Exotic derivatives: How the cookie crumbled

In November last year, software company Hexaware Technology made provisions of $20-25 million (Rs 78.8-98.25 crore then) to cover the exposure from "unauthorised" derivatives deals entered into by an employee.

The company said the information regarding these transactions was intentionally withheld by the employee from the senior management and the board.

The company later reported a net loss of Rs 81 crore for the quarter ended December 2007 after the actual damage on account of these transactions ended up being Rs 103 crore.

Hexaware is the first in a growing list of companies, which have either declared losses on their foreign exchange derivatives exposure or have gone to court against their bankers for misleading them into buying exotic products.

Rajshree Sugar, for example, entered into 10 derivatives transactions with Axis Bank in the last four years. While nine of them were undertaken to reduce the cost of rupee loans, only one was an "exotic" transaction based entirely on the probable fluctuation of the US dollar and the Swiss franc.

Rajshree, which is involved in a legal dispute with Axis Bank, said in its petition that the bank "lured" it to enter into such an exotic contract "" a charge Axis Bank sources denied. The contract was entered into on June 22, 2007, when the rate was $1 = CHF 1.2355. The US dollar has since weakened to about 0.985 against the Swiss franc.

Rajshree posted third quarter losses of Rs 10.45 crore on a total income of Rs 67.30 crore. The company now faces the prospect of having to spend Rs 160 crore and has said in its petition that this contract alone has the potential to "destroy the company and render its net worth negative".

Accounting firms and forex consultants said Hexaware and Rajshree Sugars were classic examples of how several hundred small- and mid-sized companies or their bankers had gone against the spirit of the Reserve Bank of India (RBI) regulations.

In fact, a study of 34 companies by Ernst & Young showed that 44 per cent have used exotic derivatives products and 35 per cent have resorted to opportunistic hedging, while only 32 per cent have board-level involvement in risk management.

Indian companies are only allowed to take forward currency positions to hedge their risk and they are prohibited from entering into deals where there's a net inflow of premium to them from selling options.

A committee appointed by RBI had also said companies should not engage in the so-called cost-reduction derivatives transactions by hiding the associated risk.

But those are precisely the kind of trades many of them have done over the past couple of years. Reason: Punting in the derivatives markets was an easy way of making money for many companies at a time when they were struggling with an appreciating rupee and tighter profit margins.

Companies have been making money in 95 per cent of such deals and, in the process, have forgotten about the risk that the 5 per cent can pose.

Also, companies can hedge using derivatives contracts only in line with the value of the underlying transaction or export. But, in many cases, the positions implied by the derivatives contracts were several times the value of the underlying export, making them a huge speculative bet on currencies.

Many banks have twisted RBI regulations to sell leveraged products to companies. "It will be interesting to see what the regulators and the department of company affairs do in these cases," said an accountant.