Chapter5 Toolsforriskmanagement 150216105200 Conversion Gate02

Chapter - 6

Tools for Risk Management

MODULE 6: Tools for Risk Management – Derivatives: Forwards,

Futures, Options, Swaps, ECGS

DERIVATIVES FOR MANAGING FINANCIAL RISK:

A firm faces several kinds of risks. Its profitability fluctuates due to unanticipated changes in demand, selling price, costs, taxes, interest rates, technology, exchange rate and other factors. Managers may not be able to fully control these risks, but to some degree they can avoid the impact through entering into Financial Contracts.

Major Events that shaped Derivative Markets: Rice futures in China 6000 years ago - ancient Sumer baked clay tokens in the

shape of sheep or goat.

Forward agreement related to rice markets in 17th century in Japan.

The first exchange for trading in derivatives appeared to be the Royal Exchange in London, which permitted forward contracting.

The first “future” contracts are generally traced to the Yodoya rice market in Osaka, Japan around 1650.

The history of futures markets are concerned was the creation of the Chicago Board of Trade in 1848.

A group of traders created the “to-arrive” contract, which permitted farmers to lock in the price and deliver the grain later.

These contracts were eventually standardized around 1865, and in 1925 the first futures clearing house was formed.

The early 20th century was a dark period of derivatives trading as bucket shops were rampant. Bucket shops are small operators in options and securities that typically lure customers into transactions and then flee with the money, setting up shop elsewhere.

In 1922 the federal government made its effort to regulate the futures market with the Grain Futures Act. In 1936 options on futures were banned in the US.

The year 1973 marked the creation of both the Chicago Board Options Exchange and the publication of perhaps the most famous formula in finance, the option pricing model of Fischer Black and Myron Scholes.

The 1980’s marked the beginning of the era of Swaps and other over-the-counter derivatives.

England’s venerable Barings Bank declared bankruptcy due to speculative trading in futures contracts by 28 year old clerk in its Singapore office.

While some minor changes occurred in the way in which derivatives were sold, most firmed simply instituted tighter controls and continued to use derivatives.

History of Derivatives in India: The history of organized commodity derivatives in India goes back to the

nineteenth century.

Cotton Trade Association started futures trading in 1875, oilseeds in Bombay (1900), raw jute and jute goods in Calcutta (1912), wheat in Hapur (1913) and in Bullion in Bombay (1920).

Speculation - With a view to restricting speculative activity in cotton market, the Government of Bombay prohibited options business in cotton in 1939.

Later in 1943, forward trading was prohibited in oilseeds and some other commodities including food-grains, spices, vegetable oils, sugar and cloth.

Parliament passed Forward Contracts (Regulation) Act, 1952 - The Act applies to goods, which are defined as any movable property other than security, currency and actionable claims.

The Exchange – FMC – Department of Consumer Affairs, Food and Public Distribution is the ultimate regulatory authority. – 3 tier authority for derivatives.

The Government set up a Committee in 1993 to examine the role of futures trading. The Committee (headed by Prof. K.N. Kabra) recommended allowing futures trading in 17 commodity groups.

The first step towards introduction of derivatives trading in India was the promulgation (new law or idea) of the securities laws (Amendment) ordinances, 1995, which withdrew the prohibition on options in securities.

SEBI set up a 24- member committee under the chairmanship of Dr. L. C. Gupta on Nov 18, 1996 to develop appropriate regulatory framework for derivatives trading in India.

The committee recommended that derivatives should be declared as “securities” so that regulatory framework applicable to trading of ‘securities’ could also govern trading of derivatives.

Future contracts on individual stocks were launched in Nov 2001; futures and options contracts on individual securities are available on more than 200 securities. – Controlled by SEBI.

Meaning of Derivatives: A derivative is an instrument whose value is derived from the value of underlying asset, which may be commodities, foreign exchange, bonds, stocks, stock indices, etc. for ex: in case of a wheat derivative, say ‘wheat futures’ the underlying asset is wheat, which is a commodity. The value of the ‘wheat futures’ will be derived from the current price of wheat. Similarly, in the case of ‘index future’, say BSE Index Futures, the BSE index (the Sensex) is the underlying asset.

Definition of Derivative: In the Indian context the Securities Contracts (Regulation) Act, 1956 (SCRA) defines “Derivative” as follows: - “A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security”. Trading of securities is governed by the regulatory framework under the SCRA. Derivative contracts include forwards, futures, options and swaps broadly.

FUNCTIONS OF DERIVATIVE MARKETS: (ECONOMIC FUNCTIONS)

It performs the price discovery function.

Derivatives market helps to transfers the risks.

Higher trading volumes.

Speculative trades shift to a more controlled environment of the derivatives market. - Margining, monitoring and surveillance activities.

Derivative act as a catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long run.

Risk associated with Derivatives:

Market Risk: Price sensitivity to fluctuations in interest rates and foreign exchange rates.

Liquidity Risk: Most derivatives are customized instruments, hence may exhibit substantial liquidity risk.

Credit Risk: Derivatives trades not traded on the exchange are traded in the Over the Counter exchange (OTC) markets. OTC contracts are subject to counter party defaults.

Hedging Risk: Derivatives are used as hedges to reduce specific risks. If the anticipated risks do not develop, the hedge may limit the funds total return.

Regulatory Risk: Owing to the high characteristic inherent in the derivatives market, the regulatory controls are sometimes too oppressive for market participants.

DERIVATIVE PRODUCTS:

Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s contracted specific price; forward contract is not traded on an exchange.

Future: A futures contract is an agreement between two parties to buy or sell a specified quantity and quality of an asset at a certain time in the future at a certain price. Futures contract are standardized exchange-traded contracts. Such contracts were originally protection against price volatility by buyers and sellers of commodities such as grain, oil and precious metals.

Options: An option is a contract which gives the right, but not the obligation, to buy or sell the underlying asset at a specific price for a specified time. Stocks are traded on BSE or Bombay Online Trading (BOLT) system and options are traded on Derivatives Trading and Settlement System (DTSS). Calls n Puts are 2 types of options.

Call Option: A call option is a contractual agreement which gives the owner (holder) of the option the right but on the obligation to purchase a stated quantity of the underlying asset (commodities, shares, indices, etc) at a specific price (called the strike price), on the expiry date.

Put Option: A put option is a contractual agreement which gives the owner (holder) of the option the right but on the obligation to sell a stated quantity of the underlying asset (commodities, shares, indices, etc) at a specific price (called the strike price), on the expiry date.

Swaps: Swaps are private arrangements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolio of forward contracts.

1. Using these products can help you to reduce the cost of an underlying asset.

2. Earn money on shares that are lying idle.3. Benefit from arbitrage (Buying low in one market and selling high

in other market)4. Protection of securities against price fluctuations.5. The most important use of these derivatives is the transfer of

market risk from risk-averse investors to those with an appetite for risk.

6. The objective of firms using derivatives is to reduce the cash flow volatility and thus to diminish the financial distress costs.

7. Some firms use derivatives not for the purpose of hedging risk but to speculate about future prices.

USES OF DERIVATIVES:

PARTICIPANTS OF DERIVATIVE MARKETS:

Hedgers: The practice of offsetting the price risk inherent in any cash market position by taking the opposite position in the futures market; hedgers use the market to protect their businesses from adverse price changes.

Speculators: Speculators who wish to bet on future movements in the price of an asset. Future and options contracts can give them an extra leverage, that is, they can increase both the potential gains and potential losses in a speculative venture.

Arbitrageurs: Arbitragers are interested in locking in a minimum risk profit by simultaneously entering into transactions in two or more markets. If the price of the same asset is different in two markets, there will be operators who will buy in the market where the asset sells cheap and sell in the market where it is costly.

Forwards: A forward contract is a customized contract or an agreement between two entities, where settlement takes place on a specific date in the future at today’s contracted specific price; forward contract is not traded on an exchange and they popular on the Over the Counter (OTC) market. Forward contracts are very useful in hedging and speculation.

Features of Forward Market: They are bilateral contracts and, hence, exposed to counter party

risks. Each contract is customer designed and, hence, is unique in terms

of contract size, expiration date and the asset type and quality. The contract price is generally not available to public domain. On the expiration date, the contract has to be settled by delivery of

the asset. If a party wishes to reverse the contract, it has to compulsorily go

to the same counterparty, which often results in high price being charged.

Limitations of Forward Contracts: Lack of centralization of trading. Liquidity. (Non-Tradable) Counterparty risk. (Default in Payment) Too much of flexibility and generality.

Futures: A futures contract is an agreement between two parties to buy or sell a specified quantity and quality of an asset at a certain time in the future at a certain price. Futures contract are standardized exchange-traded contracts. Such contracts were originally protection against price volatility by buyers and sellers of commodities such as grain, oil and precious metals. Two types of future categories / types

Commodity Futures: Where the underlying is a commodity or physical asset such as wheat, cotton, etc. such contracts began trading on Chicago Board of Trade (CBOT) in 1860s.Financial Futures: Where the underlying is a financial asset such as foreign exchange, interest rates, shares, Treasury bill or stock index.

STANDARDIZED ITEMS IN A FUTURE CONTRACT: 1. Quantity & Quality of the underlying instrument.2. The date and month of delivery.3. Location of settlement or place of delivery.4. The Underlying asset or instrument.5. The type of settlement and last trading date.6. The currency in which the futures contract is quoted.7. The units of price quotation and minimum price change.8. Other details such as the commodity tick, the minimum

permissible price fluctuation.

FUTURE TRADING FUNCTIONS: Price Discovery Price Risk Management. Information dissemination by exchanges. Improved product standards. Facilities access to credit / financing.

Spot Price: The price at which an instrument/asset trades in the spot market.Future Price: The price at which the futures contract trade in the future market.Contract Cycle: The period over which a contract trades. For instance, the index futures contracts typically have one month, two months and three months expiry cycles that expire on the last Thursday of the month.Expiry Date: It is the date specified in the futures contract. (Last Thursday)Contract Size: The amount of asset that has to be delivered not be less than one contract. For instance, the contract size of the NSE future market is 200 Niftiest.Basis: Basis is defined as the futures price minus spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.

FUTURE TERMINOLOGIES:

Cost of Carry: The relationship between futures prices and spot prices can be summarized in terms of cost of carry. This measures the storage cost plus the interest that is paid to finance the asset, less the income earned on the asset.Initial Margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is the initial margin.Marking to Market: In futures market, at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. Maintenance Margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

DIFFERENCES BETWEEN FUTURES AND FORWARD CONTRACT:

Delivery: Delivery tendered in case of futures contract should be of a standard quantity and quality as per contract specification, at designated delivery centers of the exchanges. Delivery in case of forward contract is carried out at delivery center specified in customized bilateral agreement.Trading Place: Futures contract is entered on the centralized trading platform of the exchange; forward contract is OTC in nature.Size of the Contract: Futures contract is standardized in terms of quantity and quality as specified by the exchange. Size of the forward contract is customized as per the terms of agreement between the buyer and seller.Transparency in Contract Price: Contract price of futures contract is transparent as it is available on the centralized trading system of the exchange. Contract price of forward contract is not transparent, as it is not publicly disclosed.

Counter Party Risk: In futures contract the clearing house becomes a counter party to each transaction, which is called ‘Novation’, making counter party risk nil. In forward contract, counter party risk is high due to decentralized nature of the transaction.Regulation: Futures contract is regulated by a government regulatory authority and the exchange. Forward contract, is not regulated by any authority or exchange. Settlement: Futures contract can be settled in cash or physical delivery, depending on the commodity futures contract specification. Forward contract is generally settled by physical delivery.Valuation of Open position (Mark to Market Position): In case of futures contract, valuation of open position is calculated as per the official closing price on a daily basis and ‘mark-to-market’ margin requirement exists. In case of forward contract, valuation of open position is not calculated on a daily basis and there is a no provision of ‘mark-to-market’ requirement.

Organized futures Exchange: Forward contracts are contracts between two parties, called the counterparties and they are not traded in any exchange. Future contracts are traded in the organized future exchanges. As stated earlier, future contracts are forward contract traded on the futures exchanges.Margin: The Buyers and sellers of the future contracts are required to deposit some cash or securities as margin. This is done to ensure that the buyers and sellers honor the deal.Liquidity: Futures contract is more liquid as it is traded on the exchange. Forward contract is less liquid due to its customized nature and mutual trade.

Consider Indian Oil Company (IOC) imports thousands of barrels of oil, The Company is expecting increase in the price of oil. The company can lock the price of oil by purchasing an option to buy oil at a predetermined future date at a specified exercise price.

It could acquire 3 month option to buy 3,000 barrels of oil at an exercise price of $50; IOC will have to pay option premium to the seller of the option. Assume that this premium is $0.60/barrel, by incurring a small cost (option premium); IOC has bought an insurance against increase in the oil price.

OPTIONS

Suppose the oil price at the time of expiry of an option is $52/barrel; since it is higher than exercise price of $50; IOC will gain by exercise option, where exercise price:- $50, spot price / market price:- $52 and in practice, firms may collect the differences between the exercise price and oil price. The net pay-off is: - (52-50)*3000 – 0.6*3000, 6000-1800=4200

The total oil cost: - 50*3000:- 150000-4200 = 145800

On the other hand, if the oil price goes down to $49, IOC will buy from spot market instead of option, here the exercise price is more than the actual price. Cost will be: - 49*3000 = 147000, +premium (.6*3000) = 1800: - 148800

CALL OPTIONAn investor buys One American call option on silver at the strike price of Rs.10000 at a premium of Rs. 500. If the market price of silver on day of expiry is more than Rs. 10000, the option will be exercised.

The investor will earn profits once the silver price crosses Rs. 10000 (Strike price + premium), suppose the price is Rs. 12000, the option will be exercised and the investor will buy 1 silver from the seller of the option at 10000 and sell it in the market at Rs. 12000 making a profit of Rs. 2000. (Spot Price – Strike Price (including Premium))

PUT OPTIONAn investor buys one American put option on copper at the strike price of Rs. 10000 at premium of Rs. 500, if the market price of copper. On the day of expiry is less than Rs. 10000, the option can be exercised as it s ‘in the money’. The Investor’s breakeven point is Rs. 9500 (Strike price – premium paid) i.e. Investor will earn profits if the market falls below Rs. 9500.

In other scenario, if at the time of expiry silver price falls below Rs. 10000 say suppose it touches Rs. 8000, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs.500), paid which shall be the profit earned by the seller of the call option.

Suppose copper price is 8000, the buyer of the put option immediately buys copper options in the market @ Rs. 8000 & exercises his option selling the copper options at Rs 10000 to the option writer thus making a net profit of Rs. 2000 {Strike Price (Including Premium – Spot Price }.

In another scenario, if at the time of expiry, market price of copper is Rs. 12000, the buyer of the put option will choose not to exercise his option to sell as he can sell in the market at a higher rate, in this case the investor loses the premium paid (i.e. Rs. 500), which shall be the profit earned by the seller of the Put option.

OPTION TERMINOLOGIES:

Index Options: These options have the index as the underlying. Some options are European while other is American.Stock Options: stock options are options on individual stocks. A contract gives the holder the right to buy or sell shares at the specified price.Buyer of an Option: The buyer of an option is the one who by paying the option premium buys the right not the obligation to exercise his option on the seller/writer.Options Premium: Option price is the price that the option buyer pays to the option seller. It is also referred to as the option premium.Expiration Date: The date specified in the options contract is known as the expiration date, the exercise date, and the strike date of the maturity.Strike Price: The price specified in the options contract is known as the strike price or the exercise price.

In-the Money Option: An in-the money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price. (that is, spot price > strike price)At-the-Money Option: An at-the money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the –money when the current index equals the strike price (that is, spot price = strike price)Out-of-the Money Option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level is less than the strike price (that is, spot price < strike price)Intrinsic value of an option: The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, it intrinsic value is zero.

SWAPS:Swaps are similar to futures and forwards contracts in providing hedge against financial risk. A swap is an agreement between two parties, called counterparties, to trade cash flows over a period of time. Swaps arrangements are quite flexible and are useful in many financial situations. The two most popular swaps are currency swaps and interest rate swaps. These two swaps can be combined when interest on loans in two currencies are swapped. The interest rate and currency swap markets enable firms to arbitrage the differences between capital markets.

CURRENCY SWAPS: Currency swaps involve an exchange of cash payments in one currency for cash payments in another currency; most international companies require foreign currency for making investments in abroad. These firms fin difficulties in entering new markets and raising capital at convenient terms. Currency swap is an easy alternative for these companies to overcome this problem.

INTEREST RATE SWAPS: The interest rate swaps can be used by portfolio managers and pension fund managers to convert their bond or money market portfolios from floating rate (or fixed rate) to synthetic fixed rate (or synthetic floating rate). There are many other possible applications of the interest rate swaps.

BACK TO BACK LOAN:Currency swaps are a form of back to back loan. For example, an Indian company wants to invest in Singapore. Suppose the government regulations restrict the purchase of Singapore dollars for investing abroad but the company is allowed to lend rupees abroad and borrow Singapore dollars. The company could find a Singapore company that needs Indian rupees to invest in India. The Indian company would borrow Singapore dollars and simultaneously lend rupees to the Singapore Company. Currency swaps have replaced the back to back loans. Back to back loans developed in UK when there were restrictions on companies to buy foreign currency for investing outside the country.

RISK MANAGEMENT - USEFUL TOOLS AND TECHNIQUES

Risk Identification: There are many tools and techniques for Risk identification. Documentation ReviewsInformation gathering techniques

BrainstormingDelphi technique – here a facilitator distributes a questionnaire to experts, responses are summarized (anonymously) & re-circulated among the experts for comments. This technique is used to achieve a consensus of experts and helps to receive unbiased data, ensuring  that no one person will have undue influence on the outcomeInterviewingRoot cause analysis – for identifying a problem, discovering the causes that led to it and developing preventive action

Checklist analysis

Assumption analysis -this technique may reveal an inconsistency of assumptions, or uncover problematic assumptions.Diagramming techniques Cause and effect diagramsSystem or process flow chartsInfluence diagrams – graphical representation of situations, showing the casual influences or relationships among variables and outcomes

SWOT analysis

Expert judgment – individuals who have experience with similar project in the not too distant past may use their judgment  through interviews or risk facilitation workshops.

RISK ANALYSISTOOLS AND TECHNIQUES FOR QUALITATIVE RISK

ANALYSIS Risk probability and impact assessment – investigating the likelihood that each specific risk will occur and the potential effect on a project objective such as schedule, cost, quality or performance (negative effects for threats and positive effects for opportunities), defining it in levels, through interview or meeting with relevant stakeholders and documenting the results.Probability and impact matrix – rating risks for further quantitative analysis using a probability and impact matrix, rating rules should be specified by the organization in advance.

Risk categorization – in order to determine the areas of the project most exposed to the effects of uncertainty. Grouping risks by common root causes can help us to develop effective risk responses.Risk urgency assessment - In some qualitative analyses the assessment of risk urgency can be combined with the risk ranking determined from the probability and impact matrix to give a final risk sensitivity rating. Example- a risk requiring a near-term responses may be considered more urgent to address.Expert judgment – individuals who have experience with similar project in the not too distant past may use their judgment  through interviews or risk facilitation workshops. 

Tools and Techniques for Quantities Risk Analysis 

Data gathering & representation techniques Interviewing–You can carry out interviews in order to gather an optimistic (low), pessimistic (high), and most likely scenarios.Probability distributions– Continuous probability distributions are used extensively in modeling and simulations and represent the uncertainty in values such as tasks durations or cost of project components\ work packages. These distributions may help us perform quantitative analysis. Discrete distributions can be used to represent uncertain events (an outcome of a test or  possible scenario in a decision tree)

Quantitative risk analysis & modeling techniques- commonly used for event-oriented as well as project-oriented analysis:

Sensitivity analysis – For determining which risks may have the most potential impact on the project. In sensitivity analysis one looks at the effect of varying the inputs of a mathematical model on the output of the model itself. Examining the effect of the uncertainty of each project element to a specific project objective, when all other uncertain elements are held at their baseline values. There may be presented through a tornado diagram.Expected Monetary Value analysis (EMV) – A statistical concept that calculates the average outcome when the future includes scenarios that may or may not happen (generally: opportunities are positive values, risks are negative values). These are commonly used in a decision tree analysis.

Modeling & simulation – A project simulation, which uses a model that translates the specific detailed uncertainties of the project into their potential impact on project objectives, usually iterative. Monte Carlo  is an example for a iterative simulation.

Cost risk analysis - cost estimates are used as input values, chosen randomly for each iteration (according to probability distributions of these values), total cost will be calculated.Schedule risk analysis - duration estimates & network diagrams are used as input values, chosen at random for each iteration (according to probability distributions of these values), completion date will be calculated. One can check the probability of completing the project by a certain date or within a certain cost constraint.Expert judgment – used for identifying potential cost & schedule impacts, evaluate probabilities, interpretation of data, identify weaknesses of the tools, as well as their strengths, defining when is a specific tool more appropriate, considering organization’s capabilities & structure, and more.

RISK RESPONSE PLANNING Risk reassessment – project risk reassessments should be regularly scheduled for reassessment of current risks and closing of risks. Monitoring and controlling Risks may also result in identification of new risks.Risk audits – examining and documenting the effectiveness of risk responses in dealing with identified risks and their root causes, as well as the effectiveness of the risk management process. Project Manager’s responsibility is to ensure the risk audits are performed at an appropriate frequency, as defined in the risk management plan. The format for the audit and its objectives should be clearly defined before the audit is conducted.

Variance and trend analysis – using performance information for comparing planned results to the actual results, in order to control and monitor risk events and to identify trends in the project’s execution. Outcomes from this analysis may forecast potential deviation (at completion) from cost and schedule targets. Technical performance measurement – Comparing technical accomplishments during project execution to the project management plan’s schedule. It is required that objectives will be defined through quantifiable measures of technical performance, in order to compare actual results against targets.Reserve analysis – compares the amount of remaining contingency reserves (time and cost) to the amount of remaining risks in order to determine if the amount of remaining reserves is enough.Status meetings – Project risk management should be an agenda item at periodic status meetings, as frequent discussion about risk makes it more likely that people will identify risks and opportunities or advice regarding responses.

EXPORT GUARANTEE CORPORATION OF INDIA (ECGC)

The government of India set up the Export Risks Insurance Corporation (ERIC) in July 1957 in order to provide export credit insurance support to Indian exporters. To bring the Indian identity into sharper focus, the corporation’s name was once again changed to the present Export Credit Guarantee Corporation of India Limited in 1983. ECGC is a company wholly owned by the government of India.

Being essentially an export promotion organization, it functions under the administrative control of the Ministry of Commerce, Government of India. It is managed by a Board of Directors comprising representatives of the Government, RBI, Banking, Insurance and exporting community.

ROLE OF ECGC OF INDIAECGC was established in year 1957 by the Government of India to strengthen the export promotion drive by covering the risk on exporting credit. The goal of ECGC is to provide cost-effective insurance and trade related services to meet the needs and expectations of the Indian export market. It provides a range of credit risk insurance cover to exporters against loss in export of goods and services. ECGC also offers guarantees to banks and financial institutions to enable exporters to obtain better facilities from them.1. Providing Credit Insurance Covers to exporters against loss in

export of goods & services.2. Providing Export Credit Guarantees to banks & FI’s to enable

exporters obtain better facilities from them.3. Providing Overseas Investment Insurance to Exporters - Indian

Entrepreneurs in Overseas Ventures. (Equity/Loans)4. DCI to Banks & Exporters.

FUNCTIONS OF ECGC

• Provides a range of credit risk insurance covers to exporters against loss in export of goods and services.

• Offers guarantees to banks and financial institutions to enable exporters to obtain better facilities from them.

• Provides Overseas Investment Insurance to Indian companies investing in joint ventures abroad in the form of equity or loan.

SERVICES PROVIDED BY ECGC TO EXPORTERS

1. To provide risk cover to the exporters against the risk associated in world market, viz., political risk and commercial risk.

2. To provide exporters information regarding credit-worthiness of overseas buyers.

3. Provides information on approximately 180 countries with its own credit ratings.

4. To help exporters to obtain financial assistance from commercial banks and other financial institutions.

5. To provide other essential services which are not provided by other commercial insurance companies.

6. To assists exporters in recovering bad debts.7. To help exporter to develop and diversify their exports.8. ECGC has also made a foray into information services by signing

an alliance with M/s Dun & Bradsheet Corporation, the largest database company in the world, to provide information on domestic as well as foreign business companies, exporters, importers banks and other institutions.

FINANCIAL GUARANTEES ISSUED BY ECGC TO BANKS

In order to provide financial assistance to the exporters through commercial banks and other financial institutions, ECGC guarantees various loans provided by these financial intermediaries to the exporters. Due to the guarantees given by the ECGC, commercial banks can liberally lend money to the exporters. The nature of guarantees provided by the ECGC depends upon the purpose of finance.

OBJECTIVES OF ECGC

1. Protecting exporters against commercial & political risks in realizing export proceeds.

2. Protecting banks against risk of default in export credit.3. Protecting investors against political risks in

shareholders’ equity and loan in overseas investments

ECGC Policies

Specific Policy

For exports under Deferred Payments,

Project Exports,Service exports

Standard Policy

For short term shipments(180 Days)

Financial Guarantees to

Banks

For Giving credit to exporters

Special Schemes

(Transfer Guarantee )

To protect BanksIssuing L/C,

Confirming L/C,Insurance Cover,Line of Credit,

Overseas Investment Insurance & Exchange

Fluctuation Risk Insurance

TYPES OF EXPORT CREDIT RISKS

RISK PERCEPTIONS

Industry riskBusiness risk

Risk of contract frustrationRisk of physical damage

Credit riskCountry Risk

RISK MANAGEMENT IN EXPORTS

Analysis, Acceptance or Mitigation Risk avoidance Risk Transfer Risk Sharing Risk retention

RISKS COVERED BY ECGC

COMMERCIAL RISK

POLITICAL RISK

RISKS NOT COVERED

× Risks of loss due to commercial or quality disputes. × Insolvency or default of any agent of the exporter or of the collecting bank. × Loss or damage to the goods which can be covered by general insurers. × Exchange Rate Fluctuation. × Exchange fluctuation risks× Physical loss/damage to goods× Failure of the exporter to fulfill the terms of the contract or negligence on his part. Causes inherent in nature of goods

SEVEN FOLD COUNTRY CLASSIFICATION

OPEN COVER COUNTRIES• Cover with No Restrictions. • Cover is offered usually on normal terms and conditions i.e. 90% cover, 4 months waiting period for ascertainment of loss and settlement of claims, etc. • Currently ECGC places 195 countries under Open Cover.

RESTRICTED COVER COUNTRIES

• Usually those countries where the political and/or economic conditions are relatively deteriorating or have deteriorated and likelihood of payment delays or non-payment are imminent or have occurred • Permits selection of risks ECGC wishes to underwrite

MAIN TYPES OF GUARANTEES OFFERED:1. Packing Credit Guarantee:- Any loan given by banks to an exporter at the

pre-shipment stage against a confirmed export order or L/C qualifies for PCG. The guarantees assure the banks that in the event of an exporter failing to discharge his liabilities to the bank, ECGC would make good a major portion of the bank’s loss; bank is required to be co-insurer to the extent of the remaining loss. Features of this guarantee are:

Any loan given to an exporter for the manufacture, processing, purchasing or packing of goods meant for export against a firm order or Letter of Credit qualifies for PCG.

Pre-shipment advances given by banks to parties who enter into contracts for export of services or for construction works abroad to meet preliminary expenses in connection with such contracts are also eligible for cover under the guarantee.

The guarantee, issued for a period of 12 months based on a proposal from the bank, covers all the advances that may be made by the bank during the period to an individual exporter within an approved limit.

Approval of ECGC has to be obtained if the period for repayment of any advance is to be extended beyond 360 days from the date of advance.

Whole-turnover Packing Credit Guarantee can be issued to banks which wish to obtain cover for packing credit advances granted to all its customers on all India basis. Under this option, premiums are lower and higher percentage of cover is offered.

2. Post shipment Export Credit Guarantee: Banks extend post-shipment finance to exporters through purchase, negotiation or discount of export bills or advances against such bills. The post-shipment credit guarantee provides protection to banks against non-realization of export proceeds and the resultant failure of the exporter to repay the advances availed. However, it is necessary that the exporter concerned should hold suitable policy of ECGC. The percentage of loss covered under this guarantee is 75%.

Features of this policy are:- Individual Post-Shipment credit Guarantee can also be

obtained for finance granted against L/C bills, even where an exporter does not hold an ECGC policy, provided that the exporter makes shipments solely against letters of credit.

This guarantee can also be issued on whole turnover basis wherein the percentage of cover under shall be 90% for advances granted to exporters holding ECGC policy. Advances to non-policyholders are also covered with the percentage of cover being 65%.

3. Export Production Finance Guarantee:- This guarantee enables banks to sanction advances at pre-shipment stage to the full extent of the domestic cost of production. Here again, the bank would be entitled to 66.67% of its loss from the corporation.

4. Export Finance Guarantee:- This guarantee covers post-shipment advances granted by banks to exporters against export incentives receivable in the form of duty drawback. The percentage of loss covered under this agreement is 75%.

5. Export Finance (Overseas Lending) Guarantee:- If a bank financing an overseas project provides a foreign currency loan to a contractor, it can protect itself from the risk of non-payment by obtaining Export Finance (Overseas Lending) Guarantee. The percentage of loss covered under this guarantee is 75%.

6. Export Performance Guarantee:- This is akin to a counter-guarantee to protect a bank against losses that it may suffer on account of guarantees given by it on behalf of exporters. Exporters are often called upon to furnish a bank guarantee to the foreign parties to ensure due performance or against advance payment or in lieu of retention money. The Export Performance Guarantee protects the banks against 75% of the losses. In the case of bid bonds relating to exports on medium/long term credit, overseas projects and projects in India financed by international financial institutions as well as supplies to such projects, guarantee is granted on payment on 25% of the prescribed premium. The balance of 75% becomes payable by the bankers if the exporter succeeds in the bid and gets the contract.

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