What Are Options?

This is in continuation of my last article on derivatives.

An option is nothing but a "Right Given to the Holder of the Option". It may be a "Right to Sell" Or "Right to Buy". The right to sell option is called a put option and the right to buy option is called a call option. 

When a person buys an option note only the right is transferred. It is not necessary that a person should execute the right on the maturity date. Then the question arises how a seller can make a profit out of it even if it is not executed on the maturity date. The buyer of the option has to necessarily pay a premium called option premium for buying that option. The buyer can buy a put option or a call option. The simple logic is a buyer who expects a price rise will buy a put option for a price determined today and a buyer who expects a price fall will buy a call option. Call and put options are there in stocks, commodities, etc. The next one is Swap which deals with currency rate exchanges that may not be that significant.

  PRABHU.S 

Futures and Options - What it means ?

What Are Futures And Options? This article is based on the request of a few people who wanted me to throw lights on futures and options. To understand this first we have to understand what derivatives are. Derivatives are instruments whose value depends on the value of the underlying asset. What do you mean by the above-mentioned statement? Let’s take the example of orange juice. The value of an orange juice depends on the value of the underlying asset orange. Hence orange juice can be termed as a derivative of orange. Like that the value of derivatives that we are going to discuss here will rely on the value of the underlying asset. Here the underlying asset can be commodities (wheat, rice, oilseeds etc), metals, currency, stocks. basically, derivatives in finance parlance can be classified into four headings. • Forward Contracts • Futures Contracts • Option Contracts • Swap Forward contracts

It is nothing but an agreement between two parties to buy a product at a future date whose price is determined by the present. Why it happens? Generally, everyone in this world is scared about uncertainties due to inflation, monsoons, etc which leads to price rise. So a seller who is scared of a price fall in the future is ready to compromise on his high profits and agrees to sell his product for an optimal profit to a buyer who is scared about a price rise in the future. So the buyer agrees to buy the product at a future date at a price determined today with the risk-minimizing attitude of if the price goes very high I am safe that I can buy with the determined price. If the price goes very high the buyer is benefited and if it falls the seller is benefited. This generally happens in agricultural commodities because of the unpredictability of monsoons. But as we all know this is a risky transaction for one and the other is benefited. So in later days a lot of people started to take a backseat when loss comes to them. So people thought about other ways of solving this problem. Here came futures and options. 

Future contracts This is the same as forward contracts but here we have two differences. 1. It takes place with the presence of a third party (the exchange) 2. It is just a notional commitment between the parties. What do you mean by notional commitment? The actual seller produces the commodity and gives it to exchange and gets the receipt. The commodity is maintained at the exchange warehouses after a quality check. Now the receipt is traded as the commodity is traded and it passes on from people to people who are interested in buying.

 The exchange takes care of it at the maturity date. Every increase in price is a benefit to the buyer and it will be accounted for in his account because that is the value of that commodity that day. Any decrease in price is deducted from his account. This was `further modified and the concept of options came to play which I will explain in the next article 

  PRABHU.S

RELIANCE PETROLEUM VALUATION

Reliance Petroleum, RPL, is entered into the capital market on April 13 with a public issue of 135 crore equity shares of Rs 10 each for cash at a premium to be decided through a 100% book building route.

 The issue was made to part-finance the Rs 27,000 crore (Rs 270 billion) export-oriented refinery being set up in a special economic zone, SEZ, at Jam agar, Gujarat. The export-oriented refinery will have a capacity to process 5,80,000 barrels per day making it the sixth-largest refinery in the world. As a part of this project, RPL is also setting up a 900,000 tonne per annum polypropylene plant. The project is likely to go on stream by December 2008. 

 The book running lead managers are Citigroup Global Markets India, Deutsche Equities India Private, DSP Merrill Lynch, Enam Financial Consultants Private, HSBC Securities & Capital Markets (India) Private, ICICI Securities, JM Morgan Stanley Private, SBI Capital Markets, UBS Securities India Private and Karvy Computer share Private is the registrar to the issue. RPL was incorporated on October 25, 2005, and as such has yet to complete a year of operations. Since the project is slated to be completed only by December 2008, revenues would flow in only from FY09. Work on the project has already started, with more than Rs 20 billion invested and orders worth Rs 150 billion already placed for long-lead items. Although the refinery is slated to start commercial production by December 2008, yet, considering RIL’s execution capabilities, positive surprises are likely. 

We recommend you subscribe to the stock at the cut-off price. <CURRENT CAPITAL STRUCTURE COMPANY HOLDINGS RIL 75% CHEVRON 5% REST 20% 

STRATEGIC ADVANTAGES HIGHLIGHTS Best of world crude oil has already been tapped and newer ones are high density with high sulfur which needs special refinery and RPL is few among the one. Most of the refineries are set to process high quality only. Norms of emissions are now becoming strict (US, EUROPE) and existing refineries are inflexible to meet these norms.

• Demand could outstrip refining capacities and existing refineries unable to process so-called dirty crude may have to be shut down
• Heavy (dirty crude) is cheaper than light crude around 5 dollars/barrel and RPL can capitalize on it.
• This leads to gross refining margin go up with the ability to produce superior products from cheaper crude.
• Some of the other refineries that plan to expand also will complete their project only on 2011.
• RPL will be one of the 5% with the ability to process heavier crude in the world.
• But the capital cost for high-tech refining set up is higher than the older method by 4 dollars/barrel/day.
• But RPL has managed itself to set up in SEZ, which has tax-redemption on exports 100% for 5 years and later 50% for next 5 years.
• Duty-free import of crude oil and capital equipment because of SEZ.
• Technology, knowledge, marketing expertise of RIL can be shared with RPL and hence synergy between both.

EQUITY VALUATION 

Since RPL is yet to start its operations we cannot use FCFE or FCFF to arrive at the value of RPL share. Hence we have used the statistical tool of multiple regression to arrive at the value of RPL. we know FCFE is a function of growth rate, share price, and cost of equity. These values for five different firms in the refinery industry are taken and multiple regression is done and the output is tested for a significance level of 5%. 

INPUT FOR REGRESSION

FCFE is a Function of ( PRICE, KE, GROWTH)

10806.85 1068 19.775 23.13 2099.97 360 15 8.6 183.74 331.5 13.16 15.7 1440.2 510 13.945 7.6 1861.17 276.5 13.85 6.2 

 LOGFCFE LOG KE LOGG

 4.033699123 1.296116 1.364176 3.32221309 1.176091 0.934498 2.264203712 1.119256 1.1959 3.158422807 1.144419 0.880814 3.269786044 1.14145 0.792392 

OUTPUT The output resulted in such a way that market price was not statistically significant and hence again regression was done using growth rate and cost of equity of all the firms. 

 The model obtained was Model R R Square Adjusted R Square Std. The error of the Estimate 1 .998 .995 .991 6.019E-02 ANOVA Model Sum of Squares Df Mean Square F Sig. Regression 1.585 2 .792 218.705 .005 Residual 7.245E-03 2 3.623E-03 Total 1.592 4 A Predictors: (Constant), VAR00004, VAR00003 B Dependent Variable: VAR00001 

COEFFICIENTS 

 Unstandardized Coefficients Standardized Coefficients t Sig. Model B Std. Error Beta 1 (Constant) -8.579 .565 -15.172 .004 VAR00003 11.599 .563 1.295 20.615 .002 VAR00004 -1.785 .166 -.674 -10.731 .009 For a significance level of 5 %, we can see both f-value and t-value are highly significant and hence the model can be taken for describing the FCFE for RPL. LOG (FCFE)=11.599*LOG (COST OF EQUITY)-1.785*LOG (GROWTH RATE)-8.579 Substituting the value of the cost of equity for RPL and growth rate (average industry growth rate) 

 We obtained an FCFE for RPL as Rs.8288.11 crores Right now free-floating shares of RPL are 720 crores From this we found expected earnings per share to be Rs. 11.55

CALCULATION OF PRICE: The average P/E of the competitors are taken into consideration and the EPS thus obtained is equated to that value of 13. ONGC-17 BPCL-9 IOCL-10 CHENNAI PET-11 GAIL-18 HINDUSTAN PET-9 AVERAGE P/E =13 

 Price of RPL=13*11.55 =149.6 RPL PRICE=150 

 PRABHU.S