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Derivatives - A Risk
Management Perspective
Dr. Rana Singh
www.ranasingh.org
Associate Professor
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The Changing Environment
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The past
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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
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The present
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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
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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
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Risk: some examples
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The Laker Experience
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In late 1970s, Laker Airlines faced the problem of plenty
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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 contributed7 to lower US bound
passenger traffic
US Savings and Loans Institutions
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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.
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Gulf War Casualty : Continental
Airlines
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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.
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The Lesson
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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
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Hence, prudent management of risk is essential
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Risk
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Any exogenous factor influencing the performance of
a business
 Exposure to uncertainty
 Volatility in earnings
 Deviation of actual from expected
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Risk Management
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Aim of risk management
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Knowledge
Ensuring that the risk levels are consistent
with corporate objectives
Ensuring that returns adequately compensate
for risks borne
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If you eliminate risks you eliminate returns
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When a corporate undertakes a project, it accepts
some risks. Derivatives can be used to mitigate those
risks.
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Types of Risk
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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
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Risk Management Procedure
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Identification
Quantification
Philosophy and strategy
Tools and Technique
Implementation and Control
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Identification
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Explicit v/s Implicit Risks
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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
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Risk Arising from Competitor
Strategy
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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
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Indian Base Metal Companies :
Dollarised revenues
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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
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Oil companies : Dollarised revenues
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Pursuant to the deregulation of the Administered
Price Mechanism, downstream oil products would be
priced based on import parity prices
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Hence, the oil companies would have dollarised
revenues and a natural hedge against USD liabilities
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Quantification
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Quantification
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Identification of suitable observable proxies
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Analysis of proxy behaviour and potential risk impact
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Determination of Mean and Variance of future P&L
streams
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Proxies for Risk Factors
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Correlation between proxy and the risk factor should
be high
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BSE Sensex could be a proxy for an equity portfolio
of a firm
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US $/Re exchange rate could be a proxy for the
cashflows of an export oriented unit
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International crude oil price could be a proxy for the
cashflows of a petrochemical unit
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Approach to Risk Management
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Firm-wide Approach to managing risk as opposed
to individual transaction based approach
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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
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Approach to risk management:
Example
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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
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Approach to risk management:
Example
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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
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Philosophy and Strategy
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Corporate Philosophy
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Mild Aggressive Philosophy:
Indian PSU
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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
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Mild Aggressive Philosophy:
Indian PSU
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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
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Risk-Averse Philosophy: Gold
Jewelry Manufacturer
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An Indian Gold Jewelry manufacturer analysed the
business and deduced that:
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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
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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
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Risk Neutral Philosophy:
Siam Cement
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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
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Strategy
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Strategy
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Arrive at an acceptable level of Risk
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Maximise returns for given levels of risk
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Tools and Techniques
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Tools and Techniques
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Use of Derivative products (as permitted by RBI)
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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
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Thank You
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