Week 6 - FIN

Derivative in Disguise

Case

Author: L Ramprasath

Online Pub Date: January 04, 2021 | Original Pub. Date: 2020

Subject: Financial Derivatives, Options & Futures, Risk Management

Level: | Type: Experience case | Length: 630

Copyright: © 2020 The Indian Institute of Management, Kozhikode. All rights reserved.

Organization: fictional/disguised | Organization size:

Region: Southern Asia | State:

Industry: Financial service activities, except insurance and pension funding

Originally Published in:

Ramprasath, L. ( 2020). Derivative in disguise. Kozhikode, India: Indian Institute of Management,

Kozhikode.

Publisher: Indian Institute of Management, Kozhikode

DOI: http://dx.doi.org/10.4135/9781529754704 | Online ISBN: 9781529754704

© 2020 The Indian Institute of Management, Kozhikode. All rights reserved.

This case was prepared for inclusion in SAGE Business Cases primarily as a basis for classroom discussion or self-study, and is not meant to illustrate either effective or ineffective management styles. Nothing herein shall be deemed to be an endorsement of any kind. This case is for scholarly, educational, or personal use only within your university, and cannot be forwarded outside the university or used for other commercial purposes. 2021 SAGE Publications Ltd. All Rights Reserved.

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Abstract

This case centers on a new advertising campaign by a leading jewelry chain in India, which offers to freeze the price of gold for customers up two months ahead of the purchase date. Students play the role of Ashish, a member of the finance team for the company, who must analyze how the derivative within the advert will impact the company financially. What are the risks of the promotion and are there hidden arbitrage opportunities?

Case

Mark Twain’s words, “It is difficult to make predictions, particularly about the future”, could not be more true for someone trying to predict oil or gold prices in the current environment. This is even more so for a middle class Indian customer who encounters equal number of bullish predictions and their opposites for the price of every commodity that matters. 1

Capitalizing on this, a leading jewellery chain has come up with a novel scheme of locking the gold rates for its customers up to two months ahead of their actual purchase date. The final draft of the ad campaign which will begin in a month’s time, gives the following information:

You can lock your gold rates for your next purchase right now!

Advance Period Amount to be paid*

10 days 10%

20 days 20%

30 days 30%

40 days 40%

50 days 50%

60 days 60%

*If the rate at the time of purchase is different from the rate at the time of booking your jewellery, the lesser rate is yours.

The firm believed that the novelty of this scheme can lure many of the customers from its competitors especially during the upcoming marriage season, when sales are typically high. This scheme will address a typical customer who is planning to buy significant amount of gold within a two month window and her concern that gold rates may rise significantly from now to the actual date of purchase. For the firm, increased advance bookings can free up part of their working capital investment in inventory. So the management thought this will be a win-win situation for both the firm and the customers.

SAGE © 2020 The Indian Institute of Management, Kozhikode. All rights reserved.

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Page 3 of 4 Derivative in Disguise

Mr. Ashish has recently joined the Finance team of this jewellery at their headquarters in Kochi after completing his MBA from a premier management institution. He chanced to look at this ad campaign at a colleague’s table and suddenly he was reminded of his Derivatives course that he took during his MBA, since the footnote at the end of the above table resembled a hedging strategy for the customer in a bullish market. When he mentioned this to his boss, she asked him to probe this similarity further and told Ashish that answers to the following questions can help the management fine tune this scheme before its actual release. She had picked up some derivatives concepts on her own while managing her personal equity investments but she has not gone beyond that. Also she added that this will be a good opportunity for Ashish to apply his learning to immediate practice and an useful addition to his performance appraisal documents for this year.

• 1. What type of a derivative is the firm selling?

• 2. What is the premium charged by the firm for these derivatives?

• 3. Assuming the firm goes ahead with the above scheme, what are the implied forecasts made by the firm about the future gold prices?

• 4. Derivative traders always look out to grab arbitrage opportunities. Does the above scheme provide any hidden arbitrage opportunities?

• 5. Should the firm allow early exercise by the customer i.e. if the customer books the jewellery and turns up at the showroom, say 15 days before the actual purchase date, can the firm advance the purchase date of the contract? If it does so, will the firm incur any additional costs?

• 6. What are the potential risks to the firm once this scheme is launched? If there are any, how should the firm hedge its exposures?

Knowing the answers to the above questions before the launch of the campaign will also make the firm more confident of its offering and avoid any unpleasant surprises.

Note

1. This case was motivated by an actual ad that appeared in the daily newspaper by a leading jewellery chain from Kerala.

http://dx.doi.org/10.4135/9781529754704

SAGE © 2020 The Indian Institute of Management, Kozhikode. All rights reserved.

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