Jamal Mecklai: Life in the time of derivatives

MARKET MANIAC

In developing a pitch for our risk management services, I read through a lot of annual reports and quarterly results, and I continue to be amazed that even today""more than one full year after Clause 49 has supposedly been complied with by all (?) listed companies""there are boundless untruths being disseminated with impunity.

Very well-considered companies proudly announce that they have xx or xxx million dollars of forward cover at the excellent rate of 45.yy, which is doubtless correct. However, in several cases, this is not the whole story""and, in terms of impact, is far from the whole story. I know of at least a dozen companies whose excellent forward covers are part of structured transactions, the other leg (or legs) of which may be heavily out of the money or carry considerable risk that they would end up out of the money. Since Indian accounting standards do not require these off-balance sheet items to be marked to market (and disclosed merely in terms of a note), the companies are fully in compliance with accounting norms.

However, from the point of view of Clause 49 compliance, and, more importantly, from the point of view of fiduciary protection of shareholder wealth, some of these companies are way out of line. One company I know, for instance, has $18 million of forward covers for the next twelve months at an average rate of 45.45 (more than 1 per cent better than today's market), but if the Swiss franc strengthens above 1.10 to the dollar, the company will have to sell $36 million at 44.50, irrespective of the market at the time. Note the risk is on a volume double that of the hedge, so if the market moves adversely, the company will not only sell its exports at a bad rate, but will also have a cash loss as it would have to buy dollars from the market to meet its obligation at 44.50. Even more bizarre, the risk the company is carrying is on the Swiss franc, a currency it has no operations in whatsoever. Now, I don't know what this company's disclosures are""to be fair, it has not distinguished itself in the fashion of some""but I have my doubts about whether the board, or even the audit committee of the board, is aware of this risk that the company is carrying. Indeed, with such a complex structure, it is difficult to value the risk on a day-to-day basis, so it is unlikely that the CFO or even the treasurer knows how much risk the company is exposed to.

Now, it is not the job of boards to get into such detailed nitty gritty of business operations, but it is certainly the board's job to understand the risks the company is exposed to. And with the era of derivatives upon us, and, make no mistake, we are just at the beginning of this era, I believe it is critical that boards, or certainly audit committees, have well-designed processes to get information on such undisclosed transactions.

Of course, this inquiry should serve to protect the company without constraining effective management action. As I mentioned earlier, I have little doubt that the use of derivatives is going to continue to increase steadily""over the past two years, we have already seen the number of companies using derivatives rise sharply to nearly 40 per cent of our client base. And, as more and more companies save/make money using derivatives (with the occasional Food Corporation of India-type blowout), managements will have to play to be able to compete.

Significantly, derivatives are finding their way into company balance sheets through non-financial routes as well. I know of a few auto parts manufacturers that have raw material price variation clauses that are linked to the value of the yen. Commodity-based companies routinely build derivative hedges into their purchase/sales contracts. Several large telecom companies have long-term technology contracts with multinational vendors with currency risk-sharing clauses. And, as the outsourcing business continues to mature, I could imagine such clauses becoming standard even in BPO contracts. Indeed, as business relationships shift more towards partnerships rather than the historic arms-length vendor customer linkages, risk sharing""derivatives, in other words""will become more and more commonplace throughout company operations.

And as derivatives become more and more part of the underlying business landscape""life in the time of derivatives, as I said earlier, with apologies to Garcia Marquez""understanding the nuances of these complex beasts will become an important part of board activity.

Of course, accounting standards will, in their way, ride to the rescue, at least in terms of disclosure. IAS 39 already requires all transactions to be marked to market, with the fluctuations being held in the equity account. [In fact, many Indian companies who have happily signed on to zero coupon convertible bonds in the belief that dilution is deferred may suffer an equity shock when the Indian Institute of Chartered Accountants actually moves on some of the proposals before it.] But by their nature, accounts are after the fact.

Boards need to be proactive, and so, from a point of view of both risk management and opportunity capture, will need to educate themselves in this actually not-so-exotic area, and, perhaps, even nominate one member who is""or can become""really expert in the field.