Oil options – Call to put ratio an indicator of volatility

Oil prices had been unidirectional for period October 2015 to January 2016. The average price fell by
33.7% from $46.22 in October 2015 to $31.68 in January 2016. This had evinced the interest of commodity
traders who then increased their exposure to Oil Options. WTI Crude Oil prices which had touched $100 in
2006 were trading at below $30 in January 2014. With every fall in the price the fear that the prices would
become volatile and the stocks would start their upward journey increases. Hence option traders are
interested in betting on the stock both ways.

Table1: Average Oil Prices

Month WTI Average

Price (USD)
October 2015 46.22
November 2015 42.44
December 2015 37.19
January 2016 31.68
Source: Federal Reserve Bank of St. Louis

During the period October–December there was a bearish trend as the supply outstripped demand and oil
producing countries were not ready to freeze supply. This led to an expectation of further drop in Prices.
The Goldman Sachs, a leading broker’s report in December 2015 added fuel to the fire. The Goldman
Sachs believed that the prices will fall in the future to $20 levels within 6 months. This was followed by a
fall of 17.39% in WTI oil price in January 2016.

This led to an hawkish outlook which prompted the traders to bet on falling oil options and hence they
bought put options - at strike prices as low as $15 a barrel, at Ney York Mercantile Exchange. West Texas
Intermediate, the U.S. benchmarkwas trading at about $37 in December 2015. The largest open interest for
WTI oil contracts for December 2016 in December 2015 was for puts at $30 a barrel. This showed that
investors expected the oil price to come down. On the other hand Open Interest for put option for June
2016 was increasing continuously. Investors investing in oil put options included hedgers who had long
position in oil companies such as Exxon Mobil Corp. There were indications that the volatility was low as
put to call option levels were low.

However there was a change in trends in February 2016 and by March 2016 it became evident that the
prices looked to have bottomed out due to changing fundamentals.

The fundamental factors which impact oil prices are :

1. Factors impacting demand of petroleum products: The demand of petroleum products is impacted
by the rate of industrial activity. When the industrial activity increases the demand for petroleum
activity increases. Total petroleum demand in US for January 2016, rose by approximately 1 percent,
to 19.4 million barrels a day. This is the maximum peak in January since 2008. Hence an increase in
demand in January indicates high price in the future.
2. Factors impacting supply of petroleum products:
The supply of petroleum depend on OPEC countries and shale companies , There are indications that
both are in favour of freezing output. Saudi Arabia, Russia, Qatar and Venezuela have agreed to freeze
Supply in February 2016. Shale companies are also planning to freeze output.

Thus with demand increasing and supply decreasing the oil spot prices tend to follow an upward trend.
Goldman Sachs on March 7 2016 predicted that the prices would keep increasing as the fundamentals
had changed. This led to the premium on WTI for December 2016 to fall to lowest level in March
since January 2016. This indicated that the volatility of oil prices had bottomed up. The direction now
 expected was upward rather than downward trend expected two months cap. The put to call ratio
which shows volatility had also bottomed up.
The oil options premium has in recent time proved that oil options premium increase when there is
volatility expected and are stable when the prices are expected to be unidirectional. Here the direction
is not important in both cases – up or down the prices are stable.

Factors influencing options premium – include future expectation of volatility. When the commodity or the stock prices ae
expected to increase or decrease and the probability of the prices being unidirectional is high; the volatility is low and hence
the prices or premium for option is low and vice versa.

Discussion questions:

(1) What are factor impacting options pricing?

Hints: Implied volatility, spot price, time value etc.

(2) What impacts volatility for commodity futures?

Hints: macro- economic stability, future expectation in terms of demand and supply

Course Reference: Concept- “Factor impacting options pricing” /Unit 15 -Option Pricing - Principles and Models:-
Risk Management and Derivatives Analysis
Sources:
(1) Javier Blas,“ Extreme Oil Bears Bet on $25, $20 and Even $15 a Barrel in 2016”, Bloomberg, December 22,
2015
(2) Joseph O Rourke, “January petroleum demand hits 8-year high: API”, CNBC, February 19, 2016
(3) Cecile Vannucci, “Goldman Sachs Sees Best Time in Two Decades to Buy S&P 500 Calls”,Bloomberg March
7, 2016
Dalal Street traders profit from market volatility using Vega
"We have seen significant buying in call option of 8600, 8700 and 8800 strike price of the Nifty; and similarly in
strike price of 7700, 7800 and 7900 put options with increase in implied volatility. This is happening because
traders are adopting long 'Vega' trade to gain from volatility in either side since the outcome of Greece is unclear,"
- Neeraj Agarwal, derivative analyst at Antique broking.

In the first half of 2015 the global markets were highly stable with the Dow Jones Industrial Average not moving
more than 3.5% throughout the period. However, in July 2015 the markets all of a sudden became highly volatile.
The uncertainty over the Greek referendum was predicted to impact the profitability of global stock markets in July
2015. The volatility would increaseand losses would be high for traders. However, some Indian traders were able to
beat the market using “long Vega options strategy ”.

The strategy involves combining various options contracts which are aimed at benefitting from an increase in
volatility. Hence, the traders are buying call and put options which are trading below the Nifty levels of 8500. The
derivative traders' call this strategy “long 'Vega' option strategy”. In other words the investors were betting on the
increase in implied volatility of the market.

Vega is the indicator of how the value of an option is impacted by change in the implied volatility. Vega
indicateshow option value changes if the implied volatility changes. Implied volatility is an important determinant of
options premium as increase in volatility to increase in options price. The price of an options is directly propotional
to implied volatility. This is because volatility increases risks for traders.

The market experts believed that the Greece referendum would lead to Greece rejecting the proposal of the
European countries which would lead to Foreign Institution Iinvestors moving out of emerging economies such as
India. This would lead to fall in the indices.

Open interest which is an important indicator of traders interest in a particular contract and is measured as “total
outstanding position in any derivative contracts” — had increased in the out of money market. Nifty strike prices
(call 8600, 8700 and 8800 & 7700, 7800 and 7900 put) had grown by almost 25% and touched 2.34 crore compared
to 1.88 crore since the beginning of new July series on June 26,2015 according to The Economic Times data. There
was also an increase in the implied volatility of these strike prices which increased to 19-21 for put options and 13-
15 for call options in the same period. This shows that there were investors and traders who were trying to profit
from the long position. The table below shows the open interest position before the greek referendrum.

Table 1: Nifty Position as on July 5th 2015

Call Option Premium Open Interest Put Option Premium Open Interest
(Rs.)
8300 257 1633125 7800 14.25 3428675
8400 188 2904675 7900 19.6 5360500
8500 130 4598850 8000 27.1 5468300
8600 83 2940950 8100 37.4 3253625
8700 50 3659150 8200 52.65 4438575
8800 27.3 2610375 8300 73.8 4108225
Source:NSE

Hence in a volatile market investors are able to profit from theoretical concepts such as Vega if it is utilized
properly. However, investors should be careful while using the vega strategy as it is a complicated strategy nd in
such cases depends on predicting the ourcome of the trigger event correctly. Here the trigger event is fall in the
prices of shares if Greece Referendum is rejected. Hence if the market has already reacted to the fall the strategy
might not work.

‘Vega Hedging’ involves gauging the volatility in the system and preparing a strategy that could counter it’s impact on the
investor’s portfolio. In the case of Greece Referendum investors profited from this strategy by going long on out of the money
contracts.
Discussion questions:
(1) What is Vega? When does it increase
Hints: Vega measures impact of implied volatility on options price. It increases when implied volatility increases.
(2) How can vega be used for trading profitably?
Hints: By combing contracts both call and put options vegas can lead to higher profitability.

Course Reference: Concept- “Vega Hedging” /Unit 16- 16. Managing an Option Portfolio - Risk Management
and Derivatives Analysis

Sources:m
(1) Ashustosh Shyam, “Dalal Street traders look to cash in on market volatility”, ET, July 6, 2015
(2) Tara Cunningham , “European equity markets plunge ahead of Greek referendum”, Telegraph , July 3, 2015
(3) Kshitij Anand, “How to Play Indian markets among Greece Referendum”, ET, July 3, 2015
Barrier Options – trading Strategy
Hedge Funds which are leveraged and invest in complex derivatives strategy always run the risk of earning huge
losses according to experts. Spruce Alpha, a hedge fund based in the United States which invested in risky
derivatives strategy to profit from volatile market conditions had to incur huge losses in August 2015. The main
reason for the losses was the company’s inability to handle the complex derivatives strategies it was using.

Spruce Alpha hedge fund was supposed to perform exceedingly well in turbulent market conditions through the
implementation of a complex trading strategy which involved derivatives. The fund which started operating in April
2014 claimed that if they existed in 2014 they would have made a profit of 600%. The fund had back-tested results
from 2006 and was managed by Robert Stock, whose expertise lay in simulation of laser defense missile. However
they were unable to replicate the success in real scenario and ended up making huge losses. Thus when markets
turned volatile in August 2015, Spruce Alpha, did not turn the volatility into gains for investors. Instead, the fund
turned in one of the worst performances losing almost 50 percent of their capital invested. The fund’s holdings in
August 2015, were under $100 million and was managed by the $1.5 billion Spruce Investment Advisors. Spruce
Investment specializes in managing money for the wealthy and institutional investors. The Spruce Alpha fund was
the asset management firm’s first direct hedge fund trading fund that was intended to raise a $500 million portfolio.

After the debacle, the fund was liquidated and the investors got back whatever was left after the huge loss. The
Spruce Alpha is an example of how derivatives funds fail to make profit even though they show profits in historical
markets using back tested results. The reason for failure of such strategies can be attributed to the fact that during
back testing optimum market conditions were assumed. However, back-tested results are derived assuming optimum
trading conditions, not what the fund will encounter in real life. The funds losses were because in August the fund
failed to predict the VIX index volatility. The VIX index measures volatility in the market and can be traded through
Exchange Traded Funds (ETFs). However, the VIX is a mean reverting index, meaning that gains can only be made
during periods of volatility and that as soon as markets calm the VIX returns to its long-term average.

Spruce Alpha also showcases the risks of relying on exchange-traded funds (ETFs) and derivatives to profit from
short-term turmoil in the stock markets. While there is no statement by the company on what exactly led to the
unenviable position clear what caused the largest losses in Spruce Alpha, it is evident that the fund used a trading
strategy involving derivatives to increase returns from ETF trades and sought to make money off of stock market
volatility which backfired for the organization..

The back-tested results for the Spruce Alpha fund did not take into account how markets and investors would react
given the kind of circumstances that took place in August. The hypothetical results could have underestimated the
fact that some E.T.F.s are used as trading instruments that big money managers move quickly in and out of in times
of extreme market volatility.

The lesson here for investor is that they should not ignore disclaimers. In it’s disclaimer the company stated that:
“The hypothetical results do not represent the results of actual trading” and “were achieved by means of the
retroactive application of a hypothetical model that was designed with the benefit of hindsight and could be adjusted
at will until desired or better performance results were achieved.,” Hence any investor who believed in the back-
tested result would end up making losses and could not blame the company for the same.

Risk management for funds investing in derivatives market is a complex process and generally ends up with the
fund being declared bankrupt if proper care is not administered. There have been instances earlier of failure of
companies and funds which were not able to handle exotic derivatives instruments such as Long Term Capital
Management which failed to handle the risk of Russia not being able to pay back in it’s own currency in 1990’s..

‘Risk management for Derivatives instruments’ requires following stringent guidelines pertaining to leveraged position so as
to prevent bankruptcy. However, it has been observed that many hedge funds do not follow the guidelines similar to Spruce
Alpha and end up making huge losses.
Discussion questions:
(1) What are hedge funds?
Hints: Funds which have high risk appetitie and are hence expected to deliver better results.
(2) Why are derivatives trading more risky?
Hints: They are risky because the traders generally have leveraged position and induge in Margin Trading

Course Reference: Concept- Risk management for Derivatives instruments /Unit 12- Market Risk
management/Subject- Risk Management and Derivatives Analysis

Sources:
 Alexandra Stevenson “Risky Strategy Sinks Small Hedge Fund”, NY Times, September 30, 2015
 Staaff Reporter,“How hedge fund got wrecked in a hurry” , Schaffer Reserach, October 2,, 2015
 Julia La Roche, “Nuclear physicists, unreported exits, and huge losses: How an $80 million hedge fund
blew up in one month”, ftseglobalmarkets.com, October 7, 2015
Hedging increases risks for airlines companies
Fuel prices account for 20-50% of the operating cost. Hence, profitability of the airlines company depends on fuel
prices. This means that airlines companies can earn huge losses if it is not able to control fuel costs. Airlines
companies globally generally enter into hedging contracts so as to reduce risk associated to oil prices. There are two
forms of risk associated – volatility in the oil prices and volatility in currency in which it buys oil vis-a- vis it’s own
currency. For example, in India the hedging of US dollar along with hedging oil prices is of prima facie importance.

In the year 2015, the oil prices have been consistently falling down. This has led to huge hedging losses for oil
companies which use oil options to hedge risk. Hence, oil options are an important tool to mitigate risk however
when the options move in one direction only the companies end up making losses. In other words, the oil companies
which gained from fall in oil prices also ended up losing because of losses in premiums in oil options strategies. The
total loss from hedging strategies for companies was huge.

In the period June 2014 to December 2014 the oil prices had fallen approximately 50 % and were trading at $60.
The call that companies hedging oil prices had to take was to what level could the oil prices fall down from the
given level. In January 2015, most airlines companies believed that the oil prices would bottom up at $40 however
by the end of 2015 the oil was trading at $30. In Europe, airlines such as Aer Lingus and Ryanair tried to lock their
2015 prices in 2016. Thai Airways on the other hand, hedged its fuel purchases completely. These hedging
transactions were based on the assumption that oil prices had bottomed up in 2015 at around $40. However, this was
not to be as by January 2015 WTI crude oil prices had touched $31. Singapore Airlines ended up earning a loss of
US $108 million due to this strategy in form of losses earned in hedging.

Companies such as South Korea’s Asiana Airlines and Air Berlin from Germany have reduced their exposure to
hedging in November 2014 itself as these companies realized that using options and futures for hedging was fraught
with risk and it could ultimately lead to huge losses especially in the case of oil prices as there was no clarity on
what level the oil prices could fall.

Such a fall in oil prices is not new. In 2008 too oil prices fell from $100 to $40 and a lot of Asian companies ended
up making huge losses. Hence Asian companies are now wary of entering into such contracts. However US and
European companies were still entering into hedging transactions.

Cathay Pacific Airways, a leading airlines based in Hong Kong has registered huge losses as the company had
hedged oil at higher than prevailing rates. The company has registered a loss of $6 billion on hedging transaction in
February 2016. On the other hand, for 2015 the airlines profit is expected to have nearly doubled to US$33 billion,
from US$17.4 billion a year earlier. This is because a lot of companies did not hedge their risks and hence gained
from the fall in prices of oil.

Thus, as can be seen that option trading can be risky especially for companies which are trying to hedge their risks
through options and futures. It should be kept in mind that the aim of options trading is to reduce costs and not to
maximize profits. Hence companies which aim at hedging should not use it to maximize profits rather it should ber
used to bring down cost.

‘Risks associated with options” pertains to the losses that companies register in options trading. This risk is often ignored by
companies which hedge risk as they try to maximize profits using the options instrument. Hence it has been observed that
companies have ended up making losses more that the cost saved through hedging.

Discussion questions:
(3) What are risks associated with options trading?
Hints: options are short term, risk depends on volatility in the price of underlined asset
(4) How can options be used for hedging?
Hints: Companies prefer to hedge their positions using options
Course Reference: Concept- Risk for Options /Unit 17- Option Trading Strategies and Exotic Options: /Subject-
Risk Management and Derivatives Analysis

Sources:
 Staff Reporter “Cathay Pacific reports wider fuel-hedging loss as oil drops” Malaymailonline.com”, March
7, 2016
 Jeffrey Dastin,“ U.S. airlines rethink hedges as oil plunges” , Reuters, January 16, 2016
 PTI, “Air India plans hedging fuel costs up to 25%”, ET, March 06, 2016
 SKS Micro-Finance Ltd. raises funds through securitization deal
In March 2016, SKS Microfinance Ltd, a leading microfinance company has raised more than INR 200 crore
through a securitization deal. This is the fifth securitization deal that the company has entered into in the FY 2015-
16. The total amount that the company, has raised through securitization is INR 1500 cr by March 2016. SKS
Microfinance in November 2015 had raised Rs 243.08 crore through securitization deal. With this transaction, the
total sum of securitization completed during 2015-16 was Rs 326.73 crore by December 2015. The company has
also securitized almost 45% of it’s loan This has further reduced the risk of losses due to bad debts.

SKS Microfinance Limited (SKS) a leading non-banking finance company (NBFC), is regulated by the Reserve
Bank of India. It was founded in 1997 by Vikram Akula, who served as its executive chair until November 2011.
The company's mission is to provide financial services to the poor under the premise that providing financial
services to poor borrowers helps to alleviate poverty In 2015, the company has presence in 17 states across the
country

The amount raised through securitization is to be treated as priority sector according to RBI norms. The rating that
the pool has got is AA (S0) which signifies high quality of loans taken by the company. In the last two quarters of
2015-16, the banks increased their exposure to agricultural loans directly and indirectly in order to fulfill statutory
requirements. This has helped the microfinance company get the loans at a very low rate of interest. They get it at
1.5% - 2% lower than the market rate. This brings down the cost of borrowing for the company. The company has a
marginal cost of borrowing of 10% in FY 2015-16 which comes down substantially with every deal that the
company enters into.

Almost one tenth of SKS Microfinance funding is done through securitization. For the rest the company depends on
term loans, commercial papers and non-convertible debentures. Thus securitisation is an important source of
financing for the company. After the microfinance crisis in 2010 when the companies such as SKS Microfinance
were asked not to be tough on borrowers, they had no choice but to find out ways of raising funds using their
existing loan advances and reduce their cost of funds. Thus securitization became popular mode of raising funds for
these companies since then.

Reducing the cost of funds has helped the company pass the benefits to the borrowers. The company has emerged
as cheapest microfinance lender globally with it’s interest rates at around 19.75% in FY 2015-16. Compared with
it’s competitors the company has been able to reduce the interests by 4-5%. This not only makes the interest rates
competitive it also provides relief to the agriculturalists and poor borrowers in rural areas in India.

Securitizatiion refers to bundling of book advances in order to raise funds. It is a low cost method of raising funds.
The 2016 budget has done away with taxes on securitization this would further make securitizaton popular among
financial companies especially microfinance companies going forward. Microfinance companies need to reduce
their cost so as to provide loans to rural masses at a lower rate of interest. Securitization is an important tool that can
help achieve the desired goal.

Securitization is an important tool to raise low cost of funds in India by bundling up advances . SKS Microfinance Ltd. Has
effectively raised funds through this method hence reducing their cost of funds effectively. Such innovations by micro-finance
companies in India are the need of the day so as to lend money at lower rates to the rural India.

Discussion questions:
(1) What is securitization ?
Hints: Bundling of advances and selling it to a third party
(2) Why do microfinance companies prefer securitization?
Hints: It reduces cost of funds.
Course Reference: Concept-Securitization/Unit 19- Mortgaged-Backed Securities /Subject-Risk Management and
Derivatives Analysis
Sources:
(1) Anuradha Himatsingka,“ Securitization markets to get a boost as Budget removes distribution tax”, ET, Feb 29
(2) Interview with Dilli Raj, President, SKS Microfinance, “Securitization to shave off 150-200 bps from
borrowing cost: SKS”, Monycontrol.com, March 7,2016
(3) Trushna Udrigar, “SKS Microfinance raises Rs216 crore through securitization deal”, March 01, 2016
 India enters into currency swap with Sri Lanka to avoid Sri Lanka from defaulting

Sri Lanka has received a $400 million currency swap from Reserve Bank of India's facility for South Asia,
The total support to the island's monetary authority is $1.1 billion dollars in March 2016. Proceeds of the
400 million dollar 3-month swap had arrived in Sri Lanka on March 08, 2016 and are a part of the country's
official reserves.

Foreign Currency Swap is a transaction, among countries with good trade relations, to help strengthen the
currencies of the country where both pay for import and export trade, at the pre-determined rates of
exchange, without bringing in third country currency like the US Dollar. In the particular case currency
swap deals was entered to improve the foreign exchange reserves. It was targeted at removing possible
short-term liquidity mismatches and supplementing existing international financial arrangements. India has
similar currency swap deals with countries such as Bhutan, Iran etc.

When Sri Lanka Company Board (SLCB) entered into swap agreement with the Reserve bank of India
(RBI), SLCB sold a specified amount of its currency to RBI in exchange for dollars at the prevailing
market exchange rate. The dollars that RBI provided was deposited in an account in Sri Lanka which was
maintained at SLCB. This helped improve the foreign reserves of the country. Concurrently, the two central
bank enter into a binding agreement for a second transaction that obligates SLCB to buy back its currency
on a specified future date at the same exchange rate. The second transaction reverses the first. At the
conclusion of the second transaction, SLCB pays interest, at a market-based rate, to RBI.

Following are reasons for Sri Lanka going for currency swaps.
1. Fitch Ratings downgraded Sri Lanka's 'BB-' rating to ‘B+’ and the outlook to negative. Standard
and Poor's downgraded the outlook on its 'B+' rating to negative in March 2016.
2. Sri Lanka has the lowest tax to GDP ratio in the world.
3. Lanka's foreign reserves came under pressure as debt was monetized to finance a sudden surge is
election related spending from January 2016.
4. Foreign investors also pulled out of rupee bond markets as the currency came under pressure as
monetized debt turned into unsustainable credit and imports, reducing the credibility of the island's
rupee peg.
5. One year old currency swap of $1.1 billion which Sri Lanka had entered into with India was due on 3 rd
March 2016. The India cabinet has given a go ahead for the currency swap.

The other steps taken by the government to improve the situation include increasing tax rates in order to
improve the foreign exchange reserve is to plan borrowing long term funds from IMF. Howevwr, to borrow
from IMF the IMF has recommended that they need to improve their tax to GDP ratio. Hence the fiacal
deficit position of the country will improve because of this. expected to correct the economic imbalances
by raising more taxes and tightening policy. Prime Minister Ranil Wickremesinghe has already announced
a hike in taxes, which will have to be legislated.

‘Currency Swaps” are a tool which both countries and companies use for countering volatility in foreign exchange. Countries
such as Sri Lanka which are facing economic turbulence enter into such transactions so as to improve their foreign currency
reserves. India which is the strongest economic power in SAARC nations takes steps to help stabilize the economy of the
region.

Discussion questions:
(1) What is currency swaps?
Hints: Foreign Currency Swap is a transaction, among countries with good trade relations, to help strengthen the
currencies of the country where both pay for import and export trade, at the pre-determined rates of exchange,
without bringing in third country currency like the US Dollar
 (2) How can central bank currency swap be used ?
Hints: Central Bank currency swap can be used to strength the foreign exchange position of a country facing
Course Reference: Concept-Currency Swap/Unit 18 – Swap Markets/Subject-Risk Management and Derivatives
Analysis
Sources:
(1) Staff Reporter, “ Sri Lanka gets second currency swap from India”, Economynext, March 15, 2016
(2) Staff Reporter, “India, Sri Lanka sign Special Currency Swap Agreement”, news.LK.com, March 20, 2015
(3) GN Bureau, “Understanding how currency-swaps work”, Governancenow, September 7, 2013

India enters into currency swap with Sri Lanka to avoid Sri Lanka from defaulting

Sri Lanka has received a $400 million currency swap from Reserve Bank of India's facility for South Asia,
The total support to the island's monetary authority is $1.1 billion dollars in March 2016. Proceeds of the
400 million dollar 3-month swap had arrived in Sri Lanka on March 08, 2016 and are a part of the country's
official reserves.

Foreign Currency Swap is a transaction, among countries with good trade relations, to help strengthen the
currencies of the When Sri Lanka Company Board (SLCB) entered into swap agreement with the Reserve
bank of India (RBI), SLCB sold a specified amount of its currency to RBI in exchange for dollars at the
prevailing market exchange rate. The dollars that RBI provided was deposited in an account in Sri Lanka
which was maintained at SLCB. This helped improve the foreign reserves of the country. Concurrently, the
two central bank enter into a binding agreement for a second transaction that obligates SLCB to buy back
its currency on a specified future date at the same exchange rate. The second transaction reverses the first.
At the conclusion of the second transaction, SLCB pays interest, at a market-based rate, to RBI.

country where both pay for import and export trade, at the pre-determined rates of exchange, without
bringing in third country currency like the US Dollar. In the particular case currency swap deals was
entered to improve the foreign exchange reserves. It was targeted at removing possible short-term liquidity
mismatches and supplementing existing international financial arrangements. India has similar currency
swap deals with countries such as Bhutan, Iran etc.

Following are reasons for Sri Lanka going for currency swaps.
6. Fitch Ratings downgraded Sri Lanka's 'BB-' rating to ‘B+’ and the outlook to negative. Standard
and Poor's downgraded the outlook on its 'B+' rating to negative in March 2016.
7. Sri Lanka has the lowest tax to GDP ratio in the world.
8. Lanka's foreign reserves came under pressure as debt was monetized to finance a sudden surge is
election related spending from January 2016.
9. Foreign investors also pulled out of rupee bond markets as the currency came under pressure as
monetized debt turned into unsustainable credit and imports, reducing the credibility of the island's
rupee peg.
10. One year old currency swap of $1.1 billion which Sri Lanka had entered into with India was due on 3 rd
March 2016. The India cabinet has given a go ahead for the currency swap.

The other steps taken by the government to improve the situation include increasing tax rates in order to
improve the foreign exchange reserve is to plan borrowing long term funds from IMF. Howevwr, to borrow
from IMF the IMF has recommended that they need to improve their tax to GDP ratio. Hence the fiacal
deficit position of the country will improve because of this. expected to correct the economic imbalances
by raising more taxes and tightening policy. Prime Minister Ranil Wickremesinghe has already announced
a hike in taxes, which will have to be legislated.

‘Currency Swaps” are a tool which both countries and companies use for countering volatility in foreign exchange. Countries
such as Sri Lanka which are facing economic turbulence enter into such transactions so as to improve their foreign currency
reserves. India which is the strongest economic power in SAARC nations takes steps to help stabilize the economy of the
region.
Discussion questions:
(1) What is currency swaps?
Hints: Foreign Currency Swap is a transaction, among countries with good trade relations, to help strengthen the
currencies of the country where both pay for import and export trade, at the pre-determined rates of exchange,
without bringing in third country currency like the US Dollar

(2) How can central bank currency swap be used ?

Hints: Central Bank currency swap can be used to strength the foreign exchange position of a country facing
Course Reference: Concept-Currency Swap/Unit 18 – Swap Markets/Subject-Risk Management and Derivatives
Analysis
Sources:
(4) Staff Reporter, “ Sri Lanka gets second currency swap from India”, Economynext, March 15, 2016
(5) Staff Reporter, “India, Sri Lanka sign Special Currency Swap Agreement”, news.LK.com, March 20, 2015
(6) GN Bureau, “Understanding how currency-swaps work”, Governancenow, September 7, 2013
 DLF raises Rs 900 cr in India’s first CMBS issue for its luxury malls in Delhi

In May 2014, DLF Emporio Ltd, a subsidiary of DLF Ltd, launched the first Commercial Mortgage Backed
Security (CMBS) issue which was more than Rs 500 cr. .DLF Promenade launched a fund of Rs. 375 cr.
The maturity period for the instrument was seven and a half years and the coupon rate was 10.5%.

DLF Emporio is a shopping mall situated in Vasant Kunj, New Delhi. It is one of the first truly zoned
luxury malls to open in India. DLF Emporio owns and operates approximately 3 lakh sq. ft of a luxury mall
in New Delhi. DLF Promenade is a shopping mall for the customers of Delhi and NCR region. Developed
by one of India’s leading real estate company, DLF, the mall has been touted as a fashion destination.

DLF Limited the promoter of these malls is a leading real estate player in India. However, due to certain
allegations of insider trading the company was hit by fund crunch. The company was looking at innovative
ways of raising funds. It then planned to raise funds based on the lease income that it generates from the
two leading properties it has in Delhi. Following were the salient features of the CMBS deal:
 The major sources for revenues of these mall are are rentals, parking charges and revenue sharing
with restaurants in the campus. This would be used to pay the interest on the debts thus taken.
 The CMBS has a coverage ratio of 1.7 to 2 which means if the interest expense is Rs. 120 cr. Then
Rental income should accumulate to approximately Rs. 240 cr . according to CRISIL the rating
agency which has rated the fund.
 The payment is guaranteed by the put option provider who guarantees to pay both principal and
interest.
 If the put provider doesn’t pay, the debenture holders can enforce the mortgage on the properties
and beyond that, there’s also shares of DLF that are pledged, which can be sold. Further the
property cannot be mortgaged further. Also there can be no further debt taken by using the
properties as mortgage. So it’s a multi level protection against default.
 Investors include Hedge Funds, Realty funds, PE funds and foreign investors, and possibly HNIs
as well. I doubt retail can play a part.
 The arranger for DLF Emporio’s CMBS issue was Trust Investment Advisors Pvt. Ltd.
 In April 2014, rating agency CRISIL had assigned stable rating to DLF’s proposed CMBS issue.
CRISIL had assigned AA(SO)/Stable ratings to Rs 525 crore and Rs 375 crore NCDs by DLF
Emporio and DLF Promenade, respectively
 DLF benefits from the deal, where they get an upfront Rs. 800 cr. in exchange for this debt.
However, their profits might still take a hit. The new debenture rules in the Companies Act, they
will have to invest 15% of the amount to be repaid each year – in this case, 15% of Rs. 120 cr, or
Rs. 18 cr. per year – into government securities. And, they will have to set aside Rs. 400 cr. as a
debenture redemption reserve. This would impact the bottomline.

The CMBS, is a good first step to reduce risk for the company from banks and the banks from a large
single borrower. However the profitability of the company would be hurt with the new debenture rule..
Under CMBS, funds available with the issuer during the tenure of the instrument are higher than lease
rental-discounting loans from banks as these loans have a structure where principal repayment is amortised
whereas CMBS instruments give the option of bullet repayment. Further, CMBS instruments have the
benefit of fixed interest rates and usually have lower funding costs.

“Types of assets” for asset backed securities generally include credit cards, student loans, tractors etc. However some
companies also use revenue generated through assets such as malls for generating funds. This is an innovative fund raising
strategy.
Discussion questions:
(1) What is asset backed securities?
Hints: Asset backed securities are securities that promise repayment based on revenue generated from certain assets.

(2) What is CMBS?

Hints: Asset backed securities that generate revenue through rentals so as to pay the interest on the securities is
known as CMBS.
Course Reference: Concept-Types of Asset Backed Securities/Unit 20 – Asset backed Securities Markets/Subject-
Risk Management and Derivatives Analysis
Sources:
(1) Seepak Shenoy, “India’s First Commercial Mortgage Based Security (CMBS) on Offer by DLF”,
CapitalMinds, April 24, 2014
(2) PTI, “DLF to raise Rs 900cr via CMBS; Crisil gives stable rating”, Business Standard, April 14,, 2015
(3) Sanjeev Choudhary, “DLF mall to house 130 global brands; launch pad for many”, ET, September 7,2007