Derivatives & Risk Management

DERIVATIVES AND RISK MANAGEMENT

RISK??? Difference between Actual & Expected outcome A business firm is exposed to wide array of risks, which are classified in to the following types 1. Technological risks 2. Economic risks 3. Financial risks 4. Internal & External Business risks

Risk Management Tools 2. Examine Financial Statements 4. Analyzing Sensitivity of the firm’s value or cash flows to changes in financial prices 6. Derivatives

Analysis of Financial Statements Understanding the Financial Position • Liquidity Ratio • Operating & Leverage Ratio • Profitability Ratio To get a clear stand • Comparative Analysis • Time Series Analysis

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

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 12.2% Exchg.Rate0.4% 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%

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

Derivatives • A financial product which has been derived from another financial product or commodity. • To manage the risk arising from Movements in markets beyond our control