Risk Management Basics

By
Pof. Trilochan Tripathy, XLRI Jamshedpur
Agenda
• Recap previous lectures
• Last but one lecture
• Views on hedging
• Identify the basic elements and characterstics of Forward and Option
contracts
• Understand forward contracts and its payoffs
• Define European, American options, moneyness, pay offs
• Options, moneyless, pay offs of currency options

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Situations
• Indian manufactures exports jewellery to US, Europe and African
customers. Prices are quoted in Indian currency terms, so fluctuations
in the exchange will have impact on the firm’s cash flows??

• Indian manufactures exports jewellery to US, Europe and African

customers. Prices are quoted in each countries currency terms, so
fluctuations in the exchange will have impact on the firm’s cash
flows??

• How can firm reduce these exchange rate fluctuation risk?

Views on Hedging
• Hedging is irrelevant: Diversified shareholders don’t’ care about firm
specific risk
• But why do some company aggressively hedges?
• For them Hedging creates value: ensures earnings and cash flow
stability, provide future investment needs, reaching targets, and
reduces chance of financial distress
• Examples of gold produces: Homestake, American barrack, Battle mountain
gold
• Oil Producers, Ag. Commodity producer……..
• Corporates with export and import business ( service or commodity)
Currency exposures MNCs ( here GM) face
• Transaction exposure: sales and purchases denominated in FX +
financial exposure and projected capital expenditure
– real economic exposure , value consequences
• Translational exposure: translation of accounting balances to a base
currency (accounting choice)
– post-mortem evacuation no direct value consequences
• Competitive exposure: arises due to changes in competitive dynamics
– real economic exposure , value consequences ( but difficult to identify)
What are the objectives of hedging policy?
What is GM hedging policy?
Basic types of derivatives
• Forward and Futures: This is a contract to exchange an asset in the
forward/futures date and a price.
• Options: Gives the holder the right to buy (call option) or sell (put
option) an asset at a specified price and time.
• Swaps: An agreement to exchange a series of cash flows at a specified
price and time.
Forward Contract
• A forward contract is a commitment to purchase (long) at a forward
date from a seller (short) a given amount of an asset at a price agreed
on today.
• Characteristics of forward contract:
• Customised, non standardised, OTC , no money exchange until delivery,
counter party default risk
• Cash delivery or physical delivery
• Provides perfect hedge
Example of a forward contract
• Current price of wheat per quintal is INR 5000
• A baker needs 1000 quintals of wheat in 6 months
• Baker wants to ensure that 1000 quintals should be available in 6
months
• farmer wants to sell 1000 quintals should be available in 6 months
• 6 M forward contract for 1000 quintal from a wheat producer is
available at INR 5100.
• What should be the decision of the baker ?
• What should be the decision of the farmer
Future is like forward but with certain differences:
Just keep it off from our discussion due to
shortage of time
 Futures Contracts vs. Options
• Forward/Futures Contract – you’ve agreed to
purchase/sell the contract. No backing out. Can
offset/ exit by buying/selling to someone else.
• Buy = long; sell = short.
• Option – contract that gives you the right but not
the obligation to purchase/sell something at pre-
specified terms. No commitment.

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Features of Option and its Types
• Gives right but not obligation to buy/sell amount of an asset (example: currency) @ fixed
price for given time duration
• Call – buyer has right to purchase
• Put – buyer has right to sell
• Buyer = holder & seller = writer.
• Two option types
• American: may exercise during life of option.
• European: may not exercise until maturity.
• Price elements
• Strike (exercise) price: exchange rate @ which foreign currency can be purchased/ sold.
• Premium, price of option
• Spot rate

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Features of Option and its Types Contd.
• Pay Premium (-c) • Receive Premium (+c)
• Right to buy at strike price • Obliged to sell at strike price
(K) but not obliged to do so • Profit from falling underlaying
• Profit from rising asset prices at least to the level of
underlaying asset prices (St) strike (k)
• Limited loss and potential • Limited profit and potential for
for unlimited gain (Pay off) Buy Sell unlimited loss
Call Call

Buy Sell
Put Put • Receive Premium (+p)
• Pay Premium (-p)
• Right to sell at strike price (K) but not • Obliged to buy at strike price (K)
obliged to do so • Profit from increasing
• Profit from falling underlaying asset underlaying asset prices (St) at
prices (St) at least below the level of least to the level of strike (k)
strike (k) • Limited profit and potential for
• Limited loss and potential for huge gain huge loss

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Option Moneyness

• May be classified as:

• At-the-money (ATM): exercise price = spot rate.
• In-the-money (ITM) options profitable, excluding premium, if exercised
immediately.
• Out-of-the-money (OTM) options not profitable, excluding premium, if
exercised immediately.
• Markets for derivatives :
• OTC Market
• Organized exchanges – NSE, MCX
• Option Clearinghouse Corporation

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Option Moneyness
0 0 0 0 0 25 50 75 100
Call Value '0' Call value= St-K
Out of the Money Call In the Money Call
Strike=100
0 25 50 75 100 125 150 175 200
Spot Price of the Underlaying (St)
Spot= 100
In the Money Put Out of the Money Put

Put Value= K-St Put value "0"

100 75 50 25 0 0 0 0 0

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 Profit & Loss Buyer of Call (Long Call)
ATM
Profit
Strike price
CeT = Max[ST - E, 0]
(INR/USD)
OTM ITM
+ 1.00

+ 0.50
Unlimited profit

0 Spot price
67.5 68.0 68.5 69.0 69.5 (INR/USD)
Limited loss
- 0.50
Break-even price
- 1.00

Loss

Profit = Spot rate – (Strike price + Premium)

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 Profit & Loss for Buyer of Put (Long Put)

Profit
“At the money” PaT=PeT=Max[E - ST, 0]
Strike price
(INR/USD)
“In the money” “Out of the money”
+ 1.00

+ 0.50

0 Spot price
67.5 68.0 68.5 69.0 69.5 (INR/USD)
Limited loss
- 0.50
Break-even
price
- 1.00

Loss

Profit = Strike price – (Spot rate + Premium)

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Lets explore Canadian dollar exposure of GM
Spot CAD Stronger CAD Weaker CAD
1.578 1.529082 1.626918

underlaying translational exposure of CAD 2143 2143 2143

USD Values 1358.048162 1401.494491 1317.214512
Pretax impact on GM due to FX move -43.44632924 40.83364988
Sh. Outstanding 550 550
EPS hit/gain -0.078993326 0.074243

50% heding
Spot CAD Stronger CAD Weaker CAD
1.578 1.529082 1.626918
underlaying transaction exposure of CAD 1682 1682 1682
required heding 841 841 841
Excess Cash 660 660 660
Hedge to be in place in CAD 181 181 181
USD Values 114.7021546 118.3716766 111.2533023
Pretax impact on GM due to FX move 3.669521975 -3.44885237
Sh. Outstanding 550 550 550
EPS hit/gain 0.006671858 -0.006270641

Gross impact on EPS -0.072321468 0.067972359

Lets explore Canadian dollar exposure of GM
Spot CAD Stronger CAD Weaker CAD
1.578 1.529082 1.626918

underlaying translational exposure of CAD 2143 2143 2143

USD Values 1358.048162 1401.494491 1317.214512
Pretax impact on GM due to FX move -43.44632924 40.83364988
Sh. Outstanding 550 550
EPS hit/gain -0.078993326 0.074243

75% heding
Spot CAD Stronger CAD Weaker CAD
1.578 1.529082 1.626918
underlaying transaction exposure of CAD 1682 1682 1682
required heding 1261.5 1261.5 1261.5
Excess Cash 660 660 660
Hedge to be in place in CAD 601.5 601.5 601.5
USD Values 381.1787 393.3733 369.7175
Pretax impact on GM due to FX move 12.19457 -11.4612
Sh. Outstanding 550 550 550
EPS hit/gain 0.022172 -0.02084

Gross impact on EPS -0.05682 0.053404

 Thank You
All the best!
For Example…Try at your end
• Suppose that:
• You wish to speculate on fall of Yen vs. $.
• Current S = Yen 120/ $ (or $.00833/Yen).
• Maturity: 90 days.
• Expected S90 = Yen 140/$ (or $.00714).
• Two options available:
Call on Yen Put on Yen
• Strike: Yen 125/$ Yen 125/$.
(or $.008/ Yen) (or $.008/ Yen)
• Premium: $.00046 $.00003

1. What option to buy?

2. Break even price on option of choice?
3. If S= Yen 140/ $, what is net profit?

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