Classification of Risks

A business firm is exposed to wide array of risks,

which are classified in to the following types

1. 2. !. #. %.

Technological risks conomic risks "inancial risks $erformance risks &egal risks

'hy Total Risk (atters)

*nsystematic Risk is uni+ue risk and is di,ersifiable,

whereas -ystematic risk is market risk and not di,ersifiable

*nsystematic risk are not priced in the financial market

and has no bearing on the re+uired rate of return

-ystematic risk is priced, and hence has an influence on

the re+uired rate of return

'hy Total Risk (atters)

*nsystematic risk can and often does hurt shareholders .n /C" 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 ha,e a disrupting effect on the operating side of the business
A distressed financial condition is likely to
Result in the problem of ad,erse incenti,es 'eaken the commitment of ,arious stakeholders .mpair the ability of the firm to a,ail its tax shelters

Ad,erse incenti,es
(anagers are inclined to choose highly risky

in,estments, e,en if their 0$1 is 2,e

(anagers tend to, or may be forced to, abandon

operations in profitable fields and li+uidate them

(anagers of such firm may lower the +uality of

goods, pro,ide inade+uate after sales ser,ices, ignore employee welfare, etc.

'eakened commitment

Ad,erse incenti,es 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.

-ales3 Compromise in +uality, lower standards of after sales ser,ices, it turns away potential customers 4perating costs3 As suppliers may not be willing to build long5term relationship, them may not offer concessions 6 discounts. ,en the employees may not be willing to stay with such firms, so it may ha,e to offer higher compensation "inancial costs3 .t has to pay a higher rate of interest on it borrowings, may face difficulty in securing credit under fa,ourable terms, thus the direct 6 indirect cost associated with financing tend to be more for a firm percei,ed to be risky

2.

!.

/iminished Tax -helter

.f a firm has highly ,ariable operating profits, it may

not be able to fully exploit the tax shelter a,ailable to it -ome of the tax shelters may ha,e to be foregone because they are a,ailable only for a limited period, and some other tax shelters may be a,ailed later thereby reducing the present ,alue of tax sa,ings

(easurement of Risks in 0on5"inancial firms

To assess and measure a firm7s exposure to 2. !. #.

financial price risks you may xamine financial statements Assess the sensiti,ity of the firm7s ,alue or cash flows to changes in financial prices Conduct monte carlo simulation

xamination of "inancial -tatements

8ou can get an idea about a firm7s financial price

risk by perusing its 9:- 6 $6&. The analysis highlights a no. of +uestions like
/oes the firm ha,e a strong li+uidity position as shown

by a high CR 6 ;uick Ratio) /oes the firm ha,e a low gearing <le,erage= ratio) 'hat is the forex transaction risk exposure) .s the firm exposed to interest rate risk) 'hat is the economic exposure of the firm) 'hat is the state of the market for the output of the firm)

-ensiti,ity
-ensiti,ity of the "irm7s 1alue or Cash "low
Analy>e the historical data on firm ,alue, cash flows and financial prices. Regress past changes in firm ,alue <or its cash flow= against past

changes in financial prices

Firm valuet = a + b ?Exchange ratet

"irm ,aluet @ A change in firm ,alue in period t

xchange ratet @ A change in exchange rate in period t

b <slope of the abo,e regression= @ the exposure of firm ,alue to

changes in exchange rate

? 9.T/At @ a B b ? xchange ratet B c ?.nterest ratet B d ?4il pricet B e ?.nflation ratet

The coefficient <b, c, d, e= of each of the independent ,ariables

<exchange rate, interest rate, oil price, inflation rate= reflects the firm7s cash flow exposure to that ,ariable

ILLUSTRATION

EBITDA
12.1% 13.5% 61.6% -90.8% 53.4% 26.2% 292.5% -53.5% 219.5% 50.5% 70.3% -33.3% 51.4% 13.3% 41.1% 23.5% 21.2% -5.5% -7.3% 8.8% 10.9% -22.5% 19.1% 12.6% -0.8% 5.5% 14.0% -8.2% -9.8% 607.9% 1940.7%

Inflation TATA STEEL 0.4% 12.2% Exchg.Rate

2.1% -0.2% 0.9% 1.7% 0.7% 1.3% 0.1% -1.0% -0.7% -1.1% -1.7% -1.8% -0.5% -4.9% 6.0% 0.4% -5.3% -0.5% 1.1% 2.5% -1.0% 3.3% -0.3% -3.8% -1.4% -6.5% -2.5% -0.8% 1.4% 7.1% -0.2% 2.2% -0.2% 1.9% 1.0% 1.1% 1.6% 1.8% 7.1% -4.0% 3.5% 1.5% 1.7% 4.9% 2.2% 2.3% 0.8% 4.2% 4.0% -1.1% 1.7% 3.2% 1.0% -2.3% -0.6% 0.6% 0.0% 3.3% 2.7% 9.5%

CASE DESCRIPTION: DATA TAKEN FROM THE FINANCIAL YEAR 2000-01 TO 20007-08 Increment ! " !#e$ re%re$$e& t' rr("e t t)e e*# t('n -: EBITDA = .413 +.406 FX + .301 WPI R2 = .324

(40T CAR&4 -.(*&AT.40

/ R.1.0C A -.(*&AT / /.-TR.9*T.40 4" 4*T$*T 1AR.A9&

< .0

4*R CA- $9T= 98 RA0/4(&8 A-.C0.0C /."" R 0T $R49A9&.T. T4 TD /."" R 0T (ACR45 C404(.C 1AR.A9& -.

-.(*&AT.40

"4R'AR/- : "*T*R -

"orwards
Definition: .t is an agreement to buy or sell an asset at a certain future time for a certain price. .t can be contrasted from a spot transaction which is an agreement to buy or sell an asset today.

"utures
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. *nlike forward contracts futures contract are traded on the exchange.

Parameters
Contract -pecifications

Forwards
Customi>ed Contract as per the needs of the parties in,ol,es There is a risk of counterparty default &ess &i+uid Can be re,ersed only with the same counterparty. 4pa+ue instruments as contract specifications are not reported in the media

Futures
-tandardi>ed as per the specifications laid sown by the exchange The clearing corporation is the counterparty. 0o counterparty risk Dighly &i+uid due to the participation of multiple parties Counterparty in most of the cases is not known. .t is assigned be the exchange. Dighly transparent. $rice information is disseminated almost instantaneously.

Counter $arty Risk &i+uidity -+uaring off

Transparency

-ettlement

-ettlement takes place on the -ettlement takes place daily due date of maturity of the contract to mark to market pro,isions

TYPE 9*8 "*T*R -

PU !"#$E P %!E 1EE

TYPE - && "*T*R -

$#&E P %!E 1EE

(ark to (arket $ro,isioning

The act of recording the price or ,alue of a security, portfolio or account to reflect its current market ,alue rather than its book ,alue.

Exam'le: 4peration of margins for a long position in 2 futures contracts. The initial margin is Rs 2EEE per contract, or Rs #EEE in total, and the maintenance margin is Rs 1%EE per contract, or Rs !EEE in total. The contract is entered into on Fune % at Rs #EE and closed out on Fune 2G at Rs !H2.!

Da(

Futures Price

Dail( gain)&oss

!um Dail( *ain

+argin ,alance

+argin !all

Fune % Fune G Fune I Fune J Fune H Fune 1E Fune 11 Fune 12 Fune 1! Fune 1# Fune 1% Fune 1G Fune 1I Fune 1J Fune 1H Fune 2E Fune 21

#EE !HI !HG.1 !HJ.2 !HI.1 !HG.I !H%.# !H!.! !H!.G !H1.J !H2.I !JI.EE !JI.EE !JJ.1 !JJ.I !H1 !H2.!

5 5GEE 51JE #2E 522E 5JE 52GE 5#2E GE 5!GE 1JE 511#E E 22E 12E #GE 2GE 5GEE 5IJE 5!GE 5%JE 5GGE 5H2E 51!#E 512JE 51G#E 51#GE 52GEE 52GEE 52!JE 522GE 51JEE 51%#E

#EEE !#EE !22E !G#E !#2E !!#E !EJE 2GGE #EGE !IEE !JJE 2I#E #EEE #22E #!#E #JEE %EGE 12GE 1!#E

stimation of "utures $rice

"@-BC " @ "utures $rice - @ -pot $rice C @ Cost of Carry @ .nterest Cost, since the Cost of Carry for "inance is .nterest cost. " @ -<1 B r=t r @ Rate of .nterest t @ Tenure of the futures contract

4$T.40-

4$T.40!all -'tion .,u(er/: .t gi,es the buyer the right but not

the obligation to buy the underlying at a particular date at an agreed upon price today.
Put -'tion .,u(er/: .t gi,es the buyer the right but not

the obligation to sell the underlying at a particular date at an agreed upon price today.
'hereas 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 respecti,ely.

TYPE 9*8 CA&&

$T %0E 11E

P E+%U+ 52E

, E#0E1E2 1!E <11E B 2E=

TYPE 9*8 $*T

$T %0E 11E

P E+%U+ 52E

, E#0E1E2 HE <11E 5 2E=

TYPE - && CA&&

$T %0E 11E

P E+%U+ 2E

, E#0E1E2 1!E <11E B 2E=

TYPE - && $*T

$T %0E 11E

P E+%U+ 2E

, E#0E1E2 HE <11E 5 2E=

TYPE 9*8 "*T*R - && "*T*R -

P %!E 1EE 1EE

, E#0E1E2 1EE 1EE

TYPE 9*8 "*T*R - && "*T*R -

P %!E 1EE 1EE

, E#0E1E2 1EE 1EE

BHARTI AIRTEL
Date 15-ep5EJ 25-ep5EJ #5-ep5EJ %5-ep5EJ J5-ep5EJ H5-ep5EJ 1E5-ep5EJ 115-ep5EJ 125-ep5EJ 1%5-ep5EJ 1G5-ep5EJ 1I5-ep5EJ 1J5-ep5EJ 1H5-ep5EJ 225-ep5EJ 2!5-ep5EJ 2#5-ep5EJ !lose Price J1G.2 J!#.G% J2%.J JE!.# J1H.J J!G.H J12 IIG.H% IIJ.J% IGG.1% II#.1 IIE.1% IG1.2% JE%.J% JEJ.J IH2.G% J1E.%%

NIFTY

eturns ln. eturns/ !lose Price eturns ln. eturns/ 4350.4 1.E22G E.E22# 4516.8 1.E!J2 E.E!I% E.HJH! 5E.E1EI 4456.05 E.HJGG 5E.E1!% E.HI2J 5E.E2I% 4366.2 E.HIHJ 5E.E2E# 1.E2E# E.E2E2 4506.5 1.E!21 E.E!1G 1.E2EJ E.E2EG 4489.05 E.HHG1 5E.EE!H E.HIE2 5E.E!E2 4417.25 E.HJ#E 5E.E1G1 E.H%GJ 5E.E##1 4304.45 E.HI#% 5E.E2%H 1.EE2# E.EE2# 4245.8 E.HJG# 5E.E1!I E.HJ!G 5E.E1G# 4068.9 E.H%J! 5E.E#2G 1.E1E! E.E1E! 4091.15 1.EE%% E.EE%% E.HH#J 5E.EE%1 4009.75 E.HJE1 5E.E2E1 E.HJJ# 5E.E11G 4044.5 1.EEJI E.EEJG 1.E%J% E.E%GH 4272.95 1.E%G% E.E%#H 1.EE!G E.EE!I 4235.9 E.HH1! 5E.EEJI E.HJEE 5E.E2E2 4143.35 E.HIJ2 5E.E221 1.E22% E.E22! 4179.95 1.EEJJ E.EEJJ

Date ,harti #irtel .x/ 2ift( .(/ 15-ep5EJ 25-ep5EJ E.E22# E.E!I% #5-ep5EJ 5E.E1EI 5E.E1!% %5-ep5EJ 5E.E2I% 5E.E2E# J5-ep5EJ E.E2E2 E.E!1G H5-ep5EJ E.E2EG 5E.EE!H 1E5-ep5EJ 5E.E!E2 5E.E1G1 115-ep5EJ 5E.E##1 5E.E2%H 125-ep5EJ E.EE2# 5E.E1!I 1%5-ep5EJ 5E.E1G# 5E.E#2G 1G5-ep5EJ E.E1E! E.EE%% 1I5-ep5EJ 5E.EE%1 5E.E2E1 1J5-ep5EJ 5E.E11G E.EEJG 1H5-ep5EJ E.E%GH E.E%#H 225-ep5EJ E.EE!I 5E.EEJI 2!5-ep5EJ 5E.E2E2 5E.E221 2#5-ep5EJ E.E22! E.EEJJ

Kx @ E.E2%J% K8 @ E.E2%%1% L @ E.J2GGJH

"4R(*&A3 Dedge Ratio @ L M Kx Ky Dedge Ratio @ E.J!I%

A person has a Rs 2 million exposure in 9harti Airtel. De wants to hedge his risk in this stock. -uggest him the appropriate strategy. xposure @ 2E,EE,EEE 9eta @ E.IG 0ifty @ #%EE &ot -i>e @ 2EE 0o. of Contracts @ xposure M 9etaNNNNNN &ot -i>e M Current $rice 0o. of Contracts @ 2EEEEEE M E.IG %E M #%EE 0o. of Contracts @ G.I% @ I contracts

xample

AdOusting the Dedge 1alue

Total xposure <9harti Airtel= @ Rs 2E,EE,EEE "utures Contract 1alue @ #%EE M %E M G.I% @ Rs 1%,1J,I%E

$cenario:
The price of 9harti increases by 1EA @ 2EEEEEE B 1EA @ 22EEEEE The price of the .ndex decreases by %A @ #2I% M %E M G.I% @ 1##2J12.% 0ew Dedge Ratio @ 1.%2 AdOusting the ,alue of the Dedge @ 22EEEEE M E.IG @ 1GI2EEE

@ 1GI2EEE 2 1##2J12.% @ 22H1JI.%

The person will ha,e to buy Rs 22H1JI.% of futures ,alue in order to balance the hedge

D /C.0C 'D 0 *0/ R&8.0C M$4-*R

Exam'le: An airline expects to purchase 2 million gallons of Oet fuel in 1 month and decided to use heating oil futures for hedging.

TYPE 9*8 *0/ R&8.0C - && "*T*R -

P %!E 1EE 1EE

, E#0E1E2 1EE 1EE

+onth 1 2 ! # % G I J H 1E 11 12 1! 1# 1%

Price of 3et Fuel .x/ 1EE 1E% 1EJ 1E! 11E 1EJ 1E# 1EG 1E% 1EI 1EH 11E 1EI 1E# 1E1

!hange in Fuel Price 5 E.E#JJ E.E2J2 5E.E#I# E.EG%J 5E.E1J! 5E.E!II E.E1HE 5E.EEH% E.E1JH E.E1J% E.EEH1 5E.E2II 5E.E2J# 5E.E2H!

Price of "eating -il .(/ 1E% 1EG 11E 1E! 1E# 1E1 1E% 1EJ 1EH 11E 1E2 1E# 1EG 1E# 1E%

!hange in Fuel Price 5 E.EEH% E.E!IE 5E.EG%J E.EEHI 5E.E2H! E.E!JJ E.E2J2 E.EEH2 E.EEH1 5E.EI%% E.E1H# E.E1HE 5E.E1HE E.EEHG

+onth 1 2 ! # % G I J H 1E 11 12 1! 1# 1%

Price of 3et Fuel .x/ Price of "eating -il .(/ 1EE 1E% 1EJ 1E! 11E 1EJ 1E# 1EG 1E% 1EI 1EH 11E 1EI 1E# 1E1 1E% 1EG 11E 1E! 1E# 1E1 1E% 1EJ 1EH 11E 1E2 1E# 1EG 1E# 1E%

Kx @ E.E!#2 K8 @ E.E!%2 L @ E.221I

"4R(*&A3 Dedge Ratio @ L M Kx Ky Dedge Ratio @ E.21%#

xample
An airline expects to purchase 2 million gallons of Oet fuel in 1 month and decided to use heating oil futures for hedging. xposure @ 2E,EE,EEE 9eta @ E.221I "utures Contract <Deating 4il= @ 1EE &ot -i>e @ 2EE 0o. of Contracts @ xposure M 9etaNNNNNN &ot -i>e M Current $rice 0o. of Contracts @ 2EEEEEE M E.221I 1EE M 2EE 0o. of Contracts @ 22.1I @ 22 contracts

TYPE 9*8 CA&& 9*8 $*T

$T %0E 12E 12E

P E+%U+ 51E 51E

1iew $rofit &oss 9reake,en Time /ecay *se 1olatility

!omments *nlimited &imited to the extent of premium paid <52E= &ow 9 $ @ -trike $rice 2 net $remium <12E 2 2E @ 1EE= Digh 9 $ @ -trike $rice B net $remium <12E B 2E @ 1#E= Durts xpecting a large breakout, *ncertain about the direction 1olatility impro,es the position.

TYPE - && CA&& - && $*T

$T %0E 12E 12E

P E+%U+ 1E 1E

1iew $rofit &oss 9reake,en Time /ecay *se 1olatility

!omments &imited to the extent of premium recei,ed <2E= *nlimited &ow 9 $ @ -trike $rice 2 net $remium <12E 2 2E @ 1EE= Digh 9 $ @ -trike $rice B net $remium <12E B 2E @ 1#E= Delps xpecting a tight sideway mo,ement 1olatility decrease helps the position

TYPE - && $*T <A= - && CA&& <9=

$T %0E 1EE 12E

P E+%U+ 1E 1E

1iew $rofit &oss 9reake,en Time /ecay *se 1olatility

!omments &imited to the extent of premium recei,ed <2E= *nlimited &ow 9 $ @ -trike A 2 net $remium <1EE 2 2E @ JE= Digh 9 $ @ -trike 9 B net $remium <12E B 2E @ 1#E= Delps xpecting a tight sideway mo,ement 1olatility decrease helps the position.

TYPE 9*8 $*T 9*8 CA&&

$T %0E 1EE 12E

P E+%U+ 51E 51E

1iew $rofit &oss 9reake,en Time /ecay *se 1olatility

!omments *nlimited &imited to the extent of premium paid <52E= &ow 9 $ @ -trike A 2 net $remium <1EE 2 2E @ JE= Digh 9 $ @ -trike 9 B net $remium <12E B 2E @ 1#E= Durts xpecting a large breakout, *ncertain about the direction 1olatility increase helps the position.

TYPE 9*8 CA&& <A= - && CA&& <9=

$T %0E 1EE 12E

P E+%U+ 52E 1E

1iew $rofit &oss 9reake,en Time /ecay *se 1olatility

!omments &imited, (ax $rofit @ 0et $remium <1E= &imited, (ax &oss @ P<9 2 A= 2 0et $remiumQ <12E 2 1EE 5 1E @ 1E= -trike A B (ax &oss <1EE B 1E @ 11E= (ixed 2 Durts for &ong Call and helps for -hort Call 9ullish 4utlook 1olatility 0eutral

TYPE 9*8 $*T <A= - && $*T <9=

$T %0E 1EE 12E

P E+%U+ 51E 2E

1iew $rofit &oss 9reake,en Time /ecay *se 1olatility

!omments &imited, (ax $rofit @ 0et $remium <2E 2 1E @ 1E= &imited, (ax &oss @ <9 2 A= 2 0et $remium <12E 2 1EE 5 1E @ 1E= -trike A B (ax &oss <1EE B 1E @ 11E= (ixed 2 Durts for &ong $ut and helps for -hort $ut 9ullish 4utlook 1olatility 0eutral

TYPE 9*8 CA&& <A= - && CA&& <9=

$T %0E 12E 1EE

P E+%U+ 52E 1E

1iew $rofit &oss 9reake,en Time /ecay *se 1olatility

!omments &imited, (ax $rofit @ 0et $remium <2E 2 1E @ 1E= &imited, (ax &oss @ <9 2 A= 2 0et $remium <12E 2 1EE 5 1E @ 1E= -trike A B (ax &oss <12E 5 1E @ 11E=

TYPE 2 Durts for &ong $T %0E P E+%U+ (ixed Call and helps for -hort Call 9*8 $*T <A= 9earish 4utlook - && $*T <9= 1olatility 0eutral 1EE 12E 51E 2E

TYPE 9*8 $*T<A= - && $*T <9=

$T %0E 12E 1EE

P E+%U+ 52E 1E

View Profit Lo## %rea&e'e( +ime ,e-a. 4#e 6o2ati2it.

Comment Limited, Max Profit = Net Premium 20 ! 10 = 10" Limited, Max Lo## = $! %" ! Net Premium 120 ! 100 10 = $ 10" )tri&e * Max Lo## 120 - 10 = 110" Mixed ! /urt# for Lo(0 Put a(d 1e23# for )1ort Put %eari#1 5ut2oo& 6o2ati2it. Neutra2

TYPE 9*8 CA&& <A= 2 - && CA&& <9= 9*8 CA&& <C=

$T %0E 1EE 12E 1#E

P E+%U+ 52E 2E 5%

View Profit Lo## %rea&e'e( +ime ,e-a. 4#e 6o2ati2it.

Comment Limited to 7 8 ! %" ! Net Premium9 7 140 ! 120" ! 159 = 5 Limited to t1e exte(t of Net Premium 3aid Lo: %;P = Midd2e )tri&e ! Profit /i01 %;P = Midd2e )tri&e * Profit Neutra2 Lar0e #to-& 3ri-e mo'eme(t u(2i&e2. . 6o2ati2it. Neutra2

TYPE - && CA&& <A= 2 9*8 CA&& <9= - && CA&& <C=

$T %0E 1EE 12E 1#E

P E+%U+ 2E 52E %

1iew $rofit &oss 9reake,en Time /ecay *se 1olatility

!omments &imited to the extent of 0et $remium recei,ed &imited to P<C 2 9= 2 0et $remiumQ P<1#E 2 12E= 2 %Q @ 51% &ow 9 $ @ (iddle -trike 2 &oss Digh 9 $ @ (iddle -trike B &oss 0eutral &arge stock price mo,ement expected . 1olatility 0eutral

TYPE 9*8 CA&& <A= - && CA&& <9= - && CA&& <C= 9*8 CA&& </=

$T %0E JE 1EE 12E 1#E

P E+%U+ 52E 1E % 5%

1iew $rofit &oss 9reake,en Time /ecay *se 1olatility

!omments &imited, maximum when spot is between 9 and C &imited, maximum when spot is R A and S/ &ow 9 $ @ 9 5 $rofit Digh 9 $ @ C B $rofit 0eutral &arge stock price mo,ement unlikely. 1olatility 0eutral

TYPE - && CA&& <A= 9*8 CA&& <9= 9*8 CA&& <C= - && CA&& </=

$T %0E JE 1EE 12E 1#E

P E+%U+ 2E 51E 5% %

1iew $rofit &oss 9reake,en Time /ecay *se 1olatility

!omments &imited, maximum when spot is R A and S/ &imited, maximum when spot is between 9 and C &ow 9 $ @ 9 5 &oss Digh 9 $ @ C B &oss 0eutral &arge stock price mo,ement expected. 1olatility 0eutral

TYPE 9*8 CA&& <A= - && $*T <9=

$T %0E 1!E 1EE

P E+%U+ 52E 1E

View Profit Lo## %rea&e'e( +ime ,e-a. 4#e 6o2ati2it.

Comment <(-rea#e# a# t1e #3ot 3ri-e i(-rea#e# <(-rea#e# a# t1e #3ot 3ri-e de-rea#e# % * Net Premium Neutra2 Lar0e #to-& 3ri-e mo'eme(t ex3e-ted. 6o2ati2it. Neutra2

TYPE 2 9*8 CA&& <A= 9*8 $*T <9=

$T %0E 1EE 1EE

P E+%U+ 5#E 52E

View Profit Lo## %rea&e'e( +ime ,e-a. 4#e 6o2ati2it.

Comment 4(2imited Limited to t1e exte(t of 3remium 3aid Lo: %;P = )tri&e Pri-e !Net Premium /i01 %;P = )tri&e Pri-e * Net Premium=2" /urt# ;x3e-ti(0 a 2ar0e >rea&out. 4(-ertai( a>out t1e dire-tio(. <(-rea#e i( t1e a##et 3ri-e more 2i&e2. 6o2ati2it. <(-rea#e im3ro'e# t1e 3o#itio(

TYPE 9*8 CA&& <A= 2 9*8 $*T <9=

$T %0E 1EE 1EE

P E+%U+ 52E 5#E

1iew $rofit &oss 9reake,en Time /ecay *se 1olatility

!omments *nlimited &imited to the extent of net premium paid &ow 9 $ @ -trike $rice 2 <0et $remium:2= Digh 9 $ @ -trike $rice B 0et $remium Durts xpecting a large breakout. *ncertain about the direction. /ecrease in the asset price more likely 1olatility .ncrease impro,es the position

The trade: 9uy 0."T8 #2EE $ut and -ell <Two lots= 0."T8 #EEE $ut 1iew: (oderately 9earish ationale: 0ifty futures ha,e filled the upward gap that it formed on (onday and ha,e shown gap down opening today on the back of good ,olumes. (ost of the 0ifty5%E stocks are trading in negati,e territory. 'e expect the .ndex to test lower le,els in the current series. 4ur strategy would be profitable in case 0ifty expires in the broad range of #1IH5!J21. +argin: Rs. #%,EEE <Approx.=

0ifty 9ear Ratio -pread

Profit 4 loss characteristics at ex'ir(:
The strategy is profitable if 0."T8 expires in the range of #1IH5

!J21.
The maximum profit would be Rs. J,H%E if 0."T8 expires at #EEE. .f 0."T8 expires abo,e #2EE then the maximum loss is limited to

Rs. 1,E%E.EE
4n the downside loss starts below !J21. ,rea56even: /epending on the strikes chosen, the position yields

a net debit of Rs. 1,E%E.EE. 9reak5e,en will occur at #1IH 6 !J21.

0ifty 9ear Ratio -pread

(aximum &oss3 <IH M %E= 2 <2H M 2 M %E= @ Rs. 1E%E

-teps for Dedging Currency xposure

The company has to identify the inflows:outflows in terms of the foreign

currency transactions. The company has to identify these transactions in terms of3 ;uantum of the transactions < xposure 1alue= xpected Time <The contract maturity time=
The company has study the markets to draw its own estimates of the

risks in,ol,ed which would help it to negotiate with the bank better
The company has to approach the banker with its re+uirements. These

re+uirements has to be in terms of3 The net recei,ables or $ayables The le,el of risk protection needed 4ther specific re+uirements

-teps for Dedging Currency xposure

The company has to cross check the rates gi,en to it

by the banks. The rates that ha,e to be checked are3

The -pot rate The "orward 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 recei,e or make payments.

-teps for Dedging Currency xposure

The company and the banker then prepare the contract note <term

sheet= which sets out the terms and conditions for the transaction. -ome of the terms are as follows3 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 ,erified copy of the contract

lea,ing the duplicate with the banker

At the time specified in the contract the bank con,erts the positions

as per the terms agreed

Term -heet
$tructure Details: -tart /ate3 Today (aturity /ate3 Today B 1 year Currency3 *-/F$8 0otional <0=3 *-/ %E,EE,EEE Additional 0otional <A0=3 *-/ !,EE,EEE T4 @ -pot T1 @ -pot on (aturity $ayoff -cenario3 Client Recei,es @ minP<1 2 <TE:T1=T0 B A0, A0=Q

-waps
+eaning: An Agreement between two parties to exchange one set of cash flows for another
(aOor two types of -waps
.nterest Rate -waps Currency -waps

.mportant /ates
-tart /ate Trade /ate xpiry /ate : (aturity /ate Reset /ate

Terms
&.94R "loating Rate "ixed Rate /ay count con,ention -pread

.nterest Rate -wap

+eaning: An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, o,er a set period of time. -waps are deri,ati,e contracts and trade o,er5 the5counter.

"eatures 2 .nterest Rate -waps

ffecti,ely translates a floating rate borrowing into a fixed

rate borrowing and ,ice ,ersa

0o exchange of principal repayment obligation -tructured as a separate contract distinct from the

underlying loan agreement

Treated as off balance sheet transaction

$lain 1anilla .nterest Rate -wap

+eaning: Company agrees to pay cash flows e+ual to interest at a predetermined fixed rate on a notional principal for a number of years. .n return, if recei,es interest at a floating rate on the same notional principal for the same period of time

xample
Consider a hypothetical ! year swap initiated on (arch %,

2EE#, between (icrosoft and .ntel. 'e suppose (icrosoft agrees to pay to .ntel an interest rate !.H%A per annum on a notional principal of U1EE million, and in return .ntel agrees to pay (icrosoft the G month &.94R rate on the same notional principal.
Fixed .ntel (icrosoft #.EEA %.2A Floating Gmonth &.94RBE.!A Gmonth &.94RB1.EA

Transaction
4%

.ntel
Fixed #.EEA %.2A

(icrosoft L<%5? * 1% Floating Gmonth &.94RBE.!A Gmonth &.94RB1.EA

.ntel (icrosoft

$ayoffs
(icrosoft
$ays &.94R B 1A to

.ntel
$ays #A to its outside

outside lenders Recei,es &.94R under the terms of -waps $ays !.H%A under the terms of -waps ffecti,ely net cash outflow of #.H%A <%.2A=

lenders $ays &.94R under the terms of -waps Recei,es !.H%A under the terms of -waps ffecti,ely net cash outflow of &.94R BE.E%A <&.94R B E.!A=

9anker7s -pread
'hen 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.
.n gi,en case net gain was E.% which was distributed

between both the parties as E.2% each. 9ut if bankers come into the picture then then will charge around E.E2 from both the parties. -o net gain for both the parties would be E.2! each and net gain for the banker would be E.E2 B E.E2 @ E.E#

*ses
-peculation Reducing funding costs Dedging interest rate exposure Corporate finance Risk management

Risks
.nterest rate risk Credit risk

Currency -waps
+eaning: A currency swap is a contract which commits two counter parties to an exchange, o,er 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.

"eatures 2 Currency -waps

An

exchange of cash flows in two different currencies

xchange 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

xample
U$D Ceneral (otors ;antas Airways %.EA I.EA #UD 12.GA 1!.EA

Transaction

*-/ %.EA

*-/ G.!A

*-/ %A Ceneral (otors

"inancial A*/ 11.HA .nstitution

;antas A*/ 1!.EA Airways

A*/ 1!A

U$D Ceneral (otors ;antas Airways %.EA I.EA

#UD 12.GA 1!.EA

$ayoffs
Ceneral (otors
$ays %A in *-/ to the

;antas Airways
$ays 1!A A*/ to the

outside lender

outside lender
$ays G.!A *-/ under the

$ays 11.HA A*/ under

swap agreement

swap agreement
Recei,es 1!A A*/ under

Recei,es %A *-/ under

swap agreement

the swap agreement

ffecti,ely net cash outflow

ffecti,ely net cash outflow

of A*/ 11.HA <12.GA=

of *-/ G.!A <IA=

*ses
-witching loan from one currency to another

currency
Tap "oreign Capital (arkets for &ow Cost "inancing &ower "inancing Costs for "oreign -ubsidiaries

Risks
.nterest rate risk Currency risk $re settlement risk
Credit default risk /owngrading of credit rating

-ettlement risk
Credit default risk

Comparison of .nterest Rate -waps and Currency -waps

.nterest Rate -waps
An exchange of

Currency -waps
An exchange of

payment in single currency

payment in two currencies

An exchange of

0o exchange of

principal amount since it is notional

principal amount
0ot an off balance

4ff balance sheet

instruments

sheet instrument

$rincipal only -waps

A corporate ha,ing a fixed liability of *-U 1EEEEE

which it wants to con,ert into Rupees as it is ,ary of the exchange rate mo,ements
.t will enter into a swap with a bank whereby it will

pay the bank a fixed amount of rupees e,ery month and the bank will in turn pay a fixed amount of /ollars to the corporate. 4nly the principal will be exchanged

/efault -waps
.t is a credit deri,ati,e to protect against default risk 9ank $ agrees to pay a fixed amount annually to 9ank ;,

as long as A, the borrower of 9ank $, does not default.

.n return, 9ank ; promises to compensate 9ank $,

should A default

.n essence 9ank $ is buying an insurance from 9ank ;

against the default risk by paying an insurance premium e,ery year.

D /C.0C '.TD .0-*RA0C

2EED$: Dedging 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

D /C.0C '.TD .0-*RA0C

The (ain Ad,antages 4ffered by an .nsurance Company Are3
V .t can pro,ide low5cost claims

administration due to speciali>ation and economy of scale

ser,ice

V .t can price risk reasonably accurately V .t has expertise in pro,iding ad,ice on measures to

reduce risks

V .t can reasonably mitigate risk by holding a large,

di,ersified pool of assets

D /C.0C '.TD .0-*RA0C

Cost of .nsurance Can .ncrease /ue To These /isad,antages3
V Administration costs incurred by insurance company V Ad,erse selection V $roblem of moral ha>ard

D /C.0C '.TD .0-*RA0C

As per discussion, when the costs incurred by insurance company due to abo,e disad,antages i.e. &oading "ee <&4A/.0C " @.nsurance premium 2 xpected payoff= are negligible then it is worthwhile to insure, are large insurance may be costly way to shed risk

Dedging with Real Tools and 4ptions

/i,ersify $roduct &ine and ser,ices to reduce economic risks .n,est in pre,enti,e maintenance to mitigate technological risks mphasi>e +uality control to reduce the product liability from

defecti,e product liabilities.

Carry extra li+uidity in order to tide o,er difficult periods &ocate plants abroad in order to mitigate currency risks -tage R 6 / in,estments rather then make huge commitments at

one time

.ncrease outsourcing in order to reduce fixed costs

Cuidelines for Risk (anagement

Align risk management with corporate strategy $roacti,ely manage uncertainties mploy a mix of real and financial methods Wnow the limits of risk management tools /on7t put undue pressure on corporate treasuries to

generate profits

&earn when it is worth reducing risk

Align risk management with corporate strategies

-ources of "inance xternal 9orrowing .nternal -ources

Costly

Cash

$ositi,e 0$1 .n,estment

Corporate 1alue

Align risk management with corporate strategies Ome% &r#%$+ ),-'t)et(c ! m#!t(n t('n ! -) rm ce#t(c ! c'.+ ($ / $e& (n t)e 0S /#t r'#%)!, 'ne ) !1 '1 (t$ re"en#e$ c'me 1r'm 1're(%n $ !e$. 2)(!e t)e c' c n 1'rec $t (t$ 1're(%n $ !e$ "'!#me re!( /!,+ (t ($ #ncert (n /'#t (t$ &'!! r " !#e /ec #$e '1 e3c) n%e r te "'! t(!(t,.

Align risk management with corporate strategies

Pa(off from -mega Drug7s 4D %nvestment

4D &evel 2EE #EE GEE

Discounted !ash Flow !2E %JE I2E

2P1 12E 1JE 12E

Dedging
/ollar $osition Appreciating -table /epreciating Dedge $ayoff <in millions of dollars= 2EE E 52EE

.mpact of Dedging
Dollar Position Appreciating -table /epreciating %nternal Funds 2EE #EE GEE 4D without "edge "edging Pa(off 2EE #EE #EE 2EE E 52EE #dditional 4D From "edging 2EE E E 1alue from "edging 2GE E 52EE

Risk (anagement
$roacti,ely (anage *ncertainties
Changing prices, shifting consumer beha,ior,

unpredictable competiti,e reactions, fluctuating interest rates

"lexible -trategies
Crowth

4ption -witching 4ption

"ocused -trategies

*ncertainty and "lexibility

Digh Threatening -ituation "ocused -trategies "lexible -trategies 'asteful "lexibility

Level of Un e!"#$n"%

&ow

&ow

Digh

Use of Flexibilit(

mploy a (ix of Real and "inancial Tools

"inancial (ethods
Restrictions of debt5e+uity

Real (ethods
&oss pre,ention Foint ,entures A,oidance of high risk

ratio "utures and forward contract 4ptions -waps "inancing instruments like con,ertible debentures and commodity bonds .nsurance

proOects Reduction of the degree of operating le,erage

Risk (anagement
Wnow the limit of Risk (anagement
Transaction cost Complete hedging not possible Risk factor

Risk (anagement
/o not put undue pressure on corporate treasuries

to generate profits
&earn when it is worth reducing the risk Risk bearing abilities 4ptimum le,el of risk Risk -ubstitution

.ndustry $rofile
.ndia is the fastest growing and third largest telecom market in the

world

.ndia7s subscriber base expected to reach #EE mn by (arch 2EEH 0et adds in .ndia has accelerated to J5H mn in recent months 0ew telecom players will re+uire ready towers for +uick rollout and

establishing national experience capex

0ew entrants will opt for co5location in order to sa,e their upfront 0etwork +uality concerns remain one of the primary reasons why

customers switch operators and the churn remains an important cost dri,er for the operators. leading to poor +uality network and fre+uent call drops

A scarcity of spectrum and e,er increasing subscriber base is

.ndustry $rofile
(4* is increasing <presently (4* is about #G#

min:month= leading to an increase in capacity re+uirement for existing subscribers

mergence of /ata application technologies like !C,

/C and 'i(AM will lead to uninterrupted high speed flow of data application while maintaining the ,oice +uality ser,ices.

Company $rofile
CT& .nfra was established in 2EE# and listed on the 9-

0- in 0o,ember 2EEG industry in .ndia

'e are the pioneers of -hared $assi,e Telecom infrastructure 'e ha,e rolled out G,E1E towers by the end of "8EJ 'e ha,e signed (aster -er,ice Agreements with six leading

.ndian Telecom 4perators

'e ser,e fi,e pan .ndia operators and three operators who

ha,e bagged pan .ndia licenses in the recent round of allotments

R.-W- A0/ -4&*T.409usiness Concentration Risk3 The risk of the a entire portion of

the company7s re,enue coming from one source <Telecom Towers=

(easures to Address the Risk3 -preading its re,enues across

geographies and customers.

Contractual Risk3 Co,enants in the -er,ice &e,el Agreements

could places the risk of liabilities with the operators.

(easures to Address the Risk3 .t limits its liability clause to

,arious identifiable risk and also has put in .nsurance co,er where,er necessary.

R.-W- A0/ -4&*T.40"inancial Risk3 Credit Risk3 The risk of the customer not paying the company as per the tenant lease.
(easures3 -preading its re,enues across customers .nterest

Rate "luctuation Risk3 The company has taken borrowings from abroad at a floating rate of interest. being in the infrastructure business.

&i+uidity and &e,erage Risk3 The li+uidity risk due to the company

(easures3 All the loans ha,e a ! year moratorium period. The

company also has a conser,ati,e le,erage ratio of 2.1%31

The company has pro,ided for .nsurance co,er for the following Risks3

.nfosys Technologies

.ntroduction
.nfosys Technologies has an integrated risk management in which the 9oard of /irectors is responsible for monitoring the risk le,els and the (anagement Council is responsible for implementing risk mitigation measures.

Classification of Risks
9usiness $ortfolio Risk3
Restrict 9usiness from any single ser,ice offering to 2%A of the

total re,enue
&imit the re,enues from any single client to 1EA of total re,enue $roacti,ely look for business opportunities in new geographical

areas to increase their contribution to the total re,eues

Closely monitor the proportions of re,enues from ,arious ,ertical

domains and focus marketing efforts in chosen domains

-olicit business from sunrise technologies to keep the risk of

technology concentration within manageable limits.

Classification of Risks
"inancial Risks3
A,oid acti,e trading positions in the foreign currency markets Dedge a portion of /ollar recei,ables in the forward market (aintain a highly li+uid 9alance -heet in which li+uid assets are around

2%A of the net re,enues and #EA of the total assets schew debt or use debt financing only for short term purposes
&egal and -tatutory Risk3 Clearly chart out a re,iew and documentation process for contracts Take sufficient insurance abroad to co,er possible liabilities arising out of non performance of the contract A,oid contracts which ha,e open ended legal obligations Da,e a compliance officer to ad,ice the company on compliance issues with respect to the laws of ,arious Ourisdictions and ensure that the company is not in ,iolation of the laws.

Classification of Risks
.nternal $rocess Risks
Adopt .-4 HEE1 and C(( &e,el % +uality standards /ocument and disseminate experienced knowledge Create a fa,orable work en,ironment, encourage inno,ation,

practice meritocracy and de,elop a well balanced compensation plan <that includes -4$= to attract and retain people (ake appropriate in,estments in technology

$olitical Risks3

xplore the possibility of establishing de,elopment centers in countries other than .ndia