sumati sethia summer training project 4108168168

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Sumati Sethia/4108168168/MBF/Indian Institute of Finance Page 1 of190

SUMMER TRANING PROJECT

ON

HEDGING RISK THROUGH DERIVATIVES

And

EQUITY ANALYSIS

FOR PARTIAL FULFILLMENT OF THE REQUIRMENTOF

MBF PROGRAME OF INDIAN INSTITUTE OF

FINANCE

Submitted To:

Prof. J.D. Agarwal

Indian Institute of Finance

Submitted By:

Sumati Sethia

(4108168168)


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ACKNOWLEDGEMENT

It gives me great satisfaction on completion of Summer Internship Projects entitled Hedging

Risk through Derivatives and Equity Analysis.

On the submission of my project report I would like to express my sincere gratitude to my guide

Prof. J.D. Agarwal (Chairman, Indian Institute of Finance) for mentoring me and taking active

interest throughout the project and for sharing his insights on the topics and for being a constant

source of inspiration & courage during the entire project work. He was always available,

correcting mistakes, intelligently directing me to proper sources of information advising to aim

for simplicity, brevity, clarity and accuracy. I would like to give special thanks to all faculty

staff and I would also like express my sincere gratitude to Prof. Aman Agarwal (Vice

Chairman), Mr. Puspendar Singh (Professor), Mr. Pankaj Jain (Professor), Indian Institute of

Finance. I am indeed thankful to them for their valuable guidance.

I would also like to express my special thanks to the Mr. Mahesh C. Gupta (Chairman), Mr.

Suman (Company Secretary), SMC Global Securities Limited and Mr. Anil Singhania (Senior

Manager - Distribution) for appointing me as project trainee and for his help & co-operation

during the Project work.

I would like to thank the entire team of SMC Global Securities Limited, for sharing their

immense experience and extending their support in carrying out this project work. I am greatly

acknowledged for their kind help.


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CERTIFICATE

This is to certify that Hedging Risk through Derivatives and Equity Research was

carried out by Sumati Sethia as a part of the requirements of management of business finance

(MBF) fourth semester program. This study is being submitted for approval to the Indian

institute of finance.

I declare that the form and contents of the above mentioned project are original and have not

been submitted in a part or full, for any other degree or diploma of this or any other organization/

institute/ university.

Signature..........................................

Name................................................

Enrolment No...................................


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PREFACE

As a part of MBF program, a student has pursued a project duly approved by the director of the

institute. I had the privilege of undertaking projects on Hedging Risk through Derivatives

and Equity Research.

My project is divided into five chapters and they are given as under.

1. Chapter one of this study contains, concept of Financial Market. It discuss about theintroduction of the financial market and basic terminology of financial market . It

also discuss about Capital Markets.

2. Chapter two deals with the review of Hedging Risk through Derivatives. Asderivatives are the instruments which are generally used for hedging by an investor.

3. Chapter three deals with Different type of Derivatives Instruments wiz. Future trading& Option trading. It also discusses the about the trading strategy by the help of examples.

4. Chapter four deals with the Analysis and Interpretation of Derivative Instruments andhow they are used to hedge risk. Chapter four also includes the equity analysis. In this

part fundamental and technical analysis of five equity shares has been done.

5. Chapter deals with the summary of major findings, discussion of results, suggestion andlimitations of the study.

Signature...........................................

Name................................................

Enrolment No...................................


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EXECUTIVE SYNOPSIS

Trainee : Sumati Sethia

Organization : SMC Global Securities Limited

Educational Institute : Management of business finance (MBF) 2008-10

Indian Institute of Finance, Greater Noida -

Address : 9B, Netaji Subhash Marg, Darya Ganj,

New Delhi - 110002

Company Guide : Sr. Relationship Manager

Topic : Equity Research and Hedging Risk through Derivatives

Duration : 8 Weeks (20t April 09 19t June 09)


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OBJECTIVES:

The present study includes different strategy of derivatives used in present

scenario. In order to appraise the equity shares I have conducted a study of five

different companies. A comprehensive study is proposed with the following

objectives.

1. To evaluate the performance of selected equity shares in terms of risk andfuture returns.

2. To evaluate the shares pattern on the basis of technical analysis.3. To examine the different strategy which are used by the investors for the

purpose of hedging risk.

4. To study the recent and proposed Derivative Instrument and there usage.

In addition to the above objectives, following secondary objectives are also there.

1. To understand the basic terminology behind working of capital market.2. To understand the concept of valuating a company on the basis of its

financials.


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ABSTRACT

This project had been initiated for the purpose of acquainting me with, right from the basics of

the financial terminology used in the stock markets, further up to gaining in depth knowledge

of all the issues concerning the management of various risks faced by Investors and brokerage

companies.

This work is a detailed study of stock market and stocks. Its about the ways in which investors

can invest in stock market. I have carried out two projects in my summer training. The initial

phase of the document explains what I have understood about the functioning of stock market.

I have tried to explain the entire cash and derivative market in detail with the help of live

examples. All these calculations give a better insight to my work. This risk arises due to number

of reasons, which I have tried to put across. The focus in this project is on Hedging Risk

through Derivatives and Equity Analysis. The entire work has not been done till date.

Application of these ways to analyze stocks is yet to be done, its in progress.

The project is divided into two parts. The first half of the project which contains Project I-Hedging Risk through Derivatives examines the working of a stock market and the role of the

Regulatory Authority in maintaining the proper working of stock markets and how one can

hedge risk using derivative instruments. It also explains about the different stock markets

working in India and about their different Indices.

The second part of the project deals with Equity Analysis work which is Project II, includes

both fundamental analysis and technical analysis. Second part of project is as important as

Project I, because whole project contains the work which is carried out by me in these two

months of summer training and I am glad to present it in my summer training project.

At the same time I am trying to analyze some top notch companies to make sure that the

companies selected for investing money are really worth to invest in a large amount. All this has

been done with the help of Annual report, Quarterly results and daily news.

The project had been carried out at SMC Global Securities Limited, Daryaganj (New Delhi).


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TABLE OF CONTENTS

1. INTRODUCTION .................................................................................................................................... 16

CHAPTER - 1 INTRODUCTION18

2. ABOUT SMC GLOABL SECURITIES ........................................................................................................... 19

SMCGLOBAL SECURITIES LIMITED.................................................................................................................................. 19

VISION: ...................................................................................................................................................................... 21

PRODUCTS AND SERVICES: ............................................................................................................................................. 22

ACHIEVEMENT BY SMC:................................................................................................................................................ 24

CONTACT US:.............................................................................................................................................................. 25

3. INTRODUCTION TO STOCK MARKET ...................................................................................................... 27

STOCK MARKET........................................................................................................................................................... 27

STOCK EXCHANGE........................................................................................................................................................ 27

WHAT IS ASHARE? ...................................................................................................................................................... 28

PRIMARYANDSECONDARYMARKETS .................................................................................................................... 28

RISKS INVOLVED IN STOCK MARKET................................................................................................................................. 30

ANALYSIS TOOLS: ......................................................................................................................................................... 30

Technical Analysis ................................................................................................................................ 31

Fundamental Analysis ........................................................................................................................... 31

SEBI(SECURITIES AND EXCHANGE BOARD OF INDIA) .......................................................................................................... 32

NSE(NATIONAL STOCK EXCHANGE): ............................................................................................................................... 34BSE(BOMBAY STOCK EXCHANGE): ................................................................................................................................. 35

INITIAL PUBLIC OFFERINGS: ............................................................................................................................................ 37

DEMAT FORM OF SHARES.............................................................................................................................................. 38

DIFFERENCE BETWEEN A BROKER AND A DP ...................................................................................................................... 38

4. PORTFOLIO AND PORTFOLIO MANAGEMENT ......................................................................................... 39

PORTFOLIO: ................................................................................................................................................................ 39

PORTFOLIO MANAGEMENT: ........................................................................................................................................... 39

Asset allocation: ................................................................................................................................... 39

Long-term returns: ............................................................................................................................... 40

Diversification: ..................................................................................................................................... 40

5. RISK ALLOCATION AND THE RATIOS ...................................................................................................... 42

ASSET VS.RISK ALLOCATION: ......................................................................................................................................... 42

DIFFERENCES IN ASSET ALLOCATION AND RISK ALLOCATION................................................................................................. 44

Asset allocation .................................................................................................................................... 44

Risk allocation ...................................................................................................................................... 44

Goal ..................................................................................................................................................... 44

Rebalancing ......................................................................................................................................... 44

Inputs to decisions ................................................................................................................................ 44

Focus ................................................................................................................................................... 44


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Rebalancing ......................................................................................................................................... 45

Advantages of Risk Allocation: .............................................................................................................. 46

Sharpe ratio:............................................................................................................................................................................. 47

Information ratio: .................................................................................................................................................................... 47M-squared: ............................................................................................................................................................................... 48

6. UNDERSTANDING STOCK MARKET RISK ................................................................................................. 49

MARKET RISK.............................................................................................................................................................. 49

INFLATION RISK ........................................................................................................................................................... 49

BUSINESS RISK ............................................................................................................................................................ 49

CURRENCY RISK ........................................................................................................................................................... 50

BETA ......................................................................................................................................................................... 50

HEDGING ................................................................................................................................................................... 50

CHAPTER - 2 REVIEW OF LITERATURE...51

CHAPTER - 3 RESEARCH METHODOLOGY...59

DERIVATIVES: .............................................................................................................................................................. 60

Types of Derivatives: ............................................................................................................................ 60

VALUATION: ............................................................................................................................................................... 61

Determining the Market Price: .............................................................................................................. 61

Determining Fair Value: ........................................................................................................................ 61

FUTURE TRADING PARAMETERS: ..................................................................................................................................... 62

DERIVATIVESINSTRUMENT: .................................................................................................................................. 63

FUTURES: ............................................................................................................................................................. 64APPLICATION OF FUTURES: ......................................................................................................... 64

FUTURE TRADING:................................................................................................................................................... 65

Derivative Stock Market Indicators: ................................................................................................... 65

VARIOUS FUNDAMENTAL INDICATORS: ................................................................................................. 66

A. Economic Cycle .................................................................................................................................................................. 66

B. Industry Analysis ................................................................................................................................................................. 66

C. Company Analysis ............................................................................................................................................................... 67

VARIOUS TECHNICAL INDICATORS: ........................................................................................................ 67

OPEN INTEREST: ....................................................................................................................................................................... 67

VOLUMES: ................................................................................................................................................................................ 68

COST OF CARRY: ....................................................................................................................................................................... 71

PUT-CALL RATIO: ...................................................................................................................................................................... 73

Playing with futures:- ........................................................................................................................... 75

Long security, sell futures: ...................................................................................................................................................... 75

Short security, buy futures: ..................................................................................................................................................... 75

OPTIONS: .............................................................................................................................................................. 76

Overview............................................................................................................................................. 76

Option buyers: ..................................................................................................................................... 77

Option Terminology: ............................................................................................................................. 77

Intrinsic value of an option: .................................................................................................................. 78

Participants in the Options Market: ....................................................................................................... 79


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OPTION PRICING:............................................................................................................................ 80

Usages: ................................................................................................................................................ 81

Insurance and Hedging ............................................................................................................................................................ 81

Speculation and Arbitrage: ..................................................................................................................................................... 81Pricing and Information Sharing: ............................................................................................................................................ 82

Playing with options:- ........................................................................................................................... 82

Buy puts when market is expected to fall: ............................................................................................................................. 82

Sell puts when market is rising: .............................................................................................................................................. 82

Buy calls when Market is rising:.............................................................................................................................................. 82

Sell Calls when market is expected to fall: ............................................................................................................................. 83

Different Option Strategy:..................................................................................................................... 84

Profit from buying a call: ......................................................................................................................................................... 84

Loss from selling a call: ............................................................................................................................................................ 85

Profit from buying a put: ......................................................................................................................................................... 86

Loss from selling a put: ............................................................................................................................................................ 87

The Buy-Write Strategy: .......................................................................................................................................................... 88The Straddles: .......................................................................................................................................................................... 89

Synthetic Long Call Position: ................................................................................................................................................... 91

Synthetic Long Put Position: ................................................................................................................................................... 92

Option Valuation: ................................................................................................................................. 93

Option Valuation Variables: .................................................................................................................. 93

Underlying Security ................................................................................................................................................................. 93

Strike price ............................................................................................................................................................................... 93

Volatility ................................................................................................................................................................................... 94

Time to Expiration ................................................................................................................................................................... 94

Risk-free rate ............................................................................................................................................................................ 94

Variables Affect on Option price: .......................................................................................................... 95

7. EQUITY ANALYSIS:- ............................................................................................................................... 96

FUNDAMENTAL ANALYSIS: ............................................................................................................................................. 99

TECHNICALANALYSISOFEQUITYSHARES: ............................................................................................................101

Moving Average Convergence/Divergence (MACD): ............................................................................. 103

Relative Strength Index (RSI): .............................................................................................................. 110

Williams %R: ..................................................................................................................................... 113

Ease of Movement: ............................................................................................................................. 115

CHAPTER - 4 ANALYSIS & INTERPRETATIONS..119

VIRTUAL FUTURE TRADING: ......................................................................................................................................... 119

Analysis: ........................................................................................................................................... 128

VIRTUAL OPTION TRADING: ......................................................................................................................................... 129

Analysis: ............................................................................................................................................ 130

FUNDAMENTALANALYSIS:.................................................................................................................................... 133

Stock Information: .............................................................................................................................. 133

Companys Basic Information: ............................................................................................................. 133

Financial Statement Summary: ............................................................................................................ 134

DLF INDIA LTD.: .................................................................................................................................. 135

GMR INFRASTRUCTURE LIMITED: ........................................................................................................ 138


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JP ASSOCIATE LIMITED: ....................................................................................................................... 141

UNITECH LIMITED: .............................................................................................................................. 144

RELAINCE INDUSTRIAL INFRASTRUCTURE LIMITED: .............................................................................. 147

Analysis: ............................................................................................................................................ 150

TECHNICALANALYSIS: ...........................................................................................................................................151

SENSEX AND NIFTY WATCH: ................................................................................................................ 151

Sensex Watch ..................................................................................................................................... 152

Nifty Watch ........................................................................................................................................ 158

TECHNICAL ANALYSIS BY CHARTS: ................................................................................................................................. 164

DLF India Ltd.: .................................................................................................................................... 165

GMR Infrastructure Ltd.: ..................................................................................................................... 168

JaiPrakash Associate Ltd.: ................................................................................................................... 171

Unitech Ltd.: ...................................................................................................................................... 174

Reliance Industrial Infrastructure Ltd.: ................................................................................................. 177

RATING OF COMPANIES ON THE BASIS OF TECHNICAL ANALYSIS: ......................................................................................... 180

CHAPTER - 5 CONCLUTIONS & SUGGESTIONS181

8. CONCLUSION .............. .................. ................ .................. ............... ................ .................. ............... .... 182

9. SUGGESTIONS: ................................................................................................................................... 185

10. LIMITATIONS: ..................................................................................................................................... 186

11. BIBLIOGRAPHY ................................................................................................................................... 187


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Table of Content (Tables):Page No.

1. FUTURE TRADING: 651.1TECHNICAL INDICATOR 67

1.1.1 OPEN INTERSET 681.1.2 EFFECT OF OI, PRICE AND VOLUMN ON MARKET 691.1.3 PUT CALL RATIO EFFECT ON MARKET 75

2. OPTION TRADING: 762.1DIFFERENT OPTION STRATEGY 84

2.1.1 PROFIT FROM BUYING A CALL 842.1.2 LOSS FROM SELLING A CALL 852.1.3 PROFIT FROM BUYING A PUT 862.1.4 LOSS FROM SELLING A PUT 872.1.5 THE STRADDLES 89

3. VIRTUAL FUTURE TRADING: 1193.1NIFTY 1193.2CNX IT 1203.3BANK NIFTY 1213.4MINI NIFTY 1223.5DLF INDIA LTD. 1233.6GMR INFRASTRUCTURE LTD. 1243.7JP ASSOCIATE LTD. 1253.8UNITECH LTD. 126


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3.9RELAINCE INDUSTRIAL INFRASTRUCTURE LTD. 1274. VIRTUAL OPTION TRADING: 129

4.1NIFTY 129

4.2ANALYSIS 1315. EQUTIY RESEARCH:

5.1FUNDAMENTAL ANALYSIS 1335.1.1 COMPANYS BASIC INFORMATION 1335.1.2 INCOME STATEMENT 1345.1.3 REPORT CARD 134

5.2FUNDAMENTAL ANALYSIS 1355.2.1 DLF INDIA LIMITED 1355.2.2 GMR IFRASTRUCTURE LIMITED 1385.2.3 JP ASSOCIATE LIMITED 1415.2.4 UNITECH LIMITED 1445.2.5 RELAINCE INDUSTRIAL INFRASTRUCTURE LTD. 147

5.3TECHNICAL ANALYSIS 1515.3.1 SENSEX WATCH 1525.3.2 NIFTY WATCH 158

5.4RATING OF THE COMPANIES 180


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Table of Content (Charts):Page No.

1. OPTION TRADING: 761.1DIFFERENT OPTION STRATEGY 84

1.1.1 PROFIT FROM BUYING A CALL 841.1.2 LOSS FROM SELLING A CALL 851.1.3 PROFIT FROM BUYING A PUT 861.1.4 LOSS FROM SELLING A PUT 871.1.5 BUY WRITE STRATEGY 881.1.6 THE STRADDLES 901.1.7 SYNTHETIC LONG CALL POSITION 911.1.8 SYNTHETIC LONG PUT POSITION 92

2. EQUITY RESEARCH 962.1TECHNICAL INDICATORS 101

2.1.1 POSITIVE DIVERGENCE (MACD) 1042.1.2 BULLISH MOVING AVERAGE CROSSOVER 1052.1.3 BULLISH CENTERLINE CROSSOVER (MACD) 1052.1.4

BEARISH MOVING AVERAGE CROSSOVER 106

2.1.5 BEARISH CENTERLINE CROSSOVER (MACD) 1072.1.6 CENTER LINE CROSSOVER (RSI) 1072.1.7 WILLIAMS %R INDICATOR 1122.1.8 WILLIAMS %R TREND 113


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2.1.9 EASE OF MOVEMENT (EXAMPLE) 1152.2TECHNICAL ANALYSIS 151

2.2.1 SENSEX WATCH 1522.2.2 SENSEX TECHNICAL CHART WITH INDICATORS 1572.2.3 NIFTY WATCH 1582.2.4 NIFTY TECHNICAL CHART WITH INDICATORS 163

2.3TECHNICAL ANALYSIS BY CHARTS 1642.3.1 DLF INDIA LIMITED 1652.3.2 GMR INFRASTRUCTURE LIMITED 1682.3.3 JP ASSOCIATE LIMITED 1712.3.4 UNITECH LIMITED 1742.3.5 RELAINCE IND. INFRA. LIMITED 177


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1.INTRODUCTION

The time one talks about stock market, another word also clicks and that is risk. People have lost

their millions in this stock market. Stocks are just like gamble for those who dont know how to

invest. The market behaves differently to different people. For speculators it can be risky. They

are the speculators, who mostly lose the most. If I talk about wise people these are always

hedgers. Hedgers always keep risk involved in mind and try to minimize it using different

strategies. One can hedge risk using derivative instruments whether using future trading oroption trading. Investor can surely take out profit from market very easily by just Analyzing the

current situation through Fundamental and Technical Analysis. It helps one to take out his

money with sufficient if not unlimited profits. When I started to learn Equity Analysis at that

time the stock market was going through its Fluctuating phase, it was a slow moving market, and

market trend came unexpectedly. So it's high time when everybody should look at trend of the

markets and stocks. Initially I have tried to show how people suffer losses and make gains in the

absence of analysis and then come understanding those strategies that would help one to gain

profit. I have tried to show all combinations that can be used for analyzing the equity. It also has

detailed study of some companies that would help one to compare those companies and decide

which is better to invest in. The future prospects of a company can also seen using this analysis.

For this some ratios like PE ratio, price to sales, price to operating profits, EPS will be used,

apart from that value at risk is another factor that helps one in making decisions.

For my understanding I referred to a book Fundamental and Technical Analysis of Equity

Shares. This was that book that actually helps me understanding the analysis Part. For all the

data collection www.moneycontrol.com, NSEs site www.nseindia.com and www.icharts.in

proved to be a great help for me. It helps me track all the historic information about companies

and to track the current trends of the market and stocks. The only limitation of this project is that

in initial phases I have chosen companies of banking sector. And I have not been able to keep a

track of all those companies because banking sector is a toughest sector as far as equity analysis

is concerned. There are two reasons for this


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It's was really not possible to analyze 30 of companies.

The companies I have decided to choose for analysis are some top notch companies

though there are some midcaps too but they are very few and banking sector has lot more

things to do in equity analysis.

Derivatives and Analysis are huge project to understand. I have tried to cover everything but due

to time constraint I have to limit its study. This may be a major limitation of this project.

The project begins with stock market its scenario and gives explanation why people prefer

investing in Indian markets. And then it shifts to its major focus risk with each step I haveunderstood it better. The following work is the detailed explanation of my work. But before I

give all the details it's important to know what are stocks.


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CHAPTER ONE

INTRODUCTION


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2.ABOUT SMC GLOABL SECURITIESIt's one of the leading firms in financial services in India. It basically deals in Mutual Fund,

Fixed Deposit Schemes, Capital Gain Bonds, GOI Taxable Bonds, NABARD Bonds and Life

and General Insurance.

I am working for SMC Global Securities Limited which is one of the leading companies of

financial services. So I would like you to have a look at the profile of the company

SMC Global Securities Limited

SMC: A ONE STOP INVESTMENT SHOP

SMC Group, a leading financial services provider in India is a vertically integrated investment

solutions company, with a pan-India presence. Over the years, SMC has expanded its domestic

& international operations. Existing network includes regional offices at Mumbai, Kolkata,

Chennai, Bangalore, Cochin, Ahmadabad Jaipur, Hyderabad and 1500+ offices across 375+

cities in India. SMC has plans to grow its network to 2,000 offices across 500+ cities in the next

3 years. The company has expanded internationally and has established office in Dubai Gold and

Commodities Exchange (DGCX). Its products and Services include Institutional and retail

brokerage of equity, commodity, currency, derivatives, online trading, investment banking,

depository services, clearing services, IPOs and mutual funds distribution, Portfolio

management, wealth advisory, insurance broking, equity and commodity research. SMC is one

of the most active trading organizations in India, averaging over 3,50,000 trades per day.

Currently, SMC has a highly efficient workforce of over 4,000 employees & one of the largest

retail network in India currently serving the financial needs of more than 5,50,000 satisfied

investors.


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"THE STRENGTH OF A TREE IS IN DIRECT PROPORTION TO THE STRENGTH OF ITS

ROOTS"

Mr. Subhash Chand Agarwal and Mr.

Mahesh Chand Gupta are the visionaries

who planted the sapling of the

Kalpavriksha called SMC. To shape their

vision into a reality they watered the

sapling with their principles of

transparency, honesty & integrity and

nourished it with their rock solid

commitment for excellence.

Professionally both are chartered

accountants, with a rich experience of

more than 20 years in the capital market.

Their exceptional leadership skills,

outstanding commitment and disciplined

style of working have fostered SMC into a

financial hub, justifying the words that the

future belongs to those who believe in the

beauty of their dreams.

Mr. Subhash C. Agarwal

Mr. Mahesh C. Gupta


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Vision:

OUR VISION is to be a global major in providing complete investment solutions, with

relentless focus on investor care, through superior efficiency and complete transparency.

OUR APPROACH:

VALUE FOR INVESTORS TRUST: SMC values the trust reposed in by the clients and is

committed to uphold it at all cost.

INTEGRITY AND HONESTY: Integrity, honesty and transparency are the underlying

principles in all our dealings.

PERSONALISZED ATTENTION: The most valued asset is our relationship with the clients,

which has been built over years by giving personalized attention.

NETWORK WHICH WORKS: SMC has a vast network extending to 375+ cities/towns

ensuring easy accessibility, convenience and hassle free trading experience.

RESEARCH BASED ADVISORY SERVICES: SMC offers proactive and timely world class

research based advice and guidance to its clients to enable them to take informed decisions.

Main Focus: Investor Care


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Investment at your finger tips

Products and Services:

Equity & Derivative Trading:

SMC Trading Platform offers online equity & derivative trading facilities for investors who are

looking for the ease and convenience and hassle free trading experience. We provide ODIN

Application, which is a high -end, integrated trading application for fast, efficient and reliable

execution of trades. You can now trade in the NSE and BSE simultaneously from any destination

at your convenience. You can access a multitude of resources like live quotes, charts, research,

advice, and online assistance helps you to take informed decisions. You can also trade through

our branch network by registering with us as our client. You can also trade through us on phone

by calling our designated representatives in the branches where you are registered as a client.

Clearing Services:

Being a clearing member in NSE(F&O & Currency), BSE (F&O & Currency), MCX, MCX-SX,

NCDEX and DGCX. SMC is clearing massive volumes of trades of our trading members in this

segment.

Commodity Trading:

SMC is a member of 3 major national level commodity exchanges, i.e. National Commodity andDerivative Exchange (NCDEX), Multi Commodity Exchange (MCX) and National Multi

Commodity Exchange of India (NMCE) offers you trading platform of NCDEX, MCX and

NMCE. You can get Real-Time streaming quotes, place orders and watch the confirmation, all

on a single screen. We use technology using ODIN application to provide you with live Trading

Terminals. In this segment, SMC have spread our wings globally by acquiring Membership of


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Dubai Gold and Commodities Exchange. We provide trading platform to trade in DGCX and

also clear trades of trading members being a clearing member.

Distribution of Mutual Funds & IPOs:

SMC offers distribution and collection services of various schemes of all Major Fund houses and

IPOs through its mammoth network of branches across India. SMC is registered with AMFI as

an approved distributor of Mutual Funds. We assure you a hassle free and pleasant transaction

experience when you invest in mutual funds and IPOs through us. We are registered with all

major Fund Houses including Fidelity, Franklyn Templeton etc. We have a distinction of being

leading distributors of IPOs. Shortly we will be providing the facility of online investment in

Mutual Funds and IPOs

Online back office support:

To provide robust back office support backed by excellent accounting standards to our branches

we have ensured connectivity through FTP and .net based Application. To ensure easy

accessibility to back office accounting reports to our clients, we have offered facilities to view

various user friendly, easily comprehendible back office reports.

SMC Depository:

We are ISO 9001:2000 certified DP for shares and commodities. We are one of the leading DP

and enjoy the trust of more than 5.5 Lac investors. We offer a quick, secure and hassle free

alternative to holding the securities and commodities in physical form. We are one of the few

Depository Participants offering depository facilities for commodities. We are empanelled with

both NCDEX & MCX.

SMC Research Based Advisory Services:

Our massive R&D facility caters to the need of Investors, who are continuously in need of

opportunities for striking rich rewards on their investment. We have one of the most advanced,

hi-tech in house R&D wing with some of the best people, process and technology resources

providing complete research solutions on Equity, Commodities, IPOs and Mutual Funds. We

offer proactive and timely world class research based advice and guidance to our clients so that

they can take informed decisions.


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SMC Investor Awareness Forum:

Our dedicated team of professionals is conducting investor meet/seminars across India . We

believe that a well-informed investor is an empowered investor. We also seek your feedback on

our services in these Investor meets.

Achievement by SMC:"AN ACHIEVEMENT IS BONDAGE. IT OBLIGES ONE TO A HIGHER ACHIEVEMENT"

ISO 9001:2000 certified DP for both shares and commodities 4th largest broking house of India in terms of trading terminals (Source: Dun and

Bradstreet, 2008)

5th largest sub-broker network in the country (Source: Dun and Bradstreet, 2007) 2nd largest distributors of IPO in Retail. (Source: Prime Data Rankings) Awarded the Fastest Growing Retail Distribution Network (Source: Business Sphere,

2008)

Awarded the Major Volume Driver by BSE for the Third year in a row i.e. 2006-07,2005-06 and 2004-05 (Awarded to top 10 Brokers)

Nominated among the top 3, in the CNBC Optimix Financial Services Award 2008 underthe "National Level Retail Category".

One of the first financial firms in India to expand operations in the lucrative gulf market,by acquiring valuable license for trading and clearing with Dubai gold and commoditiesexchange (DGCX)

Amongst a Elite group of brokers having proprietary desk for doing risk-free arbitrage incommodities

First trade on DGCX for silver and First currency trade for rupee-dollar


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SMC's diverse network ensures that its investors avail of prompt services whenever they

might need them. SMC has a presence in all the major cities of the country. The contact

addresses of SMC Regional offices, across India are given below.

Contact Us:

SMC - CORPORATE OFFICE

11/6B, Shanti Chamber, Pusa Road, New Delhi-110005

Tel.: 91-11-30111000Fax: 91-11-25754365E-mail:[email protected]

SMC - REGIONAL OFFICES

Delhi-Daryaganj8B, 9B & 17, Netaji Subhash Marg,Daryaganj, New Delhi-110002,Tel.: 91-11-30111333Fax: 91-11-23263297

E-mail: [email protected]

Chennai

2A, 2nd Floor, Mookambika ComplexNo 4, Lady Desikachari Road,Mylapore, Chennai-600004

Tel.: 91-44-42108069, 42088256Fax: 91-44-24661798


Mumbai1st Floor, Dheeraj Sagar,Opp. Goregaon Sports Club,Link Road Malad(W), Mumbai-400064,Tel.: Tel: 91-22-67341600,Fax: Fax: 91-22-28805606,


Kolkata18, Rabindra Sarani, Poddar Court, GateNo-4, 4th Floor, Kolkata-700001Tel.: 91-33-39847000

Fax: 91-33-39847004Email: [email protected]


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PROJECT I

HEDGING RISK THROUGH

DERIVATIVES


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3.INTRODUCTION TO STOCK MARKET

Before Moving to stock markets derivative segment we need to understand the basics of stock

market. After that we can easily understand the concept of derivatives segment. Intro to stock

market includes working of stock market, Stock exchanges, financial sector of India, etc.

Stock MarketA stock market (also known as a stock exchange) has two main functions. The first function is to

provide companies with a way of issuing shares to people who want to invest in the company.

This can be illustrated by an example: Suppose a company has a mining lease over an area with

some rich ore deposits. It wants to exploit these deposits, but it doesnt have any equipment. To

buy the equipment it needs money. One way to raise money is through the stock market. The

company issues a prospectus, which is a sort of advertisement informing people about the

prospects of the company and inviting them to invest some money in it. When the company is

floated (established) on the stock market, interested investors can become part-owners of the

company by buying shares. If the company operates at a profit, shareholders benefit in two

ways through the issuing of dividends in the form of cash or more shares, and through growth

in the value of the shares. On the other hand, if the company does not operate at a profit (e.g., ifthe price of the product dips), the shareholders will probably lose money. The second function of

the stock market, related to the first, is to provide a venue for the buying and selling of shares.

Stock ExchangeAn exchange is an institution, organization, or association which hosts a market where stocks,

bonds, options and futures, and commodities are traded. Buyers and sellers come together to

trade during specific hours on business days. Exchanges impose rules and regulations on the

firms and brokers that are involved with them. If a particular company is traded on an exchange,

it is referred to as "listed". Companies that are not listed on a stock exchange are sold OTC (short

for Over-The-Counter). Companies that have shares traded OTC are usually smaller and riskier

because they do not meet the requirements to be listed on a stock exchange.


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What Is A Share?In finance a share is a unit of account for various financial instruments including stocks, bonds,

mutual funds, limited partnerships. In simple Words, a share or stock is a document solely to

stocks is so common that it almost replaces the word stock itself.It is issued by a company,

which entitles its holder to be one of the owners of the company. A share is issued by a company

or can be purchased from the stock market. By owning a share you can earn a portion in the firm

and by selling shares you get capital gain. So, your return is the dividend plus the capital gain.

However, you also run a risk of making a capital loss if you have sold the share at a price below

your buying price.

PRIMARY AND SECONDARY MARKETSThere are two ways for investors to get shares from the primary and secondary markets. In

primary markets, securities are bought by way of public issue directly from the company. In

Secondary market share are traded between two investors.

Primary Market

Market for new issues of securities, as distinguished from the Secondary Market, where

previously issued securities are bought and sold.A market is primary if the proceeds of sales

go to the issuer of the securities sold.

Secondary Market

The market where securities are traded after they are initially offered in the primary market is

known as secondary market. Most trading is done in the secondary market. Generally, most

shares have a face value (i.e. the value as in a balance sheet) of Rs.10 though not always offered

to the public at this price. Companies can offer a share with a face value of Rs.10 to the

public at a higher price. The difference between the offer price and the face value is called the

premium. As per the SEBI guidelines, new companies can offer shares to the public at a

premium provided:

1. The promoter company has a 3 years consistent record of profitable working.

2. The promoter takes up at least 50 per cent of the shares in the issue.


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3. All parties applying to the issue should be offered the same instrument at the same terms,

especially regarding the premium.

4. The prospectus should provide justification for the propose premium.

On the other hand, existing companies can make a premium issue without the above restrictions.

A companys aim is to raise money and simultaneously serve the equity capital. As far as

accounting is concerned, premium is credited to reserves and surplus and it does not increase the

equity. Thus the companies seek to make premium issues. In a buoyant stock market when good

shares trade at very high prices, companies realize that its easy to command a high premium.

The biggest difference between them is the length of time you hold onto the assets. An investoris more interested in the long-term appreciation of his assets, counting on that historical rise in

market equity.

Hes not generally concerned about short-term fluctuations in prices, because hell ride them out

over the long haul. An investor relies mostly on Fundamental Analysis, which is the analytical

method of predicting long-term prospects of a particular asset. Most investors adopt a buy and

hold approach to assets, which simply means they buy shares of some company and hold onto

them for a long time. This approach can be dangerous, even devastating, in an extremely volatilemarket such as todays BSE or NSE Indexes Show. What most investors need to remember is

this: investing is not about weathering storms with your beloved company its about making

money. Traders, on the other hand, are attempting to profit on just those short-term price

fluctuations. The amount of time an active trader holds onto an asset is very short: in many cases

minutes, or sometimes seconds. If you can catch just two index points on an average day, you

can make a comfortable living as a Trader.


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Risks Involved In Stock MarketTo make Money in the Stock Market, you must assume High Risks.

Tips to Lower your Risk:

1. Do not put more than 10% of your money into any one stock

Do not own more than 2-3 stocks in any industry

Buy your stocks over time, not all at once

Buy stocks with consistent and predictable earnings growth

Buy stocks with growth rates greater than the total of inflation and interest ratesUse stop-loss orders to limit your risk

2. Buy Stocks on the Way Down and Sell on the Way Up.

False: People believe that a falling stock is cheap and a rising stock is too expensive. But on the

way down, you have no idea how much further it may fall. If a stock is rising, especially if it has

broken previous highs, there are no unhappy owners who want to dump it. If the stock is fairly

valued, it should continue to rise.

3. You can Hedge Inflation with Stocks.

When interest rates rise, people start to pull money out of the market and into bonds, so that

pushes prices down. Plus the cost of business goes up, so corporate earnings go down, along with

the stock prices.

4. Young People can afford to take High Risk.

False: The only thing true about this is that young people have time on their side if they lose all

their money. But young people have little disposable income to risk losing. If they follow the tips

above, they can make money over many years. Young people have the time to be patient.

Analysis Tools:Analysis tools have very important in capital market. As these tools are generally used for

purpose of calculating market price.


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Technical Analysis

It is a method of evaluating future security prices and market directions based on statistical

analysis of variables such as trading volume, price changes, trends etc., to identify patterns. It is

a stock market term meaning- the attempt to look for numerical trends in a random function. The

stock market used to be filled with technical analysts deciding what to buy and sell, until it was

decided that their success rate is no better than chance. Now technical stock analysis is virtually

non-existent. There are many instances of investors successfully trading a security using only

their knowledge of the security's chart, without even understanding what the company does.

Technical analysis helps to understand the pattern or trend of the market or of the particular

stock/script.

Fundamental Analysis

Fundamental analysis looks at a shares market price in light of the companys underlying

business proposition and financial situation. It involves making both quantitative and qualitative

judgments about a company. Fundamental analysis is carried out by taking expected EPS and

expected earning into consideration with Discounted Future Cash Flows. Fundamental analysis

can be contrasted with 'technical analysis, which seeks to make judgments about the

performance of a share based solely on its historic price behavior and without referring to the

underlying business, the sector it's in, or the economy as a whole.


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SEBI (Securities and Exchange Board of India)In 1988 the Securities and Exchange Board of India (SEBI) was established by the Government

of India through an executive resolution, and was subsequently upgraded as a fully autonomous

body (a statutory Board) in the year 1992 with the passing of the Securities and Exchange Board

of India Act (SEBI Act) on 30th January 1992. In place of Government Control, statutory and

autonomous regulatory boards with defined responsibilities, to cover both development &

regulation of the market, and independent powers have been set up. Paradoxically this is a

positive outcome of the Securities Scam of 1990-91.

The basic objectives of the Board were identified as:

To protect the interests of investors in securities; To promote the development of Securities Market; To regulate the securities market and For matters connected therewith or incidental thereto.

Since its inception SEBI has been working targeting the securities and is attending to the

fulfillment of its objectives with commendable zeal and dexterity. The improvements in the

securities markets like capitalization requirements, margining, establishment of clearing

corporations etc. reduced the risk of credit and also reduced the market.

SEBI has introduced the comprehensive regulatory measures, prescribed registration norms, the

eligibility criteria, the code of obligations and the code of conduct for different intermediaries

like, bankers to issue, merchant bankers, brokers and sub-brokers, registrars, portfolio managers,

credit rating agencies, underwriters and others. It has framed bye-laws, risk identification andrisk management systems for Clearing houses of stock exchanges, surveillance system etc. which

has made dealing in securities both safe and transparent to the end investor.

Another significant event is the approval of trading in stock indices (like S&P CNX Nifty &

Sensex) in 2000. A market Index is a convenient and effective product because of the following

reasons:


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It acts as a barometer for market behavior; It is used to benchmark portfolio performance; It is used in derivative instruments like index futures and index options; It can be used for passive fund management as in case of Index Funds.

Two broad approaches:

SEBI is to integrate the securities market at the national level, and also to diversify the trading

products, so that there is an increase in number of traders including banks, financial institutions,

insurance companies, mutual funds, and primary dealers etc. to transact through the Exchanges.

In this context the introduction of derivatives trading through Indian Stock Exchanges permitted

by SEBI in 2000 AD is a real landmark.

SEBI appointed the L. C. Gupta Committee in 1998 to recommend the regulatory framework for

derivatives trading and suggest bye-laws for Regulation and Control of Trading and Settlement

of Derivatives Contracts. The Board of SEBI in its meeting held on May 11, 1998 accepted the

recommendations of the committee and approved the phased introduction of derivatives trading

in India beginning with Stock Index Futures. The Board also approved the "Suggestive Bye-

laws" as recommended by the Dr LC Gupta Committee for Regulation and Control of Trading

and Settlement of Derivatives Contracts.

SEBI then appointed the J. R. Verma Committee to recommend Risk Containment Measures

(RCM) in the Indian Stock Index Futures Market. The report was submitted in November 1998.

However the Securities Contracts (Regulation) Act, 1956 (SCRA) required amendment to

include "derivatives" in the definition of securities to enable SEBI to introduce trading in

derivatives. The necessary amendment was then carried out by the Government in 1999. The

Securities Laws (Amendment) Bill, 1999 was introduced. In December 1999 the new framework

was approved.

Derivatives have been accorded the status of `Securities'. The ban imposed on trading in

derivatives in 1969 under a notification issued by the Central Government was revoked.

Thereafter SEBI formulated the necessary regulations/bye-laws and intimated the Stock


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Exchanges in 2000. The derivative trading started in India at NSE in 2000 and BSE started

trading in the year 2001.

NSE (National Stock Exchange):The National Stock Exchange of India Limited (NSE), is a Mumbai-based stock exchange. It

is the large stock exchange in India in terms daily turnover and number of trades, for both

equities and derivative trading. Though a number of other exchanges exist, NSE and the Bombay

Stock Exchange are the two most significant stock exchanges in India, and between them are

responsible for the vast majority of share transactions.

NSE is mutually-owned by a set of leading financial institutions, banks, insurance companies

and other financial intermediaries in India but its ownership and management operate as separate

entities. As of 2006, the NSE VSAT terminals, 2799 in total, cover more than 1500 cities across

India. In October 2007, the equity market capitalization of the companies listed on the NSE was

US$ 1.46 trillion, making it the second largest stock exchange in South Asia. NSE is the third

largest Stock Exchange in the world in terms of the number of trades in equities.[4]It is the second

fastest growing stock exchange in the world with a recorded growth of 16.6%.

The National Stock Exchange of India was promoted by leading Financial institutions at the

behest of the Government of India, and was incorporated in November 1992 as a tax-paying

company. In April 1993, it was recognized as a stock exchange under the Securities Contracts

(Regulation) Act, 1956. NSE commenced operations in the Wholesale Debt Market (WDM)

segment in June 1994. The Capital Market (Equities) segment of the NSE commenced operations

in November 1994, while operations in the Derivatives segment commenced in June 2000.

Markets

Currently, NSE has the following major segments of the capital market:

Equity Futures and Options Retail Debt Market Wholesale Debt Market


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NSE Indices

S&P CNX Nifty CNX Nifty Junior CNX IT Bank Nifty Mininifty CNX 100 CNX Midcap

BSE (Bombay Stock Exchange):Bombay Stock Exchange Limited is the oldest stock exchange in Asia with a rich heritage.

Popularly known as "BSE", it was established as "The Native Share & Stock Brokers

Association" in 1875. It is the first stock exchange in the country to obtain permanent

recognition in 1956 from the Government of India under the Securities Contracts (Regulation)

Act, 1956.The Exchange's pivotal and pre-eminent role in the development of the Indian capital

market is widely recognized and its index, SENSEX, is tracked worldwide. Earlier an Association

of Persons (AOP), the Exchange is now a demutualised and corporatized entity incorporated

under the provisions of the Companies Act, 1956, pursuant to the BSE (Corporatization and

Demutualization) Scheme, 2005 notified by the Securities and Exchange Board of India (SEBI).

Of the 22 stock exchanges in the country, Mumbai's (earlier known as Bombay), Bombay Stock

Exchange is the largest, with over 6,000 stocks listed. The BSE accounts for over two thirds of

the total trading volume in the country. Approximately 70,000 deals are executed on a daily

basis, giving it one of the highest per hour rates of trading in the world. There are around 3,500

companies in the country which are listed and have a serious trading volume. The market

capitalization of the BSE is Rs.5 trillion. The BSE `Sensex' is a widely used market index for the

BSE.

With demutualization, the trading rights and ownership rights have been de-linked effectively

addressing concerns regarding perceived and real conflicts of interest. The Exchange is

professionally managed under the overall direction of the Board of Directors. The Board


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comprises eminent professionals, representatives of Trading Members and the Managing

Director of the Exchange. The Board is inclusive and is designed to benefit from the

participation of market intermediaries.

In terms of organization structure, the Board formulates larger policy issues and exercises over-

all control. The committees constituted by the Board are broad-based. The day-to-day operations

of the Exchange are managed by the Managing Director and a management team of

professionals.

The Exchange has a nation-wide reach with a presence in 417 cities and towns of India. The

systems and processes of the Exchange are designed to safeguard market integrity and enhancetransparency in operations. During the year 2004-2005, the trading volumes on the Exchange

showed robust growth.

The Exchange provides an efficient and transparent market for trading in equity, debt

instruments and derivatives. The BSE's On Line Trading System (BOLT) is a proprietary system

of the Exchange and is BS 7799-2-2002 certified. The surveillance and clearing & settlement

functions of the Exchange are ISO 9001:2000 certified.

BSE - Other Indices

Apart from BSE SENSEX, which is the most popular stock index in India, BSE uses other stock

indices as well:

BSE 100 BSE 200 BSE PSU BSE MIDCAP BSE SMLCAP BSE BANKEX


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BSE CAPITAL GOODS BSE AUTO BSE DOLLEX 200 BSE REALTY BSE TECH

Initial Public Offerings:

Corporate may raise capital in the primary market by way of an initial public offer, rights issue

or private placement. An Initial Public Offer (IPO) is the selling of securities to the public in the

primary market. This Initial Public Offering can be made through the fixed price method, book

building method or a combination of both.

In case the issuer chooses to issue securities through the book building route then as per SEBI

guidelines, an issuer company can issue securities in the following manner:

100% of the net offer to the public through the book building route. 75% of the net offer to the public through the book building process and 25% through the

fixed price portion.

Under the 90% scheme, this percentage would be 90 and 10 respectively.


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Demat Form of SharesThere are two forms of shares physical or dematerialized (demat) shares. Though the company is

under obligation to offer the securities in both physical and demat mode, you have the choice to

receive the securities in either mode. If you wish to have securities in demat mode, you need to

indicate the name of the depository and also of the depository participant with whom you have

depository account in your application. It is, however desirable that you hold securities in demat

form as physical securities carry the risk of being fake, forged or stolen.

Just as you have to open an account with a bank if you want to save your money, make cheque

payments etc, Nowadays, you need to open a demat account if you want to buy or sell stocks So

it is just like a bank account where actual money is replaced by shares. You have to approach the

DPs (they are like bank branches), to open your demat account. Let's say your portfolio of

shares looks like this: 150 of DLF, 50 of Axis Bank, 200 of GMR Infra and 100 of RIL. All these

will show in your demat account. So you don't have to possess any physical certificates showing

that you own these shares. They are all held electronically in your account. As you buy and sell

the shares, they are adjusted in your account. Just like a bank passbook or statement, the DP will

provide you with periodic statements of holdings and transactions.

Is a demat account a must? Nowadays, practically all trades have to be settled in dematerialized

form. Although the market regulator, the Securities and Exchange Board of India (SEBI), has

allowed trades of up to 500 shares to be settled in physical form, nobody wants physical shares

any more. So a demat account is a must for trading and investing. Most banks are also DP

participants, as are many brokers.

Difference between a Broker and a DPA broker is separate from a DP. A broker is a member of the stock exchange, who buys and

sells shares on his behalf and on behalf of his clients. A DP will just give you an account to hold

those shares in dematerlized form. Broker can also provides the facility of DP but he need to take

a permission of either NSDL or CDSL two DP service provider in india.


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4.PORTFOLIO AND PORTFOLIO MANAGEMENT

Portfolio:A portfolio is an appropriate mix of or collection of investments held by an institution or a

private individual. In building up an investment portfolio a financial institution will typically

conduct its own investment analysis, whilst a private individual may make use of the services of

a financial advisor or a financial institution which offers portfolio management services. Holding

a portfolio is part of an investment and risk-limiting strategy called diversification. By owning

several assets, certain types of risk (in particular specific risk) can be reduced. The assets in the

portfolio could include stocks, bonds, options, warrants, gold certificates, real estate, futures

contracts, production facilities, or any other item that is expected to retain its value.

Portfolio Management:Portfolio management involves deciding what assets to include in the portfolio, given the goals

of the portfolio owner and changing economic conditions. Selection involves deciding what

assets to purchase, how many to purchase, when to purchase them, and what assets to divest.

These decisions always involve some sort of performance measurement, most typically expected

return on the portfolio, and the risk associated with this return (i.e. the standard deviation of the

return). Typically the expected return from portfolios of different asset bundles are compared.

The unique goals and circumstances of the investor must also be considered. Some investors are

more risk averse than others.

Asset allocation:

The different asset classes and the exercise of allocating funds among these assets (and among

individual securities within each asset class) is what investment management firms are paid for.

Asset classes exhibit different market dynamics, and different interaction effects; thus, the

allocation of monies among asset classes will have a significant effect on the performance of the

fund. Some research suggested that allocation among asset classes have more predictive power

than the choice of individual holdings in determining portfolio return. Arguably, the skill of a

successful investment manager resides in constructing the asset allocation, and separately the


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individual holdings, so as to outperform certain benchmarks (e.g., the peer group of competing

funds, bond and stock indices).

Long-term returns:

It is important to look at the evidence on the long-term returns to different assets, and to holding

period returns (the returns that accrue on average over different lengths of investment). For

example, over very long holding periods (eg. 10+ years) in most countries, equities have

generated higher returns than bonds, and bonds have generated higher returns than cash.

According to financial theory, this is because equities are riskier (more volatile) than bonds

which are themselves more risky than cash.

Diversification:

Diversification in finance is a risk management technique, related to hedging, that mixes a wide

variety of investments within a portfolio. Because the fluctuations of a single security have less

impact on a diverse portfolio, diversification minimizes the risk from any one investment.

A simple example of diversification is this one. On a particular island the entire economy

consists of two companies: one that sells umbrellas and another that sells sunscreen. If a portfolio

is completely invested in the company that sells umbrellas, it will have strong performance

during the rainy season, but poor performance when the weather is sunny. The reverse occurs if

the portfolio is only invested in the sunscreen company, the alternative investment: the portfolio

will be high performance when the sun is out, but will tank when clouds roll in. To minimize the

weather-dependent risk in the example portfolio, the investment should be split between the

companies. With this diversified portfolio, returns are decent no matter the weather, rather than

alternating between excellent and terrible.

There are three primary strategies used in improving diversification:

1. Spread the portfolio among multiple investment vehicles, such as stocks, mutual funds, bonds,

and cash.

2. Vary the risk in the securities. A portfolio can also be diversified into different mutual fund

investment strategies, including growth funds, balanced funds, index funds, small cap, and large


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cap funds. When a portfolio includes investments with varied risk levels, large losses in one area

are offset by other areas.

3. Vary your securities by industry, or even by geography. This will minimize the impact of

industry- or location-specific risks. The example portfolio above was diversified by investing in

both umbrellas and sunscreen. Another practical application of this kind of diversification is

mixing investments between domestic and international funds. By choosing funds in many

countries, events within any one country's economy have less effect on the overall portfolio.


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5.RISK ALLOCATION AND THE RATIOS

In a sense, risk allocation also referred to as risk budgeting is another step in theevolution of investment management practices.

In the mid-1900s, the dominant investment style was asset selection (also known as picking

winners). Investors tried to select stocks and other assets with high expected returns and low

risk (i.e., low variance or returns).

Modern portfolio theory revolutionized investing by making clear the importance of correlations

of asset returns, in addition to expected returns and the variance of returns. By the 1970s, the

dominant investment style had become asset allocations. Investors tried to hold efficient

portfolios portfolios of assets with low correlations so that all but the market risk would be

diversified away. This gave rise to the common practice of managing to some benchmark

portfolio.

With the rise in benchmarking, the task of an active portfolio manager was to beat the index.

Clearly, one way to beat the index was to take on more risk than in the index a tactic not

necessarily in line with the wishes of the investor.

Risk allocation emerged in the late 1990s, in response to concerns about the level or risk being

accepted in the portfolio and as a consequence of the development of risk measurement and

management tools. While the phrase risk allocation seems to mean different things to different

people, it can be defined broadly as an investment style where allocations are based on the

assets risk contribution to the portfolio, as well as on the assets expected return. In this regards,

it is a direct application of the original Markowitz (1952) perspective on portfolio construction,

where both risk and return expectations play explicit roles in the asset allocation process. Under

risk allocation, the task of the active portfolio managers is to beat the index without taking

more risk than the index.

Asset vs. Risk Allocation:As described by Rawls & Izakson (1999), differences between asset allocation and risk

allocation can be highlighted by examining the investment portfolio management process. In

the initial stages of the process, the differences between an asset allocator and a risk budgeter are


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relatively limited. They are primarily related to different emphasis on, and measurement of, the

risk characteristics of the asset classes:

Defining the feasible set the set of asset classes that could be included in the portfolio.

Both the asset allocator and the risk budgeter would determine the relevant characteristics

expected returns, expected volatilities and expected covariances for each asset class. While

both the asset allocator and the risk budgeter are interested in reliable estimates of expected

returns, the risk budgeter will have a stronger incentive to obtain careful estimates of the

volatilities and co variances of each of the asset classes.

For example, the two might differ with respect to the horizon over which the volatilities and

correlations are gauged. Since asset allocators often use a relatively long history to form a

baseline for expected return, they are likely to use this long history to form baseline estimates of

the volatility and covariance for each asset class. However, because volatility and covariance

tend to have strong autoregressive conditional heteroscedasticity characteristics, the risk

budgeter will put more weight on the recent behavior of the asset classes in estimating volatilities

and covariance.

Choosing initial asset allocations

The initial asset allocation should be some optimization between risk and expected risk. Asset

allocators often centered the allocation on generally accepted allocations for a portfolio with the

desired level of risk (say, 40% debt and 60% equity). In contrast, the risk budgeter might use

something like a value-at-risk assessment to determine the risk tolerance.


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Differences in Asset Allocation and Risk Allocation

Asset allocation Risk allocation

Goal

An allocation of assets

across a set of different

classes such that the

portfolio targets achieve a

desired return on assets.

The constraint is that theallocations weights sum to

one

An allocation of risk

across assets such that the

portfolio achieves a

desired return on the risk

taken. The constraint is

that the total portfolio riskis limited

Rebalancing

Rebalances when dollar

values of positions deviate

from target

Rebalances when total

portfolio risk deviates

from target

Inputs to decisions

Most emphasis on expected

return

More emphasis on

volatility and correlation

Monitoring the

allocations

Monitors actual dollar

increase/decrease in

portfolio value. Typically

ignores forecast errors on


Monitors forecast errors in


in addition to gains and

losses

Focus

Focuses only on the

composition of the parts of

the portfolio

Focuses on overall

portfolio, as total risk is

what is important


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Suppose the risk allocator determines that, at a 95% confidence level, the portfolio would lose no

more than 10% over a month horizon. The risk allocator them implicitly defines a 6% monthly

standard deviation as a risk tolerance for the portfolio.

Given the determination of the risk tolerance, the initial asset allocations are made to maximize

the return for this level of portfolio risk. Thus risk allocation makes it explicit that the initial

asset allocation derives from a carefully defined risk tolerance of the investor. (While this may

be the case in asset allocation, it is generally implicit rather than explicit.)

More noticeable differences between the asset allocator and risk budgeter come in themonitoring and rebalancing of the portfolio.

Monitoring: Over time, the asset allocator monitors risk exposures (increases and

decreases in the values of the positions). The risk budgeter worries not only about changes in

risk exposures but also about changes in the volatilities and correlations. The risk allocator

recognizes that volatilities and correlations often move faster than portfolio values, and can result

in significant cha

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