Full circle on the derivatives front

MARKET INSIGHT

With the first wave going awry, the second wave of derivative users will be much more aware of the risks, which would lead to safer investments.

It is interesting to see how quickly financial engineering trends change. Just two or three years ago, most Indian CFOs would have denied any interest in currency derivatives.

In 2007-8, India Inc used derivatives extensively and logged many losses in Q3. More losing positions will surely surface in Q4 results. Therefore, in the coming 2008-09 fiscal, most Indian corporates will be scared to go within a mile of currency derivatives.

That is a pity. These are useful instruments and the last six months have seen treasuries embark on a painful but necessary learning curve. So long as the treasury isn't attempting to turn into a major profit centre, these instruments can hedge risks at low cost.

From the information surfacing, it seems many treasuries entered derivatives without attempting to understand the basics.

In cases like Hexaware's catastrophic loss, greed clearly took over. But most treasury managers acted on banker/ broker's advice without independent thought.

There's no excuse for highly-qualified CFOs to have embroiled themselves in complicated scenarios of barrier options and cross-currency swaps without trying to understand the nuts-and bolts implications. That's part of their core competency.

A currency swap starts with an exchange of a specific amount of one currency for another currency. This is coupled to an agreement to exchange the same amounts back at the end of a specific period.

In between, there could be agreements to swap streams of fixed versus floating cash-flows of interest rates, etc. Regardless, if there's a rate change between inception and termination of swap, somebody must lose. Hence, both parties must hedge.

A barrier option is a cheap possible hedge. This is a path-dependent call option. For example, a call with a strike of 110 Yen/ USD may have a barrier set at 100 Yen. If the rate dips below 100 Yen, the option is cancelled or "knocked out". Barriers are path-dependent. They don't revive even if the rate returns to the green zone "� the path is critical.

It doesn't take a rocket scientist to realise the danger in combining these positions "�if the barrier is hit, the currency risk is unhedged. At issue are several things.

One, currency swaps enable users to shop for the lowest interest rates. Two, barrier options are cheaper than standard forward contracts. Three, the user must take a view on how much fluctuation will occur in the given time.

I suspect that most users didn't really think very hard about the third point because they were seduced by the first and second considerations. Most Indian corporates blindly followed their banker-broker's assessment of hedges. As a result, reports suggest that Axis Bank, ICICI and Kotak are now all embroiled in legal disputes with clients alleging mis-selling.

Currencies being what they are, fluctuations could bring many red positions back to the black. It depends on when specific deals terminate and where rates are at that instant. A prudent corporate will provision anyway. But this is not mandatory and since such deals are off-balance-sheet, shareholders may not have a clue until and unless a big loss is booked.

This could lead to a peculiar situation. A few more revelations of derivative positions turning sour may lead to all corporates with derivatives exposure being downgraded en masse.

It could also lead to a situation where, in the interests of maintaining valuations, corporates voluntarily reveal more than they are required to as indeed, Amtek Auto has done. It's also likely that Indian GAAP will soon be reviewed and amended to tighten disclosure norms.

One hint: A comparison of balance-sheets compiled under US GAAP and IFRS versus Indian GAAP could be illuminating. There are many Indian companies listed abroad with ADRs, GDRs etc. It will be fascinating looking at their Indian and overseas filings and the treatment differences would provide clues about diagnosing high-risk situations.

The fact is that derivatives will be less popular in the near future. On the other hand, companies that do use them will employ them more judiciously. The second wave of derivative users will be much more aware of risks.

For the investor, this could lead to profitable disconnects between perception and reality. A corporate that has stated derivative exposures may be downrated in 2008-09. The down-rating will also, in many cases, be unfair.