes. The gold rushes, and later the South African
discoveries, radically altered the picture but Russian production continued to
rise, reaching around 60 tonnes in 1914. The crucial turning point in the
history of the gold mining industry came with the discovery at Sutters Mill
on the American River in January 1848, which ushered in a new age of gold.
Gold mining now took on a quite different dimension. Output from
California soared, reaching 77 tonnes in 1851 (the year gold was also
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discovered in Australia) and peaked in 1853 at 93 tonnes. The Australian
find triggered a gold rush there, which reached a climax in 1856 with 95
tonnes. World production at this time climbed to 280 tonnes in 1852 and
thence to almost 300 tonnes as Australia flourished. Production was lifted on
to an even higher plane in 1886 with the discovery of the huge gold reefs in
the Witwatersrand Basin of South Africa. Gold had first been found in
eastern Transvaal in 1873, but from the outset it was obvious that the
Witwatersrand deposits were of a completely different order. South Africa
ousted the United States as the worlds premier producer in 1898, a position
it has held almost continuously ever since. From 1884, the first year of
recorded output, South Africa has been the source of close to 40% of all the
gold ever produced. The most productive year was 1970 when over 1,000
tonnes were mined, representing more than three-quarters of western world
output. While the South African gold mining industry was ta