How forex derivatives work

Companies entered into derivatives structures to reduce their interest costs. Many companies had gone for dollar loans.

The appreciation of the rupee eroded the revenues and profits of exporters as they made fewer rupees for every dollar earned abroad. On the other hand, they had to service the dollar loans, on which they incurred a higher interest outflow.

To offset the losses due to the rupee appreciation, corporates did derivatives trade, hoping to make money through them. One popular option was a currency swap in the Japanese yen or the Swiss franc, with embedded option protection.

The option protection was structured in such a way that the option protection knocked out (disappeared) if the dollar depreciated beyond a point against the franc/yen.

The Japanese yen or the Swiss franc was a natural choice, considered the most stable currencies against the dollar. In the last 25 years, for instance, the Swiss franc has never moved below 1.11 to the dollar and hence corporates hedged the swap by buying options, where the knock-out will get activated if the Swiss franc moved below 1.10 to a dollar. The strategy worked well for companies.

Corporates made money on these positions last fiscal, boosting their other income and profits. The problem began when the dollar began to depreciate against all currencies, including the yen and the franc.

Once the frank broke below 1.10-level against the dollar, the option protection got knocked out. So, corporates had to repay an equivalent of the franc on maturity of these swaps.

When the yen was trading at 120 to a dollar, a lot of trades were done with a knock-out of 105-102 yen to a dollar. Similarly, when the franc was trading at 1.20 to a dollar, many trades were struck with a knock-out of 1.10-1.05 franc to a dollar.

''Now, all these options have got knocked off. A lot of corporates are sitting on these swaps, where they have to incur huge losses unless the dollar regains strength before these swaps mature,'' said an expert.

Corporates have to buy the Swiss franc or the yen at market rates and unwind these trades. ''Corporates have done a lot of trade in swaps with knock-outs. A lot of knockouts have happened. When a yen/franc trade is knocked out, they will have to bear a loss of 10-15 per cent of the notional swap,'' said a forex expert.

For instance, on a swap amount of $5 million, the loss could be $0.5 million to $0.75 million. A knock-out happens when the currency appreciates beyond a point and the option protection disappears. ''Now, if the clients (corporates) do not pay for these losses, the banks will be in trouble,'' said a forex expert.