derivatives and risk management

Classification of Risks A business firm is exposed to wide array of risks,

which are classified in to the following types1. Technological risks

2. Economic risks

3. Financial risks

4. Performance risks

5. Legal risks

Why Total Risk Matters?Unsystematic Risk is unique risk and is diversifiable,

whereas Systematic risk is market risk and not diversifiable

Unsystematic risk are not priced in the financial market and has no bearing on the required rate of return

Systematic risk is priced, and hence has an influence on the required rate of return

Unsystematic risk can and often does hurt shareholders

In DCF model, unsystematic risk may lower the expected cash flows

A firm with a high total risk exposure is likely to face financial difficulties which tend to have a disrupting effect on the operating side of the business

A distressed financial condition is likely to Result in the problem of adverse incentives Weaken the commitment of various stakeholders Impair the ability of the firm to avail its tax shelters

Why Total Risk Matters?

Adverse incentivesManagers are inclined to choose highly risky

investments, even if their NPV is –ve

Managers tend to, or may be forced to, abandon operations in profitable fields and liquidate them

Managers of such firm may lower the quality of goods, provide inadequate after sales services, ignore employee welfare, etc.

Weakened commitment Adverse incentives and actions on the part of mgmt. of such firms are

anticipated by its stakeholders

As a result they become reluctant to deal with financially troubled firms

The weakened commitment has an impact on

1. Sales: Compromise in quality, lower standards of after sales services, it turns away potential customers

2. Operating costs: As suppliers may not be willing to build long-term relationship, them may not offer concessions & discounts. Even the employees may not be willing to stay with such firms, so it may have to offer higher compensation

3. Financial costs: It has to pay a higher rate of interest on it borrowings, may face difficulty in securing credit under favourable terms, thus the direct & indirect cost associated with financing tend to be more for a firm perceived to be risky

Diminished Tax ShelterIf a firm has highly variable operating profits, it may

not be able to fully exploit the tax shelter available to it

Some of the tax shelters may have to be foregone because they are available only for a limited period, and some other tax shelters may be availed later thereby reducing the present value of tax savings

Measurement of Risks in Non-Financial firms To assess and measure a firm’s exposure to

financial price risks you may

1. Examine financial statements

2. Assess the sensitivity of the firm’s value or cash flows to changes in financial prices

3. Conduct monte carlo simulation

Examination of Financial StatementsYou can get an idea about a firm’s financial price

risk by perusing its B/S & P&L. The analysis highlights a no. of questions likeDoes the firm have a strong liquidity position as shown

by a high CR & Quick Ratio?Does the firm have a low gearing (leverage) ratio?What is the forex transaction risk exposure?Is the firm exposed to interest rate risk?What is the economic exposure of the firm?What is the state of the market for the output of the

firm?

Sensitivity Sensitivity of the Firm’s Value or Cash Flow

Analyze the historical data on firm value, cash flows and financial prices.

Regress past changes in firm value (or its cash flow) against past

changes in financial prices

Firm valuet = a + b ∆Exchange ratet

Firm valuet = % change in firm value in period t

Exchange ratet = % change in exchange rate in period t

b (slope of the above regression) = the exposure of firm value to

changes in exchange rate

∆EBITDAt = a + b ∆Exchange ratet + c ∆Interest ratet + d ∆Oil pricet

+ e ∆Inflation ratet

The coefficient (b, c, d, e) of each of the independent variables

(exchange rate, interest rate, oil price, inflation rate) reflects the

firm’s cash flow exposure to that variable

ILLUSTRATION

∆EBITDA ∆ Exchg.Rate

∆ Inflation

12.1% 0.4% 12.2%13.5% 2.1% -0.2%61.6% -0.2% 2.2%-90.8% 0.9% -0.2%53.4% 1.7% 1.9%26.2% 0.7% 1.0%

292.5% 1.3% 1.1%-53.5% 0.1% 1.6%219.5% -1.0% 1.8%50.5% -0.7% 7.1%70.3% -1.1% -4.0%-33.3% -1.7% 3.5%51.4% -1.8% 1.5%13.3% -0.5% 1.7%41.1% -4.9% 4.9%23.5% 6.0% 2.2%21.2% 0.4% 2.3%-5.5% -5.3% 0.8%-7.3% -0.5% 4.2%8.8% 1.1% 4.0%

10.9% 2.5% -1.1%-22.5% -1.0% 1.7%19.1% 3.3% 3.2%12.6% -0.3% 1.0%-0.8% -3.8% -2.3%5.5% -1.4% -0.6%

14.0% -6.5% 0.6%-8.2% -2.5% 0.0%-9.8% -0.8% 3.3%

607.9% 1.4% 2.7%1940.7% 7.1% 9.5%

TATA STEEL

CASE DESCRIPTION:

DATA TAKEN FROM THE FINANCIAL YEAR 2000-01 TO 20007-08

Incremental values regressed to arrive at the equation -:

∆ EBITDA = .413 +.406 ∆FX + .301 ∆WPI

R2 = .324

MONTE CARLO SIMULATION DERIVING A SIMULATED DISTRIBUTION OF OUTPUT VARIABLE ( IN

OUR CASE PBT) BY RANDOMLY ASIGNING DIFFERENT PROBABLITIES

TO THE DIFFERENT MACRO- ECONOMIC VARIABLES.

SIMULATION

FORWARDS / FUTURES

Forwards

Definition:

It is an agreement to buy or sell an asset at a certain future time for a certain price.

It can be contrasted from a spot transaction which is an agreement to buy or sell an asset today.

Futures

Definition:

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price.

Unlike forward contracts futures contract are traded on the exchange.

Parameters Forwards Futures

Contract Specifications

Customized Contract as per the needs of the parties involves

Standardized as per the specifications laid sown by the exchange

Counter Party Risk

There is a risk of counterparty default

The clearing corporation is the counterparty. No counterparty risk

Liquidity Less Liquid Highly Liquid due to the participation of multiple parties

Squaring off Can be reversed only with the same counterparty.

Counterparty in most of the cases is not known. It is assigned be the exchange.

Transparency Opaque instruments as contract specifications are not reported in the media

Highly transparent. Price information is disseminated almost instantaneously.

Settlement Settlement takes place on the date of maturity of the contract

Settlement takes place daily due to mark to market provisions

TYPE PURCHASE PRICE

BUY FUTURES 100

TYPE SALE PRICE

SELL FUTURES 100

Mark to Market Provisioning

The act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value.

Example:

Operation of margins for a long position in 2 futures contracts. The initial margin is Rs 2000 per contract, or Rs 4000 in total, and the maintenance margin is Rs 1500 per contract, or Rs 3000 in total. The contract is entered into on June 5 at Rs 400 and closed out on June 26 at Rs 392.3

Day Futures Price Daily gain/Loss Cum Daily Gain Margin Balance Margin Call

June 5 400 - 4000

June 6 397 -600 -600 3400

June 7 396.1 -180 -780 3220

June 8 398.2 420 -360 3640

June 9 397.1 -220 -580 3420

June 10 396.7 -80 -660 3340

June 11 395.4 -260 -920 3080

June 12 393.3 -420 -1340 2660 1340

June 13 393.6 60 -1280 4060

June 14 391.8 -360 -1640 3700

June 15 392.7 180 -1460 3880

June 16 387.00 -1140 -2600 2740 1260

June 17 387.00 0 -2600 4000

June 18 388.1 220 -2380 4220

June 19 388.7 120 -2260 4340

June 20 391 460 -1800 4800

June 21 392.3 260 -1540 5060

Estimation of Futures PriceF = S + C

F = Futures PriceS = Spot PriceC = Cost of Carry = Interest Cost, since the Cost of Carry

for Finance is Interest cost.

F = S(1 + r)t

r = Rate of Interestt = Tenure of the futures contract

OPTIONS

OPTIONS Call Option (Buyer): It gives the buyer the right but not

the obligation to buy the underlying at a particular date at an agreed upon price today.

Put Option (Buyer): It gives the buyer the right but not the obligation to sell the underlying at a particular date at an agreed upon price today.

Whereas the buyer has a right in an option the seller of the option has the obligation to buy or sell for a call or put option respectively.

TYPE STRIKE PREMIUM BREAKEVEN

BUY CALL 110 -20 130 (110 + 20)


BUY PUT 110 -20 90 (110 - 20)


SELL CALL 110 20 130 (110 + 20)


SELL PUT 110 20 90 (110 - 20)

TYPE PRICE BREAKEVEN

BUY FUTURES 100 100

SELL FUTURES 100 100

BHARTI AIRTEL NIFTYDate

Close Price Returns ln(Returns) Close Price Returns ln(Returns)

1-Sep-08 816.2 4350.4 2-Sep-08 834.65 1.0226 0.0224 4516.8 1.0382 0.03754-Sep-08 825.8 0.9893 -0.0107 4456.05 0.9866 -0.01355-Sep-08 803.4 0.9728 -0.0275 4366.2 0.9798 -0.02048-Sep-08 819.8 1.0204 0.0202 4506.5 1.0321 0.03169-Sep-08 836.9 1.0208 0.0206 4489.05 0.9961 -0.0039

10-Sep-08 812 0.9702 -0.0302 4417.25 0.9840 -0.016111-Sep-08 776.95 0.9568 -0.0441 4304.45 0.9745 -0.025912-Sep-08 778.85 1.0024 0.0024 4245.8 0.9864 -0.013715-Sep-08 766.15 0.9836 -0.0164 4068.9 0.9583 -0.042616-Sep-08 774.1 1.0103 0.0103 4091.15 1.0055 0.005517-Sep-08 770.15 0.9948 -0.0051 4009.75 0.9801 -0.020118-Sep-08 761.25 0.9884 -0.0116 4044.5 1.0087 0.008619-Sep-08 805.85 1.0585 0.0569 4272.95 1.0565 0.054922-Sep-08 808.8 1.0036 0.0037 4235.9 0.9913 -0.008723-Sep-08 792.65 0.9800 -0.0202 4143.35 0.9782 -0.022124-Sep-08 810.55 1.0225 0.0223 4179.95 1.0088 0.0088

Date Bharti Airtel (x) Nifty (y)

1-Sep-08

2-Sep-08 0.0224 0.0375

4-Sep-08 -0.0107 -0.0135

5-Sep-08 -0.0275 -0.0204

8-Sep-08 0.0202 0.0316

9-Sep-08 0.0206 -0.0039

10-Sep-08 -0.0302 -0.0161

11-Sep-08 -0.0441 -0.0259

12-Sep-08 0.0024 -0.0137

15-Sep-08 -0.0164 -0.0426

16-Sep-08 0.0103 0.0055

17-Sep-08 -0.0051 -0.0201

18-Sep-08 -0.0116 0.0086

19-Sep-08 0.0569 0.0549

22-Sep-08 0.0037 -0.0087

23-Sep-08 -0.0202 -0.0221

24-Sep-08 0.0223 0.0088

σx = 0.02585

σY = 0.025515

ρ = 0.826689

FORMULA:

Hedge Ratio = ρ X σx σy

Hedge Ratio = 0.8375

ExampleA person has a Rs 2 million exposure in Bharti Airtel. He wants to hedge his risk in this stock. Suggest him the appropriate strategy.

Exposure = 20,00,000Beta = 0.76Nifty = 4500 Lot Size = 200

No. of Contracts = Exposure X Beta______ Lot Size X Current Price

No. of Contracts = 2000000 X 0.76 50 X 4500

No. of Contracts = 6.75 = 7 contracts

Adjusting the Hedge ValueTotal Exposure (Bharti Airtel) = Rs 20,00,000

Futures Contract Value = 4500 X 50 X 6.75 = Rs 15,18,750

Scenario:

The price of Bharti increases by 10% = 2000000 + 10% = 2200000

The price of the Index decreases by 5% = 4275 X 50 X 6.75 = 1442812.5

New Hedge Ratio = 1.52

Adjusting the value of the Hedge = 2200000 X 0.76 = 1672000 = 1672000 –

1442812.5 = 229187.5

The person will have to buy Rs 229187.5 of futures value in order to balance the hedge

HEDGING WHEN UNDERLYING EXPOSURE

Example:

An airline expects to purchase 2 million gallons of jet fuel in 1 month and decided to use heating oil futures for hedging.

TYPE PRICE BREAKEVEN

BUY UNDERLYING 100 100

SELL FUTURES 100 100

Month Price of Jet Fuel

(x)Change in Fuel

Price Price of Heating Oil (y)Change in Fuel

Price

1 100 - 105 -

2 105 0.0488 106 0.0095

3 108 0.0282 110 0.0370

4 103 -0.0474 103 -0.0658

5 110 0.0658 104 0.0097

6 108 -0.0183 101 -0.0293

7 104 -0.0377 105 0.0388

8 106 0.0190 108 0.0282

9 105 -0.0095 109 0.0092

10 107 0.0189 110 0.0091

11 109 0.0185 102 -0.0755

12 110 0.0091 104 0.0194

13 107 -0.0277 106 0.0190

14 104 -0.0284 104 -0.0190

15 101 -0.0293 105 0.0096

Month Price of Jet Fuel

(x) Price of Heating Oil (y)

1 100 105

2 105 106

3 108 110

4 103 103

5 110 104

6 108 101

7 104 105

8 106 108

9 105 109

10 107 110

11 109 102

12 110 104

13 107 106

14 104 104

15 101 105

σx = 0.0342

σY = 0.0352

ρ = 0.2217

FORMULA:

Hedge Ratio = ρ X σx σy

Hedge Ratio = 0.2154

ExampleAn airline expects to purchase 2 million gallons of jet fuel in 1 month and decided to use heating oil futures for hedging.

Exposure = 20,00,000Beta = 0.2217Futures Contract (Heating Oil) = 100Lot Size = 200

No. of Contracts = Exposure X Beta______ Lot Size X Current Price

No. of Contracts = 2000000 X 0.2217 100 X 200

No. of Contracts = 22.17 = 22 contracts

TYPE STRIKE PREMIUM

BUY CALL 120 -10

BUY PUT 120 -10

View Comments

Profit Unlimited

Loss Limited to the extent of premium paid (-20)

Breakeven Low BEP = Strike Price – net Premium (120 – 20 = 100)High BEP = Strike Price + net Premium (120 + 20 = 140)

Time Decay Hurts

Use Expecting a large breakout, Uncertain about the direction

Volatility Volatility improves the position.

TYPE STRIKE PREMIUM

SELL CALL 120 10

SELL PUT 120 10

View Comments

Profit Limited to the extent of premium received (20)

Loss Unlimited

Breakeven Low BEP = Strike Price – net Premium (120 – 20 = 100)High BEP = Strike Price + net Premium (120 + 20 = 140)

Time Decay Helps

Use Expecting a tight sideway movement

Volatility Volatility decrease helps the position

TYPE STRIKE PREMIUM

SELL PUT (A) 100 10

SELL CALL (B) 120 10

View Comments

Profit Limited to the extent of premium received (20)

Loss Unlimited

Breakeven Low BEP = Strike A – net Premium (100 – 20 = 80)High BEP = Strike B + net Premium (120 + 20 = 140)

Time Decay Helps

Use Expecting a tight sideway movement

Volatility Volatility decrease helps the position.

TYPE STRIKE PREMIUM

BUY PUT 100 -10

BUY CALL 120 -10

View Comments

Profit Unlimited

Loss Limited to the extent of premium paid (-20)

Breakeven Low BEP = Strike A – net Premium (100 – 20 = 80)High BEP = Strike B + net Premium (120 + 20 = 140)

Time Decay Hurts

Use Expecting a large breakout, Uncertain about the direction

Volatility Volatility increase helps the position.

TYPE STRIKE PREMIUM

BUY CALL (A) 100 -20


View Comments

Profit Limited, Max Profit = Net Premium (10)

Loss Limited, Max Loss = [(B – A) – Net Premium] (120 – 100 - 10 = 10)

Breakeven Strike A + Max Loss (100 + 10 = 110)

Time Decay Mixed – Hurts for Long Call and helps for Short Call

Use Bullish Outlook

Volatility Volatility Neutral

TYPE STRIKE PREMIUM

BUY PUT (A) 100 -10

SELL PUT (B) 120 20

View Comments

Profit Limited, Max Profit = Net Premium (20 – 10 = 10)

Loss Limited, Max Loss = (B – A) – Net Premium (120 – 100 - 10 = 10)

Breakeven Strike A + Max Loss (100 + 10 = 110)

Time Decay Mixed – Hurts for Long Put and helps for Short Put

Use Bullish Outlook


TYPE STRIKE PREMIUM



TYPE STRIKE PREMIUM

BUY PUT (A) 100 -10

SELL PUT (B) 120 20

View Comments


Loss Limited, Max Loss = (B – A) – Net Premium (120 – 100 - 10 = 10)

Breakeven Strike A + Max Loss (120 - 10 = 110)

Time Decay Mixed – Hurts for Long Call and helps for Short Call

Use Bearish Outlook


TYPE STRIKE PREMIUM

BUY PUT(A) 120 -20

SELL PUT (B) 100 10

View Comments


Loss Limited, Max Loss = (A– B) – Net Premium (120 – 100 - 10 = 10)

Breakeven Strike A + Max Loss (120 - 10 = 110)

Time Decay Mixed – Hurts for Long Put and helps for Short Put

Use Bearish Outlook


TYPE STRIKE PREMIUM


2 SELL CALL (B) 120 20

BUY CALL (C) 140 -5

View Comments

Profit Limited to [(C – B) – Net Premium] [(140 – 120) – 15] = 5

Loss Limited to the extent of Net Premium paid

Breakeven Low BEP = Middle Strike – ProfitHigh BEP = Middle Strike + Profit

Time Decay Neutral

Use Large stock price movement unlikely .


TYPE STRIKE PREMIUM

SELL CALL (A) 100 20

2 BUY CALL (B) 120 -20

SELL CALL (C) 140 5

View Comments

Profit Limited to the extent of Net Premium received

Loss Limited to [(C – B) – Net Premium] [(140 – 120) – 5] = -15

Breakeven Low BEP = Middle Strike – LossHigh BEP = Middle Strike + Loss

Time Decay Neutral

Use Large stock price movement expected .


TYPE STRIKE PREMIUM

BUY CALL (A) 80 -20


SELL CALL (C) 120 5

BUY CALL (D) 140 -5

View Comments

Profit Limited, maximum when spot is between B and C

Loss Limited, maximum when spot is < A and >D

Breakeven Low BEP = B - ProfitHigh BEP = C + Profit

Time Decay Neutral

Use Large stock price movement unlikely.


TYPE STRIKE PREMIUM

SELL CALL (A) 80 20

BUY CALL (B) 100 -10

BUY CALL (C) 120 -5

SELL CALL (D) 140 5

View Comments

Profit Limited, maximum when spot is < A and >D

Loss Limited, maximum when spot is between B and C

Breakeven Low BEP = B - LossHigh BEP = C + Loss

Time Decay Neutral

Use Large stock price movement expected.


TYPE STRIKE PREMIUM


SELL PUT (B) 100 10

View Comments

Profit Increases as the spot price increases

Loss Increases as the spot price decreases

Breakeven B + Net Premium

Time Decay Neutral

Use Large stock price movement expected.


TYPE STRIKE PREMIUM

2 BUY CALL (A) 100 -40

BUY PUT (B) 100 -20

View Comments

Profit Unlimited

Loss Limited to the extent of premium paid

Breakeven Low BEP = Strike Price –Net PremiumHigh BEP = Strike Price + (Net Premium/2)

Time Decay Hurts

Use Expecting a large breakout. Uncertain about the direction. Increase in the asset price more likely

Volatility Volatility Increase improves the position

TYPE STRIKE PREMIUM


2 BUY PUT (B) 100 -40

View Comments

Profit Unlimited

Loss Limited to the extent of net premium paid

Breakeven Low BEP = Strike Price – (Net Premium/2)High BEP = Strike Price + Net Premium

Time Decay Hurts

Use Expecting a large breakout. Uncertain about the direction. Decrease in the asset price more likely

Volatility Volatility Increase improves the position

The trade: Buy NIFTY 4200 Put and Sell (Two lots) NIFTY 4000 Put

View: Moderately Bearish

Rationale: Nifty futures have filled the upward gap that it formed on Mondayand have shown gap down opening today on the back of good volumes. Most ofthe Nifty-50 stocks are trading in negative territory. We expect the Index to testlower levels in the current series. Our strategy would be profitable in case Niftyexpires in the broad range of 4179-3821.

Margin: Rs. 45,000 (Approx.)

Nifty Bear Ratio SpreadProfit & loss characteristics at expiry:

The strategy is profitable if NIFTY expires in the range of 4179-3821.

The maximum profit would be Rs. 8,950 if NIFTY expires at 4000.

If NIFTY expires above 4200 then the maximum loss is limited to Rs. 1,050.00

On the downside loss starts below 3821.

Break-even: Depending on the strikes chosen, the position yields a net debit of Rs. 1,050.00. Break-even will occur at 4179 & 3821.

Nifty Bear Ratio Spread

Maximum Loss: (79 X 50) – (29 X 2 X 50) = Rs. 1050

Steps for Hedging Currency Exposure

The company has to identify the inflows/outflows in terms of the foreign currency transactions. The company has to identify these transactions in terms of:Quantum of the transactions (Exposure Value)Expected Time (The contract maturity time)

The company has study the markets to draw its own estimates of the risks involved which would help it to negotiate with the bank better

The company has to approach the banker with its requirements. These

requirements has to be in terms of:The net receivables or PayablesThe level of risk protection neededOther specific requirements

The company has to cross check the rates given to it by the banks. The rates that have to be checked are:

The Spot rateThe Forward RateThe premium charged by the bank for the structure

suggested

The company then in consultation with the banker

locks the rates at which it would like to receive or make payments.


The company and the banker then prepare the contract note (term sheet) which sets out the terms and conditions for the transaction. Some of the terms are as follows:The amount sold/purchasedRate at which it is sold/purchasedTenure of the contract

The contract note has to be stamped by the banker (legal stamping) (franking). The contract after it has been signed becomes legally binding

The company needs to get back the verified copy of the contract

leaving the duplicate with the banker

At the time specified in the contract the bank converts the positions

as per the terms agreed


Term SheetStructure Details:

Start Date: TodayMaturity Date: Today + 1 yearCurrency: USDJPYNotional (N): USD 50,00,000Additional Notional (AN): USD 3,00,000TO = SpotT1 = Spot on Maturity

Payoff Scenario:

Client Receives = min[(1 – (T0/T1)*N + AN, AN)]

Swaps

Meaning:

An Agreement between two parties to exchange one set of cash flows for another

Major two types of SwapsInterest Rate SwapsCurrency Swaps

Important DatesStart Date

Trade Date

Expiry Date / Maturity Date

Reset Date

Terms

LIBOR

Floating Rate

Fixed Rate

Day count convention

Spread

Interest Rate Swap

Meaning:

An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Swaps are derivative contracts and trade over-the-counter.

Features – Interest Rate Swaps

Effectively translates a floating rate borrowing into a fixed rate borrowing and vice versa

No exchange of principal repayment obligation

Structured as a separate contract distinct from the underlying loan agreement

Treated as off balance sheet transaction

Plain Vanilla Interest Rate Swap

Meaning:

Company agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. In return, if receives interest at a floating rate on the same notional principal for the same period of time

ExampleConsider a hypothetical 3 year swap initiated on March 5,

2004, between Microsoft and Intel. We suppose Microsoft agrees to pay to Intel an interest rate 3.95% per annum on a notional principal of $100 million, and in return Intel agrees to pay Microsoft the 6 month LIBOR rate on the same notional principal.

Fixed Floating

Intel 4.00% 6month LIBOR+0.3%

Microsoft 5.2% 6month LIBOR+1.0%

Transaction

Intel Microsoft4%

LIBOR + 1%

Fixed Floating

Intel 4.00% 6month LIBOR+0.3%

Microsoft 5.2% 6month LIBOR+1.0%

Payoffs

MicrosoftPays LIBOR + 1% to

outside lendersReceives LIBOR under

the terms of SwapsPays 3.95% under the

terms of Swaps Effectively net cash

outflow of 4.95% (5.2%)

IntelPays 4% to its outside

lendersPays LIBOR under the

terms of SwapsReceives 3.95% under

the terms of SwapsEffectively net cash

outflow of LIBOR +0.05% (LIBOR + 0.3%)

Banker’s Spread

When bankers act as an intermediary in this type of transaction, they take some portion of the profit taken by both the parties in the form of charges.

In given case net gain was 0.5 which was distributed between both the parties as 0.25 each. But if bankers come into the picture then then will charge around 0.02 from both the parties. So net gain for both the parties would be 0.23 each and net gain for the banker would be 0.02 + 0.02 = 0.04

Uses

SpeculationReducing funding costsHedging interest rate exposureCorporate financeRisk management

Risks

Interest rate risk

Credit risk

Currency SwapsMeaning:

A currency swap is a contract which commits two counter parties to an exchange, over an agreed period, two streams of payments in different currencies, each calculated using a different interest rate, and an exchange, at the end of the period, of the corresponding principal amounts, at an exchange rate agreed at the start of the contract.

Features – Currency Swaps

An exchange of cash flows in two different currencies

Exchange of principal amount at the beginning or at the end of the contract

Calculated using different interest rates

The agreed exchange rate need not be related to the market

Example

USD AUD

General Motors 5.0% 12.6%

Qantas Airways 7.0% 13.0%

Transaction

USD 5.0% USD 6.3%

AUD 13%

AUD 11.9% AUD 13.0%

General Motors

Qantas Airways

Financial Institution

USD 5%

USD AUD

General Motors 5.0% 12.6%

Qantas Airways 7.0% 13.0%

Payoffs

General MotorsPays 5% in USD to the

outside lender Pays 11.9% AUD under

swap agreement

Receives 5% USD under swap agreement

Effectively net cash outflow of AUD 11.9% (12.6%)

Qantas Airways Pays 13% AUD to the

outside lender

Pays 6.3% USD under the swap agreement

Receives 13% AUD under the swap agreement

Effectively net cash outflow of USD 6.3% (7%)

Uses

Switching loan from one currency to another currency

Tap Foreign Capital Markets for Low Cost Financing

Lower Financing Costs for Foreign Subsidiaries

RisksInterest rate risk

Currency risk

Pre settlement riskCredit default riskDowngrading of credit rating

Settlement riskCredit default risk

Comparison of Interest Rate Swaps and Currency Swaps

Interest Rate SwapsAn exchange of

payment in single currency

No exchange of principal amount since it is notional

Off balance sheet instruments

Currency SwapsAn exchange of

payment in two currencies

An exchange of principal amount

Not an off balance sheet instrument

Principal only SwapsA corporate having a fixed liability of US$ 100000

which it wants to convert into Rupees as it is vary of the exchange rate movements

It will enter into a swap with a bank whereby it will pay the bank a fixed amount of rupees every month and the bank will in turn pay a fixed amount of Dollars to the corporate. Only the principal will be exchanged

Default SwapsIt is a credit derivative to protect against default risk

Bank P agrees to pay a fixed amount annually to Bank Q, as long as A, the borrower of Bank P, does not default.

In return, Bank Q promises to compensate Bank P, should A default

In essence Bank P is buying an insurance from Bank Q against the default risk by paying an insurance premium every year.

HEDGING WITH INSURANCE

NEEDS:

Hedging the risk of plant destruction in a fire, risk of liabilities arising from legal suits, risk of losing key persons and so on are the needs for which business firms go for hedging with insurance


The Main Advantages Offered by an Insurance Company Are:

• It can provide low-cost claims administration service due to specialization and economy of scale

• It can price risk reasonably accurately

• It has expertise in providing advice on measures to reduce risks

• It can reasonably mitigate risk by holding a large, diversified pool of assets

Cost of Insurance Can Increase Due To These Disadvantages:

• Administration costs incurred by insurance company• Adverse selection• Problem of moral hazard


As per discussion, when the costs incurred by insurance company due to above disadvantages i.e. Loading Fee (LOADING FEE =Insurance premium – Expected payoff) are negligible then it is worthwhile to insure, are large insurance may be costly way to shed risk


Hedging with Real Tools and Options Diversify Product Line and services to reduce economic risks

Invest in preventive maintenance to mitigate technological risks

Emphasize quality control to reduce the product liability from defective product liabilities.

Carry extra liquidity in order to tide over difficult periods

Locate plants abroad in order to mitigate currency risks

Stage R & D investments rather then make huge commitments at one time

Increase outsourcing in order to reduce fixed costs

Guidelines for Risk Management

Align risk management with corporate strategy

Proactively manage uncertainties

Employ a mix of real and financial methods

Know the limits of risk management tools

Don’t put undue pressure on corporate treasuries to generate profits

Learn when it is worth reducing risk

Align risk management with corporate strategies

Internal SourcesExternal Borrowing

Cash

Positive NPV Investment

Corporate Value

Sources of Finance

Costly

Omega drugs, a hypothetical multinational pharmaceutical co., is based in the US but roughly one half of its revenues come from foreign sales. While the co can forecast its foreign sales volume reliably, it is uncertain about its dollar value because of exchange rate volatility.


Payoff from Omega Drug's R&D Investment

R&D Level Discounted Cash Flow NPV

200 320 120

400 580 180

600 720 120


Hedging

Dollar Position Hedge Payoff (in millions of dollars)

Appreciating 200

Stable 0

Depreciating -200

Impact of Hedging

DollarPosition

InternalFunds

R&D withoutHedging

HedgePayoff

AdditionalR&D FromHedging

Value from Hedging

Appreciating 200 200 200 200 260

Stable 400 400 0 0 0

Depreciating 600 400 -200 0 -200

Risk Management

Proactively Manage Uncertainties Changing prices, shifting consumer behavior,

unpredictable competitive reactions, fluctuating interest rates

Flexible StrategiesGrowth OptionSwitching Option

Focused Strategies

Uncertainty and Flexibility

Level of Uncertainty

HighThreatening

SituationFlexible Strategies

LowFocused Strategies

Wasteful Flexibility

Low High

Use of Flexibility

Employ a Mix of Real and Financial Tools

Financial Methods

Restrictions of debt-equity ratio

Futures and forward contract

OptionsSwapsFinancing instruments like

convertible debentures and commodity bonds

Insurance

Real Methods

Loss preventionJoint venturesAvoidance of high risk

projectsReduction of the degree of

operating leverage

Risk Management

Know the limit of Risk Management

Transaction costComplete hedging not possibleRisk factor

Risk ManagementDo not put undue pressure on corporate treasuries

to generate profits

Learn when it is worth reducing the riskRisk bearing abilitiesOptimum level of riskRisk Substitution

Industry Profile India is the fastest growing and third largest telecom market in the

world

India’s subscriber base expected to reach 400 mn by March 2009

Net adds in India has accelerated to 8-9 mn in recent months

New telecom players will require ready towers for quick rollout and establishing national experience

New entrants will opt for co-location in order to save their upfront capex

Network quality concerns remain one of the primary reasons why customers switch operators and the churn remains an important cost driver for the operators.

A scarcity of spectrum and ever increasing subscriber base is leading to poor quality network and frequent call drops

Industry ProfileMOU is increasing (presently MOU is about 464

min/month) leading to an increase in capacity requirement for existing subscribers

Emergence of Data application technologies like 3G, EDGE and WiMAX will lead to uninterrupted high speed flow of data application while maintaining the voice quality services.

Company Profile

GTL Infra was established in 2004 and listed on the BSE & NSE in November 2006

We are the pioneers of Shared Passive Telecom infrastructure industry in India

We have rolled out 6,010 towers by the end of FY08

We have signed Master Service Agreements with six leading Indian Telecom Operators

We serve five pan India operators and three operators who have bagged pan India licenses in the recent round of allotments

RISKS AND SOLUTIONSBusiness Concentration Risk: The risk of the a entire portion of

the company’s revenue coming from one source (Telecom Towers)

Measures to Address the Risk: Spreading its revenues across geographies and customers.

Contractual Risk: Covenants in the Service Level Agreements could places the risk of liabilities with the operators.

Measures to Address the Risk: It limits its liability clause to various identifiable risk and also has put in Insurance cover wherever necessary.

Financial Risk:Credit Risk: The risk of the customer not paying the company as

per the tenant lease.

Measures: Spreading its revenues across customers

Interest Rate Fluctuation Risk: The company has taken borrowings from abroad at a floating rate of interest.

Liquidity and Leverage Risk: The liquidity risk due to the company being in the infrastructure business.

Measures: All the loans have a 3 year moratorium period. The company also has a conservative leverage ratio of 2.15:1

RISKS AND SOLUTIONS

The company has provided for Insurance cover for the following Risks:

Infosys Technologies

Introduction Infosys Technologies has an integrated risk management in which the Board of Directors is responsible for monitoring the risk levels and the Management Council is responsible for implementing risk mitigation measures.

Classification of RisksBusiness Portfolio Risk:

Restrict Business from any single service offering to 25% of the total revenue

Limit the revenues from any single client to 10% of total revenue

Proactively look for business opportunities in new geographical areas to increase their contribution to the total reveues

Closely monitor the proportions of revenues from various vertical domains and focus marketing efforts in chosen domains

Solicit business from sunrise technologies to keep the risk of technology concentration within manageable limits.

Classification of RisksFinancial Risks:

Avoid active trading positions in the foreign currency markets Hedge a portion of Dollar receivables in the forward market Maintain a highly liquid Balance Sheet in which liquid assets are around

25% of the net revenues and 40% of the total assets Eschew debt or use debt financing only for short term purposes

Legal and Statutory Risk: Clearly chart out a review and documentation process for contracts Take sufficient insurance abroad to cover possible liabilities arising out of non

performance of the contract Avoid contracts which have open ended legal obligations Have a compliance officer to advice the company on compliance issues with

respect to the laws of various jurisdictions and ensure that the company is not in violation of the laws.

Classification of RisksInternal Process Risks

Adopt ISO 9001 and CMM Level 5 quality standardsDocument and disseminate experienced knowledgeCreate a favorable work environment, encourage innovation,

practice meritocracy and develop a well balanced compensation plan (that includes ESOP) to attract and retain people

Make appropriate investments in technology

Political Risks: Explore the possibility of establishing development centers in

countries other than India

derivatives and risk management

Documents

rate risk

firms financial price

market risk

unique risk

diversifiableunsystematic

financial price risks

financial market

total risk matters