WEATHER DERIVATIVES IN INDIA

Government is planning to introduce a bill in the Parliament for permitting trading in hybrid derivative products like weather and rain derivatives. These products are intended to help the producers of commodities which are dependent on rain and changes in weather conditions so that they would be able to hedge their price risks. In this brief article I am trying to examine the use of weather derivatives for hedging the price risk of commodity producers of agricultural commodities like paddy, wheat, sugar etc. and plantation crops like rubber, pepper, cardamom etc.

The first over the counter weather derivatives were introduced in 1997 (Hull, 2003). The Weather Risk Management Association was formed to serve the interest of the weather risk management industry. Weather derivatives are also contracts similar to equity or commodity derivatives. However, the pay offs in the case of weather derivatives are based on weather related measurements such as temperature, rainfall, snow fall, wind speed etc. Around 85 per cent of the weather derivatives contracts are based on temperature. These contracts are structured based on number of Heating degree Days (HDD) or Cooling Degree Days (CDD).

Heating Degree Days (HDD) is calculated by deducting the average temperature of each day in the reference period from a reference temperature. Average temperature is calculated by taking the average of midnight-to-midnight high and low temperature of a day. The reference period can be one year or one month depending up on the risk exposure of the firm. Internationally the reference temperature is taken as 18° C or 65°F. Where the day’s temperature is less than the reference temperature it is taken as HDD. The HDD cannot be negative. HDD indicates how many days heating is necessary. Cooling Degree Days are calculated by deducting the reference temperature from the day’s temperature.
Exchange-traded weather derivatives based on temperature are now also offered on the London International Financial Futures Exchange and the Helsinki Exchange. There are no exchange-traded derivatives available for wind- or precipitation-based derivatives. Of late wind derivatives are also traded in exchanges.
Privately negotiated weather derivatives contracts are typically based on the standard International Swaps and Derivatives Association (ISDA) Master Agreement, which is the same form agreement used for derivative agreements involving physical commodities.In October 2003, in response to the growing volume of weather derivatives transactions, ISDA published a series of new template confirmations and appendices, including form confirmations for weather index swaps, put options and call options, as well as form appendices for CDD, HDD and CPD index transactions.
Weather related derivatives can be futures, options or swaps. Futures are contracts for delivery on a future date where the price will be fixed now. The futures are priced by applying the cost of carry model. Under this model it is assumed that the hedger takes a position by borrowing and on maturity he sells the futures and pay off his/her borrowings with interest. As the contacts approaches the expiry, the future price and spot price converges due to the low demand for the futures. The futures are generally exchange traded where margin as per the norms of the exchange. The margin requirements enable the exchange to ensure liquidity and avoid the counter party risk.
Another type of weather derivative is options. Options are contracts for delivery of the underlying assets on a future date. The underlying asset can be shares, bonds, commodities, weather etc. The buyer of an option enjoys the right of protection where as no obligation for delivery. Therefore, he/she can abandon the options if the price moves against him. The options can be American type or European type. While American options permit the buyer to take/give delivery on any day during the life of the option, European option can be exercised only on the expiry date. Since the option buyer enjoys the right to abandon, he/she has to pay an upfront fee as premium. The price mutually agreed upon for the delivery of the asset is known as the strike price. The option pay off is calculated by finding out the difference between the strike price or exercise price and spot price. If the spot price is more than the strike in the case of a call option, the option is considered as in-the-money. Whereas if the strike is more than the spot price in the case of call option, the option is considered to be out-of-the-money. The difference between the spot and strike prices is known as intrinsic value. The option can be deep in the money or deep out of the money depending on the size of option pay off.
A number of models are available for pricing the options among which the most commonly used formula is by Black and Scholes. Option price can also be calculated using a binomial tree. The option prices are influenced by certain factors such as spot price of the underlying asset, strike/exercise price, volatility of the asset price, risk free interest rate and the period to maturity. A hedger is able to protect his asset by taking an opposite position in the derivative market. For example, if a hedger is long in asset, he should be short in derivatives.
Weather/rain futures and options are helpful to farmers and producers of commodities to hedge their price risk because the weather conditions can increase or decrease the crop production. For example take the case of paddy or rubber. Good monsoon can increase the paddy crop. At the same time heavy rain can reduce the latex production and in turn reduce the rubber production. Given the increasing demand for rubber by tyre manufacturers, the rubber prices can go up if production comes down and prices can go down if production goes up, provided the synthetic rubber which is the substitute for natural rubber becomes costly or cheaper due to changes crude oil prices. A producer, who expects that the monsoon will be strong and his production will increase, may also face the danger of flood if the monsoon becomes extremely heavy which can damage the paddy crops. Take for example a rubber producer who expects that the monsoon will be strong and he considers that the latex production will be affected leading to increase in prices. He can buy rain futures and lock in his prices so that if the monsoon becomes weak and production is not affected, he can protect himself from a fall in price. On the other hand if the monsoon becomes strong and the prices go up he can sell the physical rubber and loss in the futures contract can be offset with the gain in physical sales. Another method is buying or selling options. But option contracts are not practiced in commodity trade in India.
Though weather derivatives are practiced in advanced countries abroad, this hybrid hedging tool is still strange in Indian market. NCDEX had come out with a proposal to introduce weather index in India and their proposal was lying with the regulators for approval. However, Government of India is now mulling to amend the Forward Contracts Regulations Act to facilitate introduction of weather derivatives in Indian commodity exchanges. The move is expected to provide Indian farmers to bet against weather changes and protect themselves from the potential losses on account of climatic factors. Though the motives behind this initiative is appreciable, in the back drop of strong protests raised by the end users of commodities against futures trading in commodity market for fear of artificial price rise, one needs to wait and see how far this move could be materialized.

How Finance Departments are Changing-Mickinsey Global Survey Results.

Please click on this link to read the McKinsey Global Survey Results on "How Finance Departments are Changing"
http://www.mckinseyquarterly.com/How_finance_departments_are_changing_McKinsey_Global_Survey_Results_2346

Just-in-Time Budgeting for a Volatile Economy

Please click on this link to read an interesting article form McKinsey Quarterly.
http://www.mckinseyquarterly.com/Just-in-time_budgeting_for_a_volatile_economy_2351

ECONOMIC RECESSION IN INDIA- OPPORTUNITIES AND CHALLENGES

The global economic recession played havoc in India also. The worst affected was the capital market. The SENSEX and NIFTY , the two major stock indices in India fell by more than half from its position at the beginning of last year. However, Indian banking system was saved from the attack of global recession thanks to the timely intervention by Reserve Bank of India. Many times the liquidity in the banking system was under pressure resulting into withholding of credit expansion. But the timely intervention by Reserve Bank of India by pumping additional liquidity into the system enabled the banks to survive the liquidity crunch. In order to ease the liquidity crisis, RBI released funds by reducing reserve ratios (SLR &CRR) and Repo rates. These steps helped the banks to continue their lending activities which were a great boon to the corporate entities in India when their counterparts elsewhere in the world were crying for more funds. Within a short gap of 3 months our stock indices picked up and started upward journey. The worst affected sector in India is the IT which had to downsize their employees to meet the decline in business. Though construction industry received a temporary setback, it is now slowly picking up. However, exports have declined due to the slump in demand abroad. Consequently, the rupee declined substantially making the imports costly. The inflation in India is all-time low and at one time people were wondering whether we would be moving to deflation. Given the present condition, India can grow by 6 to 6.5%. A good monsoon can bring better crops and if this happens, India can hope for a better growth. The Indian economy is poised to rebound and reach its full glory by mid-2010. FIIs have already become active in the capital market. One biggest problem we may have face is the return of expatriates on account of job-loss abroad and giving them a position in India. Let us hope that the industrial and business expansion during the coming days can absorb them also. The Indian experiences are excellent lessons for countries across the world.

A Conversation With Rober Shiller-Video from McKinsey

http://www.mckinseyquarterly.com/Surveying_the_economic_horizon_A_conversation_with_Robert_Shiller_2345

AUDIT PROFESSION INDIA: CERTAIN ISSUES

The Satyam imbroglio has made several fingers pointed at the sanctity of audit reports in India. Sections 224 to 233 of Companies Act 1956 clearly set out the qualifications, appointment and certain statutory requirements to be complied with auditors of a limited company. The Act thrust upon the responsibility of professionalizing the auditing by stipulating that only a registered member of the Institute of Chartered Accountants of India is eligible to become auditors of companies. The Institute of Chartered Accountant of India (ICAI) is a statutory body incorporated under the Chartered Accountants Act, 1949. The website of ICAI shows the names of the Council who governs the Institute, takes policy decisions, controls, regulates and supervises the auditing operations in India. According to Section 224, the auditor of a company is appointed by the General Body Meeting. Hence the auditors are accountable to the shareholders of the company who constitutes the General Body.

Today’s Economic Times carried a report stating that Price Waterhouse Coopers, statutory auditors of the Satyam Computers pointed out that the audit reports of the company were not signed by their partners (See page 5 of ET). Now the following question arises:

(1) Is it not the responsibility of the auditor appointed by the General Body of a Company as per the provisions of Companies Act 1956 to inform the appointing authority about who all were authorized to conduct the audit and who all were authorized to sign the reports?

(2) The General Body appointed PwC as the statutory auditor and how can they delegate the power of audit to Lovelock and Lewes (Remember the famous maxim “Delgatus Non Protest Delgare” which a delegate cannot delegate his powers to another person).

(3) ICAI who has been empowered as the statutory body as far as accounting and auditing is concerned and Mr. S.Gopalakrishnan one among the disputed signatories of Satyam’s audit report and member of Lovelock and Lewes is a member of the ICAI’s Council. Then how this fact did not come to the notice of ICAI?

(4) In an interview with Mr. Patrick de Cambourg of Mazars (See page 11 of ET), it is stated that though the cash and bank balances are to be independently verified by auditors, often this did not happen and shortcuts were adopted due to complexity of procedures. In this era of technologically enabled banking system, the auditor can even get the username and password of all bank accounts of the company and download the latest account statements directly from the respective banks. Later on the company could change the password. Another statement was that the checking of bank accounts was typically given to the junior accountants. Does this mean that the senior auditors are not responsible for what the juniors do? Is it not the duty of the senior auditors to teach right practices to the auditors?

(5) Another critical issue is that Mr. S.Gopalakrishnan who signed the audit reports of Satyam continues to be a member of the council of ICAI who has to enquire about the audit practices at Satyam. Is it not a conflict of interest? One has to naturally doubt whether ICAI is having a soft approach to the issue because a few days back there was a remark by ICAI President that the auditors could be misled by the company management. Is ICAI trying to protect PwC or Mr.Gopalakrishnan?

(6) Given this conditions how a shareholder can trust the audit reports? The valuations of companies are done based on the audited financial statements and the latest revelation indicates that around hundred odd reports may also face this problem. We are investing in shares looking at the valuation of the company and if the valuation goes wrong our investment decisions also will go wrong. Another important aspect is that the rating agencies also depends heavily on audited financial results and in the above context the rating of instruments and institutions also can go wrong. What would be the solution for this contagious problem?

(7) Now Satyam’s officials are facing prosecution. Why the auditors also are not being booked under the law and subjected to prosecution process. Was there any unholy relationship between the audit staff and the Satyam management?

(8) A few years back in the case of Tata Finance, A.F. Fegusson withdrew its report and the senior partner of Fergusson Mr. Kaley resigned from the position. At that time ICAI had indicated that a review committee would be reviewing the audit reports on a random basis. Did this take place? If so why the Satyam’s report missed from their review process?

(9) The Minister in charge of Corporate Affairs has stated that the company officials could not escape from financial misappropriations by simply remitting the penalty. What about the auditors? Are they also not accountable?

(10) Now the capital market is dwindling and bears dominate the market. A year back, the booming market prompted many investors to put their hard earned money in equity and derivative securities as also mutual funds. Now under the current market condition, many of these investments are considerably below the preliminary investments. The two stimulus packages announced by the government could not instill confidence among investors and many of them are still shy in investing in stock market and related instruments. The confidence in corporate accounting and the audit reports have been lost. It is not that the companies are strong that the investors shy away, but it is the sentiments play high now in the stock market. What would be the measures by the government to bring back the investor confidence?

SATYAM FIASCO: IS IT A FAILURE OF CORPORTE GOVERNANCE?

Satyam Fiasco has raised several eyebrows against the credibility of corporate governance in Indian corporate entities. This is not the first time that companies promoted by family groups defraud the investors. But Satyam has a different face because the Chairman himself admitted the fraud and wrote to the Board of Directors and the Capital Market Regulator about the manipulations which have made all regulatory frameworks a mockery. The first corporate governance issue came up on account of the ‘conflict of interest’ in the case of AF Fegusson who acted as auditor and consultant to the Tata Finance Limited in which case the TFL Managing Director had committed financial manipulations which the auditor had failed to bring out. In the case of Satyam, the financial manipulations amounted to about Rs.7000 crores. These manipulations were in the form of understatement of liabilities and inflated cash balance. Satyam reported a net profit of Rs. 649 crores whereas the real profit was only Rs.61 crores. The website of the company shows that the revenue for Q2 of 2008 had gone up by 38.8 per cent and Net Profit had gone up by 42 per cent on a YoY basis. The quarterly results had been filed with stock exchanges, SEBI, and the other stakeholders in compliance with the statutory requirements. It is also stated that the audited financial statements had been prepared in compliance with the Indian GAAP, US GAAP and IFRS guidelines. While the standalone financial statement under Indian GAAP is audited by Price Waterhouse Coopers (PWC), one among world’s four leading audit firms, the other statements are unaudited. This reminds me the role of Arthur Anderson in the case of Enron where, Anderson became a party to hiding the real financial position of Enron. Consequently, the audit wing of Anderson had to be closed down.

Another interesting aspect of Styam story is that two academicians were on the Board of Satyam. They were not mere academicians, but were from two leading business schools. While Prof. Rammohan Rao was from the Hyderabad based Indian Business School, which is the leading business school in India, Prof. Krishna Paleppu was from the famous Harvard Business School. Prof. Rao also held various important positions in various bodies in India where as Prof. Paleppu is professor in Harvard and corporate governance happens to be one of his primary areas of interest. Now I am wondering how these eminent personalities failed in ensuring the implementation of the declared corporate governance practices of the company? They were considered to be independent directors, but their actions raise doubts about their independent functioning. The company’s corporate governance statement for 2007 shows that an audit committee was functioning overseeing the financial reporting and disclosure process as also the ensuring the sufficiency, correctness and credibility of the financial statements. It is also seen that Prof. Rammohan Rao was a member of the audit committee. How far the audit committee was committed to the responsibilities thrust upon them?

The statutory auditors of Satyam were PWC. With my two years experience as internal auditor of a leading commercial bank in the private sector, I fail to understand the principles of audit followed by the auditors of PWC. Normally auditors insist on a certificate of balance from the company’s bankers and the banks balance as per the balance sheet should tally with the balance as revealed by this certificate. Wherever the balance does not tally, the company has to prepare a reconciliation statement and produce before the satisfaction of the auditors. Similarly the liabilities were understated. Now the question is how the auditors were satisfied with the company’s statements. Did they blindly believe the company? Or did they physically verify documentary evidences in support of company’s claims. Mr. Ramalinga Raju’s letter to the Board reveals that the practice of inflating the profit was vogue in the company for the last several years. If this is true, how the auditors’ failed to find out this manipulation and bring this in their report? PWC owes answer to the investors because they have certified the company’s financial statements.

Satyam episode pulled down the stock market indices heavily. Sensex lost 7.25 per cent and NSE lost 6.18 per cent on a single day consequent to the revelation of financial manipulation and Ramalinga Raju’s resignation from the Board. Satyam lost over 70 per cent in the market. Now the fate of over 50,000 employees of Satyam is in doldrums. The investors who had great faith in Satyam lost heavily in this game. The clients have already expressed their reactions by blacklisting the company. Now how will compensate the investors?

I have great appreciation towards Mr. Ramalinga Raju because he was bold enough to openly admit which otherwise would have remained in the dark corridors resulting into damages at a much higher scale. I feel that Mr. Raju is not as much guilty as the independent directors and the auditors. It is unbelievable that the financial manipulations of this much magnitude went unnoticed by the colleagues of Mr. Raju. Probably, Mr. Raju may be trying to save all his colleagues by owning up the whole responsibility. By this action he has exhibited the qualities of a true leader. However, these actions do not dilute the gravity of the offence he committed and the law has to take its own course. It is high time that we should redefine the punishments to financial offences by enhancing the value of punishments so as to make it costlier to pay the penalty than compliance of rules and regulations (now it is the other way).

Incidentally, Satyam is the winner of Golden Peacock Global Award for Excellence in Corporate Governance. They had also won award for best learning centre from American Society for Training and Development and another award for Corporate Social Responsibility. I am wondering weather this is the type of corporate governance and corporate social responsibility for which awards and recognitions are being given?

While concluding, the following questions still remain in my mind:

(1) What is the value of corporate governance principles declared by the companies? As an investor how much can I believe them?
(2) What is the role of independent directors on the board of companies? How much they are accountable?
(3) What is the function of the audit committee of the Board constituted as per the corporate governance guidelines? How much they are statutorily accountable to the regulator, investors and the stakeholders?
(4) How far investors can rely on audit reports? What is the sanctity of audited financial statements?
(5) What is the role of academicians in the boards of companies? How do they justify their actions to their students whom they teach good governance and corporate ethics? Are they using their expertise for the benefit of the company?
(6) What is the role of market regulator? How are they going to protect the investors? How are they going to fix accountability with the auditors and company directors?
(7) As an investor whom can I trust now? Is it the company? Is it the independent directors? Is it the market regulator? How far my investments in equity and equity related investments are safe?
(8) What would be the penal action against Mr. Ramalinga Raju? Will it be the usual peanuts or some thing larger which would make him lose a fortune?
(9) What would be the regulatory initiative to prevent spread of this decease to other corporate entities and protect the interest of the investors?
(10) What would be the action against the auditors? Will ICAI show the courage to blacklist PWC from undertaking audit work of any corporate entities India?