Friday, October 17, 2008

Grasping the oil price, inflation linkage

Hindu Businessline-Racy Cases, 28.09.08 , Co-author: Arindam Mahato, IBS Hyd, Class of 2009

“Are the economic principles of demand and supply still valid?” asked a friend. We are at a loss for words for we are staunch supporter of economics. He continues, “I am scared to buy a car, for fear of oil prices touching the roof. Obviously the demand-supply position of oil has not changed drastically in the past one year, but the oil prices have more than doubled in one year and about quadrupled in the past five years. Now once again they are on the way down, and are now at around $100 per barrel! What’s the reason? Has the entire world economy become the playground of speculators? Are the prices purely driven by speculation?"

He was angry. Angry at everything around him. Angry at the policymakers for letting it all happen. Angry at the helplessness of the common man. We had no answers for all these questions. We too keep wondering about disillusionment cast by the entire financial and economic system around the world. However, his outburst did result in us taking a closer look at the oil prices.

Oil price drivers
A few macroeconomic factors which are said to be responsible for driving world crude oil prices are inflation, exchange rates, gold prices and OPEC’s decision on supply. These have an impact on oil prices either directly or indirectly.

Plotting the last five years’ data for all four of them along with the crude oil prices, we notice that gold and crude oil prices seem to have a very high correlation (0.9166). Oil and gold have been priced in US dollars since 1975.

Up to 1971 the dollar could be converted into gold by central banks. The price of gold was fixed at $35 an ounce and oil was steady at $3 a barrel. When the convertibility was removed, some of the oil producing countries converted the dollars into gold (this means that the demand for dollar went down and demand for gold went up). This had an impact on both oil and gold prices. Even today, an increase in the price of oil results in an increase in the price of gold and a decline in dollar value.

The euro-dollar exchange rates also seem to have a very high correlation with oil prices (0.8847). This could be due to the following: first, oil exporters have some price setting capacity; second, oil exporters receive a substantial share of their imports from Europe, particularly from euro area countries; third, oil invoicing takes place in US dollars; and, fourth, the US is itself a major importer of oil.

The OPEC supply has a much lower correlation of 0.7265. The supply of oil has remained more or less stable during the past five years. However, we can assume that the demand has been increasing due to the increasing appetite of emerging countries such as China and India. Also, oil is a finite resource and this has been recognised long back.

Depleting stock
According to a study, global oil resources are depleting at an annual rate of 6 per cent while demand is growing at an annual rate of 2 per cent. Thus, scarcity premium will continue to rise over time. This justifies the increase in prices. But what it does not justify is the sharp price rises and falls.

An increase in oil price results in inflation, which affects oil-importing countries. It also affects the cost of the finished products and prices in the economy. According to a research done by LeBlanc and Chinn of the University of California, Santa Cruz, oil price increases of as much as 10 percentage points will lead to direct inflationary increases of 0.1-0.8 percentage points in the US and the EU.

The correlation between world inflation and oil prices are the lowest amongst the four variables that we have considered (0.6879).

After doing this analysis, we went back to our friend to explain our findings. The response we got was “this is all very good and sounds logical too. But how does this have an impact on the common man? When the oil was $142 per barrel, I was paying Rs 56.60 per litre of petrol. Today, oil is around $100 a barrel and I am still paying around Rs 56 for a litre of petrol.

Unanswered questions
“The entire media quoted learned analysts and economists saying that inflation is going up because of oil prices. Now oil prices have fallen drastically but inflation has not come down. Do you have an answer for that?”

No we don’t. Now, with financial sector biggies such as Lehman Brothers and AIG collapsing, the general public is perplexed about the sanctity of the financial and economic systems, the acumen of analysts who slash the credit ratings of companies only after they actually collapses, and of the regulators who wake up only when such crises actually arise.

Monday, September 1, 2008

Currency Futures are here!

Hindu Businessline, 1st September 2008, Co-author-Zohra Zabeen
Currency futures are derivative instruments that allow investors and companies to hedge against exchange rate volatility.

Ravini is in a gloomy mood. As usual, she feels let down by the management education system of which she is a part — as a student, that is. She has absolutely no clue about the recently launched currency futures on the NSE (National Stock Exchange). In the last few days, she was haunted by currency derivatives even in her sleep.
On her way to the library, Ravini tries to put together all that she had learnt about futures, and as luck would have it, she sees Prof. Nicky walking out of the library. The only link between Nicky and Ravini was that they happened to live in the same locality some ten years back, and now, Ravini was a student at the same B-School at which Nicky was a Professor of Finance. This connection in an Indian setting means, Ravini considers it her right to call on Nicky anytime, anywhere and for anything.
Professor Nicky smiles knowingly as she looks at Ravini who has a perpetual question mark on her face. Nicky wastes no time in pleasantries, before asking, “So what’s bothering you today?”
Ravini: Hello Professor! I was wondering if you had some time to discuss currency futures.
Nicky: Ah! Indeed…I should have guessed. What do you already know about it?
Ravini: As the name suggests, it must be a futures contract, with currencies as the underlying asset. Beyond that I know nothing!
Nicky: Yes. You are right. These contracts were first created at the Chicago Mercantile Exchange in 1972 to hedge the exchange rate risks faced by businesses. After the collapse of the Bretton Woods Agreement, most of the countries shifted to a floating exchange rate regime, making exchange rates volatile.
So exchange rates, which were not something that needed to be managed earlier, now became a matter of concern for many exporters and another avenue to bet on, for speculators. Last week, on August 29, they were launched for trading at the NSE as well.
Ravini: So, currency futures are derivative instruments that allow investors and companies to hedge against exchange rate volatility?
Nicky: Yes, it allows exchange of one currency with another at a specified date in future at a prefixed price. Currency futures work the same way as futures in stocks.
Ravini: We already had Over the Counter currency forwards amounting to a huge daily turnover of $34billion in India, right? Then why do we need currency futures?
Nicky: The purpose of both is to protect the investors or companies from unfavourable movements in exchange rates. But the difference lies in the contract specifications. Forwards are customisable in terms of the amount and time for which the hedge is required. On the other hand, futures are standardised as per the specifications of the exchange.
Ravini: But then wouldn’t everyone want a customised contract?
Nicky: No. Exchange-traded futures (ETFs) would be preferred by many as the default risks would be limited due to the daily mark-to-market settlement and the involvement of National Securities Clearing Corporation (NSCCL) as the legal counterparty to all the trades that are executed at the NSE. Also, while exchange traded currency futures would be very liquid in nature, forwards are not liquid, they cannot be bought and sold as and when desired. Also, in the case of forwards, trading takes place only between large players, typically between banks and corporations or between banks themselves. This causes lack of transparency in the pricing of the products.
Ravini: Oh! This means investors, fund managers, and companies can now hedge currency risk without the fear of default and illiquidity risks and with better price discovery mechanism.
Nicky: Absolutely. The step taken forward by the RBI and SEBI (Securities and Exchange Board of India) to introduce currency futures in India is indeed laudable and bears utmost importance keeping in mind current macroeconomic conditions. Fear of forex losses are haunting Indian corporates and this initiative is expected to bring some respite. Currency futures offer several advantages to companies with international operations, fund managers, individuals, exporters, importers, hedge funds, non-banking institutions and speculators alike.
From the corporate perspective, currency risk hedging has assumed greater importance in the wake of excess volatility in the foreign exchange market, which has impacted the export performance and balance-sheet of the companies.
Many reputed companies have reported huge foreign exchange losses in the quarter ended June 30, 2008.
Moreover, in the current scenario where Indian companies are acquiring or buying foreign companies and seeking loans and funds abroad, the risk of exposure to various currencies have increased all the more.
From the investor’s point of view, a well-balanced portfolio through diversification and low systematic risk is beneficial. According to a few empirical studies price fluctuations in currency futures have very low correlations with price movements in stock market values and interest rates. Hence, this low correlation can reduce portfolio risk when equities and bonds are in depressed state.
Ravini: I read that RBI’s working group has suggested the contract size of $1000 with a maximum maturity of 12 months only for these contracts. Is there any specific reason for doing so?
Nicky: Yes, a small-sized contract (in value) would encourage more participants with even small currency exposures to take advantage of these contracts.
Ravini: If the currency futures have so many benefits, why are the FIIs and NRIs being barred from entering the market?
Nicky: As of now, there are many apprehensions regarding the success of currency futures launch. Hence, RBI and SEBI are being cautious in order to reduce the fear of speculation and volatility. However, this is a big step by them and must be applauded.
I am sure this is the first step towards creating a full fledged foreign exchange derivative market in India and would take the country closer to full capital account convertibility. Now, if you excuse me please, I must rush for a class.
Ravini: Sure professor. Thanks you very much and I hope to see you soon if I have further queries.
Happy and contented with the answers of Prof. Nicky, Ravini takes a U-turn to the canteen to show off her newly acquired gyan to her friends!

Friday, August 15, 2008

Futures’ cool, but options’ smarter

DNA, 15th August 2008
The derivative tool can be used by investors to good effect

Kishorilal switches on the telly a few minutes before the programme on investment strategies is to begin. In the last episode, he had watched Nicky, a professor in finance at a renowned business school explain how futures could be used as an investment tool. Today, she would be dealing with options.They are still playing advertisements, but Kishorilal desists from switching channels for fear he would miss out on parts of the programme. He even catches himself humming the familiar refrain of a paint company: “Jab ghar ki raunak badhani ho, deewaron ko jab sajaana ho…” If only he could own his dream bungalow... May be Nicky’s tips would help him realise that.He doesn’t have to wait long. The smiling professor soon appears and runs the viewers through the basics of option contracts, explaining how options allow the buyer more freedom than futures contracts do.Options are contracts that give one the right to buy (call option) or sell (put option) a stock at a predetermined price (exercise price) sometime in the future, she says. This right comes at a price, known as the premium.In a call option, if the market price of the asset is lower than the exercise price on the expiry date, the buyer of the call option will simply let the contract lapse. He is not obliged to buy the asset from the seller. Whereas, if the price is higher, the buyer will decide to exercise the option and the seller must deliver the asset. Hence, in this case, the buyer of a call option has limited his losses, but can also take advantage of unlimited gains if the price of the asset falls.A put option, on the other hand, gives the buyer of the contract the option to sell an asset at a predetermined price in the future. Just as in the case of call options, the buyer of the put option will simply let the contract lapse if the market price of the asset is higher than the exercise price on the expiry date.So far so good, thinks Kishorilal. But, how does one actually make money using these contracts?Nicky seems to be reading his mind. She starts explaining how various combinations of option contracts (known as strategies) could be used in different circumstances.“For example, if you know that the share price is going to move substantially, but are not sure in which direction, up or down, you can enter into a ‘straddle’,” she says.Now what’s a straddle? Well, it involves a call and a put option with the same exercise price and same expiry date. So, if an investor believes the price of Reliance shares will move substantially in the coming days, he can buy call options and at the same time buy put options which expire on the same date. The exercise price for both the options must be the same.From the investor’s point of view, the maximum loss in this case is the premium paid for obtaining the options. But, the maximum profit is unlimited.Kishorilal finds himself nodding. Certainly, the maximum loss will be the premium paid to obtain the call and put options in the event that both are not exercised. But how can the profit potential be unlimited?Say the exercise price of Reliance call and put options is Rs 2,160, Nicky explains. Now, upon expiration, if the stock price of Reliance goes up to Rs 3,000, the investor can exercise the call option, which gives him the right to buy the shares at Rs 2,160. Then, he can sell those shares in the market for Rs 3,000, making a profit of Rs 840 per share. Higher the price of Reliance shares, higher will be the gain from exercising the call option. Also, in a scenario where the price of the shares rises, the put options expire unused.On the other hand, if the price of Reliance falls to say Rs 1,600, the investor can exercise his put option, which gives him the right to sell the shares for Rs 2,160. Thus, he buys the shares from the market at Rs 1,600 and sells them for Rs 2,160, making a profit of Rs 560 per share. Lower the price of Reliance shares, higher will be the gain from exercising the put option. Also, in a scenario where the price of the shares falls, the call options expire unused. In order to calculate the net profit, the premium paid for buying the options must be deducted from the profits. Let’s assume that the premium paid to buy the call option was Rs 65 and the put option was Rs 100. Even after deducting the total premium of Rs 165, the investment in a straddle turns out to be very profitable.Nicky closes the session with a quote from Walter D Hopps: “Derivatives are nothing more than a tool. And just as a saw can build your house, it can cut off your arm if it isn’t used properly.”“The statutory disclosure,” thinks Kishorilal, but agrees that it can cut both ways. He is glad to have sat through the session, for now he knows he can invest in derivatives and get higher returns while keeping his maximum losses under control. He decides to study a few stocks closely for sometime before taking the plunge. His dream house couldn’t be very far away.

Saturday, August 9, 2008

For the equity riches, try derivatives

DNA, 9th August 2008
Ek bangla bane nyara… ek bangla bane nyara…

Listening to Saigal sing his favourite song on the radio transports Kishorilal to his long-cherished vision of this huge house, with grills of silver, etc, where he lives happily with his entire family. Alas, he is nowhere close to realising this dream yet.Having retired last year, Kishorilal gets a pension of Rs 15,000 per month. During his working life, while he was never in an uncomfortable position financially, he could not chase his own dreams in the race to fulfill the needs of his family. And today, he just isn’t earning enough to realise any dream.With an income of Rs 15,000 per month, he is left with only about Rs 6,000 by the end of the month. The bank assures him that if he opens a recurring account with them, depositing Rs 6,000 per month, he will have Rs 12 lakh in 10 years. That translates into a return of approximately 9% per year, Kishorilal calculates. “That’s far too low a return and the Rs 12 lakh he gets at the end of 10 years won’t be enough for the bungalow of my dreams.”The other alternative is to invest in the stock market. His neighbour Ravi recently made a lot of money by buying the shares of Reliance at Rs 1,960 apiece in September last year and selling them at around Rs 3,000 per share in January this year, getting over 100% annualised returns.However, Kishorilal feels the market is too volatile. Besides, it isn’t exactly booming right now. He also remembers this former colleague who was forced to commit suicide after losing lakhs in the stock market in 1994. Kishorilal turns on the TV and switches channels nonchalantly. Images blur in front of his eyes, but suddenly, a few words catch his attention. A young lady (the banner at the bottom of the screen identifies her as Nicky, professor in finance at a renowned business school) is talking about making big bucks with small investments on CNBC. Take to derivatives trading, she says.Kishorilal always thought these contracts were for the likes of Warren Buffett and J P Morgan. But, Nicky says anyone can invest in derivatives. How come?Nicky is giving an example. To cash in on the rising share prices, one can invest in stocks that he thinks are going to rise in value in the coming days. However, investing in stocks can be a very expensive affair. Instead, one can buy the futures of that stock. Let’s say one now invests in Reliance futures, which expire on September 25 (last Thursday of the month). Say the price of one Reliance futures is Rs 2,300 currently.A good point about futures is that one only needs to pay a small percentage of the total contract value as margin initially. Let us say that the initial margin that the investor needs to pay is approximately 10%. Each contract has a lot size; for Reliance, the lot size is 75. Thus, the initial investment is only 10% of the value of contract (which is 75 times Rs 2,300 = Rs 1,72,500). This equals an investment of only Rs 17,250 per contract. Kishorilal’s face lights up. His savings last year totalled more than Rs 70,000. Going by Nicky’s calculations, he could invest in 4 Reliance futures contracts, which would cost him only Rs 69,000.But what will happen on September 25, when the contract expires? Nicky goes on to explain that upon expiry, the investor will receive his initial investment and the profit or loss on the futures contract. Suppose the shares of Reliance are trading at Rs 3,000 at that time. The gain will be (Rs 3,000-Rs 2,300)*75, i.e. Rs 52,500 per contract, or Rs 2,10,000 for four contracts. This is a gain of 304% in just two months.Kishorilal runs some mental calculation and concludes that if he keeps reinvesting his profits and the initial investment after every three months, he will have enough money to buy his dream house in just two years.This is too good to be true, he thinks. There has to be a catch.There is, he remembers from experience. Haven’t experts always advised investors to be careful in judging where the stock prices are headed? Imagine Ravi’s plight had the prices of Reliance shares had fallen instead of rising.Ben Golub’s famous words come to mind, “Risk management is akin to a dialysis machine. If it doesn’t work, you might have a noble obituary, but you’re dead.” Nicky’s not finished yet, though. According to her, if you are convinced that the share price of Reliance will go up in the next three months, you must take advantage of the Reliance futures. However, if there is any chance of the share prices falling, a different strategy may be adopted.Kishorilal sees a glimmer of hope. He switches off the TV and puts on the radio. Luckily for him, the music isn’t over yet.

Wednesday, July 23, 2008

Use 'weather derivatives' to weather droughts

(Interview by D. Murali and Kumar Shankar Roy, Hindu Businessline)

Chennai: With drought looming large over 14 meteorological sub-divisions, spare a thought for the planted crops that are in grave danger. For the farmers in Maharashtra, Andhra Pradesh, Karnataka and Kerala this monsoon has brought everything except the much-needed moisture. "Come rainy season and nearly 59 per cent of the Indian population, the people dependent on agriculture, keep their fingers crossed. Some pray to the rain God to ensure that it does not pour so hard that their crops get destroyed. On the other hand, in some villages, the farmers tie two frogs to a pole and get them married, a superstition which is supposed to bring good rainfall," quips Dr Nupur Pavan Bang, Faculty Member at ICFAI Business School (Hyderabad).

Superstitions apart, the seriousness of weather cannot be over-emphasized. "When livelihoods are dependent on rainfall, it is only fair that people will go to any extent to make sure that their farms get adequate amounts of rains...the farmers and various other businesses in the US have been using the weather derivatives since 1997, to mitigate risks due to adverse weather conditions," Dr Bang told Business Line. Weather derivatives, what are those? These derivative contracts are being used successfully by farmers, theme parks, ski resorts, ice-cream manufacturers, energy and utilities companies etc. since over a decade now. Read the short Q&A on 'weather derivatives' with Dr Bang done over the email to gain new insights.

Does India's size often become a disadvantage?
India, as a country, faces great variations in weather conditions due to its diverse geographical structure. While some places are hit by flood, some other by drought, rising temperatures are scaling new peaks and chilling winters are breaking old records. Such diversity in weather conditions affects the business processes of many industries directly or indirectly. The aviation industry takes the toll of fog in northern India during winters; floods in many parts leave their impact not only on agriculture but also on the tourism industry.

Tell us about these weather derivatives.
Weather derivatives are unique in many ways. The primary being, there is no physical underlying asset. The underlying asset is the weather, that is, the temperature measured in degrees Celsius or Fahrenheit or rainfall measured in centimeters. On the Chicago Mercantile Exchange, the values of these contracts are calculated based on a weather index. The index can represent either a Heating Degree Day (HDD) or a Cooling Degree Day (CDD). A HDD is the difference between a baseline temperature and the average temperature for a day in winters. A CDD is the difference between the average temperature for a day and a baseline temperature in summers. The baseline temperature is fixed; it is 65 degrees Fahrenheit in the US and 18 degrees Celsius in Europe.

From where will the derivatives derive their value?
The value of the contract would be some multiple of the HDD or the CDD. The contract can be valued on a daily basis, or weekly, or fortnightly or monthly or for a season; depending on the contract specifications. In 2005, NCDEX launched a rain day index for the Mumbai city for informational purposes only.

Can you explain the utility of weather derivatives with an example?
Let's consider a farmer growing paddy in a village in Andhra Pradesh. He is worried because of the expectations of unusually low rainfall in the state this year. He usually produces 50 quintals of paddy in his farm. But this year, he thinks the production will drop to 40 quintals. The Minimum Support Price for paddy is Rs770/quintal. This means that the farmer fears losing Rs 7,700 this season due to poor rainfall.

If the farmer had access to weather derivatives, he could have bought or sold (depending on the future outlook for rainfall) rain day futures contracts today and entered into an equal but opposite contract at a later date, making a profit on the transaction, thus offsetting the losses due to low volumes produced.

What are the other uses of these weather derivatives?
Apart from applying weather derivative as a measure of hedging risk against adverse weather conditions it can also be used as the mode of trading in derivatives. The most advantageous factor of weather derivatives is the fact that they can't be manipulated by any means like insider trading as the raining patterns are natural and beyond the scope of humans.

Are there challenges to a widespread adoption of this type of financial instrument?
The key challenge is to educate the people about such contracts and their usage. The knowledge of derivatives in itself is limited to certain segments of the society, leave alone the weather derivatives. In spite of the challenges, it is time the Government speeded up the process of launching weather derivatives in India too.

Monday, July 14, 2008

Understanding options, the Greek way

DNA, 14thJuly 2008

Walking down eat street, lost in thoughts of Hari Puttar (the greatest wizard of all times), Monsoon bumps into her friend Nicky, once neighbor and now a professor of finance at a business school,. She is delighted, “Hey Nicky, I have been hunting for you since the past few months. I had a strange dream on one of those days when I slept in the middle of reading Hari Puttar and the Quarter Muscle King. I saw some ghosts in a graveyard, discussing a ghostly contract known as options. It sure looked like a great financial discovery which could be used to make humongous amounts of money on the stock markets at low risk.

I brushed off the dream thinking that I have been reading too much about wizards and broomsticks and shadows. But lo-behold, just a few days later, my Security Analysis professor at the Business School started teaching us Derivatives! It was as though I was reliving my dream in the class. The ghosts sure were absolutely right. But what I learnt in the class is that one has to pay a premium to acquire an Option. The premium is calculated based on some scary looking models namely the Black-Scholes Model or the Binomial Option Pricing Model. However, the option premium is not constant. They keep changing like the share prices. Now I am puzzled. Why do the premiums change? What are the factors that affect the price of the option contacts? When I asked my professor about it, she said “It’s not in your syllabus”.

My interest is piqued by the wonderful world of options. And who else is better than you at explaining the nuances of derivative products?

Clearly pleased about meeting Monsoon, Nicky thinks, “Something’s never change. And one of them is the non-stop chattering of Monsoon”. Having been declared an expert on derivatives, Nicky is all enthusiastic about clearing Monsoon’s doubts. She chuckles, “You are absolutely right. The option premium keeps changing due to changes in various factors like the volatility of the underlying asset, the time to maturity of the contract, the risk free rate and the price of the underlying asset”.

Monsoon looks lost and says “Nicky, it all seems like Greek to me. Can you speak in plain English?” Nicky laughs at the unintended pun. “You are right Monsoon. It is indeed called the Greeks. The changes in Option Premiums with changes in variables that affect the premiums are known as the Greeks.” Monsoon looks further lost. Nicky explains, “When the price of the underlying asset increases, the price of a call option will increase and the price of a put option will fall. The sensitivity of Option price to a change in the price of the underlying is measured by Delta. Similarly, when interest rates rise, the value of the call option rises as the opportunity cost of buying stocks will be higher due to high borrowing cost.”

Monsoon is beginning to understand how the option premiums change due to changes in various variables. She nods at Nicky in complete understanding and poses another question, “How about the time to expiration and the volatility of the underlying stocks? How do they affect the premium?” Nicky is ready as usual, “If the time to maturity, or the expiration period of the option contract is increased, the premiums will increase as the writer of the option will have to bear the risk for a longer period of time and the writer would want to be compensated for the time value of money. This is measured by Theta.”

Nicky further explains, “Monsoon, as you know, the primary objective of options is to ascertain a certain amount of cash flows at some time in the futures. Traders and investors use options extensively to hedge the risk of changing prices in the spot market. Thus, higher the changes in price of an asset, greater will be the demand for option contracts. That is, greater the volatility of the underlying asset, higher will be the option premium. The sensitivity of option premiums to changes in volatility is measured by Vega”

Monsoon is not satisfied. She has another question, “Will the premiums for both Call and Put options be higher with higher time to maturity and higher volatility of the underlying asset?” Nicky is pleased that Monsoon’s thoughts are going on the right track. She says, “You are absolutely right Monsoon. Both call and put option will be more valuable when the time to maturity is higher and the volatility of the underlying asset is higher.”

Before Monsoon could pose another question, Nicky quickly added, “Now that you know about Delta, Rho, Theta and Vega, let me tell you something about Gamma too. Gamma is the sensitivity of the delta with respect to changes in underlying asset prices. This means that Gamma is a second order derivative. Higher the gamma, higher is the risk of changes in option premium due to changes in prices of the underlying.”

Monsoon finally breathes easy. She has finally learnt the meaning of the Greeks. Just as she is fascinated by Hari Puttar and his world of magic, she is awestruck by Options and the world of Greeks. She profusely thanks Nicky and in her characteristic chatter-pattar begins to fill in Nicky with all the gossip in the colony from where Nicky had moved out after being offered a house at the University campus.