Classification of Risks

 A business firm is exposed to wide array of risks,

which are classified in to the following types
1. Technological risks
2. Economic risks
3. Financial risks
4. 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
Why Total Risk Matters?
 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
Adverse incentives
Managers 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 Shelter
If 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
2. Examine financial statements
3. Assess the sensitivity of the firm’s value or cash
flows to changes in financial prices
4. Conduct monte carlo simulation
Examination of Financial Statements
You 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 like
Does 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 ∆ ∆ Inflation TATA STEEL

12.1% Exchg.Rate0.4% 12.2%
13.5% 2.1% -0.2%
61.6% -0.2% 2.2%
-90.8% 0.9% -0.2% CASE DESCRIPTION:
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% DATA TAKEN FROM THE
50.5%
70.3%
-0.7%
-1.1%
7.1%
-4.0%
FINANCIAL YEAR
-33.3% -1.7% 3.5% 2000-01 TO 20007-08
51.4% -1.8% 1.5%
13.3% -0.5% 1.7%
41.1% -4.9% 4.9%
23.5% 6.0% 2.2% Incremental values regressed to
21.2%
-5.5%
0.4%
-5.3%
2.3%
0.8%
arrive at the equation -:
-7.3% -0.5% 4.2%
8.8% 1.1% 4.0%
10.9% 2.5% -1.1% ∆ EBITDA = .413 +.406 ∆FX
-22.5%
19.1%
-1.0%
3.3%
1.7%
3.2%
+ .301 ∆WPI
12.6% -0.3% 1.0%
-0.8% -3.8% -2.3%
5.5% -1.4% -0.6% R2 = .324
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%
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 Customized Contract as per Standardized as per the
Specifications the needs of the parties specifications laid sown by the
involves exchange

Counter Party There is a risk of counterparty The clearing corporation is the

Risk default counterparty. No counterparty
risk
Liquidity Less Liquid Highly Liquid due to the
participation of multiple parties
Squaring off Can be reversed only with the Counterparty in most of the
same counterparty. cases is not known. It is assigned
be the exchange.
Transparency Opaque instruments as Highly transparent. Price
contract specifications are not information is disseminated
reported in the media almost instantaneously.
Settlement Settlement takes place on the Settlement takes place daily due
date of maturity of the contract 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 Price
F=S+C

F = Futures Price
S = Spot Price
C = Cost of Carry = Interest Cost, since the Cost of Carry
for Finance is Interest cost.

F = S(1 + r)t

r = Rate of Interest
t = 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 NIFTY
Close
Date 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 0.0375
4-Sep-08 825.8 0.9893 -0.0107 4456.05 0.9866 -0.0135
5-Sep-08 803.4 0.9728 -0.0275 4366.2 0.9798 -0.0204
8-Sep-08 819.8 1.0204 0.0202 4506.5 1.0321 0.0316
9-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 -0.0161
11-Sep-08 776.95 0.9568 -0.0441 4304.45 0.9745 -0.0259
12-Sep-08 778.85 1.0024 0.0024 4245.8 0.9864 -0.0137
15-Sep-08 766.15 0.9836 -0.0164 4068.9 0.9583 -0.0426
16-Sep-08 774.1 1.0103 0.0103 4091.15 1.0055 0.0055
17-Sep-08 770.15 0.9948 -0.0051 4009.75 0.9801 -0.0201
18-Sep-08 761.25 0.9884 -0.0116 4044.5 1.0087 0.0086
19-Sep-08 805.85 1.0585 0.0569 4272.95 1.0565 0.0549
22-Sep-08 808.8 1.0036 0.0037 4235.9 0.9913 -0.0087
23-Sep-08 792.65 0.9800 -0.0202 4143.35 0.9782 -0.0221
24-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 σx = 0.02585
4-Sep-08 -0.0107 -0.0135
5-Sep-08 -0.0275 -0.0204
8-Sep-08 0.0202 0.0316 σY = 0.025515
9-Sep-08 0.0206 -0.0039
10-Sep-08 -0.0302 -0.0161
11-Sep-08 -0.0441 -0.0259
ρ = 0.826689
12-Sep-08 0.0024 -0.0137
15-Sep-08 -0.0164 -0.0426 FORMULA:
16-Sep-08 0.0103 0.0055
17-Sep-08 -0.0051 -0.0201 Hedge Ratio = ρ X σx
18-Sep-08 -0.0116 0.0086 σy
19-Sep-08 0.0569 0.0549
22-Sep-08 0.0037 -0.0087
Hedge Ratio = 0.8375
23-Sep-08 -0.0202 -0.0221
24-Sep-08 0.0223 0.0088
Example
A 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 = 20,00,000
Beta = 0.76
Nifty = 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 Value
 Total 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
 Price of Jet Fuel Change in Fuel Change in Fuel
Month (x) Price Price of Heating Oil (y) 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
 Price of Jet Fuel
Month (x) Price of Heating Oil (y)
1 100 105 σx = 0.0342
2 105 106
3 108 110
σY = 0.0352
4 103 103
5 110 104
6 108 101 ρ = 0.2217
7 104 105
8 106 108
9 105 109 FORMULA:
10 107 110
Hedge Ratio = ρ X σx
11 109 102
σy
12 110 104
13 107 106
14 104 104 Hedge Ratio = 0.2154
15 101 105
Example
An airline expects to purchase 2 million gallons of jet fuel in 1
month and decided to use heating oil futures for hedging.

Exposure = 20,00,000
Beta = 0.2217
Futures Contract (Heating Oil) = 100
Lot 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
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 TYPE – Hurts for Long
Mixed STRIKE PREMIUM
Call and helps for Short Call
Use BUY PUT
Bearish (A)
Outlook 100 -10
Volatility SELL PUT
Volatility (B)
Neutral 120 20
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
Breakeven -Strike
10 = A10)
+ 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]
Loss = 5
Limited to the extent of Net Premium paid
Breakeven Low BEP = Middle Strike – Profit
High 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 – Loss
High 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 - Profit
High 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 - Loss
High 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 Premium
High 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 Monday
and have shown gap down opening today on the back of good volumes. Most of
the Nifty-50 stocks are trading in negative territory. We expect the Index to test
lower levels in the current series. Our strategy would be profitable in case Nifty
expires in the broad range of 4179-3821.

Margin: Rs. 45,000 (Approx.)

 Nifty Bear Ratio Spread
Profit & 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 Payables
 The level of risk protection needed
 Other specific requirements
 Steps for Hedging Currency
Exposure
The company has to cross check the rates given to it
by the banks. The rates that have to be checked are:

 The Spot rate

 The Forward Rate
 The 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/purchased
 Rate at which it is sold/purchased
 Tenure 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
 Term Sheet
Structure Details:

Start Date: Today

Maturity Date: Today + 1 year
Currency: USDJPY
Notional (N): USD 50,00,000
Additional Notional (AN): USD 3,00,000
TO = Spot
T1 = 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 Swaps

Interest Rate Swaps
Currency Swaps
 Important Dates
Start 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
Example
Consider 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

4%
Intel Microsoft

LIBOR + 1%

Fixed Floating
Intel 4.00% 6month LIBOR+0.3%
Microsoft 5.2% 6month LIBOR+1.0%
 Payoffs
Microsoft Intel
 Pays LIBOR + 1% to
outside lenders
 Receives LIBOR under
the terms of Swaps
 Pays 3.95% under the
terms of Swaps
 Effectively net cash
outflow of 4.95% (5.2%)
 Pays 4% to its outside
lenders
 Pays LIBOR under the
terms of Swaps
 Receives 3.95% under
the terms of Swaps
 Effectively 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
Speculation
Reducing funding costs
Hedging interest rate exposure
Corporate finance
Risk management
 Risks
Interest rate risk

Credit risk
 Currency Swaps
Meaning:

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%

USD 5% General Qantas AUD 13%
Financial
Motors AUD 11.9% Institution AUD 13.0% Airways

USD AUD

General Motors 5.0% 12.6%

Qantas Airways 7.0% 13.0%

 Payoffs
General Motors
 Pays 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

 Risks
Interest rate risk

Currency risk

Pre settlement risk

Credit default risk
Downgrading of credit rating

Settlement risk
Credit default risk
Comparison of Interest Rate Swaps and Currency
Swaps

Interest Rate Swaps Currency Swaps

 An exchange of  An exchange of
payment in single payment in two
currency currencies

 No exchange of
 An exchange of
principal amount since
it is notional principal amount

 Off balance sheet  Not an off balance

instruments sheet instrument
 Principal only Swaps
A 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 Swaps
It 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
 HEDGING WITH INSURANCE
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 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

Sources of
Finance

External Borrowing Internal Sources

Costly Cash

Positive NPV
Investment

Corporate Value
 Align risk management with corporate strategies

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

 Hedging
Dollar Position Hedge Payoff (in millions of dollars)

Appreciating 200

Stable 0

Depreciating -200
 Impact of Hedging
Additional
R&D
Dollar Internal R&D without Hedge From Value from
Position Funds Hedging Payoff Hedging 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 Strategies
 Growth Option
 Switching Option

Focused Strategies
Uncertainty and Flexibility

Threatening Flexible
High
Situation Strategies

Focused Wasteful
Level of Low
Strategies Flexibility
Uncertainty

Low High

Use of Flexibility
 Employ a Mix of Real and Financial Tools

Financial Methods Real Methods

 Restrictions of debt-equity  Loss prevention

ratio  Joint ventures
 Futures and forward  Avoidance of high risk
contract projects
 Options  Reduction of the degree of
 Swaps operating leverage
 Financing instruments like
convertible debentures and
commodity bonds
 Insurance
 Risk Management
Know the limit of Risk Management

Transaction cost
Complete hedging not possible
Risk factor
 Risk Management
Do not put undue pressure on corporate treasuries
to generate profits

Learn when it is worth reducing the risk

Risk bearing abilities
Optimum level of risk
Risk 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 Profile
MOU 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 SOLUTIONS
Business 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.
 RISKS AND SOLUTIONS

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
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 Risks
Business 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 Risks
 Financial 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 Risks
Internal Process Risks
 Adopt ISO 9001 and CMM Level 5 quality standards
 Document and disseminate experienced knowledge
 Create 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