MANAGING RISK

Brealey-Myers Ch. 27 & Ch. 28

Contents
1.
2.
3.
4.
5.
6.
7.
8.

Why manage risk?

Insurance
Forward & futures contracts
Swaps
Setting up a hedge
Case: Metallgesellschaft
Should cos. trade in derivatives?
International risks
2

1. Why Manage Risk?

A. Reducing risk of cash shortfalls / financial
distress
B. Mitigating agency costs
C. Evidence on risk management

1A: Reducing Risk of Cash Shortfalls

Cash shortages resulting from risk factors result in:
Inability of the firm in meeting its expenses &
other dues on time
Foregoing profitable investment / business
opportunities
Not hedging certain types of risk can result in
such large potential outflow of funds that firm
will face bankruptcy
4

1A: Reducing Risk of Cash Shortfalls

Lenders are aware of all risks in any industry and
require the firms to arrange hedging / insurance
arrangements, to protect themselves
It is only by hedging risks, as required by the
lenders, a firm can avail of the benefits of debt
financing

1B: Mitigating Agency Costs

Agency costs relate to the behaviour of managers & the
decisions they take
In order to increase their incentives they may try to
improve profitability by taking very high risks this can
affect the existence of the firm
In order to protect their jobs they may not even take
the reasonable risks this can affect the growth of firm
Managers can be better monitored & motivated in the
presence of hedging
In the presence of hedging their performance can be
separately identified from the impact of market
volatility
6

1C: Evidence on Risk Management

Risks Hedged
Fire, accidents, theft
Market risks: Currency
Market risks:
Commodities: input /
output
Market risks: Interest
rates

Hedging Tools
Insurance
Derivatives
Derivatives

Derivatives

1C: Evidence on Risk Management

Hedging tends to be common practice when
top management holds large personal equity
shareholdings in the co.
Hedging is less common when top
management holds stock options instead of
equity positions. Why?
Firms that hedge tend to have high debt ratios

2. Insurance
Firms use insurance to protect against specific risks
fire, accidents, natural calamities
Insurance is a risk transfer mechanism
Insurance cannot be used to cover macroeconomic
risks
Buying insurance is not a Zero-NPV deal for the
insured because the premium charged by insurer
has to compensate for: 1. Losses on risk covered, 2.
Admin. costs 3. Adverse selection 4. Moral hazard 5.
Profit
When the costs related with 1, 2, 3 & 4 above are
large, insurance is an expensive tool of protection
9

2. Insurance
Most of the risks faced by the insurance cos. follow
a jump process (jump risks): a sudden strike of
hurricane & widespread damages, sudden terrorist
attack causing widespread loss of life & property
Insurers have started to protect themselves from
such large risks by issuing catastrophe bonds (Cat
Bonds)
These bonds are a means of sharing catastrophic
risks with investors
Payment on a Cat Bond depends on whether a
specified catastrophe occurs & how much is lost
10

2. Insurance: Cat Bonds

Public issue of 1st Cat Bond was made by
Winterthur, Swiss Auto-insurance giant
Purpose: To protect itself from storm damage which
generally leads to large no. of claims
The Cat Bonds had an embedded condition: Interest
payments will not be made if there was a hailstorm
in which 6000 or more cars insured by it, were
damaged
Effectively the investors in the Cat Bonds had
coinsured the insurance cos risks
11

2: Caselet: British Petroleum (BP)

Conventional practice of cos is to buy insurance against
large potential losses & do not buy insurance against
routine losses because large losses can cause financial
distress but not the small ones
BP questioned the conventional practice & changed its
insurance strategy
It allowed local managers to buy insurance against
routine risks (those risks in which insurance cos. were
more efficient in assessing & pricing risk, & charge
competitive premiums due to intense competition)
It decided not to buy insurance for losses over $10 m
12

2: Caselet: British Petroleum (BP)

According to BP insurance cos. were less efficient in
assessing such large & specialised risks than BP
itself & hence less effective in advising on the
protective measures
Hence the insurance premiums charged on such
large risks were not competitively priced
BP assessed large losses of over $ 500 m have a very
low probability of occurrence (once in 30 years ).
For smaller cos. this would mean bankruptcy. But
for a giant like BP, such loss after tax adjustment
would be less than 1% of its equity value
13

2: Caselet: British Petroleum (BP)

Before implementing the new insurance
strategy BP was paying $ 115 m a year in
premiums & receiving $ 25 m a year in
claims
Assume that $ 35 m of premiums & the
entire amount of claims were for routine
risks and its opportunity cost of capital is
10%
14

2: Caselet: British Petroleum (BP)

Que 1: What would be the value of savings made by
the change in strategy without considering the
expected cost of not insuring for the big risks?
Que 2: What would be the expected cost of not
taking insurance protection for the big risks?
Que 3: Is the change in insurance strategy justified
financially?

15

2: Caselet: British Petroleum (BP)

Conclusion: For very low-probability risks
investors themselves can eliminate the
impact by holding diversified portfolios
(thus stock market could absorb the risk
more efficiently than the insurance
industry)

16

3. Forward & Futures Contracts

A.
B.
C.
D.
E.
F.
G.

What is a forward contract?

What is futures contract?
Pricing of financial futures contracts
Commodity spot & futures prices
Option Contracts
Related matters
Concept of forward interest rates
17

3A: What is a Forward Contract?

It is a contract of purchase & sale of a specified
asset for delivery & payment to be made in future
The specified price is for future delivery: hence
called forward price in contrast with the price for
immediate delivery called spot price
The buyer is said to have a long position; seller is
said to have a short position
Both parties eliminate their business risks: buyer
fixes the costs & seller fixes the revenues
However both are exposed to counterparty risk
18

3B: What is a Futures Contract?

A futures contract is a standardised forward
contract
Futures contracts are traded on futures
exchanges
Futures contracts are marked to market
Each day the profits / losses on the position are
calculated & the parties pay to the exchange any
losses incurred in a day or receive any profits
earned in the day from the exchange
19

3B: What is a Futures Contract?

Effectively each day the parties close out their
position at a profit / loss and reopen a new contract
at the prevailing market price for the same delivery
date
The futures exchange settles each futures contract
on a daily basis with the resulting cash flows from
profits / losses paid & received
By this mechanism the futures exchange guarantees
the contracts & eliminates counterparty risk
20

3C: Pricing of Financial Futures

An index futures contract is an example of a
financial futures
For a specified maturity index futures are sold
at a specified price and each index futures
contract is for a specified multiple of the index
So if the index is an artificial asset then the
multiple represents the quantity of the asset

21

3C: Pricing of Financial Futures

If a person sells an index futures to you for delivery
of the index after six months then the seller has to:
1. Buy the index today at the spot price
2. In order to pay for the spot price he has to arrange
for money & incur financing cost at the prevailing
interest rate
3. Hold the index for six months
4. Earn any income the index distributes during the 6month holding period
22

3C: Pricing of Financial Futures

So the price of the index futures contract today
should be equal to:
Spot price of index today + (Interest on the spot
price - Any income/dividends generated by the
index during the period up to the maturity)
Ft S0 (1 rf y)t

23

3C: Pricing of Financial Futures

Eg 4: Calculate the price of 6-month DAX index
futures contract if the current value of the index is
3970.22, risk-free interest rate is 3.5% pa and the
dividend yield on the index is 2% pa. Assume semiannual compounding.

24

3D: Commodities Spot & Futures Prices

Differences between buying commodities spot &
futures:
Buying futures allows the buyer to save on the cost
of financing
There is no need of storage; so futures buyer can
save on the storage costs, wastage, security etc
But buyer of commodity futures loses the gains
from any opportunities which require immediate
availability of the commodity: convenience yield
25

3D: Commodities Spot & Futures Prices

So the price of a commodities futures contract today
should be equal to:
Spot Price
+ (Interest on spot price + Storage costs
- Convenience Yield) up to the maturity of contract
Ft S0 (1 rf Storage Cost - Convenience Yield)t

Exception: There is no convenience yield for

commodities like electricity
26

3D: Commodities Spot & Futures Prices

Eg 5: In Jan 2006 the spot price of coffee was Rs. 102 /
kg & 3 month futures price was Rs. 98 / kg. The
interest rate was 6% pa. Calculate net convenience
yield (convenience yield storage costs).

27

3E: Option Contracts

An option contract gives the holder the right to
buy/sell the underlying asset by a specified
future date for a specified price
2 types: Call & Put options
A call option gives the holder right to buy
A put option gives the holder right to sell
The writer of the option has the obligation to
take the opposite position of the holder
The holder may not exercise the right
28

3F: Related Matter

Trading in futures contracts happens in large
volumes due to their liquidity. They are very liquid
because they are standardised & have limited no. of
maturity dates in a year
If futures contracts on an asset do not suit the
needs of an investor then forward contracts can be
customised to the suit the specific requirements
Forward contracts are also possible on: Electricity,
Interest rates
29

3G: Concept of Forward Interest Rates

Suppose the interest rates prevailing now are:
For 1 year: 10% pa
For 2 years: 12% pa
The interest rates available now are called spot rates
The spot interest rate for 2 years includes: (a) the spot
rate of interest for 1st year & (b) the rate of interest for
the 2nd year decided now (called forward rate)
Forward rate of interest is the rate applicable to a
future time period decided now
30

3G: Concept of Forward Interest Rates

So:
(1 + 2-year spot rate)2 = (1 + Spot rate for year 1) X
(1 + Forward rate for year 2)
Hence: Forward interest rate for year 2 =
(1 2 - year spot rate)
-1
(1 1 - year spot rate)
2

1.122

- 1 0.1404 14.04%
1.10
31

3H: Creating a Synthetic Forward Lending

A forward lending is a commitment given now for
lending at a future point of time
The interest rate applicable in a forward lending
or forward borrowing commitment is a forward
interest rate

32

3H: Synthetic Forward Lending: Example

Eg. 6:
How will you create a synthetic forward lending
transaction for 1 year, given the following data?
Funds available now: 100
Spot rate of interest for 1 year: 10%
Spot rate of interest for 2 years:12%
Demonstrate the transaction by showing the cash
flows.
Also calculate the rate of interest applicable to the
forward lending transaction
33

3H: Synthetic Forward Lending: Eg. 6: Sol.

Steps:
1. Borrow 100 now for 1 year at 10%
2. Lend 100 now for 2 years at 12%
3. Draw the net cash flows for now, year 1 & year 2

34

3H: Creating a Synthetic Forward Lending

Net cash Flows in Year 0, 1 & 2
Borrow for 1 year at 10%
Lend for 2 years at 12%
Net cash flow

YEAR 0 YEAR 1 YEAR 2

100
-110
0
-100
0 125.44
0
-110 125.44

The net cash flows show: 1) There is no cash flow in

year 0; 2) There is a synthetic forward lending of
110 at the end of year 1, for a period of 1 year
Forward Rate of Interest = 125.44 1 0.1404 14.04%
110

35

3H: Creating a Synthetic Forward Lending

Conclusion: A synthetic forward lending transaction
is created when you borrow now for a shorter term
and lend now for a longer term.
Question: How will you create a synthetic forward
borrowing?

36

4. Swaps
A. Interest rate swaps
B. Currency swaps

37

4A: Interest Rate Swap: Example

ABC Bank has made a 5-year Rs. 50 m loan carrying
interest rate of 8%, to a project
Interest receipts are of Rs. 4 m pa; the principal is to be
repaid in year 5
ABC Bank wants to receive interest payments at a
floating rate; so it wants to exchange the fixed interest
receipts for floating interest receipts. How can we
determine the amount of floating interest receipts?
Given its credit rating ABC can borrow at 6% fixed rate
for 5 years
So its annual receipt of Rs. 4 m can support a fixed rate
loan of: 4 / 0.06 = Rs. 66.67 m
38

4A: Interest Rate Swap

Fixed-To-Floating Rate Swap thru a Swap Dealer:
Counterparty: Swap Dealer
Swap payments on a loan of Rs. 66.67 m at 6%
fixed rate for an equivalent loan with MIBOR
floating rate to be received from counterparty
Rs. 66.67 m principal is notional. It is never
exchanged.
Swap Dealer is quoting a rate of 6% against MIBOR
Example in Excel sheet: Fixed-to-Floating Swap
39

4A: Interest Rate Swap

IRSs have no initial cost / value (NPV = 0) for both
parties
But the value of an IRS drifts away from 0 with time
as long term interest rates change one of the
counterparty gains other loses
Swap dealers try to protect their position by a series
of forward / futures contracts / by an offsetting
swap with a 3rd party
Swaps are exposed to counterparty risk
40

4A: Interest Rate Swap

Example 6A:
Calculate the value of the previous swap if the
market interest rates for long term fixed rate debt,
have increased to 7% with 3 yrs. remaining to
maturity

41

4A: Interest Rate Swap

Example 6: Solution
PV(Fixed rate payments of 4m pa for 3 yrs &
maturity value 66.67m) at 7% discount rate = Rs.
64.92 m
The value of swap = 66.67 64.92 = Rs. 1.75 m

42

4B: Currency Swap: Example

ABC Co. of US requires 8m to finance its European
operations. At present exchange rates 8m = $ 10m
EUR interest rate is 5%; USD interest rate is 6%
ABC is better known in US & not in Europe
What will happen if it borrows in Europe instead of
in US?
So ABC decides not to borrow Euros directly.
Instead it raises $ 10m by issuing 5-year 6% notes in
US & arranges for a swap with a counterparty, XYZ,
to convert the USD loan to a EUR loan
43

4B: Currency Swap

Under the currency swap arrangement XYZ agrees
to pay ABC the USD amount to service its USD debt
In exchange ABC agrees to make a series of annual
payments in EUR to XYZ for servicing its EUR loan

1. Issue USD Loan

2. Swap USD for EUR
3. Net Cash Flow

Year 0
Years 1-4
Year 5
USD EUR USD EUR USD EUR
10
-0.6
-10.6
-10
8 0.6 -0.4 10.6 -8.4
0
8
0 -0.4
0 -8.4
44

4B: Currency Swap

The impact of the swap is:
Line 3 in table: Convert a 6% $ loan into 5% loan
Line 2 in table: Year 1-4: A series of contracts to buy
USD by paying EUR i.e. Buying USD 0.6m by paying
EUR 0.4m. Year 5: A contract to buy USD 10.6m by
paying EUR 8.4m

45

4C: Credit Derivatives

Protect lenders from default risks
A bank can give loan to a borrower with the credit risk
transferred to another bank
Common tool: Default Swap
Like an insurance on loans given with annual premiums
Can be applied to both individual / portfolio of loans
Bank A has given loan to customer X & enters into a
Default Swap with Bank B
Under this Bank A pays a fixed sum every year to Bank
B as long as Co. X has not defaulted. If X defaults then B
compensates A for loss; otherwise pays nothing
46

5. Setting Up a Hedge
A position in an asset can be hedged by using
derivatives: Futures or Options
Setting up a hedge with Futures corporate finance
perspective
Setting up a hedge with Options corporate finance
perspective

47

5. Setting Up a Hedge With Futures: Example

A farmer produces Type A potatoes & wants to hedge
the price of his produce by selling potato futures.
The potato futures are based on Type B potatoes
Historical data suggests that 1% change in the price of
potato futures (with Type B potatoes underlying) is
associated with 0.8% change in price of Type A
potatoes
If the farmer wants to hedge the price for 100 MT Type
A potatoes then he should sell 0.8 x 100 MT of potato
futures = 80 MT worth of potato futures
If 1 potato futures contract = 10 MT then this means
farmer should sell: 80 / 10 = 8 potato futures contracts
48

5. Setting Up a Hedge with Futures: Generalisation

The hedging problem referred to in the example will
not occur if the asset to be hedged & the asset
underlying the futures contract are the same
In that case generally a 1% change in the futures
price of the underlying asset will be associated with
1% change in the value of the asset to be hedged
So the quantity of asset sold by futures contracts
should be exactly equal to the quantity of asset held
The hedging problem referred to in the example is a
situation of Cross Hedging a common problem
49

5. Setting Up a Hedge with Futures: Generalisation

The problem of cross hedging occurs when the
asset to be hedged is different from the one
underlying the futures contract
Suppose the following relation holds between
Changes in Prices of Asset A and Changes in Futures
Prices on Asset B (underlying asset)
Change in Price of A = + (Change in Price of B)
The is called hedge ratio.
Setting up a hedge requires estimating the hedge
ratio
50

5. Setting Up Hedge with Options

Concept applied: Option Delta
Delta represents the change in the value of an
option that occurs with the change in the value of
the underlying asset
For a call option: Delta is +ve: This means an
increase in the value of the asset results in an
increase in the value of the option & vice versa
Based on Delta a position in the asset can be
hedged by taking a position in call option & a
position in call option can be hedged by taking a
position in the asset
51

5. Setting Up Hedge with Options

Because the Delta is +ve a long position in the asset
can be hedged by taking a short position in a call
option on the asset; short position in the asset can
be hedged by a long position in the call
Similarly a long position in a call option can be
hedged by taking a short position in the asset; a
short position in the call option can be hedged with
a long position in the asset
The value of Delta is used to determine the number
of call options to be sold or bought
52

6. Caselet: Metallgesellschaft
In 1993 the MGRM, US subsidiary of German Co.
Metallgesellschaft issued its customers price guarantees on
gasoline, heating oil & diesel for up to 10 years. This way it
aggressively attracted sales.
It had sold > 150 million barrels of oils at prices 3-5 USD
higher than the prevailing spot prices.
It could not protect itself with futures contracts because for
such long years futures contracts do not exist.
So it bought a large no. of short dated futures contracts &
rolled them over at the end of their maturity
Since oil has +ve convenience yields generally, each time it
rolled over its futures it used to sell the maturing contracts at
a higher price than the price it had to pay for the new futures
53

6. Caselet: Metallgesellschaft
In 1993 oil suddenly started showing negative
convenience yields. So the maturing futures
contracts could be sold only at lower prices.
So MGRM had to pay higher to roll over its short
dated futures contracts
Since these oil futures were marked to market & oil
prices continued to fall in 1993, MGRM had to incur
huge marked-to-market losses and had to pay large
amounts in response to margin calls
The fall in oil prices indicated that its long term
forward contracts (guarantees) were appearing
profitable, but this was only in books.
54

6. Caselet: Metallgesellschaft
The BoD of the co. fired the CEO of its US subsidiary
& instructed it to cease all hedging activities & start
negotiating with its customers to cancel the long
term contracts.
Almost at the same time the fall in oil prices
reversed. If MGRM had held on to its long term
contracts then they would have earned huge profits
Discussion Questions:
Was the CEO wrong or the BoD wrong?
Whos mistake led to the massive losses?
55

6A: Other Cases of Derivatives Disasters

Company
Event
Showa Shell, Japanese co. $1.5 billion loss on
positions in forex futures
Barings Brothers:
$ 1.4 billion caused by one
Blue-chip British merchant of its derivatives traders,
bank with 200 year track Nick Leeson, at its
record
Singapore office because
of taking very large bets
on the Japanese stock
market index
56

7. Should Cos. Trade in Derivatives?

In 1970s & 80s cos. turned their treasury functions
into profit centres by entering into derivatives
trading & profits from such activities were also
reported as part of their operations
Losses arising out of indiscriminate trading occurred
because cos. did not understand the risks of such
activities & the potential losses that could result;
they only focused on the profits they had earned
Cos. should not cease derivatives trading. Rather
they should exercise caution in doing so.
57

7. Should Cos. Trade in Derivatives?

Precautions:
1. Senior management should regularly monitor their
derivatives positions and should do sensitivity
analysis of their impact on the firm on a regular
basis
2. They should allow taking large positions only when
they have superior information that increases the
likelihood of profiting from the transactions
58

8. International risks
A. Impact of interest rates on foreign exchange
rates
B. Impact of inflation rates on foreign exchange
rates
C. Relation between interest rates & inflation rates
D. Forward premium & changes in spot rates
E. Transaction exposure & Economic exposure
F. International investment decisions
59

8A: Interest Rates & Exchange Rates

Country A: currency A
Country B: currency B
Exchange rate between currencies of A & B
expressed as: A / B (no. of units of A per unit of B)
Two types of exchange rates between currencies of
A & B: 1. Spot rate (S) & 2. Forward rate (F)
There are two interest rates in currencies A & B:
rA & rB
60

8A: Interest Rates & Exchange Rates

At any point of time the two interest rates: rA & rB
and the two exchange rates: S & F have to fulfill the
following relationship:
1 rA
F

1 rB
S

The above relationship is called Interest Rate Parity

theory
LHS denotes Difference in interest rates between
the two countries / currencies
RHS denotes Difference between forward & spot
exchange rates
61

8A: Interest Rates & Exchange Rates

If the two interest rates: rA & rB and the two
exchange rates: S & F, do not fulfill the above
relationship then there will be opportunities for
earning risk-free arbitrage profits.
Market operators will continue doing arbitrage until
the time the exchange rates (S & F) and the interest
rates (rA & rB ) attain revised values which fulfill the
above relationship

62

8A: Interest Rates & Exchange Rates

Example: Verify whether the IRP theory holds for the
following data:
USD interest rate for 1 year: 1.22% pa
Mexican Peso interest rate for 1 year: 6.7% pa
Spot exchange rate (Peso/USD): Peso 10.9815/ USD
1 year forward exchange rate (Peso/USD):
Peso 11.5775 / USD

63

8B: Inflation Rates & Exchange Rates

Relation between changes in Spot exchange rates &
inflation rates
Arbitrage ensures that in general:
a) Goods that can be bought more cheaply in the
foreign country will be imported and their domestic
prices will be forced down
b) Goods that can be bought more cheaply in the
domestic country will be exported and their foreign
prices will be forced down
64

8B: Inflation Rates & Exchange Rates

Country A: currency A
Country B: currency B
Exchange rate between currencies of A & B
expressed as: A / B (no. of units of A per unit of B)
S : Spot exchange rate between currencies A & B
E(S) : Expected spot exchange rate between
currencies A & B
iA : Inflation rate in country A (currency A)
iB : Inflation rate in country B (currency B)
65

8B: Inflation Rates & Exchange Rates

Due to differences in inflation rates between countries
A & B the Spot exchange rate between currencies A & B
will change over time
Hence inflation rates in the two currencies, the spot
exchange rate and the Expected spot exchange rate
have to fulfill the following relationship:
E (1 i A ) E ( S )

E (1 iB )
S
where E(S) & S are expressedas units of A per unit of B

This relationship is called Purchasing Power Parity

LHS denotes Expected difference in inflation rates
RHS denotes Expected change in spot rate

66

8B: Inflation Rates & Exchange Rates

Example: Given the following data calculate the
Expected spot rate between Peso & USD: Peso/USD
Spot rate: 10.9815 Peso / USD
Inflation rate in Mexico (Peso): 6.5%
Inflation rate in US (USD): 1.5%

67

8C: Interest Rates & Inflation Rates

Capital tends to flow where returns are highest
Investors are concerned with real returns nominal
returns minus inflation
So capital will flow to countries which offer higher real
returns
So as long as the real return differs across countries
there will be flow of funds across countries until the
real rates become equal in all countries
This implies that real returns will be equal across
countries
Hence differences in nominal returns between
countries will be equal to differences in inflation rates
across them
68

8D: Forward Premium & Changes in

Spot Rates
If investors do not care about risk then the
forward exchange rate would be equal to
what they expected the spot rate to be
If 1 year forward Peso-USD rate is Peso
11.5775 / $ then it implies that traders expect
the spot rate in 1 year to be Peso 11.5775 / $

69

8D: Forward Premium & Changes in

Spot Rates
If they expect the spot rate after 1 year to be Peso
12 / $ then nobody will by buy Peso forward by
paying dollars because they will get more Pesos for
each $ by waiting for 1 year & buying spot
If they expect the spot rate after 1 year to be Peso
11 / $ then nobody will buy dollar forward by
paying Pesos because they will pay less Pesos for
dollars if they wait for 1 year & buy $ at spot rate
Expectations theory: The percentage difference
between forward rate & spot rate =
70

8D: Forward Premium & Changes in

Spot Rates
Expectations theory:
Between any two currencies, A & B, the percentage
difference between forward rate & spot rate =
Expected change in spot rate
F
E (S )

S
S
Where both F & S are expressed in terms of A/B

71

8E: Transaction & Economic Exposure

Transaction exposure arises out of the risk that the
exchange rate of a foreign currency may change
adversely for any business, from the time it entered
into a transaction with a foreign party to the time it
is settled
For importers an increase in the exchange rate of
the foreign currency from the time of entering into
the contract to the time the payment is made it
increases their cost
For exporters a decrease in exchange rate from the
time of contracting to the time of receiving the
revenues it decreases their revenues
72

8E: Transaction & Economic Exposure

Transaction exposure can be hedged by entering
into forward contracts
Importers should buy the currency of payment
forward
Exporters should sell the currency of receipts
forward

73

8E: Transaction & Economic Exposure

Economic exposure: An exporter may be affected
even when it is not having any receivables from its
customers.
Exchange rate volatility may make the products sold
by its competitors in other countries, cheaper
When such a thing happens the exporter will lose
business to its foreign competitors
This exposure is called economic exposure
It is difficult to measure
74

8F: International Investment Decisions

In the presence of currency risks investment
decisions should be separated from the decision to
hedge / take currency risks
Two ways of deciding
1. Calculate the cash flows in home currency (which
will be received if the currency risk were hedged) &
discount them in home currency cost of capital
OR
2. Forecast the cash flows in foreign currency &
discount them in foreign currency cost of capital
75

8F: Example (BM/771-3)

A Swiss pharma co. is planning to invest in a plant in
India
The forecasted cash flows in Rs. millions are:

Year

Cash
Flow

-1300

400

450

510

575

650

The rupee cost of capital is 12%

Spot rate: Rs. 38 / SFr.
Rupee risk-free interest rate: 6%
SFr. risk-free interest rate: 4%
Evaluate the project using both approaches
76

8F: Sol: Approach 1

Step 1: Forecast the cash flows in Rs: Given
Step 2: Discount cash flows in Step 1 in Rupee
cost of capital & calculate NPV in Rs.
Step 3: Convert NPV in Rs. to NPV in SFr. By
using Rs./SFr. Spot exchange rate

Refer to Excel sheet

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8F: Sol: Approach 2

Step 1: Estimate the forward exchange rate for
conversion of Rs. to SFr. for each year during the
lifetime of the project using the Interest Rate Parity
theory
Step 2: Use the forward exchange rates for the various
years to convert the cash flows in Rs. to cash flows
in SFr.
Step 3: Estimate the cost of capital in SFr.
Step 4: Calculate the NPV in SFr. Refer to Excel sheet
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8F: Sol: Approach 2

Step 1: Estimating the projected forward rate:
1 rRs.

t - Year ForwardRate (F) S

1 rSFr.
Where :
S is spot rate; Both S & F are in Rs./SFr.

Step 3: Cost of Capital in SFr:

1 SFr. Interest Rate

1 SFr. Return 1 Rs. Return
1 Rs. Interest Rate
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8F: Cost of Equity: Example (BM/773-4)

A Swiss co. is planning to invest in a project in India

Swiss risk-free interest rate: 4%
Market risk premium in Switzerland: 8.4%
Beta of Indian cos. in that industry relative to Swiss
market index: 0.7
Indian risk-free interest rate: 6%
Calculate the cost of equity for the Swiss Co. in SFr.
Calculate the cost of equity for the Swiss Co. in INR
80

8F: Cost of Equity: Example (BM/773-4)

Cost of equity of Swiss Co. in SFr. = Required Return
in SFr. = SFr. Risk-free Rate + (Beta wrt Swiss Index *
Swiss Market Risk Premium) = 4 + (0.7 x 8.4) = 9.9%
Cost of equity of Swiss Co. in INR (= Required Return
in INR) should fulfill the following relationship:

1 Rs. Interest Rate

1 Rs. Return 1 SFr. Return
1 SFr. Interest Rate
(1 + Rs. Return) = 1.099 x 1.06/1.04 = 1.12
So: Rs. Return = 1.12 1 = 0.12 = 12%
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