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Security Analysis and Portfolio Management




                    Notes          Introduction

                                   The emergence of the market for derivative products, most notably forwards, futures and options,
                                   can be traced back to the willingness of risk-averse economic agents to guard themselves against
                                   uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets
                                   are marked by a very high degree of volatility. Through the use of derivative products, it is
                                   possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk
                                   management, these generally do not influence the fluctuations in the underlying asset prices.
                                   However, by locking-in asset prices, derivative products minimize the impact of fluctuations in
                                   asset prices on the profitability and cash flow situation of risk-averse investors.
                                   Derivative products initially emerged, as hedging devices against fluctuations in  commodity
                                   prices and commodity-linked derivatives remained the sole form of such products for almost
                                   three hundred years. The financial derivatives came into spotlight in post-1970 period due to
                                   growing  instability in the financial markets. However, since their emergence, these  products
                                   have become very popular and by 1990s, they accounted for about two-thirds of total transactions
                                   in  derivative  products.  In  recent  years,  the  market  for  financial  derivatives  has  grown
                                   tremendously both in terms of variety  of  instruments  available, their  complexity and  also
                                   turnover. In the class of equity derivatives, futures and options on stock indices have gained
                                   more popularity than on individual stocks, especially among institutional investors, who are
                                   major users of index-linked derivatives.

                                   Even small investors find  these useful  due to high correlation  of the  popular indices with
                                   various portfolios and ease of use. The lower costs associated with index derivatives vis-à-vis
                                   derivative products based on individual securities are another reason for their growing use.

                                   The following factors have been driving the growth of financial derivatives:
                                   1.  Increased volatility in asset prices in financial markets.
                                   2.  Increased integration of national financial markets with the international markets.

                                   3.  Marked improvement in communication facilities and sharp decline in their costs.
                                   4.  Development of more sophisticated risk management tools, providing economic agents a
                                       wider choice of risk management strategies, and

                                   5.  Innovations in the derivatives markets, which optimally combine the risks and returns
                                       over a large number of financial assets, leading to higher returns, reduced risk as well as
                                       transactions costs as compared to individual financial assets.

                                   Derivative is a product whose value is derived from the value of one or more basic variables,
                                   called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying
                                   asset can be equity, foreign exchange, commodity or any other asset. For example, wheat farmers
                                   may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that
                                   date. Such a transaction is an example of a derivative. The price of this derivative is driven by the
                                   spot price of wheat which is the 'underlying.'
                                   In the Indian context, the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines "equity
                                   derivative" to include:
                                   A security derived  from a debt instrument, share, loan  whether secured  or unsecured, risk
                                   instrument or contract for differences or any other form of security.
                                   A contract, which derives its value from the prices, or index of prices, of underlying securities.
                                   The derivatives are securities under the SC(R) A and thus the regulatory framework under the
                                   SC(R) A governs the trading of derivatives.




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