Jamal Mecklai: Money for nothing

MARKET MANIAC

Banks have become amazingly expert at packaging derivative products to look like money for jam. And its remarkable how many normally sound CFOs are being attracted by these offers, which really pack a sucker punch.

One particularly "attractive" structure doing the rounds is as follows:

The company and a bank enter into a swap for, say, Rs 50 crore, where the bank will pay the company Rs 50 crore plus 2.2 per cent (that's the Rs 1.1 crore for free, apparently) at the end of one year, while the company will pay the bank 13.27 million Swiss franc at the then prevailing market rate. (13.27 million is the Swiss franc equivalent of Rs 50 crore today, at 1.1550 CHF/USD and 43.50 USD/INR).

Of course, this would subject the company to risk, and so, to protect the company from the risk, the bank will also embed two options into the transaction, which will only expose the company to the market if the Swiss franc rises above 1.01 (to the dollar); on the rupee side, the company is protected beyond 44.50 to the dollar.

The bank, helpfully, also points out that the lifetime high of the Swiss franc, hit in April 1995, was 1.1150, that's a full 10 per cent stronger than the level at which the protection gets knocked out""the implication being that the probability of the protection being knocked out is quite remote.

On further reading, however, the structure gets more complex. In return for providing this protection (at 1.0100), the bank needs the company to give up some upside. This give-up is structured so that if at any time in the last month of the option, the Swiss franc trades weaker than 1.2375, the company has to buy the 13.27 million Swiss franc that it has to pay the bank on the swap at a fixed price of 1.1550; clearly, there would be some opportunity loss.

The second bit of the give-up is actually in favour of the company""if the market does not hit either 1.0100 or 1.2375 at any time during the last month of the option, the company can buy at 1.1550 or the market, whichever is better.

All very complicated, of course, but""as the bank, continually helpful, as ever, points out""the risk seems quite low, since the Swiss franc is extremely unlikely to climb above 1.0100, isn't it? Which would mean that the Rs 1.1 crore that the company was earning as interest on the swap""well, it certainly looks like money for nothing.

Over the years, as I've gotten older, I've become a bit more conservative""I have learned that in life you never get something for nothing. Except love, but that's another story.

So, let's look a bit more closely at the swap. First of all, while all-time highs do get broken from time to time, I am not here to bet on it one way or another. And, I suspect, few companies are really in the business of making such bets.

The market, however, is constantly making such bets""in fact, the market is specifically about making such bets. And market players""banks, usually, know how to calculate the probability that the market ascribes to such events.

There are many approaches to do this; one of the most commonly used is Monte Carlo simulation, where, using the volatility of the asset in question, you generate 10,000 random scenarios and then find the probability of a particular level being hit. We have run such a simulation and find, surprise, surprise ""the probability of 1.0100 being reached after 11 months is as high as 12.93 per cent.

Does this mean that there's a nearly 13 per cent chance that the option protection will expire? Actually, from a purely statistical point of view, the chances are even higher. The 13 per cent probability was for 1.0100 to be touched on a single day, 11 months from today. Since this particular knock-out runs for a full month, the probability of the knock-out being hit is higher""and possibly much higher!

Note, I am not making a case that the Swiss franc will strengthen to that level. I am simply stating that in the market you can buy products that protect against such levels or enable you to bet on such levels.

So, let's see if we can figure out the market price of this complex product ""that is the value the bank could get for this "product" in the market.

Our analysis shows that there is a 12.93 per cent probability that the Swiss franc will be stronger than 1.0100 after a year, with an average price of 0.9570 to the dollar; and a 12.94 per cent probability that it will be higher than 1.2375, with an average price of 1.2986. Note this means that there is a 12.94 per cent probability that the bank will earn the difference between 1.1550 and 1.2986 ""a cool Rs 5.5 crore! The statistically most probable value of the structure is 1.1338 Swiss franc to the dollar, which values the product at Rs 1.98 crore.

Of this amount, the bank is paying the company about Rs 1.04 crore (the present value of the Rs 1.1 crore interest payable on the "swap"). Now, while this may, at first pass, appear a not unreasonable sharing, I would like to point out that for "earning" this approximately Rs 1 crore, the bank is carrying no risk (other than credit risk on the company). The company, on the other hand, is carrying significant risk.

The statistically calculated worst-case cost to the company""if the Swiss franc strengthened above 1.01""works out to a whopping Rs 28.33 crore! On the flip side, the best case would be a gain of Rs 3.38 crore (including the Rs 1.1 crore paid by the bank). Even under the most likely scenario, the company will end up losing around a crore of rupees at the end of the year (again, after factoring in the Rs 1.1 crore paid by the bank).

Money for nothing? Hah!

The author is CEO of Mecklai Financial