term paper derivatives

8/7/2019 term paper derivatives

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FULL DESCRIPTION

ICICI Bank Limited (the Bank), incorporated on January 5, 1994, is a banking company

engaged in providing a range of banking and financial services, including commercial

banking and treasury operations. It operates under four segments: retail banking,

wholesale banking, treasury and other banking. The Banks subsidiaries include ICICI

Prudential Life Insurance Company Limited, ICICI Lombard General Insurance

Company Limited, ICICI Trusteeship Services Limited, ICICI Prudential Pension Funds,

Management Company Limited, ICICI Home Finance Company Limited and ICICI

Securities Limited.

Retail Banking Group

The retail sales and service architecture has been organized into four geographies.

These have been further divided into zonal and regional structures. The Retail Strategy,

Product & Policy Group has been formed to develop customer-segment specific

strategies, including product design and service propositions. The Retail Banking Group

is also responsible for inclusive and rural banking. The Banks retail portfolio (including

builder finance and dealer funding) as of March 31, 2010 was Rupees 790.45 billion,

constituting 43.6% of its overall loan portfolio.

The Bank has segmented offerings for the small and medium enterprises sector while

adopting a cluster based financing approach to fund small enterprises that have a

homogeneous profile, such as engineering, information technology, transportation and

logistics and pharmaceuticals. It also offers supply chain financing solutions to the

channel partners of corporate clients and business loans (in the form of cash

credit/overdraft/term loans) to meet the working capital needs of small businesses. The

Banks corporate banking strategy is based on providing customized financial solutions

to its corporate customers. It offers a range of corporate banking products, including

rupee and foreign currency debt, working capital credit, structured financing, syndication

and commercial banking products and services.


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The Banks international strategy is focused on building a retail deposit franchise,

meeting the foreign currency needs of its Indian corporate clients, taking select trade

finance exposures linked to imports to India and achieving the status of the preferred

non-resident Indian (NRI) community bank in key markets. It also seeks to build

wholesale funding sources and syndication capabilities to support the corporate and

investment banking business, and to expand private banking operations for India-centric

asset classes. ICICI Bank has subsidiaries in the United Kingdom, Russia and Canada,

branches in Singapore, Bahrain, Hong Kong, Sri Lanka, Dubai International Finance

Centre, Qatar Financial Centre and the United States and representative offices in the

United Arab Emirates, China, South Africa, Bangladesh, Thailand, Malaysia and

Indonesia. The Banks wholly owned subsidiary ICICI Bank UK PLC has 11 branches in

the United Kingdom and a branch each in Belgium and Germany. ICICI Bank Canada

has nine branches. ICICI Bank Eurasia Limited Liability Company has two branches.

Wholesale Banking Group

Wholesale Banking includes all advances to trusts, partnership firms, companies and

statutory bodies. It comprises the Corporate Banking Group, Commercial Banking

Group, Investment Banking Group, Project Finance Group, Financial Institutions and

Capital Markets Group, Government Banking Group and Mid-corporate & Small

Enterprises Group.

Treasury

Treasury includes the entire investment portfolio of the Bank. It provides foreign

exchange and derivative products and services to its customers through the Global

Markets Group. These products and services include foreign exchange products for

hedging currency risk, foreign exchange and interest rate derivatives like options and

swaps and bullion transactions. The Bank also hedges its own market risks related to

these products with banking counterparties. The Banks overseas branches and


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"In this instance, with the limited one-year tenor on dollar/rupee options, we used our

book to develop five-year options, something that doesn't exist in the market."

The dealer has also worked hard to promote a long-tenor - that is, up to five years -

currency options business in India. "Dollar/rupee has been quite volatile in the pastyear," says Kumar. "But the options market is only liquid up to one year. As one of the

biggest market-makers in the field, we have been working hard to extend the volatility

curve on dollar-rupee options, and have completed some large-size transactions this

year."

ICICI also worked with an Indian drinks maker, the second largest liquor business in the

world, to find a cost-reduction solution on a pound-denominated floating-rate liability.

The company entered into a floating-to-fixed interest rate swap in which the bank

embedded a series of range accruals, enabling the corporate to save 50 basis points on

its liability.

The bank has also sought - through its position on the Derivatives Review Committee,

set up by the Securities and Exchange Board of India - to encourage the growth of

equity derivatives in India, particularly equity derivatives options. It has also been

providing a great deal of input to India's Fixed Income Money Markets and Derivatives

Association on the development of the long-awaited credit derivatives markets in India.

Reputation for research

Meanwhile, ICICI's derivatives research shines brightest in the Indian banking sector.

The research team created its Global Risk Index for clients in 2007, combining

individual measures of risk - such as the Chicago Board Options Exchange Volatility

Index, currency volatility, interest rate swap spreads and emerging market and

corporate bond spreads - into a consolidated whole. ICICI also created a series of Data

Surprise indexes to capture the effects of economic and financial news on the forex andrates markets.

On an international level, ICICI started its offshore client-centric treasury desk - the first

initiative of its kind by an Indian bank. Its key objective is to manage the risks arising

from the structuring solutions provided to overseas clients. This division plays a dual


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role by market-making in vanilla non-rupee derivatives, such as foreign-currency

interest rate swaps and vanilla currency options, as well as structuring and executing

trades for its overseas franchise.

For example, the bank has emerged as a one-stop shop for Nepalese banks looking tobuy a range of structured derivatives products and has helped Singaporean and Kazakh

companies manage their liability and funding risks. ICICI has also has been working

with Sri Lankan banks to help create depth in their domestic derivatives and forex

market, by offering them its own online platform to cover transactions at interbank rates.

ICICI has comfortably justified its claims to this award yet again.


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Currency risk:

is a form of risk that arises from the change in price of one currency against another.

Whenever investors or companies have assets or business operations across national

borders, they face currency risk if their positions are not hedged.

Transaction risk is the risk that exchange rates will change unfavorably over time. It

can be hedged against using forward currency contracts;

Translation risk is an accounting risk, proportional to the amount of assets held in

foreign currencies. Changes in the exchange rate over time will render a report

inaccurate, and so assets are usually balanced by borrowings in that currency.

The exchange risk associated with a foreign denominated instrument is a key element

in foreign investment. This risk flows from differential monetary policy and growth in real

productivity, which results in differential inflation rates.

For example if you are a U.S. investor and you have stocks in Canada, the return that

you will realize is affected by both the change in the price of the stocks and the change

of the Canadian dollar against the U.S. dollar. Suppose that you realized a return in the

stocks of 15% but if the Canadian dollar depreciated 15% against the U.S. dollar, you

would make a small loss.

When a firm conducts transactions in different currencies, it exposes itself to risk. The

risk arises because currencies may move in relation to each other. If a firm is buying

and selling in different currencies, then revenue and costs can move upwards or

downwards as exchange rates between currencies change. If a firm has borrowed funds

in a different currency, the repayments on the debt could change or, if the firm has

invested overseas, the returns on investment may alter with exchange rate movements

this is usually known as foreign currency exposure.

Currency risk exists regardless of whether you are investing domestically or abroad. If

you invest in your home country, and your home currency devalues, you have lost

money. Any and all stock market investments are subject to currency risk, regardless of


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the nationality of the investor or the investment, and whether they are the same or

different. The only way to avoid currency risk is to invest in commodities, which hold

value independent of any monetary system.

Currency risk has been shown to be particularly significant and particularly damaging forvery large, one-off investment projects, so-called megaprojects. This is because such

projects are typically financed by very large debts nominated in currencies different from

the currency of the home country of the owner of the debt. Megaprojects have been

shown to be prone to end up in what has been called the "debt trap," i.e., a situation

where due to cost overruns, schedule delays, unforeseen foreign currency and

interest rate increases, etc. the costs of servicing debt becomes larger than the

revenues available to do so. Financial restructuring is typically the consequence and is

common for megaprojects.

Commodity risk refers

to the uncertainties of future market values and of the size of the future income, caused

by the fluctuation in the prices of commodities.[1] These commodities may

be grains, metals, gas, electricity etc. A commodity enterprise needs to deal with the

following kinds of risks:

Price risk (Risk arising out of adverse movements in the world prices, exchange

rates, basis between local and world prices)

Quantity risk

Cost risk (Input price risk)

Political risk


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There are broadly four categories of agents who face the commodities risk:

Producers (farmers, plantation companies, and mining companies) face price risk,

cost risk (on the prices of their inputs) and quantity risk

Buyers (cooperatives, commercial traders and trait ants) face price risk between the

time of up-country purchase buying and sale, typically at the port, to an exporter.

Exporters face the same risk between purchase at the port and sale in the

destination market; and may also face political risks with regard to export licenses or

foreign exchange conversion.

Governments face price and quantity risk with regard to tax revenues, particularly

where tax rates rise as commodity prices rise (generally the case with metals and

energy exports) or if support or other payments depend on the level of commodityprices.

Interest rate risk

is the risk (variability in value) borne by an interest-bearing asset, such as a loan or a

bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate

bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's

duration.

Asset liability management is a common name for the complete set of techniques used

to manage risk within a general enterprise risk management framework.


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Banks and interest rate risk

Banks face four types of interest rate risk:

Basis risk

The risk presented when yields on assets and costs on liabilities are based on different

bases, such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate.

In some circumstances different bases will move at different rates or in different

directions, which can cause erratic changes in revenues and expenses.

Yield curve risk

The risk presented by differences between short-term and long-term interest rates.

Short-term rates are normally lower than long-term rates, and banks earn profits by

borrowing short-term money (at lower rates) and investing in long-term assets (at higher

rates). But the relationship between short-term and long-term rates can shift quickly and

dramatically, which can cause erratic changes in revenues and expenses.

Repricing risk

The risk presented by assets and liabilities that reprice at different times and rates. For

instance, a loan with a variable rate will generate more interest income when rates rise

and less interest income when rates fall. If the loan is funded with fixed rated deposits,the bank's interest margin will fluctuate.

Option risk

It is presented by optionality that is embedded in some assets and liabilities. For

instance, mortgage loans present significant option risk due to prepayment speeds that

change dramatically when interest rates rise and fall. Falling interest rates will cause

many borrowers to refinance and repay their loans, leaving the bank with uninvested

cash when interest rates have declined. Alternately, rising interest rates causemortgage borrowers to repay slower, leaving the bank with more loans based on prior,

lower interest rates. Option risk is difficult to measure and control.

Most banks are asset sensitive, meaning interest rate changes impact asset yields more

than they impact liability costs. This is because substantial amounts of bank funding are


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not affected, or are just minimally affected, by changes in interest rates. The average

checking account pays no interest, or very little interest, so changes in interest rates do

not produce notable changes in interest expense. However, banks have large

concentrations of short-term and/or variable rate loans, so changes in interest rates

significantly impact interest income. In general, banks earn more money when interest

rates are high, and they earn less money when interest rates are low. This relationship

often breaks down in very large banks that rely significantly on funding sources other

than traditional bank deposits. Large banks are often liability sensitive because they

depend on large concentrations of funding that are highly interest rate sensitive. Large

banks also tend to maintain large concentrations of fixed rate loans, which further

increases liability sensitivity. Therefore, large banks will often earn more net interest

income when interest rates are low.

Megaprojects and interest rate risk

Interest rate risk has been shown to be particularly significant and particularly damaging

for very large, one-off investment projects, so-called megaprojects. This is because

such projects are typically debt-financed and are prone to end up in what has been

called the "debt trap," i.e., a situation where due to cost overruns, schedule delays,

unforeseen interest rate increases, etc. the costs of servicing debt becomes larger

than the revenues available to pay interest on and bring down the debt.[1]

Hedging interest rate risk

Interest rate risks can be hedged using fixed income instruments or interest rate swaps.

Interest rate risk can be reduced by buying bonds with shorter duration, or by entering

into a fixed-for-floating interest rate swap.


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Methods:

A method for hedging an investor against a currency risk associated with a purchase of a

security having a value, said investor purchasing said security in a foreign currency and said

investor desiring to receive proceeds from a sale of at least a portion of said security in a homecurrency, said foreign currency and said home currency having an exchange rate at the time of

said purchase and an exchange rate at the time of said sale, said method comprising the steps

of: receiving a request for hedging against said currency risk for a time period;

calculating a cost for hedging against said currency risk based on said foreign currency, said

home currency, said exchange rate at the time of said purchase, said value and said time

period;

providing the investor with said proceeds from said sale based on said exchange rate at the

time of said sale if said exchange rate at the time of said sale is greater than the exchange rateat the time of said purchase; and

providing the investor with said proceeds from said sale based on said exchange rate at the

time of said purchase if said exchange rate at the time of said purchase is greater than or equal

to the exchange rate at the time of said sale,

wherein at least one of said steps is performed by a computer.

2. The method of claim 1, wherein said value of said security appreciates after said purchase,

and the step of calculating a cost includes the step of:

calculating said cost for hedging against said currency risk based on said appreciated value of

said security.

3. The method of claim 1, wherein said investor desires to extend the time period for hedging

against said currency risk, and the step of calculating a cost includes the step of:

calculating said cost for hedging against said currency risk based on said extended time period.

4. The method of claim 1, wherein said purchase is a limit order purchase comprising a plurality

of individual purchases each having a value and wherein said calculating step includes the step


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of:

calculating a cost for hedging against said currency risk for each of said plurality of individual

purchases based on said foreign currency, said home currency, said exchange rate at the time

of said each of said plurality of individual purchases, said value of said each of said plurality of

individual purchases and said time period.

5. The method of claim 1, further comprising the step of:

hedging against the currency risk using an American-style non-tradable foreign exchange

option.

6. The method of claim 1, further comprising the step of:

hedging against the currency risk using currency certificates of the bear type having standard

strike levels and maturity dates and being broken down into currency units.

7. A system for hedging an investor against a currency risk associated with a purchase of a

security having a value, said investor purchasing said security in a foreign currency and said

investor desiring to receive proceeds from a sale of at least a portion of said security in a home

currency, said foreign currency and said home currency having an exchange rate at the time of

said purchase and an exchange rate at the time of said sale, said investor desiring to insure

against said currency risk for a time period, the system comprising:

a foreign exchange rate data source; and

a pricing engine, said pricing engine receiving said exchange rate at the time of said purchase

and the exchange rate at the time of said sale from said foreign exchange rate data source, said

pricing engine calculating a cost for hedging against said currency risk based on said foreign

currency, said home currency, said exchange rate at the time of said purchase, said value and

said time period;

wherein the investor is provided with said proceeds from said sale based on said exchange rate

at the time of said sale if said exchange rate at the time of said sale is greater than the


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exchange rate at the time of said purchase and the investor is provided with said proceeds from

said sale based on said exchange rate at the time of said purchase if said exchange rate at the

time of said purchase is greater than or equal to the exchange rate at the time of said sale.

8. The system of claim 7, wherein said value of said security appreciates after said purchase,

and wherein said pricing engine calculates said cost for hedging against said currency risk

based on said appreciated value of said security.

9. The system of claim 7, wherein said investor desires to extend the time period for hedging

against said currency risk, and wherein said pricing engine calculates said cost for hedging

against said currency risk based on said extended time period.

10. The system of claim 7, wherein said purchase is a limit order purchase comprising a plurality

of individual purchases each having a value and wherein said pricing engine calculates a cost

for hedging against said currency risk for each of said plurality of individual purchases based on

said foreign currency, said home currency, said exchange rate at the time of said each of said

plurality of individual purchases, said value of said each of said plurality of individual purchases

and said time period.

11. The system of claim 7, further comprising a trading engine, said trading engine causing said

security to be purchased by the investor through a securities exchange, wherein said pricing

engine receives said value of said security from said trading engine.

12. The system of claim 11, further comprising a trading station, said pricing engine receiving

from said trading station said time period for hedging against said currency risk.

13. The system of claim 12, wherein said trading engine receives from said trading station a

request to purchase said security and a request to sell said security.


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Calculating capital requirements for commodities risk

y 1.Each position in commodities or commodity derivatives shall be expressed in terms of

the standard unit of measurement. The spot price in each commodity shall be expressed

in the reporting currency.

y 2.Positions in gold or gold derivatives shall be considered as being subject to foreign-

exchange risk and treated according to Annex III or Annex V, as appropriate, for the

purpose of calculating market risk.

y 3.For the purposes of this Annex, positions which are purely stock financing may be

excluded from the commodities risk calculation only.

y 4.The interest- rate and foreign - exchange risks not covered by other provisions of this

Annex shall be included in the calculation of general risk for traded debt instruments and

in the calculation of foreign- exchange risk.

y 5.When the short position falls due before the long position, institutions shall also guard

against the risk of a shortage of liquidity which may exist in some markets.

y 6.For the purpose of point 19, the excess of an institution's long (short) positions over its

short (long) positions in the same commodity and identical commodity futures, options

and warrants shall be its net position in each commodity.

y The competent authorities shall allow positions in derivative instruments to be treated, as

laid down in points 8, 9 and 10, as positions in the underlying commodity.

y 7.The competent authorities may regard the following positions as positions in the same

commodity:

o (a)positions in different sub- categories of commodities in cases where the sub -

categories are deliverable against each other; and

o (b)positions in similar commodities if they are close substitutes and if a minimum

correlation of 0,9 between price movements can be clearly established over a

minimum period of one year.

Particular instruments

y 8.Commodity futures and forward commitments to buy or sell individual commodities

shall be incorporated in the measurement system as notional amounts in terms of the

standard unit of measurement and assigned a maturity with reference to expiry date.

The competent authorities may allow the capital requirement for an exchange- traded

future to be equal to the margin required by the exchange if they are fully satisfied that it

provides an accurate measure of the risk associated with the future and that it is at least

equal to the capital requirement for a future that would result from a calculation made


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using the method set out in the remainder of this Annex or applying the internal models

method describedin

The competent authorities may also allow the capital requirement for an OTC commodity

derivatives contract of the type referred to in this point cleared by a clearing house

recognised by them to be equal to the margin required by the clearing house if they are

fully satisfied that it provides an accurate measure of the risk associated with the

derivatives contract and that it is at least equal to the capital requirement for the contract

in question that would result from a calculation made using the method set out in the

remainder of this Annex or applying the internal models method described in Annex V.

9.Commodity swaps where one side of the transaction is a fixed price and the other the

current market price shall be incorporated into the maturity ladder approach, as set out in

points 13 to 18, as a series of positions equal to the notional amount of the contract, with

one position corresponding with each payment on the swap and slotted into the maturity

ladder set out in Table 1 to point 13. The positions would be long positions if the

institution is paying a fixed price and receiving a floating price and short positions if the

institution is receiving a fixed price and paying a floating price.

Commodity swaps where the sides of the transaction are in different commodities are to

be reported in the relevant reporting ladder for the maturity ladder approach.

y 10.Options on commodities or on commodity derivatives shall be treated as if they were

positions equal in value to the amount of the underlying to which the option refers,multiplied by its delta for the purposes of this Annex. The latter positions may be netted

off against any offsetting positions in the identical underlying commodity or commodity

derivative. The delta used shall be that of the exchange concerned, that calculated by the

competent authorities or, where none of those is available, or for OTC options, that

calculated by the institution itself, subject to the competent authorities being satisfied

that the model used by the institution is reasonable.

However, the competent authorities may also prescribe that institutions calculate their

deltas using a methodology specified by the competent authorities.

Other risks, apart from the delta risk, associated with commodity options shall be

safeguarded against.

The competent authorities may allow the requirement for a written exchange- traded

commodity option to be equal to the margin required by the exchange if they are fully


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satisfied that it provides an accurate measure of the risk associated with the option and

that it is at least equal to the capital requirement against an option that would result from

a calculation made using the method set out in the remainder of this Annex or applying

the internal models method described in Annex V.

The competent authorities may also allow the capital requirement for an OTC commodity

option cleared by a clearing house recognised by them to be equal to the margin required

by the clearing house if they are fully satisfied that it provides an accurate measure of the

risk associated with the option and that it is at least equal to the capital requirement for

an OTC option that would result from a calculation made using the method set out in the

remainder of this Annex or applying the internal models method described in Annex V.

In addition they may allow the requirement on a bought exchange- traded or OTC

commodity option to be the same as that for the commodity underlying it, subject to the

constraint that the resulting requirement does not exceed the market value of the option.

The requirement for a written OTC option shall be set in relation to the commodity

underlying it.

11.Warrants relating to commodities shall be treated in the same way as commodity

options referred to in point 10.

12.The transferor of commodities or guaranteed rights relating to title to commodities in a

repurchase agreement and the lender of commodities in a commodities lending

agreement shall include such commodities in the calculation of its capital requirement

under this Annex.

(a) Maturity ladder approach

y 13.The institution shall use a separate maturity ladder in line with Table 1 for each

commodity. All positions in that commodity and all positions which are regarded aspositions in the same commodity pursuant to point 7 shall be assigned to the appropriate

maturity bands. Physical stocks shall be assigned to the first maturity band.

y

y


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Table 1

Maturity band

(1)

Spread rate (in %)

(2)

0 1 month 1,50

> 1 3 months 1,50

> 3 6 months 1,50

> 6 12 months 1,50

> 1 2 years 1,50

> 2 3 years 1,50

> 3 years 1,50

y 14.Competent authorities may allow positions which are, or are regarded pursuant to

point 7 as, positions in the same commodity to be offset and assigned to the appropriate

maturity bands on a net basis for the following:

o (a)positions in contracts maturing on the same date; and

o (b)positions in contracts maturing within 10 days of each other if the contracts are

traded on markets which have daily delivery dates.

y 15.The institution shall then calculate the sum of the long positions and the sum of the

short positions in each maturity band. The amount of the former (latter) which are

matched by the latter (former) in a given maturity band shall be the matched positions in

that band, while the residual long or short position shall be the unmatched position for

the same band.

y 16.That part of the unmatched long (short) position for a given maturity band that is

matched by the unmatched short (long) position for a maturity band further out shall be

the matched position between two maturity bands. That part of the unmatched long or

unmatched short position that cannot be thus matched shall be the unmatched position.

y 17.The institution's capital requirement for each commodity shall be calculated on the

basis of the relevant maturity ladder as the sum of the following:

o (a)the sum of the matched long and short positions, multiplied by the appropriate

spread rate as indicated in the second column of Table 1 to point 13 for each

maturity band and by the spot price for the commodity;

o (b)the matched position between two maturity bands for each maturity band into

which an unmatched position is carried forward, multiplied by 0,6 % (carry rate) and

by the spot price for the commodity; and


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o (c)the residual unmatched positions, multiplied by 15 % (outright rate) and by the

spot price for the commodity.

y 18.The institution's overall capital requirement for commodities risk shall be calculated as

the sum of the capital requirements calculated for each commodity according to point 17.

(b) Simplified approach

y 19.The institution's capital requirement for each commodity shall be calculated as the

sum of:

o (a)15 % of the net position, long or short, multiplied by the spot price for the

commodity; and

o (b)3 % of the gross position, long plus short, multiplied by the spot price for the

commodity.

y 20.The institution's overall capital requirement for commodities risk shall be calculated as

the sum of the capital requirements calculated for each commodity according to point 19.

(c) Extended Maturity ladder approach

y 21.Competent authorities may authorise institutions to use the minimum spread, carry

and outright rates set out in the following table (Table 2) instead of those indicated in

points 13, 14, 17 and 18 provided that the institutions, in the opinion of their competent

authorities:

o (a)undertake significant commodities business;

o (b)have a diversified commodities portfolio; and

o (c)are not yet in a position to use internal models for the purpose of calculating the

capital requirement on commodities risk in accordance with Annex V.

y witregel

y

Table 2

Precious metals

(except gold)

Base

metals

Agricultural

products (softs)

Other, including

energy products


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Spread rate

(%)

1,0 1,2 1,5 1,5

Carry rate

(%)

0,3 0,5 0,6 0,6

Outright rate

(%)

8 10 12 15

The commodities cycle has yet again turned bullish. Although better placed than their

retail counterparts, manufacturing companies are not insulated from the impact of rising

raw material prices. There is little relief from the rising wholesale price inflation. The

inflation index has moved up to 8.4% in December from 7.5% in November. If thesenumbers are any indication, prices of most basic items of consumption have shot up

(see the table). Prima facie, this indicates an inflated raw material bill for manufacturing

companies but it is not bad news for all.

Companies use variety of means to protect their bottom lines from escalating input

costs. Some enter into forward contracts by booking the price of a key commodity in

advance for the next few quarters. There are others, which hedge their commodity

exposure by taking a position in the futures market equivalent to their physical market

requirement. Some other companies ensure supply of raw materials at competitive

prices through contracts with farmers or producers. While all these measures do help in

mitigating the risk of input prices, none of these is enough to ensure a complete

insulation. Though companies from almost all sectors are impacted, some sectors bear

the brunt more so than others. Even within a sector, some companies end up getting

severely impacted than others due to their distinct product profiles.

To understand this better, ET Intelligence Group studied the impact of rising costs on a

sample of companies that feature in the BSE 500 index. We analysed the impact of

increasing input costs on companies, which spend more than 40% of their revenues to


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cover raw material costs. We excluded corporate producers of commodities. Read on to

know more about the impact of higher costs on these companies and which of them

could still be able to maintain their profitability.

CAPITAL GOODS

These companies typically spend 60-70% of their revenues on sourcing raw materials

like ferrous and non-ferrous metals. Capital goods players such as ABB , Siemens ,

Thermax, Voltas , Cummins India , Crompton Greaves, Havells India, BEML and Bhel

figure in our study. Rise in input costs has a negative impact on capital goods

companies. But the companies that command a premium on products would be in a

position to pass on higher input prices to customers. Also, those who enjoy flexibility in

contracts with their clients could reduce the impact of cost escalation by revising the

contract prices upwards. Companies such as ABB, Siemens, Thermax and Suzlon that

have fixed price contracts are likely to adversely impact due to a rise in input prices. On

the other hand, Bhel, which mostly has long-term projects in its order book, is likely to

be less impacted. Cummins is also not likely to have a significant impact because of its

high pricing power due to superior product profile. Voltas, with high pricing power inselected markets, will also be among the less affected ones.

AUTO

Input costs constitute 65-75% of total revenues of automobile manufacturers. These

include Maruti Suzuki , Ashok Leyland , Bajaj Auto , Hero Honda , M&M and Tata

Motors. Despite firm input costs, Tata Motors (on a consolidated basis) has been able to

withstand a difficult operating environment over the past few quarters. This is largely

due to revival in sales volumes in emerging markets for its Jaguar Land Rover brands.

In addition, the companys earlier cost-cutting plans have paid off. This trend is

expected to continue in the coming quarters. In contrast, Maruti Suzukis operating profit


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margins have been under pressure as it has not been able to fully pass on higher input

costs to customers. Its margins for the December quarter are expected to fall by 350 to

400 basis points.

CONSUMER GOODS

Inflationary environment is conducive for the growth of the consumer-oriented sector. It

is partly due to a rise in consumer buying during a period of high inflation. The other key

reason is companies with branded products can afford to increase prices without

impacting sales. The only concern is that rise in the product price may not be

proportionate to the increase in input costs. Asian Paints, HUL, Castrol, Nestle, Godrej

Consumer Products , Dabur, Tata Global Beverages and Marico are the companies that

figure in our list. While these companies may register contraction in their profit margins

on account of high input costs, they will also report higher revenue growth. HUL, the

industry leader, is likely to gain the most.

term paper derivatives

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