Derivatives and Risk Management
Transcript of 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)
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 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
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
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 (120 - 10 = 110)
Time Decay Mixed – Hurts for Long Call and helps for Short Call
Use Bearish Outlook
Volatility Volatility Neutral
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 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
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
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 .
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 – LossHigh 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 - ProfitHigh 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 - LossHigh 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 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
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 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.
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/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
Steps for Hedging Currency Exposure
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
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
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 INSURANCE
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.
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
Align risk management with corporate strategies
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