Derivatives - A Risk Management Perspective Dr. Rana Singh ranasingh Associate Professor

1. Derivatives - A Risk Management PerspectiveDr. Rana Singhwww.ranasingh.orgAssociate Professor

2. The Changing Environment

3. 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

4. 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

5. 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

6. Risk: some examples

7. The Laker Experience • In late 1970s, Laker Airlines faced the problem of plenty • The US Dollar was weak compared to pound sterling • British 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

8. 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.

9. 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.

10. 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

11. Risk • Any exogenous factor influencing the performance of a business • Exposure to uncertainty • Volatility in earnings • Deviation of actual from expected

12. Risk Management • Aim of risk management • Knowledge • Ensuring that the risk levels are consistent with corporate objectives • Ensuring 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.

13. 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

14. Risk Management Procedure • Identification • Quantification • Philosophy and strategy • Tools and Technique • Implementation and Control

15. Identification

16. 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

17. 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

18. 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

19. 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

20. Quantification

21. Quantification • Identification of suitable observable proxies • Analysis of proxy behaviour and potential risk impact • Determination of Mean and Variance of future P&L streams

22. 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

23. 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

24. 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

25. 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

26. Philosophy and Strategy

27. Corporate Philosophy

28. 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

29. 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

30. 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 process • a 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

31. 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

32. Strategy

33. Strategy • Arrive at an acceptable level of Risk • Maximise returns for given levels of risk

34. Tools and Techniques

35. 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

36. Thank You