RISK

MANAGEMENT
STRATEGIES :
ECB/ADR/GDR

GROUP 1
 External Commercial borrowing (ECB)

Include commercial loans availed from non-resident lenders with a minimum

average maturity of 3 years in the form of bank loans, buyers credit, suppliers
credit, securitized instruments (Eg: floating rate notes and fixed rate bonds)

Routes of ECBs

 ECBs can be accessed under two routes-

(i) Automatic Route - Borrower enters into a loan agreement with the lender in
compliance with ECB Guidelines

and

(ii) Approval Route - Prospective borrower submits an application in the prescribed

form through authorized dealer (AD) to RBI
Benefits of ECB

• No dilution in ownership.

• Considerably large funds can be raised as per requirements of borrower.

• Usually only a fixed rate of interest is to be paid

• Easy availability of funds because ECB is more appealing to Investors.

• Nourish 2 sectors:- Infrastructure SME

• Easy to acquire foreign loans for SME’s

• Low cost of funds in the global market.

• ECB is for specific period, which can be as short as three years.

• Fixed Return, usually the rates of interest are fixed

What is ADR ?

 ADR is a negotiable US certificate ownership of

shares in an non-US corporation. It is quoted and
traded in US dollars in US securities market and
dividends are paid to investors in US dollars

 ADR is specifically designed to facilitate purchase,

holding and sale of non-US securities by US investor
and to provide corporate finance vehicle for non-US
companies
Mechanism to issue ADR/GDR

Company issues Ordinary Shares

Kept with Domestic Custodian

Transferred to the Overseas Depository Bank

ADR’s /GDR’s are issued by ODB

Receipts given to the foreign investors

ADR RATIO

 Single
1 ADR = 1 SHARE
ADR Ratio = 1:1
 
 Multiple
1 ADR = 5 SHARES
ADR Ratio = 1:5
 
 Fraction
1 ADR = ½ SHARE
ADR Ratio = 2:1
 
 Types of ADR

ADR Listed in - NASDAQ, AMEX, NYSE

 Unsponsored ADRs
 Created in response of investors, brokers - dealers and
depository.
 Exempted from reporting requirements of the SEC.
 Not Listed on any exchange.

Advantages: Disadvantages:
 Inexpensive.  No control over the
 Expands investors base. activity.
 Minimal SEC compliance and  Conversion
reporting requirements. becomes costly.
 Sponsored ADRs
 Initiated by Issuer.
 Established jointly by an Issuer and Depository.
 Agreement between Issuer and Depository.
 Depository provides shareholders communication and
other information to ADR holders.
 Through Depository ADR holders can exercise voting
rights.
 Level I Level II Level III
Least Expensive More Expensive Most
Expensive
Minimal SEC Full SEC SEC reporting
registration registration & is more
&reporting reporting detailed than
requirements. requirements. Level II.
Cannot be listed on Listed on
National exchange of Listed on National National
US. exchange of US. exchange of
US.
Capital Raising is not Capital Raising is Capital can be
permitted. not permitted. raised through
Public offering.
Advantages of ADR
 It is an easy and cost effective way to buy shares of a foreign company

 Reduces administrative costs and avoids foreign taxes on every transaction

 Helps companies which are listed to tap the American equity markets

 Any foreigner can purchase these securities

 The purchaser has a theoretical right to exchange shares ( non- voting right
shares for voting rights)
 GDR – Global Depositary Receipts
 A bank certificate issued in more than one country for shares in a foreign
company

 Offered for sale globally through the various bank branches

 Shares trade as domestic shares

GDR – CUSTODIAN BANK – DEPOSITORY

BANK
 Custodian Bank located in same country

 Works with the Depository Bank and follows instructions from the
depository bank

 Collects, remits dividends and forwards notices received from the depository
bank
GDR Listing
 London Stock Exchange
 Luxembourg Stock Exchange
 DIFX
 Singapore Exchange
 Hong Kong Exchange
 GDR- Advantages and Dis-advantages

 GDRs allow investors to invest in foreign companies without worrying about foreign
trading practices and laws

 Easier trading, payments of dividends are in the GDR currency

 GDRs are liquid because they are based on demand and supply which is regulated by
creating or cancelling shares

 GDR issuance provides the company with visibility, more larger and diverse shareholder
base and the ability to raise more capital in international markets

 However, they have foreign exchange risk i.e. currency of issuer is different from
currency of GDR
What Does Currency Risk Mean?
 The risk that a business' operations or an
investment's value will be affected by changes in
currency exchange rates.

 The risk that an investor will have to close out a

long or short position in a foreign currency at a loss
due to an adverse movement in exchange rates.
Currency Risk
Types

Types of Currency Risk

Economic Risk Accounting or

(Effects Cash Flows) Translation Risk
(Do not effect Cash Flows)

Transaction Risk
(Current Cash Flows)

Operating Risk
(Future Cash Flows)
Currency Risk
1. Transaction Risk

 Concerned with the impact of changes in exchange rate

on Current Cash Flows.

 Mainly because of following:

 Export & Import

 Borrowing & Lending in Foreign Currency

 Intra-Firm flow in an Multinational Company

 Currency Risk
2. Operating Risk

 Concerned with the impact of changes in exchange rate

on Future Cash Flows.

 Which is related to Costs and Revenues of firm

 Mainly because of following:

 Increase in Cost of imported Raw-Material
 If domestic currency depreciates
 Decrease in Export Revenue
 If domestic currency appreciates
 Increase in other factors cost
 Currency Risk
3. Translation Risk

 Also known as Accounting Risk

 Emerges on account of consolidation of financial statements (P&L,

BS) of multinationals

 It is done by converting financial statements of subsidiaries

denominated in different currencies into the domestic currency of
parent company

 Any change in exchange rate effects the consolidated statements

 Example
 Let’s suppose you’re an American investor and you put $10,000 into a Indian stock market.

 Your investment is not hedged, you’re exposed to currency risk.

 Suppose over 12 months the Indian market and therefore your Investment goes up 20% in local
INR terms

 If the dollar and the INR is at the same exchange rate after 12 months as when the investment,
the holding is now worth $12,000. (i.e.$10,000 increased by 20%)

 Say the dollar appreciated by 25% versus the INR over 12 months. The holding would be worth
$9,600 (12,000 / 1.25). i.e Your INR position now buys fewer dollars

 Say the dollar depreciated by 25% versus the INR over 12 months. The holding would be worth
$16,000 (12,000 / 0.75). i.e. Your INR position now buys more dollars.
Interest Rate Risk
 Interest rate risk is the risk (variability in value)
borne by an interest-bearing asset, such as a loan or
a bond, due to variability of interest rates. In
general, as rates rise, the price of a fixed rate bond
will fall, and vice versa

 This risk can be reduced by diversifying the

durations of the fixed-income investments that are
held at a given time
FORWARD CONTRACTS
 A Forward contract is a bilateral contract that
obligates one party to buy & other party to sell a
specific quantity of an asset , at a set price , on a
specific date in the future
 The party that agrees to buy is called the Long & the
party that agrees to sell is called as short
 Two Types:
• Deliverable forward contract
• Forward contract with cash settlement
 Deliverable forward contract
 Example :
 Party A agrees to buy a $1000 Face value , 90-day
T-bill from Party B 30 days from now at a price of
$990
 If 30 days from now T-bills are trading at $992,the
short must deliver T-bill to the long for $990
 If T-Bills are trading at $988, the long must
purchase the T-bill from short for $990
Forward contract with cash settlement

 Example:
 If the price of T-bill on expiration date was $992,
then short would satisfy the contract by paying $2
to long
 If the price of T-bill at settlement date was $988,the
long would make payment to the short. Purchasing
T-bill at market price of $988 , together with this
$2 payment , would market total cost $990, just as
deliverable contract.
Forward Rate Agreement
 A forward rate agreement can be veiwed as a
forward contract to borrow/lend money at a certain
rate at some future date.
 Generally these contracts settle in cash, but no actual
loan is made at settlement date.
 If the floating rate at the contract expiration (LIBOR)
is above the rate specified in the forward agreement ,
the long position can be viewed as right to borrow
below market rates & long will receive a payment
Forward Rate Agreement
 Consider an FRA that expires in 30 days , notional
principal amount of $ 1 million, is based on 90-day
LIBOR , specifies a forward rate of 5%
 Assume that actual 90 day LIBOR at expiration is

6%
 So the interest saved on 90-day , $1 million would be

(0.06-0.05)(90/360)* 1 million = $2500

Using present value, payment at settlement from short
to long is: 2500/(1+(.06*(90/360)))=$ 2463
Currency forward contracts
 Under currency forward contract, one party agrees
to exchange a certain amount of one currency for a
certain amount of another currency at a future date
 Currency forwards can be deliverable or settled in
cash
 The cash settlement amount will be the amount
necessary to compensate the party who would be
disadvantaged by actual change in market rates as
of settlement date
 Currency forward contracts
Example :
 A Co. expects to receive EUR 50 million three months

from now & enters into cash settlement currency

forward to exchange Euros for USD 1.23 per euro
 Market exchange rate at settlement is USD 1.25/ euro

 Under the terms Co. will receive , 50 million * 1.23 =

Usd 61.5 million

 Without forward contract , Co would receive , 50 million

* 1.25 = USD 62.5 million

 Therefore, the co. must pay USD 1 million to

counterparty
Future Contracts
 Futures are similar to Forward contracts with some
following differences :
 Futures trade on organised exchanges while
forwards are private contracts and do not trade
 Futures are highly standardised & single clearing
house is counterparty to all future contracts
 Government regulates the future market
 INTEREST RATE OPTIONS
 Hedging tool for interest rate fluctuation risk
 An investment tool whose payoff depends on the
future level of interest rates.
 Interest rate Options are European-style, cash-settled
options on the yield of U.S. Treasury securities.
 As of now, trading in options on interest rate products
is not allowed in India.
CURRENCY OPTIONS
 Underlying asset is a foreign currency.
 Also known as forex options and FX options
 The contract is between a buyer and a seller and gives the buyer the right
(but not the obligation) to buy or sell the underlying foreign currency at a
specified price on an agreed upon date in the future.
 Currency options are of two types: call option and put option.
 When an investor believes that the US dollar will appreciate against the
Euro, he purchases a currency call option on USD/EUR. If the value of the
US dollar actually increases against the Euro, the buyer can exercise his
right to earn a profit.
 Soon to be launched in India by NSE and USE.
 INTEREST RATE SWAPS
 An is an over-the-counter (OTC) derivative instrument available in the market
where counter parties can exchange a floating payment for a fixed payment and
vice-versa related to an interest rate.
 Financial institutions going for foreign borrowings usually buy interest rate
swaps to hedge their interest rate exposure due to fluctuating interest rates.
 Swaps can broadly be classified into two types:
 Fixed to Floating

 Floating to Floating

 Trade date, Effective Date, Maturity Date

INTEREST RATE SWAPS

8.65%

A B

LIBOR + 0.70%
CASE STUDY
RANBAXY :
FOREIGN CURRENCY DERIVATIVES
 CASE STUDY : RANBAXY
 Entered into foreign currency derivatives transactions with various banks
 Estimated loss of over Rs. 2500 Cr as on Feb 2009
 Entered into numerous “Forex Strip Options”
 A strip is like a series of options that mature on certain dates over a period of
time, and these contracts are settled on monthly basis.
 At that time USD-INR was Rs. 39.90
 Ranbaxy speculated that INR would appreciate further.
 The strategy used :
 Bought “Put” options from bank
 Sold “Call” options to banks
 Dollar appreciated against Ranbaxy’s expectations
 Banks exercised the “Call” options
 Loss from fair valuations of derivatives was alone Rs. 784 Cr
 CASE STUDY : RANBAXY
 Since Ranbaxy had opted for a put and call the risk in any direction should
have been hedged.

 But the options were present in the ratio of 1: 2.5 ie One put was bought and
2.5 calls were sold.

 Anticipated profit for Ranbaxy

 Income from Premium on writing call + Profit on exercising put option

 Loss incurred by Ranbaxy

 Loss due to writing of call option + Premium on put option
CASE STUDY : RANBAXY
 BUY A “CALL” OPTION

 WRITE A “PUT” OPTION

 When the rupee depreciates the call buyer will exercise the call option and
buy the dollar at the strike price which is lower than the current market
price. Also there will be income for the writer of a put in the form of
premium as the put buyer will not exercise the put option adding to profits.
 SWAP
A SWAP is a series of forward contracts where one party
agrees to pay the floating rate of interest on some
principle amount and the counterparty agrees to pay a
fixed rate of interest in return on the same principal
amount, either in same currency or in different currency.

Currency swaps are used by corporate to hedge for the

following major risks
1. Interest rate risk (IRS)
2. Exchange rate risk.
 Lends Rs 4560 million, India Currency Swap
@ Fix Rate 12%

Oversea
Banks Corporate
lender
Lends $ 100 million, India Lends $ 100 million, USA
@ LIBOR + 200 bps @ LIBOR + 200 bps
Corporate
LIBOR Receives from Pays Oversea Net pay
Bank lender
8% -2% 10% 12%
9% -1% 11% 12%
10% 0% 12% 12%
11% 1% 13% 12%
12% 2% 14% 12%
13% 3% 15% 12%
14% 4% 16% 12%
15% 5% 17% 12%
 Infosys
 Revenue in dollar terms grew by 35% in 2008, while it grew just by
19% in INR
 Notionally loss is around Rs.2000 cr in revenue and Rs. 1000 cr in net
profit.
 98.4% of its revenue is from export, exposing it to foreign exchange
risk.
 Infosys hedges its foreign currency risk in different currencies as
different currencies do not appreciate/depreciate similarly.
 Infosys uses forwards and options (including exotic options) to hedge its
currency risk.
 % share in Revenue
Geography 2008 Currency 2008 ( %) 2007 ( %)

North America 63 US Dollar 70.7 73.7

Europe 27 UK Pound 14.1 11.6
Rest of World 8.6 Euro 5.7 4.9
India 1.4 Australian Dollar 4.6 4.9

2008  2007 2006

  INR cr % INR cr % INR cr %
Forward Contract 2148 80.9% 723 40.3% 445 31.9%
Option contract            
Range Barrier 400 15.1% 884 49.3% 934 67.0%
Euro accelerator 76 2.9% 138 7.7% 16 1.1%
Euro forward 32 1.2% 47 2.6%    
Total 2656   1792   1395  
 Figures in Cr 2008 2007 2006
Transaction & Translation losses -98 -21 -8
Option/ Forward contract gains (losses) 103 63 -69
Net 5 42 -77

Figures in Cr 2008 2007 2006

Income 15648 13149 9028
Hedged Exposure 2656 1928 1418
% hedged 17% 15% 16%
Hedges around 15-17% of its annual revenue at any point of time
Hedges around 85-90% of Debtors or around 2 months receivables.
THANK YOU