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RISK MANAGEMENT
Facilitator: Rajesh Biyani
Group Members
Abhishek Kumar
Bhakti Ghag
Danish Memon
Dhrupad Parekh
Shalini Sinha
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
1.Examine financial statements
2.Assess the sensitivity of the firm’s value or cash flows
to changes in financial prices
3.Conduct monte carlo simulation
Examination of Financial 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
ü 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
∆EBITDA
12.1%
13.5%
∆ Exchg.Rate ∆
0.4%
2.1%
Inflation
12.2%
-0.2%
TATA STEEL
61.6% -0.2% 2.2%
-90.8% 0.9% -0.2%
53.4% 1.7% 1.9%
26.2%
292.5%
0.7%
1.3%
1.0%
1.1%
CASE DESCRIPTION:
-53.5% 0.1% 1.6%
219.5% -1.0% 1.8%
50.5% -0.7% 7.1%
70.3% -1.1% -4.0%
-33.3% -1.7% 3.5%
51.4% -1.8% 1.5% DATA TAKEN FROM THE
13.3% -0.5% 1.7%
41.1%
23.5%
-4.9%
6.0%
4.9%
2.2%
FINANCIAL YEAR
21.2%
-5.5%
0.4%
-5.3%
2.3%
0.8% 2000-01 TO 20007-08
-7.3% -0.5% 4.2%
8.8% 1.1% 4.0%
10.9% 2.5% -1.1%
-22.5%
19.1%
-1.0%
3.3%
1.7%
3.2%
Incremental values regressed to
12.6%
-0.8%
-0.3%
-3.8%
1.0%
-2.3% arrive at the equation -:
5.5% -1.4% -0.6%
14.0% -6.5% 0.6%
-8.2% -2.5% 0.0%
-9.8%
607.9%
-0.8%
1.4%
3.3%
2.7%
∆ EBITDA = .413 +.406 ∆FX
1940.7% 7.1% 9.5% + .301 ∆WPI
R2 = .324
MONTE CARLO SIMULATION
DERIVING A SIMULATED DISTRIBUTION OF OUTPUT VARIABLE ( IN OUR
CASE PBT) BY RANDOMLY ASIGNING DIFFERENT PROBABLITIES TO
THE DIFFERENT MACRO- ECONOMIC VARIABLES.
SIMULATION
RISK MANAGEMENT
TOOLS
FORWARDS / FUTURES
Forwards
Definition:
account to reflect its current market value rather than its book
value.
Example:
F = Futures Price
S = Spot Price
F = S(1 + r)t
r = Rate of Interest
t = Tenure of the futures contract
RISK MANAGEMENT
TOOLS
OPTIONS
TYPES OF 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.
CALL OPTION (BUY)
hedge his risk in this stock. Suggest him the appropriate strategy.
Exposure = 20,00,000
Beta = 0.76
Nifty = 4500
The person will have to buy Rs 229187.5 of futures value in order to balance
the hedge
HEDGING WHEN UNDERLYING EXPOSURE
Example:
Exposure = 20,00,000
Beta = 0.2217
Time Decay Mixed – Hurts for Long Call and helps for Short Call
Use Bullish Outlook
Volatility Volatility Neutral
BULL PUT SPREAD
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.
The strategy is profitable if NIFTY expires in the range of 4179-
3821.
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 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:
Currency: USDJPY
T
O = Spot
T
1 = Spot on Maturity
Payoff Scenario:
Fixed Rate
Day count convention
Spread
Interest Rate Swap
Meaning:
Fixed Floating
Intel 4.00% 6month
Microsoft 5.2% LIBOR+0.3%
6month
LIBOR+1.0%
Transaction
4% 3.95%
Intel
Microsoft
LIBOR + 1%
LIBOR
Fixed Floating
Intel 4.00% 6month
Microsoft 5.2% LIBOR+0.3%
6month
LIBOR+1.0%
Payoffs
Microsoft
Intel
USD AUD
Payoffs
General Motors Qantas Airways
Pays 5% in USD to the Pays 13% AUD to the
outside lender outside lender
Pays 11.9% AUD under Pays 6.3% USD under the
swap agreement swap agreement
Receives 5% USD under
Receives 13% AUD
swap agreement
under the swap
Effectively net cash
agreement
outflow of AUD 11.9%
(12.6%) 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
Settlement risk
Credit default risk
Comparison of Interest Rate Swaps and Currency
Swaps
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
Stable 0
Depreciating -200
Impact of Hedging
Dollar Internal R&D without Hedge Additional Value from
Position Funds Hedging Payoff R&D Hedging
From
Hedging
Appreciating 200 200 200 200 260
Focused Strategies
Uncertainty and Flexibility
Level of High Threatening Flexible
Uncertainty Situation Strategies
Low High
Use of Flexibility
Employ a Mix of Real and Financial Tools
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
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:
THANK YOU