A V Rajwade: Marketing complex derivatives

WORLD MONEY

Why many of these seem risky and inappropriate for most corporate clients.

In last Friday's article, I had referred to how some extremely complex derivatives are being marketed in India. To me, many of these seem risky and inappropriate for most corporate clients. (Incidentally, many of the really sophisticated players stick to plain vanilla derivatives for the sake of price transparency and an easy exit route.) The driving force for marketers is obviously the far higher margin in proprietary, complex, structured products "" no matter that several of these seem to contravene the regulatory guidelines on the corporate use of derivatives. To give an example, one popular product is the so-called range accrual swap. While referred to as a swap, it requires the corporate counter-party to write a series of binary options and receive fee there from through the difference in the receive and pay legs of the swap. Regulations proscribe the net receipt of premium on options written by corporates.

In another recent case, the structure being marketed to an obviously unsophisticated corporate client, with no natural hedge to currency fluctuations, involved swapping rupee interest rate into dollars (coupon swap), and rupee principal into Japanese yen (the Swiss franc is another popular currency for such transactions). The transaction also involved spread options on dollar swap rates, purchase of a call option with a knock out feature and sale of a dollar: Yen put option! Regulations also require derivatives to be used for hedging corporate exposures. It is very difficult to imagine what the corporate is hedging through options on the spread between five- and one-year swap prices in dollars.

One widespread practice seems to be for such complex structures to be pre-sold by the structuring bank to a corporate client, before inviting an Indian bank, often a public sector one, to step in as an intermediary, ostensibly because the structuring bank does not have a credit limit on the corporate counterparty. One sometimes wonders whether the transactions meet with the structuring bank's own internal appropriateness standards and, therefore, whether the corporate leg is best kept on somebody else's books. The Indian banks seem to think that if something is "back-to-back", in other words, there is no exposure to market risk, it is safe to undertake the transaction. They seem to overlook the credit, regulatory and indeed appropriateness issues involved. I have even seen transactions structured by Bank A abroad, marketed by Bank B in India, and finally, the corporate transaction being booked by Bank C. With each of the intermediaries taking his pound "" or kilogram "" of flesh, the dice are heavily loaded against the end-user, that is, the corporate counterparty in India. Even if one is willing to take risk in the hope of saving money or making profit, surely speculative exposures should be taken at market prices? What is happening in such cases is similar to investing in a share at prices 20 per cent above the market. Even if the share appreciates, the chances of making profits are obviously low.

At least, a few Indian banks have told me that when they went to the regulator to clarify the regulatory compliance of such transactions, the answer was in the negative. On the other hand, the banks complain, the regulator is doing nothing to stop other banks from marketing them. As far as banking regulation on such issues is concerned, I find that regulators like the HKMA, the MAS, the FSA in London, the Comptroller of Currency in the US, and so on, have imposed much more stringent guidelines than the RBI. While the RBI has come out with a code of conduct for banks' dealings with individual customers and, in recent months, barred various structures used by Indian banks to "hedge" their own tier 2 bonds, it seems to be reticent and unwilling to be specific where the end-user is a corporate. Surely, it has a duty to the corporate sector as well "" and, in any case, regulatory responsibility towards the counterparty banks.

Meanwhile, what should the corporate treasurer's approach be?

First, decide exactly what you wish to do "" reduce risks, that is, uncertainties about the outcome, or take on risk in the hope of reducing costs or making profits. Needless to add, in the latter case, there should be adequate knowledge and data about the market and variables on whose movement risk is being taken.

Whether reducing or adding to risk, consider the simplest and most transparent way of doing so. Be proactive, instead of merely reacting to presentations by others wanting to sell some product. Put in place a performance evaluation system.

Any risk-taking should have prefixed stop losses and exit routes at market prices.

As a rule, do not deal in products you cannot price, or whose prices are not available on the screen.

Remember, stringent accounting standards for derivatives and hedge accounting are likely to be introduced shortly, and many transactions may not qualify as hedges. The mark-to-market differences will need to be accounted and disclosed.

Email: avrco@vsnl.com