TABLE OF CONTENTS Title List of Tables List of Figures/Charts Executive Summary 1.Introduction 1.1 Definition of risk 1.

2 Types of risks 2. Risk Management Process 2.1 Identification of risks 2.2 Analysis of risks 2.3 Prioritization of risks 2.4 Treatment of risks 3.About the organization 3.1 State Bank of India 3.2 Mid Corporate group 4. Derivative products offered by SBI 4.1 Derivatives 4.2 Introduction of derivative products 5.Problem Formulation 5.1.Need for the Study 5.2.Problem Definition 5.3.Research Objectives 5.4.List of Information Required 6.Research Methodology 6.1.Research Design 6.2.Sources of Data 6.3.Scope of the project 6.4.Methodology 7.Analysis, Findings and Interpretation 7.1 Preliminary analysis of 6 companies Page No. 03 04 -- 06 06 08 09--11 09 09 1214 13 13 13 14 1517 15 16 1828 18 20 2930 29 29 29 30 3135 31 31 31 32 3680 3638

2 7.2 Industry scenario and company profile of ABC Ltd 7.2.1 The concept of subsidy 7.2.2 Company profile 7.3 SWOT ANALYSIS 7.4 Process of risk management 7.4.1 Identification of risks 7.4.2 Analysis and quantification of risks 7.4.3 Prioritization of risks 7.4.4 Treatment of risks and findings 8. Recommendations 8.1 Recommendations regarding currency risk 8.2 Recommendations regarding interest rate risk 8.3 Recommendations regarding commodity price risk 8.4 Recommendations regarding hedging. 9.Conclusion 10.Limitations Annexure faced by companies along with the explanation of the questionnaire Annexure-B Methodology used for ranking of company AnnexureC Method of calculating risk priority number Bibliography 98-102 103--107 108 74--76 7780 81-85 81 82 83 84 86 87 88--107 3843 38 40 4345 45--80 4551 5273

Annexure-A QUESTIONNAIRE to identify various risks 88--97

List of Tables Sl No 1. 2. 3 Title Table showing the decision tree analysis for derivative products Table showing the measuring parameters used while ranking Table showing the market position of the company ABC Ltd. XIME Page No 24 35 43

3 4. 5. 6. 7. 8. 9. 10 Table showing the ranking of business risk parameters Table showing the ranking of industry risk parameters Table showing ranking of financial risk parameters Table showing ranking of market risk parameters Table showing the calculation of risk priority number Table showing decision analysis regarding risk priority Table showing the various risk management strategies 56 59 66 73 75 75 85

List of Figures Sl No 1. 2. 3. 4. 5. 6. 7. Title Page no Flowchart showing the risk management process 12 Graph showing the position of various banks in India in terms of service quality and geographical reach 15 Comparative identification of various risks faces by companies 36 Comparison of ranks of risk management strategies adopted by 37 various companies BCG matrix to analyze business risk 46 Michael Porter 5 forces model 48 Chart showing the comparison between sales and subsidies 50 XIME

4 receivable by ABC Ltd. Charts showing the comparison of sales and break-even sales 53 of both the companies Chart showing the comparison of PV ratios of both the 54 companies Chart showing the comparison technology up gradation ratio 55 of both the companies Chart showing the comparison of turnover growth of both the 57 companies Charts showing the comparison of value added and growth rate 58 of value added to both the companies Chart showing the comparison of productivity of labor of both 59 the companies Charts showing comparison of liquidity ratios Charts depicting credit risk Charts showing operating and financial leverage Charts showing the import ratios in comparison to industry Sensitivity analysis of ABC Ltd. Chart showing various parameters as a ratio to interest payable 61 63 65 67 68 71

8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

for the year Charts showing a comparison of changes in cost of 5 most 72 important raw materials Pie chart showing a comparison of various risks faced by the 76 company Chart showing the USD/INR exchange rate over the last 2 78 years Normal distribution curve of USD/INR rate over the last 78 5years Chart showing the interest rate changes over the past 2 years 79

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EXECUTIVE SUMMARY
A. OBJECTIVE: Risk is inevitable within business environments. Taking and managing risk is part of what organizations must do to create profits and shareholder value. As more and more Indian companies approach the international capital market, the degree of risks also increases and sophisticated investors start demanding disclosure of internal policies for management of risks. So the objective of my project is to analyze the risks faced by the company under the case study and suggest risk management strategies to the company. By understanding the broad risks facing a company and how they are interrelated, a company is better able to manage them and create a sustainable strategic advantage while maximizing shareholder value. Basically the objectives of the study are to answer these questions for the company under study. What is the organizations enterprise risk management strategy? How does each division/unit/team contribute to meeting the goals of the Enterprise risk management? What is the organizations definition of risk? What are the estimated probability and severity dimensions for the risks which the company faces? What are the financial consequences of the risks to the company? Which risks are material? How should the identified risks be prioritized? How are these risk currently managed? What risk management processes are appropriate based upon the findings of the above elements? What action plans should be in place?

B. RESULTS XIME

6 1. After analyzing the filled up questionnaire, it was found that, Most of the companies dont go for hedging. Those companies which go for hedging are generally interested in forward contracts and they hedge only a negligible portion of their exposure, keeping a major portion open. All the companies have good relationship with the STATE BANK OF INDIA. SBI has an excellent Brand Name and Image but Customer awareness about SBI is low. Many companies are not aware of the derivative products offered by SBI. One particular section of the questionnaire dealt with the risk management strategies adopted by the companies under study. The answers to such question were also ranked and it was found that there is not enough risk management strategies are in place. 2. While going through the company under the case study i.e. ABC Ltd., it was found that the company faces a substantial amount of various types of risk, but it is trying to adopt various risk management strategies. 3. On prioritization risks in case of ABC Ltd it was found that the most severe risk to which it is exposed to is foreign exchange risk and interest rate risk. C. CONCLUSION Every company has its own risk/reward preferences and must identify the risks to which it is exposed, decide which risks it is willing to accept and finally, find out how to dispose of the others, the costs involved and whether it is worthwhile. So deciding to hedge is one thing, and getting it right is quite another. A further risk is involved with risk management, i.e. the risk that risk management strategy can itself cause additional losses should the underlying bases on which the strategy was built changes. This means that risks can be reduced, but never be eliminated.

D. RECCOMMENDATIONS XIME

7 1. The term loans taken by the company bears an interest rate, which can be revised by the lending bank in every 2 years as according to the reset clause. Considering the above scenario it is recommended that the company should go for coupon only swap so as to take advantage of lower interest rates prevailing in other currencies like Japanese yen, euro, us dollars etc. 2. One way in which the company can hedge its interest rate exposure is to go for interest rate swap in which one party exchanges a stream of interest for another party's stream. 3. The company has huge amount of imports. Because of this factor the company usually opens letter of credit. Buyers credit is available for a maximum of 1 year for import of non capital goods and 3 years for import of capital goods and as per the extant RBI guideline, the cost of buyers credit has to be restricted to 50 basis points over LIBOR. This will limit the exposure of the company within that range. So the company should go for buyers credit. 4. The recommendation to the company is to go for range forward options, since it is a zero cost option. Unlike the forward hedge, which locks in a specific price for the underlying, the range forward locks in a price range for the underlying. In this way, the holder participates in small moves in the underlying while being protected from larger moves. 5. If the view of the company is that the exchange rates will experience a little volatility in the near future then the company can go for a type of option known as ratio spread options. The ratio spread is a strategy in options trading that involves buying a number of options and selling more options of the same underlying stock and same expiration date but at a different strike price.

1. INTRODUCTION
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8 The world of finance has always had an intuitive understanding of risk. Almost all commercial activity involves not one but several financial risks. The risks that emerge from the increased variety and complexities of business as well as due to globalization and liberalization has pushed the contours of risk management in corporates much beyond than what would probably have existed in the more traditional forms of closed economy. Even companies which have no international business are exposed to exchange rate risk because their domestic markets may switch to foreign suppliers. 1.1 DEFINITION OF RISK Risk is the uncertainty of an outcome, be it a positive opportunity or a negative threat, which may impact on the organizationsManagement: A Holistic Enterprise Risk ability to achieve its objectives at a corporate, operational, programmed or project level. It is the possibility of actual outcome being different from the expected outcome. It includes both downside and upside potential. Downside potential is the possibility of actual results being adverse compared to the expected results and upside potential is the possibility of actual results being better than the expected results. 1.2. TYPES OF RISKS 1.2.1 BUSINESS RISK: Business risk can be thought of as the risk of a destructive shift in the assumptions, parameters and targets that underpin a business initiative. Less is the experience in doing a business more will be the risk. The sum total of business risk is made up of systematic and unsystematic risk. Unsystematic Risks are firm specific risks, like depending on a single supplier, customer, single technology, massive breakdown of plant and machinery etc, whereas Systematic Risks are common to all the firms in an economy and hence are unavoidable, e.g. fiscal policy of government, political environment in the country, economic changes in the country etc. 1.2.2 INDUSTRY RISK: The objective here is to understand the attractiveness of the industry in which the company operates. Operational Risk is the risk run by a firm that its internal practices, policies and systems are not rigorous or sophisticated enough to cope with untoward market conditions or human or technological errors. Sources of XIME

9 operational risk include: failure to correctly measure or report risk, lack of controls to prevent unauthorized or inappropriate transactions being made, lack of understanding or awareness among key staff. It is also a part of industry risk. 1.2.3 MANAGEMENT RISK: Efficient management to a business is like a backbone to a human body. The Management of a Company or unit means the promoters or directors or partners and the key operating functionaries. The ability and response of the management of a company to the various challenges posed by the environment has a bearing on the possible risk of default. Due to its supreme importance in a business, Management risk factors are assessed first and only if the company meets the sub-hurdle requirements then only other risks are assessed otherwise not. 1.2.4 FINANCIAL RISK: The most commonly discussed form of risk is financial risk. Risk also increases as the debt component in the capital structure increases. This is because debt involves mandatory cash outflows, while equity holders can be paid dividends at the discretion of the company. The overall financial risk is assessed in three parts which are as follows: Quantitative ratios: The ratios that look into the borrower units i.e. Liquidity, Profitability, Turnover and efficiency of operations are considered. Quantitative Industry Division: The various indicators are also compared with that of others in the industry. Qualitative Financial Factors: Here financial risks are also assessed on the basis of certain qualitative factors that could have impact on the financial and profitability of the borrowing company such as, contingent liabilities, auditors qualifying remarks and accounting policies. 1.2.5 MARKET RISK: Market risk is the risk of adverse deviations due to market movements. It is the risk that the value of on and off-balance sheet positions of a financial institution will be adversely affected by movements in market rates or prices such as interest rates, foreign exchange rates, equity prices, credit spreads and/or commodity

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10 prices resulting in a loss to earnings and capital. There are three basic types of market risks. A. Currency Risk: It is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged. The risk inherent in running open foreign exchange positions have been heightened in recent years by the pronounced volatility in exchange rates, thereby adding a new dimension to the risk profile of companys balance sheets, the risk that a business operations or an investment's value will be affected by changes in exchange rates. B. Interest Rate Risk: A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with different principal amounts, maturity dates or repricing dates, thereby creating exposure to unexpected changes in the level of market interest rates. Market interest rates of various instruments seldom change by the same degree during a given period of time. Interest-rate risk can be defined as a loss ensuing from an adverse change in the value of interest-rate sensitive assets and liabilities, in consequence of change in interest rates. C. Commodity Risk: It refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. A Commodity enterprise needs to deal with the following kinds of commodity price risks: Input price risk: This risk arises if the cost prices of raw materials changes, which can affect the profitability of the business. Output price risk: This is a kind of risk which arises when the prices of finished goods changes and the profitability of the business is hampered Risk in any business activity is inevitable and hence the only way out for corporates is to manage these risks effectively.

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2. RISK MANAGEMENT:
Risk management is defined as identification, assessment and economic control of those risks that endanger the assets and earning capacity of a business. Risk Management is a process through which the companies control their level of risks. The diagram shown below is one step leads to the other. Figure No 1. Flowchart Showing the Risk Management Process a flowchart that shows the various steps of risk

management as mentioned above in the form of a flow diagram explaining as a to how

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12 2.1. IDENTIFICATION OF RISKS: This is the phase where threats, vulnerabilities and the associated risks are identified. It is very important that during this stage all risks are identified and recorded, regardless of the fact that some of them may already be known and likely controlled by the organization. The first step is to generate a comprehensive list of sources of threats, risks and events that might have an impact on the achievement of each of the objectives. These events might prevent, degrade, delay or enhance the achievement of those objectives. Risk identification techniques include interviews with experts in the area of interest and questionnaires. Other methods and tools used to identify risks and their occurrence include checklists, judgments based on experience and records, flow charts, brainstorming, systems analysis, scenario analysis and systems engineering techniques.

2.2 ANALYSIS AND QUANTIFICATION OF RISKS: Risk analysis is the phase where the level of the risk and its nature are assessed and understood. This information is the first input to decision makers on whether risks need to be treated or not and what is the most appropriate and cost-effective risk treatment methodology. Risk analysis involves thorough examination of the risk sources, their positive and negative consequences, the likelihood that those consequences may occur and the factors that affect them. It was stated by the famous writer, educator, and management consultant, Peter Drucker that "If you can't measure it, you can't manage it. The level of risk can be estimated by using statistical analysis and calculations combining impact and likelihood. Information used to estimate impact and likelihood usually comes from past experience or data and records, reliable practices, international standards or guidelines, market research and analysis, experiments and prototypes, economic, engineering or other models, specialist and expert advice etc. 2.3 PRIORITATION OF RISKS: During the risk evaluation phase decisions have to be made concerning which risks need treatment and which do not, as well as concerning on the treatment priorities. Analysts need to compare the level of risk determined during the analysis process with risk criteria established in the Risk Management context (i.e. in the risk criteria identification stage). The decisions made are usually based on the level of XIME

13 risk but may also be related to thresholds specified in terms of consequences (e.g. impacts), and the likelihood of events.

2.4 TREATMENT OF RISK: The various ways in which a risk can be treated are as under; A. Risk avoidance: It means not performing an activity that could carry risk. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning profits because more is the risk, more is the return.

B. Risk reduction: It means methods that reduce the severity of the loss. The various
ways of risk reduction are diversification and netting. C. Risk retention: This method involves accepting the loss when it occurs. All risks that are not avoided or transferred are retained by default. This may be acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals of the organization too much. D. Risk transfer: It means causing another party to accept the risk, typically by contract or by hedging. Insurance is one type of risk transfer that uses contracts. On the other hand, taking offsetting positions in derivatives is typically how firms use hedging to financially manage risk. One of the best methods to transfer risk is to use derivative instruments as hedging tool.

3. ABOUT THE ORGANISATION.

3.1 STATE BANK OF INDIA (SBI): INDIAS LARGEST BANK: XIME

14 State Bank of India (SBI) is the largest commercial bank in terms of profit, assets, deposits, branches and employees in India, and the fourth largest when compared with foreign banks working in India. The bank has been actively involved since 1973 in nonprofit activity called Community Service Banking. FORTUNE magazine has included SBI in the list of Fortune 500 companies with SBI ranking 498. Each branch of SBI takes care of businesses of very large corporations, medium corporations, small business units, agriculture, government business and retail loans including mortgages. It has a branch network of 9,000 and if the branches of its associate banks are taken into considerations then the number of branches would increase to 14,000.

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15 Figure 2: Graph Showing the Position Of Various Banks In India In Terms Of Service Quality and Geographical Reach.

hg H i

Citibank Stan C ABN Amro HSBC

Karur Vysya

ICICI Bank HDFC IndusInd Bank Vysya Bank State Bank of India Bank of Baroda Bank of India PNB Andhra Bank Canara Bank

y il a u Q ec vr e S t i

woL

Co-operative Banks Rural Banks

Rural

Regional

Urban

State Bank has over 2 lakh employees on its payroll and including its associates its 3 lakhs. State Bank is keen on positioning itself as a global bank. It has been trying to increase its global footprint through overseas acquisitions. The chart shown above shows the reach and service quality of STATE BANK OF INDIA in comparison to other major banks in India. It can be clearly seen that SBI has the optimum service quality and the most dispersed reach.

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16 3.2 MID-CORPORATE GROUP (MCG): A MCG has been set up in the bank under Corporate Banking Group to cater to the various banking requirements of Mid-Corporates. It provides business solutions to its customers through its 28 dedicated branches all over the country. I worked in the mid corporate group of SBI Bhubaneswar which is also the commercial branch of SBI, Bhubaneswar. A Mid-Corporate has been defined as a business entity having annual turnover between Rs.25 crores to Rs.350 crores or an entity having a minimum fund based limit of Rs.5 crores(including Term loans.). Mid-Corporate SBU provides variety of Services to Mid Corporate accounts through following products:

Core Credit Products: Advances: Apart from usual credit products like cash credit, term loans etc. extremely fine interest rates are offered under CP Linked WCDL, MIBOR linked WCDL and LIBOR linked FCNB.

FOREX: While competitive exchange rates are offered for Export and Import transactions, Special exchange rates are offered for discounting of bills under LCs.

Government Business: Authorized branches in Mid-Corporate SBU accept excise/other tax receipts. Trade Finance Products: Trade Finance Products like LC & BG are available for Mid Corporate accounts with competitive rates. Cash Management Product (CMP): Cash Management Product is available for collections and will soon be available for Payment module also for all Mid Corporate accounts.

Derivatives: Treasury Department at Corporate Centre provides Derivatives operations for Mid Corporate accounts. Supply Chain Financing: Supply Chain Financing services will soon be operational for Mid Corporate accounts.

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4. DERIVATIVE PRODUCTS OFFERD BY STATE BANK OF INDIA

4.1 DERIVATIVE: A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps. Definition of a Derivative: A derivative is a financial instrument: XIME

18 (a) whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the 'underlying'); (b) that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions; and (c) that is settled at a future date. Advantages Of Using Derivatives The arguments in favor of using derivatives are as follows:

A tool for hedging: Derivatives provides an excellent mechanism to hedge the future price risk. Risk management: Derivatives provide an excellent mechanism to Portfolio Managers for managing the portfolio risk and to Treasury Managers for managing interest rate risk. The importance of index futures & Forward Rate Agreement (FRA) in this process cant be overstated.

Better avenues for raising money: With the introduction of currency & interest rate swaps, Indian corporate will be able to raise finance from global markets at better terms.

Price discovery: These derivative instruments make the spot price discovery more reliable using different models like Normal Backwardation hypothesis. These instruments will cause any arbitrage opportunities to disappear & will lead to better price discovery.

Increasing the depth of financial markets: When a financial market gets such sort of risk-management tools, its depth increases since the Institutional Investors get better ways of hedging their risks against unfavorable market movements.

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Empirical evidence: There is strong empirical evidence from other countries that after derivative markets have come about, the liquidity and market efficiency of the underlying market has improved.

Disadvantages Of Derivative Instruments Now taking a look at arguments against:

Speculation: Many people fear that these instruments unnecessarily increase the speculation in the financial markets, which can have far reaching consequences.

Market efficiency: Many people fear that the Indian markets are not mature & efficient enough to introduce these instruments. These instruments require a well functioning & mature spot market.

Volatility: The increased speculation & inefficient market makes the spot market more volatile with the introduction of derivatives.

Counter party risk: Most of the derivative instruments are not exchange traded. So there is a counter party default risk in these instruments.

Liquidity risk: Liquidity of a market means the ease with which one can enter or get out of the market. There is a continued debate about the Indian markets capability to provide enough liquidity to derivative trader.

4.2 INTRODUCTION TO DERIVATIVE PRODUCTS 4.2.1. OPTIONS An option gives the buyer the right but not the obligation to buy/sell the underlying asset at a specified strike price on a particular date. Options are contracts that confer on the buyer of the contract certain rights (rights to buy or sell an asset) for a predetermined price on or before a pre-specified date. The buyer of the option has the right but not the obligation to exercise the option. The two major types of options are; XIME

20 Call Options: A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. Put Options: A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. The seller of the put option (one who is short put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. Some of the advantages of using options are as follows: Besides offering flexibility to the buyer in form of right to buy or sell, the major advantage of options is their versatility. They can be as conservative or as speculative as one's investment strategy dictates. High leverage is possible by using options as by investing small amount of capital (in form of premium); one can take exposure in the underlying asset of much greater value. The option buyer faces a pre-known maximum risk in the form of premium paid. The option buyer has an unlimited upside and a limited downside. Options are like insurance contracts; they protect the company from the downside and at the same time allow to reap the benefits from any upside, unlike forward contracts which are fixed pricing agreements. Some of the disadvantages of options are as follows: Standard contracts may not coincide with the underlying transaction and cause a mismatch Premiums can be high Holder undertakes a credit risk if the option is an over the counter option Pricing of options is highly technical

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21 Types Of Options 1. Plain Vanilla Option It is the simplest type of option. A Call Option gives you the right to buy the underlying currency on a certain date at a certain price (strike price). A Put Option gives you the right to sell the underlying currency on a certain date at a specific price (strike price). The price in the contract is known as the exercise price or strike price. The date in the contract is known as the expiration date or maturity. If, during the life of the option, you no longer need some or all of the protection of the currency option, you can sell the option back to the Bank and receive back the part of the market value of the premium. Advantage: Options gives the benefit to the buyer to gain from future price movements while protecting them from any downside. (Like insurance) Disadvantage: A premium needs to be paid to avail this facility. 2. Range Forward A zero cost structure of options that involves selling a call option and buying a put option (for exporters) or buying a call option and selling a put option (for importers/outward remittance), both out-of-the-money and for the same expiration. The strikes can be chosen so that the purchase /sale price of the call exactly offsets the sale /purchase price of the put so that the no premium needs to be paid by the customer you. It limits the downside and the upside. It may be useful in managing the currency risk associated with exporting or importing goods denominated in foreign currency, investing or borrowing overseas, repatriating profits, converting foreign currency denominated dividends, or settling other foreign currency contractual arrangements. Advantages It provides protection against unfavorable foreign exchange rate movements, while providing with some ability to participate in any favorable movements. This can assist managing foreign currency exposures. These are flexible. They can be tailored to meet your particular requirements. XIME

22 In range forward options the customer is protected within the band decided at the time of entering into the contract. Any changes in exchange rates within the band are not harmful to the customer. Disadvantages The rate achieved with this option may not be a favorable one as compared to the rate that could have been achieved with a forward foreign exchange contract. While these options can be cancelled, there may be a cost involved in doing so.

3. Ratio Spread A zero cost strategy involving a simultaneous buy and sell of calls and puts in ratio to one another. Though at the time of booking, the net rate could be better than the existing forward rate, it also carries the inherent risk of an option seller (unlimited downside). (To achieve zero cost it involves selling of more options than buying). The ratio spread is a strategy in options trading that involves buying a number of options and selling more options of the same underlying stock and same expiration date but at a different strike price. This strategy is used when the options trader thinks that the underlying stock will experience little volatility in the near term.A Ratio Spread is initiated by purchasing one stock (or index) option that is close-to-the-money and then selling two farther out-of-themoney options within the same option month. Advantages One of the biggest benefits of the Ratio Spread is that if the stock doesn't move as expected, and the holder received a credit when the spread was initiated, he will not sustain a loss. Disadvantages

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23 The biggest disadvantage of ratio spread is that it tempts the customer to use ratios like 1:3, 1:5 in ratio spread transactions and tries to speculate, and then he may face a big loss in future. The best time to initiate a Ratio Spread is when the stock has made a quick, straight move up. This type of price action normally increases the demand for out-of-the-money options as discussed earlier. A rapid price move also seems to be the time when there is the greatest disparity in premiums between close-to-the-money options and out-of-the-money options which provides the best opportunity for successful Ratio Spread trades. The farther out-of-the-money you can successfully sell an option, the greater your potential for profits and safety.

4.2.2 FORWARD CONTRACT A forward contract locks-in on the trade date, the exchange rate for your payables or receivables, at which you can buy or sell currency on a future date. The funds are exchanged only on the future date as agreed in the contract. A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today. Advantages The forward contract enables one to cover foreign exchange obligations as well as proceeds in advance. One can lock into an exchange rate for payables and receivables in foreign exchange for a future date. Ones costs can get fixed against your earnings and thereby net earnings can be crystallized to a large extent. Disadvantages

If future cash flows are not known with a reasonable certainty, then forward contracts are of no use. It has substantial credit risk as it is an over the counter derivative instrument

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24 Table No 1: Table Showing Decision Analysis As To When to Book Forward Contract, When to Go For Option and When to Keep the Position Open CONFIDENCE High Seller of USD Low Seller of USD

V I USD/IN E W R

Buyer of USD

Buyer of USD

Keep exposure open

Book forward

Buy a Call

Buy a Put

firming USD/INR Book forward weakenin g

Keep exposure open

Buy a Call

Buy a Put

Variants of Forward Contract 1. USD/INR forward contract One can lock in an exchange rate today, and buy/sell USD against INR for delivery in the future. The forward contract can help protect USD receivables or payables from the exchange rate fluctuations. 2. Cross Currency forward contract One can buy or sell currencies other than the Rupee for delivery in the future. In case where the exposure is in a foreign currency (CCY) other than USD, one can break the exposure into (CCY)/USD and USD/INR and take an independent view of the two legs. For example: Under a cross currency forward contract if one has an EUR/INR exposure, depending on ones view, one would cover only EUR/USD and leave USD/INR position open or alternately would cover USD/INR and keep EUR/USD position open. 3. Third currency forward contract

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25 In this case one can cover only the base currency in the cross currency pair against a third currency. For example: Under a Third currency forward contract if one has a GBP/INR exposure, depending on ones view one could cover the pound in terms of a third currency like the EURO. So the exposure would be covered in terms of GBP/EUR while leaving the positions in EUR/USD and USD/INR open. This enables the customer to shift the exposure to a currency of his choice.

4.2.3. FUTURES Futures are exchange-traded contracts to sell or buy financial instruments or physical commodities for Future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument/ commodity in a designated Future month at a price agreed upon by the buyer and seller. To make trading possible, the exchange specifies certain standardized features of the contract. Advantages

Futures eliminate credit risk since they are exchange traded. Standardized format of futures makes them cheap and easy to use. Futures can be reversed anytime because there is a large liquid market available for them.

Disadvantages Futures are only available for certain instruments in India The standard amounts and the dates may not coincide with the actual requirements of the customer Prices of futures can be affected by speculation.

4.2.4. SWAPS

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26 Swap can be defined as a financial transaction in which two counterparties agree to exchange streams of payments, or cash flows, over time on the basis agreed at the inception of the arrangement. It is like a series of forward contracts. While the two main kinds of swaps are interest rate swaps and currency swaps, commodity swaps and tax rate swaps too are being introduced. Advantages Swap contracts can be tailor made to suit individual cash flows They are available for up to 10 years in some of the cases

Disadvantages They involve considerable credit risk on the counterparty Tax and accounting issues are not yet clarified regarding swaps

Types Of Swaps 1. Interest Rate Swaps (IRS) An interest rate swap is a transaction in which two parties agree to exchange streams of cash flows based on a notional principal amount where one stream is calculated with reference to a floating interest rate and the other stream is calculated based on a fixed interest rate. An interest rate swap is an exchange between two parties, of interest rate obligations (payments of interest) or receipts (investment income) on an agreed notional amount of notional principal for an agreed period of time which would help one to swap fixed rate borrowings for floating or floating rate borrowings for fixed rate borrowings based on the view on the movement of interest rates. These can be used for hedging the interest rate risk of rupee loans as well as for hedging of foreign currency loans like external commercial borrowings, FCNR (B) loans, floating rate notes and euro bonds. ADVANTAGES Hedges an existing exposure. An IRS can help the corporate to optimally hedge its floating rate liability. A corporate having predominantly floating rate liability XIME

27 linked to a bank PLR can enter into a swap where it pays fixed rates for t years and receive bank PLR for that duration. The corporate could thus hedge its business from risks arising out a possible upward movement in interest rates. Low Credit Risk. Only the net interest payments are exchanged, thereby circumventing the need to exchange gross amounts on the settlement date. This leads to a lower credit exposure on the counter-party. The credit exposure of an IRS is less than a cash market. 2. Currency And Interest Rate Swaps (CIRS) A Currency Swap or a Currency and Interest Rate Swap entails a transaction in which two counterparties agree to exchange their respective principal and interest rate positions in an agreed currency pair. A currency swap (CS) may be viewed as an "exchange of borrowings", involving the exchange of principal and interest payments in one currency for principal and interest payments in another currency, in accordance with a pre-determined amortization schedule. It is a contractual arrangement between two counter-parties in which one counterparty agrees to make payments in one currency to the second counter-party, in return for receiving payments in another currency from the latter. It offers the flexibility to move from a foreign currency (FC) liability to a Rupee liability or vice versa, through this mechanism. The CS could be structured in any of the following ways: The Client pays fixed Rupee interest and receives floating FC interest. The Client pays fixed Rupee interest and receives fixed FC interest. The Client pays fixed FC interest and receives fixed Rupee interest. The Client pays floating FC interest and receives fixed Rupee interest.

CIRS variants 1. Principal Only Swaps (POS): It covers only the exchange risk of the principal. It is done when movement in interest rates is not anticipated. It is like a long-term

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28 forward contract. It enables one to hedge exposure to exchange risk on only the principal. 2. Coupon Swap: There is an exchange of interest rate on the foreign currency, and not of the principal . It involves a view on only the interest payments while leaving the principal untouched. This instrument enables one to take advantage of the comparative cost of funds available in global markets, while at the same time gaining protection from any adverse interest rate movement.

5. PROBLEM FORMULATION
5.1. NEED FOR STUDY: With increasing exposures to exchange rates, and volatility of both exchange rates and interest rates, more and more companies are considering it necessary to introduce formal risk management policies for managing the exposures. Moreover as more Indian companies approach the international capital market, the more sophisticated investors are demanding disclosure of internal policies for management of risks. In many ways, the need for the formal XIME

29 policy frameworks has increased after the recent appreciation of the rupee against the dollar.

5.2. PROBLEM DEFINITION: Identifying the various risks faced by 6 selected companies in Orissa and a detailed case study of financial risk management of one of the companies in the list. 5.3. RESEARCH OBJECTIVES: o To identify major risks faces by the organization o To find the different ways to identify the risks o To study the FOREX exposure of the company under the case study o To study the requirements of other value added services o To study the market perception of SBI, as regards derivative products o To study the derivative products & services offered or planned to be offered by SBI o To study what performance factors in case of SBI are important for availing the facility of derivatives o To take systematic account of internal and external changes that may impact the organizations a major extent. o To estimated probability and severity dimensions for the risks which the company faces.

o To know what are the financial consequences of the risks to the company. o To know which risks are material. o To know how should the identified risks be prioritized o To know how the risks are currently managed o To respond to risks in a balanced way, mindful of cost benefit and the relationship to resource constraints o To do a comparative study of the company with the best in the industry XIME

30 o To list down some of the silent findings about the treatment of risks till now. o To recommend ways in which the company can manage market risks.

5.4. LIST OF INFORMATION REQUIRED: o The balance sheet of the companies to be studied o Current sources of working capital financing o Current sources of Long-term financing o Market share of the products of the company o The expected growth in the industry to which the company belongs o Finding with which banks they are transacting at this moment and the reasons for that o What percentage of their total revenue comes from exports? o The biggest growth obstacles for them o The financial data about the company ad the best in the industry o The hedging strategies used till now. o The industry scenario of the company under study o The major competitors of the company.

6. RESEARCH METHODOLOGY
6.1 RESEARCH DESIGN: Exploratory Research: - This form of research was used at two different stages of the project:-Firstly, it was used in the problem formulation stage to get insight into the whole business of the company under study, and also to get information regarding the industry in which the company operates. Secondly, it was used while finding the products and services offered to companies in Orissa by SBI. XIME

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6.2 SOURCES OF DATA: 6.2.1 SECONDARY SOURCES: a. Websites of : Reserve Bank of India, State bank of India, b. Some published articles related to risk management c. Some published articles related to derivatives d. Training manual of SBI on Derivatives e. A book on Foreign Exchange, International Finance and Risk Management by A. V. Rajwade. f. CMIE database/ PROWESS 6.2.2 PRIMARY SOURCES : a. Balance sheet of the last 2-3 years of the company b. Discussion with a person from the financial department of the companys office in Bhubaneswar 6.3. SCOPE OF THE PROJECT: 1. Any model especially a financial model is a time dependent entity. This entity is always a combination of quantifiable and unquantifiable parts commonly referred to as objective and subjective elements in assessment. The degree of objectivity and subjectivity in a particular scenario is dependent on the level of mathematical techniques developed and employed in a particular place. The risk equivalence can be expressed as follows: Risk in an enterprise = Fixed part + Perturbative Fluctuations = Quantifiable + Unquantifiable = Objectivity + Subjectivity. So in my project report I have concentrated only on the quantitative analysis of risk leaving the qualitative risks like management risk, reputation risk etc.

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32 2. I have read the 2005-06 balance sheet of the company ABC Ltd. The recent 2006-07 balance sheet was not available during the time I was doing my project. So the findings and analysis of the company has been done by me based of the financials of the last financial year. However during the later phase of my project I got access to some of the audited financials of the company. I have used it in some of the places in my project wherever I could relate it to the past performance. 3. All the financials of the company and its competitor are limited to the financials I got from the PROWESS database. However the company under study was also studied through the help of the auditors report, directors report and other information about the industry in general and the industry in general from various websites and news paper editorials. 4. The treatment of risk part which includes analysis of forward contracts booked is limited to the amount of data I could get through the State bank of India, commercial branch. If the company has booked forward contracts through any other bank then this is out of the scope of my project. 5. There are some assumptions which have been taken in doing the above analysis The company may not be importing all the raw materials at one time. But here I have assumed that all the purchases take place at the end of the year. The assumption has been made because of unavailability of datas regarding their individual consignment. As the USD/INR exchange rate doesnt remain stable through out the year so here we have assumed the exchange arte of USD/INR to be the average rate for the year 200506 which is 44.2. 6.4 METHODOLOGY The methodology I have used in this project is as under: 1. The first step was to learn about risk management as much as possible.

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33 2. The next step was to scan the recent balance sheet of six selected companies out of the various companies based in Orissa. 3. The next step was to prepare a questionnaire for the information which couldnt be derived from the balance sheet. The questions were prepared in such a manner as to identify some of the risks faced by the company and to get a feedback of the hedging strategies used by the company and also a general feedback as to derivatives trading. 4. After going through the balance sheet, a meeting was fixed with some official of the company with the help of my project guide. They helped me in filling up the questionnaire. 5. After filling up the questionnaire for 6 companies, I assigned ranking to the answers I got on the basis of importance of risk. 6. 7. Then I calculated the total risk and section wise risk (segregated into different types of risk) of each of the company and analyzed it. Then I was asked to choose one company out of those six companies and do a case study on it. 8. The case study involved these steps: 9. IDENTIFICATION OF RISKS: For this an arrangement was made by my project guide, MR SUDHIR DAS, AGM International Banking division, SBI, to meet the chartered accountant of the company MR SRIRAM TRIPATHY, at its head office in Bhubaneswar. I met the concerned person and during the talk I got good amount of knowledge about the company and the industry to which it belongs. Till now I had identified the major risks threatening the company. 10. ANALYSIS AND QUANTIFICATION OF RISKS: After filling up of the questionnaire, I was advised by my faculty guide to rank the risks to which the company is exposed to against the main competitor of the company. So I found out that the main competitor of ABC Ltd was IFFCO. So I quantified the major risks which I had earlier identified through various measures and then ranked the company in comparison to IFFCO.At some places I have ranked both the companies in comparison to the industry averages of top 15 fertilizer companies in India as regards turnover, and wherever I could not get the XIME

34 industry averages I have used the PROWESS database to get the financials of 5 fertilizer companies which have comparable turnover with ABC Ltd as industry averages, and at some places where I could not get any data about the industry I have ranked the companies as according to my knowledge about the industry in consultation with my project guide, keeping 100% objectivity in my mind. 11. PRIORITIZATION AND TREATMENT OF RISKS: After ranking both the companies I have used the FMEA template to find out the priority of risks to be managed by the company. There is a risk priority number whish has been calculated by taking into account three important factors which are severity, occurrence and probability. The priority of risk was fixed depending on the scenario of probability and impact of each particular risk. 12. TREATMENT OF RISK: This step deals with the analysis of the strategies which the company has adopted to fight with currency risk and interest rate risk. The analysis has been done looking at the past rend of exchange rates and interest rates. 13. After following these 4 steps I came up with some findings about the company and I have used those findings as the base for giving recommendations to the company. It was found that 2 of the most severe risks facing the company which need immediate attention are currency risk and interest rate risk. So my recommendations are limited to these to risks only. The detailed ranking methodology for the company ABC Ltd is given in the annexure along with the explanations of the whole motive of using a questionnaire. The FMEA technique has also been explained in detail in annexure. The ranking methodology in a nutshell is given in the next page.

Table No 2: Table Showing the Measuring Parameters Used While Ranking Rating What I intend to How I measured it XIME

35 measure Possibility that the entity may incur losses due to exposure of business to market risks

Market risk

Understanding the characteristics of the industry and the level of exposure of the business to market risks, including exposure to foreign currency exchange rate movements and changes in commodity prices Availability of natural hedges (such as offtake contracts, foreign exchange earnings to hedge borrowings); exposure to each market risk net of the corresponding hedge

Financial risk

Possibility that market risk exposure will lead to significant change in earnings or financial position

Determining the level of balance sheet exposure of the issuer to market risks, especially to interest rate movements, changes in foreign currency exchange rates, and, if the firm has listed equity investments, to equity market risks. Actual losses or gains due to market risk exposures (commodity prices, interest rates, exchange rates) or derivative contracts in the last five years in relation to the size of the firm's business.

7. ANALYSIS, FINDINGS & INTERPRETATION

7.1. ANALYSIS OF THE QUESTIONNAIRE The questionnaire given in the annexure was filled up for 6 different companies which are the customers of SBI. After filling up the questionnaire I allotted ranks to each of the possible answers. The rankings were given in the increasing order of risk. More is the risk XIME

36 identified from a question, more will be the rank. The different questions were splitted into sections with section trying to identify one particular risk. The maximum rank i.e. 4 is the rank for the highest risk and the lowest rank i.e. 1, is for the least risk face by a particular company. After filling up the questionnaire these are the rankings for each of the risks face by those 6 different companies. Fig No 3: Comparative Identification of Risks Faced By Companies

COMPARATIVE IDENTIFICATION OF RISKS FECED BY COMPANIES

4.5 4 3.5 3

RANKINGS

Concentration risk Currency risk Regulation risk Pure risk Operations risk

2.5 2 1.5 1 0.5 0 Company 1 Company 2 Company 3 Company 4 Company 5 Company 6

Product risk
COMPANY

Interestrate risk

It can be made out from the diagram that there is as such no particular trend in terms of a particular risk faced by the companies due to their location (all the companies under study are from Orissa). But some other observations from the questionnaire are: 1. Most of the companies dont go for hedging. 2. Those companies who go for hedging are generally interested in forward contracts and they hedge only a negligible portion of their exposure, keeping a major portion open. 3. All the companies have good relationship with the STATE BANK OF INDIA.

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37 One particular section of the questionnaire dealt with the risk management strategies adopted by the companies under study. The answers to such question were also ranked. More is the rank, less is the company prepared to face the risk. So the rankings for risk management strategies are as follows. Fig No 4: Comparison Of Risk Management Strategies Adopted By Various Companies
Risk management strategies
4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 1 2 3 COMPANIES 4 5 6

It can be seen from the diagram that company 5 is the best in adopting risk management strategies, but the irony of the situation is that company 5 is the company which is running into losses and is also exposed to a substantial amount of risk. So I chose this company as my case study.

7.2 INDUSTRY SCENARIO AND COMPANY PROFILE OF THE COMPANY UNDER STUDY, ABC Ltd. Agriculture, which accounts for one fifth of GDP, provides sustenance to two-thirds of our population. Besides, it provides crucial backward and forward linkages to the rest of the economy. In Indias success in agriculture sector, not only in terms of meeting total requirement of food grains but also generating exportable surpluses, the significant role played by chemical fertilizers is well recognized and established. Green revolution in the

RANKINGS

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38 late sixties gave an impetus to the growth of fertilizer industry in India and the seventies and eighties then witnessed a significant addition to the fertilizer production capacity. India is the third largest Nitrogen and Complex fertilizers producer in the world with about 60 units producing about 19 million tones and total turnover of Rs.33000 crores. The annual consumption of fertilizers has increased from 0.7 lakh metric tonne in 195152 to 203.40 lakh metric tonne in 2005-06. The installed capacity as on 31.01.2007 has reached a level of 120.61 LMT of nitrogen and 56.59 LMT of phosphatic nutrient. The country's current fertiliser production is about 35 million tonnes. It is estimated that about 55 million tonnes of fertiliser products will be needed by the end of Eleventh Plan period. This leaves a huge gap of 20 million tonnes to be met through imports. This will put the country's food security at grave risk. The fertiliser industry, once a core sector, has taken a back-seat. The Tenth Plan (2002-2007) witnessed a very slow growth (just about 2 per cent) in the agricultural sector and failed to achieve the target of 4 per cent set in the National Agricultural Policy 2000. The Tenth Plan period also witnessed, after several years, large-scale fertiliser imports to meet domestic demand. Food grains production too fell well below the requirement and the country had to resort to imports. Now that the Eleventh Plan is under way, it is time to take stock of the reforms planned for the fertiliser sector at the start of the Tenth Plan and what has been achieved so far.

STRUCTURE OF FERTILISER INDUSTRY IN A NUTSHELL Capacity Production

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Major Players Public Sector

FACT, Cochin NFL - Bhatinda, Nangal, Panipat, Vijaipur Rashtriya Chemicals & Fertilizers, Trombay, Thane Gujarat Narmada Fertilizers Corporation, Bharuch Gujarat State Fertilizers Corporation, Vadodara

Co-operative sector

IFFCO, Kalol and Kandla, Phulpur, Aonla Kribco, Hazira & Gorakhpur

Private sector

Chambal Fertilizer, Katedan Duncans Industries, Panki Indo Gulf Corporation, Jagdishpur Oswal Chemicals & Fertilizers, Shahjanpur XIME

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SPIC, Tuticorin

Fertilizers : Key Issues Key Success Factors

Tight control on costs Increasing productivity, energy and process efficiencies Managing environment regarding prices Product mix Distribution channel network management Future Prospects

Demand Drivers Government policies, particularly those concerning pricing subsidies and imports.

Food grain production during Kharif, Rabi seasons Prices of fertilizers (domestic, international)

Expect phased (slow) decontrol of urea - next 5 - 7 years Fertilizer market will continue to be driven by urea demand Fertilizer demand likely to grow at 3 - 3.5% per annum during next 5 years

Imports of urea likely to decline

Summing up

Prospects for fertilizer industry hinges on the regulatory policies perused by the government.

7.2.1 THE CONCEPT OF SUBSIDY: Fertilizer subsidy is the difference between the selling price and reasonable cost of production and distribution based on certain norms, all fixed by the Government for each individual unit. In order to cushion the impact of increase in prices of fertilizers, the Ministry of Agriculture introduced a scheme of concession on sale of decontrolled XIME

41 fertilizers. For this purpose Department of Fertilizers fixes the indicative MRP at which the manufacturers/importers are required to sell decontrolled fertilizers. The delivered normative cost price of this fertilizer is generally higher than the MRP. The manufacturers/importers are provided the difference between the normative cost and MRP in the form of concession. Under the concession Scheme, the on account payment i.e. 85% of the concession is released to the manufacturers/importers on submission of details of sales in the prescribed Proforma-A. The balance payment of concession is released to the manufacturers/importers after the State Governments certify the sales. The idea behind releasing on account payment of concession is to ensure the availability of liquidity with the manufacturers/importers in the event of delay in the certification of sales.

7.2.2 COMPANY PROFILE ABC Ltd is a premier fertilizer company in the state of Orissa. The Company, which is a joint venture of the Zuari Industries Limited and the OCP Group of Morocco, is a major manufacturer of phosphatic fertilizers and has Asias second largest integrated plant. With its Corporate Office at Bhubaneswar, ABC Ltd has been in the fertilizer business for the last 24 years. At present it produces over 1.25 million tonnes of DAP & other complex phosphatic fertilizers annually. ABC Ltd is an ISO 9001 and ISO 14001 Company, testifying to its adherence to international quality standards. ABC Ltd was incorporated on 24th December, 1981 as a joint venture of the Government Of India and the Republic of Nauru. On withdrawal of the Republic of Nauru from the company, in June 1993 the Company became a Public Sector Undertaking (PSU).On February 28, 2002, the Government of India divested 74% of its stake in favor of selected strategic partner, Zuari Maroc Phosphates Pvt. Ltd. The government of Indias share holding has subsequently reduced with infusion of additional capital by ZMPL, to about 20%. Zuari Maroc Phosphates Pvt Ltd., a 51-49 Joint Venture of Zuari Industries Limited and Zuari Maroc Phosphore SA of Morocco acquired a majority (74%) stake in ABC Ltd in the year 2002. XIME

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A. Products ABC Ltd produces a wide range of specially formulated fertilizers which is marketed under the brand name Navratna and which caters to almost all types of crops. All the fertilizers produced by ABC Ltd strictly adhere to specification as per the Fertilizer Control Order. All the products are packed in 50 Kg. HDPE/PP laminated bags. B.RAW MATERIALS Sulphur (in powder form) is imported from USA, Canada, and European Countries etc. Major raw materials like phosphoric acid, ammonia, rock phosphates, sulphur and MOP are imported from Morocco, Tunisia, and Indonesia, Gulf countries, Jordan, Saudi Arabia and CIS countries. C.SALES: ABC Ltd. is the second largest integrated DAP Plant in India. It boasts of a market share of 21%, with a wide marketing network covering all the major States in India. With turnaround strategies in place to ramp up ABC Ltd's capacity from its present 7,20,000 tonnes per annum to well over a million tonnes, the Zuari-Chambal-ABC Ltd combine is poised to become the largest player in phosphatics fertilizers in the country. Besides manufactured products, ABC Ltd also markets its by-product Phospho-Gypsum which is

used for soil conditioning. ABC Ltd also imports and markets Muriate of Potash (MOP) through its network of private and institutional trade throughout the country. ABC Ltd has also a selling arrangement through its sister concerns viz. Zuari Industries Ltd. (ZIL) and Chambal Fertilizers & Chemicals Ltd. (CFCL) to cater to the markets in other parts of the country. The Sales network of ABC Ltd comprises of Private as well as the Institution channels. For marketing of its products, the Company has seven regional marketing offices at Vijayawada, Bhopal, Raipur, Ranchi, Lucknow, Bhubaneswar and Kolkata with 1843 dealers. The company achieved improved market position as given below due to vigorous marketing and promotion. XIME

43 Table 3: Table Showing the Market Position Of The Company ABC Ltd. State Orissa, M.P., Chattisgarh Jharkhand, West Bengal, U.P. Maharashtra A.P. Market position 2005-06 1 2 3 4

The information about the company including news, quotes, data and other information, was provided mostly from company sources on the condition that the name of the company will not be used anywhere in the project. Hence keeping this in mind, a hypothetical name has been used for the company in the case study. 7.3 SWOT ANALYSIS A. STRENGTHS: 1. ABC Ltd produces Phosphoric acid, which is an advantage of the company over others because Prices of Phosphoric acid has been increasing. While other fertilizer manufacturing Companies are facing problems for procurement of Phosphoric Acid, ABC Ltd manufactures about half of its phosphoric acid requirement in-house. Moreover Maroc Phosphore, a promoter of ABC Ltd, is a group company of OCP Group of Morocco, which is one of the largest producer and supplier of Phosphoric Acid and Rock Phosphate of the world. 2. Presently, ABC Ltd is the second largest integrated DAP plant in the country, next to Oswal Chemicals and Fertilisers Ltd. Major markets are WB, Jharkhand, Chhatisgarh, Bihar, and Orissa. In all these areas, ABC Ltd is either the market leader or No.2. B. WEAKNESSES: 1. A decade and a half since the liberalisation process began in India; the fertiliser sector is even now the most controlled industry. The government sets concession prices and the maximum retail price (MRP) for farmers, and dictates how much to produce, and where to sell. The industry is heavily controlled.

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44 2. The subsidy rates are calculate and announced quarterly after taking into account the average price of raw material & intermediates of the preceding quarter and the average exchange rate of the current quarter. Accordingly, the benefit of subsidy on fertilizers is passed on to the farmers by making the fertilizers available to them at the subsidized selling price. Input prices are either internationally determined or fixed by Government of India. Moreover output prices fixed by Government of India. The industry lacks flexibility and autonomy in decision making. C. OPPORTUNITIES: 1. Green revolution in the late sixties gave an impetus to the growth of fertilizer industry in India. And the demand for fertilizers is continuously increasing. This is a very good opportunity for the company. 2. In this annual budget there was a stress on agricultural sector, which indirectly means a growth in fertilizer industry. Agricultural growth is mainly dependent on advances in farming technologies and increased use of chemical fertilizers.

D. THREATS: 1. The company is almost fully dependent on imported raw material/intermediates (i.e. rock phosphate, sulphur and phosphoric acid) for the production of phosphatic fertilizers. This brings into picture the foreign exchange risk. 2. External factors such as weather and monsoon conditions as well as policy changes regarding fertilizer production, use and agricultural output enhancement, exert significant influence on capacity utilization in the industry. For instance, following the decontrol of price and distribution of potassic and phosphatic fertilizers in 1992 capacity utilization for phosphatic plants fell to 66.3% in 1993-94 from a high at 92.4% in 1991-92. 7.4 PROCESS OF RISK MANAGEMENT: After going through details about the company and the SWOT analysis of the company, the process of risk management of the company is as follows. IDENTIFYING THE RISKS XIME

45 ANALYSISNG AND QUANTIFYING THE RISKS PRIORITISATION OF RISKS SOME FINDINGS WITH RISK PERSPECTIVE This process as shown in above is followed in case of ABC Ltd. 7.4.1. IDENTIFYING THE RISKS: The various types of risks faced by ABC Ltd. are as follows. 1. BUSINESS RISK: For identifying if ABC Ltd faces business risk, I have analyzed in which stage of business the company is presently in with the help of the BCG Matrix given below. According to me ABC Ltd falls in the question mark section because they have high demands for finished goods but low returns. Moreover their cash usage is high whereas cash generation is low. After disinvestment, the company is turning round and has started making profits. The Company had continuously incurred losses since inception till disinvestment. After disinvestment, losses started coming down drastically due to improved turnover and cost cutting. In the year 2005-06, the Company achieved a turnaround and posted a net profit of Rs. 12.10 crores, which was about 3 times the level estimated. The only big obstacle now is the government regulation regarding subsidies, which restricts its revenue generation. But since recently the company has started exporting to Nepal and Bangladesh with the condition of payment obligation in rupees, so the company is doing well. Fig No 5: BCG Matrix to Analyze Business Risk

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A. Concentration Risk: ABC Ltd does not face concentration risk because they have a 10 year contract with their raw material supplier for sulphuric acid, MITSIBUSHI CORPORATION. Moreover for their other raw materials like phosphoric acid and rock phosphate they again have a 10 year contract with OCP Moroco. Besides there are other suppliers also like TRANSFERT, TRANS AMMONIA, RUSA GROW INTERNATIONAL, LONDON, etc ABC Ltds wide range of specially formulated fertilizers is marketed under the brand name Navratna which cater to almost all types of crops. ABC Ltds wide range of products, one of the largest in Industry, caters to almost all agricultural applications. ABC Ltd has managed this risk by spreading its revenues across several geographies, industry verticals, service offerings and customers. ABC Ltd sells its products in 16 states in India, and recently it has started exporting to NEPAL and BANGLADESH. B.Technology Risk: ABC Ltd Laboratory which is equipped with the latest equipment such as Electronic balances; Spectro photometer; Flame photometer; Atomic Absorption XIME

47 Spectrophotometer, Digital PH Meter & Conductivity bridge; and Mechanical Shakers has the facility to analyze the quality of raw material, in the process product, finished product & byproducts. At present in ABC Ltd, quality control laboratory is also involved for testing micro nutrients in soil as well, in order to ensure the balanced use of fertilizer. But the capacity utilization of the machines has been increasing year after year. It has reached almost 175% which I think is a cause of concern even though MR SRIRAM TRIPATHY, the chartered accountant of the firm in a personal interview says that they are doing wonders. I think if plant is operating at such high capacity there must be a lot of wear and tear in the machines, which increases the technology risk associate with the plant. C.Pure Risk: The manufacturing plant of ABC Ltd is based in ORISSA, which is constantly threatened by frequent floods and cyclones. As I came to know from the questionnaire the super cyclone of 1999 had a major impact on the plant. Hence it can be said that the company faces a substantial amount of pure risk. 2. INDUSTRY RISK I have used the Michael Porter 5 forces model to identify the industry risk faced by the company. The diagram below shows the Michael Porter 5 forces model and the main parameters to identify industry risk. Out of all the parameters present in the model, that parameters to which the company is exposed to is discussed below.

Fig No 6: Table Showing the Michael Porter 5 Forces Model

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A.Buyer Power: There is an increasing demand for fertilizers, but I think too much of fertilizers will degrade the soil and make it unusable further. So there will be a period when the demand of fertilizers will decrease. BUT this is my view in the long term hence buyers volume will decrease with time. Moreover it can be said that buyers do have some amount of bargaining power, because of the presence of the scheme of subsidies. B. Supplier Power: The raw materials for products manufactured by ABC Ltd are price sensitive in the sense that if the cost price of raw materials increases, then ABC Ltd has to submit a draft for fresh amount of subsidies to be received on account of increase in cost of manufacturing which may or may not be received. Hence its turnover is heavily dependent on subsidies. C. Industry Competitors: ABC Ltd operates in intensely competitive markets across several geographies and service offerings; the competition can only increase in the future. Its major competitor is IFFCO, Indian Farmers Fertiliser Co-operative Limited (IFFCO) which was registered on November 3, 1967 as a Multi-unit Co-operative Society and XIME

49 which has larger financial, technical and marketing resources and hence it may be able to respond faster and better to new and emerging technologies or dynamism in customer requirements. Other competitors include Chambal fertilizers, Coromendel Fertilizers. For ABC Ltd, the result could be price reduction, fewer customer orders, reduced profit margins and loss of market share. 3. FINANCIAL RISK: There are basically two types of financial risks faced by the company. A. Liquidity Risk: Fertilizer companies require high working capital due to the seasonal nature of their sales and the long credit period given to farmers. Liquidity includes both the ability to turn an asset into cash and to do so without being required to significantly reduce the price below its current level. ABC Ltd has substantial dues to unpaid creditors. It has dues to Office Cherifien des Phosphates (OCP)/ Maroc Phosphore, SA, to the tune of Rs 268.64 crores inclusive of interest. Besides this, the total Sundry Creditors level was at Rs.610.18 crores as on 31.03.2006, which includes dues payable to Grouped Chimique Tunisiens (GCT) and other foreign suppliers to the tune of Rs 107.13 crore. An idea about the liquidity position of the company was got by the help of current and acid test ratios for the previous 3 years. The ratio is < 1 which indicates the company has substantial amount of liquidity risk. B. Credit Risk: Subsidies form a major part of the revenues .Although government is the counterparty to ABC Ltd but it has a substantial counterparty risk because the subsidy is always delayed due to which the revenues of the company is restricted. A comparison of sales without including subsidy received from the government and the profits made in the last 10 years of the company is shown below. The graph clearly shows that the subsidies form a major part of the turnover, which is generally payable by the government and is received very late. ABC Ltd faces credit risk in the sense that its subsidies are totally dependent on government regulations which change from time to tile. As told to me by the junior charted accountant of the company, the subsidy payment is worked out by a complicated formula. The two major components of the formulae are XIME

50 raw material rates for the previous quarter and exchange rate for the present quarter. ABC Ltd gets 85 % of the total subsidies receivable from the central government and 15 % from the state government which is mostly pending due to changing government regulations. Fig No 7: Chart Showing The Comparison Between Sales And Subsidies Receivable By ABC Ltd.

1400

4. MARKET RISK:

1200
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Market risk generally falls into three categories. They are: A. Currency Risk: It is one of the major risks to which the company is exposed to. This is due to the fact that the company imports substantial amount of raw materials. It is almost 90% of the total purchases of the company in a year on an average. Moreover there are no exports of the company which acts as a natural hedge to vulnerability to currency risk. The company has recently started exporting to Nepal and Bangladesh, but the payment obligation is in rupees. B. Interest Rate Risk: While going through the balance sheet I found out that the company is paying interest per annum which is almost 3 times the profit made last year. As a result the interest coverage ratio of the company is very poor. This shows the companys exposure to interest rate risk. Moreover the company has huge amount of borrowings in the balance sheet as liabilities. Most of it is fixed rate liabilities and the rest of it, which is for working capital financing bears floating rate of interest. C. Commodity Price Risk: The input price of commodity is determined by the government from time to time. But there are fluctuations in it which exposes the company to interest rate risk. But the company has advantage as regards to phosphoric acid, which is manufactured in India and rock phosphate which is supplied under a contract basis by a company which has recently become the promoter of the company.

7.4.2 ANALYSING AND QUANTIFYING THE RISKS XIME

52 For this step I have compared ABC Ltd to IFFCO, the best fertilizer company in India, After quantitative comparison I have ranked each company in terms of severity of risk. 1. QUANTIFICATION OF BUSINESS RISK A. Break Even Sales and Margin of Safety Business risk is a risk due to the nature of business, the product it sells, the external economic environment and the internal manufacturing activities. If all these variables are in a steady state, the business suffers from no risk. But if there is volatility, then there is business risk. This volatility is first reflected in sales, and as a consequence on the profitability of the business. One way to measure it is margin of safety. Margin of safety measures the sensitivity of business to variation in sales. A business deals in an uncertain situation and hence various economies, social, and political factors may affect the sales, and hence profit of the firm adversely. So the need is to know that if the sales fall below a certain point, what the condition of the business would be. It needs to be seen whether the businesses would be able to withstand fall in sales, and if so to what extent. The margin of safety indicates the shock absorbing capacity of the business. The two line charts shown below shows the movement of gross sales and the required breakeven sales for both the companies. The two graphs below shows the movement of gross sales and break even sales of ABC Ltd and IFFCO. As can be made out from the charts, ABC Ltd was a loss making company so its breakeven sales required to make profit was very high but recently since it started making profits, the breakeven sales required has drastically come down. In comparison, IFFCO is doing much better as regards to profits and hence the breakeven sales required are always less than gross sales. The effect of this scenario results in a good margin of safety for IFFCO in comparison to ABC Ltd. As IFFCO has greater margin of safety than ABC Ltd, so it gets a better ranking as it is less risky to changes in sales. Moreover since ABC Ltd was incurring losses, so the first 4 years the margin of safety is not calculated and the rating has been given taking into account the margin of safety of the last two years. On Ranking The Two Companies I interpret ABC Ltd =5, IFFCO = 3.It means ABC Ltd has

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53 high risk from the margin of safety perspective and IFFCO has moderate risk with good performance record. Fig No 8: Charts Showing the Comparison Of Sales And Break Even Sales

ABC Ltd
1 0,000.00 8 ,0 0 0 . 0 0 6 ,0 0 0 . 0 0 4 ,0 0 0 . 0 0 2 ,0 0 0 . 0 0 0.00 1 2 3 4 5 6 1 2 ,0 0 0 . 0 0 1 0 ,0 0 0 . 0 0 8 ,0 0 0 . 0 0 6 ,0 0 0 . 0 0 4 ,0 0 0 . 0 0 2 ,0 0 0 . 0 0 0.00 1 2 3

IFFCO

G R O S S S A LE S B RE A K E V E N S A LE S

G R O S S S A LE S B R E A K E V E N S A LE S

B. Profit Volume Ratio to Measure Product Risk It is the ratio of profits made in a year to the net sales for the same year. This ratio indicates the intrinsic strength of a product. If this ratio is declining, the conclusion is that the product is losing the market or when the variable group of coasts loses proportionality with the sales. It is very helpful in comparing the performance of two units selling the same products. The graph shows the profit volume ratio of both the companies in percentage terms. From the graph it can be seen that the profit volume ratio of ABC Ltd has been increasing steadily year after year, whereas that of IFFCO is almost the same with marginal decrease in the last two years. As far as my knowledge goes ABC Ltd is not losing market share but may be its variable costs had lost proportionality with sales in the earlier years, because of the past losses. The ratio has started increasing recently because the company is now making profits. On comparison of the average profit volume ratio of both the companies it can be said that IFFCO is in a much better position than ABC Ltd. On ranking the two companies, ABC Ltd gets a rank of 5 which means the

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54 company has high product risk and doubtful performance and IFFCO gets a rank of 3 with moderate risk with good performance certificate. Fig No 9: Chart Showing the Comparison Of PV Ratio

CHART SHOWING PROFIT VOLUME RATIO

25 20 15 10 5 0 -5 -10 IFFCO ABC LTD 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06

C. Technology Risk XIME

55 I have analyzed the risk with the help of a ratio which indicates the level of replacement of assets and hence the state of technology of a business. This ratio is called technology up gradation ratio. This ratio indicates whether the management is replacing the fixed assets regularly. This ratio is essential particularity for capital intensive industry like fertilizers, because if proper replacements are not made then the unit might fall sick soon. If this ratio is less than 1( if depreciation is measured on straight line basis only ), it means the fixed assets are being run down without replacements the business is not replacing the fixed assets but investing the depreciation fund for some other purpose. A unit can fall sick because of non replacement of fixed assets. This ratio is defined as the ratio of capital expenditure to depreciation. Capital expenditure has been calculated by adding the depreciation, capital work in progress and the additions to fixed assets. From the figure it can be said that more or less both the companies have the same ratio in the first 5 years of the study, but in the last year IFFCO shows a huge increase in the ratio than ABC Ltd. It indicates some recent major additions to plant and machinery in IFFCO. Generally this ratio is calculated over a period of 3-5 years and is averaged out because replacement of fixed assets does not happen every year. The average ratio for ABC Ltd is 2 and that of IFFCO is 3.9. Fig No 10: Chart Showing the Comparison Of Technology Up gradation Ratio

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TECHNOLOGY UPGRADATION RATIO

16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 2000-01 2001-02 2003-03 2003-04 2004-05 2005-06

TECHNOLOGY UPGRADATION RATIO OF IFFCO TECHNOLOGY UPGRADATION RATIO OF ABC LTD

The ratio is very high for the last year in case of IFFCO indicating a major addition to fixed assets. ABC Ltd is raising term loans this year for its technology up gradation. An additional chiller has been added to the DAP plant, which has resulted in increase in efficiency and production. ABC Ltd is getting its capacity re-rated. Considering this factor I have given ABC Ltd a ranking of 4, which means a reasonable risk and a fair performance certificate. IFFCO gets a ranking of 3 which means moderate risk with a good performance certificate.

Table No 4: Table Showing the Ranking Of Business Risk Parameters

SL NO. 1 . 2 . 3 .

BUSINESS RISK PARAMETERS BREAKEVEN SALES AND MARGIN OF SAFETY ANALYSIS PROFIT VOLUME RATIO TO MEASURE PRODUCT RISK TECHNOLOGY RISK TOTAL

ABC Ltd 5 5 4 14

IFFCO 3 3 3 9

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2. QUANTIFICATION OF INDUSTRY RISK A. Competition Risk Measured By Turnover Growth The analysis of growth rate of turnover over a period of years provides an insight into competitive position of a company with regard to the industry. The chart given below compares the growth rate of both the companies with the industry and it is found that the average growth rate of both the companies is greater than industry growth rate which is a good sign. Moreover it is found that the growth rate of turnover of ABC Ltd is much more than that of IFFCO. The average industry turnover growth rate is 9.94%. Both the companies are doing well with regards to annual turnover growth rate. In this case ABC Ltd is showing a great improvement over the previous years with average growth rate of 20.52% in comparison to IFFCO at 13.97%. On the basis of average growth rate of the companies and the industry I have ranked both the companies as according to the industry meter given in methodology. Hence ABC Ltd gets a rank of 1 with performance certificate as excellent i.e. much better performance than industry with no risk certificate and IFFCO gets a rank of 2 with negligible risk and very good performance certificate. In this case at least ABC Ltd is doing very well in comparison to IFFCO. Fig No 11: Chart Showing the Comparison Of Turnover Growth

CHART SHOWING GROWTH RATE OF TURNOVER

80 60 40 20 0 -20 -40 GROWTH RATE OF IFFCO GROWTH RATE OF INDUSTRY GROWTH RATE OF ABC LTD 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06

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B. Growth Rate of Value Added Value added is defined as the profit before interest and taxes, plus depreciation, plus salaries and wages. It is a way to measure the growth of an industry because it is the ultimate source of profit. With the help of this we can find out whether the industry is growing or shrinking. The first line graph shows the value added to ABC Ltd and IFFCO over the last 5-6 years. Value added in case of ABC Ltd was negative for some time because of negative operating profit. As can be seen from the second chart below, which shows the growth rate of value added, the growth rate of value added for the last 5 years of ABC Ltd was negative. The only year when there was a growth in value added is the last year and the rate is shown in the form of a blue dot. The period for which the growth rate of value added was negative has not been plotted on the graph. This can be explained by the company incurring losses for the past 24 years. In comparison the growth rate of value added in IFFCO is good although for a couple of years it was negative. The rank of ABC Ltd is 5 with doubtful performance and high risk whereas the rank of IFFCO is 3 with good performance and moderate risk. Fig No 12: Chart Showing Comparison Of Value Added To Each Of The Companies And The Growth Rate Of Value Added

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CHART SHOWING GROWTH RATE OF VALUE ADDED

60.00 40.00 20.00 0.00 -20.00 -40.00 GROWTH RATE OF IFFCO GROWTH RATE OF ABC LTD 2000-01 2001-02 2003-03 2003-04 2004-05 2005-06

CHART SHOWING GROWTH RATE OF VALUE ADDED

60.00 40.00 20.00 0.00 -20.00 -40.00 GROWTH RATE OF IFFCO GROWTH RATE OF ABC LTD 2000-01 2001-02 2003-03 2003-04 2004-05 2005-06

B. Productivity Of Labor: This is the change in value added per employee. Here the intention is to find out how much value has been added to the industry for Rs 1 spent on salaries and wages. It has been found that plants that have substantial scope of progress on productivity also have large potential for cutting costs and hence increasing profits. The chart given below shows the productivity of labor in the two companies. ABC Ltd had negative productivity of labor due to negative value added, whereas IFFCO has a positive productivity of labor. The average productivity of labor of IFFCO was 3.84% XIME

60 whereas in case of ABC Ltd it was 0.37 %. The rank of ABC Ltd is 5 with high risk and doubtful performance certificate, whereas the ranking for IFFCO is 3 with good performance certificate and moderate risk. Fig No 13: Chart Showing a Comparison Of Productivity Of Labor
CHART SHOWING PRODUCTIVITY OF LAOUR
6.00 5.00 4.00 3.00 2.00 1.00 0.00 -1.00 -2.00 -3.00

2000-01

2001-02

2003-03

2003-04

2004-05

2005-06

PRODUCTIVITY OF LABOUR OF IFFCO PRODUCTIVITY OF LABOUR OF ABC LTD

Table No 5: Table Showing the Rankings Of Industry Risk Parameters

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61 SL NO. 1. 2. 3. INDUSTRY RISK PARAMETERS COMPETITION: TURNOVER GROWTH GOWTH RATE OF VALUE ADDED PRODUCTIVITY OF LABOUR TOTAL ABC Ltd 1 5 5 11 IFFCO 2 3 3 8

3. QUANTIFICATION OF FINANCIAL RISK I have checked the financial health of a company in much the same fashion as the previous risks by analyzing the financial statements. The vital signs are tested mostly by various financial ratios that are calculated from the financial statements. Apart from the vital ratios there are other parameters like operating leverage, financial leverage and financial margin of safety which are analyzed in the financial risk perspective. A. Liquidity Risk Analysis I have analyzed the liquidity risk faced by both the companies by the help of liquidity ratios. The graphs showed below shows the various liquidity ratios of both the companies in comparison to the industry average of the corresponding ratios over a period of 6 years from 2000-01 to 2005-06. The observations are as follows; The net worth for ABC Ltd was negative for the first 5 years under study because of past losses. The debt equity ratio and the current ratio shown in case of ABC Ltd are not average for the last 6 years because of the above reason, but are of the last year under study. It can be clearly made out from the graph that ABC Ltd is exposed to high credit risk. This is because the total debt to equity ratio is much high in comparison to the industry and the current ration is less than industry. The second graph shows some of the parameters used to judge the liquidity position of any company. The gross working capital cycle in terms of number of days is much high XIME

62 in comparison to the industry as well as IFFCO. But holding period of inventory & receivables improved from 237 days in 2003-04 to 146 days 2004-05. With the delay in receipt of subsidy receivables from the GOI, the subsidy receivables mounted up thereby increasing holding period of inventory & receivables to 175 days in 2005-06, which is comparable to the industry average. Moreover the net working capital cycle in terms of number of days has improved in the recent years because of which the average at the end of 6 years has become comparable to the industry as well as IFFCO. However in terms of average payment period and average receivable period ABC Ltd still lags behind by a large extent. Fig No 14: Charts Showing Some Liquidity Ratios
CHART SHOWING SOME LIQUIDITY RATIOS
9 8 7 6 5 4 3 2 1 0 TOTAL DEBT/EQUITY IFFCO ABC LTD CURRENT RATIO INDUSTRY

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CHART SHOWING LIQUIDITY POSITION

250 200 150 100 50 0 GROSS WCC NET WCC AVG DAYS OF DEBTORS INDUSTRY AVG DAYS OF CREDITORS

IFFCO

ABC LTD

After ranking all the liquidity ratios individually, I have taken average of the ranks to determine the overall ranking of liquidity risk of ABC Ltd in comparison to IFFCO. The ranks are rounded to 2 decimal places. The rank for ABC Ltd is 5 with doubtful performance certificate and high risk whereas the rank if IFFCO is 2 with very good performance certificate and negligible risk. B. Credit Risk Both the companies ABC Ltd and IFFCO are in fertilizer industry and hence are dependent on subsidies receivable from the government of India from time to time as regards the selling price of fertilizers. The company lodges subsidy claims to GOI on monthly basis. 85% of the claim is normally settled within 1-2 months. This is however subject to availability of budget. Towards end of the year, GOI exhausts the budget and hence subsidy payment is delayed. . Moreover, a part of the subsidy claim is paid after considerable delay. This adds to the amount of debtors in the balance sheet. Debtors form a major chunk of the total receivables of ABC Ltd. The major reason for it is the subsidy payments which get delayed and gets accumulated. An analysis of debtors as a percentage of total receivables of the company in any form has been shown under. On an average the debtors form around 26% of total receivables of IFFCO whereas in case of ABC Ltd it is 88% for the last 6 years. Maximum cover period under receivables would XIME

64 be 90 days (other than GOI subsidy). The maximum cover period of GOI subsidy is taken at 270 days, as the company gets final subsidy of 15% in 6-9 months from becoming due. This happens particularly towards the end of the year when the GOI exhausts the subsidy budget. Some financial parameters which are considered necessary for credit risk assessment have been taken here. These financial parameters are measured over a period of 6 years for both the companies as well as the fertilizer industry in particular. Then these parameters are averaged out and the proportionality of variance with respect to the industry has been calculated and then accordingly the rating has been done. The immediate graph shown below shows the comparison of total outside liabilities to total net worth ratio, the profit after tax to net sales ratio and the net sales to total tangible assets ratio of ABC Ltd, IFFCO and the industry average calculated by taking into account the top 15 fertilizers industry in India.

Fig No 15: Charts Depicting Credit Risk

CHART SHOWING DEBTORS AS A PERCENTAGE OF TOTAL RECEIVABLES

120.00 100.00 80.00 60.00 40.00 20.00 0.00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06

DEBTORS AS % TOTAL RECEIVABLES OF IFFCO DEBTORS AS % TOTAL RECEIVABLES OF ABC LTD

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CHART SHOWING SOME FINANCIAL PARAMETERS

6 4 2 0 -2 -4 -6 -8 -10 IFFCO ABC LTD INDUSTRY TOL/TNW PAT/NET SALES NET SALES/TTA

OBSERVATIONS FROM THE GRAPH: 1. TOL/TNW is negative for ABC Ltd throughout the period under study. It means the net worth of the company is negative, which is due to losses incurred during the pre-disinvestment period. Because of negative net worth pf the company it can be said that the financials of the company are weak. Hence in this case ABC Ltd gets a poor ranking. The lesser the ratio, the better is the company. 2. PAT/ NET SALES: This ratio indicates the profitability of the company, which is again negative because of past losses. Hence in this case also the company gets a poor ranking. The more the ratio, the better the ranking the company gets. 3. NET SALES/ TTA: This is a ratio of net sales of the company to the total tangible assets of a company in a tear. The more the ratio, the better it is for the company. This ratio of ABC Ltd is very good, almost equal to IFFCO and much better than the industry average. This means the turnover of the company is much more as compared to the total tangible assets in the company which is a good sign of performance. Hence the company under study gets a good ranking. So after final ranking ABC Ltd =5 AND IFFCO =3

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66 C. Leverage Analysis: I had earlier analyzed the business risk of both the companies in terms of the volatility or uncertainty of sales. The impact of this volatility on the operating and financial structure of the business adds to the total risk of the enterprise. This risk can be measured by operating leverage which is the extensions of the break even concept.

Operating leverage shows the relationship between sales and operating profit of a business. It means if there is a fall in sales by a certain percentage, then the fall in operating profit will be the operating leverage times the percentage decrease in sales. The risk proneness of a business increases with increasing operating leverage. Leaving the years for which ABC Ltd was making huge losses, operating leverage for the last 2 years of analysis is much high as compared to IFFCO. It implies the presence of relatively high fixed costs. A very low level of OL means a low incidence of fixed costs relative to contribution, suggesting a high margin of safety of the business to withstand future shocks.

Financial leverage: It shows the relationship between operating profit and net profit of an enterprise. Firms are motivated towards high leverage in order to maximize the returns on shareholders funds. Since interest as a cost is tax deductible, so shareholders can maximize their value by high debt financing. But it is often at the cost of the lender because their riskiness of the business rises with the increase in leverage.

Fig No 16: Charts Showing Operating and Financial Leverage

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6.00 4.00 2.00 0.00 -2 . 0 0 2 0 0 0 -0 1 0 1 -0 2 0 2 -0 3 0 3 -0 4 0 4 -0 5 0 5 -0 6 20 20 20 20 20 O P E R A T IN G L E V E R A G E O F IF F C O O P E R A T IN G L E V E R A G E O F A B C L T D

1 5 .0 0 1 0 .0 0 5 .0 0 0 .0 0 -5 . 0 0 2 0 0 0 -0210 0 1 -0220 0 2 -0230 0 3 -0240 0 4 -0250 0 5 -0 6 F IN A N C IA L L E V E R A G E O F IF F C O F IN A N C IA L L E V E R A G E O F A B C L T D

As can be observed from the above column chart, the operating leverage of IFFCO is around two for the last 6 years, whereas in case of ABC Ltd it was negative for a couple of years and later it is very high, signifying high risk. It means the fixed cost of the company is high as compared to the contribution made to the company. Similarly in case of financial leverage if we consider the case of ABC Ltd we will see that the operating profit is generally negative and the interest cost is very high. This can be known from the last year figure of financial leverage which is around 11%. It means the debt burden relative to capital is very high. An idea of this was already got from the huge liabilities in the balance sheet, which indirectly means a huge amount of interest to be paid each year. Financial Breakeven Point Of Sales And Financial Margin Of Safety: Financial breakeven point of sales is the point of sales at which the profit after tax becomes zero. The usual breakeven point of sales which we had calculated earlier did not take into consideration the finance cost. This is the difference between the two concepts. A high breakeven point of sales and consequently a low margin of safety indicate the presence of high fixed overhead burden, which can be absorbed only by increasing the sales. This is exactly the case for ABC Ltd which has a high breakeven sales and a low margin of safety. The company has to see that if the present line of products is reaching a saturation point, then the company will have to look for opportunities to diversify into other profitable products. The financial margin of safety of ABC Ltd was negligible, signifying XIME

68 high risk. After ranking the operating leverage, financial leverage and financial margin of safety separately, the average rank for the companies is as follows. ABC Ltd gets a rank of 5 with doubtful performance certificate and high risk category company classification, whereas IFFCO gets a ranking of 2 with very good performance certificate and negligible risk category company classification. Table 6: Table Showing the Rankings Of Financial Risk Parameters SL NO. 1. 2. 3. FINANCIAL RISK PARAMETERS LIQUIDITY RISK ANALYSIS CREDIT RISK ANALYSIS LEVERAGE ANALYSIS TOTAL ABC Ltd 5 5 5 15 IFFCO 2 3 2 7

4. QUANTIFICATION OF MARKET RISK A. Import and Export Ratios to Measure Currency Risk The import ratio and the export ratio are two important ratios to analyze the sensitivity of business to changes in international markets. These two ratios have become very important these days because of growing uncertainty in international trade and exchange rates. More the ratio more is the risk associated. Raw material imports as a percentage of sales in case of ABC Ltd are much more as compared to IFFCO; hence ABC Ltd faces more exchange risk. Moreover in case of ABC Ltd there are no exports till now which increases the vulnerability to exchange rates as there is no natural hedge available which is present in case of IFFCO. ABC Ltd has substantial imports of raw materials as compared to IFFCO on one hand and on the other IFFCO has imported some fixed assets from outside, which means both the companies face foreign exchange risk to a substantial extent. XIME

69 The total raw material imports of both the companies under study as percentage of total raw material purchases for the last 6 years from 2000-01 to 2005-06 depicts, that the percentage of raw material imports in case of ABC Ltd is on an average 90% whereas it is only 50% on an average for IFFCO. This shows the seriousness of vulnerability of ABC Ltd to exchange rate fluctuations. As I came to know from the company sources, the raw materials have generally a credit period of 180 days as a buyers credit is taken for their payment from time to time. The chart shows the import ratios of ABC Ltd, IFFCO and industry on an average for the last 6 years. More is the ratio, more is the risk associated. On this basis I have ranked the companies as under. ABC Ltd straight away gets a rank of 6 with very poor performance certificate and highest risk category whereas; IFFCO gets a rank of 3, with moderate risk and good performance certificate ratios. Fig No:17 Chart Showing The Import Ratios Of Both The Companies In Comparison To Industry
CHART SHOWING IMPORT RATIOS
90 80 70 60 50 40 30 20 10 0 Raw material import as % of raw material purchases IFFCO ABC LTD Imported capital goods as % of purchase of fixed assets INDUSTRY

I have done a sensitivity analysis of the company under study that is ABC Ltd. Which analyses the operating profit and margin of safety of the company under different scenarios which are mentioned in the figure as cases with specific numbers foe each scenario. XIME

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SENSITIVITY ANALYSIS OF ABC Ltd Sensitivity analysis is a process of analyzing possible future events by considering alternative possible outcomes (scenarios), but unlike scenario analysis, one scenario at a time is taken. The analysis is designed to allow improved decision-making by allowing more complete consideration of outcomes and their implications. ABC Ltd imports most of its raw materials and indigenous production is almost nil. All its import obligation payments are in dollars as I came to know from the company sources. So a small change in exchange rate of USD/INR causes a major impact on the total raw material cost of the company and hence on the profitability. It can be seen from the chart that if the raw material cost increases by 5% only the break even sales increases to a great extent. Fig No 18: Sensitivity Analysis Of The Company ABC Ltd

3500 3000 2500 2000 1500 1000 500 0 PR ES EN T C A S E 1 C A S E 2 C A S E 3 C A S E 4 R E V E N U E F R O M S A L B S EA K EV E N S A L E S ER

M A R G IN O F S A F E T Y 1 0 0 .0 0 5 0 .0 0 0 .0 0 -5 0 .0 0
E1 CA SE 2 E3 CA S PR ES EN CA S E4 CA S T

-1 0 0 . 0 0

M A R G IN O F S A F E T Y

The various cases as mentioned in the chart are as follows keeping other expenses constant. Case 1 An increase of 5% in raw material cost Case 2 A decrease of 5% in raw material cost Case 3 A decrease e of 5% in subsidies receivable from the government of India Case 4 An increase of 5% in subsidies receivable from the government of India XIME

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The first figure on the left shows the revenue from sales which is assumed to be constant, while changing the raw material receivable and subsidy receivable, which are shown as different cases. In the present situation it can be seen that the breakeven sales is around 1500 crores, but in case of case 1 scenario (i.e. an increase of 5 % in raw material cost due to exchange fluctuation, keeping other things constant,) the breakeven sales shows a steep rise to 3000 crores. This shows the extent of impact of exchange rate on the profitability of the company. The second chart shows the effect of the different scenarios on the margin of safety. As can be seen from the line chart the impact is huge on the margin of safety. This clearly shows the sensitivity of ABC Ltd to a slight change in exchange rate because almost 90% of its raw material is imported and the subsidies receivable from the government of India is worked out by a formula which takes into account the raw material rate of the previous quarter and exchange rate of the present quarter. So if rupee depreciated in the previous quarter and appreciates in the present quarter the cost of raw materials would go up which will impact the company only when they pay for heir raw materials may be in the future quarter when again the scenario can be different ,but will impact the present quarter subsidies receivable. As I came to know from the company sources, during the year 200405 there was an income due to exchange fluctuation to the extent of 2.79 crores whereas during the next financial year there was an expense to the extent of 24.85 crores .

B. Interest Rate Risk: Interest rate risk generally arises if there are assets or liabilities at a floating rate of interest. Moreover according to a recent RBI guideline even the fixed rate loans are no more 100% fixed. As according to the situation of the economy and the inflation rate prevailing at a particular point of time the central bank has the authority to revise the fixed interest rates also. Moreover if there are foreign currency assets or liabilities then XIME

72 interest rate risk becomes more serious situation because of the additional risk of foreign exchange fluctuation. This brings into picture interest rate risk. The liabilities which are prone to interest rate risk are called risk sensitive liabilities. I have used the interest coverage ratio as a parameter to judge the interest rate risk faced by the company. Interest coverage ratio is defined as the ratio of earning before interest and taxes and the interest as a whole paid during the year under study. More is the ratio; less is the interest rate risk to which the company is exposed to. The graph shows a comparison of the interest coverage ratio of the company under study, ABC Ltd its competitor, IFFCO, and the industry average calculated taking into account, ABC Ltd, IFFCO, Chambal Fertilizers, Coromandel Fertilizers, And Fertilizers And Chemicals,Travencore Ltd. The average for the 6 years comes out to be - .48 for ABC Ltd, 6.30 for IFFCO and, 2.01 for the industry. More is the ratio, less is the risk associated because more ratio means interest paid during a year forms a lesser part if represented as a percentage of operating profit. Based on the extent of variation from the industry, I have ranked ABC Ltd as 6 with a poor performance certificate and a high risk category company, whereas IFFCO gets a rank of 1. This is because of its performance is much better than the industry. Hence it falls in the no risk category with excellent performance certificate.

Fig No 19: Chart Showing the Various Parameters as A Ratio To Interest Payable For The Year

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CHART SHOWING INTEREST COVER

7 6 5 4 3 2 1 0 -1 -2 IFFCO ABC LTD PBIT/ interest Cash profits / interest Operating cash flow / interest

INDUSTRY AVERAGE

C.Commodity Price Risk: Commodity price risk arises due to changes in cost prices of raw materials or due to changes in selling prices of finished products. In case of fertilizer industry, commodity price risk is only present from the point of view of input price risk because the government fixes the selling price of fertilizers from time to time and there is no hand of manufacturers in this case. Even if the government increases the prices of fertilizers, the manufacturers are paid the increase in the form of subsidy. Fertilizer production is an energy-intensive operation. Over the years, the energy price has zoomed. Other components of production cost capital cost, overheads, etc., have also increased, though not as much as oil. However, the selling price of fertilizer has moved at a niggardly pace. Naturally, the gap between production cost and selling price has progressively widened, leading to corresponding increase in subsidy payments.

Fig No 20: Charts Showing The Comparison Of Changes In Cost Of 5 Important Raw Materials. XIME

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CHANGES IN COST OF RAW MATERIALS OFABC LTD 30000 20000 10000 0
Am onia m P hosphoric Acid R ock P hosphate Sulphur Sulphuric Acid

2004-05

2005-06

CHANGES IN RAW MATERIAL COST OF IFFCO 30000 25000 20000 15000 10000 5000 0
m on ia Ac id ha Po ta sh N ap ht ic U re a

2004-05 2005-06

The two charts depict the movement in cost price of some important and regularly used fertilizers by both the companies. As can be seen from the chart, in case of ABC Ltd the cost prices of ammonia and phosphoric acids have increased with decrease in cost price of rock phosphate and sulphuric acid. This is because ABC Ltd produces almost 50% of sulphuric acid in house and Maroc Phosphore SA, a promoter of ABC Ltd, is a group company of OCP Group of Morocco, which is one of the largest producer and supplier Phosphoric Acid and Rock Phosphate of the world. The price of sulphur has remained constant. In contrast, in case of IFFCO, the prices of almost all the important raw materials have increased. The average degree of volatility in case of ABC Ltd is 0.29 % for five important raw material s, and it is 17. 18 % in case of IFFCO, basing on this factor I have ranked ABC Ltd = 2, and IFFCO as 5.

Ph o

sp ho r

Am

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75 Table No 7: Table Showing the Rankings Of Market Risk Parameters SL NO. 1. 2. 3. MARKET RISK PARAMETERS CURRENCY RISK INTEREST RATE RISK COMMODITY PRICE RISK TOTAL ABC Ltd 5 6 2 12 IFFCO 3 1 5 9

7.4.3. PRIORITISATION OF RISK After the analysis of major risks to which the company is exposed is identified, the risks which are most important to be addressed first should be prioritized. To prioritize the XIME

76 risks I have used the FMEA template i.e. Failure Mode and Effect Analysis template, which is generally used in manufacturing industries to identify the causes of failure of a particular process, the severity , occurrence frequency and detection probability or probability of occurrence and when these three factors are multiplied we get a risk priority number. This number helps to decide which risks need the first attention. 1. SEVERITY: This is a number which depicts as to how severe the risk is faced by the company under study in comparison to the best company in the industry. This is the ranking I have given to ABC Ltd in comparison to IFFCO. 2. OCCURENCE: This number depicts the frequency of the occurrence of the risks faced by the company. This figure is also out of 6 as I have analyzed the data for 6 years for both the companies. This figure in the table is the number which represents the number of times the company was in a comparatively worse position than the competitor in the span of 6 years. IMPACT: This is the number which is calculated by multiplying the severity and occurrence for each of the risks faced by the company. PROBABILITY: It means the probability of the same risks faced by the company in future. The calculation of this part was very difficult because of the limit of time and information. Hence certain assumptions were taken and this was calculated. (Assumptions are mentioned in annexure C) To fully understand Risk Management, the two characteristics mentioned above are essential. The table below depicts various combinations of both the parameters and tries to suggest strategies to be followed in each case. In practice the process can be very difficult, and balancing between risks with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence can often be mishandled.

Table No 9: Table Showing the Decision Analysis Regarding Risk Priority

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Table No 8: Table Showing the Calculation Of Risk Priority Number

TYPES OF RISK Severity Occurrence Probability Risk priority number 666.67 666.67 22.22 5.56 520.83 666.67 1,041.67 666.67 1,500.00 3,600.00 3,600.00 44.44

BREAK EVEN SALES RISK PRODUCT RISK TECHNOLOGY RISK COMPETETION RISK OPERATIONS RISK PRODUCTIVITY RISK LIQUIDITY RISK CREDIT RISK LEVERAGE RISK CURRENCY RISK INTEREST RATE RISK COMMODITY PRICE RISK

5.00 5.00 4.00 1.00 5.00 5.00 5.00 5.00 5.00 6.00 6.00 2.00

4.00 4.00 1.00 1.00 5.00 4.00 5.00 4.00 6.00 6.00 6.00 2.00

33.33 33.33 5.56 5.56 20.83 33.33 41.67 33.33 50.00 100.00 100.00 11.11

In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled in descending order.

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78 Fig No 21: Pie Chart Showing The Comparative Percentage Of Risks

COMMODITY PRICE RISK 0% INTEREST RATE RISK 28%

BREAK EVEN SALES RISK 5%

PRODUCT RISK 5%

TECHNOLOGY RISK 0% COMPETETION RISK 0% OPERATIONS RISK 4% PRODUCTIVITY RISK 5%

LIQUIDITY RISK 8%

CREDIT RISK 5% CURRENCY RISK 28%

LEVERAGE RISK 12%

After identifying and quantifying all the major risks facing the company, the risks are shown in percentage terms in the form of a pie chart. The pie chart clearly shows that the XIME

79 two most important risks to which the company is exposed to is currency risk and interest rate risk. So further while giving the recommendation, I have kept this fact in mind, and have concentrated on these two risks. 7.4.4- TREATMENT OF RISKS BY THE COMPANY/FINDINGS A. Foreign Exchange Risk On prioritization risks in case of ABC Ltd it was found that the most severe risk to which it is exposed to is foreign exchange risk, because of huge imports of raw materials and to a certain extent due to effect of exchange rates on subsidy calculation on the finishes products. As a result it becomes increasingly important for the company to concentrate on mitigation of this particular risk. The best way to hedge foreign exchange risk is to use hedging tools available in the market. Usually the company used to book forward contracts to hedge the forex exposure, but recently the company has started using options protect against foreign exchange risk.

During the financial year 2005-06 the company had imported raw materials and stores and spares worth 1447.91 crores. There were no exports till then. So there is no natural hedge to protect them from foreign exchange. This situation increases the seriousness of the problem which the company can face if the exchange rate moves against them. The payment period for most of the raw materials imported is around 180 days except for ammonia, for which the payment period is 60 days. Assuming the supply of raw materials to be symmetric throughout the year, it can be said that the raw materials and stores and spares imported during the last quarter of the financial year 2005-06 can be said to be around th of the total raw material imports for the year, which comes out to be 361.98 crores. As I came to know from the records maintained in the commercial branch, International Banking division of SBI, which is one of the bankers of the company, the company has booked forward contracts to the extent of 50.089 crores during the first quarter of the financial year 2005-06. This comes out to be 13.8% of the net foreign exposure of that quarter. Till now the company has booked forward contracts worth 155 crores from state bank alone. The company may have booked more forward contracts XIME

80 through other banks, but that is out of scope of my project. So it can be said that the company has thought of hedging its exposure through booking of forward contracts.

Fig No 22: Chart Showing the Movement Of USD/INR Exchange Rate

Fig No 23: Figure Showing The Normal Distribution Curve For USD/INR Exchange Rate
0 0 0 0 0 0 39.31887595 43.34847595 47.37807595 51.40767595

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81 The graph shows the USD/INR rate over the last two and a half years. After looking at the graph it can be safely said that the extent of impact of foreign exchange rate on imports and exports of companies can be huge. The second graph shows the normal distribution curve for the exchange rates from Jan 2000 to July 2005. The standard deviation was 1.679 with mean of 46.03. The maximum variation 99.99 % of the times can be 51.07 and the minimum can be 40.99. Thus the maximum variation at any point of time can be 10.08 rupees per dollar which is a huge variation.

B. Interest Rate Risk

Regarding interest rate risk, to which the company is exposed to a large extent, the company has till now not thought about hedging of this risk, which I think is an important aspect to be covered in risk management. The company has kept its 100% exposure open regarding interest rate risk. The graph below shows the interest rate movements over a period of about last 2 years. The interest rates which were around 6 % in 2004 are hovering around 11-12% in 2007. This shows the vulnerability of any company to interest rates and especially of a company like ABC Ltd which has huge loans. Fig No 24: Figure Showing the Movement of Interest Rate

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82 3. Commodity Price Risk In a market-driven system, the moment a company is faced with any development that has the effect of increasing its production cost, the entire team is put on alert to work out strategies and plans to combat it. But, under the RPS/GPS, all a company has to do is to prepare a revised cost-sheet that captures the impact of this development on production cost and submit it to the Government for additional subsidy reimbursements. Why should the cost increase be reimbursed at all? A standard answer is that producers cannot increase their selling price. The product being seasonal, there would be wide variations between the receivable holdings & finished goods. There would be more of receivables and less of finished goods during the busy season whereas there would be less of receivables and more of finished goods during the non-peak season. The existing system gives a wrong signal to all those supplying inputs/raw materials/intermediates/feedstock to the fertilizer producers. The former take advantage of the fact that whatever increase in price they seek from the latter will get compensated under the RPS/GPS. Under the RPS/GPS, known as retention price scheme (RPS) until 2003 and group pricing scheme (GPS) thereafter the Government reimburses to the producer the excess of his production cost over the selling price, which is controlled each producer is paid a price/subsidy "specific" to it, even as all farmers/users, irrespective of their location, pay a uniform price. After analyzing the filled up questionnaire, it was found that, Most of the companies dont go for hedging. Those companies which go for hedging are generally interested in forward contracts and they hedge only a negligible portion of their exposure, keeping a major portion open. All the companies have good relationship with the STATE BANK OF INDIA. SBI has an excellent Brand Name and Image but Customer awareness about SBI is low. Many companies are not aware of the derivative products offered by SBI. There is not enough risk management strategies are in place.

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8. RECCOMMENDATIONS
After the whole process of going through the balance sheet of the company, interviewing the finance manager of the company and reading the various news items about the company in the last year, I got a good idea about the companys exposure to there risks faced. So these recommendations are given to the company in consultation with my project guide: 8.1 RECCOMMENDATIONS REGARDING INTEREST RATE RISK a. One way in which the company can hedge its interest rate exposure is to go for interest rate swap in which one party exchanges a stream of interest for another party's stream. This will help the company to convert its fixed interest loans to floating or floating to fixed. Interest rate swaps are normally 'fixed against floating', but can also be 'floating against floating' rate. A single-currency 'fixed against fixed' rate swap would be theoretically possible, but since the entire cash-flow stream can be predicted at the outset there would be no reason to maintain a swap contract as the two parties could just settle for the difference between the present values of the two fixed streams Interest rate swaps are often used by companies to alter their exposure to interest-rate fluctuations, by swapping fixed-rate obligations for floating rate obligations, or vice versa. By swapping interest rates, a company is able to alter their interest rate exposures and bring them in line with management's appetite for interest rate risk. b. ABC Ltd has a huge amount of borrowings as mentioned previously. Banks decide the interest rate risk depending on the PLR i.e. prime lending rate. This PLR is the break even point for the bank and at this rate bank lends to its best customer. Generally the rates are specified as PLR + 1%, PLR +2% etc. so the interest rates not fixed but variable. Generally the working capital loan is for one year and hence inflation plays a major role in deciding the interest rates by the banks. Hence the interest rates keep on changing from year to year. The term loans taken by the company bears an interest rate which can be revised by the lending bank in every 2 years. Considering the above scenario it is recommended that the company should go for coupon only swap so as to take advantage of lower interest rates prevailing in other currencies like Japanese yen, euro, us dollars XIME

84 etc. This instrument enables the company to take advantage of the comparative cost of funds available in global markets, while at the same time gaining protection from any adverse interest rate movements. This instrument can be used to hedge the interest rate exposure from term loans. But if the board of the company wants to hedge the interest rate risk from the term loans as well as working capital loan, then the company should go for principal only swaps. C.The Company has huge amount of imports as analyzed previously. Because of this factor the company usually opens letter of credit. The usance period of these LCs is generally 60 days. The LC issuing bank makes the payment under LC on the due date by debit to the cash credit account of the company. As a result the cost of funds for the company to source raw material is the rate of interest applied to the cash credit account, which is presently 12.75%. In order to reduce this interest burden the company can convert their entire LC bill amount to buyers credit so as to avail the cheap source of finance available overseas. Buyers credit is available for a maximum of 1 year for import of non capital goods and 3 years for import of capital goods. Moreover as per the extant RBI guideline, the cost of buyers credit has to be restricted to 50 basis points over LIBOR. This will limit the exposure of the company within that range.

8.2 RECCOMMENDATIONS REGARDING FOREIGN EXCHANGE RISK OR CURRENCY RISK. 1. Till now the company has been hedging their foreign exchange risk by booking forward contracts. They used to hedge a part of their foreign exposure and keep a part exposed to exchange risk. Recently this year the company started taking options in the form of plain vanilla option, which involves a premium to be paid. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. The recommendation to the company is to go for range forward options, since it is a zero cost option. Unlike the forward hedge, which locks in a specific price for the underlying, the range forward locks in a price range for

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85 the underlying. In this way, the holder participates in small moves in the underlying while being protected from larger moves 2. A range forward option provides protection against unfavorable exchange rate movements by allowing you to exchange one currency for another at a pre-agreed ceiling rate or a floor rate on an agreed maturity date. At the same time it provides you with an ability to participate in any favorable exchange rate movements to a predetermined level. For this the company should find out the level of exchange rate at which it makes a reasonable profit over break even, and ask for a zero cost range forward option price from the bank. In a range forward option there is no up front out of pocket costs involved. A RFC provides protection against unfavorable exchange rate movements while giving the company some ability to participate in any favorable exchange rate movements. Moreover these are flexible and can be tailor made for a particular company. In case of range forward, the more the option is out of money; greater is the band for the company in which the company is protected. So as a part of the risk management policy, the board can stipulate the reasonable profit amount, which should be taken into account for asking for range forward option. If the view of the company is that the exchange rates will experience a little volatility in the near future, then the company can go for a type of option known as ratio spread options. The ratio spread is a strategy in options trading that involves buying a number of options and selling more options of the same underlying stock and same expiration date but at a different strike price. 8.3 RECCOMMENDATIONS REGARDING COMMODITY PRICE RISK No recommendations have been given regarding hedging through currency futures because it has not started in INDIA. Moreover there are no recommendations regarding hedging through commodity futures because fertilizer as a commodity is not traded in INDIA. The company will have to wait till fertilizer is listed as a commodity trading in NCDEX.

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86 8.4 GENERAL RECCOMMENDATIONS REGARDING HEDGING Minimum hedge ratio may be calculated to minimize risk in case of future contracts. This ratio allows the hedger to determine the number of contracts that must be employed in order to minimize risk of the combined cash futures position. In hedging, to strike a balance between uncertainty and risk opportunity loss is a challenge. Hedging itself is a risk, and disastrous if it is applied incorrectly and with the intent of doing speculation. The problem of settling an effective hedge ratio has two dimensions. l Uncertainty: If a firm does not hedge the transaction, it cannot know with certainty at what rate of exchange it can lock its exposures. It could be a better rate or a worse rate. 2. Opportunity: If firms enter into hedge transactions like forward contracts, currency options etc, they would of course be certain at a rate at which they are locking their exposures. But now they have taken an infinite risk of opportunity loss. Perfect Hedge Ratio So construction of an exact opposite position to the existing risk exposure results, in a perfect hedge, which is a challenge. There is yet another dimension to hedging. Hedging has a cost. If the expected risk does not materialize, hedging will prove an ineffective way of doing business. All these complexities associated with hedging through derivatives pose a great challenge to arrive at a right Hedge ratio. Systematic assessment requires thinking through the following decision tree process: To hedge or not? If no, the receivable is converted at maturity to rupees at the prevailing spot rate. If yes, then: a) Estimate likely spot rate values at maturity with associated probabilities, as a probability distribution. b) Specify managements risk preferences (utility curve) for the range of probable outcomes.* c) Estimate and factor in the cost of hedging different amounts of exposure with forward contracts, futures, or options. XIME

87 d) Simulate likely outcomes of the risk-adjusted return to the company from hedging different levels of exposure. e) Select the method (a forward contract, futures, or options) that preferred is likely to yield the preferred results. The table given below tries to suggest strategies of risk management to the company in general depending on the profit motive of the company and the appetite for risk. It is recommended for the company to go for selective hedging in this phase of extreme volatility in exchange rates. Table No 10: Table Showing the Various Risk Management Strategies.

9. CONCLUSION

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88 Hedging is a risk management technique, primarily done to protect the foreign exchange exposures against the volatility of exchange rates, by using derivatives like Currency Options, Currency Futures, Forward Contracts, Currency Swaps, and Money Markets etc. by taking off-setting positions against the underlying asset. The treasury manager should completely understand the firms exposure and risk policy before applying hedging techniques. Moreover the company should not hedge for its 100% exposure otherwise the company will loose the opportunity gain which may arise if the exchange rate moves in its favor. So the risk management committee should decide a perfect hedge ratio. As the global footprint of firms expands, so too do the risks they face on a daily basis. Extended supply chains, technology interdependencies, IT vulnerabilities, mutating viruses, turbulent geo-politics, flat world economics and even weather phenomena all combine to make doing business --- well, a risky business. For firms, resilience in the face of increasing risk the ability to avoid, deter, protect, respond, and adapt to market, technology and operational disruptions is becoming a linchpin of profitability, shareholder value and competitiveness. Every company has its own risk/reward preferences and must identify the risks to which it is exposed, decide which risks it is willing to accept and finally, find out how to dispose of the others, the costs involved and whether it is worthwhile. So deciding to hedge is one thing, and getting it right is quite another. Hedging should also be done without speculation. Further, incorrect application of hedging strategies along with no trade off between uncertainties associated with exchange rate and opportunity loss, makes a hedging foreign exchange risk itself a risk. A further risk is involved with risk management, i.e. the risk that risk management strategy can itself cause additional losses should the underlying bases on which the strategy was built changes. This means that risks can be reduced, but never be eliminated.

10. LIMITATIONS
Some risks are difficult to quantify. An example of such risk is management risk. These risks can only be analyzed qualitatively which needed a thorough XIME

89 discussion with the management which was not possible in this short duration of 2 months. So I have not analyzed the management risk of the company. In case of commodity price risk, I was unable to get the data of some of the common raw materials used. So for whichever raw materials I had the data, I have used them in ranking. Due to non-access to many companies because they were very busy with their auditing work, and also because of other company specific problems, I was unable to get accurate answers to my questions in the interview. Hence the questionnaire was filled up with the help of balance sheet data only, taking some assumptions. Due to time and cost factors convenience sampling was used and only 6 companies could be analyzed, most of which were from the manufacturing sector, because I was supposed to analyze only those companies who were good customers of the bank. It was really difficult to get information from the banks through personal interview for they feared that this was a study conducted as part of Summer Project for a bank and company specific information will be revealed to their competitors. That is why most of the data was collected from the websites of the companies and many assumptions were taken into account while filling up the questionnaire. Some of the areas couldnt be explored for the time period was only 2 months. Things like specific requirements were not revealed from the study. After following these 4 steps I came up with some findings about the company and I have used those findings as the base for giving recommendations to the company. It was found that 2 of the most severe risks facing the company which need immediate attention are currency risk and interest rate risk. So my recommendations are limited to these to risks only. ANNEXTURE A QUESTIONNAIRE QUESTIONNAIRE FOR IDENTIFICATION OF RISKS

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90 SECTION 1- TO IDENTIFY CONCENTRATION RISK Q1.What is the dependence of your revenue from a single product? A. Negligible /nil B. Small C. Moderate D. Large Q2.What is the dependence of your revenue from a single Geographical region? A. Negligible /nil B. Small C. Moderate D. Large Q3. What is the extent of dependence in revenue from a single customer to the total revenue collected in a year? A. Negligible /nil B. Small C. Moderate D. Large Q4. What is the extent of dependence in terms of procurement from a single supplier? A. Negligible /nil B. Small C. Moderate D. Large SECTION 2- TO IDENTIFY CURRENCY RISK Q5.What was the share of imported raw materials to total raw material consumption during last year? XIME

91 A. Negligible /nil B. Small C. Moderate D. Large Q6 To what extent is your revenue dependent on exports? A. Negligible /nil B. Small C. Moderate D.Large Q7 Do you import in multicurrency? A. Yes B. No Q8. Do you export in multicurrency? A. Yes B. No

Q9 Do you have any other receivable / payables (apart from import/export) in foreign currency? A No B Yes SECTION 3 TO IDENTIFY REGULATION RISK Q10.What is the extent of dependence of your revenues on subsidies from the Government of India, if any? A. Negligible /nil B. Small XIME

92 C. Moderate D. Large Q11.To what extent do changes in any Government regulations (like changes in excise or customs) affect your business? A. Negligible /nil B. Small C. Moderate D. Large SECTION 4 TO IDENTIFY PURE RISK Q12. To what extent the super cyclone of 1999 affected your business? A. Negligible/nil B. Small C. Moderate D. Large SECTION 5 TO IDENTIFY OPERATIONS RISK Q13. To what extent any labor problems can affect your company? A. Negligible /nil B. Small C.Moderate D.Large

Q14. To what extent is your company dependent on power? A. Negligible /nil B. Small C. Moderate XIME

93 D. Large Q15 What is the status of your technology? A. Obsolete/ not updated B. Regularly updated. SECTION 6 TO IDENTIFY PRODUCT RISK Q16. How are your customers in relation to the market? A. Many customers and steady market. B. Few customers and steady market C. Many customers and unsteady market D. Few customers and unsteady market Q17. What is the state of your product viability? A. Becoming popular. B. Becoming obsolete. Q18. How is your present market share in the industry? A. Large B. Moderate C. Small D.Negligible /nil

SECTION 7 TO IDENTIFY INTEREST RATE RISK Q19. What is the nature of interest rate on your loans? A. Fixed B. Floating

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94 Q 20. How sensitive is your companys profits to hike in interest rates on loans? A. Negligible B. Less C. Moderate D. Much SECTION 8 TO IDENTIFY THE RISK MANGEMENT STRATERGIES Q21. Do you hedge to cover your market exposures? A. Yes B. No Q22. Whether there is any MIS to assess the effectiveness of hedging? A. Yes B. No Q23.Does your company has a special risk management committee to look after the potential risks the company faces or might face? A.Yes B. No Q24.Do you timely assess the contingent liabilities? A. Regularly B. Occasionally C. Very remote D. Never SECTION 9 TO GET SOME INFORMATION Q25.What is the break up of your hedging? Which derivative instrument do you use the most? A. Forward B. Options C. Swaps XIME

95 D. Futures Q26. Was the hedging effective for the company in the last year? A. Yes B. No Q27. Why do you hedge? A To cover your cost of production B With profit motive Q28. What policy do you adopt in case of inflation? A. You pass on the cost to your customer by increasing the price of the finished product B.You squeeze your profit margins Q29. How much percentage of your exposure do you hedge? A. negligible B. small C. moderate D. large SECTION 10 RELATED TO STATE BANK OF INDIA Q30. How is your companys relationship with bankers? A. Poor. B. Moderately good. C. Good. D. Excellent. Q31. How much portion of your exposure do you hedge from the STATE BANK OF INDIA? A. Negligible B. Small XIME

96 C. Moderate D. Large Q32. While selecting your bank, how important are the following factors for you? Give a mark in the preferred box against each factor. FACTORS V.Imp Imp Neither Imp UnImp a) Terms and conditions b) Hassle-free formalities c) Friendliness of Personnel d) Understanding and appreciation of problems of the company e) Flexibility f) Transparency (In terms Not nor Imp Not at All Imp

of

costs

involved) g) Quickness of decision making h) Time taken in the settlement of transactions i) Diversified portfolio of products ( One Bank All Solutions) j) Location No. of Branches k) Past relationship with the bank l) Customization of Products & Services m) Brand Name of the Bank Q 33.If SBI comes forward as a solution provider to your problems, would you accept it as your banker? Yes No Cant Say

EXPLAINATION OF THE QUESTIONNAIRE SECTION 1 This section of the questionnaire deals with concentration risk from the point of view of suppliers, products, geographical region and customer. More is the dependence on a XIME

97 single supplier, single product, single geographical region or a single customer, more is the risk. So the lowest ranking has been given to the company which has the least dependence on these parameters I terms of the revenues. SECTION 2 This section deals with currency risk in specific. The questions aim to find the extent of dependence of the company on foreign currency in any form be it imports, exports, capital goods or any form of foreign assets and liabilities. More is the dependence on foreign currency more is the currency risk. Moreover if a particular company has foreign currency exposure in multi currencies then the currency risk is reduced in some cases due to offsetting movements in different currencies. So such companies have been assumed to be less risky. Also if the company imports as well as exports, then this acts as a natural hedge and makes the currency risk exposure less.

SECTION 3 This section of the questionnaire deals with regulation risk. This risk is measured in terms of loss to the company if any changes take place in the government regulations. Some examples of it could be changes in customs duty, excise duty, subsidy receivable by government, etc. more is the change in the negative direction, and more is the risk faced by the company. SECTION 4 This section deals with pure risk. This section is supposed to identify the extent of impact of super cyclone of Orissa on the companies. More was the impact; more is the company prone to pure risk later also. SECTION 5 This section of the questionnaire deals with the operation risk to which the company may be exposed to. Some examples are the extent of dependence on power, labor etc. more is the dependence more is the risk aced by a particular company. XIME

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SECTION 6 This section deals with the product risk faced by a company. This is identified by collecting information of the present market share, present demand of the product in the market etc. more popular the product is, less is the risk faced by the companies SECTION 7 This section of the questionnaire deals with the interest rate risk to which a company is exposed to this risk van is identified by finding out as to what is the nature of interest paid on loans. It needs to be seen if the interest paid is fixed or floating. Fixed interest rate loans are good in times of rising interest rates and floating interest rates is profitable in terms of falling interest rates. Looking at this questionnaire from the point of view of present state of our economy, fixed rate of interest rate is an indication of more interest rate risk. SECTION 8 This section of the questionnaire deals with the risk management strategies adopted by a particular company. The risk management strategies are the choices in the questions. SECTION 9 This section f the questionnaire is given to collect some general information about the companies under study. Some general information here maybe, why does companies under study hedge and what is the break up of hedging. SECTION 10 This section of the questionnaire deals with STATE BANK OF INDIA. It is basically included to see the perception of the bank in the minds of customers. This will help to know if the bank has good chances of its regular customers turning to it for derivative products as well.

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ANNEXTURE B METHODOLOGY USED FOR RANKING THE COMPANIES While ranking the companies the following table was used.

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PERFORMANCE METER EXCELLENT VERY GOOD GOOD FAIR DOUBTFUL POOR

RISK METER NO RISK NEGLIGIBLE RISK MODERATE RISK REASONABLE RISK HIGH RISK HIGHEST RISK

RANK 1 2 3 4 5 6

INDUSTRY METER MUCH BETTER THAN INDUSTRY (>100%) BETTER 100%) ALMOST SAME AS INDUSTRY(1020% VARIATION ) LITTLE POOR THAN INDUSTRY (20-50%) MUCH POOR THAN INDUSTRY (50100%) VERY (>100%) POOR THAN INDUSTRY THAN INDUSTRY (20-

1. This table was used to rank the companies in terms of margin of safety. PERFORMANCE METER EXCELLENT VERY GOOD GOOD FAIR DOUBTFUL POOR RANK 1 2 3 4 5 6 MARGIN OF SAFETY >100% 75-100% 50-75% 25-50% 0-25% <0%

2. This table was used to rank the profit volume ratio of both the companies PERFORMANCE METER EXCELLENT VERY GOOD GOOD FAIR DOUBTFUL RANK 1 2 3 4 5 PROFIT VOLUME RATIO >20% 15-20% 10-15% 5-10% 0-5% XIME

101 POOR 6 <0%

3. This table was used to rank the companies in terms of the technology up gradation ratio. PERFORMANCE METER EXCELLENT VERY GOOD GOOD FAIR DOUBTFUL POOR RANK 1 2 3 4 5 6 TECHNOLOGY UPGRADATION RATIO >5 4-5 3-4 2-3 1-2 0-1

4. This is the table which was used for ranking the companies in terms of growth rate of the turnover in comparison to the industry. PERFORMANCE METER EXCELLENT VERY GOOD GOOD FAIR DOUBTFUL POOR RANK COMPETETION RISK 1 2 3 4 5 6 MUCH BETTER THAN INDUSTRY (>100%) BETTER THAN INDUSTRY (20-100%) ALMOST SAME AS INDUSTRY(10-20% VARIATION ) LITTLE POOR THAN INDUSTRY (20-40%) MUCH POOR THAN INDUSTRY (40-100%) VERY POOR THAN INDUSTRY (>100%)

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102 5. This is the table which was used for ranking the companies in terms of growth rate of value added to measure the industry risk. PERFORMANCE METER RANK EXCELLENT VERY GOOD GOOD FAIR DOUBTFUL POOR 1 2 3 4 5 6 GROWTH RATE OF VALUE ADDED >20% 15-20% 10-15% 5-10% 0-5% <0%

6. This is the table which was used to rank the companies in terms of the productivity of labor of employees in the company. PERFORMANCE METER EXCELLENT VERY GOOD GOOD FAIR DOUBTFUL POOR RANK 1 2 3 4 5 6 PRODUCTIVITY OF LABOUR >6% 4.5-6% 3 4.5% 1.5-3% 0-1.5% <0NEGATIVE

7. This is the table which was used for ranking the companies under study in terms of financial margin of safety. PERFORMANCE METER NO RISK NEGLIGIBLE RISK MODERATE RISK REASONABL;E RISK RANK 1 2 3 4 XIME FINANCIAL MARGIN OF SAFETY >60% 30-60% 10-30% 5-10 %

103 HIGH RISK HIGHEST RISK 5 6 0-5% 0

8. This is the table which was used for ranking the companies in terms of commodity price risk. PERFORMANCE METER NO RISK NEGLIGIBLE RISK MODERATE RISK REASONABL;E RISK HIGH RISK HIGHEST RISK RANK 1 2 3 4 5 6 TOTAL % INCREASE IN RAW MATERILA COST 0-5% 5-15% 15-25% 25- 35% 35- 50 % > 50 %

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ANNEXTURE C: METHOD USED TO CALCULATE THE RISK PRIORITY NUMBER; I have used the FMEA technique to decide the priority of risk for the company. I have used the FMEA template for the calculation of a risk priority number. The risk priority number is a number which is calculated by multiplying three factors. Those three factors are severity, occurrence and detection probability, in case of factory operations. I have used this template to calculate the risk priority number for a company as a whole, so the meaning of these terms in this context is as follows: 1. SEVERITY: This is a number which depicts as to how severe the risk is faced by the company under study in comparison to the best company in the industry. This is the ranking I have given to ABC Ltd in comparison to IFFCO. The implications of these rankings a re as follows: 6: HIGHEST RISK 5: HIGH RISK 4: REASONABLE RISK 3: MODERATE RISK 2: LITTLE RISK 1: NO RISK 2. OCCURENCE: This number depicts the frequency of the occurrence of the risks faced by the company. This figure is also out of 6 as I have analyzed the data for 6 years for both the companies. This figure in the table is the number which represents the number of times the company was in a worse position than the competitor in the span of 6 years.

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105 6: EVERYTIME ALL 6 TIMES IN 6 YEARS 5: VERY FREQUENT 5 TIMES IN THE LAST 6 YEARS 4: FREQUENT 4 TIMES IN THE LAST 6 YEARS 3: OCCASIONAL 3 TIMES IN THE LAST 6 YEARS 2: LOW 2 TIMES IN THE LAST 6 YEARS 1: REMOTE ONCE IN LAST 6 YEARS6 IMPACT: This is the number which is calculated by multiplying the severity and occurrence for each of the risks faced by the company. PROBABILITY; this means the probability of the same risks faced by the company in future. The calculation of this part was very difficult because of the limit of time and information. There are three ways to calculate probabilities. They are: 1. Probability used in case of non availability of data, for example tossing of a coin. 2. Historical probability or probability of the event in the past. This can be used in case of situations when it is certain that the pat will continue in future. 3. Estimated probability, which is the probability that an event will occur in near future. This estimation is done for a future period of a certain number of years. In this case, I have used the time period as next 3 years. It means the company will be exposed to these particular risks I various proportion for the next 3 years. The probability is allotted based on some logic. The historical probability is calculated by this formula. Historical probability = occurrence/6*100. The future probability is calculated by multiplying a fraction to the past probability and logic is as follows; 1. BREAK EVEN SALES RISK: The Company suffers from this risk severely because of the break even sales being greater than the actual sales by the company because of past losses. Since the company was suffering from losses for the past 24 years so it will take time to deal with this risk. But the company has started making profits for the last 2 years. Last year the profit was 109 crores. Keeping this point in mind I have assumes the past probability to go down by 50 %. So the formula used here = past probability*1/2. XIME

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2. PRODUCT RISK: This risk is calculated by the profit volume ratio for the company for each of the 6 years. This is similar to the previous analysis of break even sales risk. So I have used the same formula to calculate the probability of this risk. 3. TECHNOLOGY RISK: This risk arises due to non replacement or non addition of fixed assets. I have assumed that the probability of this risk will go down because I have got the information form company sources that they have taken a financial lease to get a ship un loader of the latest technology, which implies that the company is thinking of additions of assets. So the formula used for this risk is = past risk*1/3. 4. COMPETITION RISK: This risk has been analyzed from the point of view of turnover growth rate in comparison to the industry. As per my analysis this companys turnover is growing at a much faster rate than the industry. Hence I assume the risk to become one third of what is present now. So the formula used for this risk is= past risk *1/3. 5. OPERATIONS RISK: This risk here has been measured from the point of view of growth rate of value added in a company in a particular year. Growth rate of value added has operating profit as major component of it. The company had negative operating profit for all these years except last year. And the reasons for making profit in the last year are strong. Moreover the promoters have infused more money into the company and are proposing to convert their past debts to 5% cumulative preference shares. So I assume the past operations risks will come down to one fourth of the present value. 6. PRODUCTIVITY RISK: This risk is measured by taking into account the productivity of labor. This risk arises mainly because of low potential for cutting costs and increasing efficiency. Since the company is regularly updating its technology and has recently one for a ship unloaded, I assume such moves will bring in economies of scale with it and hence the productivity of labor risk will drastically come down. Hence I assume the formula for this risk to be; future risk= past risk * . XIME

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7.LIQUIDITY RISK: This risk is measured in terms of ratios like debt equity, current ratio, average days of debtors, average days of creditors etc. these quantitative factors are not satisfactory as compared to industry average, but Promoters have already infused Rs.142.80 crore of equity and would bring in another Rs.137.20 crore to improve the financials. Moreover there is a proposal to convert the overdue of creditors into noncumulative preference shares. Hence I am assuming that liquidity risk will go down by 50 %.

8. CREDIT RISK; The main reason for this risk to be present is delay in payment of subsidies by the government to the company which has resulted in the percentage of debtors of the company as a percentage of total receivables of the company to be as high as 90%. Subsidy (Retention Price Mechanism) is likely to be phased out in 3 to 5 years by GOI as a matter of policy, thereby hitting the demand curve through price rise. This would affect all the producers and hence most of the burden is likely to be passed on to farmers by increasing prices. This is likely to shift the nature of fertilizer mix in the short run and the mix would depend on relative prices of different nutrients. Since ABC Ltd has the flexibility to vary the product mix amongst variants of NPK, it can face the situation better. Moreover in the recent plans by the government, it is assured that the subsidies will be released timely. Hence I assume that the credit risk of the company will go down by 50%. 9. LEVERAGE RISK: This risk is basically a result of the above risks because of which the ratios like operating leverage, financial leverage etc are not satisfactory. Since I have assumed a 50% reduction in the risks mentioned above, so I assume the probability of this risk also to go down by 50%. 10. CURRENCY RISK: This risk arose due to the recent extreme volatility in the USD/INR exchange rate. Looking at the difficult situation through which the Central Bank is going I assume that the probability of the rupee appreciating further is high and hence the probability of extreme volatility of exchange rates remains very high. XIME

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11. INTEREST RATE RISK: The volatility of interest rates is related to the probability of volatility of exchange rate of a country. Moreover the company has left its interest rate exposure completely open. So as in the above case, I assume the probability of volatility of interest rates will remain high, especially on the upper side.

12. COMMODITY PRICE RISK: The major portion of the Companys raw material requirement is through import, which entails exchange fluctuation risk. If the International price of Phosphoric Acid / Rock Phosphate becomes unfavorable, it would affect all the competitors. Rather ABC Ltd has advantage in such a case. Maroc Phosphore SA, a promoter of ABC Ltd, is a group company of OCP Group of Morocco, which is one of the largest producer and supplier of Phosphoric Acid and Rock Phosphate of the world. Moreover while other fertilizer manufacturing Companies are facing problems for procurement of Phosphoric Acid, ABC Ltd manufactures about half of its phosphoric acid requirement in-house. ABC Ltd has an advantage over others on this account. Hence I assume that the probability of commodity risk of the company will go down to a third of what it was.

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109 \ BIBLIOGRAPHY 1. FOREIGN EXCHANGE, INTERNATIONAL FINANCE AND RISK MANAGEMENT BY, A.V. RAJWADE 2. SBI TRAINING MANNUAL 3. Websites : a. www.rbi.org.in b. www.riskglossary.com c. www.statebankofindia.com d. www.erisk.com e. www.investoprdia.com f. www.riskmetrics.com

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