Derivatives And Risk Management

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

which are classified in to the following types 1. 2. 3. 4. 5.

Technological risks Economic risks Financial risks Performance risks 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

Why Total Risk Matters?  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

Adverse incentives Managers 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 Shelter If 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 2. 3. 4.

financial price risks you may Examine financial statements Assess the sensitivity of the firm’s value or cash flows to changes in financial prices Conduct monte carlo simulation

Examination of Financial Statements You 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 like Does 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 12.1% 13.5% 61.6% -90.8% 53.4% 26.2% 292.5% -53.5% 219.5% 50.5% 70.3% -33.3% 51.4% 13.3% 41.1% 23.5% 21.2% -5.5% -7.3% 8.8% 10.9% -22.5% 19.1% 12.6% -0.8% 5.5% 14.0% -8.2% -9.8% 607.9% 1940.7%

∆ ∆ Inflation TATA STEEL 0.4% 12.2% Exchg.Rate 2.1% -0.2% 0.9% 1.7% 0.7% 1.3% 0.1% -1.0% -0.7% -1.1% -1.7% -1.8% -0.5% -4.9% 6.0% 0.4% -5.3% -0.5% 1.1% 2.5% -1.0% 3.3% -0.3% -3.8% -1.4% -6.5% -2.5% -0.8% 1.4% 7.1%

-0.2% 2.2% -0.2% 1.9% 1.0% 1.1% 1.6% 1.8% 7.1% -4.0% 3.5% 1.5% 1.7% 4.9% 2.2% 2.3% 0.8% 4.2% 4.0% -1.1% 1.7% 3.2% 1.0% -2.3% -0.6% 0.6% 0.0% 3.3% 2.7% 9.5%

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 Settlement takes place daily due date of maturity of the contract 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

June 5

400

-

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

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

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

Margin Call

4000

1340

1260

Estimation of Futures Price F=S+C F = Futures Price S = Spot Price C = Cost of Carry = Interest Cost, since the Cost of Carry for Finance is Interest cost. F = S(1 + r)t r = Rate of Interest t = 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)

TYPE

STRIKE

PREMIUM

BREAKEVEN

BUY PUT

110

-20

90 (110 - 20)

TYPE

STRIKE

PREMIUM

BREAKEVEN

SELL CALL

110

20

130 (110 + 20)

TYPE

STRIKE

PREMIUM

BREAKEVEN

SELL PUT

110

20

90 (110 - 20)

TYPE

PRICE

BREAKEVEN

BUY FUTURES

100

100

SELL FUTURES

100

100

TYPE

PRICE

BREAKEVEN

BUY FUTURES

100

100

SELL FUTURES

100

100

BHARTI AIRTEL Date 1-Sep-08 2-Sep-08 4-Sep-08 5-Sep-08 8-Sep-08 9-Sep-08 10-Sep-08 11-Sep-08 12-Sep-08 15-Sep-08 16-Sep-08 17-Sep-08 18-Sep-08 19-Sep-08 22-Sep-08 23-Sep-08 24-Sep-08

Close Price

NIFTY

Returns ln(Returns) Close Price Returns ln(Returns) 816.2 4350.4 834.65 1.0226 0.0224 4516.8 1.0382 0.0375 825.8 0.9893 -0.0107 4456.05 0.9866 -0.0135 803.4 0.9728 -0.0275 4366.2 0.9798 -0.0204 819.8 1.0204 0.0202 4506.5 1.0321 0.0316 836.9 1.0208 0.0206 4489.05 0.9961 -0.0039 812 0.9702 -0.0302 4417.25 0.9840 -0.0161 776.95 0.9568 -0.0441 4304.45 0.9745 -0.0259 778.85 1.0024 0.0024 4245.8 0.9864 -0.0137 766.15 0.9836 -0.0164 4068.9 0.9583 -0.0426 774.1 1.0103 0.0103 4091.15 1.0055 0.0055 770.15 0.9948 -0.0051 4009.75 0.9801 -0.0201 761.25 0.9884 -0.0116 4044.5 1.0087 0.0086 805.85 1.0585 0.0569 4272.95 1.0565 0.0549 808.8 1.0036 0.0037 4235.9 0.9913 -0.0087 792.65 0.9800 -0.0202 4143.35 0.9782 -0.0221 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

Example

A 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 = 20,00,000 Beta = 0.76 Nifty = 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 Value  Total 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

Example An airline expects to purchase 2 million gallons of jet fuel in 1 month and decided to use heating oil futures for hedging. Exposure = 20,00,000 Beta = 0.2217 Futures Contract (Heating Oil) = 100 Lot 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

SELL CALL (B)

120

10

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

Volatility

Volatility Neutral

TYPE

STRIKE

PREMIUM

BUY CALL (A)

120

-20

SELL CALL (B)

100

10

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 (120 - 10 = 110)

Time Decay

TYPE – Hurts for Long STRIKE PREMIUM Mixed Call and helps for Short Call

Use

BUY PUT (A) Bearish Outlook

100

-10

Volatility

SELL PUT (B) Volatility Neutral

120

20

TYPE

STRIKE

PREMIUM

BUY PUT(A)

120

-20

SELL PUT (B)

100

10

View

Comments

Profit

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

Loss Breakeven

Limited, Max Loss = (A– B) – Net Premium (120 – 100 -Strike 10 = A10) + Max Loss (120 - 10 = 110)

Time Decay

Mixed – Hurts for Long Put and helps for Short Put

Use

Bearish Outlook

Volatility

Volatility Neutral

TYPE

STRIKE

PREMIUM

BUY CALL (A)

100

-20

2 SELL CALL (B)

120

20

BUY CALL (C)

140

-5

View

Comments

Profit

Limited to [(C – B) – Net Premium] [(140 – 120) – 15] = 5 Limited to the extent of Net Premium paid

Loss Breakeven

Low BEP = Middle Strike – Profit High BEP = Middle Strike + Profit

Time Decay

Neutral

Use

Large stock price movement unlikely .

Volatility

Volatility Neutral

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 – Loss High BEP = Middle Strike + Loss

Time Decay

Neutral

Use

Large stock price movement expected .

Volatility

Volatility Neutral

TYPE

STRIKE

PREMIUM

BUY CALL (A)

80

-20

SELL CALL (B)

100

10

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 - Profit High BEP = C + Profit

Time Decay

Neutral

Use

Large stock price movement unlikely.

Volatility

Volatility Neutral

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 - Loss High BEP = C + Loss

Time Decay

Neutral

Use

Large stock price movement expected.

Volatility

Volatility Neutral

TYPE

STRIKE

PREMIUM

BUY CALL (A)

130

-20

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.

Volatility

Volatility Neutral

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 Premium High 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

BUY CALL (A)

100

-20

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 Monday and have shown gap down opening today on the back of good volumes. Most of the Nifty-50 stocks are trading in negative territory. We expect the Index to test lower levels in the current series. Our strategy would be profitable in case Nifty expires in the broad range of 4179-3821. Margin: Rs. 45,000 (Approx.)

Nifty Bear Ratio Spread Profit & 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 Payables  The level of risk protection needed  Other specific requirements

Steps for Hedging Currency Exposure The company has to cross check the rates given to it

by the banks. The rates that have to be checked are:  The Spot rate  The Forward Rate

 The 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.

Steps for Hedging Currency Exposure  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/purchased  Rate at which it is sold/purchased  Tenure 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 Sheet Structure Details: Start Date: Today Maturity Date: Today + 1 year Currency: USDJPY Notional (N): USD 50,00,000 Additional Notional (AN): USD 3,00,000 TO = Spot T1 = 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 Swaps Interest Rate Swaps Currency Swaps

Important Dates Start 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 overthe-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

Example Consider 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 4%

Intel

Microsoft LIBOR + 1% Fixed

Floating

Intel

4.00%

6month LIBOR+0.3%

Microsoft

5.2%

6month LIBOR+1.0%

Payoffs Microsoft

Intel

 Pays LIBOR + 1% to

 Pays 4% to its outside

outside lenders  Receives LIBOR under the terms of Swaps  Pays 3.95% under the terms of Swaps  Effectively net cash outflow of 4.95% (5.2%)

lenders  Pays LIBOR under the terms of Swaps  Receives 3.95% under the terms of Swaps  Effectively 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 Speculation Reducing funding costs Hedging interest rate exposure Corporate finance Risk management

Risks Interest rate risk Credit risk

Currency Swaps Meaning: 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% General Motors

USD 5.0%

USD 6.3%

Financial AUD 11.9% Institution

Qantas AUD 13.0% Airways

USD

AUD

General Motors

5.0%

12.6%

Qantas Airways

7.0%

13.0%

AUD 13%

Payoffs General Motors  Pays 5% in USD to the

outside lender

 Pays 11.9% AUD under

swap agreement

 Receives 5% USD under

swap agreement

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 AUD 11.9% (12.6%)

 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

Risks Interest rate risk Currency risk Pre settlement risk Credit default risk Downgrading of credit rating

Settlement risk Credit default risk

Comparison of Interest Rate Swaps and Currency Swaps Interest Rate Swaps  An exchange of

payment in single currency

 No exchange of

principal amount since it is notional

 Off balance sheet

instruments

Currency Swaps  An exchange of

payment in two currencies  An exchange of

principal amount  Not an off balance

sheet instrument

Principal only Swaps A 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 Swaps It 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

HEDGING WITH INSURANCE The Main Advantages Offered by an Insurance Company Are: • It can provide low-cost claims

administration due to specialization and economy of scale

service

• 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

HEDGING WITH INSURANCE Cost of Insurance Can Increase Due To These Disadvantages: • Administration costs incurred by insurance company • Adverse selection • Problem of moral hazard

HEDGING WITH INSURANCE 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 Sources of Finance External Borrowing

Internal Sources

Costly

Cash

Positive NPV Investment

Corporate Value

Align risk management with corporate strategies 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.

Align risk management with corporate strategies

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 Dollar Position

Internal Funds

R&D without Hedge Hedging Payoff

Additional R&D From Hedging

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 Strategies  Growth

Option  Switching Option Focused Strategies

Uncertainty and Flexibility

Level of Uncertainty

High

Threatening Situation

Flexible Strategies

Low

Focused Strategies

Wasteful Flexibility

Low

Use of Flexibility

High

Employ a Mix of Real and Financial Tools Financial Methods

Real Methods

 Restrictions of debt-equity

 Loss prevention

ratio  Futures and forward contract  Options  Swaps  Financing instruments like convertible debentures and commodity bonds  Insurance

 Joint ventures  Avoidance of high risk

projects  Reduction of the degree of operating leverage

Risk Management Know the limit of Risk Management Transaction cost Complete hedging not possible Risk factor

Risk Management Do not put undue pressure on corporate treasuries

to generate profits Learn when it is worth reducing the risk Risk bearing abilities Optimum level of risk Risk 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 Profile MOU 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 SOLUTIONS Business 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.

RISKS AND SOLUTIONS 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

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 Risks Business 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 Risks  Financial 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 Risks Internal Process Risks  Adopt ISO 9001 and CMM Level 5 quality standards  Document and disseminate experienced knowledge  Create 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