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Derivatives - A Risk Management Perspective Dr. Rana Singh www.ranasingh.org Associate Professor. The Changing Environment. The past. India had a highly regulated financial sector regime till 1991 which virtually eliminated financial price risk - PowerPoint PPT Presentation
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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