Of hedges and exotic options

SMARTSHARE

Away from the scrutinising eyes of the RBI, corporate India has a cache of skeletons hidden in its foreign exchange dealings. Some aggressive private sector banks have been partners in crime or, shall we say, abettors of the crime in the first instance.

Just like the old hands on Dalal Street who could possibly never participate in the rally thinking the markets were expensive at all levels, companies having exposure to foreign currency have not known what to do with an appreciating dollar.

The sharp slide in the dollar meant there was dire need to protect revenues that were earned in dollars. Hedging was a natural corollary. As long as companies were merely selling their forex earnings in advance, there was no risk. This hedging would come at a price which would reduce the earnings by about 100 basis points.

So how do corporates who earn their income in forex or have a foreign currency debt to retire cope? Rather than diversify the earnings away from weak currencies, corporates took the easy way out "" of giving their treasury managers a long rope.

And here entered our modern day alchemists, the banking brigade. Instead of pure hedges, the bankers sold exotic options to these profit hungry forex and treasury managers.

Merely buying a put in the currency is costly. So they would advice writing a higher call at a point above which, in the wisdom of the banker, the currency would not go. This reduced the cost of the hedge for the corporate as long as the currency did not appreciate beyond the strike price at which the call was sold.

Higher risk-takers, in order to further reduce costs, could write two calls for each put bought. Further, at the end of the period from the strike at which the call was written, the losses increased. Similarly, call could be bought or puts written at different strikes. Here, if the price moved below the strike at which the put was written, losses started happening.

The aforesaid is only a simple example. One could complicate matters by buying a higher call or selling a lower put. As long as the currencies behaved in a manner that was envisaged at the time of building the initial structure, profits arose or cost was reduced and all concerned were happy. But if things did not follow the script written by the banker, costs mounted. The more complicated the strategy, higher the cost of unwinding and more losses at the end.

Due to lax accounting norms, open positions in the currency options and their resultant marked to market loss are not usually reported. As the true position is known only to the company and his banker who sold the exotic options, there is no valid dependable data on this.

But estimates are that of the 1,000-odd corporations that dabble in currency options, many have been singed badly. It may be wrong to quote a figure here, but the marked to market losses are understood to be substantial enough to warrant a closer look by the authorities.

Some corporations have taken exposure with more than one bank for the same underlying, multiplying their risk. Some of the companies that have taken exposure to currency options do not even have one dollar of foreign exchange earnings.

Some corporations are refusing to own up the mounting marked to market losses, which may leave the baby in the lap of the bank that fathered the exotic child.

In the days to come, you will see the booting out of some rogue traders and advisers both from corporate and banking circles. My sympathies will be with these sacrificial lambs as both the companies and the banks knew what they were doing.