Archive for June, 2010

Weekly Update 28th June – 2nd July

China’s central bank move to increase flexibility in yuan against the dollar pushed global markets higher with the onset of the week. The optimism for the demand of commodities rose as the move is expected to increase Chinese consumers demand with the rise in purchasing power. Thereafter, the worrisome news flow from both U.S. & Europe only gave weakness to the markets.

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Disappointing earnings forecast by U.S. companies reignited the growth concerns in the market during the week. Fed policy makers left the overnight interbank lending rate target unchanged in a range of zero to 0.25 percent. Fed echoed that low inflation, stable price expectations and high unemployment “are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

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It said the U.S. recovery is progressive but not strengthening and “Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad.” Concerns also rose about solvency position of both U.K. and Global banks. Bank of England said that U.K. banks remain “vulnerable” to further writedowns on their assets because of a potential decline in investor appetite for risk. Overall investors are circumspect of the global recovery and are not sure whether the austerity plan by various government will lead to economic prosperity.

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The Indian government now seems to be batting its second innings in power by working on many reforms that were in its agenda for long time. On the recommendations of Kirit Parekh committee, the government decided to go ahead by linking petrol prices to market linked prices & giving Rs. 2/-, Rs. 3/- & Rs. 35/- hike in diesel, kerosine & LPG prices respectively. The long awaited step is expected to cool down the burgeoning under-recoveries of OMC’s & will help consequently in lowering the fiscal deficit. As per our estimates the said increase will accentuate inflation by close to 0.50%. The move that was quite necessary from the long term perspective may put some pressure on the Equity & Bond Markets. As we are already facing high inflation & are on mercy of good monsoon, the step is likely to increase worries. We expect now, with the robust manufacturing activity & clear signs of demand pull inflation the next step may come soon from the monetary body by hiking policy rates. The move may lead to some correction in the capital markets & bond prices may fall.

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Trend of Indian stock markets is up though U.S. and other markets is down which is giving rise to volatility here. Even dollar index is taking some reaction which might give some relief rally to metals in coming week. Nifty has support between 5200- 5100 levels and Sensex between 17300-17000 levels.

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Notwithstanding the doubt over the health of world economy, especially U.S. and Europe, commodity is reacting optimistically on every small news and statements.

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CRB index is going through a consolidation phase; any positive news can result in good upside. Two factors; flattish dollar index amid strong Asian economic growth accompanied by commodity demand can keep commodity on stronger side. In past seven months dollar index has rallied around 20%, the move was not showing the inner strength of dollar, rather it was majorly due to European debt crisis and safe haven demand. If we see rangebound to bearish movements in dollar index again it will boost up commodities prices. However, we can see some correction in between, but that should be considered as good buying opportunity.

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MINIMUM SUPPORT PRICE…… “The Farmer’s Armor”

MSP is a part of agricultural pricing policy of the central government. It is considered as a form of market intervention and also as one of the supportive measures (safety nets) to the agricultural producers.

In the phase of liberalization, MSP has a strong linkage to the market. In this situation, three important aspects deserve attention:

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(i) insulating the farm producers against the unwarranted fluctuations in prices, provoked by higher production and the international price variations and

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(ii) creation of an incentive structure for the farm producers in order to direct the allocation of resources towards desired crops and

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(iii) insulating consumers against sharp price rise, which may have been created by monsoon failure or even by vested interest by creating artificial scarcity. The focus is to providing remunerative prices for the cultivators.

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ROLE OF CACP

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The Commission on Agricultural Costs and Prices (CACP) discusses the price situation of various commodities with the representatives of the State government and various stakeholders to declare the prices of any agricultural product. The CACP while recommending MSPs takes into account factors such as cost of production, change in prices of inputs, demand and supply, market price trends and cost of living among other factors. MSP is determined by the principle of full cost of production that includes the rental value of land, an imputed value of family labor and returns to farmers.

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In fixing the support prices, CACP relies on the cost concept which covers all items of expenses of cultivation including in that the imputed value of inputs owned by farmers such as rental value of owned land and interest on fixed capital. Some of the important cost concepts used by CACP are the C2 and C3 costs.

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C2 cost includes all actual expenses in cash and kind incurred in production by actual owner plus rent paid for leased land plus imputed value of family labour plus interest on value of owned capital assets (excluding land) plus rental value of owned land (net of land revenue). Now, C3 cost is derived as: Cost C2 + 10 percent of cost C2 to account for managerial remuneration to the farmer.

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Costs of production are calculated both on per quintal and per hectare basis. Since cost variations are large over States, CACP recommends that MSP should be considered on the basis of C2 cost.

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Role of FCI

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On behalf of the Central Government, Food Corporation of India (FCI) along with State Governments and their agencies responsible for procurement of agri product on MSP fixed by CACP. But FCI procure the commodities from such states where production of any specific product is surplus. The main areas for procurement of wheat and rice are the surplus states like Punjab, Haryana, and some parts of Uttar Pradesh for both crops and Andhra Pradesh for rice. This has led two kinds of problems. One, growing buffer stock with FCI and our go-down are overflowing stocks of food grains, but, at the same time some parts of the country reported starvation. Second rest part of country producing these commodities doesn’t access the advantage of MSP.

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Farmers of those states do not fully get the benefit of the support price. This has created serious imbalances in demand and supply of principal crops in the country.

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Similarly, the country has been facing large shortages of pulses and edible oils .

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Latest Development

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The Cabinet Committee on Economic Affairs, chaired by Prime Minister Manmohan Singh, increased the minimum support price (per quintal): Arhar-Rs. 3,000, Moong-Rs. 3,170, Urad- Rs. 2,900, Paddy (common variety) Rs.1,000, and for grade A at Rs.1,030, Groundnut- Rs.2,300, Sunflower-Rs. 2,350, Niger seed Rs. 2,450,Soyabean (black)- Rs.1,400, Soyabean (yellow)- Rs.1440 and sesame- Rs.2900, Jowar (hybrid), bajra andmaize, the minimum support price has been raised by Rs. 40 and fixed at Rs. 880. MSPs of Jowar (Hybrid), Bajra and Maize each have been raised by Rs. 40 per quintal and fixed at Rs.880 per quintal.

Conclusion

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The policy has a favorable impact on farm income and has led to an economic growth. The implementation of Minimum Support Prices (MSP) has played an important role in meeting the ultimate goal of improving the agricultural production and the welfare of the agricultural community. Presently, 25 major crops are covered under the minimum support price program. Thus now MSP is oriented to crop diversification which had not encouraged earlier. Our policy makers are trying to effective implementation of MSP in all over the country.

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Weekly Update 21st – 25th June

Global markets saw synchronized gains of more than two percent this week except China’s Shanghai Composite Index which closed in the negative. The recent measures that were taken in China to cool down the economy like larger down payment for home buyers and increase in reserve requirements for banks seems to have started showing its effects as reflected by the weakening demand for construction metals like Nickel pig iron. Asset price bubble concerns rose after property prices in China rose by 12.4 percent in May.

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China Banking Regulatory Commission said that risks associated with home mortgages are growing and a “chain effect” may reappear in real-estate development loans. The economic restructuring in China has raised the possibility of resurgence in credit risks. The index of leading indicators in US, a gauge of the outlook for growth over the next three to six months, climbed 0.4 percent in May. It is viewed that the largest economy will continue expanding though at a moderate pace in the second half of the year without stoking inflation & creating fewer jobs. This would help the Federal Reserve in continuing with low interest policy for longer time. The European Union’s decision to publish the results of stress tests came after more than a year when U.S. published the results of stress tests on 19 financial institutions. The details of the tests including whether they include a sovereign debt restructuring is not yet disclosed by the European Union. However the step is welcomed by the investors as it will reveal the soundness of the European financial system.

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Coming back at home, as mentioned last week the possibility of hike in policy rates by RBI is gaining strength after Inflation accelerated to 10.16 percent in May giving concerns of generalized Inflation in the economy. Demand side pressures are quite evident now with the encouraging growth in Industrial production together with healthy growth in Exports and Imports. The European concerns that may have a bearing effect on the India’s trade and temporary liquidity squeeze in the Banking system has so far refrained the Banking regulator to continue its exit from an expansionary policy in a calibrated manner.

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Indian Stock Markets went up sharply last week and are looking much better but the problem it seems is with other world markets. It has to be seen whether the Indian markets are able to pull the other markets up or the weaker markets pull down India. Base metal commodities are not doing well though precious metals are all looking good. It seems volatility is likely to continue in such a scenario.

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Nifty has support between 5200-5100 levels and Sensex between 17300-17000 levels.

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Market players were enthralled with the captivating movements commodities noticed last week. Base metals and energy touched multi months low in the beginning of the week while second half of the week witnessed steep profit booking. Sideways congestion may be witnessed in commodities this week, as investors are endeavoring to figure out the next direction in commodities.

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However, the week is full of event risk and may trigger volatility in between.

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Many meets and high importance economic releases from US, UK and other nations are scheduled this week. Traders may refrain to create large position before FOMC meeting, which is scheduled on Wednesday.

CHANGE IS FOR BETTER

With great pleasure we announce that we have changed our online trading portal to http://www.smctradeonline.com for better. Experience a new level of online trading with more information, better aesthetics, advanced technology, world class financial tools & user friendly console on our new broking site.

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Come june 22nd and http://www.smcindiaonline.com , our corporate site will also come in its new avatar providing detailed information about SMC Group & its wide array of financial services.

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For any query, email us at brand@smcindiaonline.com

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RBI in Favour of Deregulating Savings Rate

Mr. K C Chakrabarty, Deputy Governor of Reserve Bank of India (RBI) has said that RBI is also in support of deregulating savings bank deposit rates of banks.

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Mr. Chakrabarty said already a debate in this regard was held, but the decision will be taken after having adequate debate on the issue.

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He said that the savings bank rates are not likely to move in a wide range after the deregulation.

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He added at this highly competitive market scenario. Prices do not vary much, but what will be the rate, what customers will get, will depend on market conditions.

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Currently, the savings bank rate is at 3.5 % and is the only administered rate in the banking system as of now.

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The banks offer this rate to the savings bank customers, which form a major part of their low-cost deposit base.

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He said further that the RBI has started to deregulate administered interest rate from 1991 as a part of financial reforms.

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VOLATILITY IN OPTION TRADING Final Part

Volatility Skew

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If we try to compute the volatility of an underlying by feeding in the required variables and the market prices of the options into the Black Scholes option pricing model, theoretically, options with same expiration date should have same implied volatility regardless of the strike prices we input.

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But in reality, the implied volatility we get across various strikes is different. This difference in volatilities across its respective strikes is known as volatility skew. When implied volatility is plotted against its respective strike price, the resulting graph can be a U-shaped or downward sloping.

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Volatility Smile, Reverse Skew, Forward Skew

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If the plotted graph is a U-shaped curve, as shown in Figure 1.1 below, this volatility skew pattern is also referred to as a volatility smile as it resembles a smile.

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The U-shaped volatility smile skew pattern is common for equity options which are near-term and options in the forex market. Volatility smile indicates that the demand is greater for options that are in-the-money or out-of-the-money.

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But, for longer term equity options and index options the reverse skew patterns are typical (Figure 1.2). In the reverse skew pattern, the implied volatility of options at the lower strikes is higher than the implied volatility at higher strikes.

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This reverse skew pattern implies that in-the money calls and out-of-the-money puts are more expensive and more in demand as compared to out-of-the-money calls and in-the-money puts.

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This pattern can arise in two cases; either, when the investors are worried about market falls, so they hedge their positions by buying puts for protection, or the other explanation can be, that in-the-money calls have become alternatives to outright stock purchases as they offer leverage and hence increased return on investment. In both cases greater demand is created for in-the-money calls and therefore it results in increased implied volatility at the lower strikes.

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As against reverse skew, forward skew is another type of the volatility smirk (Fig. 1.3), where, the implied volatility for options at the lower strikes is lower than the implied volatility at higher strikes.

In this case, the out-of-the-money calls and in the-money puts are in greater demand as compared to in-the-money calls and out-of-the money puts. The forward skew pattern is common for options in the commodities market where there can be a supply crunch, business houses would be ready to pay higher prices to secure supply than to risk supply disruption.

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Concluding, for option traders the best market direction assessment and option price evaluations can only be drawn by inter comparison of implied volatility with historical, current and forecasted volatilities, by assessing if they are over or under priced.

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This is the Volatility Smile of Nifty as on at the market closing of 11th June 2010. As mentioned above it is a typical long term index option, with the reverse skew pattern.

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VOLATILITY IN OPTION TRADING Part 1 :)

We calculate an option’s theoretical value by using option pricing models, two of the primary, well know models are the ‘Black-Scholes Model’ and the ‘Binomial Model’. To compute the value minimum five of the option and its underlying’s related variables are required to be fed in these models; these five necessary inputs are the option’s exercise price, the time remaining to expiration, the current price of the underlying, the risk free interest rate over the life of an option and the volatility of the underlying.

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Out of the above mentioned inputs, volatility plays an important role in actual trading situations. Volatility is a statistical measurement of the degree of fluctuation of a market or security. Volatility is computed as the annualized standard deviation of daily percentage price changes of the security and is expressed as a percentage. Changes in our assumptions and marketplace assessments about volatility can have significant effect on an option’s value.

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Though the option traders are affected by the direction of the market, they are extremely sensitive to the speed of the market. This speed of the market is measured through volatility. In low volatility markets, the market of the underlying fails to move at a sufficient speed, and therefore, the options on that underlying will have lesser probability to achieve the option’s exercise price or the strike price within its expiry. But in markets which move quickly or in other words, in high volatility markets the market of the underlying is likely to move at sufficient speed and accordingly options on that underlying will have greater probability to achieve the option’s exercise price within expiry.

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Every Option trader is well acquainted with three types of volatilities- Historical Volatility, Forecast Volatility and Implied Volatility (IV). Historical volatility measures how volatile the security has been in the past. We compute historical volatility over a defined historical period, which is usually a twenty day period as it approximates the number of trading days in a month. Forecast volatility is an attempt to forecast directional moves in the price of the underlying, i.e. future volatility; it is usually calculated using time-series methods.

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Finally, implied volatility of an option contract is the volatility implied by the market price of the option derived from an option pricing model. In other words, it is the volatility that, when fed in a particular pricing model, yields a theoretical value for the option equal to the current market price of that option. This means it is possible to have a unique implied volatility for each given market price of an option. This implied volatility is best regarded as a rescaling of option prices which makes doing comparisons between different strikes, expirations, and underlyings easier and more spontaneous.

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