5 Financial Risk Management

Financial risk
management
CAFTA – Finance with Finesse

Overview
This module on financial risk management focuses on management of foreign exchange risk, interest rate risk
and commodity risk for different type of business organisations.
Section I focuses on the techniques and processes to manage foreign exchange risks in corporates that are
involved in import and export activities. It details out the internal and external hedging options available and
impact of risk appetite on the choice of hedging options.
Furthermore, it details out the thresholds established to monitor performance and risk management in Treasury
operations.
Section II focuses on interest rate risk management from the perspective of insurance companies, banking
institutions and corporates that are involved in borrowing and investing activities in the capital markets.
It explains the operational guidelines of interest rate derivatives issued by the Reserve Bank of India.
Section III details out the various types of risks in commodity trading followed by the methods to assess and
manage these risks.
At the end of this module, you shall be able to:
1. Familiarise yourself with the specific terminologies pertaining to foreign exchange, interest rate and
commodity risk management.
2. Understand the different types of exposures under each of the risk types.
3. Learn the different methods of assessing the impact of these risks on the organisation’s profits.
4. Understand the risk mitigation techniques and strategies applied by corporates internally in the daily course
of business.
5. Learn about the different hedging instruments available to manage each of these risks and their
corresponding costs.
6. Understand the operational guidelines for the hedging instruments.
7. Learn about the different monitoring techniques used to keep a check on the adopted hedges, variances and
profits.
Financial risk management 2

Contents
I Foreign exchange risk management ...................................................................................................................... 4
1 Understanding nuances of currency terminology .................................................................................................. 4
1.1 Local currency ............................................................................................................................................... 4
1.2 Foreign currency ............................................................................................................................................ 4
1.3 Presentation currency .................................................................................................................................... 4
1.4 Functional currency........................................................................................................................................ 5
2 Exposure identification ........................................................................................................................................ 5
2.1 Types of exposure .......................................................................................................................................... 5
2.1.1 Accounting exposure ............................................................................................................................... 5
2.1.2 Forecasted exposure or Cashflow exposure ............................................................................................... 6
2.2 Defining a benchmark rate for FX exposure ...................................................................................................... 7
2.2.1 Benchmark rate for balance sheet exposure .............................................................................................. 7
2.2.2 Benchmark rate for forecasted exposure ................................................................................................... 8
3 Risk mitigation techniques and instruments ........................................................................................................ 11
3.1 Internal hedging methods ............................................................................................................................. 11
3.1.1 Invoicing in home currency ..................................................................................................................... 11
3.1.2 Natural hedging ..................................................................................................................................... 11
3.1.3 Netting of exposure ............................................................................................................................... 12
3.1.4 Leading and lagging approach ................................................................................................................ 12
3.2 External hedging instruments and its execution .............................................................................................. 13
3.2.1 Forwards ............................................................................................................................................... 13
3.2.2 Futures ................................................................................................................................................. 15
3.2.3 Options ................................................................................................................................................. 17
4 Risk appetite and deciding hedge ratio ............................................................................................................... 19
4.1 Understanding risk appetite .......................................................................................................................... 19
4.2 Defining risk appetite and deciding hedge ratio .............................................................................................. 21
4.3 Construct FX risk management policy ............................................................................................................ 23
5 Risk mitigation strategies .................................................................................................................................. 24
5.1 Static hedging .............................................................................................................................................. 24
5.2 Dynamic hedging .......................................................................................................................................... 24
5.2.1 Rolling hedge strategy ........................................................................................................................... 24
5.2.2 Layered hedge strategy ......................................................................................................................... 25
5.3 Different approaches followed by corporates to undertake hedges .................................................................. 27
5.3.1 Market view hedging .............................................................................................................................. 27
5.3.2 View neutral hedging ............................................................................................................................. 29
5.3.3 Core and non-core hedging..................................................................................................................... 29
6 Monitoring KPIs and KRAs .................................................................................................................................. 29
6.1 Net exposure and hedge ratio ....................................................................................................................... 29
6.2 Variance analysis of exposure ....................................................................................................................... 30
6.3 FX profit and loss analysis ............................................................................................................................. 31
6.4 Counterparty limits ...................................................................................................................................... 32
II Interest rate risk management ........................................................................................................................... 33
1 Interest rate risk for corporates ......................................................................................................................... 33
1.1 Exposure identification ................................................................................................................................. 33
2 Interest rate risk for insurance companies .......................................................................................................... 33
3 Interest rate risk for banks and NBFC ................................................................................................................. 36
4 Risk mitigation techniques and instruments ........................................................................................................ 37
4.1 Internal ....................................................................................................................................................... 37

4.1.1 Diversification ....................................................................................................................................... 37
4.2 External ....................................................................................................................................................... 37
4.2.1 Interest Rate Futures (IRF) ..................................................................................................................... 37
III Commodity risk management .......................................................................................................................... 40
1 Introduction to commodity price risk .................................................................................................................. 40
2 Exposure to commodity price risk ....................................................................................................................... 40
2.1 Producer of a commodity .............................................................................................................................. 40
2.2 Consumer of a commodity ............................................................................................................................ 40
3 Financial impact of commodity price risk ............................................................................................................ 41
4 Nuances of commodity markets.......................................................................................................................... 42
4.1 Spot price .................................................................................................................................................... 42
4.2 Benchmark price .......................................................................................................................................... 42
4.3 Futures price ............................................................................................................................................... 43
4.4 Contango ..................................................................................................................................................... 43
4.5 Backwardation ............................................................................................................................................. 43
5 Spread in commodity markets ............................................................................................................................ 44
6 Commodity Market Risks .................................................................................................................................... 45
6.1 Commodity – Forex price risk ........................................................................................................................ 45
6.2 Basis risk ..................................................................................................................................................... 45
6.3 Freight risk .................................................................................................................................................. 45
7 Risk Mitigation Techniques and Instruments ....................................................................................................... 46
7.1 Internal hedging methods ............................................................................................................................. 46
7.1.1 Diversification ....................................................................................................................................... 46
7.1.2 Production contracts and Storage ........................................................................................................... 46
7.1.3 Supplier Negotiation .............................................................................................................................. 47
7.1.4 Alternative Sourcing .............................................................................................................................. 47
7.2 External hedging methods ............................................................................................................................ 47
7.2.1 Commodity swap ................................................................................................................................... 47
7.2.2 Proxy hedge .......................................................................................................................................... 47
I Foreign exchange risk management
Foreign exchange risk (FX risk) arises when the currency of the transaction undertaken by a company is different
than the local/functional currency. The transactions could be on account of any payments or receipts for
business operations.
1 Understanding nuances of currency terminology

1.1 Local currency
It refers to the main currency in the country of operation of a company. The local currency for a company
operating in India will be INR. Dealing only in local currency poses no foreign exchange risks to the corporates.
1.2 Foreign currency

It refers to any currency other than the local currency to which a corporate is exposed to, in the form of either
import/ export or debt/investment.
1.3 Presentation currency

It refers to the currency in which the entity prepares its financial statements. It is also called reporting currency.

1.4 Functional currency
It refers to the currency of the primary economic environment in which the entity operates. Typically, functional
currency is the currency in which an entity undertakes most of its transactions. All transactions which are not
in the functional currency are treated as foreign currency transactions. An entity’s local currency can be
different from the functional currency. The newly introduced Ind AS 21, which is similar to IAS 21, provides
corporates with an option to prepare their financial statements in the functional currency instead of the local
currency. A company primarily having transactions in a particular foreign currency may choose to prepare its
financial statements in the foreign currency instead of the local currency.
Example
Company ABC Ltd. is an Indian software company and exports software technology services to the USA and
earns 95% of its revenue in USD. The major expenses are related to salary payments, which are paid in USD to
software developers working with offshore clients. This expense amounts to approximately 70% of the total
expenses of the company. Around 15% of salary expenses are incurred in EUR since the software developers are
based in Germany. Rest of the expenses are incurred locally in INR.
Following are the type of currencies currently involved:
 Local currency: INR
 Foreign currency: USD, EUR
 Presentation currency: INR
After introduction of Ind AS 109, the company decided to adopt USD as its functional currency since majority of
the transactions are carried out in USD. Adopting functional currency as USD would ensure that the overall
business performance can be properly measured, and the financial statements can most accurately represent
the true financial state of the company.
In the above example, following are the different currencies:
 Local currency: INR
 Foreign currency: EUR
 Functional currency: USD
 Presentation currency: USD
2 Exposure identification
2.1 Types of exposure
Accurate identification of FX exposure and its measurement is necessary for a company to ensure that the FX
risk is accurately known, and such risks can be effectively managed.
FX exposure can be categorised into following two broad areas.
FIGURE 1.1: Areas of FX Exposure
2.1.1 Accounting exposure

Accounting exposure or balance sheet exposure is the risk that a company’s assets and liabilities will change due
to fluctuations in FX rate between two reporting periods.

2.1.1.1 Exposure due to restatement
At every reporting period, foreign currency assets and liabilities, such as foreign currency debtor, creditor, loan
and investments, which are reported in balance sheet need to be restated in the functional currency. Due to
changes in FX rates between two reporting periods, such foreign currency assets and liabilities will be restated
at a different amount on every restatement. This exposure to FX movement is called balance sheet exposure on
account of restatement of accounts.
For example, a foreign currency debtor worth USD10 million was recognised in the books of account on 1
January 2019 when the USD/INR rate was 70 at INR 700 million. The restatement of the FX debtor was carried
out on 31 January 2019 basis the FX rates on that date. Following are the two scenarios of the gain/loss:
Date Scenario Spot FX rate Debtor Debtor Restatement
(USD/INR) Amount (USD Amount (INR Gain/Loss (INR
million) million) million)
31 I 68 10 680 Loss – 20
January
31 II 71 10 710 Gain – 10
January
2.1.1.2 Exposure due to consolidation of accounts

Financial accounts of its foreign branches/subsidiaries prepared in a foreign currency are consolidated into the
financial accounts of the holding/parent company. If the functional currencies of the subsidiary and parent entity
are different, FX fluctuation between two reporting periods will impact the reporting of subsidiary’s equity,
assets and liabilities in the parent’s functional currency. This exposure to FX movement is called balance sheet
exposure on account of consolidation of accounts.
2.1.2 Forecasted exposure or Cashflow exposure
On a periodic basis, companies forecast their sales, purchase and other costs of business operations to identify
the free cash flow that the business will generate and the subsequent need to raise money in future. If the
company imports or exports its goods, the forecasted sales and purchases will be in a foreign currency. Due to
movement in FX rates, the amount of local currency realised on exports or the amount of local currency to be
paid on imports will be different from the forecasted amount. FX fluctuations will create a variance between the
forecasted cash flow and the actual cash flow. This exposure to FX movement is called forecasted exposure. It
can also be called cash flow exposure since it impacts future cash flows of the company.
Example
Company ABC forecasts to import ten mobile phones from US every month for the next 3 months. Each mobile
phone costs USD 1,000. It expects to sell these mobile phones in India for INR 80,000. The current USD/INR
rate is 70.00. The company forecasted its profit for the next 3 months assuming a USD/INR rate of 70.00 for
all the 3 months.
Table 1.1: Forecasted Profit
Particulars Month 1 Month 2 Month 3
Quantity in units 10 10 10
Forecasted purchase (in USD) 10,000 10,000 10,000
Forecasted purchase (in INR) 700,000 700,000 700,000
Total sales 800,000 800,000 800,000
Profit 100,000 100,000 100,000
When the company purchased the mobile phones and paid in USD, the USD/INR rate changed from the
forecasted rate of 70.00. This resulted in difference between the actual profit and the forecasted profit. The

following table 1.2 illustrates the impact on profit or cash flows of the company due to difference in the
forecasted and actual rate.
Table 1.2: Actual Profit
Actual purchase (in USD) 10,000 10,000 10,000
USD/INR rate 69 72 75
Actual purchase (in INR) 690,000 720,000 750,000
Sales 800,000 800,000 800,000
Profit 110,000 80,000 50,000
2.2 Defining a benchmark rate for FX exposure

Benchmark rate for FX exposure means the FX rate of the foreign currency exposure that the company wants
to protect.
Assigning a benchmark FX rate can help achieve the following objectives:
1. Develop a risk management strategy:
A defined benchmark rate helps the treasury ascertain a tolerable FX rate movement. The company’s
treasury can develop a risk management strategy and the instruments to be used to protect the benchmark
rate.
2. Price and negotiate sales/purchase contracts with international vendors:
If a benchmark rate is set, the company will have visibility on the FX rate that should be used for pricing its
imports or exports and further pricing negotiations with various vendors to achieve the desired profitability
from the contract.
3. Analyse and measure business performance:
By setting an FX benchmark rate, the company can measure its business performance by analysing the
extent to which the currency movement impacted its target revenue and costs.
Companies choose benchmark rates depending on the type of exposure that the company wants to protect its
profit or cash flow from.
2.2.1 Benchmark rate for balance sheet exposure

For a foreign currency asset or liability that was recorded in the balance sheet in the current reporting period,
the benchmark rate will be the FX rate on the date of recording such asset or liability in the balance sheet.
Since FX risk to the balance sheet exposure is the adverse restatement of foreign currency assets and liabilities,
the benchmark rate is the previous reporting period’s FX rate.
Example
An Indian company exports textile to Europe and receives payments in EUR. The company exported a
consignment of t-shirts to its European buyer on 18 December. The company will receive the money on 18 May.
The EUR/INR rate on different dates is as follows:
Date EUR/INR
18 December 80
31 December 81
31 March 79
18 May 82

Since the functional currency of the Indian company is INR and it prepares its balance sheet in INR, the USD10
million of receivable assets has to be recorded in INR, has to be restated at the reporting period and ultimately,
settled in INR when the money is received. The timeline of the flow at various dates is as follows:
Table 1.3: EUR/INR Rate at Different Time Periods
Period EUR/INR Remarks Restatement Gain/Loss
18 80 Asset of INR 800 million (EUR 10 million × 80) is

December created in the books of account.
31 81 EUR receivable restated on 31 December at a Gain of INR 1 million
December EUR/INR rate of 81, which led to a restatement
gain of INR 1 million (EUR 10 million × (81 − 80).
This captures the movement from the invoice
date to the reporting period date.
31 March 79 EUR receivable restated on 31 March at a Loss of INR 2 million
EUR/INR rate of 79, which led to a restatement
loss of INR 2 million (EUR 10 million × (79 − 81).
This captures the movement between the two
reporting period dates.
18 May 78 EUR receivable is settled on 18 May at a Loss of INR 1 million
EUR/INR rate of 78, which led to a settlement
loss of INR 1 million (EUR 10 million × (78 − 79).
This captures the movement between the
reporting period date and the settlement date.
Net gain/loss INR 2 million
In the above case, the company will want to protect the EUR/INR rate of 80 since this is the rate at which the
asset is recorded in the books of account. Subsequently, on 31 December and 31 March, the company will want
to protect the rates of 81 and 79 since the asset is restated at these rates in the respective reporting periods.
2.2.2 Benchmark rate for forecasted exposure
Usually, companies would have a separate team called financial planning and analysis (FP&A) or business
planning and analysis (BPA) who create company-wide operating plans for a future period. This team takes
forecast from various departments for sales, purchase and other inflows/outflows from business operations.
Typically, companies conduct an annual budgeting exercise to forecast the free cash flow that the company will
generate. This helps the company to plan its cash flow and identify periods when there is shortfall. This annual
exercise is called annual operating plan (AOP). Companies will periodically update the AOP depending on
changing market conditions.
For companies that have import and export exposure, the FP&A/BPA team will need to convert the forecasted
foreign currency inflows and outflows into local currency to arrive at free cash flow, highlighted in the below
example.
An Indian company has a production setup in India. The company sells its product in both India and USA. The
sales proceeds from the USA are received in USD. The forecasted operating plan created by the FP&A/BPA team
for the next 3 months to forecast the company’s free cash flow is as follows:

Table 1.4: Forecasted Operating Plan for Next 3 Months (Amount in Crores)
A. Sales
In INR 700 800 900
In USD 5 7 9
B. Cost of goods sold (COGS)
In INR 140 160 190
C. Salary and admin expenses (in INR) 100 155 175
D. Sales and promotion expenses (in 150 145 160

INR)
Some of the forecasted sales are in USD. Since the final free cash flow number has to be prepared in INR, the
FP&A/BPA team will need inputs from the treasury with respect to the forecasted rate to be taken for different
months to convert the USD amount into INR amount.
The treasury team advised the FP&A/BPA team to use the prevailing USD/INR rate of 70.00 in the AOP exercise.
After incorporating the USD/INR rate, the FP&A/BPA team will prepare the operating plan in INR which forecasts
the cash flow of the company.
Table 1.5: Forecasted Operating Plan for Next 3 Months (Amount in Crores)
A. Sales
In INR 700 800 900
USD sales in INR (USD sales * 70) 350 490 630
B. Cost of goods sold (COGS)
In INR 140 160 190
C. Salary and admin expense (in INR) 100 155 175
D. Sales and promotion expenses (in 150 145 160

INR)
Free cash flow = A – (B + C + D) 660 830 1005
For the treasury team, the FX rate provided in the forecasted operating plan becomes the benchmark rate that
the treasury needs to protect. Since any adverse movement in the FX rate from the rate provided in AOP will
alter the forecasted cash flow of the company.
There are different methods to assign a benchmark rate for forecasted import and export forecasted import or
export.
2.2.2.1 Current FX rate
Under this method, the prevailing FX rate at the time of making the forecast is used as a benchmark. While this
is the simplest method to create a benchmark rate, the drawback of this method is that the spot rate is not the
rate that can be hedged for an exposure which is forecasted to occur in a future period. The company will have
to pay a hedging cost to protect the spot rate.

2.2.2.2 Forward rate
Under this method, a company can use the forward rate quoted in the market as the benchmark rate. The
rational under this approach is that the Treasury can hedge the forecasted exposure at the forward rate, and
hence, the forward rate will be used as a benchmark.
FIGURE 1.2: Bloomberg Snapshot of EUR/USD Forward Rate Quotes
2.2.2.3 Historical average rate

An average of past period is taken as the benchmark rate. This is also a simple method to arrive at a benchmark
rate. However, the benchmark rate can be different based on the historical time frame selected.
For example, if the average of the last calendar year (January 2018–December 2018) is taken as the benchmark
rate, the benchmark rate will be 68.36. While a benchmark created based on average of the last financial year
(April 2018–March 19) will be 69.90.
2.2.2.4 In-house forecasted FX rate

The company’s treasury team forecasts FX rates based on their expertise and different models or tools. These
in-house forecasted FX rates are used as a benchmark rate. This method is used by companies with a
sophisticated treasury that is capable of forecasting FX rates.
2.2.2.5 Consensus forecast
Under this method, an average of forecasted rates from independent sources is taken as the benchmark rate.
Typically, companies will take average of forecasted rates given by various banks.
A Bloomberg screenshot showcasing average forecast based on inputs from multiple banks of various currencies
for different periods is presented below:

FIGURE 1.3: Bloomberg Snapshot of Average Consensus Forecasts
for Multiple Currency Pairs Across Time Periods
3 Risk mitigation techniques and instruments

3.1 Internal hedging methods
The following hedging methods are the inhouse hedging techniques deployed by a company to protect itself
from the FX rate fluctuation in their foreign currency exposure.
3.1.1 Invoicing in home currency

It refers to invoicing the import or export in the local currency instead of foreign currency to avoid the FX risk.
For example, a textile company exports fabrics worth USD10 million and will receive the money after 30 days.
Currently the USD/INR rate is INR 70 per USD, but there is uncertainty regarding the USD/INR rate after 30
days.
Therefore, the company is exposed to foreign currency risk. If the rate after 30 days is less than INR 70, then
the company stands to lose because it will get lower cash flow.
To avoid such a situation, the company can invoice its exports in INR, that is, sell the fabric for INR 700 million
itself instead of USD10 million. This will eliminate the FX risk caused by FX rate fluctuation, and thus, there will
be no uncertainty regarding the USD/INR rate after 30 days.
In such cases, the currency risk is transferred to the foreign counterparty, and the foreign counterparty, that
has to pay INR 700 million to buy the fabric from the Indian textile company, is now exposed to the fluctuation
in the USD/INR rate. Since the foreign counterparty has to pay a hedging cost to protect itself from the USD/INR
movement, it can negotiate to pay an amount lesser than INR 700 million.
3.1.2 Natural hedging

A company importing and exporting in different countries, makes itself vulnerable to FX movement of various
currencies. To reduce its FX exposure to different currencies, it can choose to make payments and receive
payments in one currency.
Example

An Indian company is a manufacturer of pipes. The raw materials are imported from USA in USD. The company
has 100% export sales to Europe and the sale proceeds are received in EUR.
Thus, the company is exposed to two foreign currencies – fluctuation of USD against INR for import payments
and fluctuation of EUR against INR for export receipts. The raw material supplier of the company in USA is ready
to accept the payment in EUR instead of USD.
The company, to effectively manage the FX exposure, can decide to avail the option provided by the supplier
and make payments in EUR. This action will benefit the company in following two ways:
 The company will only be exposed to one foreign currency fluctuation, that is, EUR, since payments and
receipts will both be in EUR.
 The company will be able to carry out netting to effectively arrive at a net exposure in EUR to hedge against
the EUR/INR risk.
3.1.3 Netting of exposure

Typically, companies view FX exposure in periodic buckets, mostly weekly or monthly. If a company prepares its
outstanding exposure at a monthly level, and it has an import exposure and an export exposure in the same
month, it can carry out the netting process to determine the net FX exposure.
Example
An auto-ancillary company manufactures spare parts and exports the finished goods to the USA and receives
the payment in USD. The company imports the raw material from China and makes payment in USD.
The payment and receipts for the month of January are as follows :
Table 1.6: Payments and Receipts for the month of
January
Date Import Export

(USD million) (USD million)
10 January 10
14 January 6
20 January 8
24 January 14
30 January 12
Net Import = (10 + 8 + 12) – (6 + 14)

Exposure = 10
3.1.4 Leading and lagging approach

Some corporates vulnerable to FX risk adopt the approach of postponing (lagging) or preponing (leading) the FX
payments or receipts to net off the exposure or take advantage of the FX rate movement. This approach is
usually used when there are no external hedging avenues (such as forwards) available. It is more widely used to
settle inter-company payments and receipts since external counterparties will not agree to alter the terms of
payments and receipts.
Example
A company in Madagascar has a USD4 million import exposure in the month of January. Since the financial
markets in the country are not developed, the company cannot take forward contracts to hedge its risk. In the
month of December, the company expects the local currency to depreciate against USD in January. The
company can lead the payment, that is, make the payment early so that it will need to pay less of local currency
for every USD of payment.

A company in Angola has a USD3 million receivable in the month of August from its parent company in the USA.
Since the financial markets in the country are not developed, the company cannot take forward contracts to
hedge its risk. In the month of July, the company expects the local currency to appreciate against USD. The
Angolan company can tell the parent company to lag the payment, that is, delay the receipt so that the Angolan
company receives more local currency.
3.2 External hedging instruments and its execution
Companies will not be able to mitigate all FX risk through internal hedging techniques. They have to enter into
hedging contracts with banks or exchanges if they are vulnerable to FX fluctuation and want to protect the risk
of adverse currency movement. For a company which is exposed to FX risk, the following hedging instruments
can be used:
FIGURE 1.4: Types of Hedging Instruments
In earlier modules, we have studied in detail the basics of these instruments along with examples of how risk can
be managed using these instruments. In this section, we will give you a full walk-through of how a treasury
executes such hedging instruments. This will give you a practitioner’s insight into the hedging activity.
3.2.1 Forwards
Exposure communication
The purchase department of the company informs its treasury that there is a forecasted exposure of USD1
million with a payment date of 15 September.
The purchase department emails the following Excel template of exposure to the treasury team:
Particulars Details
Nature of exposure Forecasted exposure
Purchase order number PQR/112033
Consignment Single shipment consignment
Counterparty name PQR LLC
Country of shipment USA
Currency of exposure USD
Amount USD1 million
Latest date of shipment 17 June
Payment terms 15 September
Check the market rate

The treasury team wants to hedge this USD1 million by using a forward contract. The treasury manager checks
the USD/INR spot rate and forward premium for 15 September on the Bloomberg screen. The current spot rate
is 70.12/70.13 and the forward premium for 15 September is 0.71/0.72. Hence, the forward rate for 15
September is 70.83/70.85. This means that the company will get a rate of 70.85 to buy USD1 million and a rate
of 70.83 to sell USD1 million.

FIGURE 1.5: Bloomberg Screenshot of USD/INR Forward Rate Quotes
Obtain quote from bank

The treasury manager approaches the company’s bank via a phone call and asks the bank’s treasury salesperson
for a quote for USD1 million for 15 September. Since the bank does not know whether the company wants to
buy or sell the forward contract, the bank will give a two-way quote (i.e., bid price and ask price). Suppose the
bank gave a quote of 70.81/70.87. This means that to buy USD1 million, the company will get a rate of 70.87
and to sell USD1 million, the company will get a rate of 70.81.
Execute the transaction

Since the rate quoted by bank is not in-line with the market quoted rate on Bloomberg, the treasury manager
requests for a better price. Bank’s treasury salesperson gives a revised quote of 70.83/70.85. Since the rate
quoted by the bank is in-line with the market quoted rate, the treasury manager confirms purchase of USD1
million at 70.85. The treasury manager can either say “I buy” or “Mine” to confirm the purchase of a forward
contract. Hence, the company has locked-in a forward contract to buy 1 million USD at 70.85 for 15 September
from the bank.
If the company wanted to sell USD, the treasury manager can either say “I sell” or “Yours”. This means that the
company has sold a forward contract at a rate of 70.83.
Confirm the transaction

Once the treasury manager executes the purchase of a forward contract by saying “I buy” or “Mine”, usually,
the bank’s treasury salesperson will confirm the deal by mentioning all the trade terms of the contract such as
currency pair, amount, date and rate, that is, the bank’s treasury salesperson will say “To confirm, Company
ABC buys USD1 million against INR at 70.85 for 15 September”. The treasury manager will reply saying “I
confirm” or “Ok” to confirm the trade details.
Record the transaction

Once the deal is executed, the treasury manager records the transaction in the company’s Treasury
Management System (TMS).
A screenshot of the deal recording screen for a forward contract in a TMS is as follows:

FIGURE 1.6: A Forward Contract Deal Recording Screen in a TMS
If a company does not have a TMS, the deal will be recorded in an Excel sheet. A template of the parameters
that will be captured in the Excel sheet are as follows:
FIGURE 1.7: Excel Sheet Template Snapshot to Record a Forward Contract Deal
Deal confirmation
Before the end of the day, the bank will email the company’s front office and back office teams mentioning the
trade details of the executed forward contract. The email contains details such as currency pair, amount, date
and rate.
The back office will perform a two-way check of the trade details based on the data entered by the front office
in the TMS and the details mentioned in the email. If the company does not have a TMS, the front office will send
an email containing all the deals executed in the day to the back office. The back office will perform a two-way
check of trade details based on the email sent by the front office and the bank.
If there is any discrepancy in the trade parameters, the back office will highlight it and bring to the notice of the
front office and the bank. The discrepancy will be rectified to ensure that both the parties (i.e., bank and
company) have the same trade details.
3.2.2 Futures
million with a payment date of 30 August.

The treasury team wants to hedge this USD1 million by using a futures contract. The treasury manager checks
the USD/INR futures rate for 30 August on the National Stock Exchange (NSE) website. The rate quoted on the
NSE website site is 69.06.

FIGURE 1.8: Snapshot of USD/INR Futures Rate Quoted on the NSE
Execute the transaction

Since futures is an exchange traded product, the treasury team does not need to obtain quotes. There are two
ways to execute a futures trade:
1. Call the broker and tell the broker to execute the trade at the current market price.
2. Execute the trade on the broker-provided online platform.
Since the prevailing rate to buy USD against INR for 30 August is 69.06, the treasury manager executes a deal
to buy USD2 million with the broker.
A screenshot of the broker’s online platform on which the treasury manager can execute the trade is as follows:
FIGURE 1.9: Snapshot of an Online Platform for Currency Futures
Record the transaction

Once the deal is executed, the treasury manager records the transaction in the company’s TMS. If the company
does not have a TMS, the deal will be recorded in an Excel sheet.
Deal confirmation
At the end of the day, the broker sends a statement to the company’s front office and back office containing the
trade details of the futures contract.

FIGURE 1.10: Snapshot of the Deal Statement Received from the Broker
in the TMS (or shared over email) and the details mentioned in the broker’s contract note.
3.2.3 Options
million with a payment date of 18 October.

The treasury team is of the view that INR might appreciate against USD in the next few months and decides to
hedge this exposure through a vanilla call option. A call option will ensure that the risk is protected and that the
company can get a better rate in event of INR appreciation.
The prevailing spot rate is 68.68 and the forward rate for 18 October is 69.56. In options contract parlance, the
prevailing forward rate is also called “At the money forward” (ATMF).
The treasury manager decides to keep the strike of the options contract at 69.60, which is nearer the ATMF.
For this option, he checks the price on the SuperDerivatives screen. To price the option, he will enter the amount,
strike price and maturity of the option in the SuperDerivatives pricer to get the premium amount to be paid for
the option.
An option price screenshot of SuperDerivatives is as follows:
FIGURE 1.11: SuperDerivatives Snapshot of USD/INR Call Option

The call option price shown by SuperDerivatives is USD35,740 for a notional of USD3 million, which means INR
2,454,603 (converted at a USD/INR spot rate of 68.68) as an absolute price. It can also be converted into per
dollar price. INR 2,454,603 is the price for USD3 million, hence, for every 1 USD, the price of the option is INR
0.8182.
Obtain quote from bank

While quoting a forward rate, banks will quote the rate shown on market terminals such as Bloomberg, Reuters
and Tickerplant. Hence, the treasury will get quote only from one bank and execute the deal. In case of an options
contract, each bank will give a different option price based on the bank’s implied volatility on the currency pair.
A bank can quote a lower option price if it has an opposite matching trade. Hence while asking for option price,
a treasury manager usually asks for quotes from multiple banks, usually from 3 or 4 banks.
To get a price for USD/INR option with a strike of 69.60 for 18 October maturity, the treasury manager asks for
quotes from 3 different banks. He will tell each bank to give price for a vanilla call option on USD/INR at spot of
68.68, with a notional of USD3 million for maturity of 18th October having a strike of 69.60.
The three banks give the below mentioned quote:

Table 1.7: Option Quote Given by Different Banks
Bank Name Spot Notional Strike Maturity Premium Premium

Rate (USD million) (INR) (INR per
USD)
Bank ABC 68.68 3 70.00 18 November 2,490,000 0.8300

2019
Bank PQR 68.68 3 70.00 18 November 2,465,100 0.8217

2019
Bank XYZ 68.68 3 70.00 18 November 2,552,000 0.8507

2019
Executing the transaction

Bank PQR has quoted a rate lower than the rate quoted by SuperDerivatives. It can either be that the bank has
a lower implied volatility or that it has a matching deal and hence is able to offer a better rate.
The treasury manager will execute the option price with Bank PQR by confirming the deal parameters, including
the premium to be paid for this option.
Confirming the transaction
Once the treasury manager executes the purchase of the vanilla call option, usually, the bank’s treasury
salesperson will confirm the deal by mentioning all the trade terms of the contract such as currency pair,
amount, maturity, strike price and absolute premium amount, that is, the bank’s treasury salesperson will
confirm by saying, “Company ABC buys USD/INR vanilla call option, with a notional of USD3 million, with a strike
of 69.60 for 18 October and pays a premium of INR 2,465,100”. The treasury manager will reply with “I
confirm” or “Ok” to confirm the trade details.
Recording the transaction

Once deal is executed, the treasury manager records the transaction in the company’s TMS.
A screenshot of a deal recording screen for an options contract in a TMS is as follows:

FIGURE 1.12: An Option Contract Deal Recording Screen in a TMS
If the company does not have a TMS, the deal will be recorded in an Excel sheet. A template of the parameters
that will be captured in the Excel sheet is as follows:
FIGURE 1.13: Excel Sheet Template Snapshot to Record an Option Contract Deal
Deal confirmation
Just like in the case of forwards, even in options, the bank will send a confirmation to the company containing
the trade details of the option deal executed. The email will be sent to the company’s front and back office teams
mentioning the trade details of the options contract. The email will contain details such as currency pair, amount,
maturity date, strike price, notional, and premium paid.
in the TMS and the details mentioned in the bank’s email. If the company does not have a TMS, the front office
will send an email containing all the deals executed in the day to the back office. The back office will perform a
two-way check of trade details based on the email sent by front office and the bank.
If there is any discrepancy in the trade parameters, the back office will highlight it and bring to the notice of the
front office and the bank. The discrepancy will be rectified to ensure that both the parties (i.e., bank and
company) have the same trade details.
4 Risk appetite and deciding hedge ratio

4.1 Understanding risk appetite
Risk appetite refers to the maximum acceptable deviation from the FX benchmark rate. Risk appetite of a
company depends on various factors such as:
 Profit margins of the company

If the profit margins of the company are high, it can absorb the deviations from the FX benchmark rates.
However, if the profit margins are low, deviations from the FX benchmark rates can result in negative cash flows
or losses for the company.
Example
Company ABC forecasts to import 10 mobile phones every month from the US for the next 3 months. Each
mobile phone costs USD1000. It expects to sell these mobile phones in India for INR 80,000. The current
USD/INR rate is 70.00. The company forecasted its profit for the next 3 months assuming a USD/INR rate of
70.00 for every month.
Forecasted purchase (in USD) 10,000 10,000 10,000
Forecasted USD/INR rate 70.00 70.00 70.00
Forecasted purchase (in INR) 700,000 700,000 700,000
Total sales 800,000 800,000 800,000
Profit 100,000 100,000 100,000
Profit margin 12.5% 12.5% 12.5%
If the company expects to sell the mobile phones for 720,000, then the margin drops to 2.8%. In this case, the
company has a very low risk appetite to any deviation from the FX benchmark rate than the first scenario where
the margins are 12.5%.
 Price elasticity of its product
If there is a deviation from the FX benchmark rate, and the company can pass on the price change to its
customers, then the company will have a higher risk appetite. If the company is not able to pass on any adverse
FX rate movement to the customer and must absorb the increase in cost or decrease in sales price, then the
company will have a lower risk appetite.
Example
An IT company in India forecasts to sell IT services worth USD1 million to its US client. It expects a USD/INR rate
of 72.00 for the realisation of its sales.
Forecasted sales (in USD) 1,000,000 1,000,000 1,000,000
Forecasted USD/INR rate 72.00 72.00 72.00
Forecasted sales (in INR) 72,000,000 72,000,000 72,000,000
Forecasted expenses (in INR) 63,000,000 65,000,000 64,000,000
Profit (in INR) 9,000,000 7,000,000 8,000,000
Profit margin 12.5% 9.7% 11.1%
If the USD/INR rate on date of sales is 69.00 and the company can pass on the adverse effect of the FX rate to
its US client, it will increase its sales price in USD to maintain the net profit and its margin as per the forecasted
profit and margin. In such a scenario, the company will have a higher risk appetite to deviation from the FX
benchmark rate.

Table 1.10: Scenario 01: Company Can Pass on the Adverse FX Movement
Actual USD/INR rate 69.00 69.00 69.00
Revised sales (in USD) 1,043,478 1,043,478 1,043,478
Actual sales (in INR) 72,000,000 72,000,000 72,000,000
Profit (in INR) 9,000,000 7,000,000 8,000,000
But if the company cannot pass on the adverse FX movement to its client and must absorb the adverse
movement, it will have a lower risk appetite to deviations from the FX benchmark rate because the adverse
movement will lower its net profit and margin.
Table 1.11: Scenario 02: Company Cannot Pass on the Adverse FX Movement
Actual USD/INR rate 69.00 69.00 69.00
Actual sales (in USD) 1,000,000 1,000,000 1,000,000
Actual sales (in INR) 69,000,000 69,000,000 69,000,000
Profit (in INR) 6,000,000 4,000,000 5,000,000
 Expertise of the treasury team
If the treasury team does not have the expertise and knowledge to manage the FX risk, the company will have a
low risk appetite.
 Prior experience of FX fluctuation
Prior experience of FX fluctuations also plays a big role in a company’s risk appetite. If the company has
experienced large adverse FX movement that impacted its net profits or margins adversely, the company will be
more risk averse and will want to ensure that adverse FX movement has least impact on its net profit and
margins.
4.2 Defining risk appetite and deciding hedge ratio

Companies use Value at Risk (VAR) or scenario analysis to define its risk appetite and the maximum adverse
movement of FX rate that it can absorb. In an earlier module, we have learned the basics of VAR and scenario
analysis. In this section, we will understand how companies interpret VAR and scenario analysis to define risk
appetite.
VAR

A pharmaceutical company exports to the USA, Germany, UK and Japan. It receives the export proceeds in four
different currencies. The FP&A/BPA team gives the following annual export forecast to the treasury team.
Table 1.12: Forecasted Annual Exports (In Millions)
Particulars USA Germany Japan UK
Currency USD EURO Yen GBP
Exports in respective 220 76 6400 43

currency
The treasury team uses Excel models to calculate VAR on its free cash flow (EBITDA). It uses 95% confidence
interval and historical volatility for the last 3 years to calculate VAR.
Based on the Excel output, the treasury team calculates the following VAR numbers and its sensitivity of EBITDA
on the unhedged portfolio.
Table 1.13: VAR
Particulars Amount
Annual exposure converted into USD 377

USD
Annual exposure INR 26,426
Forecasted EBITDA INR 7,550
VAR at 95% confidence interval INR 2,857
Sensitivity to EBITDA 37.84%
The treasury team communicates to the management that if the company does not take any hedges on its FX
exposure, the company faces a maximum potential loss of INR 2,875 million due to adverse FX movement. This
translates to 37% of its forecasted annual EBITDA. The company can tolerate a sensitivity of only 10% to EBITDA
due to adverse FX movement. The treasury team analyses reduction in VAR at various levels of hedge ratio to
bring the sensitivity to EBITDA to <10%.
Based on Excel models, the sensitivity to EBITDA at various hedge ratios is as follows:
Table 1.14: VAR and Sensitivity to EBITDA at Different Hedge
Ratios
Hedge VAR Hedges Sensitivity to

Ratio (INR million) (USD) EBITDA
Pre- 2,857 0 37.84%

hedging
25% 2,163 94 28.64%
35% 1,875 124 24.83%
50% 1,442 188 19.09%
75% 720 282 9.53%
Since sensitivity to EBITDA is <10% at 75% hedge ratio, the company decides to keep the minimum hedge ratio
at 75%.

4.3 Construct FX risk management policy
As explained in the above sections, when managing FX risk, a company must decide on one of the options at
every stage of FX risk management process such as:
 Exposure to hedge (balance sheet exposure or cash flow exposure)

 Risk appetite of the company
 Instruments to use for hedging
 Strategy to be adopted
To ensure that there is no ambiguity for the treasury team while implementing the company’s philosophy and
objectives towards FX risk management, it is imperative to document the FX risk management policy. The policy
also outlines the hedge ratio, hedging strategy and instruments that can be used so that the treasury team can
promptly execute the FX risk management framework.
The FX risk management policy is a policy approved by the board of directors that outline the philosophies and
objectives of FX risk management and sets out the strategy and procedures that the treasury team should abide
by.
Typically, the board of directors decide the philosophy, objectives and risk appetite of a company. The objectives
specify whether the company should protect balance sheet exposure or cash flow exposure from FX fluctuations.
The board of directors, in consultation with the treasurer, will also decide the following:
 Method to arrive at the benchmark rate for the exposure

 Operational parameters of the hedging program such as:
 Hedge ratio and strategy

 Instruments used for hedging
 Various limits
 Governance framework such as organisation structure and roles and responsibilities

 Reporting framework for treasury function
A sample of the table of contents of a typical FX risk management policy is as follows:

1. FX RISK MANAGEMENT PROGRAM OVERVIEW
1. Overview of the company’s operations
2. Company’s exposure to FX risk
3. Philosophy and objectives of FX risk management
4. Deciding risk appetite
5. Method of deciding the benchmarking rate
2. HEDGING PROGRAM
1. Hedge ratio
2. Hedging strategy
3. Authorised instruments
4. Authorised dealers
5. Limits
a. Dealer limit
b. Hedge instrument limit
c. Counterparty limit
3. GOVERNANCE FRAMEWORK
1. Treasury organisation structure
2. Roles and responsibilities
a. Front office
b. Middle office
c. Back office
4. REPORTING FRAMEWORK
1. Treasury reports
2. Management reports
3. Exception reports

5 Risk mitigation strategies
5.1 Static hedging
This strategy is typically used when the company’s policy is to hedge cash flows and the operating plan is
prepared only once during a period. Typically, the hedges are placed at one single point in time when the
operating plan is shared with the treasury team. When the operating plan for the next period is shared, hedges
for the new period will be undertaken.
For example, a company follows a static hedging strategy. It prepares a quarterly plan basis which the treasury
team undertakes its hedging activities. Following forecast is provided on 30 December for the January–March
quarter. All the hedges for January, February and March are undertaken on 31 December.
Forecast for March quarter
Particulars January February March
FX exposure (in USD) 20 30 40
Hedges (in USD) 20 30 40
Hedge ratio 100% 100% 100%
Hedging for the next quarter will be undertaken only at the end of March when the new operating plan for the
April–June quarter is made available to the treasury team.
This strategy is typically used when:
 The operating plan exercise is a static activity and is not revised every month.
 The forward rate is used as a benchmark rate and the treasury team wants to protect the benchmark rate.
Table 1.15: Advantages and Disadvantages of Static Hedging

Strategy
Advantages Disadvantages
Effective to minimise Hedges are not undertaken until

variance between the the subsequent AOP plan is
benchmark rate and the received
hedging rate
If the cost of hedging is high, the
absolute hedge rate for farther
months will always be higher than
the near months
5.2 Dynamic hedging

5.2.1 Rolling hedge strategy
This strategy can be undertaken for both cash flow exposure and balance sheet exposure. Under this strategy,
at the end of each month, the exposure for the new month is determined and hedges for this new month are
undertaken. Under this strategy, at the end of each month, the treasury team obtains exposure for the new
month.
The different monthly buckets at the end of each month are shown in the following table 1.15. The same example
can be extended to half-yearly or annual buckets.

Table 1.16: Monthly Buckets of Exposure
Period Month 1 Month 2 Month 3
Exposure at the January February March

end of December
Exposure at the February March April
end of January
Exposure at the March April May
end of February
Under this strategy, the hedges are taken on a rolling basis throughout the year, that is, hedges are undertaken
when the exposure for the new month is provided to the treasury team. A constant hedge ratio is maintained
throughout the hedging period.
For example, company ABC based in India imports from the US and is exposed to the USD/INR risk. It hedges its
balance sheet exposure on a rolling basis and the hedge ratio is kept at 50%. At the end of December, the
treasury team receives the following balance sheet exposure:
Table 1.17: Balance Sheet Exposure as on 31 December
January February March
Hedge ratio to be 50% 50% 50%

maintained as per policy
Hedges to be undertaken 10 15 20
for a hedge ratio of 50%
(in USD)
On 30 January, the treasury team receives information that the balance sheet exposure for the month of April
is USD70 million. At the end of January, the exposure profile of the company will be as follows:
Table 1.18: Balance Sheet Exposure on 31 January
February March April

Existing hedges (in USD) 15 20 0
Additional hedges to be 35
taken (in USD)
Since the exposure for February and March is same, no additional hedges are required for these months. For the
new month added to the exposure profile, the treasury team will take hedges of USD35 million to achieve a
hedge ratio of 50% for the month of April.
5.2.2 Layered hedge strategy

Layered hedging is similar to the rolling hedging strategy except that the hedge ratio is not kept constant
throughout the hedging period.

For example, company XYZ based in India exports its goods to the US and is exposed to the USD/INR risk. It
hedges its forecasted exposure and has adopted a layered hedging strategy for the same. It follows the following
layered hedge ratio:
Table 1.19: Layered Hedge Ratio
Hedge ratio 50% 40% 30%
At the end of December, the treasury team receives the following balance sheet exposure:
Table 1.20: Forecasted Exposure as on 31 December
January February March

Hedges to be undertaken 10 12 15
for 50% hedge ratio (in
USD)
On 31 January, the treasury team receives an updated forecast for February and March. It also receives a fresh
forecast for April.
Table 1.21: Forecasted Exposure as on 31 January
February March April
Existing hedges (in USD) 12 15 0

(A)
Hedges required to 25 16 21
maintain hedge ratio (in
USD) (B)
Additional hedges to be 13 1 21
undertaken (B − A)
The updated exposure for February increased from USD30 million to USD50 million, while it decreased from
USD50 million to USD40 million for March. At the end of January, since February is Month 01, treasury needs
to take USD13 million of additional hedges to achieve the hedge ratio of 50% on the updated forecasted exposure
of USD50 million. Similarly, March is Month 02 and hence, the treasury needs to hedge 40% of the updated
exposure. Since USD15 million of hedges were already taken, only USD1 million of additional hedges are required
for March to achieve the required hedge ratio of 40%.
Layered hedging strategy is suitable for hedging for forecasted exposure while rolling hedging strategy is more
suitable for balance sheet exposure.
In the above example of rolling hedge, company ABC’s treasury team received the same exposure for the months
of February and March, once at the end of December and then again at the end of January.

Table 1.22: Monthly Buckets of Balance Sheet Exposure for
ABC
Period February March
Exposure at the end of 30 40

December
January
Hence, keeping a constant hedge ratio across different months is beneficial since the exposure also remains
constant.
In the example of layered hedging strategy for company PQR, its treasury team received a forecasted exposure
in December and January. Since the exposure needs to be forecasted, different factors affect the forecast,
which leads to a changed forecast. Hence, the treasury team received a different forecast for the months of
February and March.
Table 1.23: Monthly Buckets of Forecasted Exposure for XYZ
Period February March

December
January
In any forecasting exercise, there is more certainty of forecast for the near period than the farther period
forecast. Hence, under this strategy, hedge ratio for near month is kept higher while for the farther month has
a lower hedge ratio.
5.3 Different approaches followed by corporates to undertake hedges

Treasuries can adopt different approaches to undertake hedges. Some of the approaches are as follows:
5.3.1 Market view hedging
In this approach, the treasury team actively tracks the markets and undertakes hedging as per its view on the
movement of the FX rate. To form a view on the movement of FX rates, the treasury team uses various methods,
as follows, to track the market and arrive at appropriate decision:
5.3.1.1 News that impact FX markets

FIGURE 1.14: Bloomberg screenshot of the top news for the day
5.3.1.2 Statements from the central bank

FIGURE 1.15: Bloomberg screenshot of the top news for the day by the central bank
5.3.1.3 Technical analysis

FIGURE 1.16: EUR/USD technical analysis chart

5.3.1.4 Economic indicators/economic data release
FIGURE 1.17: EUR/USD technical analysis chart
5.3.2 View neutral hedging

It refers to a strategy where instead of taking a market view to undertake hedges, hedges are undertaken at
specified periodic intervals. This ensures that hedging decisions are not based on any views of the treasury team
and hence, hedging decisions are minimally impacted by the movement/volatility of the FX markets.
5.3.3 Core and non-core hedging

Under this approach, the treasury undertakes hedges to achieve minimum policy compliance either through a
market view hedging or through a view neutral hedging. This is called core hedging. Based on a treasury’s view
of the market, additional hedges are undertaken to protect exposure against adverse FX movement. These
additional hedges are called non-core hedges.
6 Monitoring KPIs and KRAs

CFOs and Treasurers periodically monitor various Key Performance Indicators (KPIs) and Key Risk Indicators
(KRIs) to ensure and evaluate the following:
 Whether the philosophies and objectives set out by the company are achieved
 Accuracy of FX exposure and its impact on financial performance of the company
 Protection of benchmark rate is achieved
 Effectiveness of hedge ratio, hedging strategy and instruments in providing protection against the
underlying exposure
 Various policy compliances are adhered to
Among the various KPIs and KRIs that a treasurer or CFO would evaluate, some of the key ones are as follows:
6.1 Net exposure and hedge ratio
Periodic evaluation of compliance to hedge ratio is necessary to ensure that the exposure is hedged adequately,
and the treasury team has not kept its exposure unprotected beyond the threshold limit.
Example
H Ltd. is a parent company of three different entities – S1 Ltd., S2 Ltd. and S3 Ltd. FX exposure of all these
three entities are handled individually by the respective treasury teams. The FX policy approved by H Ltd.

mandates all entities to have a hedge ratio in the range 90%–100 %. The central treasury team carries out a
quarterly hedge performance review and presents it to the CFO.
A snapshot of the exposure and hedges report received by the central treasury during one of the quarterly
reviews is as follows:
Table 1.24: Snapshot of an exposure and hedges report
Sr. Entities Outstanding Outstanding Hedge

No. exposure (A) hedges (B) (USD) ratio (B/A)
(USD)
1 S1 Ltd. 100,000 125,000 125%
2 S2 Ltd. 250,000 200,000 80%
3 S3 Ltd. 50,000 48,000 96%
Following observations were made by the central treasury to the CFO in the review:
 S1 Ltd.: It has a situation of an overhedged position since the outstanding hedges exceed the outstanding
exposure. S1’s treasury clarified the situation by giving the following explanation:
 USD14,000 of exposure was forecasted by the business unit against which hedges were undertaken,
but it has not materialised.
 On USD20,000 of exposure, timely cancellation of hedges was not carried out on hedges that are
tagged to an underlying which no longer exists.
The CFO highlighted that apart from being a policy non-compliance, overhedging will have the following issues:
 Excess hedging cost will be incurred due to additional derivatives being obtained.
 No offset of derivative gain/loss available due to non-existence of an underlying against it.
 Possibility of incurring losses at the time of unwinding/cancellation of the additional derivatives
obtained.
Considering the above things, the CFO of H Ltd. advised the front office of S1 Ltd. to unwind the position
forthwith and bring the hedge ratio to the acceptable level.
 S2 Ltd.: It has a situation of underhedging since the hedge ratio is lower than the minimum policy compliance
of 90%. S2’s treasury clarified the situation by giving the following explanation:
 It has not hedged USD50,000 of exposure since the treasury team did not get good quotes on option
hedge.
The CFO pointed out that apart from being a policy non-compliance, underhedging will have the following issues:
 Absence of gain/loss offset on exposure due to non-existence of a hedge against the exposure.
 No protection provided to the underlying unhedged exposure against FX rate fluctuation.
Considering the above things, the CFO advised the treasury team of S2 Ltd. to obtain additional hedges and
bring the hedge ratio within the policy compliance level.
 S3 Ltd.: The CFO was satisfied since S3 Ltd. was adequately hedged as per the FX policy.
6.2 Variance analysis of exposure

Variance analysis of exposure needs to be performed to evaluate the effectiveness of exposure forecasting
carried out by business teams. Incorrect exposure forecasting directly impacts hedging performance, which
ultimately impacts the P/L position of the company. Variance analysis comprises of two parts:

 Forecast versus forecast analysis: This analysis compares the previously made forecasts with the
current forecasts for a revenue/expense item for the same period.
 Actual versus forecast analysis: This analysis compares the forecasts made with the actual cash flow
for the respective revenue/expense.
Example
ABC Ltd. carried out a variance analysis of the exposure as a part of its quarterly review. Following reports were
provided by the treasury team to the CFO:
Report 1: Forecast versus forecast report
In April, the forecasted USD exports exposure for June was USD1,000,000 while in May, the forecasted USD
export for June was USD1,500,000.
In the review, the treasury team updated the CFO on the variation of forecast citing that for the same month of
June, different export forecasts were provided in April and May. Due to the increased forecast, the treasury
team had to take additional hedges in May at an adverse FX rate.
Report 2: Actual versus forecast analysis
In June, the actual exports were USD1,250,000.
In the review, the treasury team updated the CFO that since the actual realisation of export was lower, the
treasury had the following impact:
 Hedges: The treasury had to cancel the additional hedges since there was no exposure against the
hedges.
 Cash flow: The treasury had to do an unplanned borrowing since the forecasted cash flow did not
materializes, which resulted in a shortage of cash.
The business team cited the following reasons for variation in actual exports compared to forecasted exports:
 Decrease in the demand of the product
 Delay in exporting the goods, that is, some goods will not be shipped in June but will be shipped in July
After reviewing the above two reports and considering the comments provided by the treasury and business
teams, the CFO advised as follows:
 The business team should improve the process of forecasting the exposure to effectively manage the
cash flows of the business.
 Incorrect exposure forecasting may also lead to under/overhedging of forecasted exposure which needs
to be avoided for efficient FX risk management.
6.3 FX profit and loss analysis

The management periodically reviews the mark to market (MTM) position of its hedges and underlying to
evaluate the effectiveness of its hedges. FX exposure and derivatives are undertaken to hedge the exposure
offer gain/loss in the opposite direction. Ideally, an effective hedge should offer a 100% offset against the
underlying movement, but that may not be the case every time.
Example
The management of XYZ Ltd. carried out a quarterly review of its outstanding hedges and exposure position,
and the following report was provided to the management:
Table 1.25: Quarterly review report of outstanding hedges and exposure
position
Sr. Derivative Derivative MTM Exposure MTM Hedge

No. Number Gain/Loss (INR) Gain/Loss (INR) Effectiveness
1 Derivative 100,000 (100,000) 100%
1

2 Derivative (126,000) 140,000 90%
2
3 Derivative 240,000 (300,000) 80%
3
After reviewing the above report, the management were provided with the following insights:
 Derivative 1 is 100% effective, that is, it offers a complete offset against exposure gain/loss. 100%
offset is provided since the front office immediately undertook hedging after the exposure was
recognised.
 Derivative 2 is 90% effective since the exposure was only hedged to the extent of 90%.
 Derivative 3 is 80% effective since the hedging was undertaken after a week of recognising the exposure
thus leading to a different initial recognition rate.
6.4 Counterparty limits

Counterparty exposure needs to be regularly monitored to keep the concentration risk under check.
Concentration risk arises if exposure with one or a group of counterparties exceeds the prescribed limit.
Generally, the FX policy of a company prescribes the exposure limits with single or multiple counterparties to
effectively manage credit and concentration risks. Following are sample counterparty limit templates in a
company’s FX risk management policy:
Table 1.26: Sample of counterparty limit template #1 Table 1.27: Counterparty limit template #2
Approved Bank Name Maximum Permitted Notional Approved Bank Name Maximum Permitted
Outstanding Amount (in USD Percentage of Total Notional
million) Outstanding Amount (%)
Bank 1 100 Bank 1 10%
Bank 2 20 Bank 2 10%
Counterparty limits are decided on the following basis:

 Credit rating of the financial institution providing hedging services. Higher limits are provided to
institutions with better credit ratings.
 Competitiveness of derivative quotes offered by different counterparties/banks. Higher limits are
allotted to institutions which provide better quotes.

II Interest rate risk management
1 Interest rate risk for corporates

To run its operations, a corporate would have to borrow funds from the capital market, bank facilities or any
other financial institutions. Interest charges on such borrowings may be structured to have a fixed interest rate
(e.g., 6.5%, 8%) or a variable (floating) interest rate (e.g., LIBOR + 1%, MIBOR + 2%). In case of a floating interest
charges, the outflow of the interest amount will change depending on the fluctuations in the benchmark rates.
There is always a risk that in scenarios where the corporates take an exposure to floating rate borrowings in
times of low interest rate, a subsequent rise in interest rates would increase the cost of debt and cash outflow,
which would impact the company’s profits.
On the other hand, when corporates have excess cash balances, it is expected that they be put into capital use
at a later point in time and are usually invested into financial assets for returns. These financial assets could
yield a fixed rate of return or variable rate which is linked to a benchmark rate. In some cases, such financial
asset investment may be earmarked for specific purposes, for example, return from pension fund assets is paid
out as pensions to former employees, and therefore, the company may be exposed to reduced cash flows from
floating rate investments if the interest rates decline.
1.1 Exposure identification
Interest rate risk arises when a corporate is exposed to the risk of changes in interest rates. Most commonly,
the interest rate risk arises from the following:
1. Cashflow exposure: It is defined as the risk arising from variability in future interest cash flows with the
change in future interest rates
a. Floating rate borrowing: When a company has an outstanding floating rate borrowing that requires a
payment of interest as per the floating rate index on each payment date, a rise in interest rate will lead
to incremental outflow of interest payment
b. Floating rate investment: When a company has an outstanding floating rate investment that pays
interest as per the floating rate index on each coupon payment date, a fall in interest rate will lead to
lower cash inflow of interest receipts
2. Accounting exposure: It is defined as the risk arising from change in fair value of fixed rate borrowing or
fixed rate investment due to changes in fair value because of movement in interest rates
a. Fixed rate borrowing: On every financial accounting period, a company that has an outstanding fixed
rate borrowing needs restate the borrowings to factor the changes in fair value of the borrowing due to
changes in interest rate
b. Fixed rate investment: On every financial accounting period, a company that has an outstanding fixed
rate investment needs to restate the investment to factor the changes in fair value of the investment
due to changes in interest rate
Since the treasury team executes the borrowing and investment activity, the treasury team is aware of the
exposure arising to its borrowings and investments due to changes in interest. Hence no other team needs to
provide any additional information to the treasury team to identify the exposure
2 Interest rate risk for insurance companies

Insurance coverage covers events occurring in the life of an insurance policyholder, such as the death of the
policyholder (life insurance) or any accident or similar unpredictable event resulting in damage and subsequent
costs to the policyholder (non-life insurance). This coverage provides a pay out if the damaging event occurs
and in exchange for this pay out, the policyholder is required to pay premium(s) over the policy term. These
premium payments are invested by the insurance providers to earn a return over the term of the policy as well
as to ensure that an adequate amount of funds is available in case of occurrence of the said event(s). Since
insurance companies want protection of capital, most of the premium amount is invested in fixed income
securities to ensure protection of capital and assured return over the life on the investment

For insurance companies, liabilities are the pay outs expected either at the maturity of the policy or during the
term of the policy as claim amounts. The assets which support payment of accruing liabilities the investments
made by the insurance company from the premiums collected from policyholders. The excess of return earned
from investments over the accrued liabilities is the profit earned by the insurance provider. As mentioned above,
since most investments are made in fixed income securities which are interest rate sensitive, interest rate
management play a significant role in determining profitability of the insurance company.
For example, when interest rates increase, the returns from financial investments made by the insurance
company are expected to go up whereas the liabilities remain relatively consistent, which results in a higher
excess return, and subsequently, a higher profit for the company.
Following is the example depicting sensitivity of interest rates to promised payments in a life insurance policy.
Following screenshots are from a brochure of a life insurance policy (having maturity benefits):
FIGURE 1.18: Life Insurance Policy Brochure – Part 1
Source: ICICI Prudential Assured Savings Insurance Plan (link to document:

https://www.iciciprulife.com/content/dam/icicipru/leaflets/IPru_ASIP_English.pdf)

Assume an individual is assured a sum of INR 500,000 in the 5-year annual premium term with 10-year policy
term option. Annual premium is set at INR 50,000. Therefore, Guaranteed Additions (GA) will be computed as
follows:
Table 1.28: Computation of GA

Year Annual Cumulative GA (9% * Cumulative
Premium (INR) Premium Paid (INR) Premiums Paid) (INR)
1 50,000 50,000 4,500
2 50,000 100,000 9,000
3 50,000 150,000 13,500
4 50,000 200,000 18,000
5 50,000 250,000 22,500
6 0 250,000 22,500
7 0 250,000 22,500
8 0 250,000 22,500
9 0 250,000 22,500
10 0 250,000 22,500
Total GA 180,000
Since GA is computed at 9% of cumulative paid premiums and there is an additional maturity benefit promised,
the insurance provider would be required to earn a return in excess of 9% on the premiums paid to have
subsequent funds available for the promised pay outs.
Assuming that over the term of the policy, market interest rates fluctuates from the 9% promised level in the
policy:
Table 1.29: Market Rate Scenarios Impacting the Return Generated on Invested Premiums
Year Annual Cumulative Returns on Premium Returns on Premium
Premium Premium when Market Rate is When Market Rate is
(INR) Paid (INR) 6.5% (6.5% * Cumulative 10.55% (10.55% *
Premiums Paid) (INR) Cumulative Premiums
Paid) (INR)
1 50,000 50,000 3,250 5,275
2 50,000 100,000 6,500 10,550
3 50,000 150,000 9,750 15,825
4 50,000 200,000 13,000 21,100
5 50,000 250,000 16,250 26,375
6 0 250,000 16,250 26,375
7 0 250,000 16,250 26,375
8 0 250,000 16,250 26,375
9 0 250,000 16,250 26,375
10 0 250,000 16,250 26,375
Total GA 130,000 211,000
Note: This is an illustrative computation assuming a constant rate over the term of the insurance policy for purpose of
explanation

When market interest rates fall, the return on investments fall which creates a deficit between the GA promised
in the policy document and the actual return generated, thus resulting in a loss for the insurance provider. In
the above example, when interest rate is 6.5% there is a loss of INR 50,000 because the actual return generated
is INR 130,000 while the GA promised is 180,000O. On the other hand, if the market interest rates rise, the
amount generated on premiums increases which results in a profit for the insurance provider. In the above
example, when interest rate is 10.55%, there is a profit of INR 31,000 because the actual return generated is
(INR 211,000 while the GA promised is INR 180,000. Thus, insurance companies are constantly exposed to
interest rate risk.
3 Interest rate risk for banks and NBFC

Banks and NBFC accept different forms of deposit from individuals or corporates, who have surplus cash, for
varied lengths of time. The deposits from customers are the liability for the bank/NBFC. Under its normal
operations, banks and NBFC lend funds from these deposits to other corporates and/or individuals who need
cash. These loans to companies/individuals are the asset for the bank/NBFC. On the deposited funds, banks
promise to pay an interest rate depending on the duration of deposits, whereas the lending could be in the form
of short- or long-term loans and have different features and costs. The difference between the borrowing rate
and the lending rate is the net interest income earned by the bank. Since interest rate in the economy keep
changing, banks will realign their deposit rate and lending rate to the prevailing interest rate. A change in
interest rate impacts bank’s net interest income since banks are exposed to interest rate risk on both sides of
their balance sheet, that is, assets and liabilities.
Example: Interest rate risk on asset side for a bank
Table 1.30: Interest Rate Exposure and Asset-liability Mismatch for Bank / NBFC
Liability Asset
Loan to Rate of Outstanding Deposit Rate of Outstanding
company interest loan tenor from interest deposit
customer tenor
INR 40,000 6.00% 6 months
INR 8.00% 2 years INR 30,000 6.50% 1 year
100,000
INR 30,000 7.00% 2 years
Total INR 8.00% 2 years INR 6.45% 1.1 years
100,000 100,000
In the above example, bank has given a loan at the rate of 8.00% for a maturity of 2 years, while the deposits
have been accepted from customers at a weighted average rate of 6.45% for a weighted average tenor of 1.1
years. Hence, the net interest income is 1.55%. However, there is an asset-liability mismatch since the liability
of the bank (deposits from customers) is for a period 1.1 years, while the asset of the bank (loan given to a
company) is for a tenor of 2 years.
At the end of 6th month, bank will return INR 40,000 to the depositor along with the interest. At this moment, if
the prevailing interest rate for a 6-month deposit is 7%, bank will have to accept a deposit of INR 40,000 at 7%.
This will push the weighted average interest cost to 6.85% and hence reduce the net interest income to 1.15%.
Example: Interest rate risk on liability side for a bank
Table 1.31: Interest rate Exposure and Asset-Liability Mismatch for Bank / NBFC
Liability Asset
Loan to Rate of Outstanding Deposit Rate of Outstanding
company interest loan tenor from interest deposit
customer tenor
INR 40,000 6.00% 6 months
2 years INR 30,000 6.50% 1 year

INR Floating rate, INR 30,000 7.00% 2 years
100,000 reset every 6
months
Total INR 2 years INR 6.45% 1.1 years
100,000 100,000
In the above example, bank has given a loan for a maturity of 2 years at a floating rate of interest. Assume the
current floating rate of interest as 7.50%. The deposits have been accepted from customers at a fixed rate of
interest having weighted average rate of 6.45% for a weighted average tenor of 1.1 years. Hence, the net
interest income is 1.05%. However, there is an asset-liability mismatch from a tenor perspective since the liability
of the bank (deposits from customers) is for a period 1.1 years, while the asset of the bank (loan given to a
company) is for a tenor of 2 years. There is also an asset-liability mismatch from an interest rate perspective
since the liability of the bank (deposits from customers) is at a fixed rate, while the asset of the bank (loan given
to company) is at a floating rate.
At the end of 6th month, bank will return INR 40,000 to the depositor along with the interest. At this moment, if
the prevailing interest rate for a 6-month deposit is 7.25%, bank will have to accept a deposit of INR 40,000 at
7.25%. Hence, the new weighted average rate of bank’s liability will be 6.95%. At the same time, the interest
rate on the asset of the bank (loan given to a company) will also change to the prevailing rate, which is 7.25%.
This reduce the net interest income to only 0.3%.
Since banks are exposed to interest rate risk on both assets and liabilities, interest rate exposure for a bank
refers to the current or prospective risk to the bank’s earnings or net interest income (lending rate − borrowing
rate) arising from adverse movements in interest rates.
Interest rate risk management for a bank revolves around managing duration of its assets and liabilities, also
called asset–liability management. Banks usually aim at matching its asset durations to those of the liabilities to
manage overall effect of interest rates.1
4 Risk mitigation techniques and instruments

4.1 Internal
4.1.1 Diversification
In this approach of interest rate risk management, banks will lend some loans at a fixed rate and some loans at
a floating rate. Hence in event of interest rate fall, fixed rate loans will continue to earn more interest while the
bank’s interest income will be negatively impacted only on floating rate loans.
4.2 External
Some of the external derivative hedging instruments for interest rate are similar to the ones used for managing
foreign exchange risk such as Interest rate futures and interest rate options. Interest rate swaps 2 are similar to
forward contract. Hedging instruments unique to managing interest rate risks are Forward rate agreement, Caps
and floors3
4.2.1 Interest Rate Futures (IRF)
The Insurance Company ABC has guaranteed a fixed return to its policy holder for policy term of 10 year. The
policy holder will pay an annual premium of INR 2 crore for a tenor of 10 years. The premium will be paid by the
1
Duration has been explained in detail in the Managing risk and return through financial instruments module.
2
Interest rate swaps has been explained in detail in the Managing risk and return through financial instruments
module
3
Forward rate agreement, Caps and Floors have been explained in detail in the Managing risk and return
through financial instruments module

policy holder every year. The insurance company is exposed to falling interest rate because it faces uncertainty
with respect to generating the guaranteed return on each yearly insurance premium.
Hence the Company ABC entered into IRF to protect its interest rate risk.
A typical deal life cycle for an IRF contract undertaken by the insurance company is explained below.
FIGURE 1.21: Snapshot of IRFs and their Contract Specifications Listed on the NSE
Step #1: Deal execution

This step involves company ABC identifying the required IRF. Following are the specific features of the selected
IRF:
IRF Security Maturity IRF Purchase Number IRF Purchase Number of Trade IRF Maturity
Bucket Date of Lots Price Bonds in a Value Date
Lot
717GD202828- 8–10 3 October 1,000 97.5 2,000 INR 28
Nov-2019 years 2019 19.5 November
crore 2019
Step #2: Open position limit

A regulatory requirement for trading in IRFs requires that the gross open positions of the trading member
(company ABC) across all contracts within a specific maturity bucket shall not exceed 10% of the total open
interest in the said maturity bucket or INR 600 crore, whichever is higher.
Open Interest on 1 Maximum Possible Open Outstanding IRF Trades Remainder Limit Trade
October 2019 for the 10- Interest Position (1) for Company ABC on 1 Available (in INR Amount (in
Year Maturity Bucket October 2019 (in INR crore) (1 − 2) INR crore)
(INR crore) crore) (2)
1,400 Higher of INR 140 crore 300 300 19.5
or INR 600 crore

Maximum limit for IRF contracts for company ABC was INR 600 crore (higher of 140 or 600) and the utilised
limit was INR 300 crore; therefore, company ABC had a remaining available limit of INR 300 crore. Since the
trade value in step #1 was of only INR 19.5 crore, the available limit was not breached.
Step #3: Initial margin and brokerage
In futures trading, a margin amount needs to be deposited with the exchange. Assuming the required initial
margin is 2% of the trade value:
Initial Margin posted with the exchange = INR 19.5 * 2% = INR 0.39 crore
Every transaction is routed through a broker charging a brokerage basis the size of the trade. Assume the
brokerage house charges INR 500 per crore of the transaction size.
Total Brokerage Paid = INR 20 * 500
= INR 9,750
Note: Trade value of 19.5 crore is rounded up to 20 crores for the purpose of brokerage calculation
Step #4: Daily MTM and month-end gain/(loss)
In futures trading, there will be a daily mark-to-market of the trade. Below table shows the price shift in the 3
days following purchase of the contract and corresponding gain/(loss) and changes in initial margin posted:
FIGURE 1.22: 3-Day MTM Snapshot
Step #5: Contract expiration at maturity date

Due to daily MTM, at expiration, the price at previous accounting date needs to be compared with the settlement
price at maturity to arrive at the net gain/(loss) amount.
FIGURE 1.23: MTM at Contract Expiration
Expiration price is highlighted in yellow.

Therefore, at expiration, the incremental gain/(loss) accounted for is INR 120,00, which leaves a balance of INR
0.306 crore in the margin account for company ABC.

III Commodity risk management
1 Introduction to commodity price risk

Commodity risk, also termed as commodity price risk is the is the financial risk for the buyer or seller of
commodity arising out of fluctuating commodity prices. Prices of commodities, whether raw materials or finished
products, are exposed to fluctuations in the market and these changes in commodity prices can adversely affect
the books of account (accounting exposure) and/or impact the future cashflow (forecasted or cashflow
exposure) of the company. Commodity price risk has similar impact to foreign exchange risk explained in Section
1 (2.1) in the Foreign exchange risk management.
Commodity price risk is driven by the decentralised market forces which are beyond a company’s control.
Increased volatility in the commodity prices can create significant challenges for a corporate leading to an impact
on the profitability, credit availability, product pricing, earnings and production costs.
2 Exposure to commodity price risk

As mentioned above, commodity price risk can affect the buyer as well as seller of any commodity depending on
the fluctuation of either the price of the raw material used, or the finished product sold (or both). First let us
look at this from the perspective of an individual. An event impacting the global supply of gasoline eventually
leads to a rise in the retail price of petroleum. An individual is exposed to commodity price risk since increasing
crude prices will result in higher petrol prices for the vehicle. Due to rise in petrol price, the fare of public
transports or taxis also increase. This is a micro level example of commodity price risk.
Corporates having exposure to a commodity price risk can be classified into two categories:
 Producer of a commodity
 Consumer of a commodity
It is important to remember that the producer of one (or more) commodity can also be the consumer for another
and therefore, one corporate/sector can have different exposures in different commodities.
2.1 Producer of a commodity

Operating sectors which are involved in the business of obtaining (e.g. minerals and metals) and/or producing
(e.g. agricultural products) commodities are termed as producers of a commodity. Some examples of commodity
producing sectors and companies are as follows:
Table 1.32: Examples of Commodity Producers in India
Sector Commodity Company

Metals and Gold, Steel, Coal Tata Steel Ltd., Coal India
minerals Ltd., Vedanta Ltd
Agricultural Wheat, cotton, sugar Balrampur Chini Mills Ltd,
products Dhampur Sugar Mills Ltd.
Energy Oil, electricity ONGC, Ruchi Soya
Commodity producers are exposed to decline in prices which would impact their revenues from the sale of the
commodity that they produce.
2.2 Consumer of a commodity
The producer of the commodity will sell the commodity to a buyer, who will either use it as raw material to make
a finished product or consume the commodity as the finished good. From an understanding perspective,
consumers are all entities which use the commodity in some form. Thus, an individual using fuel in his/her private
vehicle as well as a large manufacturing company using fuel for the running its factory are termed as consumers.
However, an individual consumer is rarely a major player in the national or global commodity markets and for

the purpose of further discussion, we shall term commodity consumers are corporates who have a exposure in
different commodities.
Following are some examples of sectors and commodities which are large consumers for mentioned
commodities:
Table 1.33: Examples of Commodity Consumers in India
Sector Commodity Company

Airlines, Oil, gas, coal Interglobe Aviation Ltd.,
Transportation NTPC Ltd.
Food and Wheat, sugar ITC Ltd., Amul India
beverages
Textile Cotton Raymond Ltd., Arvind Ltd
Commodity consumers are exposed to an increase in the price of the commodity which would in turn increase
the cost of finished goods, thus, impacting profit margins on the finished goods.
3 Financial impact of commodity price risk

From the above section on producers and consumers of commodities, we can conclude that any industry
involved in purchase or sale of tangible commodities is exposed to the volatility in price of the specific
commodity. The side on which the exposure lies as well as the quantum of exposure is dependent on the position
of the industry in the finished products value chain and the commodity variants/substitutes available.
Following table outlines the financial impacts resulting from the rise and fall in commodity prices, on the major
business growth drivers for producers and consumers:
Table 1.34: Impact of rise and fall in commodity prices on growth drivers for commodity producers and
consumers
Growth drivers Producers of commodity Consumers of commodity
Revenue  Fall in price: Reduces the selling price
per unit for the producer leading to an
overall decline in revenue No impact
 Rise in price: Increased sales value
due to a higher price per unit of sale
Purchase/Cost of  Fall in price: Reduces the cost of
Goods Sold (COGS) purchasing the raw material
leading to a reduction in the cost of
goods sold
No impact
 Rise in price: Increases the cost of
goods sold via higher purchasing
price for the raw material
commodity
Profitability/Earnings  Fall in price: Lower revenue with no  Fall in price: Lower COGS due to
impact on COGS leads to lower reduced input cost leads to
earnings increase in profitability
 Rise in price: Higher revenue with  Rise in price: Higher COGS
consistent COGS leads to higher adversely impacts gross and net
profitability and earnings margins, thus, reducing earnings

Inventory  Fall in price: Net realisable value of  Fall in price: After buying the
finished goods inventory declines commodity, if price falls, there is an
constraining future profitability and opportunity loss of holding the
cash flows inventory at higher price.
 Rise in price: Net realisable value of  Rise in price: After buying the
finished goods inventory increases commodity, if price rises, there is
leading to a rise in future sales, an opportunity gain of holding the
profitability and cash flows inventory at lower price
4 Nuances of commodity markets

4.1 Spot price
Commodity spot prices are a factor of basic demand and supply factors existing in the market. Demand is
impacted by commodity value to local and global end-users whereas supply is a factor of production and storage
feasibility and costs and existing inventory levels with producers and distributors.
The price of a commodity is also dependent on factors such as quality grade (price of 24 carat gold is different
from price of a 22 carat gold) or its location of delivery (price of 24 carat gold in one city can be different from
another city due to transportation cost).
4.2 Benchmark price

Since quality grade and location of delivery for every commodity will differ, stock exchanges where commodities
are traded have standardized a benchmark quality grade and location for each commodity. The prices quoted in
financial markets are for these benchmarked commodities, which have a standard quality grade, location
delivery etc. If there is a change in quality grade or location, a relevant premium or discount is applied.
Below is a table showing the benchmark underlying for some of the actively traded commodities globally are
London Metal Exchange (LME) and Multi Commodity Exchange (MCX):
Table 1.35: Underlying Commodity Benchmark for Actively Traded Commodities – Globally and India
Type Commodity International Benchmark on international Benchmark on Multi
Exchange exchange Commodity Exchange
(MCX)
Aluminium High grade primary Primary aluminium ingots
aluminium with minimum purity of
99.70%
Copper GRADE A copper Grade 1 electrolytic copper
Base London Metal as per B115 specifications
Metals Exchange (LME)
Nickel Nickel Primary Nickel Cathode
Zinc Special high-grade Zinc Primary High-Grade Zinc
Lead Lead Lead Ingots
Crude palm Bursa Malaysia BMD operates the world Indian Crude Palm Oil
oil Derivatives benchmark for crude palm oil futures bear a strong
futures (FCPO) and option on correlation with BMD futures
Energy the FCPO contract (OCPO) at 94%
WTI, Brent New York Light sweet crude oil Light sweet crude oil with
Mercantile specifications: sulphur
Exchange (0.42%); API gravity (37–42
(NYMEX) degree)

Agriculture Corn Chicago Corn futures Maize rabi
Mercantile
Exchange (CME)
4.3 Futures price

Since commodity is a physical asset, storage costs play a very important role in determining its future period
price4. For example, a metric ton of wheat purchased today by a flour-producing company leads to blocking
funds in the inventory and incurring storage costs by the company. On the other hand, a wheat futures contract
for the same quantity is a financial asset which can be later used to purchase the physical asset, thus enabling
the firm to release funds blocked in inventory and avoid storage costs.
Futures Price ≈ Spot Price * (1 + Risk-Free Rate) + Storage Cost
Here, (1 + Risk-Free Rate) depicts the funds which become available due to entering a futures contract versus
an outright purchase in the spot market.
Storage cost increase the cost of the commodity to the producer thus, has a positive effect on the futures price.
Continuing on the example of a wheat producer mentioned above. A wheat contract specifying delivery date for
100 tonnes of wheat at a date 3 months in the future leads to a storage cost incurred by the producer for a
period of 3 months which is added to the final price which shall be paid by the long position in the contract.
However, sometimes, there is an additional benefit accrued from holding inventory than from a futures contract.
For example, if there is an expectation of political uncertainty increasing in the Middle East, oil supply could be
impacted. Thus, there is a benefit in holding inventory of crude over the futures. This additional benefit is priced
into commodity futures pricing via “Convenience Yield”.
Futures Price ≈ Spot Price * (1 + Risk-Free Rate) + Storage Cost – Convenience Yield
4.4 Contango
Contango is a situation in which a commodity’s future prices are higher than its current spot prices. The curve
representing forward prices is upward sloping, that is, future contracts are trading at a premium price than spot
transactions are. Few of the reasons for contango are high storage costs of commodity, inflation or expectation
that prices will be higher in the future.
FIGURE 1.24: Futures Prices in a Contango Market
4.5 Backwardation
In a situation when a commodity’s futures prices are lower than the spot prices, the futures curve is downward
sloping and it is called backwardation. A higher convenience yield, that is, higher benefit incurred from physically
owning a commodity inventory (and begin output processing) than its associated storage costs can lead to
futures price being lower than spot prices. A typical reason for backwardation can be a current shortage of
4
As explained in the module on Introduction to Financial Markets

commodity and hence higher demand, while the production in future is expected to be higher, which will increase
the supply of the commodity.
FIGURE 1.25: Futures Prices in a Backwardation Market
5 Spread in commodity markets

In parlance of a financial and physical markets, a spread can be defined as the difference between two
product/listed price, coupons or yield rates. For example, a bid-ask spread the difference between the bid
(purchase) and ask (sale) prices for a given financial or physical asset. The below table outlines the spreads
pertaining to the commodity markets:
Table 1.36: Major Type of Spreads in Commodity Market
Spread Description
Commodity It is the difference between the price of the raw material of a commodity and the price of
product the finished good created from the said raw material. It is also termed as processing spread
spread Such spreads are commonly seen in case of energy and agricultural products industry.
Some examples of commodity spread are:
 Crack spread – A term used in the oil sector. It is the difference between per barrel rate
of crude oil and the petroleum products such as gasoline, heating oil, etc. derived from
the crude oil.
 Crush spread – A common term in the agricultural sector, crush spread is the difference
in the price of soybeans (futures) and the price of the soybean oil (futures).
 Spark spread – Spark spread is used among electricity producers and is defined as the
difference between the price of natural gas used in production of electricity and the price
per unit from sale of electricity. It is a standard metric used to determine the profitability
of electricity generation via a natural gas generator.
Location This spread depicts the difference in prices of the same commodity posted at two different
spread locations/exchange. For example, Silver prices for listed in Mumbai and in London. The
difference between the price quoted in these places is known as the location spread. Note:
the price difference should be taken in one currency (mostly USD)
Quality spread Same commodity can vary in terms of its quality. The price of commodity will defer based
on the quality parameters. In case of gold - the quality of gold is measured in carats and
there are alternatives such as 20, 22, 24 carat gold, etc. The price of 22 carat gold is
different from price of 24 carat gold in the same location. Similarly, coffee is an example in
agricultural products wherein different variants of coffee such as Arabica and Robusta
coffee are traded at different prices for the same location. The difference between the
price of two variants of the same commodity is termed as quality spread.

6 Commodity Market Risks
Apart from the risks associated with the financial markets such as operational, liquidity, counterparty,
geopolitical risk, etc., following are few of the risks specific to the commodity markets arising out of the physical
nature of the asset as well as the availability of derivative products on specific commodities.
6.1 Commodity – Forex price risk

Forex-commodity price risk is the risk arising out of the volatility of commodity prices and corresponding FX rate
in which the commodity price is denoted. Let us try to understand this with an example of an Indian coffee
importer ABC Co. who enters into a contract to import 1000 kgs of coffee in 3 months and payment is to be
made on the day on delivery:
Table 1.37: Example of Commodity – Forex Price Risk
Date Transaction FX Exposure Cash outflow
1st Dec Enters into a contract. Forecasted: USD/INR: INR 70/USD
Payment is to be done on 1st $100 X 1000 kgs = $ 100,000 X 70
March. = $100,000 =INR 7,000,000
Current price of coffee is $100 (Estimated)
per kg
1st Coffee price increases to $120 Actual: USD/INR: INR 75/USD
March per kg $120 X 1000 kgs = $ 120,000 * 75
= $120,000 = INR 9,000,000 (Actual)
As it can be seen from the above example, for a consumer of coffee ABC Co. cash outflow increased from INR
7,000,000 to INR 9,000,000 because of the increase in commodity price as well as depreciation of the local
currency. This combination of exposure is termed as commodity-forex risk.
6.2 Basis risk
Basis price is the difference between the spot price and futures price of the same commodity. The spot price is
the cash price for purchase of the commodity today whereas the futures price is the price of a futures contract
on the same commodity for settlement at a later date. The factors impacting the price of a futures contract are
the spot price of the commodity plus the on-going risk-free rate, storage costs, etc. Thus, there is a difference
in the physical commodity and a derivative contract on it. This difference between the physical asset and a
financial asset used for hedging the physical asset it is termed as basis risk.
Let us take the example of a trader in the gold market. He buys gold in the spot market today and takes a short
position in a gold futures contract requiring physical settlement expiring after a period of 3 months. The spot
rate for an ounce of gold is $1477 and the futures prices is $1480 per ounce. In this case, the basis risk arises
out of the difference in the physical asset (gold) and the financial asset (gold futures). Basis risk = Spot price –
Futures price = $1477 - $1480 = $3 per ounce.
Managing basis risk and understanding the working and nuances of basis behaviour is essential to capture
profitable trading opportunities. As mentioned above, the price behaviour of a hedging instrument differs from
that of the physical commodity due to the factors involved in pricing of the hedging instrument. Therefore,
evaluating the basis risk is essential.
6.3 Freight risk
In international trading of commodities, the cost of shipping is an essential contributor to determine trade
profitability, especially in case of finished goods having low margins. Freight rates depend upon demand and
supply factors, the commodity being shipped. In order to protect against the risk of rising freight costs,
commodity traders fix the leasing costs in advance using freight derivatives. Generally, Freight Forward
Agreements (FFA) handle this where the commodity trading firms are the usual charterers, and therefore, the
usual buyers of the agreement.

FFAs are used by trading firms to safeguard themselves against fluctuating freight rates. Being natural sellers,
the ship owners intend to protect themselves against the falling freight rates in the future.
For instance, a commodity trader fears that the shipping rates might rise. He wants to lease a tanker within 15
days to transport his cargo of crude for a period of 30 days to a specific location. He may decide to buy an FFA
and thus lock the current freight rate of $19,000 a day.
Suppose, for instance, the fear proves right and the average rate for the same month reaches $22,000 a day.
Here, the FFA safeguards him. Since the average price is above the agreed FFA price, the FFA buyer will receive
the difference multiplied by the number of days of the agreement:
$22,000 − $19,000 = $3,000 × 30 days = $90,000
On the other hand, the charterer is saved from the increased freight price he might have had to pay in the
absence of an FFA. For the ship owner (the counterpart), the contrast happens as a gain on the freight price is
negated by the loss on the FFA. But, with the derivative in place as above, and the cash flow being stabilised,
neither party is worse off or better off.
7 Risk Mitigation Techniques and Instruments

Risk management is elemental in case of commodity risk as is in the case of foreign exchange and interest rate
risk. Furthermore, commodity price risk directly affects the operationality of a business making it imperative to
manage it as effectively as possible. In this section, we shall look at the internal and external
methods/instruments used for mitigating commodity risk from a business.
7.1 Internal hedging methods
Due to the varying impact of commodity price movement on different drivers such as revenue, profitability, etc.
(discussed above under section3), the internal methods of risk management vary between producer and supplier
of commodities.
In case of a producer of commodity, fluctuations in prices directly impacts the revenue. Risk management
techniques for a producer can be diversification, flexibility in manufacturing/production, defined production
contracts, pooling and storing. Let us look at each of them in detail:
7.1.1 Diversification
Diversification involves taking exposure in production of more than one commodity (generally related) in order
to diversify and thus, reduce any impact from adverse price movement arising due to price of one commodity.
For example, domestic jewellery manufacturers/retailers generally diversify business by selling jewellery made
out of gold, silver and other precious metals with the intention of minimising the overall impact of decline in the
global price of one precious metal (e.g. gold price decline).
However, diversification has economic costs associated with it such as lower efficiencies arising out of increased
machinery or labour requirements and lower economies of scale. In case of the jewellery manufacturer example,
due to diversification into more than one precious metal, the manufacturing firm will require the labour and/or
machinery to work different metals which adds costs to the overall operations of the business while hedging
against metal price movement
7.1.2 Production contracts and Storage
These methods are useful for managing the price risk faced by commodity producers. Production contracts are
similar to order placed by buyers wherein a price and quantity can be fixed for immediate delivery or for an
extended term of the contract. The producer must deliver the specified quantity at the locked-in price in the
contract.
Storage is another key method of managing price risk. In case of producers, in times of excess global production,
price of the commodity can reduce due to the increased supply of commodity. At such times, inventory can be
stored for sale in the future date when prices rise, thus, managing the net realisable value recovered from the
entire production.

Consumer of commodities face different problems when compared to producers of commodities. Such sectors
have employed one or more of the following techniques to manage commodity price risks:
7.1.3 Supplier Negotiation
This method involved enhanced negotiation with commodity suppliers to arrive at a better (lower) purchase price
per unit of the raw material either from larger purchase volume or usage of alternative products.
7.1.4 Alternative Sourcing
Alternative sourcing involves identifying alternative commodities (substitutes) or alternative sources of
procurement for the same commodity from suppliers for key raw materials used by the consumer’s
business/company. It can also lead to sourcing the commodity from a new supplier. Alternative sourcing involves
a regular review of the procurement process and implementing enhancements on the same.
7.2 External hedging methods

Apart from the hedging products explained in above section such as forwards, futures and options, external
hedging techniques specific to commodity market are commodity swap and proxy hedge.
7.2.1 Commodity swap
A commodity swap is a contract which involves the two parties to the contract agreeing to exchange cash flows
dependent on the price of an underlying commodity or commodity index. Usually, commodity swaps are
implemented to protect or hedge against the price movement of a commodity. This contract has been in trade
since the mid-1970s through over-the-counter markets. Commodity swaps involve a floating-leg component and
a fixed-leg component. The floating-leg component is tied to the market price of the underlying commodity or
the mutually agreed-upon commodity index. On the other hand, the fixed-leg component is specified in the
contract. Most commodity swaps are based on oil, though any type of commodity may be considered. This
includes precious metals, industrial metals, natural gas, livestock and grains. Having considered the nature and
sizes of the contracts, large financial institutions would engage in these commodity swaps rather than individual
investors.
7.2.2 Proxy hedge

A problem for commodities which are not commonly used or in case of countries whose physical asset markets
are not developed is the lack of availability of a direct hedging instrument. Proxy hedge is a hedge taken in one
commodity to protect commodity price risk of another similar commodity since no direct hedging instrument is
available. It is imperative that prices of both the commodities are corelated to each other or are impacted by
similar factors in order for the proxy hedge to be effective.
Under direct hedge, to hedge an exposure to crude oil, a oil refining company in India takes position in crude oil
futures listed on the MCX. However, under proxy hedge, an Airline company which requires jet fuel for operation
may not find futures or options on jet fuel listed on the exchange. In such times, the airline company can take a
proxy hedge in crude oil futures since jet fuel is derived from crude oil and therefore, its price is related to the
of the crude oil.

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Financial risk

CAFTA – Finance with Finesse

Financial risk management 2

Financial risk management 3

I Foreign exchange risk management

1 Understanding nuances of currency terminology

1.2 Foreign currency

1.3 Presentation currency

Financial risk management 4

2.1.1 Accounting exposure

Financial risk management 5

2.1.1.2 Exposure due to consolidation of accounts

Financial risk management 6

2.2 Defining a benchmark rate for FX exposure

2.2.1 Benchmark rate for balance sheet exposure

Financial risk management 7

Period EUR/INR Remarks Restatement Gain/Loss

18 80 Asset of INR 800 million (EUR 10 million × 80) is

Financial risk management 8

Particulars Month 1 Month 2 Month 3

In INR 700 800 900

B. Cost of goods sold (COGS)

In INR 140 160 190

C. Salary and admin expenses (in INR) 100 155 175

D. Sales and promotion expenses (in 150 145 160

Particulars Month 1 Month 2 Month 3

In INR 700 800 900

USD sales in INR (USD sales * 70) 350 490 630

B. Cost of goods sold (COGS)

In INR 140 160 190

C. Salary and admin expense (in INR) 100 155 175

D. Sales and promotion expenses (in 150 145 160

Financial risk management 9

2.2.2.3 Historical average rate

2.2.2.4 In-house forecasted FX rate

Financial risk management 10

3 Risk mitigation techniques and instruments

3.1.1 Invoicing in home currency

3.1.2 Natural hedging

Financial risk management 11

3.1.3 Netting of exposure

Date Import Export

Net Import = (10 + 8 + 12) – (6 + 14)

3.1.4 Leading and lagging approach

Financial risk management 12

Check the market rate

Financial risk management 13

Obtain quote from bank

Execute the transaction

Confirm the transaction

Record the transaction

Financial risk management 14

Check the market rate

Financial risk management 15

Execute the transaction

FIGURE 1.9: Snapshot of an Online Platform for Currency Futures

Record the transaction

Financial risk management 16

Check the market rate

Financial risk management 17

Obtain quote from bank

The three banks give the below mentioned quote:

Bank Name Spot Notional Strike Maturity Premium Premium