Derivatives As Risk Management Tool For Corporates

Preface
This paper examines the different Derivatives instruments that are being used by corporate to hedge their risk. The economic climate and markets can be affected very quickly by changes in exchange rates, interest rates, and commodity prices. Counterparties can rapidly become problematic. As a result, it is important to ensure financial risks are identified and managed appropriately. The financial markets have created their own way of offering insurance against financial loss in the form of contracts called derivatives. It is necessary for the corporate to have fair estimate of the risk they will run into if conditions become unfavorable. One of the methods of identifying the Value at Risk (VaR) is Monte Carlo Simulation. The study is a sincere effort to understand these problems, analyze them and suggest ways to eliminate the same.
Derivatives as Risk Management Tool for Corporates
Derivatives as a Risk Management Tool for Corporate
Table of Contents
Table of Contents....................................................................................................... 2 1.Introduction............................................................................................................. 4 1.1 Factors that Impact Financial Rates and Prices.................................................6 1.2 Factors that Affect Interest Rates......................................................................6 1.3 Factors that Affect Foreign Exchange Rates......................................................6 1.4 Factors that Affect Commodity Prices...............................................................7 1.5 Transaction Exposure........................................................................................ 9 1.6 Translation Exposure......................................................................................... 9 1.7 Foreign Exchange Exposure from Commodity Prices......................................10 1.8 Strategic Exposure.......................................................................................... 10 1.9 Commodity Risk.............................................................................................. 11 1.10 Credit Risk..................................................................................................... 11 1.11 Operational Risk............................................................................................ 12 1.12 Derivatives.................................................................................................... 12 1.12.1 FORWARDS ............................................................................................. 13 1.12.2 Contingent Claims .................................................................................. 14 1.13 Indian Accounting Practices...........................................................................16 1.13.1 Foreign Exchange Forwards....................................................................16 1.13.2 Accounting of Index Futures....................................................................16 2

1.13.3 Regulatory Framework............................................................................17 1.13.4 Daily Mark to Market............................................................................... 18 1.13.5 Recognition of Profit or Loss....................................................................18 1.13.5 Accounting at Financial Year End............................................................19 1.13.6 Accounting for Derivatives as per FAS 133.............................................19 1.13.7 Derivatives used as hedging instruments...............................................20 1.13.8 Hedge Recognition .................................................................................20 1.14 Indian Market................................................................................................ 21 2.0 Review of Literature........................................................................................... 24 3.0 Data and Methodology....................................................................................... 29 3.1 Data................................................................................................................. 29 3.2 Methodology.................................................................................................... 31 4.0 Analysis and Interpretation................................................................................. 33 4.1 Manufacturing Industry................................................................................... 33 4.1.1 Buyers Credit............................................................................................. 33 4.1.2 Commodities Contract (Gain/Loss)............................................................36 4.1.3 Export Earnings......................................................................................... 40 4.1.4 Investments.............................................................................................. 41 4.2 Banking Sector................................................................................................ 44 4.2.1 Forex Transactions.................................................................................... 44 4.2.2 Currency Swaps......................................................................................... 47 4.2.3 Investments.............................................................................................. 49 4.2.4 Borrowings................................................................................................ 51 4.2.5 Deposits.................................................................................................... 53 4.2.6 Credit Exposure Overseas.......................................................................55 4.2.7 Credit Exposure Domestic.........................................................................58 4.2.7 Currency Derivatives.................................................................................60 4.2.8 Interest Rate Derivative Assets.................................................................63 5.0 Main Findings/Inference...................................................................................... 64 6.0 Scope of Further Research.................................................................................64 7.0 Conclusion.......................................................................................................... 65 8.0 Bibliography....................................................................................................... 66 9.0 Appendix............................................................................................................ 67 3
1.Introduction
Although financial risk has increased significantly in recent years, risk and risk management are not contemporary issues. The result of increasingly global markets is that risk may originate with events thousands of miles away that have nothing to do with the domestic market. Information is available instantaneously, which means that change, and subsequent market reactions, occur very quickly. The economic climate and markets can be affected very quickly by changes in exchange rates, interest rates, and commodity prices. Counterparties can rapidly become problematic. As a result, it is important to ensure financial risks are identified and managed appropriately. Risk refers to the probability of loss, while exposure is the possibility of loss, although they are often used interchangeably. Risk arises as a result of exposure. Exposure to financial markets affects most organizations, either directly or indirectly. When an organization has financial market exposure, there is a possibility of loss but also an opportunity for gain or profit. Financial market exposure may provide strategic or competitive benefits. Risk is the likelihood of losses resulting from events such as changes in market prices. Identifying exposures and risks forms the basis for an appropriate financial risk management strategy. Financial risk arises through countless transactions of a financial nature, including sales and purchases, investments and loans, and various other business activities. It can arise as a result of legal transactions, new projects, mergers and acquisitions, debt financing, the energy component of costs, or through the activities of management, stakeholders, competitors, foreign governments, or weather.
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When financial prices change dramatically, it can increase costs, reduce revenues, or otherwise adversely impact the profitability of an organization. Financial fluctuations may make it more difficult to plan and budget, price goods and services, and allocate capital. There are three main sources of financial risk: Financial risks arising from an organizations exposure to changes in market prices, such as interest rates, exchange rates, and commodity prices Financial risks arising from the actions of, and transactions with, other organizations such as vendors, customers, and counterparties in derivatives transactions Financial risks resulting from internal actions or failures of the organization, particularly people, processes, and systems Financial risk management deals with the uncertainties resulting from financial markets. It involves assessing the financial risks facing an organization and developing management strategies consistent with internal priorities and policies. Addressing financial risks proactively provides an organization with a competitive advantage. It also ensures that management, operational staff, stakeholders, and the board of directors are in agreement on key issues of risk. The passive strategy of taking no action is the acceptance of all risks by default. Organizations manage financial risk using a variety of strategies and products. Strategies for risk management often involve derivatives. There are three broad alternatives for managing risk: Do nothing and actively, or passively by default, accept all risks. Hedge a portion of exposures by determining which exposures can and should be hedged.
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Hedge all exposures possible.
1.1 Factors that Impact Financial Rates and Prices

Financial rates and prices are affected by a number of factors, in turn; impact the potential risk of an organization.
1.2 Factors that Affect Interest Rates

Interest rates are a key component in many market prices and an important economic barometer. They are comprised of the real rate plus a component for expected inflation, since inflation reduces the purchasing power of a lenders assets. Interest rates are also reflective of supply and demand for funds and credit risk. Interest rates are particularly important to companies and governments because they are the key ingredient in the cost of capital. Factors that influence the level of market interest rates include: Expected levels of inflation General economic conditions Monetary policy and the stance of the central bank Foreign exchange market activity Foreign investor demand for debt securities Levels of sovereign debt outstanding Financial and political stability
1.3 Factors that Affect Foreign Exchange Rates

Foreign exchange rates are determined by supply and demand for currencies. Supply and demand, in turn, are
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influenced by factors in the economy, foreign trade, and the activities of international investors. Capital flows, given their size and mobility, are of great importance in determining exchange rates. Some of the key drivers that affect exchange rates include: Interest rate differentials net of expected inflation Trading activity in other currencies International capital and trade flows International institutional investor sentiment Financial and political stability Monetary policy and the central bank Domestic debt levels (e.g., debt-to-GDP ratio) Economic fundamentals
1.4 Factors that Affect Commodity Prices

Physical commodity prices are influenced by supply and demand. Unlike financial assets, the value of commodities is also affected by attributes such as physical quality and location. Commodity supply is a function of production. Supply may be reduced if problems with production or delivery occur, such as crop failures or labor disputes. In some commodities, seasonal variations of supply and demand are usual and shortages are not uncommon. Demand for commodities may be affected if final consumers are able to obtain substitutes at a lower cost. There may also be major shifts in consumer taste over the long term if there is supply or cost issues. Commodity prices may be affected by a number of factors, including:

Expected levels of inflation, particularly for precious metals Interest rates Exchange rates, depending on how prices are determined General economic conditions Costs of production and ability to deliver to buyers Availability of substitutes and shifts in taste and consumption patterns Weather, particularly for agricultural commodities and energy Political stability, particularly for energy and precious metals Major market risks arise out of changes to financial market prices such as exchange rates, interest rates, and commodity prices. Major market risks are usually the most obvious type of financial risk that an organization faces. Major market risks include: Foreign exchange risk Interest rate risk Commodity price risk Equity price risk Other important related financial risks include: Credit risk Operational risk Liquidity risk Systemic risk

The interactions of several risks can alter or magnify the potential impact to an organization. Risks faced by an organization can be broadly classified as
1.5 Transaction Exposure

Transaction risk impacts an organizations profitability through the income statement. It arises from the ordinary transactions of an organization, including purchases from suppliers and vendors, contractual payments in other currencies, royalties or license fees, and sales to customers in currencies other than the domestic one. Organizations that buy or sell products and services denominated in a foreign currency typically have transaction exposure.
1.6 Translation Exposure

Translation risk traditionally referred to fluctuations that result from the accounting translation of financial statements, particularly assets and liabilities on the balance sheet. Translation exposure results wherever assets, liabilities, or profits are translated from the operating currency into a reporting currency. Translation exposure affects an organization by affecting the value of foreign currency balance sheet items such as accounts payable and receivable, foreign currency cash and deposits, and foreign currency debt. Longer-term assets and liabilities, such as those associated with foreign operations, are likely to be particularly impacted. Foreign currency debt can also be considered a source of translation exposure. If an organization borrows in a foreign currency but has no offsetting currency assets or cash flows, increases in the value of the foreign currency vis--vis the domestic currency mean an increase in the translated market value of the foreign currency liability.

1.7 Foreign Exchange Exposure from Commodity Prices
Since many commodities are priced and traded internationally in U.S. dollars, exposure to commodities prices may indirectly result in foreign exchange exposure for non-U.S. organizations. Even when purchases or sales are made in the domestic currency, exchange rates may be embedded in, and a component of, the commodity price. In most cases, suppliers of commodities, like any other business, are forced to pass along changes in the exchange rate to their customers or suffer losses themselves. By splitting the risk into currency and commodity components, an organization can assess both risks independently, determine an appropriate strategy for dealing with price and rate uncertainties, and obtain the most efficient pricing. Protection through fixed rate contracts that provide exchange rate protection is beneficial if the exchange rate moves adversely. However, if the exchange rate moves favorably, the buyer might be better off without a fixed exchange rate.
1.8 Strategic Exposure

The location and activities of major competitors may be an important determinant of foreign exchange exposure. Strategic or economic exposure affects an organizations competitive position as a result of changes in exchange rates. Economic exposures, such as declining sales from international customers, do not show up on the balance sheet, though their impact appears in income statements. The prices of goods exported by the firms competitors, who are coincidentally located in a weak-currency environment, become cheaper by comparison without any action on their part.
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1.9 Commodity Risk
Exposure to absolute price changes is the risk of commodity prices rising or falling. Organizations that produce or purchase commodities, or whose livelihood is otherwise related to commodity prices, have exposure to commodity price risk. Some commodities cannot be hedged because there is no effective forward market for the product. Generally, if a forward market exists, an options market may develop, either on an exchange or among institutions in the over-the-counter market.
1.10 Credit Risk

Credit risk is one of the most prevalent risks of finance and business. In general, credit risk is a concern when an organization is owed money or must rely on another organization to make a payment to it or on its behalf. The failure of counterparty is less of an issue when the organization is not owed money on a net basis, although it depends to a certain degree on the legal environment and whether funds are owed on a net or aggregate basis on individual contracts. Credit risk increases as time to expiry, time to settlement, or time to maturity increase. The move by international regulators to shorten settlement time for certain types of securities trades is an effort to reduce systemic risk, which in turn is based on the risk of individual market participants. It also increases in an environment of rising interest rates or poor economic fundamentals. Organizations are exposed to credit risk through all business and financial transactions that depend on the payment or fulfillment of obligations of others. Credit risk that arises from exposure to counterparty, such as in a derivatives transaction, is often known as counterparty risk.
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1.11 Operational Risk
Operational risk arises from human error and fraud, processes and procedures, and technology and systems. Operational risk is one of the most significant risks facing an organization because of the varied opportunities for losses to occur and the fact that losses may be substantial when they occur.
1.12 Derivatives
The financial markets have created their own way of offering insurance against financial loss in the form of contracts called derivatives. A derivative is a financial instrument that offers a return based on the return of some other underlying asset. Its return is derived from another instrument. As the definition states, a derivative's performance is based on the performance of an underlying asset. It trades in a market in which buyers and sellers meet and decide on a price; the seller then delivers the asset to the buyer and receives payment. The price for immediate purchase of the underlying asset is called the cash price or spot price. A derivative also has a defined and limited life. A derivative contract initiates on a certain date and terminates on a later date. Often the derivative's payoff is determined are made on the expiration date, although that is not always the case. Derivative contracts can be classified into two general categories: Forward Commitments Contingent Claims Within the category of forward commitments, two major classifications exist: Exchanged-traded contracts, specifically futures
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Over-the-counter contracts ( forward contracts and swaps) 1.12.1 FORWARDS The forward contract is an agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset at a future date at a price established at the start. The parties to the transaction specify the forward contract's terms and conditions, such as when and where delivery will take place and the precise identity of the underlying. Each party is subject to the possibility that the other party will default. These contracts call for the purchase and sale of an underlying asset at a later date. The underlying asset could be a security (i.e., a stock or bond), a foreign currency, a commodity, or combinations thereof, or sometimes an interest rate. The forward market is a private and largely unregulated market. Any transaction involving a commitment between two parties for the future purchase or sale of an asset is a forward contract. A Futures contract is a variation of a forward contract that has essentially the same basic definition but some additional features that clearly distinguish it from a forward contract. A futures contract is not a private and customized transaction. Instead, it is a public, standardized transaction that takes place on a futures exchange. A futures exchange, like a stock exchange, is an organization that provides a facility for engaging in futures transactions and establishes a mechanism through which parties can buy and sell these contracts. The contracts are standardized, which means that the exchange determines the expiration dates, the underlying, how many units of the underlying are included in one contract, and various other terms and conditions. Another important distinction between forward contracts and futures contracts lies in the ability to engage in offsetting
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transactions. Forward contracts are generally designed to be held until expiration. A Swap is a variation of a forward contract that is essentially equivalent to a series of forward contracts. Specifically, a swap is an agreement between two parties to exchange a series of future cash flows. One party agrees to pay the other a series of cash flows whose value will be determined by the unknown future course of some underlying factor, such as an interest rate, exchange rate, stock price, or commodity price. The other party promises to make a series of payments that could also be determined by a second unknown factor or, alternatively, could be preset. Swaps, like forward contracts, are private transactions and thus not subject to direct regulation. Swaps are arguably the most successful of all derivative transactions. Probably the most common use of a swap is a situation in which a corporation, currently borrowing at a floating rate, enters into a swap that commits it to making a series of interest payments to the swap counterparty at a fixed rate, while receiving payments from the swap counterparty at a rate related to the floating rate at which it is making its loan payments. The floating components cancel, resulting in the effective conversion of the original floating-rate loan to a fixed-rate loan. 1.12.2 Contingent Claims Contingent claims are derivatives in which the payoffs occur if a specific event happens referred as options. An option is a financial instrument that gives one party the right, but not the obligation, to buy or sell an underlying asset from or to another party at a fixed price over a specific period of time. An option that gives the right to buy is referred to as a call; an option that gives the right to sell is referred to as a put. The fixed price at which the underlying can be bought or sold is called the exercise price,
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strike price, striking price, or strike, and is determined at the outset of the transaction. The payoff of the option is contingent on an event taking place. In contrast to participating in a forward or futures contract, which represents a commitment to buy or sell, owning an option represents the right to buy or sell. To acquire this right, the buyer of the option must pay a price at the start to the option seller. This price is called the option premium or sometimes just the option price.
Figure 1 Derivatives
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1.13 Indian Accounting Practices Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be issued by the Institute of Chartered Accountants of India. 1.13.1 Foreign Exchange Forwards An enterprise may enter into a forward exchange contract, or another financial instrument that is in substance a forward exchange contract to establish the amount of the reporting currency required or available at the settlement date of transaction. Accounting Standard 11 provides that the difference between the forward rate and the exchange rate at the date of the transaction should be recognized as income or expense over the life of the contract. Further the profit or loss arising on cancellation or renewal of a forward exchange contract should be recognized as income or as expense for the period. AS-11 suggests that difference between the forward rate and Exchange rate of the transaction should be recognized as income or expense over the life of the contract. The Standard requires that the exchange difference between forward rate and spot rate on the date of forward contract be accounted. As a result, the benefits or losses accruing due to the forward cover are not accounted. AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange should recognize as income or as expense for the period. 1.13.2 Accounting of Index Futures Internationally, fair value accounting plays an important role in accounting for investments and stock index futures. Fair value is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arms length transaction. Simply stated, fair
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value accounting requires that underlying securities and associated derivative instruments be valued at market values at the financial year end. This practice is currently not recognized in India. Accounting Standard 13 provides that the current investments should be carried in the financial statements as lower of cost and fair value determined either on an individual investment basis or by category of investment. Current investment is an investment that is by its nature readily realizable and is intended to be held for not more than one year from the date of investment. Any reduction in the carrying amount and any reversals of such reductions should be charged or credited to the profit and loss account. On the disposal of an investment, the difference between the carrying amount and net disposal proceeds should be charged or credited to the profit and loss statement. In countries where local accounting practices require valuation of underlying at fair value, size=2 index futures (and other derivative instruments) are also valued at fair value. In countries where local accounting practices for the underlying are largely dependent on cost (or lower of cost or fair value), accounting for derivatives follows a similar principle. In view of Indian accounting practices currently not recognizing fair value, it is widely expected that stock index futures will also be accounted based on prudent accounting conventions. The Institute is finalizing a Guidance Note on this area, which is expected to be shortly released. 1.13.3 Regulatory Framework The index futures market in India is regulated by the Reports of the Dr L C Gupta Committee and the Prof J R Verma Committee. Both the Bombay Stock Exchange and the National Stock Exchange have set up independent derivatives segments, where select broker-members have been permitted to operate. These broker-members are required to satisfy net worth and other criteria as specified by the SEBI Committees.
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Each client who buys or sells stock index futures is first required to deposit an Initial Margin. This margin is generally a percentage of the amount of exposure that the client takes up and varies from time to time based on the volatility levels in the market. At the point of buying or selling index futures, the payment made by the client towards Initial Margin would be reflected as an Asset in the Balance Sheet. 1.13.4 Daily Mark to Market Stock index futures transactions are settled on a daily basis. Each evening, the closing price would be compared with the closing price of the previous evening and profit or loss computed by the exchange. The exchange would collect or pay the difference to the member-brokers on a daily basis. The broker could further pay the difference to his clients on a daily basis. Alternatively, the broker could settle with the client on a weekly basis (as daily fund movements could be difficult especially at the retail level). 1.13.5 Recognition of Profit or Loss A basic issue which arises in the context of daily settlement is whether profits and losses accrue from day to day or do they accrue only at the point of squaring up. It is widely believed that daily settlement does not mean daily squaring up. The daily settlement system is an administrative mechanism whereby the stock exchanges maintain a healthy system of controls. From an accounting perspective, profits or losses do not arise on a day to day basis. Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be recognized in the Profit & Loss Account of the period in which the squaring up takes place. If a series of transactions were to take place and the client is unable to identify which particular transaction was squared up, the client could follow the First In First Out method of accounting. For example, if the October series of SENSEX futures was purchased on 11th October and again on 12th October and sold
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on 16th October, it will be understood that the 11th October purchases are sold first. The FIFO would be applied independently for each series for each stock index future. For example, if November series of NIFTY are also purchased and sold, these would be tracked separately and not mixed up with the October series of SENSEX. 1.13.5 Accounting at Financial Year End In view of the underlying securities being valued at lower of cost or market value, a similar principle would be applied to index futures also. Thus, losses if any would be recognized at the year end, while unrealized profits would not be recognized. A global system could be adopted whereby the client lists down all his stock index futures contracts and compares the cost with the market values as at the financial year end. A total of such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the total is a loss, a relevant provision would be created in the Profit & Loss Account. The actual profit or loss would occur in the next year at the point of squaring up of the transaction. This would be accounted net of the provision towards losses (if any) already effected in the previous year at the time of closing of the accounts. 1.13.6 Accounting for Derivatives as per FAS 133 The standard requires that every derivative instrument should be recorded in the Balance Sheet as assets or liability at fair value and changes in fair value should be recognized in the year in which it takes place. The standard also calls for accounting the gains and losses arising from derivatives contracts. It is important to understand the purpose of the enterprise while entering into the transaction relating to the derivative instrument. The derivative instrument could be used as a tool for hedging or could be a trading transaction unrelated to hedging. If it is not used as a hedging
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instrument, the gain or loss on the derivative instrument is required to be recognized as profit or loss in current earnings. 1.13.7 Derivatives used as hedging instruments Derivative instruments used for hedging the fair value of a recognized asset or liability, are called Fair Value Hedges. The gain or loss on such derivative instruments as well as the offsetting loss or gain on the hedged item shall be recognized currently in income. 1.13.8 Hedge Recognition Accounting treatment for trading and hedging is completely different. In order to qualify as a hedge transaction, the company should at the inception of the transaction:

Designate the hedge relationship Document such relationship Identifying hedge item, hedge instrument and risks being hedged Expect hedge to be highly effective Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be reported in the current financial statements earnings.
Earlier there was no concept of partial effectiveness of hedge. However FASB recognized that not all hedging transactions can be perfect. There can be a degree of ineffectiveness which should be recognized. The Statement requires that the assessment of effectiveness must be consistent with risk management strategies documented for that particular hedge relationship. Further the assessment of effectiveness is required whenever financial statements or earnings are reported.
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1.14 Indian Market
The banking system in India has three tiers. These are the scheduled commercial banks; the regional rural banks, which operate in rural areas, not covered by the scheduled banks; and the cooperative and special purpose rural banks. There are approximately 80 scheduled commercial banks, Indian and foreign; almost 200 regional rural banks; more than 350 central cooperative banks, 20 land development banks; and a number of primary agricultural credit societies. In terms of business, the public sector banks, namely the State Bank of India and the nationalized banks, dominate the banking sector. Scheduled commercial banks constitute those banks, which have been included in the Second Schedule of the Reserve Bank of India (RBI) Act, 1934. These banks enjoy certain privileges such as free concessional remittances facilities and financial accommodation from the RBI. They also have certain obligations like minimum cash reserve ratio (CRR) to be kept with the RBI. Some co-operative banks are scheduled commercial banks albeit not all co-operative banks are. At present the banking system can be classified into following categories: Public Sector Banks Private Sector Banks Co-Operative Sector Banks Development Banks India's manufacturing sector is on an uptrend with the majority of sectors recording positive trends in the first half of fiscal year 2009-10, as compared with the corresponding period in 2008-09, according to a Confederation of Indian Industry (CII) survey. The buoyant manufacturing growth in the first half is led
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by a rise in production of basic goods, intermediate goods and consumer durables. Quarterly estimate of GDP for April-June (Q1) 2009-10, according to the Central Statistical Organization data, for manufacturing stood at US$ 40.85 billion at current prices. According to data, the cumulative growth in the manufacturing index for the period April to September 2009 as compared to the same period last year has been 6.3 per cent. The below extract from the speech of the Deputy Governor shows the derivative transaction volumes taken by the Indian Market Derivative markets worldwide have witnessed explosive growth in recent past. According to the BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity as of April 2007 was released recently and the OTC derivatives segment, the average daily turnover of interest rate and non-traditional foreign exchange contracts increased by 71 % to $2.1 trillion in April 2007 over April 2004, maintaining an annual compound growth of 20 per cent witnessed since 1995. Turnover of foreign exchange options and cross-currency swaps more than doubled to $0.3 trillion per day, thus outpacing the growth in 'traditional' instruments such as spot trades, forwards or plain foreign exchange swaps. The traditional instruments also show an unprecedented rise in activity in traditional foreign exchange markets compared to 2004. Average daily turnover rose to $3.2 trillion in April 2007, an increase of 71% at current exchange rates and 65% at constant exchange rates. Relatively moderate growth was recorded in the much larger interest rate segment, where average daily turnover increased by 64 per cent to $1.7 trillion. While the dollar and euro clearly dominate activity in OTC interest rate derivatives, their combined share has fallen by nearly 10 percentage points since the 2004 survey, to 70 per cent
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in April 2007, as turnover growth in several non-core markets outstripped that in the two leading currencies. Indian Forex and derivative markets have also developed significantly over the years. As per the BIS global survey the percentage share of the rupee in total turnover covering all currencies increased from 0.3 percent in 2004 to 0.7 percent in 2007. As per geographical distribution of foreign exchange market turnover, the share of India at $34 billion per day increased from 0.4 in 2004 to 0.9 percent in 2007. The activity in the Forex derivative markets can also be assessed from the positions outstanding in the books of the banking system. As of August end, 2007, total Forex contracts outstanding in the banks' balance sheet amounted to USD 1100 billion (Rs. 44 lakh crore), of which almost 84% were forwards and rest options. As regards interest rate derivatives, the inter-bank Rupee swap market turnover, as reported on the CCIL platform, has averaged around USD 4 billion (Rs. 16,000 crore) per day in notional terms. The outstanding Rupee swap contracts in banks balance sheet, as on August 31, 2007, amounted to nearly USD 1600 billion (Rs. 64,00,000 crore) in notional terms. Outstanding notional amounts in respect of cross currency interest rate swaps in the banks books as on August 31, 2007, amounted to USD 57 billion (Rs. 2,24,000 crore). The size of the Indian derivatives market is clearly evident from the above data, though from global standards it is still in its nascent stage. Broadly, Reserve Bank is empowered to regulate the markets in interest rate derivatives, foreign currency derivatives and credit derivatives. Until the amendment to the RBI Act in 2006, there was some ambiguity in the legality of OTC derivatives which were cash settled. This has now been addressed through an amendment in the said Act in respect of derivatives which fall under the regulatory purview of RBI (with underlying as interest rate, foreign exchange rate, credit rating or
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credit index or price of securities) provided one of the parties to the transaction is RBI, a scheduled bank or any other entity regulated under the RBI Act, Banking Regulation Act or Foreign Exchange Management Act (FEMA).
2.0 Review of Literature

In the literature on the competitive exporting firm under exchange rate risk, it was typically assumed that the risk averse firms makes its production and export decision prior to the resolution of exchange rate uncertainty (e.g. Benninga et al 1985, Kawai and Zilcha, 1986, Adam Muller 2000).In this case the firm is inflexible since it cannot react on the realized exchange rate. Its profits are linear in the exchange rate. Consequently, the existence of futures contract is sufficient to derive a separation theorem which states that firms production decision is independent of its attitude towards risk and the exchange rate distribution. In an unbiased future market, the firm completely eliminates exchange rate risk by holding a full hedge position. As shown by Lapan al (1991) and Batterman (2000), fairly priced currency options play no role for an inflexible firm. As per the paper The Effects of Derivatives on Firm Risk and Value written by Sohnke M. Bartram, Gregory W. Brown, and Jennifer Conrad although data on derivatives usage are more widely available, the empirical evidence on the effects of derivative use on firms risk and value is still mixed. Using a sample of firms that initiate derivative use, Guay (1999) finds that the total risk, idiosyncratic risk, and risk exposures to interest rate changes of these firms decline, but he finds no significant change in the market risk of these firms.
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In contrast, Hentschel and Kothari (2001) found that the difference in risk for firms that use derivatives is economically small compared to firms that do not use them. Allayannis and Weston (2001) present evidence that hedging foreign currency risk is associated with large (approximately 4%) increases in market value; Graham and Rogers (2002) found that hedging can add an economically significant 1.1% to their market value by allowing firms to increase their debt capacity. However, Guay and Kothari (2003) showed that the magnitude of the cash flows generated by hedge portfolios is modest and unlikely to account for such large changes in value. Consistent with this, Jin and Jorion (2006) used a sample of oil and gas producers and find insignificant effects of hedging on market value. Bartram and Brown in their paper on Derivatives said that there is strong evidence that the use of financial derivatives reduces both total risk and systematic risk. The effect of derivative use on firm value was positive but more sensitive to endogeneity and omitted variable concerns. However, hedging with derivatives was associated with significantly higher value, abnormal returns, and larger profits during the economic downturn in 2001-2002, suggesting firms are hedging downside risk. This might be because of a change in the (perceived) value of risk management, with the value of firms that hedged increasing during the economic decline. Alternatively, these results simply reflect the unstable nature of the value results. As per Modigliani and Miller (henceforth MM, 1958), a firm managed by value maximizing agents, in a world of perfect capital markets, with investors who have equal access to these markets, would not engage in hedging activities since they add no value. Anything the firm could accomplish through hedging could equally well be accomplished by the investor acting on his or her own account. If the perfect capital markets assumption is not met, however, there may be rational reasons for the firm to hedge. The
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theoretical literature on hedging relaxes the MM assumptions and develops specific reasons why individual firms may optimally choose to hedge. As one might expect, these reasons tend to involve either market frictions, such as taxes, transactions costs, and informational asymmetries, or agency problems. Smith and Stulz (1985) show that a convex tax function implies that a firm can reduce expected tax liabilities by using hedges to smooth taxable income. In addition, hedging may increase a firms debt capacity, enabling it to add value by increasing the value of the debt tax shield (Leland, 1998). Froot, Scharfstein and Stein (1993) showed that managers facing external financing costs may use hedging to reduce the probability that internal cash flows are insufficient to cover investments; Smith and Stulz (1985) show that hedging can reduce expected costs of distress. Empirical researchers have used data disclosed by firms to examine the question of whether and how hedging affects the risks of the firm. The evidence was mixed. Guay (1999) investigates a sample of 234 U.S. non-financial firms that begin using derivatives in the early 1990s and found that measures of total and idiosyncratic risk decline in the following year. He found no significant evidence for changes in systematic risk. Hentschel and Kothari (2001) examined the risk characteristics of a panel of 425 large U.S. non-financial firms from 1991 to 1993. Their results showed no significant relationship between derivatives use and stock return volatility even for firms with large derivatives positions. The evidence for the effect of derivative use on market value was also mixed. Allayannis and Weston (2001) found that firm value (as measured by Tobins q) is higher for U.S. firms with foreign exchange exposure that use foreign currency derivatives to hedge.
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Brown and Conard conducted univariate results and found that derivative use is more prevalent in firms with higher exposures to interest rate risk, exchange rate risk and commodity prices. Despite this, firms that used derivatives had lower estimated values of both total and systematic risk, suggesting that derivatives are used to hedge risk, rather than to speculate. There are significant differences between derivative users and non-users along other dimensions, emphasizing the importance of multivariate tests. They employed three different types of multivariate tests but concentrated on propensity score matching, in which derivative users and non-users were matched on the basis of their estimated propensity to use derivatives. Compared to firms that do not use derivatives, they found that hedging firms had lower cash flow volatility, idiosyncratic volatility and systematic risk; these results were robust to a number of different matching specifications, and the differences were both statistically and economically significant. This suggests that nonfinancial firms overall employ derivatives with the motive and effect of risk reduction. Consistent with the evidence in Allayannis and Weston (2001), derivative use is associated with a value premium, although the statistical significance of this premium is weak. These results suggest that the estimated effects of derivative use on risk measures are robust. Even small differences in sample construction, control variables and testing method could change the estimated effect. A 1995 survey of major non-financial firms revealed that at least 70 percent were using some form of financial engineering to manage interest rate, foreign exchange, or commodity price risk (Wharton-Chase, 1995). Financial firms, including banks (Gunther and Siems, 1995, and Shanker, 1996), savings and loans (Brewer, et al., 1996), and insurers (Colquitt and Hoyt, 1997, Cummins, Phillips, and Smith, 1997), also were active in derivatives
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markets. Although the types of risks confronting managers vary across industries, there was substantial commonality in the underlying rationale for the use of derivatives and the financial engineering techniques that were employed. Cummins, Phillips, and Smith (CPS) (1997) presented extensive descriptive statistics on the use of derivatives by U.S. life and property-liability insurers and conducted a probit analysis of the participation decision. Colquitt and Hoyt (CH) (1997) analyzed the participation and volume decisions for life insurers licensed in Georgia. The paper Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry by David Cummins suggests the following regarding the usage of derivatives in Insurance Industry. In this paper, they formulated and tested a number of hypotheses regarding insurer participation and volume decisions in derivatives markets. We base our hypotheses on the financial theories of corporate risk management that have developed over the past several years. The two primary, and non-mutually exclusive, strands of the theoretical literature held that corporations were motivated to hedge in order to increase the welfare of shareholders and/or managers. Their results provided a considerable amount of support for the hypothesis that insurers hedge to maximize value. Several specific hypotheses were supported by their analysis. In terms of participation in derivatives markets, they found evidence that insurers were motivated to use financial derivatives to reduce the expected costs of financial distress the decision to use derivatives was inversely related to the capital-to-asset ratio for both life and property-liability insurers. They also found evidence that insurers use derivatives to edge asset volatility, liquidity, and exchange rate risks. Life insurers appeared to use
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derivatives to manage interest rate risk and the risk from embedded options present in their individual life insurance and GIC liabilities. There was also some evidence that tax considerations play a role in motivating derivatives market participation decisions by insurers. Finally, they provided support for the hypothesis that there were significant economies of scale in running derivatives operations. Thus, only large firms and/or those with higher than average risk exposure would find it worthwhile to pay the fixed cost of setting up a derivatives operation. Interestingly, however, they found that, conditional on being a user of derivatives, the relationship between the volume of derivatives activities and these same risk measures often displayed exactly the opposite result to those found in the participation regression. Their analysis provided only weak support for the utility maximization hypothesis. The only variable that carried significant implications regarding utility maximization was the ratio of surplus notes to assets, which was positively but weakly, related to both the participation and volume decisions for property-liability insurers.
3.0 Data and Methodology

3.1 Data The data come from Schedules and Notes to Accounts and Managerial Discussion of the 2009 Annual statements released by
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Banks (ICICI and Indian Bank) and Manufacturing Companies (Hindalco and Tata Iron and Steel Company). Data list for banks has been grouped under different heads for analysis. The groups are Hedging Transaction Trading Transaction It also gives details about the Notional Amount involved in the Derivative Transactions. It also shows about the mark to market value of the assets and liabilities that arise because of the derivative transaction. It also contains the details about the FRA and Interest Rate Swap Agreements taken by the bank during the last financial year. The relevant table also contains the details about the collateral required for entering into those transactions. It also speaks about the split of domestic and foreign exposure taken by the bank and the capital requirement for different kind of risks taken by the bank during the last financial year. Banks primary Income is influenced by interest rates as its assets consists of domestic loans and foreign currency loans. Impact of interest rate in each of these currencies has an impact on the net interest income of the bank. This effect is also provided in the data set collected for the purpose of evaluating Translation Risk. For the data pertaining to manufacturing sector the samples that were considered were Hindalco and that of Tata Iron and Steel Company. The data shows the export contracts that these companies had during the last financial year. It also speaks about Buyers
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Credit, imports and foreign currency earnings made by the organization. Data set also contains the Foreign Currency Exposure that is not hedged by derivative instruments. It also contains the details about the various derivative contracts entered by the company for hedging foreign currency exposures which includes commodity. One of the tables shows the split of the income the company makes from domestic market and foreign market. Details also include the extent to which raw materials are imported for the production and operation of the company. 3.2 Methodology VaR method of calculation is used to calculate the risk involved in the transaction and suitable derivative instrument of relevant value is used. VaR defines the loss in market value of say, a portfolio, over the time horizon T that is exceeded with probability 1 PVaR. In other words, it is the probability that returns (losses), say , are smaller than VaR over a period of time (horizon) T , or:
where PT () is the probability distribution of returns over the time period (0, T ). Monte Carlo Simulation method of calculating VaR will be used. MS Excel addin will be the software used for calculation using this method.
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Hypothetical value will be assumed for minimum and maximum value for each of the transaction that a company (Bank and Manufacturing) undergoes where minimum and maximum value will be based on the value obtained from the data collected. Hypothetical sample size will be assumed which is one of the constraints in the calculation of VaR The scenario will be simulated for different confidence level and VaR of each hypothetical transaction will be arrived. The simulated values form a probability distribution for the value of a portfolio which is used in deriving the VaR figures. By using Monte Carlo techniques one can overcome approaches based solely on a Normal underlying distribution. Based on the nature of the transaction and VaR arrived suitable derivative instrument is opted. The value of the derivative contract is determined based on the nature of the instrument, expiry of the instrument and VaR arrived earlier.
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Derivatives as Risk Management Tool for Corporates 4.0 Analysis and Interpretation
4.1 Manufacturing Industry
Hindalco and JSW Steel were the companies that were considered for deriving the base value for the hypothetical situations. 4.1.1 Buyers Credit Buyers Credit is the credit availed by an importer from the overseas lender. Manufacturing industries avail these options for purchasing raw materials etcIn this case Hindalco has taken buyers credit on an average of 48.525 million USD with a standard deviation of 21.95 million USD. By running Monte Carlo Simulation and converting the input sample as a normal function with mean of 48.525 and standard deviation of 21.95 for sample of 30, 0000 VaR is arrived. This method is Variance-Covariance Approach as the mean and standard deviation is determined based on historical value. The Exchange rates that have been used in the conversion are also converted as normal distribution for arriving at Indian Rupee. The mean so obtained from last one year data was 48.339 INR and standard deviation so obtained was INR 1.4922 VaR so obtained with 99% confidence level with right tail suggests that there is a 1% probability that credit value will go above 99.512 million USD. Below figures show the normal distribution of input data i.e. Exchange Rate and Credit Values.
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Figure 2 Buyers Credit MTM
Figure 3 Buyers Credit
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Figure 4 Exchange Rate Probability
Buyers Credit(million USD) Mean SD 48.525 21.95566556
Exchange Rate 48.33938821 1.49223283
Table 1 Buyers Credit
Buyers Credit( million USD) VaR 99.55124051
Buyers Credit MTM(INR Crores) 4828.304403 2995.727385
Buyers Credit Present 64.05 Value
Table 2 Buyers Credit VaR
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Company could hedge itself by entering into Forex Forwards for the credit taken at the specified Exchange rate. But these contracts have counter party risk. It can also hedge its position using Currency Futures. Company should enter into currency futures by buying dollars at the desired risk level. This hedge comes with a cost of initial margin. If not the company should be prepared to VaR level at the worst case scenario.
Instrument Forex Forwards Currency Futures
Disadvantage Counter Party Risk Initial Margin
Table 3 Buyers Credit and Derivative Instruments to be used 4.1.2 Commodities Contract (Gain/Loss) Manufacturing companies enter into these types of contracts to hedge their position against commodity price risk which they might face because of uncertain conditions. Hindalco on an average has 24.44 Crores in INR with a standard deviation of INR 12 Crores. Monte Carlo simulation is executed with these mean values and standard deviation was decided using variance method. Input is varied as normal distribution using random number generation and VaR is calculated as INR 3.561 Crores. Company could hedge its position using Commodity Futures and Forward Contracts.
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Figure 5 Commodities Contract
Commodities(INR Crores) Mean SD 24.44 12 Table 4 Commodities Contract
Commodities(INR Crores) VaR -3.56561
Table 5 Commodities Contract VaR Company should be ready to face a loss of INR 3.56561 Crores in its worst case. Commodity Contracts are also entered in foreign Currency for which hedging has to be done with currency futures along with Commodity Futures to hedge the position.
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Monte Carlo Simulation is run with exchange rates being normally distributed along with the mean commodity contracts entered into in the foreign currency.It has to be noted that company has been incurring loss on these type of contracts based on historical data which is reflected in its mean data. Contracts which are taken for hedge should theoretically result in no loss or no gain position. But these contracts which have been taken is consistently showing loss which shows the uncertainity in the commodity price movements in foreign market or it could be the wrong positions taken by the companies. The below graph shows the Commodities Contract MTM values in INR (millions) which is obtained by simulating the exchange rate which is also assumed to be distributed normally.
Figure 6 Commodities Contract MTM
The below graph is obtained by considering the gain/loss value of the contracts in USD and is normalized based on the mean value which is obtained based on historic data.This graph
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doesnt consider the exchange rate fluctuation which was considered in the earlier case.
Figure 7 Commodities Contract
Figure 8 Exchange Rate
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VaR obtained by considering the transaction in USD is found to be -11.701 million USD which is approximately INR 565.65 million while the VaR obtained by considering normal distribution of exchange rates comes to be INR 566.753 million. Variation is little because of lesser fluctuation in exchange rates which could be considerable if a volatile currency is considered.
4.1.3 Export Earnings These manufacturing companies export their finished goods to different countries and expect their payment at future date. Mean value of export earnings made by the company is calculated using co variance approach and arrived as INR 5148.18 Crore and standard deviation of INR 2500 Crore.
Figure 9 Export Earnings
Monte Carlo Simulation when run based on these data showed VaR loss of INR 582.2 Crores. This shows that company
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has to prepare itself for loss accounting 582.2 Crores which has the probability of occurrence of 1%. Company could hedge its earning by entering into Forward Contracts and by selling Currency Futures.
Export Earnings(INR Crores) Mean SD 5148.18 2500 Table 6 Export Earnings
Export Earnings(INR Crores) VaR -582.2 Table 7 Export Earnings VaR Exchange rate fluctuation is not considered for analysis because of lack of availability of data in each currency. Instrument Forex Forwards Forex Futures Disadvantage Counter Party Risk Initial Margin
Table 8 Export Earnings and Derivative Instruments to be used 4.1.4 Investments Manufacturing Companies invest their excess cash at different investment centers to make effective use of them. There is a greater possibility that companies could benefit out of it. If
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the company has taken wrong decision or invested in poor performing sector it is bound to erode its investment value. Mean of investment value made by Hindalco is arrived using historical covariance approach as INR 492.755 Crores with a standard deviation of INR 41.755 Crores. When Monte Carlo Simulation is run based on these values with normal distribution as Input variations VaR at 99% confidence level arrived to be INR 396.7425 Crores which means there is a probability of 1% that the investment made could fall below this value. Company should hedge its position by investing in derivatives thereby preventing the erosion of the investment value. Kind of derivative instruments that the company should enter in highly depends on the type of investment that the company has made. If the company has invested in foreign companies it should hedge its position using currency futures and options. If on the other hand if the investment is bound to fluctuate based on the interest rate variations then it should hedge itself by opting for Interest Rate Futures and Interest Rate options. Company should opt for Option contracts if the company has more positive view on the investment growth features. Option Contracts are generally used as hedge instruments to protect itself from adverse movements and these option contracts should be at the VaR level to avoid further erosion. Below graph shows the normal distribution of the investment value with mean and standard deviation arrived using covariance method.
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Figure 10 Investment Value
Investment Value (INR Crores) Mean SD 492.755 41.755 Table 9 Investments
Investment Value (INR Crores) VaR 396.7425 Table 10 Investments VaR
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Instrument Forex Futures Interest Rate Futures
Scenario Investments are in Foreign Currency Investments vulnerable with adverse interest rate movements To serve as insurance at adverse movements
Option Contracts
Table 11 Investments and Derivative Instruments to be used
4.2 Banking Sector

Banking industries use derivative instruments to hedge its position against different exposures it has taken in its business activity. Banks that have been considered for arriving at the base values for the simulation are ICICI and Indian Bank. Some of the transactions that are taken by the banks are listed below. 4.2.1 Forex Transactions Forex Transactions that have been entered by the banks could be in different currencies. Because of the constraint in availability of individual split up in each currency the Forex Transaction value in denomination of USD, which is converted in INR, is taken into consideration for analysis. Based on historical variance approach mean of Forex Transaction Profit /Loss that the bank makes in its Forex Transaction is arrived to be INR 592.935 million with a standard deviation of INR 719.5328 Crores.
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Standard Deviation of these transactions is very high because of the huge fluctuations in the last financial year due to the financial crisis. Many of the transactions incurred a huge loss and saw huge swing in their values because of the crisis the world was going on. Monte Carlo Simulation when run based on these values gave a VaR of INR -1080.97 million at 99% confidence level. The above statement implies that there is a 1% probability that these transactions could eat their profit books by a value of INR 1080.97 Million or more. Companies could hedge its position by using derivative contracts especially Forex Forwards and Forex Futures. It could also opt for option contracts if there is a high probability of its view going right and in this case it should enter into option contracts taking in its view VaR value arrived. Below graph shows the normal distribution of the investment value with mean and standard deviation arrived using covariance method.
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Figure 11 Forex Transaction Profit/Loss
Forex Transactions (Million INR) Mean SD 592.9325 719.5328 Table 12 Forex Transactions
Forex Transactions (Million INR) VaR -1080.97
Table 13 Forex Transactions VaR
Instrument
Scenario
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Forex Futures Interest Rate Futures
Investments are in Foreign Currency Investments vulnerable with adverse interest rate movements To serve as insurance at adverse movements
Option Contracts
Table 14 Forex Transactions and Derivative Instruments to be used
4.2.2 Currency Swaps Currency Swaps are the transactions that banks make to warehouse its position at different currency exposures and also as trading instruments for profit making. Mean Value of Swap value made by the bank on these transactions arrived to be INR 523.3435 million with a standard deviation of INR 65.48445 million. VaR arrived based on these values for the above transaction using normal distribution arrived to be INR 674.6693 million at 99% confidence level. Below graph shows the normal distribution of the investment value with mean and standard deviation arrived using covariance method.
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Figure 12 Currency Swaps
Currency Swaps(Million INR) Mean SD 523.3435 65.48445 Table 15 Currency Swaps
Currency Swaps(Million INR) VaR 674.6693 Table 16 Currency Swaps VaR This VaR value is necessary in calculation of ALM in banks.
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4.2.3 Investments Banks invest their excess cash at different investment centers to make effective use of them. There is a greater possibility that companies could benefit out of it. If the company has taken wrong decision or invested in poor performing sector it is bound to erode its investment value. Mean of investment value made by ICICI is arrived using historical covariance approach as INR 1072.563 million with a standard deviation of INR 59.36869 Crores. When Monte Carlo Simulation is run based on these values with normal distribution as Input variations VaR at 99% confidence level arrived to be INR 396.7425 Crores which means there is a probability of 1% that the investment made could fall below this value. Company should hedge its position by investing in derivatives thereby preventing the erosion of the investment value. Kind of derivative instruments that the company should enter in highly depends on the type of investment that the company has made. If the company has invested in foreign companies it should hedge its position using currency futures and options. If on the other hand if the investment is bound to fluctuate based on the interest rate variations then it should hedge itself by opting for Interest Rate Futures and Interest Rate options. Company should opt for Option contracts if the company has more positive view on the investment growth features. Option Contracts are generally used as hedge instruments to protect itself from adverse movements and these option contracts should be at the VaR level to avoid further erosion.
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Below graph shows the normal distribution of the investment value with mean and standard deviation arrived using covariance method.
Figure 13 Investments Outside India
Investments (outside India) (Million INR) Mean SD 1072.563 59.36869 Table 17 Investments Outside India
Investments (outside India) (Million INR) VaR 933.4768 Table 18 Investments Outside India VaR
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Instrument Forex Futures Interest Rate Futures
Scenario Investments are in Foreign Currency Investments vulnerable with adverse interest rate movements To serve as insurance at adverse movements
Option Contracts
Table 19 Derivative Instruments for Investment Outside India Transactions
4.2.4 Borrowings Borrowings made by the banks in terms of ECB and other foreign currency loans come under this head. These values are highly impacted by change in Exchange Rates and interest rate fluctuations which could add up to the interest rate burden and also in terms of redemption. When these rates go in adverse direction could impact the interest paid by the banks and reduce the profit levels. With mean value of INR 703.938 million and standard deviation of INR 141.995 million Monte Carlo simulations run on these parameters produced a VaR of INR 1029.978 million at 99% confidence level. This implies that there is 1 % probability that borrowings could increase above INR 1029.978 million.
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The derivative instruments that could be used are series of FRAs and Interest Rate Swaps. These instruments would help the borrower in raising Interest rate scenarios. Below graph shows the normal distribution of the investment value with mean and standard deviation arrived at using covariance method.
Figure 14 Borrowings Outside India
Borrowings (outside India) (Million INR) Mean SD 703.938 141.9955 Table 20 Borrowings
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Borrowings (outside India) (Million INR) VaR 1029.978 Table 21 Borrowings VaR
Instrument FRA Interest Rate Futures
Scenario Likely change in interest rate scenario Borrowings vulnerable with adverse interest rate movements Cap contracts when there is a likely increase in interest rate
Option Contracts
Table 22 Derivative Instruments for Borrowings Made
4.2.5 Deposits These are the deposits made by the retail investors with the bank. These are the source of fund for the banks. Fluctuation of these deposits indicates the fluctuation in source of money for the bank. Mean of the Deposits held by the bank is arrived as INR 88.586 Crores with a standard deviation of INR 23.354 Crores. VaR so generated out of this method suggests that there is a 1% probability of deposits running lower to INR 34.527 Crores and below.
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Bank should take up necessary measure to ensure the liquidity problem that might occur because of this adverse effect to be mitigated or reduced. If the banks deposit level reaches this level along with other cash outflows or business requirements remaining constant it should look for other sources of generating income. If the fluctuation in deposit is mainly due to FCNRB Deposits then bank should make necessary provisions to handle this liquidity problem. Below graph shows the normal distribution of the investment value with mean and standard deviation arrived at using covariance method.
Figure 15 Deposits
Deposits (outside India)
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(Crores INR) Mean SD 88.586 23.35574 Table 23 Deposits
Deposits (outside India) (Crores INR) VaR 34.57277 Table 24 Deposits VaR 4.2.6 Credit Exposure Overseas Credit Exposures are the exposures that bank has taken in overseas market. These are classified under two heads Fund Based and Non Fund Based. Fund Based exposures are where the banks have paid in cash in behalf of client which implies cash has left the system e.g. of Fund based exposure are Cash Credit and Term loans. Non Fund Based exposures are where the banks are liable to pay in case of default made by the client e.g. of Non Fund Based Exposure are Bank Guarantee and Packing Credit. Mean value of Fund based exposure taken by the bank arrived using historical covariance approach are shown below and the values are INR 874.32 Crores with standard deviation of INR 103.91 Crores. Monte Carlo Simulation when run based on these values produced a VaR of INR 627.59 which implies that there is one percent probability that credit exposure could fall to such low value and below that. Company could hedge its position using Credit Default Swaps with other banks or other financial institutions to hold its position at the worst case.
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Mean value of Non-Fund based exposure taken by the bank arrived using historical covariance approach are shown below and the values are INR 169.72 Crores with standard deviation of INR 118.91 Crores. Monte Carlo Simulation when run based on these values produced a VaR of INR -105.32 which implies that there is one percent probability that credit exposure could fall to such low value and below that. Company could hedge its position using Credit Default Swaps with other banks or other financial institutions to hold its position at the worst case. On Fund Based Credit Exposure are source of high income for the banks as they dont have charge on the capital.
Figure 16 Credit Exposures (Overseas) - Fund Based
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Figure 17 Credit Exposures (Overseas) - Non Fund Based
Fund Based (Crores INR) Mean SD 874.32 103.91
Non Fund Based (Crores INR) 169.72 118.9
Table 25 Credit Exposure- Overseas Transactions
Fund Based (INR) VaR 627.5952
Non Fund Based (Crores INR) -105.321
Table 26 Credit Exposure-Overseas Transactions VaR
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Instrument Credit Swaps Forex Futures Scenario When Credit Rating of the assets are poor To avoid Translation Risk
Table 27 Derivative Instruments for Credit ExposureOverseas Transactions
4.2.7 Credit Exposure Domestic This is similar to Credit Exposure in Overseas Market except for the absence of Translation risk. Mean value of Fund based exposure taken by the bank arrived using historical covariance approach are shown below and the values are INR 2663.09 Crores with standard deviation of INR 47.22 Crores. Monte Carlo Simulation when run based on these values produced a VaR of INR 2552.981 which implies that there is one percent probability that credit exposure could fall to such low value and below that. Company could hedge its position using Credit Default Swaps with other banks or other financial institutions to hold its position at the worst case. Mean value of Non-Fund based exposure taken by the bank arrived using historical covariance approach are shown below and the values are INR 1478.532 Crores with standard deviation of INR 321.038 Crores. Monte Carlo Simulation when run based on these values produced a VaR of INR 737.595 which implies that there is one percent probability that credit exposure could fall to such low value and below that. Company could hedge its position using Credit Default Swaps with other banks or other financial institutions to hold its
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position at the worst case. On Fund Based Credit Exposure are source of high income for the banks as they dont have charge on the capital.
Figure 18 Credit Exposures (Domestic) - Fund Based
Figure 19 Credit Exposures (Domestic)- Non Fund Based

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Fund Based (Crores INR) Mean SD 2663.09 47.22
Non Fund Based (Crores INR) 1478.532 321.038
Table 28 Credit Exposure Domestic Fund Based (Crores INR) VaR 2552.981 Non Fund Based (Crores INR) 737.595
Table 29 Credit Exposure Domestic VaR 4.2.7 Currency Derivatives These are the existing instruments with the bank. Notional Principal amount is just the indication of risk that bank will get exposed to if it goes in the worst case. Notional Principal MTM value suggests that there is a 1% probability of this value going below USD 8.0258 million. Similarly MTM Value of Notional Principal Amount on Trading Exposures has 1% probability of going below USD -862.577 million. Banks use this value in calculation of risk parameters in BASEL II norms. Mean and Standard Deviation are arrived using Covariance method.
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Figure 20 Currency Derivatives Notional Principal Amount - Hedging MTM
Figure 21 Currency Derivatives Notional Principal Amount - Trading MTM
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Figure 22 Exchange Rate
Notional Principal AmountHedging (Million USD) Mean SD 0.498072 3.718675
Notional Principal AmountTrading (Million USD) 28.30608 378.2576
Exchange Rate
48.33939 1.492233
Table 30 Currency Derivatives
Notional Principal Notional Amount - Hedging(Million Principal USD) Amount 62

Trading (Million USD) VaR -8.02518 -862.577
Table 31 Currency Derivatives VaR
4.2.8 Interest Rate Derivative Assets These are the interest rate derivative assets that the bank holds. The probability of these assets falling below INR 3770.23 Crores is 1%. Bank should revisit its position in interest rate futures and swaps that it has got exposed to.
Figure 23 Interest Rate Derivative Assets
Interest Rate Derivative Assets (Crores INR) Mean SD 1888.65 2409.891

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Table 32 Interest Rate Derivative Assets
Interest Rate Derivative Assets (Crores INR) VaR -3770.23 Table 33 Interest Rate Derivatives VaR
5.0 Main Findings/Inference

Based on the VaR arrived using simulation method organization should take up the necessary derivative instrument to hedge its position. VaR so arrived varies depending on the input variables that are being fed to the system for its calculation. Input feed for simulation should be varied if the input is going to be biased and then corresponding VaR has to be evaluated and suitable derivative hedge value has to be arrived.
6.0 Scope of Further Research

VaR which has been evaluated for each transaction is based on 5 year historical mean and Standard Deviation. The input data that has been used is normalized based on the above mentioned mean and standard deviation. Different scenarios can be simulated by using different input distribution based on the conditions.
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Confidence level that has been used for the calculation was 99%.With more information available VaR can be calculated at 95% and 90% confidence level to reduce hedging cost. There are certain situation which doesnt follow normal distribution hence the data fed has to be modified based on that to arrive at proper Value. VaR calculation could also be employed in identifying the risk involved in non securitized loan transactions undertaken by the bank with the availability of data. Monte Carlo Simulation that is being run is based on the historical data which is generally 5 years with availability of data for 20 years or more many scenarios can be simulated and VaR at each scenario can be evaluated. Moreover mean and standard deviation calculated using more samples will help to get the data identical to real life scenario.
7.0 Conclusion
In this paper a large sample of 30000 records has been used in calculation of VaR, to analyze the effect of derivative use on measures of risk and value. Derivatives use is more prevalent in firms with higher exposure to interest rate risk, exchange rate risk and commodity price. Despite this, firms that use derivatives have lower estimated value of both total and systematic risk, suggesting that derivatives are used to hedge risk, rather than to speculate. The paper focuses on the different kinds of transactions that Manufacturing Companies and Banks undertake. It also discusses about the different types of derivative instruments that are present in the market which are being used for hedging and speculation.
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Input data that is being used for VaR calculation is normalized with mean and standard deviation calculated based on historical data. For each transaction Monte Carlo simulation is run based on simulated input data which is normally distributed with mean and SD calculated for that transaction. VaR is calculated at 99% confidence level for each of the transaction. Monte Carlo simulation along with VaR calculation will help in determining the risk which each transaction will be exposed to if the unwanted event happens and it will help in taking necessary precautionary measures to handle those scenarios. Based on the above calculated VaR derivative instrument for each transaction is suggested. This has been done for Manufacturing and Banking Industry separately.
8.0 Bibliography
White Paper Risk Management with Derivatives by Dealers- Narayan y Naik from SSRN website White Paper Restricted Export Facility and Risk Management with Options and Futures- Axel FA Adam Miller from SSRN website White Paper Effect of Derivatives on Firms Risk and Value- Gregory W Brown from SSRN website White Paper Risk Analysis and Monte Carlo Simulation- Lawrence Goldman from Google
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Reference Book Essentials of Financial Risk Management by Karen A Horcher Reference Book The Hand Book of Risk by BenWarWick Reference Book Investment Risk Management by Yen Yee Chong Reference Book Mathematics for Finance by Marek Capenski Reference Book Options Futures and Other Derivatives by Hull Reference Book Risk Aversion and Portfolio Choice by Donald D Hester Reference Book Risk and Financial Management by Charles Tapiero http://en.wikipedia.org/wiki/Wiki http://economictimes.indiatimes.com/news/economy/
http://wiki.answers.com/
9.0 Appendix
Below are the sample data for performing Monte Carlo Simulation ICICI Bank
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68
Hindalco
69
70
Sample Hypothetical Data and VaR Calculation
71

Exchange Rate(USD/INR) Buyers Credit MTM(INR) Random Variable Z P(z) Z P(z) 0.34702 47.75238 0.24744 1595.089742 0.161235 46.86298 0.163873 2205.593503 0.152364 46.80784 0.157882 1656.404717 0.927153 50.51046 0.092773 1339.883038 0.891725 50.18342 0.124586 2647.345257 0.135604 46.6975 0.145945 2263.04135 0.494302 48.31807 0.267319 2766.265992 0.912753 50.3657 0.106334 2465.81703 0.351517 47.77051 0.248608 2639.466722 0.034165 45.61931 0.050764 1701.70533 0.457551 48.18031 0.265831 2734.279228 0.994255 52.11092 0.010963 2331.801862 0.87775 50.07606 0.135818 3783.613505 0.434559 48.0935 0.263741 3663.48364 0.815181 49.67815 0.17877 3109.046198 0.058581 46.00137 0.078345 1804.406443 0.200325 47.08522 0.187796 2798.860313 0.448713 48.14702 0.265134 1679.674885 0.536464 48.47597 0.266228 1964.922301 0.43617 48.09961 0.263917 -482.7860082 0.907988 50.32177 0.110623 1975.970007 0.082982 46.27221 0.102414 3212.068046 0.165254 46.88731 0.166516 2942.67609 0.743846 49.31717 0.215696 640.2054867 0.137305 46.70911 0.147195 2152.999304 0.568762 48.59788 0.263365 1811.762931 0.301226 47.56212 0.233431 2454.275318 0.00044 43.37615 0.001059 2757.880326 0.500075 48.33967 0.267346 1390.003192 0.95334 50.84357 0.065396 2283.95918 0.102055 46.44436 0.119365 2918.558049 0.279109 47.4657 0.225235 2752.08543 0.857686 49.93605 0.150824 421.5710897 0.555865 48.54904 0.26472 2158.698019 0.049404 45.87622 0.068457 2107.747574 0.059682 46.01532 0.079497 4155.270773 0.617242 48.78444 0.255716 381.1946878 0.718329 49.20173 0.226234 1383.212094 0.638372 48.8678 0.251099 3960.578409 0.730823 49.25756 0.221239 606.80895 0.49254 48.31148 0.267299 4249.964082 0.39699 47.9497 0.258383 2276.837592 0.011756 44.95946 0.020561 1864.224357 0.588142 48.67181 0.260794 2620.865926
0.003546737 0.002971054 0.00239854 0.001020462 0.002222183 0.002651855 0.0044884 0.00193176 0.004310095 0.000809445 0.004502852 0.00019628 0.001156499 0.002168555 0.002646215 0.00130141 0.003015491 0.003972247 0.004527436 0.000136756 0.001839071 0.001183345 0.002452059 0.001057087 0.002658233 0.004197271 0.004200088 1.52095E-05 0.003238694 0.00117237 0.001753603 0.003730138 0.000517731 0.004728493 0.001235318 0.000236328 0.000832764 0.002668307 0.001523232 0.001032109 0.000967112 0.004689642 0.000354775 0.004601492
72

Investment Value (INR) RandomVariable Z P(z) 0.971132665 571.9938 0.001578305 0.852990722 536.5705 0.005509276 0.69772276 514.3783 0.008355391 0.41160151 483.4258 0.009318836 0.418852711 484.2023 0.00935602 0.833974015 533.2569 0.005968873 0.094016319 437.7878 0.004016918 0.940490249 557.847 0.002834624 0.740858688 519.7285 0.007755039 0.750769416 521.0195 0.007598052 0.687860503 513.2064 0.008474384 0.610284812 504.449 0.009186916 0.195079626 456.8737 0.006604655 0.907672805 548.1455 0.00396346 0.1261759 444.9599 0.004962349 0.528811366 495.7731 0.009529433 0.719282126 517.0026 0.008071871 0.873001072 540.3846 0.004984872 0.208203982 458.822 0.006867377 0.502956356 493.0644 0.009554097 0.403253026 482.5277 0.009272015 0.003310062 379.3746 0.000239398 0.10812374 441.1221 0.004447967 0.913339576 549.609 0.003781066 0.710226283 515.8892 0.008194917 0.238904445 463.116 0.007426595 0.82449191 531.6966 0.006184879 0.532613482 496.1723 0.009522416 0.908882106 548.4521 0.003924934 0.905507563 547.6039 0.004031912 0.612728722 504.7152 0.009170338 0.229627084 461.8531 0.007265533 0.44836442 487.3354 0.009474218 0.354457322 477.1673 0.008911261 0.702144183 514.9093 0.008299882 0.700065769 514.6592 0.008326143 0.800064409 527.9065 0.006703573 0.785200671 525.7364 0.006993936 0.643972798 508.1667 0.008925218 0.834779656 533.3921 0.005950127 0.467293915 489.328 0.009522234 0.857036115 537.3117 0.005406754 0.605925431 503.9752 0.009215563 0.347751162 476.4121 0.008849854
73

Export Earnings(INR) Gain /Loss RandomVariable Z P(z) 0.755894653 6881.074 0.000125498 0.761636084 6927.118 0.000123885 0.873825532 8009.837 8.28805E-05 0.66136206 6188.638 0.000146338 0.607286563 5828.815 0.000153771 0.582391666 5668.219 0.000156162 0.092544541 1835.061 6.6313E-05 0.129731065 2329.022 8.44968E-05 0.018572207 -62.2531 1.81857E-05 0.499157783 5142.902 0.000159577 0.379613664 4381.941 0.000152255 0.299459715 3833.292 0.000138964 0.933083611 8896.074 5.18725E-05 0.955349638 9395.925 3.76773E-05 0.850669967 7746.458 9.29854E-05 0.292039304 3779.588 0.000137371 0.713470961 6557.064 0.000136146 0.017159987 -142.55 1.69994E-05 0.276140548 3662.316 0.000133741 0.684279671 6347.43 0.000142233 0.275252041 3655.668 0.000133529 0.554832885 5492.883 0.000158067 0.881142678 8099.976 7.94778E-05 0.786765664 7136.303 0.000116317 0.874160918 8013.887 8.27268E-05 0.668937294 6240.632 0.000145046 0.828835717 7522.116 0.000101665 0.154576053 2605.673 9.51428E-05 0.600215653 5782.943 0.000154515 0.611972427 5859.339 0.000153249 0.659745832 6177.604 0.000146606 0.980072265 10286.29 1.93079E-05 0.013328371 -393.09 1.36819E-05 0.343164015 4138.572 0.000147081 0.055883105 1172.419 4.50599E-05 0.62583091 5950.258 0.000151572 0.193729922 2987.597 0.000109846 0.677461828 6299.712 0.000143516 0.035167148 623.8007 3.10291E-05 0.160443737 2666.591 9.7501E-05 0.539807067 5398.049 0.000158782 0.689674607 6385.501 0.000141182 0.378153478 4372.345 0.000152075 0.667609247 6231.483 0.000145277
74

Commodities Contract(INR) Gain /Loss RandomVariable Z P(z) 0.17087395 13.03139 0.02115716 0.61717547 28.01685 0.031800658 0.19942551 14.3159 0.023289819 0.748634069 32.48237 0.026557912 0.388786962 21.05022 0.031944884 0.048686012 4.547243 0.008413824 0.497751829 24.37238 0.033244662 0.733753816 31.93047 0.027360315 0.364360567 20.27807 0.031304615 0.286211711 17.66617 0.02834889 0.955893157 44.89876 0.007772359 0.671140504 29.75678 0.0301371 0.748825884 32.48959 0.026547195 0.047551895 4.411177 0.008256619 0.681513309 30.10322 0.029741664 0.785382677 33.92602 0.024323997 0.854036173 37.08683 0.019078367 0.095168853 8.725031 0.014103306 0.542013962 25.70611 0.03306066 0.542681341 25.72629 0.033054745 0.190108127 13.91003 0.022621682 0.959727902 45.41045 0.007220809 0.581225231 26.90035 0.032553721 0.917792456 41.1245 0.012645976 0.112099013 9.854711 0.0158832 0.270639628 17.10944 0.027586406 0.870321002 37.97492 0.017598608 0.382094236 20.84018 0.031782459 0.73974101 32.15057 0.027044311 0.357827592 20.06874 0.031111054 0.219451006 15.15142 0.024639095 0.337526605 19.40932 0.030448483 0.743840576 32.30278 0.026822634 0.385521191 20.94786 0.031866847 0.901302971 39.90814 0.014485305 0.883290358 38.73916 0.016345593 0.014115341 -1.88879 0.002995011 0.186320582 13.74156 0.022342507 0.700967094 30.76621 0.02893201 0.650648169 29.08485 0.030845724 0.660188955 29.39575 0.030527695 0.330986388 19.19371 0.030215108 0.013388182 -2.13715 0.002861436 0.380106125 20.77758 0.031732327
75

Commodities Contract(USD) Gain/Loss Exchange Rate(USD/INR) Commodities MTM(INR) RandomVariable Z P(z) RandomVariable Z P(z) Z P(z) 0.565955389 -6.65985 0.196738862 0.183065 46.99079 0.177712 -312.95152 0.47215864 -7.13171 0.198985195 0.028996 45.51047 0.044327 -324.5674542 0.030019528 -10.753 0.034039338 0.288924 47.50891 0.22899 -510.8649745 0.041561919 -10.4577 0.044447098 0.879172 50.08658 0.134706 -523.7905854 0.403722673 -7.47947 0.193633871 0.295377 47.53695 0.231356 -355.5510181 0.78666654 -5.4022 0.145435118 0.622816 48.80629 0.254575 -263.6615351 0.409970904 -7.44726 0.194370119 0.072551 46.16513 0.092484 -343.803705 0.998444998 -1.07872 0.002521309 0.942927 50.69686 0.076755 -54.6876935 0.436928703 -7.30954 0.196973083 0.252925 47.34658 0.214267 -346.0818455 0.380578813 -7.59994 0.190465948 0.069871 46.13573 0.08985 -350.6289009 0.057301655 -10.1477 0.057448361 0.486726 48.28973 0.267198 -490.0293183 0.726584986 -5.78699 0.166360343 0.763542 49.41043 0.206638 -285.9374711 0.442016526 -7.28374 0.19736054 0.911295 50.35207 0.107657 -366.7512842 0.799897885 -5.30951 0.140023922 0.455109 48.17112 0.265652 -255.7649244 0.146342335 -9.09652 0.114669501 0.391329 47.92775 0.257365 -435.975784 0.077121412 -9.84143 0.072296739 0.962472 50.99575 0.054824 -501.8709839 0.166929383 -8.92476 0.12505248 0.546361 48.51319 0.265539 -432.9687012 0.53326548 -6.82506 0.198777284 0.916709 50.40355 0.102701 -344.0071664 0.047384846 -10.3335 0.049400233 0.110308 46.51157 0.126263 -480.6288911 0.81453545 -5.20255 0.133672766 0.94305 50.69846 0.076625 -263.7613805 0.792734075 -5.36013 0.142991732 0.865438 49.98843 0.145175 -267.9445337 0.111038059 -9.43407 0.094652959 0.116118 46.55674 0.130973 -439.2196845 0.468792391 -7.14863 0.198860518 0.875833 50.06203 0.137307 -357.8750328 0.018868665 -11.1474 0.023040612 0.318875 47.63678 0.239295 -531.0268443 0.694115955 -5.97692 0.175364284 0.282065 47.47879 0.226386 -283.7768353 0.512240904 -6.93064 0.199377235 0.968116 51.10569 0.047955 -354.1953304 0.098181013 -9.57599 0.086578869 0.940118 50.66095 0.079706 -485.1288671 0.498371892 -7.00018 0.199469479 0.87736 50.0732 0.136122 -350.5215455 0.045447548 -10.3734 0.047772254 0.593413 48.69205 0.259983 -505.1026471 0.747917768 -5.65612 0.159587102 0.730554 49.25635 0.22135 -278.5996993 0.995558649 -1.75895 0.006504794 0.32163 47.64827 0.240157 -83.81086009 0.128840982 -9.25579 0.10511821 0.344791 47.74336 0.246848 -441.9027079 0.54543744 -6.76374 0.198175966 0.60598 48.74059 0.257856 -329.6684733 0.448370702 -7.25158 0.197798392 0.34397 47.74003 0.246628 -346.1905496 0.439730735 -7.29532 0.197190528 0.797037 49.57956 0.189273 -361.6989804 0.781459021 -5.43776 0.147481669 0.129489 46.65494 0.141378 -253.6983876 0.341143811 -7.81071 0.183440163 0.252094 47.3427 0.213896 -369.7800066 0.817663891 -5.17902 0.13226402 0.355092 47.78486 0.249509 -247.4789586 0.280781701 -8.15306 0.168539023 0.947252 50.75498 0.072119 -413.8085367 0.612835494 -6.41859 0.19143843 0.330076 47.68325 0.242711 -306.0590496 0.814341093 -5.20401 0.13375968 0.124585 46.61979 0.13763 -242.6096411 0.218220107 -8.54846 0.147356902 0.878236 50.07965 0.135438 -428.1037879 0.8482697 -4.93394 0.117472856 0.139647 46.72493 0.148901 -230.5379714 0.151572955 -9.05144 0.117391872 0.322382 47.6514 0.24039 -431.3138467
0.034962829 0.008820319 0.00779468 0.005987274 0.044798398 0.037024101 0.017976223 0.000193522 0.042204768 0.017113421 0.01535008 0.034376306 0.021247215 0.037197571 0.029511908 0.003963581 0.033206259 0.020414713 0.006237414 0.010242616 0.020758871 0.012396935 0.027304917 0.005513493 0.039699987 0.009561102 0.006900846 0.027152108 0.012419976 0.03532457 0.001562169 0.025948258 0.051100851 0.048782588 0.037322911 0.02085068 0.039237027 0.033001123 0.012154919 0.046464295 0.018409364 0.019957734 0.017491805 0.028219777
76

Bank Data
77

Forex Transactions RandomVariable Z P(z) 0.766032325 1115.2 0.000426046 0.069372242 -472.323 0.000185315 0.017023026 -932.136 5.8661E-05 0.711634962 994.5522 0.000474468 0.762199469 1106.244 0.000429879 0.418933977 445.7007 0.00054296 0.761255131 1104.05 0.000430813 0.189727478 -39.4656 0.000376808 0.056208001 -549.273 0.000157277 0.888358926 1469.213 0.000264118 0.646383006 863.1699 0.00051669 0.540905762 666.8399 0.000551529 0.152375247 -145.524 0.000327447 0.288912515 192.4661 0.000474892 0.842134661 1314.818 0.000335189 0.356417579 328.1077 0.000518137 0.439218736 482.8797 0.000547999 0.965653572 1902.795 0.00010574 0.826944188 1270.846 0.000355718 0.314508897 245.3192 0.000493376 0.256531588 122.3038 0.000447673 0.901385057 1520.758 0.000241431 0.949122058 1770.376 0.000145339 0.983341952 2124.28 5.75837E-05 0.338004436 292.2286 0.000508082 0.386871276 386.0791 0.000532002 0.263547972 137.8674 0.000453945 0.625400864 822.9647 0.000526824 0.281924636 177.666 0.000469387 0.560907015 703.2147 0.000547972 0.087104428 -384.771 0.000220257 0.72872554 1031.101 0.00046061 0.576970029 732.6284 0.000544095 0.718607853 1009.334 0.00046896 0.633581501 838.548 0.000523067 0.192330038 -32.5876 0.00037997 0.853400131 1349.254 0.00031911 0.56855533 717.1939 0.00054624 0.1231492 -241.285 0.000283123 0.092983453 -358.725 0.00023121 0.513707326 617.6599 0.000554119 0.552167022 687.2908 0.000549699 0.008661022 -1119.41 3.26631E-05 0.807171192 1217.141 0.000380572
78

Currency Swaps RandomVariable Z P(z) 0.373075588 502.145 0.005781176 0.727568237 562.9927 0.005071842 0.059941008 421.4976 0.001817702 0.111668266 443.6028 0.002902588 0.168700092 460.5233 0.003845338 0.905317551 609.2892 0.002574687 0.583185639 537.0985 0.005959243 0.629899084 545.0572 0.005766293 0.630760069 545.2066 0.005761918 0.347153928 497.6071 0.005639375 0.608340165 541.3514 0.005866116 0.609820769 541.604 0.005859855 0.764453608 570.5383 0.004698758 0.084402702 433.2335 0.002363737 0.981650309 660.1466 0.000687186 0.774340476 572.6676 0.004587501 0.17906541 463.1677 0.003993969 0.304772696 489.8991 0.005347265 0.529949577 528.2642 0.006074993 0.96361602 640.8412 0.001218082 0.385813544 504.3368 0.005840885 0.716413866 560.8151 0.005172135 0.606469844 541.0328 0.005873901 0.741404444 565.7566 0.004939472 0.612094443 541.9923 0.00585007 0.504810535 524.1331 0.006091725 0.750306698 567.5753 0.004849541 0.11131178 443.4799 0.002895954 0.123808065 447.6331 0.003122557 0.537535004 529.5138 0.006065183 0.19824285 467.8183 0.004252575 0.155005354 456.8637 0.003638927 0.025521262 395.5753 0.000908069 0.933442072 621.6964 0.001972124 0.750233594 567.5602 0.004850295 0.162087247 458.7814 0.003747126 0.933008872 621.4773 0.001982048 0.67878236 553.7477 0.00546967 0.317990921 492.3481 0.00544657 0.411814222 508.7483 0.005942715 0.209064628 470.3226 0.004389522 0.632446193 545.4995 0.005753264 0.12361661 447.5717 0.003119175 0.128083762 448.9862 0.003197369
79

Investments (outside India) RandomVariable Z P(z) 0.660024343 1097.054 0.006171609 0.951950736 1171.357 0.001682845 0.101483474 996.9781 0.002987993 0.40282532 1057.956 0.006519396 0.910827031 1152.465 0.002716578 0.960352676 1176.743 0.00144109 0.572238825 1083.373 0.006609274 0.252319115 1032.952 0.005378801 0.033970199 964.1913 0.001269983 0.937783114 1163.779 0.002064208 0.873465631 1140.417 0.00349701 0.383197939 1054.925 0.006429636 0.703869019 1104.359 0.00582196 0.22449652 1027.615 0.005045282 0.570538731 1083.116 0.006614426 0.180645501 1018.365 0.004429778 0.152747083 1011.727 0.003974988 0.105840138 998.414 0.003080529 0.683399843 1100.895 0.005996506 0.181350257 1018.524 0.004440599 0.923915249 1157.574 0.002410577 0.944989218 1167.44 0.001874035 0.628559421 1092.038 0.00636774 0.119186452 1002.564 0.003353332 0.62352783 1091.25 0.006394979 0.730514461 1109.037 0.005564042 0.419029347 1060.429 0.006580856 0.375572101 1053.735 0.006390189 0.21664213 1026.043 0.004943373 0.012614619 939.7033 0.000549365 0.473101757 1068.557 0.006704463 0.365275138 1052.117 0.006332825 0.281496799 1038.224 0.005684687 0.378892498 1054.254 0.006407681 0.666985366 1098.187 0.006122122 0.590428264 1086.137 0.006546367 0.047464741 973.4203 0.001666433 0.562347407 1081.879 0.006637513 0.481065201 1069.744 0.006712172 0.567985974 1082.73 0.006621929 0.453956617 1065.696 0.006674938 0.879997953 1142.32 0.003369502 0.047995126 973.7372 0.001681328 0.777337654 1117.875 0.005021797
80

Borrowings (outside India) RandomVariable Z P(z) 0.341289109 645.8693 0.002584164 0.092163662 515.4321 0.001163961 0.339471831 645.1653 0.002578899 0.982251782 1002.505 0.000308034 0.323378789 638.8655 0.002529483 0.203463971 586.1794 0.001992006 0.080135832 504.5538 0.001048322 0.788589184 817.7525 0.002037638 0.675983117 768.7583 0.002531538 0.162185572 563.9993 0.001728755 0.546226727 720.4285 0.002790659 0.578035942 731.8929 0.002755619 0.360190943 653.1109 0.002635196 0.589175382 735.9472 0.002739055 0.727634913 789.9412 0.00233871 0.466515831 692.006 0.002799639 0.737565157 794.2268 0.002295301 0.667492048 765.4218 0.002558132 0.42127766 675.734 0.002754663 0.390566631 664.4856 0.002703164 0.143223241 552.5779 0.00159185 0.267467251 615.831 0.002317564 0.065933605 489.9821 0.000902875 0.553572796 723.0638 0.002784171 0.543043786 719.2884 0.002793172 0.797421766 822.1418 0.001986823 0.574550191 730.629 0.002760342 0.640244007 754.9302 0.002634098 0.781399752 814.2585 0.002077596 0.931082485 914.6454 0.000934297 0.594572625 737.9209 0.002730223 0.001927638 293.604 4.3181E-05 0.482745781 697.7948 0.002806913 0.641855741 755.5425 0.002629997 0.157280675 561.1335 0.001694365 0.022112851 418.2508 0.000371227 0.034949095 446.5612 0.000543523 0.749126617 799.3226 0.002242074 0.291856233 626.1287 0.002417867 0.38065758 660.8063 0.002682872 0.182457772 575.2846 0.001863709 0.025204199 426.1263 0.000414414 0.393698544 665.6429 0.002709202 0.869228845 863.3639 0.001495909
81

Deposits (outside India) RandomVariable Z P(z) 0.787607766 107.2273 0.01242181 0.682799072 99.6926 0.015254961 0.918174526 121.1181 0.006474641 0.688201498 100.048 0.015143206 0.6828211 99.69404 0.015254513 0.482860278 87.58226 0.017065359 0.824958301 110.4102 0.011038583 0.564285536 92.36598 0.016858878 0.622824392 95.89418 0.01626505 0.713716859 101.7651 0.01456717 0.465167597 86.54417 0.017015976 0.846207422 112.4159 0.01014992 0.871213525 115.0281 0.008998848 0.864789999 114.3263 0.009306066 0.903249295 118.9552 0.007334552 0.102251614 58.95164 0.007637075 0.917983683 121.0887 0.006486017 0.784407016 106.9708 0.012530437 0.546571585 91.31872 0.016964605 0.26858391 74.17314 0.014119644 0.954750604 128.1219 0.004076484 0.676981806 99.31272 0.015371377 0.191426213 68.20455 0.011672233 0.49036118 88.02165 0.01707614 0.442637861 85.21613 0.01690425 0.912756783 120.3014 0.006793657 0.520056497 89.76069 0.017059535 0.897781388 118.2247 0.007635282 0.628828391 96.26424 0.016182577 0.5793954 93.26525 0.016741734 0.89651441 118.0595 0.00770393 0.64691195 97.39103 0.015909412 0.93100924 123.2307 0.005684885 0.204710158 69.31952 0.0121549 0.247528587 72.65067 0.013534148 0.134835286 62.80544 0.00928837 0.76868189 105.7411 0.013042582 0.577363782 93.14396 0.016758935 0.745871141 104.0371 0.013724024 0.098999885 58.52083 0.007459143 0.236860721 71.85308 0.013214741 0.858377967 113.6481 0.009604626 0.041788311 48.17356 0.003822881 0.104242113 59.21045 0.007744738
82

Overseas Fund Based Non Fund Based Random Variable Z P(z) RandomVariable Z P(z) 0.038124986 690.1009 0.000797522 0.685834274 227.2767171 0.002984311 0.942692127 1038.267 0.001105827 0.087620427 8.544531722 0.001338794 0.77492533 952.7893 0.002886815 0.034837811 -45.9662251 0.000647401 0.753587802 945.5839 0.003034706 0.922659733 338.9375167 0.001218714 0.479826413 869.0633 0.003834396 0.570995541 190.992316 0.003302004 0.251955695 804.8719 0.003070827 0.109276224 23.42705836 0.001573982 0.39759126 847.3463 0.003712104 0.524099444 176.9069266 0.003349152 0.405084162 849.3599 0.003730124 0.678005871 224.6672304 0.003015459 0.478295698 868.664 0.003833623 0.709441825 235.3236471 0.002881518 0.943136902 1038.671 0.001099066 0.938128082 352.7365515 0.00102623 0.334011803 829.7569 0.003501986 0.72896272 242.2108168 0.002786203 0.673913913 921.1571 0.003468441 0.871776837 304.6513518 0.001762289 0.054106534 707.4118 0.001056782 0.190655457 65.62501854 0.002287131 0.54620879 886.3828 0.003813523 0.670668105 222.2451156 0.003043349 0.491981846 872.2314 0.00383853 0.683765945 226.5846216 0.002992681 0.398842993 847.6834 0.003715212 0.527577071 177.9455743 0.003347256 0.408124197 850.1741 0.003737037 0.002179356 -169.259431 5.76446E-05 0.704343563 930.1129 0.003323912 0.924098757 340.1267323 0.001201429 0.219798922 794.0108 0.002848025 0.874751563 306.3531448 0.001733719 0.636703334 910.6532 0.003611634 0.573245711 191.6741252 0.003298564 0.395853519 846.8779 0.003707726 0.082541595 4.66576894 0.0012802 0.426770975 855.1381 0.003774443 0.34584273 122.5679691 0.003101545 0.476589107 868.2188 0.003832693 0.012684163 -96.1103603 0.000275615 0.584026281 896.3702 0.003753828 0.231577831 82.48776343 0.002563581 0.510536907 877.0648 0.003837967 0.227864407 81.0326847 0.002540477 0.256593769 806.3751 0.003100336 0.258176526 92.5565998 0.002718141 0.095289426 738.3155 0.001630233 0.819439224 278.3030554 0.002211209 0.699447889 928.6455 0.003348876 0.603945057 201.0586878 0.003240731 0.925182448 1024.036 0.00135976 0.796028367 268.1119444 0.002382477 0.30803398 822.2163 0.003385749 0.154423325 48.72199855 0.001999172 0.948791886 1044.031 0.001011604 0.168980033 55.78958343 0.002120086 0.764678049 949.284 0.002959617 0.147274924 45.08989184 0.001937077 0.017784806 655.9206 0.000421676 0.731447183 243.1045718 0.002773385 0.453165438 862.0931 0.003812819 0.334430132 118.8649536 0.003061989 0.816722156 968.1449 0.002553941 0.3188837 113.7391887 0.003003256 0.832473328 974.4877 0.002412486 0.840503294 288.2072421 0.002042142 0.617984532 905.5129 0.003670156 0.694629164 230.2418899 0.002947584 0.918866618 1019.533 0.001446005 0.324957462 115.7536226 0.003026874 0.357868902 836.48 0.003592991 0.370300872 130.3573721 0.003176356 0.225930306 796.1468 0.002893021 0.334813267 118.9900516 0.003063366 0.418699488 852.9954 0.003759303 0.56130334 188.0632353 0.003315584 0.138944744 761.5701 0.002131019 0.353613938 125.0633325 0.003126778 0.384889204 843.9092 0.003678354 0.183448776 62.43653575 0.002233258
83

Domestic Fund Based Non Fund Based Random Variable Z P(z) RandomVariable Z P(z) 0.273654797 2634.673 0.007049239 0.609706715 1567.958648 0.001195376 0.100544519 2602.721 0.003731371 0.243924218 1255.816715 0.000976894 0.133674718 2610.714 0.004566975 0.739836119 1684.908148 0.001010692 0.578062442 2672.389 0.008286326 0.029975014 874.6078519 0.000211797 0.498221415 2662.879 0.008448503 0.056423866 969.5191159 0.000353567 0.008239371 2549.85 0.000476385 0.97122563 2088.221588 0.000204729 0.025422314 2570.879 0.001255215 0.707583553 1653.927598 0.00107038 0.374374198 2647.966 0.008026161 0.816620411 1768.28823 0.000826917 0.24190017 2630.026 0.006611806 0.455115559 1442.335921 0.00123479 0.624060368 2678.019 0.008036711 0.852596855 1814.863004 0.000717836 0.99683825 2792.025 0.000203139 0.837305877 1794.255364 0.00076619 0.919092885 2729.151 0.003175308 0.054792666 964.8520237 0.000345474 0.006890477 2546.791 0.000406978 0.481972576 1464.019978 0.001241395 0.284716795 2636.227 0.007186352 0.893553138 1878.43228 0.000572031 0.715976541 2690.049 0.007177984 0.449835941 1438.05686 0.001232827 0.159551154 2616.045 0.005143265 0.809075282 1759.277717 0.000847798 0.022080352 2568.057 0.001114935 0.054049642 962.6896582 0.000341763 0.336109444 2643.111 0.007725221 0.452834064 1440.487633 0.001233969 0.450559111 2657.223 0.008383624 0.062362752 985.6624298 0.000382426 0.730690416 2692.126 0.006993259 0.285773041 1296.896413 0.001058874 0.327618766 2642.006 0.007647042 0.930598077 1953.751743 0.000415477 0.327942425 2642.049 0.0076501 0.687939516 1635.846487 0.001102079 0.026790742 2571.946 0.001311477 0.267594158 1279.454563 0.001025307 0.150598471 2614.271 0.004950832 0.190402194 1197.169435 0.000846374 0.337794274 2643.329 0.007740235 0.898047164 1886.4116 0.000554421 0.216717889 2626.101 0.006216453 0.968160238 2073.870324 0.000222646 0.08274824 2597.604 0.003229617 0.528378265 1501.387934 0.001239518 0.689254951 2686.404 0.00747908 0.340250367 1346.334995 0.001141651 0.741757909 2693.725 0.006845182 0.797331234 1745.676235 0.000879009 0.32899367 2642.186 0.007659988 0.924718346 1940.038446 0.000442192 0.669603797 2683.811 0.007673079 0.038924465 912.4438388 0.000262536 0.83322732 2708.752 0.005293382 0.471684052 1455.726342 0.001239532 0.277430923 2635.207 0.007096912 0.037494131 906.9122409 0.000254642 0.016124681 2561.978 0.00085334 0.252560046 1264.574506 0.000995187 0.369686039 2647.381 0.007993747 0.564082682 1530.324596 0.001226597 0.049951358 2585.398 0.002182457 0.488733015 1469.463993 0.001242168 0.533797062 2667.095 0.008418251 0.472659159 1456.512947 0.001239744 0.719625175 2690.559 0.007133452 0.825748384 1779.503996 0.000800761 0.700444405 2687.913 0.007358308 0.284461696 1295.656624 0.001056555 0.592056533 2674.085 0.008222649 0.911047459 1911.045108 0.000501445 0.220004822 2626.628 0.006270591 0.667857174 1617.863725 0.001130972 0.385843926 2649.388 0.008100295 0.213666336 1223.703504 0.000906854 0.040806502 2580.861 0.001854764 0.707100309 1653.476302 0.001071202
84
tional Principal Amount - Hedging MTM(INR) Notional Principal Amount - Trading MTM(INR) P(z) Z P(z) 0.002490657 1880.637561 4.5185E-05 0.008633136 481.892692 9.40937E-05 0.018755318 6856.787687 0.000177733 0.021982233 -9223.775657 0.000232149 0.017890758 20523.49874 0.000112183 0.019182044 5371.095709 0.000227175 0.022878094 23036.28632 0.000124555 0.026513617 24631.75646 0.000119865 0.006392936 7802.667357 0.000186057 0.014478442 16604.93137 0.000198936 0.009789868 -4629.940386 0.000167124 0.020765776 -24169.95878 7.42476E-05 0.014910516 13698.31469 0.000130707 0.017391481 16483.33337 0.000160394 0.021604127 3592.80977 0.000211077 0.025193372 -498.1584914 0.000246607 0.020683768 -19083.5307 0.000130368 0.004455304 -2264.893789 0.00027116 0.020323684 -24391.69357 0.000104425 0.015597954 6777.40422 0.000200282 0.018934975 -21568.47852 0.000105988 0.024777947 17544.31465 0.000162331 0.01040887 13313.35744 0.0002155 0.018991938 -19237.58792 0.00014859 0.021437667 18872.78206 0.000152533 0.015183622 -10945.0672 0.000122514 0.009724274 -11903.82442 0.000199768 0.011232056 6114.910676 0.000110326 0.016812381 13325.40387 0.000201607 0.002411876 -20097.54465 0.00013757 0.005385685 -12380.98836 0.000198285 0.021337744 -16837.79976 0.000171791 0.024355078 15636.9335 0.000206244 0.001690883 -4632.731437 4.85066E-05 0.024919616 10288.36403 0.000233437 0.013124653 -15302.15022 0.000108987 0.025747515 -20318.39628 0.000128352 0.021498214 -33539.89332 3.70622E-05 0.02265289 7084.837579 0.000246303 0.017947043 -1215.683134 0.000177199 0.003316838 -17172.57888 2.08107E-05 0.005992423 12674.49689 0.000207304 0.011645517 32481.05406 6.6013E-05 0.004218611 16796.63461 2.77764E-05
85

Interest Rate Derivative Assets (INR) RandomVariable Z P(z) 0.277865293 468.7549 0.000139165 0.48697068 1809.93 0.000165455 0.628363158 2677.94 0.000156899 0.170970816 -401.555 0.00010539 0.133904111 -781.808 8.9592E-05 0.279457344 480.179 0.000139553 0.241111072 195.1403 0.000129324 0.947448436 5794.122 4.45254E-05 0.219951088 27.3507 0.00012285 0.050328638 -2067.61 4.30209E-05 0.244313994 219.8184 0.000130251 0.837151057 4257.13 0.000102133 0.389979929 1215.396 0.000159208 0.310389501 696.3648 0.000146474 0.3707101 1093.451 0.000156772 0.307563406 677.0321 0.000145889 0.454491486 1613.148 0.000164465 0.150667673 -602.15 9.70375E-05 0.004360801 -4431.96 5.31085E-06 0.864531625 4541.718 9.03089E-05 0.549796397 2190.24 0.000164252 0.710982455 3229.169 0.000141815 0.293213036 577.6156 0.000142773 0.364809244 1055.712 0.000155945 0.78350518 3778.212 0.000121734 0.851723587 4404.225 9.60068E-05 0.569855534 2312.806 0.000162999 0.624525316 2653.52 0.000157412 0.656527616 2859.847 0.000152632 0.055069832 -1961.31 4.62068E-05 0.511736054 1959.554 0.000165472 0.845795935 4343.287 9.85432E-05 0.951219347 5881.34 4.19615E-05 0.383314875 1173.428 0.000158411 0.787610267 3812.121 0.000120387 0.660575168 2886.425 0.000151946 0.90384109 5030.552 7.07639E-05 0.910304512 5124.248 6.72155E-05 0.66399814 2908.997 0.000151351 0.234355316 142.495 0.000127323 0.43241061 1478.39 0.000163162 0.350379626 962.5393 0.00015376 0.919996063 5274.655 6.16923E-05 0.089779902 -1345.69 6.72625E-05
86

Derivatives As Risk Management Tool For Corporates

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Preface

Derivatives as Risk Management Tool for Corporates

Derivatives as a Risk Management Tool for Corporate

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

1.1 Factors that Impact Financial Rates and Prices

1.2 Factors that Affect Interest Rates

1.3 Factors that Affect Foreign Exchange Rates

Derivatives as Risk Management Tool for Corporates

1.4 Factors that Affect Commodity Prices

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

1.5 Transaction Exposure

1.6 Translation Exposure

Derivatives as Risk Management Tool for Corporates

1.8 Strategic Exposure

Derivatives as Risk Management Tool for Corporates

1.10 Credit Risk

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

2.0 Review of Literature

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

3.0 Data and Methodology

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Derivatives as Risk Management Tool for Corporates

Figure 2 Buyers Credit MTM

Figure 3 Buyers Credit

Derivatives as Risk Management Tool for Corporates

Figure 4 Exchange Rate Probability

Buyers Credit(million USD) Mean SD 48.525 21.95566556

Exchange Rate 48.33938821 1.49223283

Table 1 Buyers Credit

Buyers Credit( million USD) VaR 99.55124051

Buyers Credit MTM(INR Crores) 4828.304403 2995.727385

Buyers Credit Present 64.05 Value

Table 2 Buyers Credit VaR

Derivatives as Risk Management Tool for Corporates

Instrument Forex Forwards Currency Futures

Disadvantage Counter Party Risk Initial Margin

Derivatives as Risk Management Tool for Corporates

Figure 5 Commodities Contract

Commodities(INR Crores) Mean SD 24.44 12 Table 4 Commodities Contract

Commodities(INR Crores) VaR -3.56561

Derivatives as Risk Management Tool for Corporates