MODULE 6: Tools for Risk Management Derivatives Futures, Options, Swaps, ECGS

1. Chapter - 6
Tools for Risk Management
MODULE 6:
Tools for Risk Management – Derivatives: Forwards,
Futures, Options, Swaps, ECGS

2. 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.

3. 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.

4.  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.

5. 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.

6.  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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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:

13. 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.

14. 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.

15. 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.

16. 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.

17. 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:

18. 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.

19. 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.

20. 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.

21. 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.

22. 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

23. 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

24. CALL OPTION
An 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))

25. PUT OPTION
An 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. RISK IDENTIFICATION:
RISK MANAGEMENT - USEFUL TOOLS AND
TECHNIQUES
1. Documentation Reviews
2. Information gathering techniques
3. Brainstorming
4. Delphi 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 outcome
5. Interviewing
6. Root cause analysis – for identifying a problem, discovering
the causes that led to it and developing preventive action.
7. Checklist analysis

32. 8. Assumption analysis -this technique may reveal an
inconsistency of assumptions, or uncover problematic
assumptions.
9. Diagramming techniques
10. Cause and effect diagrams
11. System or process flow charts
12. Influence diagrams – graphical representation of
situations, showing the casual influences or relationships
among variables and outcomes
13. SWOT analysis
14. 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.

33. RISK ANALYSIS
TOOLS AND TECHNIQUES FOR QUALITATIVE RISK
ANALYSIS
1. 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.
2. 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.

34. 3. 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.
4. 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.
5. 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.

35. Tools and Techniques for Quantities Risk
Analysis
1. Interviewing–You can carry out interviews in order to
gather an optimistic (low), pessimistic (high), and most
likely scenarios.
2. 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)

36. 3. 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.
4. 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.

37. 5. 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.
6. 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.
7. 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.
8. 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.

38. 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.

39. 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.

40. 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.

41. ROLE OF ECGC OF INDIA
ECGC 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)
FUNCTIONS OF ECGC

42. 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.

43. 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

44. 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 Banks
Issuing L/C,
Confirming L/C,
Insurance Cover,
Line of Credit,
Overseas Investment
Insurance & Exchange
Fluctuation Risk
Insurance

45. TYPES OF EXPORT CREDIT RISKS
RISK PERCEPTIONS
Industry risk
Business risk
Risk of contract frustration
Risk of physical damage
Credit risk
Country Risk

46. RISK MANAGEMENT IN EXPORTS
 Analysis, Acceptance or Mitigation
 Risk Avoidance
 Risk Transfer
 Risk Sharing
 Risk Retention

47. RISKS COVERED BY ECGC

48. COMMERCIAL RISK

49. POLITICAL RISK

50. 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

51. SEVEN FOLD COUNTRY CLASSIFICATION

53. 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

55. 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.

56. 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%.

57. 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%.

58. 6. Export Performance Guarantee:- This is similar 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.