Case: Derivative-in-Disguise

FINANCIAL RISK MANAGEMENT

SUBMITTED TO-Dr. JAIDEEP SHARMA SIR

PRESENTED BY: GRPUP- ‘3’

ROHAN KUMAR (22GSOB2010974)
SAHEB ALI (22GSOB2010897)
NEELU LAMGADE (22GSOB2010946)
SHALU RANJAN (22GSOB2010947)
SHUBHAM KUMAR (22GSOB2010975)
SUSHANT SINGH (22GSOB2010765)
Outline:
• INTRODUCTION OF THE CASE
• SUMMARY OF THE CASE
• WHAT TYPE OF A DERIVATIVE IS THE FIRM SELLING?
• WHAT IS THE PREMIUM CHARGE BY THE FIRM FOR THESE DERIVATIVES?
• ASSUMING THE FIRM GOES AHEAD WITH THE ABOVE SCHEME, WHAT ARE
THE IMPLIED FORECASTS MET BY THE FIRM ABOUT THE FUTURE GOLD
PRICES?
• DERIVATIVE TRADERS ALWAYS LOOK OUT TO GRAB ARBITRAGE
OPPORTUNITIES.DOES THE ABOVE SCHEME PROVIDE ANY HIDDEN
ARBITRAGE OPPORTUNITIES?
• SHOULD THE FIRM ALLOW EARLY EXERCISE BY THE CUSTOMER i.e. IF THE
CUSTOMER BOOKS THE JEWELLERY AND TURNS UP AT THE SHOWROOM,SAY
15 DAYS BEFORE THE ACTUAL PURCHASE DATE, CAN THE FIRM ADVANCE THE
PURCHASE DATE OF THE CONTRACT?
SUMMARY OF THE CASE:
• In the current unpredictable environment of fluctuating oil and gold prices, a leading jewelry
chain in India has devised an innovative scheme to address the concerns of middle-class Indian
customers who encounter conflicting predictions about commodity prices. The scheme allows
customers to lock in gold rates for their future purchases up to two months in advance. The
amount to be paid in advance depends on the booking period, ranging from 10% for a 10-day
advance booking to 60% for a 60-day advance booking. Importantly, if the gold rate at the time
of purchase is lower than the rate at the time of booking, customers will be charged the lower
rate.The jewelry chain believes that this novel scheme will attract customers, especially during
the upcoming marriage season when demand is typically high. It targets customers planning to
buy a significant amount of gold within a two-month window who are concerned about
potential price increases. Additionally, the scheme can benefit the company by increasing
advance bookings and freeing up working capital tied up in inventory.Mr. Ashish, a recent
MBA graduate in the company's Finance team, recognizes similarities between the scheme and
hedging strategies he learned during his Derivatives course. His boss encourages him to
explore this further and provides a set of questions to fine-tune the scheme before its launch.
She views this as an opportunity for Ashish to apply his knowledge to practical situations and
enhance his appraisal document for the year.This case highlights the jewelry chain's innovative
approach to addressing customer concerns in a volatile market and Mr. Ashish's opportunity to
leverage his derivatives knowledge to refine the scheme. It underscores the value of integrating
financial concepts like hedging into marketing strategies.
WHAT TYPE OF A DERIVATIVE
IS THE FIRM SELLING?

The firm is essentially selling a financial

derivative known as a "Forward Contract."
In this case, it's a gold price forward
contract. Customers are essentially locking
in the future purchase price of gold by
booking in advance.
WHAT IS THE PREMIUM CHARGE BY
THE FIRM FOR THESE DERIVATIVES?

The premium charged by the firm is the

percentage of the total purchase amount
required as an upfront payment. The
premium ranges from 10% for a 10-day
advance booking to 60% for a 60-day
advance booking.
ASSUMING THE FIRM GOES AHEAD WITH THE
ABOVE SCHEME, WHAT ARE THE IMPLIED
FORECASTS MET BY THE FIRM ABOUT THE
FUTURE GOLD PRICES?

Implied volatility is the market's forecast of a likely movement in a

security's price. It is a metric used by investors to estimate future
fluctuations (volatility) of a security's price based on certain predictive
factors. Implied forecast is denoted by the symbol σ (sigma)
By offering this scheme, the firm is implied forecasting that gold prices
are expected to increase in the future. This expectation is based on the
fact that customers can secure a lower rate by booking in advance,
protecting themselves against potential price hikes.
DERIVATIVE TRADERS ALWAYS LOOK OUT TO GRAB
ARBITRAGE OPPORTUNITIES.DOES THE ABOVE SCHEME
PROVIDE ANY HIDDEN ARBITRAGE OPPORTUNITIES?

Yes, there could be hidden arbitrage opportunities. If customers anticipate a significant

rise in gold prices and lock in rates at a lower premium, they can potentially profit if
prices increase substantially before the purchase date.
The scheme provides the investors with arbitrage opportunities involving buying and
selling the assets in different market arenas. They aim to take advantage of price
differences and generate profits. It is evident in how the company describes the jewelry
purchase rate, which tells them as an advantage to the buyer during the biking time. It
depicts that in the future, there might have different rates which set the sellers on
profits in the markets. The firm should allow the customers to exercise before the actual
purchase dates. The firm can also advance the purchase dare of the contracts.
SHOULD THE FIRM ALLOW EARLY EXERCISE BY THE
CUSTOMER i.e. IF THE CUSTOMER BOOKS THE
JEWELLERY AND TURNS UP AT THE SHOWROOM,SAY 15
DAYS BEFORE THE ACTUAL PURCHASE DATE, CAN THE
FIRM ADVANCE THE PURCHASE DATE OF THE CONTRACT?

• Allowing early exercise of a purchase contract is a business decision that depends on the firm's policies and agreements with
customers. If the firm permits early exercise, it could benefit from increased customer satisfaction and loyalty. However, there
are potential considerations:

1. Inventory Management: Allowing early exercise may affect inventory management. The firm would need to ensure that it
has the items in stock earlier than initially planned.

2. Cash Flow: Early exercise might impact the firm's cash flow, as revenue would be recognized sooner.

`3. Contractual Agreements: The firm should review its contracts and terms with customers to ensure they Send a message Free
Research Preview.

4. Additional Costs: Depending on the nature of the jewelry, there could be additional costs, such as storage, security, and
insurance, if items are held in stock for a longer period.

5. Customer Communication: Clear communication with customers about the terms and implications of early exercise is crucial .
Ultimately, the decision should be made after considering the firm's operational capabilities, financial implications, and customer
expectations. Legal and financial advisors can provide specific guidance based on the firm's situation.
What are the potential risks to the firm once this scheme is launched ? If there are any ,how
should the firm hedge its expousres ?

• The main risk to the firm is that if gold prices fall significantly after customers lock in their rates, the
firm will be stuck purchasing gold at a higher cost than the market price. To hedge this risk, the firm
could consider buying financial instruments like gold futures contracts to offset potential losses.

1. Regulatory and Legal Risks: Engaging in deceptive or fraudulent practices in the derivatives market
can lead to severe legal consequences, including fines, penalties, and legal actions.

2. Reputation Damage: If the scheme is discovered, the firm's reputation may be irreparably damaged,
leading to a loss of trust from clients and partners.

3.Counterparty Risk: The firm may face counterparty risk if counterparties become aware of the deception,
leading to disputes and potential financial losses.

4. Market Risk: Derivative positions can be highly sensitive to market fluctuations. If the market moves
against the firm's positions, it could result in substantial financial

5. Ethical Practices: Encourage ethical behavior and a strong corporate culture that values honesty and
integrity.
Thank you