Derivatives turn 'exotic'

Corporates strike complex forex deals with banks to offset volatility.

The recent market volatility has led companies and banks to enter into complicated foreign exchange derivatives structures, termed 'exotic' in market parlance.

Dealers said these complex derivatives are also being struck for trading purposes, in addition to hedging requirements. The RBI currently does not allow companies to trade in derivatives.

A derivative is a contract between two parties, the value of which is determined by the changes in the underlying asset. The assets include currencies, interest rates, bonds, commodities and stock. 

GAINING CURRENCY
(Rs crore)	Currency derivatives		Interest rate derivatives
	2006	2007	2006	2007
Citibank	46,314	2,86,697	1,49,640	3,59,320
HSBC	1,26,691	2,12,219	1,79,024	3,49,636
Standard Chartered	47,021	1,14,504	2,15,374	4,57,204
ABN Amro	10,636	16,576	1,42,451	2,42,303
Deutsche Bank	16,163	46,473	2,07,187	3,87,320
SBI	9,672	49,939	97,968	1,86,611
ICICI Bank	42,858	73,237	2,21,576	2,93,981
Source: BSRB Disclaimer: Trading and hedging positions included

An example of such exotic derivatives is a "target knockout option" (referred to as target redemption), which is the current flavour in the market. In this structure, the bank and company enter into a structure wherein pay-in or pay-outs are linked to the currency movement.

Under the structure, the loss to both the parties is capped. Depending on the movement of the currency, one of the counterparties pays or gets paid.

The payment is capped through a ceiling or floor on the currency movement. The deal gets nullified the moment a currency breaches the contracted level and the payment by either of the parties becomes due.

Another such product preferred for trading is "snowball" structures, where if the currency in the structure runs favourable to a bank's customer, it may lead to cumulative gains.

However if the market turns adverse, may lead to cumulative losses since the loss in the subsequent leg of the transactions during the entire period of the deal are interlinked with the previous tranches.

Companies are even working out options embedded in the original structures as well. Just for trading, a company is obliged to sell dollars in the month end at a predetermined price under a structure just to take advantage of his view that the currency will appreciate.

While this in itself is a structure for trading, another option will be worked out to cover the losses in the previous deal wherein the company will sell or buy a currency which is running favourable to him and not so volatile.

Dealers said most companies, which have high exposure to the European markets and have pound denominated structures incurred heavy losses when the British currency breached 2.0 per dollar level. The pound is currently around 2.02 a dollar.

The complex derivatives contracts are also being struck in the absence of guidelines by the Reserve Bank of India (RBI) on foreign exchange derivatives.

The RBI is expected to issue the guidelines soon. The guidelines on interest rate derivatives were issued in April 2007, covering broad generic principles for undertaking derivative transactions, management of risk and sound corporate governance requirements and detailed guidance on suitability and appropriateness policy to be adopted by market makers.

The RBI guidelines on interest rate derivatives have waived the requirement for companies to disclose their earlier deals and the financial implications to the banks.

Therefore, most banks active in such deals do not have any idea on the total financial risk taken by these companies.