Derivative in Disguise

Case

Author: L Ramprasath
Online Pub Date: January 04, 2021 | Original Pub. Date: 2020
Subject: Financial Derivatives, Options & Futures, Risk Management
Level: | Type: Experience case | Length: 630
Copyright: © 2020 The Indian Institute of Management, Kozhikode. All rights reserved.
Organization: fictional/disguised | Organization size:
Region: Southern Asia | State:
Industry: Financial service activities, except insurance and pension funding
Originally Published in:
Ramprasath, L. ( 2020). Derivative in disguise. Kozhikode, India: Indian Institute of Management,
Kozhikode.
Publisher: Indian Institute of Management, Kozhikode
DOI: http://dx.doi.org/10.4135/9781529754704 | Online ISBN: 9781529754704
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© 2020 The Indian Institute of Management, Kozhikode. All rights reserved.

© 2020 The Indian Institute of Management, Kozhikode. All rights reserved.

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Abstract
This case centers on a new advertising campaign by a leading jewelry chain in India, which
offers to freeze the price of gold for customers up two months ahead of the purchase date.
Students play the role of Ashish, a member of the finance team for the company, who must
analyze how the derivative within the advert will impact the company financially. What are the
risks of the promotion and are there hidden arbitrage opportunities?

Case
Mark Twain’s words, “It is difficult to make predictions, particularly about the future”, could not be more true
for someone trying to predict oil or gold prices in the current environment. This is even more so for a middle
class Indian customer who encounters equal number of bullish predictions and their opposites for the price of
every commodity that matters. 1

Capitalizing on this, a leading jewellery chain has come up with a novel scheme of locking the gold rates for
its customers up to two months ahead of their actual purchase date. The final draft of the ad campaign which
will begin in a month’s time, gives the following information:

You can lock your gold rates for your next purchase right now!

Advance Period Amount to be paid*

10 days 10%

20 days 20%

30 days 30%

40 days 40%

50 days 50%

60 days 60%

*If the rate at the time of purchase is different from the rate at the time of booking your jewellery, the lesser
rate is yours.

The firm believed that the novelty of this scheme can lure many of the customers from its competitors
especially during the upcoming marriage season, when sales are typically high. This scheme will address a
typical customer who is planning to buy significant amount of gold within a two month window and her concern
that gold rates may rise significantly from now to the actual date of purchase. For the firm, increased advance
bookings can free up part of their working capital investment in inventory. So the management thought this
will be a win-win situation for both the firm and the customers.
Derivative in Disguise
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Mr. Ashish has recently joined the Finance team of this jewellery at their headquarters in Kochi after
completing his MBA from a premier management institution. He chanced to look at this ad campaign at a
colleague’s table and suddenly he was reminded of his Derivatives course that he took during his MBA,
since the footnote at the end of the above table resembled a hedging strategy for the customer in a bullish
market. When he mentioned this to his boss, she asked him to probe this similarity further and told Ashish that
answers to the following questions can help the management fine tune this scheme before its actual release.
She had picked up some derivatives concepts on her own while managing her personal equity investments
but she has not gone beyond that. Also she added that this will be a good opportunity for Ashish to apply his
learning to immediate practice and an useful addition to his performance appraisal documents for this year.

• 1.
What type of a derivative is the firm selling?
• 2.
What is the premium charged by the firm for these derivatives?
• 3.
Assuming the firm goes ahead with the above scheme, what are the implied forecasts made by the
firm about the future gold prices?
• 4.
Derivative traders always look out to grab arbitrage opportunities. Does the above scheme provide
any hidden arbitrage opportunities?
• 5.
Should the firm allow early exercise by the customer i.e. if the customer books the jewellery and
turns up at the showroom, say 15 days before the actual purchase date, can the firm advance the
purchase date of the contract? If it does so, will the firm incur any additional costs?
• 6.
What are the potential risks to the firm once this scheme is launched? If there are any, how should
the firm hedge its exposures?

Knowing the answers to the above questions before the launch of the campaign will also make the firm more
confident of its offering and avoid any unpleasant surprises.

Note
1. This case was motivated by an actual ad that appeared in the daily newspaper by a leading jewellery chain
from Kerala.

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