1

introduction

LEARNING OBJECTIVES

After completing this chapter, you While dealing with derivatives, a number of points are to be kept
will be able to answer the following in mind. First, a derivative contract is based on a zero-sum game,
questions: which means that for every person who makes money from de-
rivatives, there must be one loser. Second, many derivative con-
What are derivatives and
 tracts are very complex and are based on advanced mathematical
what are the main uses of concepts; and many traders do not understand clearly how these
derivatives? derivative contracts work. Third, hedge funds and banks that trade
What are forwards, futures,
 in derivatives use borrowed funds and high leverage to enhance
options, and swaps? the returns from derivatives, and this can lead to financial diffi-
What are risks and how do
 culties for these organizations. Because of these factors, deriva-
they affect businesses? tives can be very risky. Evidence suggests that even sophisticated,
professional investors have no idea as to the level of risk they un-
What are commodity price

dertake while trading derivatives.
risks, interest rate risks, and
currency risks? Source: Chris Sholto Heaton, “The Dangers of Derivatives,”
Why is it important to manage
 MoneyWeek, September 27, 2006.
risks?
What is meant by hedging?

What are the approaches to
 BOX 1.1 Caution While Using Derivatives
risk management?

Derivatives contracts, which have been in existence for more than 2000 years now, started as a way for
farmers and merchants to manage the risks of the price of agricultural commodities moving against
them. They started off as very simple contracts, and the parties entering into the contract had a good
understanding of the risks involved. Currently, there are derivative securities to manage the risks as-
sociated with equity and debt investments; credit exposures; and changing commodity prices, currency
exchange rates, and interest rates. According to the Bank for International Settlement (BIS), the notional
value of all derivatives contracts by the end of December 2008 was USD 644,686 billion. This shows the
importance of the derivatives market in the world.
Derivatives trading in India has grown rapidly since 2000, when exchanges in India were allowed to
trade derivative contracts. Prior to 2000, derivatives were only available as contracts between private

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Notes parties. The total turnover of derivatives contracts has increased from INR 23.65 billion in 2001 to INR
68,896.41 billion in 2009, an annual growth rate of 242 per cent. In addition to the derivatives traded on
the exchanges, the value of currency derivatives has increased from USD 1,647 billion in 2005 to USD
7,044 billion in 2008. The value of interest rate derivatives has also increased from INR 100 billion in 2005
to INR 300 billion in 2009. These statistics show that derivatives have become a very important part of the
Indian market and that Indian businesses are using derivatives securities to a large extent. Therefore, it is
important to know what derivatives are and how they can be used and traded.
Popular opinion about the existence of derivatives contracts has been mixed. While their advantages
in managing risks have been understood, they have also been identified with the following incidents
(explained in detail in later chapters):
 Huge losses incurred by Metallgesellschaft AG in 1993

 Bankruptcy faced by Orange County, California in 1994

 Collapse of the Barings Bank in 1995

Near-collapse of Long-Term Capital Management (LTCM) and its ultimate bailout in 1998
 

 Collapse of Lehman Brothers in 2008

 Bailout of AIG in 2008

 Financial crisis of 2008–2009

  In the Chairman’s letter of the 2002 Annual Report of Berkshire Hathaway, Inc., finance guru, Warren
Buffett cautioned the use of credit derivatives with the following phrase: “I view derivatives as time
bombs, both for the parties that deal in them and the economic system. Derivatives are financial weapons
of mass destruction, carrying dangers that, while now latent, are potentially lethal”.
Even though the financial crisis of 2008–2009 is attributed to credit derivatives, it is widely accepted
that the crisis was caused because the users of derivatives did not really understand the risks involved in
these instruments.
Box 1.1 captures why caution needs to be used while using derivatives. Popular opinion, too, is divided
on the subject of increasingly complex securities and their negative impact on the economy. In this book,
discuss the advantages of derivative contracts and the dangers associated with their use.

1.1  What Are Derivatives?

All investors have the opportunity to invest in either real assets or financial assets. Real assets are assets
such as land, buildings, precious metals, and machinery. An investor would get the return from the in-
vestment in real assets on the basis of the changes in the price of these assets.
For example, if Rekha invests in 10 sovereigns of gold at INR 1,200 per sovereign, her total investment
in gold would be INR 12,000. She will get a positive return if the price of gold increases and a negative
return if it decreases. For example, if the price of gold increases to INR 1,250 per sovereign, she will gain
INR 50 per sovereign, or INR 500 on an investment of INR 12,000. On the other hand, if the price of gold
decreases to INR 1,100, she would lose INR 100 per sovereign, or lose INR 1,000 of the investment. Thus,
the return on investment from real assets depends directly on the changes in the real asset prices.
A financial asset, on the other hand, is a claim on an issuer of financial security. Examples of financial
assets could be bonds or equity securities. Consider a bond—the issuer of the bond will issue a piece of
paper to the buyer indicating that they are indebted to the buyer for the face value of the bond and will
promise to make periodic coupon payments, as stated in the paper. Thus, the buyer of the bond is eligible
to receive the amount that was stated by the issuer at the time of issue of the bond. Thus, a bond invest-
ment provides a predetermined set of payments from the issuer.
Equity security is also known as the share or stock of a company, and it represents ownership in the
company. The shareholder is eligible to receive periodic dividends issued by the company. Since divi-
dends are issued from the profits made by the company, the return from investing in shares is based on
the efficiency with which the real assets owned by the company are utilized to realize profits. Thus, the
value of shares will depend on how well the company utilizes its assets.

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 Introduction  3

Notes Both bonds and shares can be considered as claims on the cash flow generated by a company by
utilizing its assets. These assets, in turn, are procured by using the funds raised from issuing bonds
and shares.
A derivative security, on the other hand, realizes its value from the value of the asset, which forms the
basis of the derivative contract. The asset whose value determines the value of the derivative contract is
known as the underlying asset. The value of the derivative product will change depending on the changes
in the value of the underlying asset. Popular derivative products are classified into forward contracts,
futures contracts, options contracts, and swap contracts.
Derivative contracts can be written on real assets as well as on financial assets. The derivative products
written on real assets are called commodity derivatives, whereas those written on financial assets are
called financial derivatives.

1.2  Derivatives Markets

Derivatives contracts can either be over-the-counter contracts or exchange-traded contracts.
Over-the-counter contracts are between private parties, and the terms of the contract are decided be-
tween the two parties. The main problem with over-the-counter contracts is searching for a party willing
to enter into the contracts. However, this problem is solved by brokers whose job is to bring the parties
together. These contracts are highly unregulated and less transparent.
Exchange-traded contracts are traded on derivatives exchanges. The exchanges decide upon the terms
of the contract, and the parties can trade these contracts in a manner similar to the trading of shares in a
stock exchange. Exchanges are regulated, and they also offer transparency.
Forward contracts and swaps are generally over-the-counter contracts. Futures always trade on
exchanges. On the other hand, options can either be traded on exchanges or they can be written as over-
the-counter contracts. The difference between over-the-counter contracts and exchange-traded contracts
for futures and options will be explained in Chapter 4 and Chapter 7, respectively.

1.3  Forward Contracts

A forward contract provides the holder of the contract the right to buy or sell the underlying asset at
a future time at a price that is agreed upon at the time of entering into the contract. Typically, forward
contracts are short-term contracts and are non-negotiable, and the two parties that enter into the contract
will have to fulfil their obligations when the contract expires. Forward contracts are usually entered into
by private parties and, hence, are called over-the-counter contracts. Forward contracts are explained in
detail in Chapter 3.

  E x am p l e 1 . 1
Iyengar Bakery enters into a forward contract with Sakthi Sugars, a sugar manufacturer, on January 1 to
buy sugar on March 31 at INR 30,000 per 1,000 kg. There will be no cash exchange on January 1; however,
on March 31, Iyengar bakery will pay INR 30,000, irrespective of the price of sugar in the market, and
Sakthi Sugars will deliver 1,000 kg of sugar to the bakery. This contract will be binding on both parties,
and both will have to honour their commitments.

  E x am p l e 1 . 2
Tiruppur Hosiery, an exporter to the United States, enters into a currency forward contract with the
Canara bank on July 1 to sell USD 25,000 on October 31 at INR 48 per U.S. dollar. There will be no
cash exchange on July 1; however, on October 31, the exporter will be paid INR 1.2 million by the
Canara Bank in exchange of USD 25,000. This amount will be paid irrespective of the exchange rate
prevailing in the market. This contract will be binding on both parties, and both will have to honour their
commitments.

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Notes 1.4  Futures Contracts

A futures contract provides the holder of the contract the right to buy or sell the underlying asset at a
future time at a price that is agreed upon at the time of entering into the contract. Although a futures
contract is similar to a forward contract, futures contracts are negotiable and either party to the contract
has the right to transfer the contract obligation to a third party anytime before the expiry of the contract.
These contracts are traded on futures exchanges. Futures contracts can either be written on real assets
or financial assets. If they are written on real assets, they are called commodity futures, and if they are
written on financial assets, they are called financial futures. Futures contracts are explained in detail in
Chapter 4.

  E x am p l e 1 . 3
Assume that Cadbury India needs 5,000 kg of cocoa on March 31 to meet the requirements of produc-
tion of chocolate in April. On January 1, Cadbury enters into a futures contract in cocoa. If the fu-
tures contract is designed for buying 1,000 kg of cocoa, Cadbury will buy five cocoa futures contracts on
January 1. The futures price on January 1 indicates the price at which Cadbury can purchase cocoa on
March 31. If the futures price is INR 40,000, it means that Cadbury will pay INR 40,000 to buy 1,000 kg
of cocoa; in other words, Cadbury is fixing a liability of INR 200,000 to buy 5,000 kg of cocoa. On March
31, when the contract matures, Cadbury will pay INR 200,000, and the seller of the futures will deliver
5,000 kg of cocoa to Cadbury.

  E x am p l e 1 . 4
Assume that Mohan has been told on November 1 that he will be receiving a bonus of INR 50,000 on
January 1. He does not have any need for that money till April 30 as he plans to take a vacation with his
family in May. Therefore, he plans to invest this amount from January 1 to April 30 in government bonds.
However, he would be unable to buy the government bonds on November 1 since he will be receiving the
money only on January 1. However, he can enter into a government bond futures contract on November
1 to buy these bonds on January 1. The price of the bonds will be determined on November 1. By entering
into the government bond futures contract, Mohan can be sure of investing this amount on the bonds on
January 1.

1.5  Options Contracts

An options contract gives the holder the right to buy or sell the underlying asset on or before the maturity
date of the contract. The major difference between options contracts and forward or futures contracts is
that the holder of forward or futures contracts will have to fulfil the obligations under the contract, ir-
respective of whether the position in the contract results in a gain or a loss. However, the options contract
holder has the option of not having to fulfil the obligations under the contract if the position results in
a loss. An options contract is more valuable than a futures contract and consequently requires an initial
investment at the time of entrance. Options contracts are explained in detail in Chapter 7. Options can be
traded in options exchanges or options can be contracted between private parties, in which case they are
known as over-the-counter options.

  E x am p l e 1 . 5
Assume that Cadbury India needs 5,000 kg of cocoa on March 31 to meet the requirements of production
of chocolate in April. However, the price of cocoa is volatile and can either increase or decrease. Thus,
Cadbury faces the risk of price fluctuations. If the price is expected to increase, it would like to settle
on a lower price. On the other hand, if the price decreases, it would like to buy at the lower price. To ac-
complish this, on January 1, Cadbury will enter into an options contract in cocoa with a strike price of
INR 38,000. If the options contract is designed for buying 1,000 kg of cocoa, Cadbury will buy five cocoa
options contracts on January 1. On March 31, Cadbury will decide on whether or not to exercise the op-
tion and buy cocoa at INR 38,000. If the price of cocoa in the market is more than INR 38,000, Cadbury

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 Introduction  5

Notes will exercise the option and buy cocoa at INR 38,000. However, if the market price for cocoa is less than
INR 38,000, Cadbury will buy cocoa in the market at the prevailing market price instead of exercising
the option. Since an option holds value to the option buyer, the buyer will have to pay the option seller a
certain amount of money, known as option premium, which is determined in the options market at the
time of entry into the option contract.

  E x am p l e 1 . 6
ITC intends to borrow Rs.100,000,000 three months in the future. Since borrowing will be done at a later
date, ITC faces interest rate risk. To hedge this risk, ITC enters into an interest rate options contract with
the strike rate of 7%. This means that if the actual market interest rate is above 7%, ITC will exercise the
option and borrow at 7%. If the market interest is below 7%, ITC will let the option expire without exer-
cise and borrow lower market interest rates. In order to get this option, ITC will have to pay the party with
which entered into the options contract upfront, which is known as the option premium.

1.6  Swap Contracts

In general, forward contracts and futures contracts have short-term maturity, whereas swap contracts can
have long-term maturity. Swaps are contracts wherein two parties agree to exchange future cash flows
according to a mutually agreeable formula. The swaps are used to exchange interest rates or currencies.
Swaps are explained in detail in Chapter 6.

  E x am p l e 1 . 7
BHP, an Australian company, may want to borrow in Indian rupees to invest in India, while Tata Steel
may be planning an investment in Australia that requires Australian dollars. In such a scenario, both
firms may find it convenient to borrow money in their own currencies and then swap the loans. Hence,
BHP will borrow Australian dollars in Australia and Tata Steel will borrow Indian rupees in India and
then the two firms will swap the loans so that BHP will pay interest on the Indian rupee loan and Tata
Steel will pay interest on the Australian dollar loan.

1.7  Uses of Derivatives

Derivatives are mainly used for risk management. Companies face risks in the form of changes in the
prices of their inputs and outputs, changes in interest rates, and changes in currency exchange rates. Since
these risks are inherent in any business, it is important that they are managed effectively. Generally, com-
panies try to reduce the risk of price variability. The process of reducing risks is known as hedging. Thus,
the major use of derivatives is in hedging. In hedging, the manager tries to fix the following: the price at
which the business will buy or sell a commodity or service, the price at which the business will buy or
sell a financial instrument, the interest rate at which the business will borrow or lend, and the currency
exchange rate at which the business will buy or sell foreign currency.
Derivatives are also used for speculation. Since the price of derivatives is based on the expected
future value of the underlying assets, one can speculate on the value of the underlying assets in the future.
Derivatives can provide a better and cheaper vehicle for speculation as compared to speculating directly
with the underlying assets. For example, assume that gold is selling at INR 1,500 per gram today. If you
believe that gold price is likely increase in the next three days, you can speculate using this information.
One way is to buy the gold today at INR 1,500 per gram and sell the same when the price increases as
expected. If the price increases as expected, say to INR 1,550, you can sell the gold at INR 1,550 and
make a profit of INR 50. However, this strategy requires an investment of INR 1,500 today. Alternatively,
you can enter into a futures contract. As will be shown in Chapter 4, futures will also provide a profit of
INR 50, but the amount of investment will be very low. Most speculators use derivatives to make profits.
It is to be noted that speculation is a risky activity, and if the price does not move as expected, it can result
in losses. In fact, most of the losses associated with derivatives (listed in the beginning of the chapter)
were due to speculations.

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Notes Derivatives are also used for the purpose of arbitrage. An arbitrage opportunity exists when one
can make non-zero profit with no net investment or risk. Since futures contract values are based on
the value of the underlying asset, there should be a relationship between the value of the futures and
the value of the underlying asset. If, at anytime, this relationship is violated, there will be an arbitrage
opportunity. For example, assume that the price of gold in the market is INR 15,000 and the theoreti-
cal value of gold futures is INR 15,500. If the futures are actually priced at INR 15,800, there will be an
arbitrage opportunity. An arbitrager can sell the futures at INR 15,800. If many arbitragers enter the
market like this, the futures price will fall to its theoretical value of INR 15,500, and the arbitrager can
buy the futures back at INR 15,500 and earn a profit of INR 300 with no risk at all. Arbitrage is an
important use of derivatives, and it provides stability to both the futures market and the market for the
underlying assets.
The concept of risk management is discussed in the following sections.

1.8 What is Risk?
All businesses face risks because they operate in a world of uncertainties. The risks that a business faces
can be classified into four major categories:
 Operating or business risk

 Event risk

 Price risk

 Credit risk

Risk makes it very difficult for company managers to forecast future cash flows, which is essential for
making appropriate financial decisions on when to finance new investments, how to finance the invest-
ments, whether to pay dividends, and so on. Therefore, risk management is critical to the ability of a
business to successfully manage its operations.

1.8.1  Operating or Business Risk

Operating or business risk is the risk imposed on a business because of economic cycles and business
cycles, and this risk affects all businesses in an industry. During an economic downturn, most people’s
wealth will decrease, resulting in a lower demand for goods and services provided by most companies.
Conversely, a turnaround in the economy results in increased wealth, an increased demand for goods and
services and, consequently, increased sales and revenue.

1.8.2  Event Risk

Event risk occurs when an unforeseen event arises and affects both the revenue and the cash flow of a
firm. For example, the OPEC cartel’s oil price increase in 1973 precipitated changes in the way most com-
panies operated. Another example is that of the Japanese auto manufacturers who gained a foothold in
the American market with their small cars—a segment that American manufacturers had not explored.

1.8.3 Price Risk
Price risk is a major risk faced by businesses, and it refers to the risk of price changes in inputs and out-
puts that have an impact on a business’ cash flow. Cash flow can be affected by:
 Changes in the prices of commodity inputs and outputs

 Changes in the prices of financial instruments

 Changes in interest rates

 Changes in currency exchange rates

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 Introduction  7

Notes Changes in prices of commodities.  When a business uses tangible goods in its operations, the
changes in the prices of its inputs and outputs will have an impact on cash flows. If input prices change,
the cost of the product changes, resulting in uncertain cash flows. If output prices change, the revenue
changes, resulting in uncertain cash flows. The impact of changes in input and output prices is related to
price volatility—high price volatility results in a large impact, whereas low price volatility results in mini-
mal impact. For example, the price of crude oil showed dramatic behaviour during 2008. From a price
of around USD 70, it increased rapidly to USD 150 within two months, and dropped to USD 40 in about
two months’ time. Similarly, the price of steel is also highly volatile. For a steel manufacturer like Tata
Steel, any increase in steel price would result in increased revenue, whereas any decrease would cause a
decrease in revenue. On the other hand, users of steel, such as a construction company, will find that the
cost of operating the business is lesser when the steel price is lower.

Changes in prices of financial instruments.  Most businesses also make investments in financial
assets. Some businesses such as investment companies invest only in financial assets. When the prices of
financial instruments change, the value of these companies’ investments also changes, and this change
can affect their cash flow. If the prices of financial instruments increase, cash flow will increase, whereas
any price decrease would decrease the cash flow. Consider the case of an insurance company. It collects
insurance premiums periodically and is required to payout the claims whenever they arise. Insurance
companies usually invest the premiums they receive in financial instruments and use the proceeds to pay
for the claims. For insurance companies, changes in the prices of the financial instruments that they have
invested in will be of great concern. This is because if the prices decline significantly, they may not be able
to pay for the claims.

Changes in interest rates.  Interest rate can be considered as being equivalent to the price of
money. When the interest rate changes, both borrowers as well as investors are affected. If the interest
rate increases, a borrower will face a higher interest charge, while an investor will be able to get a higher
return on the investment. Conversely, if the interest rate decreases, a borrower will get a loan at a cheaper
rate, while an investor will get a lower return. Since interest paid or received is part of the total cash flow
of an organization, any change in interest rate will also affect its cash flow.

Changes in currency exchange rates.  Changes in the currency exchange rate affect businesses
that have cash flows denominated in foreign currency. If the local currency appreciates against the foreign
currency, a business with foreign currency inflows will receive less local currency, thereby resulting in a
reduced cash flow. On the other hand, a business with foreign currency outflows will pay less local cur-
rency, thereby resulting in an increased cash flow. Conversely, if the local currency depreciates against
foreign currency, foreign currency outflows will result in lower cash flows and foreign currency inflows
will result in higher cash flows.

Credit risk.  Many businesses provide credit to customers who are considered creditworthy and con-
form to the standards set by the company. However, the credit standing of a customer may change after
the credit is granted, and this may prevent even a very good creditworthy customer from paying the
due amount. This is particularly true for banks that grant credit to a number of customers. The unpre-
dictability of the creditworthiness of customers causes credit risks. Many credit derivatives have been
introduced to reduce credit risks.

1.9  Risk Management

Risks are unavoidable. However, businesses can take steps to ensure that they are fully equipped to man-
age these risks and can consequently plan to have more control over their cash flows. Operating or busi-
ness risks and event risks are not faced by businesses on a regular basis; these arise at various irregular
intervals. The higher management is responsible for anticipating the possible timing of these risks and for
planning to cope with them. In other words, these risks are managed at a strategic level. Credit risks also
do not arise often. Companies can regularly monitor the creditworthiness of the customers and take the
appropriate action when necessary.

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Notes On the other hand, businesses face price risks on a regular basis. It is essential that businesses develop
strategies to manage price risks. In managing price risks, the task for the manager is not to forecast prices,
but to ensure that prices are fixed for buying and selling at a future time without having to worry about
price volatility. This is known as hedging the price risk. Hedging strategies would depend on the expected
direction of movement of prices. The process of hedging using forward contracts, futures contracts, op-
tions contracts, and swap contracts will be explained in later chapters.

1.10  A Brief History of Risk Management

Risk management in commodity prices was one of the earliest forms of risk management. This practice
started in agricultural and livestock industries, where buyers and sellers of agricultural commodities and
livestock engaged in the first futures markets. An example would be a store owner agreeing to purchase
the entire harvest of a farmer at a set price before planting even took place. It is important to note that risk
management is necessary only when there is a chance of price volatility of the underlying commodity.
Risk management in financial instruments did not gain importance until the early 1970s. Interest rates
in most countries were government regulated as instruments of monetary policy to manage the economy.
Further, prior to 1973, exchange rates among currencies were fixed using strict rules that governed the
timing of devaluing or revaluing of the currency by a country. In a world of fixed currency exchange rates
and interest rates, the volatility of interest rates and exchange rates was more or less non-existent; hence,
there was no need for risk management.
In 1973, many currencies changed from a fixed- to a floating-rate regime. Under the floating-rate
regime, currency exchange rates were fixed by market forces rather than by governments, with a conse-
quent increase in the currency exchange rate volatility. When currency exchange rates became volatile,
mechanisms were needed to manage currency risk. The mechanisms that were developed to do this in-
cluded currency options and currency futures.
This change to a floating-rate currency regime also resulted in a change in the way interest rates
were fixed. Since currency exchange rates are related to the interest rates prevailing in each country, the
floating-rate regime prohibited the government from exercising its freedom to fix interest rates, which
also came to be determined by market forces.
By this time, the Eurodollar market had also grown to be an important segment of the financial world.
In the Eurodollar market, floating-rate loans, in which the interest rate on a long-term loan is fixed peri-
odically in short-term intervals, became the norm. Floating-rate loans soon found their way into national
markets as well. Under the floating-rate loan system, it became necessary and important to hedge the risk
of changing interest rates at the next short-term interval. To assist in this hedging activity, new instru-
ments such as forward rate agreements, interest rate futures, and interest rate options were developed.

1.11 Implications for Hedging

Hedging risk is the process by which a financial manager tries to fix a price for a future purchase or sale
of a given asset. This can be accomplished by any of the four following instruments:
 forward contracts

 futures contracts

 options contracts

 swap contracts

When prices are volatile, they can either increase or decrease from their current levels. Consider the
case of a company planning to borrow money three months from today. Because interest rate could
change over time, it is not certain what the interest rate might be when the company seeks to borrow.
The interest rate could rise, in which case it would be making a higher interest payment on the loan as
compared to what it would be making if the borrowing took place today. On the other hand, if the interest
rate goes down, the amount of interest would be lower than what it would be if the borrowing took place

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 Introduction  9

Notes today. If the interest rate moves up, the interest rate is said to move against the interests of the company,
and if the interest rate moves down, it is said to move in the company’s favour. The direction of movement
of interest rate will have implications on hedging activities.

1.12  Upside and Downside Risks

Hedging with futures or forward contracts enables a company to fix the interest rate at which it will bor-
row. For example, assume that the current interest rate is 8% and the interest rate under a futures contract
for borrowing three months later is 9%. In this contract, the company is fixing the future interest rate at
9%, irrespective of what the market interest rate will be after three months. However, market interest rates
can move in any direction. If the market interest rate was to rise to 10% after three months, the decision
to hedge and fix the rate at 9% would be considered fruitful. On the other hand, if the interest rate moved
only to 8.5%, the company would be paying 9% interest on the loan under the futures contract; it would
have had to pay only 8.5% had it not hedged.
This example shows that the company benefits from hedging using futures contracts only if the interest
rate moves against the company. If the interest rate moves in favour of the company, hedging becomes
costly. When the interest rate moves against the company, the firm is said to face a downside risk, and if
the interest rate moves in favour of the company, it is said to face an upside risk.
It is important that a business considers the implications of both upside and downside risks. It is also
important that a business uses hedging instruments when there is a possibility of downside risk, as this
would produce beneficial results. However, if the price moves in favour or if there is a possibility of an
upside risk, then that factor should also be considered in taking a hedging decision. If the competitors of
a business consider the upside risk in their hedging decisions but the business does not, then the competi-
tors will gain an advantage, which could become crucial in the survival of the business.
Futures contracts and forward contracts provide favourable results when a business faces downside
risks, but hedging using forwards and futures could be costly when a business faces an upside risk. On the
other hand, options contracts may provide favourable results when the company faces either a downside
risk or an upside risk. This can be illustrated with an example.
Suppose the same company as in the previous example had entered into an options contract to borrow
at 9% in three months’ time. If the actual interest rate were 10% after three months, when the company
actually borrows, the company would exercise the right and borrow at 9%. If market interest rates were
below 9%, say, 8.5%, the company could choose to not exercise the right and could instead borrow at the
lower market rate of 8.5%.
This example indicates that options provide protection against downside risks, and at the same time
they provide an upside potential. Because of this range of pay-off possibilities, options are assets and they
require an upfront investment in order to buy them. The critical question then is whether the benefits
provided by options are worth their cost.

1.13  Commodity Price Risk

Price risk arises because the price at which a commodity can be bought or sold at a future time is not
known. For example, consider the case of a manufacturer of confectionery products. This company will
need sugar as an ongoing ingredient. However, the price of sugar in the future is uncertain. This uncer-
tainty of the future price of sugar will have a bearing on the pricing of the confectionery produced by the
company as well as on the profits of the company.
Price risk arises because of many reasons. In India, especially when the agricultural commodity output
is dependent on the monsoon, the weather can have an impact on the prices of agricultural inputs. If the
monsoon is good, the output is likely to be good, and this would result in comparatively lower prices, as
opposed to when the monsoon is poor and the output is low. The prices of inputs based on petroleum,
such as chemicals and tyres, will depend on the variability in the price of oil.
Two of the major determinants of price risk are volatility of the movement of prices and liquidity of
the market.

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 10   Financial Risk Management

Notes 1.13.1 Volatility
The two major determinants of price risk are commodity price volatility and commodity market liquidity.
Volatility refers to the average change in the price of a commodity over a specific time interval. If the vola-
tility is low, the average change in price is small and hence the risk of price changes is also small. However,
a high volatility means that the average price change is large and hence the risk of price changes is also
large. When the risk of price changes is small, the company using the commodity will not have to worry
much, because it will not be required to reconsider its pricing decisions and the impact on its profits will
be almost negligible. On the other hand, if the risk of price changes is large, then it is important that the
company takes steps to reduce the risk of price changes, because large changes in the prices of input com-
modities will have a heavy impact on pricing and profitability.

1.13.2 Liquidity
Market liquidity can have an impact on price volatility. Liquidity refers to the ease with which a com-
modity can be sold without causing significant price changes. A commodity is said to have high liquid-
ity if there is active trading in the commodity. When a market has high liquidity, price changes will be
comparatively small, thereby leading to lower volatility. This relationship between liquidity and volatility
is more applicable for financial assets. The volatility of non-financial assets could be affected by factors
other than liquidity.
Volatility changes with the period over which it is estimated. Intra-day volatility refers to the aver-
age price changes over a single day, weekly volatility refers to the average price change over a week, and
monthly volatility refers to the average price change over an interval of a month. The appropriate measure
of volatility to estimate the risk of price change for a company that is trying to manage its price risk de-
pends on the period for which the risk needs to be managed. Non-financial assets typically exhibit lower
short-term and higher long-term volatility, whereas financial assets exhibit higher short-term and lower
long-term volatility.

1.14 Interest Rate Risk

Interest rate risk arises because the future interest rates are not known. Investors, fund managers, and
portfolio managers (for example, mutual fund managers) face risk from interest rate changes, because
they hold fixed-interest rate securities whose value changes when the interest rates change. Corporations
face interest rate risk because they need to obtain funds by issuing fixed-interest securities.
Until the early 1970s, interest rates were highly regulated in all countries. The central bank used to
fix the interest rate on deposits as well as on the loans provided by banks and, therefore, interest rate
risk did not arise during the period of regulation. In 1973, various governments led by the United States
started to deregulate the interest rates and allowed the market to determine the interest rate. The mar-
ket determines the interest rates on the basis of the demand and supply of funds at any given time; this
led to an increase in the uncertainty about the future interest rate. In addition to the market forces, the
governments also influenced the interest rates, because they used interest rate as a tool for developing
the monetary policy. Next, we shall discuss these changes to show why businesses need to hedge their
interest rate risks.

1.14.1 Deregulation and Interest Rate as a Tool for Developing

Monetary Policy
Interest rates can be classified as short-term and long-term rates. Short-term interest rates are those
that are determined in the cash market. The basis of cash markets are settlement accounts that the banks
hold with the central bank. The banks use these accounts to settle balances arising from their clearing
processes and to implement transactions with the central bank.
The central bank controls the cash rates so that it can determine the amount of base money in
the financial system. The central bank does this by buying or selling foreign currency and government

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 Introduction  11

Notes securities. When the central bank buys foreign currency and government securities, it adds cash to the
financial system. When it sells foreign currency and government securities, cash is taken out.
The central bank first decides the interest rate it wants to set based on its monetary policy to combat
inflation and then adjusts the money supply that is consistent with this desired interest rate. This means
allowing variations in the money base, because the demand for cash changes over time. If the central bank
attempted to maintain a constant value for the money base, interest rates would become highly volatile
because of fluctuations in demand.
Cash interest rate is the sole instrument of the central bank’s monetary policy in a deregulated envi-
ronment. Thus, it is used to deal with the most pressing economic problems. If there is high inflation or
current account deficit, a high interest rate can be maintained, whereas the stimulation of a depressed
economy will require easing of the monetary policy or fixing a low interest rate.
This reliance on monetary policy to deal with economic problems has implications for interest
rates. First, this creates a wide cycle in interest rates with huge variations. Second, in order to forecast
interest rates, economic developments and the central bank’s response to the developments have to
be predicted.
Interest rate volatility has increased in many countries because of increased government deregula-
tion and reliance on interest rates as the only flexible tool for developing monetary policy. Deregulation
in these countries has removed the ceiling on interest rates on both deposits and loans by banks and
other financial institutions. Thus, on the basis of their profitability, banks and financial institutions can
determine the interest rates they charge on loans as well as the rates they pay on deposits. Owing to this
deregulation, many financial institutions started to offer floating rate loans and deposits, as opposed to
fixed rate loans and deposits.

1.14.2  Floating Rate Loans

In a floating rate loan, the interest is fixed for a short period, and when that period expires, a new inter-
est rate is fixed for the next period, which could be higher or lower than the one for the previous period.
The interest rate is based on a reference rate, and a premium over this reference rate is also specified. The
reference rate is set such that it takes the reset period into account. The reset period indicates how often
the interest rate is going to be reset. If the interest rate is reset every six months, the reference rate will be
the rate for six months. For example, the loan rate can be expressed as six-month Mumbai interbank of-
fer rate (MIBOR) + 200, where 200 is the premium stated in basis points. A basis point equals 1/100 of a
per cent, i.e., 100 basis points equal one per cent.

  E x am p l e 1 . 8
Consider a floating rate loan taken on January 1, 2008, with the following characteristics:
Principal amount INR 1 million
Interest reset period Every six months
Maturity of loan 3 years
Base rate 6-month MIBOR
Premium over base rate 200 basis points or 2%
Assume that the actual rates on January 1, 2008; July 1, 2008; and January 1, 2009, are:
6-month MIBOR as of January 1, 2008   5%
6-month MIBOR as of July 1, 2008 5.4%
6-month MIBOR as of January 1, 2009 4.8%
(i)  What will be the interest rate starting January 1, 2008; July 1, 2008; and January 1, 2009?
The interest rate for any period is calculated as:
Interest rate for period starting on date t = 6-month MIBOR on date t + Premium
Since the 6-month MIBOR on January 1, 2008, is 5% and the premium over MIBOR is 200 basis
points or 2%, the interest rate for six months starting January 1, 2008 = 5.0% + 2% = 7.0%.

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 12   Financial Risk Management

Notes In a similar manner, the interest rate starting on July 1, 2008, and January 1, 2009, can be calculated as:
Interest rate for six months starting July 1, 2008 = 6-month MIBOR on July 1, 2008 + Premium
= 5.4% + 2% = 7.4%
Interest rate for six months starting January 1, 2009 = 6-month MIBOR on January 1, 2009 + Premium
= 4.8% + 2% = 6.8%
(ii)  What will be the amount of interest payments on June 30, 2008; December 31, 2008; and June 30, 2009?
The interest due on June 30 can be calculated as follows:
Since the interest rates are specified on an annual basis and the period for which interest amount is
calculated is over six months, the appropriate rate over the six-month period will be equal to half the
annual interest rate. The amount of interest is obtained by multiplying this rate with the principal
amount. Thus,
Interest rate for six months starting January 1, 2008 
Amount of interest = Principal amount  
 2
7%
= 1,000,000 × = INR 35,000
2
In a similar manner, the interest due on December 31, 2008 and June 30, 2009 can be calculated as:
7.4%
Interest due on December 31, 2008 = 1,000,000 × = INR 37,000
2
6. 8%
Interest due on June 30, 2009 = 1,000,000 × = INR 34,000
2
The main problem with a floating rate loan is that the future interest rates are not known, and if the
interest rates rise, debt service payments can be quite high, thereby leading to high funding costs
for the company.

1.14.3 Interest Rates and Inflation

It is believed that inflation is a major determinant of nominal interest rates, i.e., the actual monetary return
earned by a lender or the monetary cost paid by a borrower. In a deregulated economy, monetary authori-
ties rely on variations in interest rates as the main tool for influencing economic conditions, and they usual-
ly react to an increase in inflation rates by tightening the monetary policy or by increasing the interest rates.
The relationship between inflation and interest rates was given by Irving Fisher, and it is termed the
“Fisher effect”. The idea behind the Fisher effect is that any investor will demand an increase in his or
her purchasing power whenever money is lent. According to the Fisher effect, the nominal interest rate,
which is the interest rate quoted on financial securities, is given by the following relation:
1 + Real interest rate
Nominal interest rate = −1
1 + Expected inflation rate
where the real interest rate is the increase in purchasing power required by investors. This relationship is
approximated as:
Nominal interest rate = Real interest rate + Expected inflation rate

  E x am p l e 1 . 9
Assume that an investor provides funds of INR 100,000 at a nominal rate of 10% for one year. If the in-
flation during the year is 6%, the increase in the purchasing power of the investor can be calculated as:
Amount received after one year = 100,000 × 1.1 = INR 110,000
INR 110, 000
Purchasing power of INR 110,000 in today’s currency value = = INR 103,773.60
1.06
Thus, the actual increase in purchasing power from this investment = 3.7736%.

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 Introduction  13

Notes This increase in purchasing power is termed as the real interest rate, and the Fisher effect relates the real
interest rate and the nominal interest rate as:
1+ Nominal rate
Real interest rate = −1
1+ Expected inflation rate

The Fisher effect is usually expressed as an approximate form as:

Real interest rate = Nominal interest rate – Expected inflation rate
In financial markets, the real interest rate is determined on the basis of supply and demand; the nominal
rate is then calculated from this real rate as:
Nominal interest rate = Real interest rate + Expected inflation rate
Note that the interest and inflation rates are for the investment period—they are not the current real rate
or inflation rate. This means that interest rates at any time depend on the expected inflation rate in the
future.

1.14.4  Components of Interest Rate Risk

Investors, fund managers, portfolio managers, and financial institutions face risk from interest rate move-
ment, because they hold fixed-interest securities as part of their investment. The value of fixed-interest
securities such as bonds and debentures changes with the interest rate. When the interest rate increases,
the prices of bonds and debentures decreases; this results in a lower portfolio value. However, when the
interest rates decrease, the prices of bonds and debentures increase, and this results in a higher portfolio
value. This aspect of interest rate risk is known as the price risk component.
Another aspect of the interest rate risk is known as the reinvestment rate risk. Regular coupon inter-
est payments received from the bond issuer must be reinvested when received. The actual return from
bond investment depends on the rates achieved on the reinvestment of these coupon interest payments.
If interest rates increase, the value of the bond portfolio decreases, but the reinvestment of coupon inter-
est payments can be made at a higher rate. If interest rates decrease, the value of the bond portfolio will
increase, but the reinvestment of the coupon interest payments will have to be made at a lower rate. It
must be noted that price risk and reinvestment rate risk move in opposite directions. Thus, the portfolio
manager cannot be certain of the portfolio value, as the future interest rates are not known.
Financial institutions also face interest rate risks because of a mismatch in the timing of cash in-
flows and outflows. Consider, for example, an insurance company. This company receives premiums and
invests them in fixed-interest instruments. These companies’ outflows increase when claims are made.
Since claims cannot be predicted, it is difficult to exactly match the inflows and outflows, and the net
interest income is subject to interest rate movements.
It will be shown in later chapters that these risks can be minimized by the use of forward contracts,
futures contracts, and swaps.

1.15  Currency Risk

A business faces currency risk or foreign exchange exposure when its economic value depends on the
exchange rate. The economic value of a business is defined as the present value of all future net cash flows.
Therefore, a company is subject to foreign exchange exposure when the value of current and future cash
flows depends on the exchange rate.
A company will face foreign exchange exposure under the following circumstances:
1. The company engages in importing goods from a foreign country. If the foreign supplier sends
the invoice in foreign currency, the importer is exposed to risk since the currency value will change
over time.
2. The company exports goods to a foreign country and sends the invoice in foreign currency. In this
case, the amount of the local currency depends on the value of the foreign currency, which will
change.

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 14   Financial Risk Management

Notes 3. The company does not import or export, but its competitors are foreign entities. In this case, if the
foreign currency depreciates, the competitors gain a competitive advantage. They can reduce the
prices of their goods and receive the same revenue.

  E x am p l e 1 . 1 0
A shoe manufacturer in the United States is selling shoes in India. The shoe costs USD 10. The shoe’s
selling price in India is INR 900. The current exchange rate is 1 USD = INR 40.00.
Profit for the manufacturer by selling one shoe = INR 900 – INR 400 = INR 500 = USD 12.50
Assume that the U.S. dollar depreciates to INR 38.
Profit for the manufacturer by selling one shoe at INR 900 = INR 900 – INR 380 = INR 520 = USD 13.68
When the U.S. dollar depreciates, the manufacturer gets a higher profit if it maintains the same price.
Alternatively, the company could reduce its price to maintain the same profit of USD 12.50.
Profit of USD 12.50 means a profit of INR 12.50 × 38 = INR 475
Cost of shoe = USD 10 = INR 380
Price at which profit remains the same = 380 + 475 = INR 855
Thus, the manufacturer could reduce the price of the shoe from INR 900 to INR 855 and still maintain
the same profit in U.S. dollars.

In Example 1.10, the manufacturer enjoys a competitive advantage. The Indian companies compet-
ing with this manufacturer will face stiffer competition, because the manufacturer is able to reduce its
prices even if its costs do not change, mainly because of the U.S. dollar depreciation. Meanwhile, Indian
companies would lose their profit if they were forced to reduce prices in following their competitor’s
example.
Currency risk has become more predominant since 1973, when most major currencies moved from
the fixed to floating exchange rate regimes. Most countries allow free floating of their currencies, whereby
the value of the currency is determined in the market on the basis of supply and demand. However,
governments do intervene in the market if they believe that the value of the currency has risen or fallen
excessively. Therefore, currency rate forecasting has to take into account possible government actions,
which makes forecasting very difficult. The firms that face currency exposure thus need to take the ap-
propriate action in order to manage this risk.
Currency exposure can be classified into three types—translation exposure, transaction exposure, and
operating exposure.
Translation exposure arises when a company has operations subsidiaries in many countries. In such
a situation, the company will have to consolidate its accounts. Consolidation requires that the assets and
liabilities of the subsidiaries located in various countries and their denominations in various currencies
be translated into a single currency. This translation can result in gains or losses, depending upon the
changes in exchange rate over time. Since translation exposure relates to financial account transactions,
this exposure needs very little management.
Transaction exposure relates to the risk that a company faces for transactions it has already entered
into. Since the transactions have already begun, the amount and timing of exposure will be clearly
known. Examples of transaction exposure include payment of imports, receipts of exports, receipt
of interest on amount invested, or payment of interest on borrowed amount. Since both the timing
and amount of exposure are known, this type of exposure can be more easily managed using derivative
instruments.
Operating exposure relates to the exposure that a company faces when its future cash flows are
affected by changes in exchange rates. This cash flow change occurs because the exchange rate
changes alter the competitive position of the company in both the domestic and foreign markets. This
is the most difficult exposure to manage, and its management requires changes in the company’s
strategic plans.

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 Introduction  15

Notes 1.16  Approaches to Risk Management

Two approaches can be used to manage risk:
Do nothing: This means the company will ignore all the risks. This is appropriate if the exposure is very
 
small or if the cost of managing the risk exceeds the benefits that might be reaped from doing so.
Cover
  everything: This means that the company will take a position in a derivative instrument
to manage every exposure. This approach allows the company to manage all the risks that can be
identified and sufficiently quantified.
The first alternative is passive, whereas the second alternative is active risk management. In active risk
management, the business leaves exposures uncovered when prices or rates appear to be moving in its
favour and covers them when the movement in prices or rates could lead to losses. This process is also
known as selective hedging.
The merits of each of these alternatives will have to be weighed against the costs in order to achieve the
best possible solution at that moment.
The success of active management relies on the ability of the business to make reasonably accurate
forecasts on future movements in prices, interest rates, or exchange rates.
In managing risks, businesses use financial instruments such as derivatives to modify the uncertainty
of future cash flows. If financial instruments are used to decrease the uncertainty of future cash flows, the
companies are said to hedge. If the instruments are used to increase the uncertainty of the future cash
flows, they are said to speculate. It should be noted that a decision to not use instruments to cover an exist-
ing exposure is also a form of speculation.
Using derivatives to hedge business risks is in itself a risky proposition. If one enters into speculative
activity using derivatives, the speculator also faces risks. The risks that are faced by hedgers and specula-
tors are discussed next.

1.17  Risks in Derivatives Trading

Earlier, a number of examples of the collapse of companies such as the Barings Bank and Lehmann
Brothers and the bankruptcy of organizations such as Orange County, AIG, and LTCM due to their trad-
ing in derivatives were cited. But where does the risk come from while trading in derivatives?
When a hedger uses derivatives to hedge, they are trying to reduce the risk of the prices going against
them. In forward contracts, futures contracts, and swap contracts, the price at which the future exchange
will take place is fixed. If the price moves against the hedger, they will benefit from these contracts. On the
other hand, if the prices move in favour of the hedger, they will face a loss. Depending upon the volume
of transaction, the losses could be large.
Speculators use derivatives on the basis of their expectations of the future price movement. In case
they are correct in their assessments, they make profits. On the other hand, if the assessments turn out to
be wrong, they face losses while using forward contracts, futures contracts, or swap contracts.
Option contracts can also result in losses, even though the amount could be comparatively less when
compared to forward contracts, futures contracts, or swaps. This is particularly true when speculators
combine options to make money on the basis of their expectations of future prices. If the price does not
move as expected, options can also result in huge losses.
Recent developments in derivatives that include complex products such as exotic derivatives and cred-
it derivatives can also result in huge losses. These losses arise because payment patterns are not very clear
in these derivatives. Most of these derivatives would result in payments when a particular event occurs. It
is very difficult to calculate the probability of such an event occurring or the amount that is to be paid if
that event occurs. Because of these factors, even sophisticated investors find it very difficult to assess the
risks of these exotic derivatives.
In using derivatives, therefore, it is important that one clearly understands the risks involved while
trading a particular derivative. If one cannot understand the conditions under which payment would
have to be made or the amount that would have to be paid, it would be better not to enter into such
derivative contracts. The popular adage “Buyers Beware” also applies to derivatives.

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 16 Financial Risk Management

CHApTER SUMMARY
 Derivative securities are used for risk management. of capital. Changes in currency exchange rates will have an
A derivative security is one whose value depends on the
 impact on cash flows denominated in foreign currencies.
underlying asset on which the derivative contract is written. It is important to identify the risks faced by a company and

In a forward contract, one party agrees to buy the underlying
 manage these risks so that there is minimum impact on the
security and the other party agrees to sell the same at a future future cash flows.
time at a price that is agreed upon at the time of entering Hedging means reducing the impact of the risks on future

into the contract. These are private contracts in the over-the- cash flows.
counter market. Upside risk means that the price moves in favour of the

In a futures contract, one party agrees to buy the underlying
 company so that future cash flows will increase, and downside
security and the other party agrees to sell the same at a future risk means that the price moves against the company so that
time at a price that is agreed upon at the time of entering into future cash flows will decrease. Although it is important
the contract. These are traded in exchanges. that downside risk should be hedged, it is also necessary to
An options contract gives the holder the right to buy or sell the
 consider the upside risk while hedging the downside risk.
underlying asset on or before the maturity date of the contract. The extent of price risk depends on price volatility and the

These contracts could be either traded in exchanges or in the liquidity of the commodity and instruments in the market.
over-the-counter market. Interest rate risk arises because future interest rates are not

Swaps are contracts where two parties agree to exchange future
 known at the current time.
cash flows according to an agreed-upon formula. These are Interest rates are determined on the basis of the supply and

usually over-the-counter contracts. demand for funds in the market and monetary policy actions.
Risk means that the future is uncertain and hence the cash
 Interest rates are related to future inflation, and the relationship

flows that will be generated in the future are also uncertain. between the interest rate and inflation is written as:
Businesses face risk in three aspects, namely, business risk,
 Nominal interest rate = Real interest rate + Expected inflation
n rate
event risk, and price risk. Business risk, also known as
operating risk, is imposed on businesses as a result of economic Interest rate risk affects in two ways: the price at which the

and business cycles, and it affects all businesses in the industry. financial instrument can be sold in the market, known as
Event risk occurs when an unforeseen event arises, affecting price risk, and the rate at which any interim cash flows from
both the revenue and the cash flow of a firm. Price risk refers the financial investment can be reinvested, known as the
to the risk of price changes in the inputs and outputs of a reinvestment rate risk.
company that will have an impact on its future cash flows. Currency risk affects a company when the value of the current

Changes in the prices of inputs and outputs affect the future
 and future cash flows depends on the exchange rate.
cash flows of a company. Changes in the prices of financial A company can manage risk in three ways: (i) do nothing

instruments mainly affect investment companies, as their cash and face the risk completely; (ii) cover everything or hedge
flow depends on the value of the financial instruments held each and every risk; (iii) cover partially, that is, hedge only a
by them. Changes in interest rates will affect a company’s cost part of the cash flow.

MUlTiplE-CHOiCE QUESTiONS
1. A one-year forward contract is an agreement where D. One side has the obligation to buy an asset for the market
A. One side has the right to buy an asset for a certain price in price in one year’s time.
one year’s time.
2. Which of the following is approximately true when size is
B. One side has the obligation to buy an asset for a certain
measured in terms of the underlying principal amounts or
price in one year’s time.
value of the underlying assets
C. One side has the obligation to buy an asset for a certain
A. The exchange-traded market is twice as big as the over-
price at some time during the next year.
the-counter market.

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 Introduction 17

B. The over-the-counter market is twice as big as the 6. Which of the following best describes a central counterparty
exchange-traded market. A. It is a trader that works for an exchange
C. The exchange-traded market is ten times as big as the B. It stands between two parties in the over-the-counter
over-the-counter market. market
D. The over-the-counter market is ten times as big as the C. It is a trader that works for a bank
exchange-traded market. D. It helps facilitate futures trades
3. Which of the following best describes the term “spot price” 7. Forward contracts are generally _________ in nature.
A. The price for immediate delivery A. OTC
B. The price for delivery at a future time B. Exchange traded
C. The price of an asset that has been damaged C. Both the above
D. The price of renting an asset D. None of the above
4. An investor sells a futures contract an asset when the futures 8. Futures contracts are preferred to forward contracts because
price is $1,500. Each contract is on 100 units of the asset. The of_______
contract is closed out when the futures price is $1,540. Which A. High liquidity
of the following is true B. High counterparty risk
A. The investor has made a gain of $4,000 C. Low liquidity
B. The investor has made a loss of $4,000 D. All of the above
C. The investor has made a gain of $2,000
9. An equity index comprises of ______.
D. The investor has made a loss of $2,000
A. basket of stocks
5. A company knows it will have to pay a certain amount of a B. basket of bonds and stocks
foreign currency to one of its suppliers in the future. Which of C. basket of tradeable debentures
the following is true D. None of the above
A. A forward contract can be used to lock in the exchange
10. Changes in interest rates is an example of:
rate
A. Business Risk
B. A forward contract will always give a better outcome than
B. Event Risk
an option
C. Price Risk
C. An option will always give a better outcome than a for-
D. None of the above
ward contract
D. An option can be used to lock in the exchange rate

Answer
1. B 2. D 3. A 4. B 5. A 6. B 7. A 8. A 9. A 10. C

REViEW QUESTiONS
1. Differentiate between a forward contract and a futures contract. 9. Discuss the impact of exchange rate risk on the value of a
2. Differentiate between a futures contract and an options con- firm.
tract. 10. What is meant by hedging? How does hedging improve the
3. Why does an options contract have an intrinsic value? effectiveness of the operations of a business?
4. Why is it that only price risk can be hedged, and not operating 11. How does inflation affect interest rates?
risk or event risk? 12. How can monetary policy and fiscal policy affect interest
5. What is meant by credit risk? How can it be reduced? rates?
6. Why does price risk exist? 13. What factors determine the need to hedge?
7. Why does commodity price risk need to be hedged by a firm? 14. What is the difference between real interest rate and nominal
8. How does interest rate risk affect a firm? interest rate?

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 18 Financial Risk Management
SElF-ASSESMENT TEST
1. Mahindra and Mahindra decide to take a floating rate loan in
the Euro market on April 1, 2009, with the following charac-
teristics:
Principal amount USD 10 million
Interest reset period Every three months
Maturity of loan Five years
Base rate 3-month USD LIBOR
Premium over base rate 250 basis points
Assume that the actual rates on April 1, 2009; July 1, 2009;
October 1, 2009; and January 1, 2010, are:
3-month LIBOR as of April 1, 2009 6.3%
3-month LIBOR as of July 1, 2009 5.6%
3-month LIBOR as of October 1, 2009 5.9%
3-month LIBOR as of January 1, 2010 6.6%
(i) What will be the effective interest rate for Mahindra and
Mahindra starting April 1, 2009; July 1, 2009; October 1,
2009; and January 1, 2010?
(ii) What will be the amount of interest payments on June
30, 2009; September 30, 2009; December 31, 2009; and
March 31, 2010?
2. Sheela, the finance manager of Gemini enterprises requires
INR 5,000,000 for expansion over a period of two years. She
approaches the bank for a loan to finance this expansion
project on January 1, 2009. The bank offers her two choices:
(i) A loan with a fixed rate of 9% for the next two years, with
interest payable every six months.
CASE STUDY
Jet Airways, which commenced operations on May 5, 1993, has
established its position as a market leader in India. The airline
has been repeatedly adjudged India’s best domestic airline by
Abacus-TAFI and has won several national and international
awards.
Jet Airways operates a fleet of 85 aircraft, which includes
10 Boeing 777-300 ER aircraft, 10 Airbus A330-200 aircraft, 54
classic and next-generation Boeing 737-400/700/800/900 aircraft,
and 11 modern ATR 72-500 turboprop aircraft. With an average
fleet age of 4.45 years, the airline has one of the youngest aircraft
fleets in the world.
Jet Airways operates to 63 destinations, both within and out-
side India. International routes include New York, San Francisco,
Toronto, Brussels, London (Heathrow), Hong Kong, Singapore,
Shanghai, Kuala Lumpur, Colombo, Bangkok, Kathmandu, Dhaka,
Kuwait, Bahrain, Muscat, Doha, Abu Dhabi, and Dubai.
Its major cost is the cost of aviation fuel. In addition to fuel
costs, the other costs include landing costs at various airports and
M01 Financial Risk Management 01 XXXX.indd 18
(ii) A floating-rate loan with the base rate of 6-month
MIBOR, with a reset period every six months. The
rate on the loan will be 6-month MIBOR + 180 basis
points, and interest will be payable at the end of every six
months. MIBOR on January 1, 2009, at the time of taking
the loan is 6%.
Sheela is not sure which of these loans she should opt
for. She has contacted some analysts to get some idea
about where MIBOR rates could be in the next two years,
and the analysts estimates are: 6-month MIBOR on July 1,
2009 is 6.8%; on January 1, 2010, is 7.3%; and on July 1,
2010, is 7.1%.
(a) Calculate the effective interest rates on January 1,
2009; July 1, 2009; January 1, 2010; and July 1, 2010,
under the floating rate loan.
(b) Calculate the interest amount on June 30, 2009;
December 31, 2009; June 30, 2010; and December
31, 2010, under both fixed rate loan and floating
rate loan.
(c) On the basis of the interests calculated, determine
which alternative should be chosen. What other
factors need to be considered in deciding on which
loan should be opted for?
3. The expected inflation for the next year is 4.6% and, currently,
the yield of treasury bills with a maturity of one year is 9%.
What is the real interest rate in the economy?
baggage handling costs. The remuneration of pilots and airline
personnel will have to be competitive since there is a huge demand
for these personnel because of the presence of a number of new
airlines that operate throughout the world.
The revenue for airlines comes mainly from passenger fares
and cargo fares. The passengers of Jet Airways come from various
countries and pay their fares in the currency of their own country.
Jet Airways finances the purchase of its airplanes by borrow-
ing money either in India or in other countries through bond
issue. The interest payments will have to be paid in the currency
in which the bond is issued. Future plans for Jet Airways include
purchase of additional planes, which will also be financed through
borrowing.
Discussion Questions
1. What are the various risks that Jet Airways is facing?
2. How can these risks be reduced using derivative securities?
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