HEDGE EFFECTIVENESS OF THE RTS INDEX FUTURES Anastasia Musorgina A Thesis Submitted to the University of North Carolina in Partial Fulfillment of the Requirements for the Degree of Master of Business Administration Cameron School of Business University of North Carolina Wilmington 2011 Approved by Advisory Committee Nivine Richie Rob Burrus Cetin Ciner Chair Accepted by _____________________________ Dean, Graduate School TABLE OF CONTENTS   ABSTRACT ............................................................................................................................. iii DEDICATION .......................................................................................................................... iv ACKNOWLEDGEMENTS ....................................................................................................... v LIST OF TABLES .................................................................................................................... vi LIST OF FIGURES ................................................................................................................. vii INTRODUCTION ..................................................................................................................... 1 Hedging .................................................................................................................................. 1 Russian Derivatives Market ................................................................................................... 2 Moscow Interbank Currency Exchange ................................................................................. 4 Russian Trading System ......................................................................................................... 5 Russian Trading System Index ........................................................................................... 6 Russian Trading System Index Futures .............................................................................. 7 Effectiveness Measurement Methods ..................................................................................... 8 LITERATURE REVIEW .......................................................................................................... 9 METHODOLOGY .................................................................................................................. 18 Sample .................................................................................................................................. 18 Statistical Methods ............................................................................................................... 19 Measures ............................................................................................................................... 20 Preliminary Tendencies ........................................................................................................ 24 RESULTS ................................................................................................................................ 25 CONCLUSION ........................................................................................................................ 27 BIBLIOGRAPHY .................................................................................................................... 29 TABLES .................................................................................................................................. 31 FIGURES ................................................................................................................................. 34 APPENDIX .............................................................................................................................. 37  ii ABSTRACT This study focuses on the Russian derivatives market and the performance of the Russian stock index futures. With the improvement of legal regulation, the derivatives market in Russia has a real growth potential. The undervaluation of the domestic enterprises and the high growth rates of the Russian economy have led the stock market to the constant rise and growth, and the Russian derivatives market to a considerable boost in activity during the last ten years. However, as the rapid development of the Russian stock market cannot go on for ever, many private investors and professional managers feel the need of derivatives for investment hedging and reaping extra financial gains in the absence of the shares and bonds price surge. The present paper analyses hedge effectiveness of the Russian Trading System Index Futures from the first day of their trading on August 3, 2005 through July 29, 2011. The choice of the Russian market is justified on the grounds that it is relatively new and is among the leading global derivatives exchanges, which is actively developing. To estimate hedge effectiveness the six year daily RTS Index and RTS Index Futures returns were divided into twelve equal semiannual periods. The coefficient of determination or the R-Squared was employed as the main measure of the effectiveness, calculated by an Ordinary Least Squares regression analysis. In addition, a Minimum Variance Hedge Ratio model was applied to the hedge coefficient or the hedge ratio calculation. Besides, the volatility of both variables was examined and compared to the hedging coefficient’s fluctuations. The results showed that the RTS Index Futures contract fully satisfies the hedge effectiveness terms and conditions, and strongly reflect the market behavior. iii DEDICATION This thesis is dedicated to my parents to whom I owe my deepest and most heartfelt gratitude, and who have made my studies at the University of North Carolina Wilmington possible. I genuinely appreciate their tender loving care and support over the whole study period and throughout my life. I am incredibly thankful for their empathy and patience and, also, for their gentle, warm and unfailing love that succor and encourage me. iv ACKNOWLEDGEMENTS I express my immense gratitude to the University of North Carolina Wilmington, the Cameron School of Business and the Graduate School. I am truly thankful to all the faculty members that teach International MBA courses at UNCW for their exceptional motivational ability and professional attitude. My special thanks go to Dr. Cetin Ciner for the offered valuable expert and considerate assistance. For the inspiration that he provided me with, facilitating to generate and explore interesting, constructive ideas. I give my sincere thanks to Dr. William Sackley for his wholehearted concern and support, and also to Dr. Joseph Farinella for his understanding and kind attention. Last but not least, I am very grateful to my committee Dr. Nivine Richie, Dr. Rob Burrus and again Dr. Cetin Ciner for their guidance and keen interest v LIST OF TABLES Table Page 1. Russian Trading System Total Trading Volume ............................................................. 31 2. FORTS Trading Volume.................................................................................................. 31 3. FORTS and MICEX Shares in the Total Derivatives Trading Volume .......................... 31 4. Descriptive Statistics for the Returns ............................................................................... 32 5. Hedge Effectiveness ......................................................................................................... 33      vi LIST OF FIGURES Figure Page 1. FORTS Instruments Trading Volume ............................................................................. 34 2. Hedging Coefficient Determination in Various Hedge Strategies ................................... 34 3. RTS Index Futures Trading Volume, contracts ............................................................... 35 4. RTSI Futures Returns Beta Coefficient ........................................................................... 35 5. RTS Index and RTS Index Futures Returns Volatility .................................................... 36 vii INTRODUCTION As a general rule, most people support the view that decision making under uncertain and risky circumstances is exceptionally difficult. In the case of financial and stock markets where the vast sums of money and even the future and the destiny of huge corporations are often at stake, this decision is twice as hard. The present paper entitled “Hedge Effectiveness of the RTS Index Futures” has its target audience of investors, executives, analysts together with finance, risk and portfolio managers. It is intended to give an account of Russian derivatives market and the extent to which eliminating risks with the most popular instrument in Russia RTS Index futures is successful. The present chapter of the paper introduces the framework and objectives of the study. This section also provides the interpretation of the hedging concept and the explanation for the Russian financial market preference. In addition, the fundamental characteristics and specific features of the hedging instrument are identified, as well as factors and indicators that influence and evaluate hedging performance. Hedging To begin with, it is important to define the notion of hedging. Hedging is one of the most essential features of the derivatives market. It is also the most attractive and convenient way to neutralize systematic risks. The hedging principle is to fix the acceptable price level of the future transactions with financial instruments, such as forwards, futures or options. The major objective, however, is not to gain profit, but to preserve transactions from market volatility. This can be realized by taking an offsetting or reverse position. There are two forms of hedging in terms of the transaction type. Long hedge or buying should be employed if the risk is that prices or rates will go up. Oppositely, if the risk is that prices or rates will decrease, selling or short hedge should be applied. As a rule, a company is long on assets and receivables, and short on liabilities and payables. As previously mentioned, futures is one of the derivatives instruments that is used for hedging. A futures contract is a standardized agreement on the future delivery of the underlying asset of standardized quantity and quality for a price agreed today. Futures are traded on the exchange, with the exchange acting as an intermediary. An underlying asset to a futures contract can be commodities, currencies, securities, other financial instruments, interest rates or such intangible asset as a stock index which is used in the current study. Russian Derivatives Market This study focuses on the Russian derivatives market and the performance of the Russian stock index futures. Such choice is justified on the grounds that Russian derivatives market is relatively new and there are not enough specialists in this area yet. Moreover, it is among the leading global derivatives exchanges and is actively developing. Russian derivatives market has its origin in 1992. From the very beginning it has been highly volatile. That is why hedging was almost not employed. However, the necessity of hedging was proved by the economic crisis of 1998 that brought Russian derivatives market to its initial place. Thirteen years ago even banks, the largest players on the market did not commonly used hedging. Dramatic financial loses have initiated capital outflow, and the insolvency of an infinite number of banks including the major ones, reflected on the financial status of their clients. Eventually, it took more than a year in order to reach former results. Still, Russian investors similarly to the investors in the developed countries are undoubtedly interested in minimizing their risks. This is vividly illustrated by the analysis of trading volume indices dynamics and the share of the derivatives market in the Russian stock market in general. In the first quarter of 2004 the trading volume was at the level of RUB 2 33.17 billion, in January 2006 it reached RUB 160.49 billion and in the middle of 2008 it was already RUB 3,241.728 billion. On August 5, 2011 the total trading volume went beyond RUB 445.592 billion (USD16.003 billion), or 8,762,666 contracts (rts.ru). In the year 2007 the Government of the Russian Federation adopted quite a few regulations that enabled the professional managers to use futures and options for hedging in the individual asset management as well as in the investment and pension fund management. Therefore with the improvement of legal regulation, the derivatives market in Russia has a real growth potential. The direct evidence to this is the fact that during the last ten years the constant rise and growth of the Russian stock market could have been observed, and the Russian derivatives market has a considerable boost in activity. The securities’ market value elevation is related to the undervaluation of the domestic enterprises, and also to the high growth rates of the Russian economy. However, the market condition demonstrated that the rapid development of the Russian stock market cannot go on for ever. That is why many private investors and professional managers felt the need of derivatives for investment hedging and reaping extra financial gains in the absence of the shares and bonds price surge. Taking into consideration such a positive trend, it can be assumed that besides actively trading speculators and arbitrageurs, hedgers are becoming more customary to the market, and hedging positions from price risks is getting more important due to instability of particular domestic economic segments and crisis situation on the global markets. A derivative trading is done through the derivatives exchanges as well as on the over-the-counter markets. Currently, on the Russian market the derivatives trading volume is far beyond stocks trading volume, which is clearly illustrated in the Table 1. This can be explained by the fact that derivative transactions are traditionally considered to be more profitable than those on the spot market. The underlying reason is not only the financial leverage but also the lack of transaction costs related to trading on the spot market, such as 3