The Hindu Business Line : India Inc’s blind date with derivatives

Effective use of derivatives to hedge foreign exchange risk is a mark of a professionally run firm. Or so we thought, until some companies recently began reporting gargantuan losses from such transactions. While companies on the wrong side of the derivative transactions have opted against meeting their mark-to-market losses citing grounds of mis-selling, banks on the other hand, have held on to their arguments that these companies were well aware of what they were getting into.

What went awry in these transactions, what is the genesis of this derivative imbroglio and what implications does it hold for the banks and companies involved? — read on as we try to unravel the turn of events.

Derivative bets go sour

It is well known that companies with a significant exposure to foreign currencies hedge their currency risk. This was conventionally done by entering option contracts that sheltered the company’s earnings against any undesirable movement of the home currency vis-À-vis the foreign currency the company had exposure to. A simple hedging strategy used to reduce price risk.

However, in recent times, exotic options, known more for not being easy to understand, came much in demand. More and more companies and banks took to exotic options, their complex nature notwithstanding. Both companies and banks appeared satisfied as the currency bets were bang on target.

No one complained — banks were minting huge commissions selling them, companies were happy adding that wee bit of ‘other income’ in their books. No one seemed bothered that the companies were taking a speculative stand on currencies they had no business dealings in. Not to mention the regulations in the Indian Contracts Law against wagering.

But all good things must come to an end. So did the currency wagers; very soon they started going sour. The US dollar weakened against most global currencies, euro, yen and the Swiss franc, leaving some of these companies with mark-to-market losses, which, in a few cases, were as huge as the company’s net worth itself!

Blame game begins

Unable to comprehend the reason for such losses, some of these companies filed cases against the banks that handled these transactions on grounds of mis-selling and more recently even questioning the very legality of such contracts under the Indian Contracts Law.

The companies said they were lured into these speculative bets by the banks and were not made fully aware of the speculative nature of the contracts. To make things worse, some of these companies had swapped their dollar liability into a yen or Swiss franc through complex derivatives.

And since the companies did not have any direct earnings exposure to these currencies, the sudden reversal in bets now threatens to eat up a good portion of their cash coffers. Certainly not acceptable! While Hexaware Technologies and Amtek Auto booked such losses almost immediately, others such as Sundaram Multi Pap, Precot Meridian, Rajshree Sugars and Nahar Industrial Enterprises have cried foul and approached the courts for succour.

Risks for banks

No crystal gazing is required to predict that tough times are ahead for banks. To begin with, banks may increasingly face credit risk since some of the companies have refused to meet their mark-to-market (MTM) obligations; many more aggrieved companies are likely to leap on to this bandwagon.

The situation may get worse if the court rules in favour of the companies citing these exotic options ‘void ab initio’ — null since inception. However, till such time banks can take comfort from the fact that their share of open contracts with larger corporates is higher considering the latter’s highly regarded credit worthiness. That only small and medium-sized companies have denied their MTM commitments so far may also assuage sentiments. Banks, to their credit, also claim to have enough legal recourse, and documentation to recover money.

Were banks equal abettors in this mess or are companies alone to be blamed for having put their money to ill use? While much can be said both in favour and against both parties, it remains to be seen what the courts decide. Till then, look out for trends in ‘other income’ components of companies and loss provisioning by banks to gauge the gravity of this mayhem.

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