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Derivatives - A Risk Management Perspective

Dr. Rana Singhwww.ranasingh.orgAssociate Professor

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The Changing Environment

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The past

India had a highly regulated financial sector regime till 1991 which virtually eliminated financial price risk

Borrowing and lending rates were prescribed, guaranteeing spreads

Regulated capital markets did not provide any incentive for innovation in resource raising

Controlled foreign exchange regime ensured rationing of overseas resources as per Government policies

License-permit raj ensured that the most sought after skill was that of obtaining license and not the business acumen

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The present

Lending and borrowing rates are freed, access to capital markets is made easier for corporates

The rupee is convertible on trade account, FDI is welcomed with a plethora of incentives, FIIs are an established force in stock markets

The government has liberalised the ECB policy and a large number of corporates, buoyed by a rock solid rupee, accessed the international capital markets heavily, for equity and debt

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The present

Due to such measures implemented by the government Indian market is less immune to external

shocks compared to a decade back thin markets exaggerate impact of shocks volatility higher than in developed markets considerable amount of jump risk in all

domestic markets with impending convertibility decreasing

effectiveness of policy intervention in smoothing out volatility

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Risk: some examples

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The Laker Experience

In late 1970s, Laker Airlines faced the problem of plentyThe US Dollar was weak compared to pound sterlingBritish vacationers were lining up for US holidays

the company bought five new DC-10s to accommodate the increased passenger traffic

the new aircraft acquisition was financed by USD denominated debt.

In early 1980s, USD strengthened against the pound, and the dollar exposure started hurting Laker as its revenues were in pounds

Rising USD also contributed to lower US bound passenger traffic

Eventually Laker had to file for bankruptcy

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US Savings and Loans Institutions

US S & L : Financed long term fixed rate mortgage loans by short term deposits

Profitable in 1970s as the yield curve was upward sloping

In 1980s, the short term interest rates rose dramatically and the yield curve inverted in shape

The S&Ls were hit badly and turned from money spinners into money pits.

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Gulf War Casualty : Continental Airlines

August 2, 1990 : Iraq invaded Kuwait Prices of Jet fuel rose by more than 100% Continental Airlines in USA was highly

leveraged The high fuel costs affected Continental

adversely While the costs moderated a few months

later, they were still high compared to the pre-invasion level

Within months of the Iraqi invasion of Kuwait, Continental went bankrupt.

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The Lesson

The changes in market parameters may not only hurt companies' bottomline, but jeopardize their survival

One solution could be to predict the movements in the market parameters : Forecasting

However, forecasters have historically failed to predict market parameters : exchange rates, interest rates or commodity prices

Hence, prudent management of risk is essential

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Risk

Any exogenous factor influencing the performance of a business

Exposure to uncertainty Volatility in earnings Deviation of actual from expected

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Risk Management

Aim of risk managementKnowledgeEnsuring that the risk levels are consistent

with corporate objectivesEnsuring that returns adequately

compensate for risks borne

If you eliminate risks you eliminate returns

When a corporate undertakes a project, it accepts some risks. Derivatives can be used to mitigate those risks.

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Types of Risk

The main types of financial price risk that Indian corporates are exposed to are as follows: Exchange Rate risk Interest Rate risk Commodity Price risk

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Risk Management Procedure

Identification Quantification Philosophy and strategy Tools and Technique Implementation and Control

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Identification

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Explicit v/s Implicit Risks

Explicit Risks Mismatch between inflows and outflows:

Currency, timing, maturity Changes in values of inflows and outflows

due to changes in prices and volumes Implicit Risks

Relationship between exchange rates and sale prices denominated in local currency - e.g.. courier, airline, hotel companies

Risks arising from competitor strategy Risks arising from variation in inflation rate

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Risk Arising from Competitor Strategy Japanese Automobile manufacturer

Costs in Yen and revenues in US $ American Competitors

Costs and revenues in US $ When Yen strengthened against US $

Japanese manufacture's costs increased US producers costs remained the same Japanese manufacturer was unable to raise

prices and even faced price cuts by American competitors

Case of Caterpillar and Komatsu

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Indian Base Metal Companies : Dollarised revenues

Base metal companies such as Copper and Aluminum companies price their products off LME

While the freight, duties, etc provide a buffer against the LME prices, the domestic prices display high degree of correlation to LME quotes

Exported products are priced strictly off LME Thus, Copper and Aluminium companies have

dollar denominated revenues and Rupee expenses

This implies that Copper and Aluminium companies have long dollar position

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Oil companies : Dollarised revenues

Pursuant to the deregulation of the Administered Price Mechanism, downstream oil products would be priced based on import parity prices

Hence, the oil companies would have dollarised revenues and a natural hedge against USD liabilities

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Quantification

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Quantification

Identification of suitable observable proxies

Analysis of proxy behaviour and potential risk impact

Determination of Mean and Variance of

future P&L streams

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Proxies for Risk Factors

Correlation between proxy and the risk factor should be high

BSE Sensex could be a proxy for an equity portfolio of a firm

US $/Re exchange rate could be a proxy for the cashflows of an export oriented unit

International crude oil price could be a proxy for the cashflows of a petrochemical unit

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Approach to Risk Management

Firm-wide Approach to managing risk as opposed to individual transaction based approach

careful study of sensitivity of revenue & expense streams to underlying risk factors

understand correlation among risk factors reduce hedging costs through internal

netting relate impact of hedging to firm and

shareholder value

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Approach to risk management:Example

A diversified co with interests in Copper, Steel and Cement

Treasury is centralised, bears financial price risk for each business unit

Centralised treasury and the Business Unit jointly decide the best funding and risk management strategy for the Business Unit

The Treasury funds the Business Units and executes the agreed risk management strategies for them

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Approach to risk management:Example

The netting off of exposures among various BUs undertaken by the Treasury

Treasury raises funds required by BUs on terms it deems most profitable

Funds are transferred to BU on terms agreed jointly and at rate appropriate for the business

Treasury manages all the risk on the resources as well as on the open position it may decide to carry

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Philosophy and Strategy

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Corporate Philosophy

AGGRESSIVE

Identifying the exposure as

profit centre and managing the risk

pro-actively using the available products

RISK-NEUTRAL

Allowing time to

decide the

matter and mainly remain inactive

RISK-AVERSE

Hedge the exposure

by booking forward contract and lock-in

the exchange rate

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Mild Aggressive Philosophy:Indian PSU

• The PSU is exposed to exchange risk due to– USD, JPY and DM liabilities (comprising present

and future (projected) liabilities)– revenue streams denominated in INR only

• The PSU did a study of the following,– rolling over short-term forward covers versus

taking uncovered positions in USD/INR– Covering cross-currency exposures– risk/return profile of a USD interest rate swap

versus a cap

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Mild Aggressive Philosophy:Indian PSU

• Based on this, the PSU adopted a mild aggressive hedging strategy,– partial hedging of Rs-USD exposures based on cost of

forward versus the budgeted interest rate differential– study the international currency market continuously

to form a view of cross currency movements– view based decisions on cross currency hedges– zero cost collars to reduce hedging costs

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Risk-Averse Philosophy: Gold Jewelry Manufacturer An Indian Gold Jewelry manufacturer analysed

the business and deduced that:the firm has over 2 tones of gold in

processa sharp fluctuation in gold prices while it

is being processed may wipe out the entire net worth of the firm

The firm adopted a Risk averse strategy and borrows linked to gold prices

As a result the firm can concentrate on its business and not worry about the gold price movements

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Risk Neutral Philosophy:Siam Cement Siam Cement is a Bangkok based cement producer It carried USD 4 bn worth foreign currency loans on

its books No hedges were utilised as overvalued Baht implied

gain due to higher interest rate differential First quarter of FY98, Profits : THB 1.69 bn Baht devalued in July 1998 Siam incurred THB 7.4 bn as carrying cost of the

foreign currency loans the carrying cost resulted in THB 5.52 bn loss in the

second quarter 1998

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Strategy

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Strategy

Arrive at an acceptable level of Risk

Maximise returns for given levels of risk

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Tools and Techniques

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Tools and Techniques

Use of Derivative products (as permitted by RBI)

Forward Exchange Cover Cross Currency Swaps Foreign Currency - Rupee Swaps Cross Currency Options Forward Forward Swaps Forward Rate Agreement Interest Rate Swaps Interest Rate Caps / Collars

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Thank You